Description

Tencent Music is the Spotify of China, but Tencent Music now has a market cap of only $13 bn vs. Spotify at $44 bn.  Earlier in the year Tencent Music peaked at $60 bn vs. Spotify at $70 bn.  This is another way of saying, Tencent Music's stock price has obviously come down quite a lot. In a world where quite early stage companies without much monetization get multi-billion valuations, is $13 bn the right price for the Spotify of China?

Tencent Music was an Archegos name and, in China internet at least, Archegos seemed to have specifically gone after high short interest names that were generally regarded as, let's just say, "not so great" (e.g. VIPS, IQ, GSX, TME).  The shorts have been vindicated in that all of these have gone down in a straight line down and to the right ever since Archegos blew up in March.  TME I think is the best of the group.  I was very skeptical about TME at >$20 earlier in the year, and there are definitely higher quality businesses and management teams out there in China internet, but I think at some point it's just too cheap. 

TME is the dominant market share leader in music streaming, through two main apps: Kugou (targeted toward lower-tier cities) and QQ Music (targeted toward higher-tier cities & younger populations).  Because it is hard to monetize through music, TME for now primarily monetizes through live streaming, where pretty girls sing or dance to receive tips (TME takes 50%).  TME has two main live streaming platforms: WeSing (a karaoke app) and Kugou Live.  68% of TME's revenue comes from live streaming; 32% comes from online music services.  TME's live streaming business generates >100% of profits because online music is lossmaking.  Thus the headline P/E ratio is misleading because what is generating the current "E" is a low-quality and low-multiple business; we should look at it instead on a sum of the parts basis, with most of the value coming from streaming music.

China's music streaming industry evolved in a way that's almost completely opposite to the West.  In the West, streaming as a model came last, after physical discs, piracy, and paid downloads; whereas in China, free streaming was the dominant model since the beginning of the mobile internet era in the early 2010s.  So whereas Spotify and Apple Music are still penetrating more customers with streaming, in China it is kind of the reverse; streaming usage has already peaked and is coming down.  Framed another way, the streaming user experience in China started off perfect (everything free, everything available) and has only gotten worse over time, as more songs move behind the paywall and as ads are added.  As a result of this history, there's no longer any user growth in music streaming; growth from this area must have to come from converting free users to paid memberships.

TME was formed through a 2016 merger between Tencent's QQ Music (QQ Music and WeSing) and China Music Corp, which was itself an online music rollup comprising the Kugou and Kuwo platforms.  TME took a commanding share of the market through a strategy of over-paying for content.  The original founders of TME recognized early on that China's music market was shifting to an IP era, and as a result moved quickly locked up very expensive exclusive contracts with the big 4 labels that also gave them the exclusive right to sublicense the music.  TME passed along the sublicensing rights at the very high prices it paid for content, creating a formidable barrier to entry from just the scale needed to afford the IP rights.  Xiami (acquired by Alibaba in 2013) went out of business earlier this year because it couldn't afford the IP rights, and NetEase Cloud Music still operates at a negative gross margin for music.  Until recently, TME was also at a negative gross margin for music; its music gross margin has now turned positive but is still deeply in the red from an operating margin perspective.  Tencent owns 56% of TME and consolidates it.  James Mitchell of Tencent sits on the board of TME.

Today, China's online music market is effectively a duopoly between TME and NetEase Cloud Music.  In terms of MAUs, TME has 650 mm music streaming MAU vs. NetEase ~150 mm; in terms of paid subs, the gap is smaller i.e. 65 mm for TME vs. 25 mm for NetEase due to NetEase targeting a higher-end and younger customer base.  There are persistent rumors that Bytedance will enter the space, and it's looking increasingly likely that some sort of streaming app will come out within the next 4-6 months.  However, as we see in examples like Apple and Prime Music/YouTube Red vs. Spotify in the West, the barriers to entry and network effects are strong in streaming music, even after the ending of exclusivity in China by the regulator.  Bytedance will be able to grab some share but I think for the most part TME and Netease Cloud Music will maintain their leading positions and habitual user bases.  Bytedance likely intends to go after differentiated and niche market positioning through promoting Douyin artists rather than going for a full-spectrum music streaming replacement product.  

I value TME on a sum of the parts basis.  I think the live streaming business is worth $6 bn ($3 bn 2023 revenue (no growth vs. 2021) * 2x multiple; which implies assumptions of 25% OPM, 17% tax, and 10x P/E) and the music subscription business is worth $10 bn ($2 bn 2023 revenue * 5x multiple, given the still very low 16% paying ratio at YE23 vs. 11% currently).  That gets to $16 bn value ($10/share) vs. $13 bn market cap today before even considering various other meaningful but harder-to-value businesses like the advertising business, long-form audio business (which the company is investing heavily in now and which is causing temporarily compressing gross margins), and most importantly, upside optionality for long-term subscription paying ratio and ARPU assumptions. 

Catalyst

More time passes and we see how the ending of exclusivity makes less difference to NetEase Cloud's and Bytedance's music competitive positions vs. TME as the market seems to be pricing in via fear.  TME laps gross margin investments in long-form audio and hits to sublicensing revenue from the ending of exclusivity.