China’s leading online music service provider’s profit grew 38.7% in the third-quarter

Key Takeaways:

  • Tencent Music’s net profit jumped by 38.7% in the third quarter to over 1 billion yuan as its paying user base rose nearly 20%
  • The company has lowered its reliance on advertisements and other services by boosting its subscription services to give it a more balanced revenue mix

By Ken Lo

After a turbulent period, China’s equivalent of Spotify is finally singing a a business model that looks like music to investor ears.

At first glance, Tencent Music Entertainment Group’s (TME.US; 1698.HK) latest quarterly earnings report looks a tad worrisome. That’s because its revenue fell 5.6% to 7.37 billion yuan ($1.03 billion) in the third quarter, mainly as a result of a 20% decline to 3.94 billion yuan for its mainstay income from social entertainment and other services. But a closer look showed that more users are realizing that good music comes at a cost, leading to a 19.8% rise in its paying music customer to 85.3 million and similar 18.3% growth in music subscription revenue to 2.25 billion yuan. That means subscription revenue now accounts for two-thirds of the company’s total from online music services.

As its paid music business grew, Tencent Music reported a non-IFRS adjusted net profit and net profit of 1.41 billion yuan and 1.06 billion yuan, up 32.7% and 38.7%, respectively, exceeding market expectations.

A BofA Securities report said the company’s profit is poised to grow further still as it enters into profit-sharing agreements with more small and medium sized music companies, lowers fixed costs with leading music companies and realizes more balanced growth. With that kind of strong outlook, the bank gave Tencent Music an “overweight” rating with a target price of $8.30 for its New York-listed shares.

Investors welcomed the upbeat report, with Tencent Music’s shares soaring 30.6% in New York to $5.81 after its latest results were published last week. Its Hong Kong-listed shares rose nearly 29% the next day, reaching a record high of HK$23.30 at one point. But the good news was muted by the subsequent announcement that Tencent Music’s parent, Tencent (700.HK), would distribute most of its stake in takeout dining internet giant Meituan (3690.HK) as a special dividend to its shareholders, leading to market worries it might make a similar reduction of its holdings of Tencent Music. As a result, Tencent Music’s New York shares fell by 9.3% in New York the day after the big rally.

Safe at home

The saying goes that “music has no boundaries,” and competition is stiff in the global music streaming business. But Tencent Music has an advantage over its global rivals by doing most of its business in its home China market, where big names like Apple Music, Amazon Music and YouTube Music have little or no presence. As a result, most of the big global names are facing tough times earning profits, including leading livestreaming platform Spotify Technology (SPOT.US), which has reported losses for the past three years. By contrast, Tencent Music has been profitable by becoming the leading player in its home China market, where a growing percentage of its users are willing to pay for its online music services. That’s helping the company to lower its previous heavy reliance on advertising and other revenue, which investors have welcomed.

Tencent Music’s latest financials also show that its gross profit grew by 4.1% year-on-year during the third quarter to 2.4 billion yuan, and its gross margin rose by three percentage points to 32.6%, well ahead of 24.7% for Spotify. The company ascribed its improved gross margin to effective content cost controls, including revenue-sharing costs for its livestreaming business, higher operational cost efficiency as well as rising revenue from digital album sales.

Comparing the company’s third-quarter results for this year with 2019, the year before the Covid-19 pandemic, highlights changes in the company’s business structure. Its music subscription revenue in this year’s third quarter totaled 2.25 billion yuan, more than double the same quarter three years ago. Meanwhile, its revenue from social entertainment and other services dropped by 15.5% over the same period, with the result that the company’s total revenue grew just 13.2% over that period.

The shifting business mix comes a year after Tencent Music was fined a relatively light 500,000 yuan for monopolistic practices that saw it sign master licensing deals for China with many major global music labels, making it the gatekeeper for all of their music in the market. Following the fine, the company has dropped all of those deals and has to compete more directly with its domestic peers, though it has relieved itself of the big costs of the master licensing agreements.

Raising prices

Tencent Music CFO Hu Min said at the results briefing that the company’s average revenue per user (ARPU) rose from 8.5 yuan in the second quarter to 8.8 yuan in the third, and the figure was expected to increase further in the fourth quarter as the company hones its pricing strategies. She added her belief that the company’s gross margin for its online music business would also rise as its subscription revenue grows and cost-cutting efforts continue to bear fruit.

Live-streaming music platforms used to depend heavily on advertising, encouraging them to expand their user bases to please advertisers. But high costs kept many from earnings profits. To move closer to profits, many global music companies are now scaling up their user subscription services and increasing prices in the hope of bringing about a more sustainable and profitable revenue structure. While it’s already profitable and doesn’t compete with the global companies, Tencent Music is also part of that wave in an increasingly competitive China music landscape.

In January, the French livestreaming music platform Deezer (DEEZR.PA) ramped up prices in its local market. Apple Music, the most expensive service provider in the industry, increased the monthly charge for its family plan to $16.99. And Amazon Music hiked the price to $15.99, remaining $1 cheaper than its top competitor Apple Music.

Most of Tencent Music’s global peers are owned by global tech giants, leaving Spotify and Deezer as the only two independent companies for direct comparisons in terms of valuation. The pair have price-to-sales (P/S) ratios of 1.38 times and 0.95 times, respectively, which is lower than Tencent Music’s 1.76 times. But that’s probably because Tencent Music is the only one in the group that’s profitable due to its dominance in a lucrative China market that’s also relatively closed to the big global operators.

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