China Ecosystems – Phase II.

Tencent has a real problem on its hands.

• The market for Digital Life services has clearly switched from one of growth to one of competition as the growing fight between Tencent and ByteDance for the engagement of users shows.
• To date, the digital ecosystem in China has been dominated by three big players (BATMen) who have occupied the Digital Life pie without stepping too much on one another’s toes.
• However, with the market slowdown and the emergence of new players like ByteDance into an already crowded market, the fight for eyeballs is already well underway.
• ByteDance has a very popular short-video service (not unlike Instagram) called Douyin (TikTok outside of China) that has been eating into the time that user’s spend engaged with WeChat.
• This has not prevented Tencent from growing, but the time that users spend with WeChat has been growing much more slowly than the overall time Chinese users spend with smartphones.
• Furthermore, it looks like ByteDance is also about to launch an assault on Tencent’s dominant gaming service which makes up a significant part of the company’s overall revenues.
• Tencent has reacted by launching a short-video service of its own that will exist within WeChat, but I think that this may be too little too late.
• While ByteDance will have difficulty attacking Tencent’s established gaming business, it has already established itself as the place to find and share short videos.
• Tencent now has to address two problems:
  • First, network effect: Douyin has been around for some time now and has established itself as the go-to place to find short video content.
  • This means that users will prefer to post their videos there as they will have the biggest audience and vice versa creating a very strong network effect.
  • Tencent will have to use the popularity of WeChat to break this preference as well as come up with a more compelling user experience.
  • I think that this will prove difficult as RFM research indicates that Tencent is still quite far behind when it comes to AI.
  • Second, AI: The cornerstone of ByteDance’s Douyin and TikTok offering is its ability to accurately assess the content that is uploaded to its service and recommend it to users that are likely to like it.
  • This is very tightly linked to the AI that it has created to characterise this content as well as understand its user’s preferences.
  • The more users engage with the service the better this recommendation becomes and I think that this is likely to prove to be a steep hill for Tencent to climb.
  • This is because Tencent has no experience with this type of content and also because it remains pretty far behind its peers in terms of its AI development.
  • Unless it can close this gap, its service is likely to remain subscale and subpar when compared to ByteDance meaning that Douyin is likely to continue eating into the time users engage with WeChat.
• This is a real problem for Tencent whose financial performance increasingly depends on the engagement of its users with WeChat.
• It has done an excellent job at monetising WeChat through content sales, financial services and advertising but the growth of this will slow as it cedes engagement to ByteDance.
• I do not see it being able to wrestle the initiative back from Douyin as its AI is too weak and it has acted too late as Douyin is now strongly established.
• The net result is that ByteDance is here to stay and I think has pretty much supplanted Baidu as the No. 3 in the Chinese Ecosystem
• Hence, I think the outlook for Tencent is deteriorating slightly which is not good news when the shares remain richly valued by the market.
• Baidu has already suffered a big knock to its valuation as it has withdrawn from providing Digital Life services, but it remains one of the cheapest ways to invest in AI available anywhere.
• Consequently, I am slightly cautious on Tencent but looking for a recovery in Baidu.