TCTZF - Tencent Music: Near-Term Challenges But Long Term Could Be Better

Summary

• Tencent Music Entertainment Group, China's biggest music streaming player, is going through a rough patch.
• Near-term challenges including industry adjustment from China's regulatory tightening and macro headwinds that may impact revenues and profits.
• Tencent Music Entertainment Group long-term growth drivers are intact.

China's biggest music streaming platform, Tencent Music Entertainment Group ( TME ), has been impacted by several challenges lately, leading to a depressed share price. There are reasons to be optimistic about their long term prospects, however.

Overview and background

Tencent Music is China's dominant music streaming platform, with a market share of around 70% . The company generates earnings through two revenue streams namely ((I)) subscriptions from premium music streaming users, and ((II)) social entertainment (which offers services such as karaoke - notably through WeSing, which the company claims is China’s biggest karaoke platform by MAUs (monthly active users) - and live streaming services, with revenues generated through user purchases of virtual gifts or premium memberships). Online music revenues were CNY 11.5 billion in 2021, a 25% YoY increase, and accounted for 37% of revenues in 2021, while social entertainment revenues were CNY 19.7 million in 2021, down less than 1% YoY and accounting for 63% of revenues in 2021.

Operating challenges in 2021 led to a steep decline in Tencent Music's share price, and at USD $8.3 it currently trades at below their IPO price of USD $13 .

Macro challenges impacted advertising revenues which declined in the first half of 2022. Meanwhile a government crackdown on tech companies saw Tencent Music being fined for anti-competitive practices (albeit a relatively light fine of CNY 500,000 ) and ordered to cease anti-competitive behavior. This saw Tencent Music lose its exclusive rights with the Big Three record labels to distribute songs from international artists in China.

The ongoing industry adjustment arising from a more level playing field impacted Tencent Music’s financials; FY 2021 (ended December 2021) saw significant paying user attrition in Tencent's social entertainment business (paying users declined by about 13% YoY from 11.7 million in 2020 to 10.3 million in 2021), a trend which largely continued in 2022 (paying users declined in all three quarters of 2022, i.e., Q1 , Q2 , and Q3 ). The impact to revenues was significant; social entertainment revenues declined by about 20% each quarter in Q1, Q2, and Q3 2022, and the company expects further downward pressure near term.

Meanwhile, online music MAUs, which have been dropping since 2019 continued their downward trend in 2022 as well, dropping in all three quarters of 2022 (from 622 million at the end of December 2021 to 604 million in Q1 2022, 593 million in Q2 2022, and 587 million in Q3 2022).

The bright spot, however, was in online music paying users, which have been consistently increasing over the years and continued their upward march in all three quarters of 2022. This, in turn, had a positive impact on online music revenues - except for Q1 2022, when online music revenues declined year-on-year due to macro headwinds - as revenues were up in Q2 and Q3 2022.

Tencent Music's outlook may not be so bleak

China's tech crackdown is expected to be largely over, which should provide some respite to the industry. Meanwhile advertising revenues, which have been picking up in Q3 2022 after sagging the previous two quarters, could continue to increase along with China’s reopening and ensuing economic revival. The World Bank expects China's economic growth to accelerate to 4.3% in 2023.

Although competitive pressures may be higher from China's regulatory overhaul, and the gradual erosion of their MAU across both business segments is concerning, Tencent Music points out that the losses were largely from casual, i.e., low-value, users. Nevertheless, Tencent is aiming to arrest the decline through initiatives including product innovation, international expansion, and virtual interactive product offerings.

It remains to be seen how successful Tencent Music would be in their efforts to retain users, but longer term Tencent has advantages to remain ahead of rivals, as the industry consolidates (Alibaba-owned ( BABA ) music streaming app Xiami is the latest casualty, having shut down in 2021). Tencent Music leverages parent company Tencent's ( TCEHY ) ecosystem (which boasts a userbase of more than one billion) to distribute content and draw users, an advantage rivals like NetEase ( NTES ) don’t have which may explain Tencent Music's MAU of 587 million versus NetEase Cloud Music's 182 million. What this means is that Tencent Music is likely to be the preferred partner for indie artists, helping Tencent differentiate itself in terms of content offering and further amplifying Tencent's library size advantage (Tencent has the biggest music content library in China). A wider content offering and more varied music library could help Tencent Music command a higher ARPU which at around CNY 8.8 currently is significantly higher than NetEase Cloud Music's CNY 6.4.

Moreover, Tencent Music's tightly integrated social elements (such as social feed, and messaging functionality thanks to parent company Tencent's ubiquitous WeChat messaging platform) could help increase user stickiness.

Several levers to drive long term growth

Paying ratio has room to grow

The drop in paying users for social entertainment, their biggest earnings stream is not encouraging, but this could be outweighed by an expanding subscriber base of paying users. Tencent Music currently has around 85.3 million paying subscribers out of their 587 million monthly active user base which translates into a paying ratio of around 15%. Rival NetEase, meanwhile, has a higher paying ratio with 37.6 million paying subscribers out of 181.9 million MAU, translating into a paying ratio of nearly 21%. Meanwhile global music streaming giant Spotify has a paying ratio of more than 40%.

With China's per capita income being about a tenth of the U.S. and other developed markets, the Chinese market is unlikely to offer similar potential near term, but as incomes rise in the country along with China's continued economic development longer term, the number of Chinese willing and able to pay for music should rise as well.

ARPU has room to grow

At CNY 8.8 as of Q3 2022, Tencent Music's ARPU is far lower than global streaming leader Spotify (SPOT), whose ARPU of EUR 4.63 amounts to around CNY 34 at current exchange rates . Growing incomes in China, as well as Tencent Music's international expansion ambitions are factors that could drive ARPU growth.

Risks

Stiffer competition due to China’s stricter anti-monopoly law increases medium term competitive pressures, not only from existing players such as NetEase Cloud Music, but also from new entrants such as short-video behemoth Douyin, who is entering the music streaming arena.

Conclusion

With a P/E of 19.95 (compared with negative for loss-making Spotify and 17.9 for NetEase) and decent earnings prospects, Tencent Music Entertainment Group stock could be viewed as approaching a reasonable price and may be worth a look. As with many tech stocks, Tencent Music Entertainment Group faces significant risks and uncertainties and may be better suited for investors with a higher risk appetite.

Analysts are generally bullish on the stock.

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