Tencent Music Entertainment Group: Buy the Dip?

Tencent Music Entertainment Group: Buy the Dip?

NYSE: TME

(Reading time: 13 minutes)

The music industry has seen the years several disruptions. Live performances became recordings, and several supports became popular one after the other. From gramophones to vinyl records, from cassettes to Compact Disks, from digital stores to streaming services: the music industry’s history is ever-changing, always seeking the best way to deliver customers the value produced by artists.

Fast forward to today, and the customers have several different ways to support their favourite artists: the leading share of business brought to the industry is one of the streaming services, with a slowly decreasing share of physical supports following and performance rights as the third segment.

The good news for the industry is that, after the last decade’s dark years of solid contraction, the sector started growing again at a favourable rate.

In fact, from the bottom level of 14 billion dollars of 2014, the sector recouped the lost ground by reaching 20.2 billion dollars in revenues in 2019.

And guess what? 2014 is also the year in which Spotify and other early birds of the music streaming industry started gaining traction.

Below is the data relating to the global industry’s revenues, divided by service type: it is clear that the recent growth is not attributable to physical sales, and also not to digital sales, but an increasing weight of streaming services and performance rights.

In the plethora of music streaming services, there is a clear leader. The Swedish Spotify continues to be in the favourable position of owning a 35% market share.

Other companies of considerable dimension could eventually hinder Spotify’s position: Apple Music is the second service per market share, with a 19%; the third, fourth and fifth spaces are occupied by notable companies such as Amazon (15%), Tencent (11%) and Youtube (6%).

The remaining 14% is divided between smaller competitors that, for now, don’t constitute a threat to Spotify’s hegemony.

As always, the story is very different in Mainland China: there’s no Spotify and no Apple Music that can compete in this market.

In China, streaming services divide into the following major players: Kugou Music holds 35% of the market share, QQ follows with 27.8%. Kuwo, NetEase and Xiami, then control each around 11-12% of the sector. These players leave next to nothing to more minor services.

So, where’s Tencent? The Chinese giant owns the first three players: Kugou Music, QQ Music and Kuwo Music.

To better manage its entertainment acquisitions, Tencent founded the Tencent Music and Entertainment Group in 2016. TME was then listed on the New York Stock Exchange in 2018.

Get ready because, as its parent Tencent, the Music and Entertainment Group has several interesting ramifications worth considering.

Read along to know more about this highly growing company!

1. The Company

History

The parent Tencent started in 2003 a line of business involved in the entertainment industry, with the launch of its social network’s music divisions.

The tech giant launched QQ’s online music services in 2003, Kugou music in 2004, QQ Music and Kuwo Music in 2005.

In September 2014, TME launched WeSing, an online karaoke service that meets Chinese citizens’ cultural love for this kind of entertainment.

To rationalise its immense subsidiaries empire and spin-off this part of the business, Tencent founded the Music and Entertainment Group in 2016. The decision was prompted by the acquisition, in July of the same year, of 60% of China Music Corporation for $1.6 billion.

CMC wasn’t new to Tencent, as the tech giant was already the owner of 15.8% of its shares before 2016.

The newly acquired business was then immediately merged with QQ Music to further increase the market share directly owned by Tencent.

The aim is to become the most influential entertainment company in the world, with the ultimate value being the use of technology “to elevate the role of music in people’s lives, by enabling them to create, enjoy, share and interact with music”.

Tencent Music Entertainment Group’s history is recent: for this reason, the company’s history is relatively synthetic.

However, despite its recent formation, the firm has been immediately recognised globally due to its subsidiaries’ power.

For this reason, a music giant like Spotify announced a share swap with TME: both the Swedish company and the Chinese group got 9% of each other.

A detail here is that Tencent Holdings own three-quarters of this 9% from a technical perspective, while TME Group owns only a quarter of that.

This deal has eventually given Tencent the leverage to strike better deals with labels like Sony Music and Warner Music, among the world’s most important ones.

In 2017, TME acquired Ultimate Music, a platform that enables smart devices and car manufacturers to develop built-in music players.

In July 2018, Sony/ATV music publishing acquired an equity stake in TME. The figures of the deal are not precise. However, by digging into TME’s 2018 annual report, there is the mention of a “record holder in the United States” that owns 5.4% of total issued and outstanding shares. This could be the actual percentage acquired with the deal from Sony/ATV, which is, in fact, a US-incorporated firm.

In December 2018, the company was ready: Tencent Music and Entertainment Group offered 164 million Class A shares (in the form of American Depositary Shares) on the New York Stock Exchange.

In January 2019, TME entered into a strategic partnership with South Korea’s largest entertainment agency, SM Entertainment, to distribute Korean music into Mainland China.

The end of 2019 sees TME acquiring 10% of Universal Music Group through a consortium led by Tencent Holdings Ltd. The transaction sees as a seller the parent company of UMG, the French Vivendi SA.

In January 2021, Tencent Music entered into a definitive agreement to acquire 100% equity interest of Shenzhen Lanren Online Technology Co, Ltd, better known as “Lazy Audio”, to enrich the audio content catalogue and boost the production of audiobooks.

On the 22nd of March 2021, TME announced a joint venture with Warner Group to co-create a Music Label in China.

Structure of the company

Like its parent company, Tencent Music Entertainment Group has several ramifications to ensure full operativity onshore and offshore.

The graph below is from the 2020 Annual Report of FY 2019 and goes through its complete structure.

It is clear that to operate efficiently and effectively, TME has a central holding offshore (in the Cayman Islands), which is the company to which we refer when thinking about the stock listed on the New York Stock Exchange.

This main holding has two subsidiaries: one is the actual subsidiary created by Tencent, and the other one is the company acquired in 2017, Ultimate Music.

The companies controlled by the direct subsidiaries of Tencent Music Entertainment Group (Cayman Islands) are all on-shore. This is because to operate directly into Mainland China, any company have to have physical establishments there.

Management Overview

2. Qualitative Analysis

Business Model Spotlights

The intrinsic mission of TME is to “use technology to elevate the role of music in people’s lives, by enabling them to create, enjoy, share and interact with music”.

TME is the largest online music entertainment platform in Mainland China. The group owns the top four music mobile apps in terms of Average Monthly Users.

Not only that: Tencent defines itself as the “all-in-one” Music Entertainment Destination.

In fact, through the use of Tencent’s social networks and general technological presence in the market, TME can allow users a fully integrated experience.

Let’s now see the product brands through which TME provides its customers with an all-around music experience.

QQ Music is the first product brand launched by Tencent back in 2003. The name originates from the group’s most famous messaging app, QQ. Since this social network targets mostly teenagers and younger people, QQ Music focuses on famous artists and mainstream hits.

This allows artists to promote their newest music with exclusive releases and interactions with the fans.

This product has currently around 28% of the online music entertainment market share in China.

Kugou was launched in 2004 and immediately reached “industry standard” status.

It is moreover divided into two primary services: Kugou Music and Kugou Live. The first one is involved in providing a comprehensive set of entertainment features to users coming from lower-tier cities. Simultaneously, the latter is a live streaming platform where users can watch performances, concerts, music variety shows in an interactive and engaging manner.

Kugou is the leader in the online music entertainment industry of the People Republic, with the broadest user base across Mainland China. It currently has an estimated 35% market share.

Kuwo is a service similar to Kugou but has a large customer base primarily in Northern China. It is also divided into two sub-apps, one focused on providing an online streaming service, while the other allows users to stream live performances.

Only Kuwo Music is different from the Kugou counterpart: Kuwo focuses on specific genres and segments, such as DJ mixes and children’s songs.

WeSing is the most recent addition to the platform collection of Tencent. But it’s booming: the app represents the choice of 77% of all online karaoke users in China and is especially popular among a young and wealthy demographic living in major cities. More than 50% of the users are in the 25-29 age range.

In synthesis, this app allows users to have fun with friends by hopping on a live karaoke without the embarrassment of doing it in public and a particular place.

The content of all the apps and product brands is substantially the same and integrated. This is because TME licenses music as a group and then makes them available to its different products.

This catalogue is the largest in China, with 40 million tracks as of December 31st, 2019.

The overall music experience for Chinese customers that Tencent Music Entertainment Group can provide is outstandingly integrated into their favourite social networks.

This aspect makes the whole entertainment journey more social and shared.

So how does Tencent Music Entertainment Group make money?

TME mainly generates revenue from online music services and social media entertainment services.

Online music services accounted in the full-year 2020 for around 32% of the total revenue figure. During last year, TME was able to increase this segment’s revenues to RMB 9.35 billion (US$1.43 billion). The increase was sensibly driven by the strong growth (+56% YoY) of music subscriptions that amounted to RMB5.56 billion (US$852 million).

Social media entertainment services summed up to RMB19.8 billion (US$3.04 billion). This is equal to around 68% of total revenues for Tencent Music Entertainment.

This segment’s growth of 8.3% YoY was mainly due to improved Average monthly Revenue Per Paying User.

The total revenue figure, then, sums up to RMB29.15 billion (US$4.47 billion). To give a comparison, the global leader of online music streaming Spotify had revenues of €7.88 billion (US$9.32 billion).

Competitors and threats

The only real competitor that TME should fear at the moment for the internal Chinese market is NetEase Cloud Music, a firm owned by NetEase Inc.

However, it seems indeed a battle that is destined to have a clear winner, at least for now, with the number of active users of NetEase not constituting even 10% of the ones of the apps controlled by TME.

For this reason, we don’t see at the moment any clear competitors that could endanger TME’s business model in the short term.

Notable apps that may rise to popularity are Xiaomi’s MIUI Music, Alibaba’s Xiami Music and Baidu’s Qian Qian. In this case, we don’t foresee any real threat to TME’s market leadership in the middle term, as these apps have a shallow user base.

3. Quantitative Analysis

Financial Performance

Above is an overview of TME’s income statement, which displays figures in $USD million. Net revenues continued to grow during last year, driven by increased statistics related to Online Music Services and Social Entertainment Services.

Total revenues saw a growth of 33.9% between 2018 and 2019 while growing “only” 14.6% between 2019 and last year.

Gross profit margin has been affected by the notable investments into new product and content offering such as long-form audio and TME Live. Moreover, during last year the revenue sharing fees were strengthened to impede market penetration to all the competition at the source. The gross profit margin percentages went from 38.3% in 2018 to 34.1% in 2019 and 31.9% in 2020.

The operating income stayed stable above the 700 million dollars mark, with a margin percentage that went from below 10.7% in 2018 to 18.2% in 2019 and 16.1% in 2020.

The net income remained positive and grew from 9.7% in 2018 to 15.6% in 2019 and 14.3 in 2020.

To understand the characteristics of Tencent Music Entertainment Group’s economies, it is also essential to check out the numbers related to the user base and the paying customers.

From this table, we can immediately spot the growing segments of the platforms.

In synthesis, TME’s management improved (as promised) the figures of paying users by implementing several paywalls.

The already large customer base, then, was prompted to contract a subscription to not miss out on the great content that Tencent has been able to aggregate in years of partnerships and joint ventures with some of the most significant and most relevant labels.

The monthly users of social entertainment services remained the same over the last three years, but the value extracted from them changed.

There has been a solid 14.58% compound annual growth in the average revenue per paying user, really positive data for TME. It means that the current customers are happy to pay more for the exclusive services offered.

The balance sheet shows a healthy expansion, even though the debt to equity ratio went from 0.18 in 2018 to 0.29 in 2020. This increase, however, is a logical response to TME’s position in the market and current growth prospects: it’s positive operative leverage that doesn’t harm the organisation.

Valuation

A company valuation’s objective is always to understand the intrinsic value, making consistent assumptions that can be relatively safe in the middle term.

In the case of TME, a Discounted Cash Flow is, for sure relevant, since the company gives us enough information to try and estimate its future revenue figures, profitability, and liquidity.

Instead, a comparative analysis is not relevant because TME is the lone leader of the Chinese Market in its industry. Other companies operate in the sector, but not at the same scale and not as a primary business: Alibaba, Xiaomi, and Baidu consider the music business as a lateral one, without further making this part of the business independent.

Let’s start from a DCF Analysis then!

DCF Analysis

The first step to understanding this company’s future value is forecasting the services’ value for the next five years, up until 2025.

The table below is an overview of the forecasts and the assumptions made for Tencent’s business evolution.

Revenue streams comprehend the already existing segments and also a new one: it is related to the acquisition in January 2021 of “Lazy Audio”, a platform leader in audiobook streaming in Mainland China. This is a significant value to be considered, as TME will enormously benefit from this part of its business in the future.

The audiobook market is growing sensibly, and it is forecasted to continue its expansion in the following years.

Analysts from Deloitte, Statista and other data platforms estimate that the audiobook industry’s market will surge at a 30% year on year pace. At the moment, researchers estimate that the value stands around 8.2 billion yuan.

Since the segment is not even explored in China yet, there’s ample space for TME to gain a considerable market share.

On the other hand, we also have to consider that among the competitors in this market, there’s also Amazon, which has seen great success with e-books.

For this reason, even though TME has good odds of conquering a large portion of the market, we have considered figures that could take into account the presence of competitors.

From the EBIT figures’ assumptions, we went forward to spread the forecasted free cash flow figures.

As shown in the following graph, Tencent Music and Entertainment Group is expected to see a growth in the EBIT and FCF figures.

After a probable stagnation of the EBIT figures in the next two years, the company will benefit from the current intense investment programs and augment its cash positions.

We identified the Debt% as 22.76% and the equity as the remaining 77.24% to calculate the Weighted Average Cost of Capital.

In the calculation of WACC, we employed the values in the following table. In the notes, you can find the sources or comments to that particular data. If not present, it’s a simple calculation or ChineseAlpha’s team estimation.

We used both the perpetual growth method and the EV/EBITDA multiple methods to determine the Terminal Value.

For the perpetual growth method, a yearly increase of 2% was estimated. This can be seen as really high, but considered the inflation and the possible further economies of scale of TME is the most senseful value. It has to be pointed out that the EV/EBITDA multiple is at the moment in an “outlier” level, as the current value is 73x. We consider it in our analysis, but this detail can help us understand the intrinsic value. Keeping the multiple as a factor in the valuation has to do with the fact that for this type of businesses that usually rely on subscription models, the EBITDA figures can be volatile. Consequently, we also observe absurd values of this multiple in the global leader, Spotify.

As can be seen, the EBITDA multiple approach gives an entirely different value of the Terminal Value.

We think that the correct value is in the middle: that’s why we took, for the determination of the Enterprise Value, the average of the results of the two methods.

At this point, we also summed the Present Values (discounted to the WACC) for the years 2021-2025.

We added to the Enterprise Value found to non-operating assets, which equate to cash, subtracted debt and other non-equity claims.

The result is an equity value of $59,539 million. This is divided by the number of ADS diluted shares outstanding as of 31/12/2020 of 1,660 million. The result is an intrinsic price of $35.86/share. The analysis then identifies TME as undervalued by the market, especially after the recent crash on the 24th and 25th of March.

But that’s not all! Continue reading the analysis to understand what are the risks of investing in this stock right now.

First, let’s see how Tencent Music and Entertainment Group can be categorised using Peter Lynch’s framework.

Peter Lynch company category

Following Peter Lynch’s guidelines, we can categorise TME as a Stalwart. The company can continue growing at a moderate to high rate, even if being a large firm.

4. Risks

Risk 1: Global Political Relations

China doesn’t have precisely the best relations with all the countries worldwide. In particular, the relationship with the US has been complicated by the Trump mandate. The new President of the United States, Joe Biden, is perceived as more peaceful towards the Celestial Kingdom.

However, Biden recently said to be “prepared to act and impose costs” over the Chinese government’s intervention on Hong Kong’s pro-democracy movement and Taiwan’s heightened intimidation.

The European Union is in the middle, mediating between the need for democracy worldwide and trade freedom.

It could be the European Union to help resolve the destructive conflicts between the US and China.

The error here could lay on the US imposing China tariffs and blocking the export of the oriental power, primarily directed to the States. That could lead the US in a prolonged and intense correction phase, together with the EU, both terribly hit from the perpetrating of COVID-19.

While the effects of these tensions shouldn’t affect TME’s business directly, international relations and some strategic partnerships could be hindered.

Moreover, there’s a slight risk that Tencent Music Entertainment Group could end up in between the political tensions, by receiving a “punishment delisting” from the US government, for the sole reason of being a Chinese business that seeks capital in the American Stock Market.

Risk 2: Chinese Government is going after Tech Companies

Tencent Music and Entertainment Group is part of that tech elite that the Communist Party sensibly targeted last month.

At the moment, the Government is said to be thinking about the possibility of setting up a state-owned company to oversee the giants of tech.

This news also caused a severe contraction in the price of TME between the 24th and 25th of March.

While this news primarily impacts other companies, TME can seem less damaged by a possible institution of that kind. It’s not sure at this time, which will be the outcome of these rumours and if the Chinese Government will implement a series of laws or restrictions to keep the tech sector under control.

Keep this into account and stay with ChineseAlpha for news on this!

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5. Conclusion and Investment Strategies

Tencent Music and Entertainment Group is overall a solid company, which can continue to grow in the future, depending on the outcome of investments in new products and services, such as the audiobook segment and WeSing.

The risks related to investing in this stock are mainly associated with the Chinese Government: its behaviour can influence TME’s international relations and Mainland China’s operativity.

We’ve seen that from the Discounted Cash Flow Analysis, the intrinsic value per diluted ADS of the company is $35.86.

Right now (Premarket of Friday, March 26th, 2021), the stock is priced between $18/share and $18.5/share.

We might see a possible contraction until the $17.90 area. If the price goes further down, the next critical level is around the $16.8 zone.

It’s not advised to go short to profit in the brief term: the presence of a possible dynamic support level constituted by the 200-period Moving Average could give power to bullish speculators, performing a bounce.

That is also the general outlook: oscillators are heading towards oversold levels, and the price action seems almost ready to give a bullish impulse.

Daily, 4Hourly and Hourly charts show the same story: a bullish signal will soon be spotted.

In conclusion, the company is overall exciting and is going to expand further in the following years. If the price gets out of this dull moment of dip, a buy around the $20/share could give enough safety on the uptrend.

At this point, the investor can hold the company in the long term (preferable) or sell across one of the critical levels around the $25-26/share.

The end of this year’s target is realistically set at $26.3/share, with a chance to see the price scale even further.


Disclaimer: Our content is intended to be used solely for informational and educational purposes, and not as investment advice. Always do your research and consider your personal circumstances before making investment decisions. ChineseAlpha is not liable for any losses that may arise from relying on information provided.


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