Tencent Music: Minor flaws but a sharp drop, was it wrongly killed?

After the Hong Kong stock market closed on August 13th Beijing time, Tencent Music (Tencent Music.US) released its financial report for the second quarter of 2024. The Q2 performance was actually good, with subscription business maintaining a high growth trend and the impact of social entertainment restructuring gradually easing. However, the latest expectations from top institutions were relatively optimistic (higher than the consensus expectations lagging behind BBG), with TME slightly missing on revenue due to more tightened cost expenditures, while profits were pulled back, thus basically meeting expectations.

Key Information Highlights:

1. Subscription Maintains High Growth: Membership subscriptions in the second quarter still saw a nearly 30% high growth, with a net increase of 3.5 million paying members. On one hand, the increase of 6.8 million in Q1 was stimulated by the Spring Festival promotion and not a normal growth situation; on the other hand, the average revenue per paying user (ARPPU) continued to slightly rise.

However, the expectations from top institutions were also relatively high, with subscription revenue growth expected to exceed 30%, mainly reflecting a gap in the expected number of paying members, as top institutions expect a net increase of 3.7 million.

2. Diminished Impact of Live Streaming: In the second quarter, social entertainment revenue mainly from live streaming and karaoke declined by 43% year-on-year, showing a slight slowdown compared to the previous quarter, which basically met expectations. Looking at a quarter-on-quarter basis, the off-season revenue was basically flat compared to the peak season of the first quarter, indicating that the impact of live streaming has likely bottomed out. Since the live streaming restructuring began in June last year, the base effect in the second half of the year will weaken, gradually leading to a clearer recovery and rebound in growth.

3. Continued Release of Advertising Inventory: Other online music businesses (licensing, digital albums, and advertising) also saw a 23% high growth, mainly being driven by the enrichment of advertising formats and the release of more inventory. We also expect good growth in digital albums, as Tencent Music has further integrated with WeChat at the beginning of the year, adding a music tab to promote advantages in music (corresponding to digital album sales) and free users (corresponding to advertising revenue).

4. Decline in Ecological Traffic: Monthly active users of online music continued to decline in the off-season of the second quarter, in line with expectations. Combining third-party data, some non-essential music users have shifted to other entertainment platforms, such as short videos, while others may have switched to soda music. Since the second quarter, soda music has shown strong promotional momentum, with short-term download volumes surpassing other online music platforms, sparking market concerns.

However, looking at monthly active users, the increase in soda music downloads did not lead to a significant rise in MAU, indicating that user mindset and usage stickiness are still relatively early stage. Currently, the gap in MAU between soda music and Tencent Music is significant, even less than one-third of that of Cloud Music, so the competitive threat in the short to medium term is not significant yet

5. Continued strict cost control: Despite missing revenue, Tencent Music's profit still meets the expectations of major banks, mainly due to the strict control of operating expenses by Tencent Music. The total sales + management expenses continued to decline by 8.5% year-on-year. In addition, costs were slightly lower than expected by institutions, still experiencing a double-digit decline.

The operating profit of the core main business (excluding non-operating related income and expenses) was 1.86 billion, maintaining a high growth of 50%, with a profit margin of 26%, a 2 percentage point increase compared to the previous period, and a 9 percentage point increase year-on-year.

The substantial profit elasticity brought by deleveraging is another reason why Dolphin Jun is optimistic about Tencent Music. This essentially reflects the advantages Tencent Music has in the industry chain and in the same industry, as well as the benign internal ecosystem of the Tencent system, collectively improving the overall group efficiency.

6. Dividends distributed, buybacks suspended: The company did not repurchase in the second quarter (non-stable repurchase, operating according to market value fluctuations), and the dividends announced in the previous quarter for 2023 have been fully distributed. Although Tencent Music has a lot of cash (350 billion RMB as of the end of Q2, equivalent to 48 billion USD), the overall dividend rate of 1.5% from buybacks + dividends is not high. This financial report did not mention more actions to reward shareholders, which may also disappoint some investors.

7. Detailed financial data overview

Dolphin's Viewpoint

Although the revenue missed the optimistic expectations of top institutions, the market's negative reaction to Tencent Music's second-quarter report (pre-market plunge of more than 10%) still has a bit of a "borrowing" momentum to kill valuation. After all, compared to other Chinese concept stocks, Tencent Music's valuation is relatively high, implying higher performance and shareholder return requirements from investors.

Last Quarter Review , while Dolphin Jun acknowledges the fundamentals, he also emphasizes the issue of full valuation (close to the valuation under relatively optimistic expectations), therefore suggesting to pay attention to marginal risks. After this period of adjustment, although Tencent Music has made some adjustments, it closed at 22.5 billion USD yesterday, corresponding to 17 times adjusted net profit for 25 years, still higher than the group Tencent.

However, Dolphin Jun believes that the fundamentals of Tencent Music are still solid. Setting aside the special status of "Chinese concept stocks," a valuation of 17 times corresponds to a CAGR profit growth rate of 15%-20% in the next three years, which is within a reasonable range. However, compared to the market's perennially popular Netflix, Spotify, and other streaming platforms with valuations often reaching 30x~40x, it is clear that there is no valuation bubble that needs to be burst.As for the market's concerns about the competition between QQ Music and Kuwo Music, Dolphin believes that there is no need to panic in the short to medium term. Currently, the user base of the two platforms is not on the same scale, so it is premature to discuss the threat of competition. What needs to be observed is whether macro pressures will affect the logic of "penetration of paid services + price increase," thus potentially slowing down the growth of subscription revenue. This will depend on the management's statements and outlook during the conference call.

Detailed Analysis Below

I. Decline in Ecological Traffic Continues in Off-Peak Season, Premature Concerns about Competition Threat

In the second quarter, Tencent Music's online music monthly active users dropped to 571 million, with a loss of 7 million users compared to the previous period. The impact of live streaming rectification has further eased, and the monthly active users in social entertainment decreased by 2 million compared to the previous period. Although it is the off-peak season, the net loss rate has slowed down compared to the first quarter.

Recently, the market may have some concerns about the trends reflected in third-party data. Compared horizontally with competitors, the trends of Cloud Music and Tencent Music are similar, but Kuwo Music's download volume has seen a rapid increase in the short term. However, from the perspective of monthly active users, the increase in Kuwo Music's download volume has not led to a significant rise in MAU, indicating that user mindset and stickiness are still in the early stages. Currently, Kuwo Music lags far behind Tencent Music in terms of MAU, even less than one-third of Cloud Music, so the threat of competition in the short to medium term is not significant.

Of course, it is necessary to continue monitoring competitors in the future, especially ByteDance's actions, to see if Kuwo Music will take further measures such as diverting traffic from Douyin and increasing investment in copyrights. Due to recent pressure on NetEase's gaming sector, there is internal motivation for cost reduction and efficiency improvement within the group, so in the short term, Cloud Music may be more inclined to maintain the status quo.

II. The Impact of Live Streaming Adjustment Has Bottomed Out

In the second quarter, social entertainment revenue continued to decline by 42% year-on-year, but the rate of decline compared to the previous quarter has slowed down, which is in line with market expectations. However, looking at it from a quarter-on-quarter perspective, off-peak season revenue is basically flat compared to the peak season in the first quarter, which to some extent indicates that the impact of live streaming has bottomed out. Since the live streaming rectification began in June last year, the base effect in the second half of the year will weaken, and clearer signs of recovery and improvement in growth rate will gradually be seen.

Analyzing the changes in volume and price relationship: In the second quarter, which is the off-peak season, the net loss of paid users was 100,000, which is a normal trend. The year-on-year decline in average revenue per paid user is 46%, mainly reflecting the impact of the rectification.

III. Price increase followed by promotions, stimulating a record high in net increase of paid users

Due to the pressure of social entertainment, despite the unfavorable macro environment, Tencent Music still needs to continue promoting its paywall strategy to unleash the growth potential of digital music payments in advance.

Meanwhile, other online music revenues are mainly driven by advertising business, including some splash screen ads, fixed layout ads, free member ads on the app, as well as sponsorship revenue from hosting annual music events.

Ultimately, online music revenue increased by 27.7% year-on-year, with a slight slowdown on a quarter-on-quarter basis. Market expectations are high, which may trigger some concerns among investors about the sustainability of high growth.

Further breakdown reveals:

1) Subscription revenue increased by nearly 30% year-on-year, with a slight slowdown on a quarter-on-quarter basis. The growth rates of paid users (+18% yoy) and average payment per user (+10% yoy) both slowed down slightly. By the end of the second quarter, the music subscription penetration rate reached 20.5%, an increase of 1 percentage point compared to the first quarter. The company's medium to long-term goal is to reach the level of long videos, which is 25% to 30%.

After the strong user growth driven by the Spring Festival promotion at the beginning of the year, the user growth in the second quarter may be somewhat affected, coupled with the off-season nature, resulting in a net increase of 3.5 million users, a significant slowdown compared to the first quarter. However, market expectations are slightly higher, which also led to a slight miss in subscription revenue.

2) Other online music services, including revenue from digital copyright sales, advertising, etc., saw a slowdown in revenue growth to 23% in the second quarter due to the release of advertising inventory in a high base period.

IV. Continued strict control over costs and expenses

Costs in the second quarter decreased by 13% year-on-year, with no significant slowdown in the contraction. Apart from the reduction in live broadcast business and the corresponding decrease in tipping commissions, estimated by Dolphin Jun, there may not have been an increase in copyright costs. Ultimately, the gross profit margin saw a slight decrease year-on-year in total revenue, but increased by 2 percentage points quarter-on-quarter to reach 42%, surpassing the company's original medium to long-term target level of 40%.

Sales and administrative expenses in the second quarter are still contracting. Among them, administrative expenses have decreased significantly, mainly due to layoffs. Sales expenses are more about the company actively maintaining a high ROI customer acquisition method. However, the optimization of sales expenses is nearing completion, dropping from a peak of 600-700 million to the current over 200 million, which is already very stringent.

The operating profit of the main business reached 1.86 billion, with a direct increase in profit margin by 2 percentage points to 26% compared to the previous period.

Excluding the impact of amortization of intangible assets generated from acquisitions, equity incentives, and non-operating investment income, Tencent Music achieved a Non-IFRS net profit of 1.985 billion in the first quarter, a year-on-year increase of 27.7%. The difference between the growth rate of operating profit of the main business (+26% yoy) and the net profit is mainly due to the fluctuation of SBC.