Tencent Music's Long-Term Earnings Growth Fueled by Subscriber Increase, Margin Improvements

Senior Equity Analyst

Ivan Su

With around 600 million monthly active users Tencent Music Entertainment is the largest music streaming platform in China. The firm monetizes through live streaming, a high margin business generating over 50% of revenue and over 100% of operating profit, while subscription-based music streaming remains loss-making. 

A low subscriber/user ratio in the midteen percentages offers a long runway for paying user growth in music streaming. With platforms putting more content, such as popular songs, behind the paywall, more users would subscribe, and fuel top-line growth. Potential revenue growth also comes from advertising, where the firm’s investments into long-form audio are likely to open up more ad inventory. Even though social entertainment (mainly video live streaming) contributes most of the firm’s revenue, we believe there will be minimal growth ahead given competition from Douyin and Kuaishou. 

With China’s antitrust laws putting an end to TME’s exclusive music copyright agreements, we anticipate more competition for users. Its peer Cloud Music is aiming to bridge the content gap by signing with previously inaccessible labels. Despite competitive headwinds, we are confident that TME will remain the largest platform for music streaming , benefiting primarily from network effect and intangible assets that maintain user engagement and stickiness. We think subscription prices are unlikely to go lower because: 1) competitors are making losses and have little incentive for price competition; and 2) Chinese streaming platforms offer almost the lowest prices worldwide, so more discounts will be less effective in attracting users. 

We also expect some margin upside for Tencent Music as growing subscription revenue brings more cost leverage. Unlike developed markets, the supply side of music in China is more fragmented, with just 30% of licensing from top five labels. As licensors sell their content on a mostly fixed cost basis, TME is well-positioned to see margin expansion as revenue grows.

Business Strategy & Outlook

We assign TME a narrow moat rating. We have confidence that the company will generate excess returns on capital over the next 10 years, as it continues to benefit from a strong network effect and intangible assets in its Tencent-affiliation, user data, and listening preferences. 

TME's network effect centers around its content library. Over the past years, TME has established the largest music content library in China, with over 40 million music pieces sourced from most of the top labels. The firm's content dominance has resulted in retaining user traffic and revenue significantly above its key competitors. We think a network effect is TME’s main economic moat source. With around 70% of the market share and over 600 million monthly active users, TME has created a network effect attracting listeners, artists, live streamers, and other content producers. Listeners represent the demand side of this network effect, while content producers represent the supply side. With TME having the go-to apps for music, more content producers are likely to make their offerings available on the apps, which will widen the array of content on the apps, in turn benefiting both existing and new users. With consumers spending more time on apps, more producers are likely to make their content available on TME, which will continue to benefit listeners. 

At present, TME's network is predominantly monetized via live streaming that is built into the music apps. The company recognizes most of this revenue by charging an estimated take rate of 30% every time a viewer donates to a streamer. We believe TME offers an attractive marketplace to both viewers and streamers. Live streamers are attracted to TME's platform by the prospect of gaining more fans and ultimately more revenue from virtual gifts and sponsored advertising. As more streamers bring their content to TME, more viewers are drawn to the platform to watch and interact with their favorite live streamers. That said, entertainment live streaming is a highly competitive business, where we estimate TME having around 10% of revenue market share, coming behind Douyin (25%) and Kuaishou (16%). The competition further escalated in recent years, with short-form video platforms offering various incentives to poach topnotch streamers. However, given the presently low paying ratio on the music streaming side (11% at TME versus 45% at Spotify), we expect TME to gradually shift monetization from live streaming to paid subscription and advertising, leading to a healthier revenue mix. 

Also, TME feeds off the network effect of China's largest digital ecosystem through maintaining a close tie with parent company Tencent. TME is the music platform that can most effectively integrate into this 1.3 billion user ecosystem. The integration process is done through WeChat ID, the backbone of the Tencent ecosystem and frequently used to register for Tencent services. From there, users can connect with friends (primarily in music and playlist sharing) across multiple Tencent platforms. While alternative music apps allow track sharing via WeChat, there is more friction from additional clicks to moving out-of-app. Although they also allow basic integration with Tencent apps like sharing music with WeChat friends, they lack the breadth of interconnecting functions like listening to music that appears in the WeChat video account through TME apps. We surmise that this convenience will make customers stickier and pave the way for the firm to uplift charges for subscriptions. Also, we view that every time users of TME share playlists on WeChat, it would serve as a promotional effort to attract more users to TME. 

Outside of its network effect, TME may also benefit from intangible assets associated with user data over time. The fact that TME has three times as many users as the second player gives itself unrivalled access to data that ultimately feeds into content curation and recommendation, increasing user stickiness and time spent. As more users listen to more music, its apps can improve their algorithms and provide all users with better playlists that closer match their listening preferences. This virtuous cycle further increases the value of its data asset, from which TME could better retain its existing users while also potentially attracting more users to its service.

On the profitability front, we have high conviction that TME will continue to generate return on invested capital, or ROIC, above WACC over the next decade. Two key considerations underpin our assertion. First, live streaming (the main part of the social entertainment segment) has already established itself as a highly profitable business with around 40% gross margin. Most of the costs are variable and are in the form of revenue-sharing with streamers. We think the strong network effect and intangible assets owned by TME will warrant itself to be a major player in live streaming over the next couple of years. Even if we were to bake in a 40% permanent loss in social entertainment revenue, TME's midcycle ROIC should still run around 35%, comfortably above our 9.4% WACC assumption. 

Our conviction in TME's profitability also comes from the ample room for more operating leverage. With the firm committing to putting more music content behind the paywall, we expect continued growth in paying users and average revenue per user, or ARPU. Continued growth in revenue will lead to more operating leverage from content, research and development, and marketing expenses. Given that top music labels control a far lower percentage of content in China versus what they do in most developed markets, we think TME enjoys stronger bargaining power over content owners. Furthermore, music labels generally license content mostly on a fixed-cost basis in China through guaranteed minimum payments, as opposed to collecting revenue-sharing royalties. This allows the business to enjoy continuing operating leverage. Given the historical ubiquity of music piracy in China, we expect minimum guarantees to remain as the major licensing model used by record labels when selling into China, as it provides incentives to music streaming platforms to curb pirating activities.

Narrow

Economic Moat

Tencent Music Entertainment Group 

Tencent Music Entertainment Group is a holding company, which engages in the operation of an online music and audio entertainment platform. Its platform is composed of online music, online audio, online karaoke, music-centric live streaming, and online concert services. The company was founded on June 6, 2012 and is headquartered in Shenzhen, China.

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Tencent Music Entertainment Group engages in the business of operating online music entertainment platforms to provide music streaming, online karaoke, and live streaming services. Its product brands include QQ Music, Kugou Music, Kuwo Music, and WeSing. The company was founded on June 6, 2012 and is headquartered in Shenzhen, China.

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