Tencent Music: Can Big Musical Dreams be Achieved by "Cutting Corners" Without Growth?

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After the Hong Kong stock market closed on March 21st Beijing time, Tencent Music.US announced its fourth quarter results for 2022.

Overall, this performance basically met market expectations and continued the performance of the previous three quarters: the optimization of the profit side was more active because the cost reduction and efficiency improvement measures continued to be implemented. Except for the continuous optimization of copyright costs, the relatively restrained customer acquisition and promotion expenses have further tightened.

Regarding the issue of short video competition that the market is more concerned about, from the perspective of user indicators, the negative impact faced by social entertainment businesses is still continuing. However, the company's strategy this year is mainly focused on tapping the value of existing users, so it is different from the accelerated deterioration of revenue of traditional live broadcast platforms (such as Douyu and Huya). In the fourth quarter, under the circumstances where the pandemic has affected the activity of live broadcasters, the decline in Tencent Music's social and entertainment revenue has showed a trend of slowing down on a month-on-month basis.

It is hoped that the impact of short video competition on Tencent Music's performance can pass the peak this year, and continue to slow down until it stabilizes, no longer significantly dragging down overall performance. In the medium and long term, the intrinsic value of the huge music library can be further reflected in member subscriptions. The company expects that the single-quarter revenue of online music will exceed that of social entertainment in 2023.

The core information of the financial report is as follows:

The overall tone of the year is to focus on "efficiency": Looking back at the whole of 2022, Tencent Music has been on the road of reducing expenses. The magnitude of the year-on-year reduction in marketing expenses is basically around 60%. By the fourth quarter, the increase in management expenses has also significantly decreased. The adjustments reflect the company's strategic thinking: reducing customer acquisition expenses and focusing on the conversion of the value of existing users (paying value, advertising value). In addition, the cost of copyright has optimization space due to industry changes.

Finally, the operating profit margin of the core main business in the fourth quarter increased to 14.6%, basically returning to the level before the epidemic. However, it must be admitted that although the profitability has recovered, the growth logic behind is broken, and more in the future will be a small and beautiful existing ecology.

Competitive pressure still exists, and performance after strategic adjustments slows down: In the fourth quarter, both user indicators were lower than market expectations. Active users are still being lost, but the number of paid users for both businesses is basically stable.

Especially for the paid users of social entertainment, although the impact of the epidemic on the activity of live broadcasters in the industry is still there, the company's operating concept has shifted to serving existing users, and the K-song penetration rate has increased, expanding the overall user base of social entertainment.

Although the turning point in competition has not yet been reached, the strategic adjustment of mining the value of core users can still help Tencent Music survive this period of macro and competition double pressure. At least compared with competitors in the industry such as traditional live broadcast and K-song platforms, Tencent Music is the least injured.

Online music continues to play a stable role: In the fourth quarter, Tencent Music's total revenue was RMB 7.425 billion, a year-on-year decrease of 2.4%. The negative impact continued to slow down compared with the third quarter, and the drag was still the live broadcast K-song business. The online music business composed of member subscriptions, digital albums, ads, etc. continued to play a stable role. In the fourth quarter, the net increase of members was 3.2 million, basically in line with the guidance of the management. In the fourth quarter, the income gap between online music and social entertainment further narrowed to 300 million, and the company expects online music to officially surpass social entertainment this year.

As a former performance pillar, social entertainment has been languishing for more than a year due to competition, regulation, and other factors. Although online music (including advertising-free listening and ad revenue) has taken a big step forward, social entertainment still accounts for a significant proportion in current valuations, so when the impact of short video competition can stabilize remains the key.

First-class earning power and rich pockets: As of the end of the fourth quarter, the company's cash and cash equivalents balance was RMB 27.4 billion, accounting for 30% of the total market value. After a quarter of valuation repair, the current cash proportion has decreased much compared to the last quarter when the financial report was released. Currently, Tencent Music earns more than RMB 1 billion per quarter and manages operating cash inflows of RMB 2.4 billion, and its reserves of cash and equivalents are growing. In a low environment, a rich pocket is also the bottom line for Tencent Music to continue to invest in new businesses in the future.
New repurchase plan: After completing the USD 1 billion repurchase announced in March 2021, the company added a new USD 500 million repurchase plan for the next two years in March of this year.

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Changqiao Dolphin Jun's Perspective

Although the performance in the fourth quarter did not exceed expectations, it basically followed the improvement path that the market hoped to see. Judging from the user indicators, the impact of competition has not yet reached a turning point. However, compared with peers, the management's adjustment of strategy and deeper value mining of existing users have helped it withstand some of the impact of the broader market environment. At the same time, it also indirectly shows that there is still room for further monetization of the traffic foundation.

In the short term, this operating strategy can continue to achieve relatively good results under the improvement of the macro environment, such as the growth of member payments, advertising, and digital album revenue, which partially offset the sustained impact of competition on social entertainment businesses. However, the market also hopes to see a clear signal of a stable traffic foundation.

In terms of cost reduction and efficiency improvement, Tencent Music executed it thoroughly last year, and the operating profit margin of its core main business has almost returned to the pre-epidemic level of 15%. Dolphin Jun estimated that there may still be some space this year, but it is not significant.

From a valuation perspective, Dolphin Jun has also conducted a simple analysis in a previous summary. We believe that current Tencent Music is not expensive but not cheap from a medium-term relatively ideal perspective. With an online music subscription income of RMB 12 billion, membership distribution and advertising income that can reach half the revenue scale, social entertainment income of RMB 14 billion that can stabilize competition impact, and a 20% after-tax operating profit margin, 15x PE corresponds to a valuation of USD 13-14 billion, although there is still RMB 4 billion in cash, it is similar to the present market value after discounting. Q3 Financial Report Review: Tencent Music Recovery on the Road, but User Base Declining

In the previous quarter's financial report, we said that Tencent Music had "passed the most difficult period". This quarter, Tencent Music has "firmly embarked on the road to recovery". However, market expectations are already quite sufficient. If we expect valuation space to further open up, we need to see more growth to step out of scale, apart from seeing the social and entertainment business stabilize.

Interpretation of Q3 Financial Report:

I. The shrinking of the user base has not yet stabilized.

In the fourth quarter, the user end still reflects the current situation of a peak in the stock, and the continued loss of competition. The average monthly active online music user has continued to fall to 567 million, a decrease of 20 million compared to the previous quarter. The monthly activity of social and entertainment is also continuing to decrease, with only 146 million active users remaining, continuing to hit new lows.

The continued loss of users reflects that the turning point of the competition stabilization has not yet arrived. The "watch ads and listen to music" function has only brought about the value realization of stock traffic, but it has not helped Tencent Music to obtain more traffic from outside the platform.

Online music continues to implement a paywall strategy. In the fourth quarter, the net increase of paid subscribers increased by 3.2 million compared to the previous quarter, and the overall number of paid subscribers was 88.5 million, which is basically in line with guidelines and expectations. The payment rate has already exceeded 15%. The management has given a long-term guidance target to look at long videos (20%-25%). However, Dolphin believes that the improvement of the payment rate will also face the loss of users. Therefore, the space for improvement is not as large as imagined when looking at the absolute scale of paid users.

The payment users of social and entertainment are more affected by macro and competition factors, but the company continues to improve services around stock users to increase penetration rates, thereby expanding the paid user base. The addition of 200,000 active users in the fourth quarter was significantly better than market expectations.

User loss in social and entertainment is the result of competition from other pan-entertainment platforms like short videos, which the company is basically unable to resist. With more songs being included in the paywall, "non-loyal users" who are sensitive to prices will continue to leave. The management team can also foresee this result, but the company's strategic focus this year is to improve services around "loyal users", explore more paid points, and help optimize the overall profitability.

Following this operational thinking, we can understand the trend of the continuous improvement in ARPPU of subscription users in the online music business. The ARPPU of subscription members in the fourth quarter continued to increase to 8.9 yuan compared to the previous quarter, but the ARPPU of other online music has also increased year-on-year, mainly because the company was responsible for the digital album release of some headlined singers. The single user ARPPU for social entertainment in the fourth quarter drops to RMB 169.6/month. The main reason is that the KTV business, with its relatively low payment amount, brings down the overall single person payment level for social entertainment services, even though the user payment penetration rate is increasing after the launch of some features and services. According to Dolphin Jun's estimate, Tencent Music's direct broadcast ARPPU can reach 200-300 yuan on average, but the KTV business may only be at the level of 40-50 yuan.

In addition, the total revenue in the fourth quarter further rebounded to RMB 7.43 billion, a year-on-year decrease of 2.4%, and the degree of decline continues to slow down, which is basically in line with market expectations. Except for the stable subscription revenue growth between 15% and 20%, the company also achieved considerable profit by working with top singers to create albums.

Although social entertainment still contributes to more than half of the revenue, in a year with improvements in macro, regulatory and other big environments, when the competition in short video will stabilize has become the only focus of attention.

More specifically:

Online music revenue was RMB 3.56 billion, a year-on-year increase of 23.6%, including RMB 2.36 billion in subscription member revenue and RMB 1.2 billion in other online music revenue (QQ Music advertising, digital album sales, copyright distribution, etc.).

The (2) revenue from other online music businesses has been experiencing headwinds to varying degrees since the third quarter of last year, including rectification of app splash screen advertising, regulation of fan culture (setting limits on the number of albums that can be purchased by fans, reducing chart-topping behaviour), and the impact of unbundling exclusive copyrights on copyright distribution, resulting in a low base in the previous year.

The third quarter of last year included revenue from the sale of Jay Chou's new album, and the fourth quarter continued to focus on digital albums. This year, in addition to digital albums, advertising also has the elasticity to recover due to the improvement of the macro environment.

As this business does not have detailed breakdown disclosure, to judge the growth of advertising revenue, Dolphin roughly separated out the advertising scale. Although the numerical value is not accurate, we can simply look at the trend.

We expect that advertising revenue will account for about 8% of total revenue in the fourth quarter (not an exact value, for reference only). Due to the epidemic in the fourth quarter, there will be short-term disturbances in the entire advertising industry repair. In the long run, there is still a lot of room for growth in the current advertising revenue scale compared with the company's target.

2. Single-season revenue for social entertainment continued to reach a new three-year low, reaching 3.87 billion yuan, down 18% year-on-year under the lower base. This business is directly influenced by short videos, especially live broadcasting, and has almost no defence against external attacks. The only way to reduce direct traffic loss is through the internal circulation of the company's ecosystem.

Three, cost cutting and efficiency increasing measures are the main theme for the whole year

In the fourth quarter, actions were taken to continue to improve operating efficiency. In addition to the sales expenses (customer acquisition and promotion expenses) continuing to accelerate to 270 million yuan, there was also significant control over administrative expenses this quarter, with a year-on-year increase of only 2.6%. In addition, there was passive optimization due to cost improvement promoted by copyright reform and reduced contribution ratio of high-margin social entertainment business.

Finally, the operating profit of the core main business was 1.09 billion yuan, plus some interest income, other income, and a tax deduction of 12%. After adjustment, the net profit reached 1.49 billion yuan, up 71% year-on-year due to the low base of the previous year. The overall trend of profit improvement is basically within market expectations. The output for the given input would be: