2023-07-25 13:04:13 ET
Summary
- The past 2 years have shown a strong link between Tencent Music's valuation and consensus EPS revisions. I think this has driven recent underperformance. But a reversal might be on the horizon.
- Based on my research, I anticipate a favorable swing in the next 2-3 years, facilitated by TME's robust online music segment and comprehensive portfolio.
- Despite my optimistic outlook for EPS revisions, my DCF analysis suggests that TME is trading at over a 60% discount to its intrinsic value of $11.5 a share.
I am confident Tencent Music Entertainment ( TME ) is a bold but exciting buy. You see, TME's share price and earnings revisions have been dancing to the same beat - when the Bloomberg 2023 adj EPS estimate was slashed by 58% over the past two years, TME's share price responded with a swift 75% drop (hence, the correlation in EPS revisions and share price growth).
That correlation has been a big negative on the stock since its IPO, and I think we will see the tune changing this year. We're past the halfway mark into 2023, and there's a new rhythm building up - one of optimism and opportunity. I've crunched the numbers, and I'm betting that TME's 2023 adj EPS will beat the consensus estimate by ~20%. Why? It all comes down to one key instrument in their ensemble - online music! This sector's margin has been hitting higher notes in the past 12 months, and I'm betting on this performance to continue. I see the positive earnings revisions hitting the perfect note to boost TME's share price in the upcoming quarters (the FY23 Q2 earnings report is on August 15th).
Finally, I believe TME is trading at a ~65% discount to its real (intrinsic) valuation, according to my DCF analysis. I use consensus estimates over a 5-year projection period, with a calculated WACC of 8.3%, and I assume a 13x EBITDA multiple (in line with current valuation) and a 1% terminal growth rate (in line with sector consensus), to derive my 12-month price tag of $11.5 through a blended average of the EBITDA and terminal growth methodologies.
Introducing Tencent Music ((TME))
TME’s Broad Portfolio
TME is not just a music streaming service – it’s a thorough music-based entertainment platform. Offering an array of services, TME is home to some of China’s top music-streaming apps, including QQ Music, Kugou Music, and Kuwo Music. Its online karaoke app, WeSing, has also gained considerable popularity while live-streaming services such as Kugou Live and Kuwo Live add to its extensive portfolio.
I think this portfolio is why TME can cast a wide net of the market and has a “Moat”. In 2022, the online music services boasted a mobile MAU of 587M, with a 14.5% paying ratio. On the flip side, its social entertainment services showed a mobile MAU of 155M, with a 4.8% paying ratio.
From 2003 to 2023 – TME’s Roots
Before TME grew into the music entertainment titan it is today; its story began in 2003. Tencent Holdings ( OTCPK:TCEHY ), the parent company, started its foray into the online music landscape through QQ, which later became a separate application in 2005. The start of TME in 2016 marked a new era, born from the merger of Tencent’s music business and the China Music Corporation, with the latter owning Kugou Music, Kuwo Music, Kugou Live, and Kuwo Live at the time.
TME’s growth trajectory shows me that it can strengthen its relationship with content suppliers. It received a $200M investment from Sony and Warner Music Group in 2018, and throughout 2020-21, TME strategically invested a total of 10% in Universal Music Group and acquired a 1% stake in Warner Music Group.
Market Dynamics
The user penetration of online music services in China is high , similar to live streaming and short videos, and surpasses that of online games. The penetration rate even matches that in the US. Yet, this high penetration level is not something I foresee as a big user base growth for leading platforms like TME and NetEase Cloud Music in the near future.
However, the seemingly stagnant user growth does not indicate a dormant market. While the online music market’s growth has decelerated in recent years due to the dominance of Tencent Music and NetEase Cloud Music, the revenue from online music continues to show robust growth . The online music industry in China, though highly penetrated, still shows considerable growth potential when it comes to the paying ratio and the pricing of monthly subscriptions:
The paying ratio for this service stood at 12% in 2021 (in China), which lags behind the US audio paying ratio of 60%, international peers such as Deezer (60%) and Spotify (43%), and even China’s online video sector (25%). But, I believe this ratio has a ton of room for growth due to more benign industry competition and companies’ increased efforts to provide premium services and superior content offerings (see a GS report on this here ).
TME Is Increasing Its Monetization
TME revealed its innovative approach to monetization in its Q1 FY22 earnings call . The firm announced its strategy to balance subscriber growth and ARPPU (Avg Revenue Per Paying User) by implementing a three-pronged strategy: (1) reducing promotions,(2) bundling super VIPS, and (3) adding more tiers to subscription plans with added privileges.
Such a strategy in my view paves the way for improving ARPPU across the industry, offering the potential for better monetization of China’s online music streaming services. Despite being a market leader, TME’s music streaming membership ARPPU was RMB8 in 2021, lower than that of Spotify (RMB31), iQiyi (RMB14), and China Online Games (RMB29).
Non-subscription sales offer another big upside for major online music platforms. Given the 15-20% paying ratio for online music content in China, there’s an 80-85% base of non-paying users, which should lead to an increase in non-subscription sales from live streaming, but I also think advertising will become another growth driver.
Online Music Streaming In China
In China’s online music streaming landscape, TME and Cloud Music hold the reins with a 73% and 20% market share of China’s online music sales in 2020, respectively. This duopoly virtually monopolizes the online music listeners in China, excluding platform overlaps.
A big advantage these platforms possess over global peers lies in the nature of China’s music content market. The top 5 labels account for less than 30% of TME’s streaming volume, while in 2021, the big 3 record label firms accounted for 70% of the global recorded-music market share.
On the other hand, China’s music distribution market is more concentrated than the rest of the world. As per IFPI , 89.2% of China’s music sales come from streaming media, while streaming accounted for 65% of global recorded music industry sales in 2021. This concentration can further bolster the position of online music platforms like TME and Cloud Music, which have a radical user base and dominant control over the online music market.
My Investment Catalysts for TME’s Growth
Catalyst 1 – Reopening Economy and Ad Recovery
As I look through the trends in the music industry, I’ve noticed that the reopening of China’s economy plays a big role in advertising recovery, an essential part of TME’s sales. In fact, advertisements contribute to the high single digits of TME’s total sales. I think this revitalization is also a great indicator of the firm’s social entertainment segment, which makes up 56% of its sales. For 2023, I am looking forward to a revenue recovery of about 9% YoY, a strong bounce back from the -9% we saw in FY22. Thus, I think this will coincide with margin expansion, driving further share price growth.
Catalyst 2 – Online Music: From Cost Center to Profit Driver
A big transformation is happening within TME’s business model, specifically in the online music segment. Competition is rationalizing, and monetization capabilities are improving.
We have seen the music segment be a cost center, but I have reason to believe those days are over. TME’s multidimensional monetization model and efficiency improvements have driven consistent financial improvement in its online music operation. It’s quite a turnaround from the -22% Operating Profit Margin of 2020 to the 3% in 2022. According to the street estimates, this growth trend should continue, with online music predicted to account for 56% of group sales with a 15% Operating Profit Margin by 2025.
Catalyst 3 – Stabilizing Social Entertainment Revenue
In 2022, TME’s high-margin social entertainment operation experienced a 20% YoY revenue drop! Yet, I think this downturn should stabilize by late 2023 or early 2024. This is because the firm’s success hinges on three key factors that I believe will be positive as the industry grows and China demand continues to rise:
- the macro recovery’s support for tipping sales,
- the continued ramp-up of sales from audio live streaming, and
- the expansion of international social entertainment revenue
Catalyst 4 – Sustainable Growth in Online Music
According to GVR , the online segment is positioned for growth, with a projected 20% CAGR from 2023-2025. This growth prediction is backed by strong metrics in music subscription service revenue and an increase in advertising revenue. Additionally, the introduction of new ad formats, such as incentive ad-based free listening models and ad sponsorship in TME Live/TME Land, is something that I expect to spur additional growth.
Catalyst 5 – Sustainable Margin Improvement
The second half of 2022 witnessed a big margin improvement for TME, driven by a rise in sales from high-margin businesses such as ads and digital albums, as well as a drop in costs such as music royalty fees and user acquisition costs. I think this margin expansion trend will continue to appear over the next 2-3 years, largely backed by a better cost structure and overall operational expenditure optimization from TME.
Discounted Cash Flow Analysis
For the following Discounted Cash Flows Analysis, I use the consensus estimates from CapIQ for the P/L assumptions, with a small uptick for FY23-24 revenue growth assumptions. Additionally, I calculated an 8.3% WACC and used a 13x EBITDA multiple (in line with the current multiple), as well as a 1% Terminal Growth rate to calculate the implied share price based on the DCF analysis.
Using the terminal growth method, I get a price tag of $11.87 (~70% upside to the current price of $7 as of writing), and with the EBITDA multiple of 13, I arrive at a similar price tag of $11.26, a share (~60% upside). Doing an average of both methods, I arrive at my 12-month price target of $11.5 a share, implying a ~65% upside to today’s prices.
See below for all assumptions, calculations, and sensitivity analysis for my DCF:
Discounted Cash Flows Analysis (Author's Data)
Intrinsic Value Calculation (Author's Data)
Sensitivity Analysis For Firm Value (Author's Data)
% Assumptions For Operating Model (Author's Data)
P&L and Balance Sheet Forecasts (Author's Data)
Cash Flow and Supplemental Statements Forecasts (Author's Data)
WACC Calculation (Author's Data)
Downside Investment Risks for TME
The following risks are the three key concerns I have going forward for TME, and they are not reflective of all the risks there are out there, such as regulatory pressures (one of which TME has recently experienced), or worse-than-expected China recovery (also has already been baked into the stock price). My top three concerns for TME are below:
- Lower-than-anticipated margin growth for online music services – This could realize from inflated content costs associated with licensed music copyright, self-created music content, and long-form audio.
- Uncertainty surrounding ARPPU and paying ratio boosts for online music subscriptions – There is a chance that competitors, such as NetEase Cloud Music, could grow/expand their licensed content pool and adhere to competitive pricing strategies to stimulate subscription revenue, suggesting a big competition risk for TME.
- Lastly, if we see a worse-than-expected outlook for the social entertainment business (due to competition stemming from analogous services offered by short video platforms), we will see a negative impact to TME’s intrinsic valuation and short-term price actions.
The Last Word
I initiate my coverage of Tencent Music ((TME)) with a “buy” rating due to my optimistic outlook on TME’s potential to sustain earnings in the mid-term. This is primarily due to the online music component becoming a pivotal revenue generator for the group. The monetization model is broad-ranging, encompassing subscriptions, advertising, digital albums, and more, and it’s coupled with a progressively improving Gross Profit Margin.
Looking ahead to 2023, I believe a revival in sales and an expansion of margins will be facilitated by a margin uplift in the online music segment and operational expenditure control. These factors are what I expect to fuel an increase in the share price.
As for investing in TME, my investment strategy is to buy and hold. I do not believe TME is a strong buy due to the inherent risks to my bold predictions – this company could have a substantial downside in the near-mid-term if things do not go as planned, but the potential downside is what I also believe could make for rewarding upside. Thus, I am setting a price tag of $11.5 a share to reflect what I believe is TME’s current intrinsic valuation based on my DCF analysis.
For further details see:
Tencent Music: It's Time To Tune In