Tencent Music Entertainment Group (NYSE:TME) is China’s largest online music and social entertainment platform in terms of monthly active users (MAU; 4Q19 total MAU: 903m). TME is a leader with twin growth engines. (Online music & social entertainment). TME, found in July 2016 through the merger of China Music Corporation (CMC) and Tencent’s online music business, is China’s largest online music entertainment platform ranked by MAU.
Source: Company Prospectus; Bloomberg
Chinese online music industry with long runway of growth
China’s online music streaming service has one of the highest long-term structural growth potentials as it benefits from rising purchasing power of Chinese middle class.
TME’s online music platform has amassed a large user base and is currently under-monetized. According to the prospectus, the paying ratio (number of paying users divided by total number of users) of music subscription in China was only 5.3% in 2018, much lower than 22.5% for online video, 14.1% for online games and 7.5% for online literature, while users’ willingness to pay for music content reached 46.3%. Compared to the US (specifically Spotify), China online music industry’s paying ratio (c.5% in 2018 vs 70% for the US) and average revenue per paying user are much lower reflecting Chinese infant online music industry.
With music entertainment features continuing to improve, and considering the shift from pay-per-download to pay-per-stream, I believe this will spur an increase in online music entertainment payment penetration rate in the long run. Consensus forecasts that the paying ratio could reach c. 20% in the long term when TME widely adopts the pay-per-stream model in China.
TME a dominant leader in the Chinese online music industry
Leveraging Tencent’s considerable user traffic from its WeChat ecosystem, TME achieved collective MAU of 903mn in 4Q19, compared to the 116mn MAU in Sept 2019 (per QuestMobile) of NetEase Cloud Music, the second-largest music entertainment provider in China by MAU.
TME is also the online music platform with the most comprehensive music content library in China; it owns more than 90% of music copy rights in China through different music sourcing channels. . In addition, TME is the only online music platform in China entitled to distribute music copyrights of the country’s top 3 music labels (Universal Music Group, Warner Music Group, and Sony), which in aggregate accounted for 59.9% of China’s music market revenue and 68.6% of global music market revenue in 2018. Thus, I believe TME has strong bargaining power when negotiating for content licensing.
Source: Company Filings
TME’s joint investment with Tencent for up to 20% of Vivendi’s Universal Music Group (UMG) should help the company to progress with its pay-per-stream strategy. TME’s investment in UMG will allow TME to provide more paywall content which will accelerate adoption of its pay-per-stream strategy and will boost its paying subscriber numbers going forward. TME’s long-term strategy is to lead rapid innovation in online music industry in China and increase user engagement within its ecosystem over short-term financial results. The company’s social entertainment business generates enough cash flows for the company to reinvest in online music business. In addition, TME leverages large user base of its parent (Tencent) so there is a limited downside risk for shareholders from this strategy.
TME has developed complete all-in-one music ecosystem which connects artists and users
TME has formed an online music ecosystem that connects music production and music distribution. For music production, TME’s Tencent Musician Program helps independent musicians to produce original music pieces. TME also produces self-made music variety shows, for example Produce 101 and The Coming One, to diversify content offerings. For music distribution, TME has strong operating capability to maximize the value of pop stars and idols. One important distribution channel is its popular songs rankings, which incentivizes fans to consume and pay for their idols’ music content so that their idols can top the ranking list. TME also sells tickets for offline music events such as live house concerts to engage with users.
Financial Analysis & Valuation
Source: Bloomberg; Author’s calculation
TME reported strong cash flow and EPS growth over the last four years. Given TME’s strong FCF profile, the company is in a strong position to re-invest capital in music content, as well as produce its own content. I expect TME to sustain growth in EPS and FCF via monetizing large MAU base within its music ecosystem.
The key assumption here is that revenues growth will fall to 15% in 2020 then make a recovery to 26% in 2021. This includes a slowdown in social entertainment revenue due to Covid-19, partially offset by growth in streaming revenue.
I also conservatively assuming costs will increase faster than its revenue in FY20-FY21 as TME increases revenue sharing ratio with live-broadcasting hosts to retain talent, and will invest in long-form audio content.
For the exit price at 2022 year-end, I assume a 26x P/E, which is much lower than TME’s 30x level before the Covid-19 outbreak. This gives a share price of $13.3 at 2022 year-end.
I believe this represents a solid, attractive return, given the uniqueness of TME as a high-quality and fast growing business. I believe there is a meaningful possibility of positive surprises, for example, if revenue growth does not deteriorate as much as I assume.
Compared to Spotify’s MAU of 248m, TME’s MAU (903m) is still under-monetized. The number of online music paying users for TME was 39.9mn in 4Q19, which was equivalent to 32% of paying users for Spotify. I believe the gap in paying user between the two entities will narrow as TME progresses with its pay-per-streaming model with TME has much better growth outlook due to its massive MAU versus Spotify.
Failure to maintain deep content library
Failure to maintain/grow MAUs
Slow growth in paying subscribers
Rising content costs
I believe a risk of capital loss is very low, given the company’s rock solid balance sheet and its ability to generate strong cash flow. Return can be much better if the company can grow its music subscription business quickly than market anticipates.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.