Tencent Music Entertainment: China's largest music streaming company.
Opdateret: 13. maj
China's music streaming market is projected to reach $3,18 billion in 2023 and is projected to grow by a compounded annual growth rate of 5,75 % until 2027. These numbers are conservative compared to the $10,2 billion music streaming market in the United States. If you believe that the music streaming market in China will grow faster than the projections, it could be an interesting market to get exposure to. Especially because Tencent Music Entertainment is a clear market leader. In this analysis, I will investigate if now is the time to buy Tencent Music Entertainment.
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 previously owned shares in Tencent Music Entertainment that I bought at $3,98 and sold at $8,06. Currently, I 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 567 million users and a market share of 60 % according to Statista. I believe it is safe to say that once a company has a market share of 60%, 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 decreased in 2022, which was the first time in the last five years. Gross profit margin, operating margins, EBITDA margin, and EBIT margin all grew from 2021 to 2022. However, margins are still lower than in 2020. The higher margins resulted in TME generating a higher net income in 2022 compared to 2021, despite the lower revenue. EPS was also higher in 2022 compared to 2021. Thus, TME was more profitable in 2022 compared to 2021 despite the lower revenue. Nonetheless, the numbers from 2022 are still lower in what TME delivered in 2020, which is something that you would like to see improving. It isn't necessarily alarming though. If you compare TME to other streaming services such as Spotify, TME is at least profitable, which Spotify is not. Furthermore, gross profit margin is also higher for TME at 31,0 % compared to Spotify's gross profit margin at 25,0 %.
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. Margins did improve in 2022 and management has previously guided that margins will increase in 2023 and onwards due to the "ample long-term growth potential" in online advertising. It seems like they are on the right track as gross profit margin in Q4 2022 reached 33,0 %. However, it is still far below the gross profit margin in 2018, which was 38,3 %. 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 2022, 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. While it seems like that regulations in China aren't coming at the same time as previously, it is still something that one should monitor moving forward. Delisting from the US stock exchange. TME listed on the Hong Kong stock exchange in 2022. Nevertheless, delisting from the US stock exchange will fuel the negative sentiment towards Chinese companies. The Holding Foreign Companies Accountable Act is still an issue as I write this, but we have seen improvements in the relationship between PCAOB and CSRC, as PCAOB could do audit inspections in Hong Kong. However, until the audit issues are sorted, it will be something that could affect the stock price of TME.
There are also potential for TME moving forward. One of them is getting more paid subscriptions. Paid subscriptions have grown from 6,2 % (39,9 million) in by the end of 2019 to 15,6 % (88,5 million) by the end of 2022. Nevertheless, 15,6 % 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 sees international expansion as strong growth and monetization potential and will continue to extend their international footprint for long-term growth. TME has made several international acquisitions. 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. Advertising. Management also sees advertising as a strong growth factor. Advertising has been hurt during Covid lockdowns, and management has mentioned that advertising revenues are recovering at a healthy pace and expects their advertising business will show growth post Covid. Advertising is a high margin business, and advertising growth should result in higher profitability. 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.
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 2022 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 3 % 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 an option in the middle at 3%. 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 19 % year over year. It is what the analysist at Finbox estimates, and I think it is realistic as it is quite conservative. I calculated with a growth in Depreciation & Amortization of 15 % a year. It is lower than the last five years median of 19,7 % but a number I feel comfortable with. Finally, I decided that Net Working Capital will decrease by 6 % a year in the next five years. 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 $10,0.
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. I believe that Tencent Music Entertainment is an interesting investment, if you can get the shares at $5, which is a 50 % discount on intrinsic value.
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