Tencent Music: China's largest music entertainment platform with 27.4% growth potential

Reason 1: Dominant market player with integrated music ecosystem and original content

Tencent Music Entertainment (TME) is the largest online music entertainment service in China with a strong social component. The company's products include music streaming, live streaming, online karaoke and long-form audio formats, which are offered under several brands. Technology conglomerate Tencent owns 52.5% of Tencent Music and controls 92.6% of the voting power in the company, according to a 20-F report. Another major shareholder is Spotify, which owns an 8.2% stake.

Tencent Music provides entertainment services across four main apps: QQ Music, Kugou Music, Kuwo Music and WeSing. The company also owns Lazy Audio, a long-format audio service acquired in 2021 that offers audiobooks, podcasts and comedy shows.

Source: Tencent Music Entertainment Investor Presentation

The core platforms, QQ Music, Kugou Music and Kuwo Music, create a rich social experience around music listening and offer additional features such as karaoke services, music blogs, ticketing and various live streaming formats. The ability to join artist fan groups, comment on tracks, and instantly jump to online karaoke makes interacting with the platform more convenient and fosters an active user community. This approach is typical of Chinese apps in general and the Tencent ecosystem in particular. Tencent Music users have the added benefit of integration with the popular Weixin (WeChat) messenger and QQ smart devices with their wide audience reach.

The apps operate independently, targeting different demographics and music preferences, but ultimately benefit from centralized marketing, optimized content acquisition costs and a unified music library, and of course, access to Tencent's broad audience. For example, since 2023, Weixin supports the music listening function, which helps to expand the user's reach. Weixin Video can automatically detect background music in videos and redirect users to QQ Music to listen to it. In addition, Tencent Music creates soundtracks for some of Tencent's video games and has provided a music player for the popular Dream Star game.

As a result, QQ Music, Kugou and Kuwo remain the largest music streaming services in China by audience size, well ahead of competitors NetEase and Migu. Tight integration with China's leading super-app Tencent and its entertainment ecosystem is expected to further strengthen Tencent Music's leadership position in the long term.

Number of active users (MAU) of the largest music streaming apps in China, September 2024

Source: Statista

Tencent Music's content library has more than 200 million audio tracks, covering five main categories: songs, live music performances, video and audio recordings, karaoke songs, as well as reviews and articles.

Like any streaming platform, Tencent Music licenses a significant portion of its catalog from rights holders — record labels and copyright owners. The company pays royalties and shares a portion of the revenue, and the terms of the agreements depend on a variety of factors, including the popularity of the artist, the type of content and the nature of the partnership.

Tencent Music has close relationships and co-labels with all three major industry players — Universal Music, Sony Music and Warner Music. The company promotes international artists in China, benefiting from their global recognition and giving musicians and labels access to one of the world's largest markets. As a result, Tencent Music is firmly integrated into the international music industry and has access to extensive content catalogs.

In addition to licensing, Tencent Music also acts as a label, funding content creation in partnership with artists and their representatives. The company directly licenses music from artists and supports the creation of user-generated content by paying royalties to creators on live streaming platforms.

Original content gives Tencent Music a strategic advantage: the company receives a portion of the revenue that would have gone to labels in the traditional model, reducing reliance on royalties and increasing overall profitability. In addition, Tencent Music can also license the content it creates to third-party platforms, creating additional revenue streams.

As a result, Tencent Music has achieved sustainable market leadership by leveraging economies of scale in content sourcing, and integration into the Tencent ecosystem significantly reduces marketing costs. This creates a unique business model with high profitability and long-term growth potential.

Reason 2: Increased monetization offsets impact of regulatory constraints

Tencent Music derives its revenue from the following sources:

• Ads that are shown to users of free music apps;
• Subscriptions that provide access to listen to ad-free content as well as exclusive content;
• Virtual gifts and tips that users send to performers during streaming and karaoke sessions (Tencent Music gets a share of these payments);
• Digital music and album sales on an ad hoc basis;
• License fees from other platforms for the use of the Tencent Music catalog.

The company formally classifies QQ Music, Kugou Music and Kuwo Music into the "music streaming" segment and WeSing into the "social entertainment" segment. However, the latter also includes revenue from streaming features available on the first three platforms.

Revenue from music streaming comes from subscriptions, advertising and one-off sales of digital music. Social entertainment, on the other hand, is primarily monetized through virtual gifts and tips, but also generates revenue from advertising, music merchandise sales and premium subscriptions. Thus, each segment has a variety of revenue sources, giving Tencent Music greater flexibility in its monetization strategy.

Source: compiled by author

The social entertainment segment has long been a key growth driver for Tencent Music, contributing more than 60% of revenue through 2022. However, in 2021, Chinese authorities tightened regulation of the IT industry. The State Administration for Market Regulation (SAMR) required Tencent Music to give up exclusive rights to music content. As it turned out, this move did not cause critical damage to the music business. A much more serious blow came to the social entertainment segment: regulators limited the size of virtual gifts, set new requirements for presenter behavior during streams, and banned gaming entertainment such as virtual lotteries, equating them to gambling.

As a result, the segment, which accounted for about 68% of revenue in 2020, halved in two years. The decline continued in 2024, with revenue falling a further 41% year-on-year (YoY) in the first nine months (9M) of the year, and its share of total revenue falling to 24%. However, Tencent Music said it has almost fully adapted to the new requirements, and the business is expected to further stabilize in the future. The company's total revenue stopped shrinking: it went to zero growth in 9M 2024, and increased by 6.79% in Q3.

This crisis has turned Tencent Music's business model towards a greater reliance on music streaming. This segment has been growing steadily, averaging more than 20% per year, with 29.3% YoY growth in 9M 2024. We believe the monetization model for online music services is more sustainable because it relies on regular and predictable streams of subscriptions and advertising deals. The company's shift from one-time payments to a subscription model makes its revenues more stable and less subject to regulatory risk.

Source: compiled by author

The main driver of music revenue growth is an increase in the share of paying users. In 2019, only 5.2% of monthly active users (MAUs) were subscribers; this figure rose to 17.1% in 2023 and reached 20.7% in Q3 2024.

However, there is a nuance: since 2019, the total number of MAUs has been declining by about 2.5% per year. Nevertheless, thanks to an annual average revenue per paying user (ARPPU) growth of 3.2%, the company has been able to maintain total music streaming revenue growth of over 20% per year, which is an extremely positive result.

Tencent Music regularly notes that Chinese users are less inclined to pay for content than Western users. In this context, reaching 20% of paying users can be considered a significant achievement. The average revenue of a subscriber is more than 10 times that of a free user, so subscriptions already account for 70% of the music segment's revenue.

Source: compiled by author

Tencent Music's management is implementing a number of strategies to increase music revenue and user loyalty.

• SuperVIP subscriptions offer users premium audio quality, enhanced access to long-form audio content, priority access to iconic digital albums, exclusive concerts and fan activities such as pre-sale tickets. Preferred car features are also available through partnerships with Xiaomi, Li Auto and NIO. The range of features is constantly expanding, incentivizing users to upgrade to more expensive subscriptions and driving ARPPU growth. In Q3 2024, the number of SuperVIP subscribers exceeded 10 million.
• Organizing music events to increase visibility and influence in the industry. In September 2024, Tencent Music held the two-day Zebra Music Festival, which attracted nearly 65,000 fans, and a live concert by pop singer Yu Jiayun, which was attended by more than 10,000 people.
• Expanding partnerships to provide in-demand content. Tencent Music has formed an alliance with Galaxy Corporation to stream music from K-pop singer G-Dragon and organize his upcoming concert tour in Asia. The company has also partnered with popular brands such as Black Myth: WuKong, Crayon Shin-chan and Disney to offer personalized interfaces and additional fan experiences.
• Leveraging the Tencent ecosystem: Tencent Music creates themed soundtracks for League of Legends: Wild Rift, Peacekeeper Elite and other popular Tencent projects. These songs regularly top the charts, increasing user engagement.
• Product and technology innovations: utilizing large language models (LLMs) for efficient content creation, artificial intelligence (AI) for song generation, and text-to-speech (TTS) technologies have enabled the company to create tens of thousands of audiobooks for the long-form audio content platform.

Thus, Tencent Music seems to have successfully overcome the pressure on the social entertainment segment and redoubled its efforts to monetize music services. The company's business model now looks even more sustainable than it did a few years ago, as it relies on recurring revenue streams and high customer loyalty. With a stabilizing social segment and rapidly growing monetization of streaming services, Tencent Music has already returned to positive revenue momentum with higher profitability and has the potential to further create shareholder value.

Financial results

Tencent Music's financial results for the trailing 12 months (TTM) as of the end of Q3 2024 are as follows:

• Revenue remained largely unchanged, up 0.3% YoY to RMB27.84 billion in 2023.
• Gross profit rose 16.5% to RMB11.4 billion, while margins increased 5.7 percentage points (p.p.) to 41.0%. In 9M 2024, Tencent Music managed to reduce service costs (content and technology costs) by 11% YoY.
• Operating profit increased by 32.3% to RMB8.02 billion. Operating margin increased by 7.0 p.p. to 28.8%. In addition to service costs, lower administrative expenses contributed to the improved operating result.
• Net profit rose 23.4% to RMB6.44 billion, with the margin increasing 4.3 p.p. to 23.1%. The growth was less than the increase in operating profit due to a nearly doubling of tax expenses, less positive results of capital investments and higher finance costs.

Source: compiled by author

TTM's operating cash flow increased 33.2% YoY to RMB9.77 billion in 2023. The company does not disclose details of cash flow for interim periods. Based on previous trends, the company's spending on acquisitions and intangible assets (Capex) rarely exceeded 3% of annual revenue, and the bulk of investment cash flows were related to liquidity management. We will use the latter figure of 2.2% of revenue to estimate Capex and calculate the possible TTM free cash flow (FCF). If our assumption is correct and Capex has not changed significantly this year, FCF probably rose to RMB9.1 billion and margins could reach a record 32.9%, 8.7 p.p. above the 2023 level.

Source: compiled by author. TTM FCF at the end of Q3 2024 is an approximation.

Tencent Music has cash and cash equivalents of RMB28.5 billion, of which RMB10.2 billion is cash and RMB18.3 billion is in term deposits. The company has a debt load of RMB5.5 billion, of which RMB2.1 billion are short-term liabilities. Thus, Tencent Music has a negative net debt. This is a comfortable position that the company can use to acquire businesses or increase payouts to shareholders.

Tencent Music currently has a share buyback program in place, but it only has $165 million left, less than 1% of the company's current market cap. Tencent Music also pays a dividend with a modest annualized yield of 1.1%. With positive business momentum and growing cash reserves, the company may consider more active support for the stock price.

Stock valuation

Tencent Music has limited comparability with other music streaming services due to its complex business structure, so we consider a broad peer group including parent company Tencent, content owners Universal Music Group and Warner Music, streaming service Spotify, and Chinese competitor NetEase with a mixed business model combining game development and music streaming.

In terms of financial performance, Tencent Music stands out with a high operating margin, strong net cash position and active cash flow generation when guided by consensus forward guidance. Due to the lack of the reliable TTM FCF metric, P/FCF multiples and FCF yields cannot be correctly calculated.

Notably, there is a premium on EV/Sales, but this multiple is not very relevant for companies with different margin levels and business models. On EV/EBITDA, Tencent Music trades at an 83% and 64% premium to peers on a historical and forward basis, respectively, while the company's forward P/FCF multiple suggests a 30% discount. In addition, Tencent Music trades at a 17% and 19% discount to its P/E multiple on a historical and forward basis, respectively.

Thus, while comparative valuation is difficult, Tencent Music trades at acceptable multiples and does not look overvalued given its profitability and ability to generate cash flows. We believe that the current valuation is not a barrier to further upside.

Source: compiled by author

Wall Street analysts are generally positive on the stock, with the worst-case scenario assuming the price remains at current levels and only two analysts estimating upside potential below 10%. The median forecast is $14.5 per ADS, while our consensus forecast of $15.0 per ADS implies a stock price increase of more than 25%.

Source: compiled by author

Key risks

• Regulatory risks have already had a negative impact on Tencent Music's social segment. Although the company has emerged from the crisis in a stronger position, the risk of new regulatory restrictions remains and could lead to similar negative consequences.
• Tencent Music does not disclose the proportion of licensed content, but it is likely to be a significant part of the company's content library. If relations with leading Western rights holders (Universal Music, Sony Music and Warner Music) deteriorate and there are problems with license renewals, the company may lose a significant portion of its content, which will negatively impact its attractiveness to users.

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