Tencent's Vanished HK$1.4 Trillion: Grow Big Enough, and the Regulators Come | 2018's Biggest Business Stories ⑤

The pace keeps quickening. The internet has just had its most heavily regulated year.

Some of this is the result of change already under way — and it will go on reshaping our lives. Some of it is the intervention of forces far less controllable, which force market participants to keep adjusting their strategies. And some of it comes from the companies themselves: once a company reaches a certain size, the question becomes how it squares itself with the public, with consumers, and with state power.

The country you have determines the companies you get. In 2018, as ever, the business world changed a great deal. The year's biggest business stories only confirm it.

On January 10, Wang Ran, founder and CEO of China eCapital, posted on Moments, asking: "What will happen to the live quiz-show market, now sprouting everywhere, within a month?"

Borrowing the format of a live quiz show, Wang offered three answers.

A. More players pile in

B. A single show with a 10-million-yuan prize

C. Regulators issue a strict policy.

Tencent CEO Pony Ma replied, choosing C.

"What reason is there to restrict such a positive-energy activity? You should pick A," Zhou Hongyi shot back. His livestreaming platform, Huajiao, had just launched a quiz product; he picked A, and added that answer A should read "the giants all pile in."

Thirty-three days later, the broadcasting regulator SAPPRFT summoned representatives of 17 audio-visual sites running live quiz shows and issued a Circular on Strengthening the Management of Livestream Quiz Programs. Besides requiring quiz content to keep to the correct political orientation and barring excessive marketing and hype, it set two thresholds for running such a show: the platform must hold an Online Audio-Visual Program Broadcasting License, and the host must meet the qualifications of a radio or television presenter.

An industry that had just sold 100 million yuan of advertising for a single show disappeared overnight.

But the strict policy Pony Ma predicted did not stop at quiz shows. It landed directly on Tencent.

In March, SAPPRFT halted game approvals, and they have not resumed.

In August, the Ministry of Education and seven other departments issued a notice on the Implementation Plan for Comprehensive Prevention and Control of Myopia in Children and Adolescents. One line in it — saying the National Press and Publication Administration would cap the total number of online games — briefly wiped nearly 10 billion yuan off the market value of A-share gaming companies that day. Add NetEase, Tencent, and Kingsoft, listed in New York and Hong Kong, and the gaming industry lost roughly 180 billion yuan overnight.

Games, the source of Tencent's growth, hit the brakes, and Tencent's profit growth fell by two-thirds.

Measured from its high early in the year, Tencent shed 34% of its market value and fell back to where it stood last September. HK$1.4 trillion evaporated.

A few years earlier, regulation fell mostly on traditional industries; online it was mainly a threshold that small companies had to clear. For big companies, regulation was just a cost.

But this year the growth of the big companies made governments everywhere realize that their influence reaches well past the internet.

Facebook, with 2 billion users, was no exception: the election scandal it set off in the United States became other governments' justification for restricting the flow of information. Google, now facing questions on Capitol Hill, was no exception: the EU also handed it a $5 billion antitrust fine.

Ant Group, in which the sovereign wealth fund CIC holds a direct stake, was no exception: the central bank crushed its banking dream this year. Didi, which had likewise pulled in a string of state-backed investors, was no exception: the ride-hailing rules written two years ago all came down at once.

Exactly 20 years ago, when Clinton's Justice Department opened its investigation of Microsoft and set out to break up the world's most valuable company, the worry was simply that a Microsoft monopoly would smother innovation.

After 20 years of a permissive climate, internet companies have in fact built monopolies in their own fields that are hard to break. But what now puts governments on guard is no longer a business question. It is how much these companies shape society itself.

Big internet companies can no longer stay outside regulation; at the biggest of them, Tencent, every revenue stream came under control this year

Tencent's regulatory risk surfaced last year.

In July 2017, People's Daily and Xinhua named Honor of Kings on consecutive days, accusing it of distorting history and getting primary-school children "hooked," and calling on the government and the game's makers to tighten controls. In a single day, HK$130 billion of Tencent's market value evaporated.

Tencent responded with an anti-addiction system for Honor of Kings, limiting users under 12 to one hour a day and those aged 12 to 18 to two.

The share price soon climbed back.

Licenses had mostly held back smaller companies; the largest could always afford them. And Tencent moved to meet the new mood halfway. Around the 19th Party Congress last year, Tencent published an article saying that more than 7,000 of its employees were Party members, about 23% of its headcount. A cube-shaped sculpture went up outside Tencent's old headquarters reading: "Start a business together with the Party." Pony Ma, meanwhile, had become the public face of the Greater Bay Area. To the capital markets, Tencent looked safe.

But under the new conditions, Tencent was no longer an exception.

The signs were there from last year, when Tencent's battle-royale games could not get publishing licenses. By this March, a government reorganization shut down the Ministry of Culture's filing site for domestic games, and it has not reopened.

Nor did the anti-addiction system Tencent built itself settle the matter. It was first hooked up to the police real-name verification system, and then confirmed for rollout across every Tencent game.

At year's end, an Online Game Ethics Committee was set up in Beijing, made up of experts and scholars on games and youth drawn from relevant departments and agencies, universities, professional bodies, news organizations, and industry associations. The committee passes ethical judgment on online games and related services that have caused, or might cause, moral controversy and public argument, and gives regulators a reference for their decisions.

In its first batch of reviews, 11 games were told to make changes to remove moral risk, and 9 were refused approval.

Games have been Tencent's most important source of revenue for years. It has been China's largest online game operator since 2009, and in the first half of 2017 its mobile game revenue passed its PC game revenue for the first time.

In the first half of 2018, growth in Tencent's game revenue slid from 38% a year earlier to 16% — one reason the stock kept falling.

Tencent has worked hard to restore confidence. But wringing more money out of the games it already has is not easy.

The company has kept refining its anti-addiction system. Besides adding facial recognition, it introduced a "shared account hours" feature, closing the loophole that let players get around the rules by registering extra accounts.

On the second-quarter earnings call, Tencent president Martin Lau told analysts the company could use the green channel SAPPRFT had opened, which he said eased the freeze on new game listings in app stores by letting approved games run a month of commercial trials.

The green channel was closed soon after.

Games, and mobile games in particular, are hardly a creative business. A studio picks a popular mechanic — card battles, Dota, shooters — dresses it in popular characters, ships it as a free download, buys ads to drive installs, and then uses the design to coax players into paying for items. That is the standard template of the entire Chinese mobile game industry.

The market turns out huge numbers of games built on fashionable characters and mechanics, chasing quick returns. In such a system old games do not hold their value for long; growth has to be carried by one new title after another.

When new games cannot clear approval, the industry's revenue is cut off at the source.

For three quarters running, Tencent raised its marketing spending to push its older games. In the third quarter its cost of revenue rose 35%, mostly on game marketing.

It did not bring the old games back to life. Tencent has now started cutting costs to protect its margins. In a company email to its game marketing executives, it told them to control cash flow and reduce spending so that everyone could "get through the hard times together." Games still awaiting government approval were to hand their remaining budgets back to Tencent.

Games are Tencent's most important revenue and took the direct hit from regulation, but games are not the only part of the company exposed.

At bottom, Tencent's business is built on social networking, and social networking holds users' attention — what the industry calls traffic.

An internet company's biggest cost is buying traffic. Tencent owns it, and its business is essentially the distribution and monetization of that traffic. Games are the most direct way it turns traffic into money; its advertising and payments businesses rest on traffic too. On top of that, an ever-larger share of Tencent's revenue comes from its investments.

This year Tencent folded content and distribution into a new Platform and Content Group (PCG), merged social advertising with the old Online Media Group's ad business into a new advertising and marketing service housed in the Corporate Development Group (CDG), and packed more ad slots into Yingyongbao.

Tencent's advertising problems are also bound up with regulation. Advertisers kept disappearing under it: the main buyers had been games, apps, peer-to-peer lending, and livestreaming, and apart from apps, which suffered as the startup boom faded, every one of those was hit by this year's rules.

By the third quarter, 40% of Tencent's profit came from investment gains, as companies it had backed — Meituan among them — went public one after another.

But many of those investments are strategic and cannot simply be sold. The gains sit on the books and do not become money the company can spend.

At the same time, Tencent's own performance has changed how the market views the future of the listed companies in its orbit. It looks nothing like a year ago.

China Literature's shares are down more than 40% over the year. Meituan passed JD.com in market value on its listing day, becoming China's fourth-largest internet company after Alibaba, Tencent, and Baidu — and then quickly fell below its offer price.

Even Tencent's traffic itself is under regulatory pressure. Its news aggregator app was pulled from stores during one of this year's clean-up campaigns; WeChat has apologized more than once for weak content review; and most recently WeChat removed Drift Bottle.

Tencent's chase after Alibaba in financial services ran into trouble as well. Before it could build a decent Yu'ebao of its own, Ant Group, the company out in front, was reined in. And handing over customer reserve funds at year's end cost Tencent another source of income.

On November 1, Tencent announced a sweeping reorganization to turn toward serving businesses. In an open letter, Pony Ma wrote: "Tencent will take root in the consumer internet and embrace the industrial internet."

For years, sitting on the traffic of QQ and WeChat, Tencent could make money in its sleep. Now it has to build new businesses — the same kind it has failed at before — and no one knows how that will go.

A year ago Tencent still looked unassailable: while everyone else talked about ecosystems, it had already built a giant private network of its own.

A year later Tencent is still growing and its revenue still looks good, but the story anyone can imagine about it has completely changed.

Content recommendation, the industry's standard habit, came under regulation on every front, from entertainment to advertising

When big companies recommend content, they follow the traffic: whatever gets clicked gets recommended. This year governments everywhere began working out how to regulate that, though not in the same way.

In the last two days of 2017, the Cyberspace Administration of China summoned Toutiao over the spread of pornographic and vulgar material, serious problems of political orientation, and "reposting news in violation of the rules without an internet news information service license." For 24 hours on December 29, Toutiao's home page was blank.

The clean-up of aggregation and recommendation started there.

Livestreaming, quiz shows, and short video then met still harsher rules. From entertainment to advertising, everything came under control.

On January 13, "Millionaire Winner," a quiz show run by 360, listed Hong Kong and Taiwan as "countries" among its answer options; the show went offline that night. On the 14th, the Beijing cyberspace office summoned Huajiao Live's executives and ordered a full clean-up. The Cyberspace Administration told local authorities to immediately inspect every company offering live quiz services and tighten management.

The whole live quiz industry was quickly brought under SAPPRFT's control.

Inke CEO Feng Yousheng had once said on Moments that he had 1 billion yuan ready for this "hot new thing." In the end the company barely mentioned it in its prospectus. In the filing it submitted to the Hong Kong Stock Exchange in March, Inke used 43 pages to describe the risks it faced, including non-compliance, foreign exchange, and government regulation.

The risk that comes with content review was already in the "operating risks" section of Sina Weibo's prospectus when it listed in 2014: "If we fail to restrict or remove, as regulators require, content that disturbs social order, undermines social stability, or is false, we could face liability and penalties, and our online business could be temporarily blocked or shut down entirely."

The content industry ran into that risk again and again over the past year. A good number of companies were summoned, pulled from stores, or ordered to clean up for "wrong orientation," "vulgar tone," or "lax review," and a batch of apps were shut down or delisted for good.

On January 28, the Beijing cyberspace office summoned Weibo, and features including the hot-search list were taken down for a week.

On March 2, Zhihu vanished from app stores for seven days; the Beijing office said the platform was loosely managed and had spread illegal and improper information.

On April 4, SAPPRFT summoned Kuaishou and Huoshan Video. The next day both apps came off the app stores.

On April 10, SAPPRFT ordered the permanent shutdown of "Neihan Duanzi," an app under Toutiao, and told Toutiao to learn the lesson and clean out every similar audio-visual product. Toutiao founder and CEO Zhang Yiming published an open letter overnight, An Apology and a Reckoning, announcing that the company's 6,000-person content review team would grow to 10,000.

On July 1, after an ad that "insulted and mocked revolutionary martyrs", Douyin, Sogou, and three other companies announced clean-ups and "voluntarily" suspended their advertising businesses.

On July 27, 16 short-video platforms including Miaopai, Bilibili, and 56.com were summoned; 12 were pulled from app stores and told not to return "without notice." Miaopai came back 79 days later. Bilibili more than doubled its review staff.

From October 20, more than 9,800 self-media accounts — "Donald Says," "Fu Shou'er," "Mr. Zhang Zizhu," "A Shaft of Light," "All-Purpose Freebies," "Unofficial History," "Late-Night Video," and others — were dealt with across the whole web by the Cyberspace Administration.

How much of the problem of values in content can an algorithm actually solve? Tech companies everywhere are being asked. Algorithms alone cannot do the reviewing: YouTube now relies entirely on people to decide what children are shown. Facebook, which has never managed to fix fake news with artificial intelligence, keeps enlarging its review team, whose new hires watch the network for inappropriate material, and Google has more than 10,000 people rating search results. Their influence over information has put their own governments on guard as well.

First it was Mark Zuckerberg. This week it was Google CEO Sundar Pichai's turn. America's tech giants have come to Capitol Hill to answer lawmakers from both chambers in open hearings, and to wait for the legislative argument to end.

Film and TV review now works backward, and holding a license does not mean you are safe

Burning money is normal for video sites. The problem this year is that the shows the money bought can suddenly disappear.

Over the past year, regulators have tightened their grip on online video, and iQiyi devoted long passages of its prospectus to the trouble content regulation can cause.

Of the three big video sites, iQiyi, the only one listed on its own, spent more than 100 lines of the prospectus explaining how hard regulation makes things.

Although it had built content monitoring systems, iQiyi wrote, "because the regulatory regime is vague or uncertain, such risks may persist; despite our internal content monitoring system, we still face suspension of licenses, contractual misrepresentation clauses, and liability for what video publishers post."

"In addition, the General Administration of Press and Publication, the State Administration of Radio, Film and Television, or SAPPRFT issue lists of content from time to time, and we must monitor content uploaded to iQiyi and delete anything that falls within those lists."

And a hit drama or variety show labeled as "promoting vulgarity and the wrong values" loses any chance of being built, season on season, into a brand that keeps earning. The Rap of China, the breakout web variety show iQiyi produced last year, disappeared as a brand the moment SAPPRFT declared that hip-hop culture "promotes vulgar and unhealthy information."

iQiyi has estimated that content costs will reach 80% of its revenue. That means spending roughly eight of every ten yuan it takes in just to keep enough new material on the platform to hold existing users and draw new ones.

In production, iQiyi has moved its original dramas toward the genres easiest to manufacture: the doctor who saves one patient per episode, the policeman or Judge Bao who cracks one case per episode. The formulas repeat easily, which also lowers the risk of untested subject matter.

Which makes it very hard for iQiyi to tell a story like Netflix's.

Licenses keep covering more ground

While live quiz shows were hot, an internet industry that invents several "year ones" a year called 2018 "the year one of mobile interactive variety shows." SAPPRFT quickly issued its policy: a quiz platform must hold an Online Audio-Visual Program Broadcasting License, and the host must meet the qualifications of a radio or television presenter. Live quiz shows had indeed become variety shows — at least in the eyes of the regulator.

Livestreaming needs a pile of licenses. In August, the national office of the anti-pornography and anti-illegal-publications working group, the Ministry of Industry and Information Technology, and four other departments jointly issued a Notice on Strengthening the Management of Online Livestreaming Services. Under it, the major platforms must hold an ICP operating license, an online culture operating license, and an Online Audio-Visual Program Broadcasting License; without them they may not operate.

The hardest of these to obtain, and the one with the widest reach, is the Online Audio-Visual Program Broadcasting License. It was not always so hard to get: LeEco picked one up easily in the early days. But the conditions added since state that an applicant must be "a wholly state-owned or state-controlled entity." Private companies that missed the looser window are unlikely to get one now, and companies that hold one cannot count on renewal.

Because it leaves so much room for interpretation, the Online Audio-Visual Program Broadcasting License is like Doraemon's pocket: anything fits inside.

When Xiaomi and Tmall made TV set-top boxes, the license was used to make sure the boxes could carry only video services the broadcasting authorities approved, softening the blow that boxes plus video sites would deal to the television system.

When Sohu and iQiyi streamed licensed American shows, the license was used to make sure every episode was reviewed by the broadcasting authorities before it aired.

When Inke and Huajiao ran livestreams, the authorities required both platforms and individual hosts to hold certificates.

When Pear Video did video news, this same license was the instrument of its clean-up, and it turned instead into the Reader (《读者》) of online video.

This year, for want of that license, live quiz shows disappeared without leaving a trace.

Ride-hailing, legislated long ago but loosely policed, was policed strictly this year

The tightening of ride-hailing rules began at the end of 2017, with Beijing and Shanghai stepping up vehicle checks. The feature Didi gave drivers in January to "hide airport and train-station orders" was itself a way of coping with traffic enforcement.

In April, the Shanghai transport commission's enforcement corps announced a two-week campaign against illegal ride-hailing, having already intensified checks at airports, train stations, and other transport hubs.

After the violent incidents involving ride-hailing, the rules got stricter still.

In June, seven government departments jointly issued a Notice on Strengthening Joint In-Process and Post-Event Regulation of the Online Ride-Hailing Industry, pooling their oversight of violations such as missing licenses, unfair competition, and mismatches between vehicle and driver records, and sharing and publishing penalty information.

The notice requires transport, cyberspace, telecoms, public security, central bank, tax, commerce, and market regulation departments at every level to set up a joint oversight mechanism for the industry. Platforms that fail to clean up face suspension of new listings, removal of their apps, termination of internet service, or up to six months disconnected or shut down for rectification.

Explaining the new policy, the Ministry of Transport said there are now more than 70 ride-hailing companies in the country. The State Council issued regulatory measures back in 2016, but they did not work well. Xu Kangming, the ministry's chief expert on taxi reform, said that earlier clean-ups rested on low-level legal authority and made breaking the rules cheap; joint regulation not only brings more tools, but lets the credit system restrict companies in areas such as fundraising and going public.

After a Didi Hitch driver murdered a flight attendant, the Ministry of Transport's WeChat account published one commentary after another on the state of ride-hailing governance, and local regulators issued tougher measures of their own.

What had been optional to enforce was now enforced.

After the Yueqing Hitch killing in August, a special investigation team formed by the Ministry of Transport and ten other departments moved into the ride-hailing companies to inspect and order changes, requiring every platform to clear out all non-compliant cars and drivers by December 31 this year.

Didi rolled out one-tap emergency alerts by text, audio and video recording, a blacklist, and a public review council; executives even went out on the street to do their own research. It also reorganized on a fairly large scale: besides merging scattered business units and groups, the changes centered on safety.

One visible result: there are fewer cars on the platform, and hailing a ride on your phone takes longer and longer.

Big companies built financial-holding power through investment, and the central bank now treats them as "too big to fail" risks

In November the People's Bank of China, the banking and insurance regulator, and the securities regulator jointly issued Guiding Opinions on Improving the Regulation of Systemically Important Financial Institutions, which brings internet companies inside the definition of a "systemically important financial institution."

Zhou Xuedong, director of the central bank's general office and head of its financial stability bureau, said that to contain the risks of financial-holding companies that have grown wildly and to hold the line against systemic financial risk, the relevant departments are moving quickly to build a regulatory regime for such companies, bring order to their growth, and fill the gap in oversight.

The financial stability report the central bank published at year's end spelled out the reasoning: "Some non-financial enterprises have, by founding, acquiring, or taking stakes in them, come to control multiple financial institutions of multiple kinds, forming a group of conglomerates with the characteristics of financial-holding companies. Some of these have grown wildly — large in size, sprawling in business, high in interconnected risk, and unsupervised — and may threaten economic and social stability."

HNA, Fosun, Ant Group, and Tencent all appear to fit the report's description. HNA spent $200 billion buying companies abroad in 2016. But as foreign-exchange and outbound-investment rules tightened, it has had to sell assets steadily to get through its debt crisis; the assets it has sold this year are worth more than $18 billion.

The "banking dreams" of Alibaba and Tencent also collapsed this year under tighter regulation.

Alipay began building its banking scaffolding with Yu'ebao, which is simply its savings business. From spending through Alipay and saving through Yu'ebao, Ant Group could score individual users' credit; it later added Huabei and Jiebei, aimed squarely at banks' personal loans and credit cards.

After four rounds of caps in nine months, Yu'ebao went from no ceiling at all to a limit of 250,000 yuan per person, then 100,000, and by early this year its total size was capped too. Yu'ebao became a wealth-management product you had to rush to buy.

Beyond savings, Alipay's lending business was tightly restricted too. Alipay lends to individuals and small businesses through Huabei and Jiebei; those loans are packaged into asset-backed securities and sold to investors, who are in effect buying a wealth-management product that pays interest. Ant Group then lends out the proceeds again, which is how it grew so fast.

At the end of last year, the central bank and the banking regulator issued new rules on cash lending, requiring microlenders to manage their funding sources prudently and capping leverage on consumer-loan and cash-loan ABS at 1.5 to 3 times. As a result, the number and value of ABS issued by Jiebei this year both fell sharply. The lending can continue, but fewer ABS means growth is throttled.

In December the central bank's payment and settlement department circulated an urgent notice on closing renminbi customer reserve accounts, requiring every third-party payment institution to close theirs by January 14, 2019.

From next year, the central bank will hold those reserves. Internet companies will not only lose the interest on them; they will also lose them as a bargaining chip with banks. Banks need deposits, and where a trillion yuan of reserves is parked has been an important piece of leverage in an internet company's negotiations with them.

These policies hit Ant Group hardest, but the effect reaches the whole industry. In Tencent's most recent quarterly results, rising payment costs were one of the drivers of its sharply higher cost of revenue.

Under one rule after another, Alipay has gone from the disruptor that Jack Ma said would "change banks" into a traffic gateway for the banks' own wealth-management and financial products.

The prosperity of the world's internet companies over the past 20 years owes something to regulation not reaching them: only in a relatively loose environment could products like mobile payment and ride-hailing be born. That is also why these consumer-internet technologies are more widespread in China than in the United States, which started earlier.

Contrary to the common view, strict license-based regulation usually does not break monopolies or spur innovation. It is more likely to feed monopoly. Big companies can bear the cost, whether it is a review team, a fine, or a license; small ones often cannot. And when a young industry that thousands of people depend on for a living can be erased by a single official document, investors will only grow more cautious about backing young industries.

The same pattern — regulation entrenching monopoly and smothering innovation — has already played out in banking, insurance, energy, and cars.

Now it is the internet's turn.

Charts / Fangyi Gong

Cover image / Yunlu Tang