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Tencent Music Entertainment: A cheap Chinese company

The stock price of Tencent Music Entertainment has dropped approximately 86 % from its all-time high. However, the company is still profitable and some of their business segments are still growing year over year. In this analysis I will investigate the company and decide whether it is time to invest in the company.

This is not a financial advice. I am not a financial advisor and I only do these post in order to do my own analysis and elaborate about my decisions, especially for my copiers and followers. If you consider investing in any of the ideas I present, you should do your own research or contact a professional financial advisor, as all investing comes with a risk of losing money. You are also more than welcome to copy me.

This analysis will be a bit different from what you are used to read in my blog. Tencent Music Entertainment did their IPO in December 2018, meaning I don't have access to the historical numbers dating back longer than that. So instead of using the principles I have learned from my Phil Town workshop, I use the principles I have learned from the GOAT academy. I should also mention that most of the numbers I use in this analysis is from Finbox, which I believe is a great tool to easily get the numbers you need from various companies.

Before I start with the analysis, I should mention that I do not currently own shares in Tencent Music Entertainment. I do however own shares in Tencent (both Tencent and through Prosus) that owns 51 of Tencent Music Entertainment. If you would like to see or copy my portfolio, you can read how to access it here. In the rest of the analysis, I will refer to Tencent Music Entertainment by using their ticker TME.

TME is often described as the Chinese Spotify. And while TME owns shares in Spotify and Spotify owns shares in TME, you cannot compare the two businesses one to one. TME is an online entertainment platform, and besides online music streaming, they also offer online karaoke, live streaming, and online concerts. Meaning, it is more like a social network, where they have other forms for revenue other than subscriptions, such as advertising, value added services (e.g., games) etc. They have several apps and the most well-known are KuGou Music, QQ Music, Kuwo Player and WeSing. They are by far the largest online music and audio entertainment platform in China, with 790 million users and a market share of 78 % according to Statista. I believe it is safe to say that once a company has a market share of nearly 80%, they have a strong brand moat. TME also owns shares in Warner Music and Universal Music Group, and they own shares in TME.

Their CEO is Zhu Liang. He became the CEO in April 2021. He has vast experience from Tencent, where he has held several positions since joining Tencent in 2003. Prior to joining Tencent he worked for Huawei. He has a doctor's degree in signal and information processing from Tianjin University. We don't have much information on Zhu Liang, and since he has only been the CEO for one year, we cannot really interpret something from the results of TME. However, he was chosen because he has a proven track record from Tencent in building successful online entertainment platform and social ecosystems and is known for delivering strong results through expansions into new business areas. One thing that makes me rather confident in Zhu Liang is that he comes from inside the organization and has been part of the organization for many years. Hence, I believe that he has worked his way up to deserve an opportunity like this. Luckily, he also gets the support from the former CEO Cussion Kar Shun Pang, who is now the Chairman of the board. Nevertheless, as the management is so new, it is still an unknown.

I believe that TME has a strong brand moat based on their market share. However, we still have a lot of unknowns when it comes to management. Later I will do a discounted cash flow model to calculate a price for TME but before I do so, let us just have a look at some key financial metrics.

Down below we see some key financial metrics TME over the last three years. The first thing that we see is that revenue is growing year over year, which is a good thing. However, when we look further into the numbers, we see that the gross profit margin is decreasing. It looks even worse for the operating margin, which is decreasing even more. This hurts profitability. which is not something you would like to see in a business. Later in this analysis will look deeper into the decreasing margins, as we will need to understand the decrease and if it means that the business is getting worse or if there is another reason for it. At first glance the numbers are fine, but the decreasing margins are worrisome but still not alarming. I know we cannot compare the businesses one to one but for comparison, I can mention that Spotify's margins last year were 26,8 % gross profit margin and operating margin was 3,2 %.

Before we continue to the discounted cashflow model, I would like to investigate the risks and potential of TME. One risk was mentioned in the paragraph above and that is the decreasing margins. The reason for decreasing margins is that lower margin businesses such as online music, is contributing more to the revenue. Social entertainment, which is a higher margin business contributed less to the revenue. According to management it was mainly due to competition and macroeconomic environment (we also saw how Tencent's advertisement business took a hit in 2021). Management guided for margins to be stable in 2022 compared to 2021 and increasing from 2023 and onwards. They also believe that the drop in advertising revenue is short-term headwinds and have "ample long-term growth potential". Another risk is competition. Their competitors are strong companies that all want a share of the pie. We already know that competition did hurt margins in 2021, and with companies such as NetEase, Baidu, Xiaomi and China Mobile all competing for customers, TME needs to continue to develop their business. Chinese regulations are another risk. In 2021 Chinese regulators eliminated the exclusive rights for TME, which greatly benefitted their competition and hurt TME. Chinese regulators have also announced that there will be regulations on streaming and value-added services. While it seems like regulations are not coming in the same pace as in 2021, it isn't over yet. Delisting from the US stock exchange. Right now, TME is only listed in the United States. However, they have applied for a direct listing in Hong Kong, and are expected to be listed on the Hong Kong stock exchange within long, without dilution of the shares. Nevertheless, delisting from the US stock exchange will fuel the negative sentiment towards Chinese companies. The Holding Foreign Companies Accountable Act means that US listed Chinese companies need to allow the SEC to inspect their audit papers. It is illegal in China for companies to share their audit papers, meaning that no Chinese company, including TME can comply. While it looks like the SEC and CSRC are working on a solution, we don't know if they will manage to come up with one. Once a company is identified for not complying to the Holding Foreign Companies Accountable Act, they have a grace period of three years to comply. However, the America Competes Act will reduce this grace period to two years. The America Competes Act already passed the House and will probably also pass the Senate. While I don't think Chinese companies will get delisted, it is a risk, and something you need to be aware of if investing in Chinese companies.

There are also potential for TME moving forward. One of them is getting more paid subscriptions. Paid subscriptions have grown from 6,2 % in Q4 2019 to 12,4 % in Q4 2021. Nevertheless, 12,4 % paid subscriptions are still a very low number and give TME a large growth opportunity. And it is something that they are focusing on. One way they want to do it is to make it possible for non-paying subscribers to watch an ad for 30-60 seconds, and it will make it possible to unlock 30-60 minutes subscription service. It will not only generate advertising revenue but increase the conversion for free subscribers to become paid subscribers. International expansion. TME has recently bought M&E Mobile Limited that operates the leading karaoke app in Japan. And according to management they are constantly on the lookout on attractive M&A opportunities. TME has plenty of cash of acquisitions like these will diversify their business. The Metaverse. TME launched TMELAND, which is China's first virtual music festival. Management believe that it fits right in at the Metaverse, as an artist can perform through an avatar. They also see other possibilities in the Metaverse, like an online karaoke room, where users can interact with each other in a virtual setting, and single rooms where users can put one's own music, which can be used like a virtual showroom. TME seems cheap. TME is currently trading below their book value per share of $4,68. Meaning that if TME liquidated all their assets, you would be in profit if you bought their shares now.

I have now investigated the financials, risks, and potential of TME. I will now look at the price by doing a discounted cash flow model. To do so I will need some numbers that you can see below. The numbers are the 2021 numbers, which I could find at Finbox. However, the perpetuity growth rate and the discount rate are numbers I have come up with myself. The reason I chose 5 % as perpetuity growth rate is that it is usually a between the historical inflation rate of 2-3% and historical GDP growth of 4-5%. I decided to go with a higher option of 5%. The chosen discount rate of 12% is because it is usually between 9-12%. I decided to go with the highest one because of the current market conditions. Remember that all the numbers made in these calculations are in millions.

I also need to determine how much EBIT, Depreciation & Amortization and Net Working Capital will evolve over the next couple of years. I decided to use an EBIT growth of 16 % year over year. It is what the analysist at Finbox believes, and I think it is realistic as it is quite conservative. I calculated with a growth in Depreciation & Amortization of 10 % a year. It is lower than the last five years median of 29,6 % but a number I feel comfortable with. Finally, I decided to keep the Net Working Capital at the 2021 numbers at -628 as it is higher than usual. I haven't found a smart way to share all my spreadsheet here but once I did my calculations, I found that the intrinsic value of TME to be $7,6.

Having investigated TME, I find the company interesting. They are a company with a huge moat, and like with other Chinese companies, they have been hit by the negative sentiment that has made all Chinese companies to drop. There are some worries as we don't have much information about the management, and the decreasing margins. Management believe that the margins will improve in 2023 and onwards, which is reassuring but not certain. Furthermore, we might see more regulations in China that will hit a company like TME. However, I think they have potential to grow, especially in online music, where only 12,4 % of their customers have paid subscriptions. It also seems like the management has a plan for the Metaverse, so if you believe it will be huge, I think that TME is a solid bet. As long as TME is trading below their book value per share of $4,68, I believe it is a solid investment. I'm still not sure if I will add the company to my portfolio or not, as I already have a quite large exposure towards China.

My personal goal with investing is financial freedom. It also means that to obtain that, I do different things to build my wealth. If you have some extra hours to spare each month, you can turn a few hours a week into a substantial amount of money in a few years. If you are interested to know how I do it, you can read this post.

I hope that you enjoyed my analysis. Unfortunately, I cannot do a post of all the companies I analyze. I am available to copy but if you do your own trades, you can follow me on Twitter instead, as I tweet when I buy or sell anything.

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