Tencent Music: Endless Gold Mine? The Charm of Small and Beautiful Vertical Categories

After the Hong Kong stock market closed on May 13th Beijing time, Tencent Music released its financial report for the first quarter of 2024. The first quarter performance exceeded expectations across the board, essentially benefiting from a stable competitive landscape in the short term and TME's monopoly advantage. In addition, it announced its first dividend payout, although the dividend yield is not high when calculated, the statement is crucial.

Key information:

1. Boost in Subscriptions during Promotions, Live Streaming Emerging from the Worst Phase

In the first quarter, Tencent Music's total revenue declined by 3.4% year-on-year, mainly due to social entertainment such as live streaming still being in the adjustment phase, with actual performance slightly exceeding market expectations.

(1) Music Subscription Business: Revenue grew strongly by 38.5%, with both volume and price increasing year-on-year. On one hand, the early-year promotions drove a record high in net user additions, with Q1 subscription rate approaching 20%; on the other hand, promotions did not affect the average price, with ARPPU in the first quarter not showing a significant decline on a quarter-on-quarter basis, but instead a 15% year-on-year growth.

While it may seem like a strategy of raising prices before promotions, it actually supports Tencent Music's continuous "indirect" price increases over the past year, reflecting its stable market competitive position. Additionally, it may be driven by the higher demand for music among the new generation of young users, leading to the overall expansion of the industry's potential TAM.

(2) Other Music Businesses: Licensing, digital albums, and advertising businesses also saw a high growth of 56%. Despite the significant impact on licensing business after the unbundling of exclusive rights, the digital music market is relatively mature. Leveraging Tencent's strong traffic base (having tested a dedicated music tab in WeChat in February), Tencent Music still has the potential to gain advantages in music distribution (corresponding to digital album sales) and free users (corresponding to advertising revenue).

(3) Social Entertainment Business: Live streaming and karaoke businesses are still recovering from adjustments, but from a marginal change perspective, they have emerged from the worst phase, with a slightly narrower year-on-year decline compared to the previous quarter. The number of paying users in the first quarter has stopped declining, but the average payment per user is still significantly reduced. Stabilizing traffic is the first step, and increasing average payment per user can be gradually achieved through enriching content offerings.

However, compared to music subscriptions, social entertainment inevitably faces long-term competition from short video platforms and niche live streaming platforms. Market expectations for this sector are not high, so being able to stabilize revenue and prevent further acceleration of decline already meets market requirements.

2. Focus on Tencent Ecosystem + TME Collaboration to Catalyze MAU, Competitors Still Lagging Behind

In the first quarter, the overall platform saw a year-on-year loss of 14 million monthly active users, with a marginal stabilization on a quarter-on-quarter basis. In terms of user numbers, the effect of WeChat testing the "music listening" tab is not yet significant, at least not driving much MAU growth. However, the company has indicated in previous communications that by embedding into the WeChat ecosystem through testing, Tencent Music has reached some middle-aged and elderly users who were originally difficult to reach through traditional promotional methods In terms of competition, Tencent Music's monopoly position remains stable. Although Cloud Music and Soda Music are trending upwards, the growth has slowed significantly, with a large gap compared to Tencent Music. In addition, Soda Music, which has traffic advantages, has lower user engagement time and has not yet gained user mindshare.

3. Cost reduction has not slowed down, and profit margin improvement is solid

Costs in the first quarter decreased by 15% year-on-year, similar to the declines in the previous two quarters. Overall, Tencent Music's total costs have been optimized for two years, but there is no sign of slowing down in the first quarter. It is expected that some significant changes will be seen in the second half of the year. We believe that in addition to the cost reduction brought about by adjustments in live broadcasting revenue sharing, TME can leverage its bargaining power in the industry chain, cooperate in multiple ways with top labels around the Tencent ecosystem to stabilize copyright costs, and reduce overall costs by increasing self-produced tracks.

Similarly, in terms of expenses, although Dolphin Jun previously expected limited room for cost optimization, Tencent Music still saved 8% year-on-year in operating expenses in Q1. Among the optimization efforts, sales expenses saw the highest reduction, further indicating the stability of the domestic digital music market and Tencent Music's monopoly position (TME can naturally attract users without additional promotional expenses).

Ultimately, Q1 gross profit margin exceeded 40%, achieving the company management's medium to long-term target ahead of schedule. Core operating profit was 1.66 billion, accelerating by 51% year-on-year, with a profit margin increase of over 4 percentage points compared to 4Q23, reaching 24%. With the potential space for optimizing revenue and costs, the medium to long-term core operating profit margin is expected to reach 30%.

4. First dividend payout, with symbolic significance outweighing actual profit increase

Although Dolphin Jun had some expectations, the quick implementation of the dividend payout plan was still quite surprising. TME is expected to distribute dividends of $210 million in 2023, at a rate of $0.0685 per share, implying a dividend ratio (as a percentage of net profit) of nearly 30%.

In addition, in the first quarter, the company spent $60 million in cash to repurchase 6.9 million ADS shares at an average price of $8.8 per share. According to the announced buyback plan of $500 million over 24 months starting in 2023, there is still $89.5 million remaining.

With dividends + buybacks, the potential overall dividend yield this year is 1.5%, which is not high, but the symbolic significance of this shareholder return outweighs the actual profit increase. Especially the dividend payout, if gradually increased in the future and becomes a stable expectation, it will also provide some support to the stock price.

5. Overview of detailed financial data

Dolphin Jun's Viewpoint

**Music subscriptions are a gold mine. Despite the relaxation of exclusive copyrights, TME's subscription revenue has maintained high growth for nearly three years. In the first quarter, with both volume and price rising, and some operational adjustments (price increase at the end of last year followed by Spring Festival promotions), the net addition of paying users hit a record high for a single quarter, making it seem like the gold in the gold mine is endless Before this, most of the content consumption in the domestic market seemed to have difficulty in gaining market value recognition. The lack of copyright awareness and low disposable income have jointly created a freeloading mentality, making it difficult for content platforms to maintain logical consistency. Once users stop expanding their circle, they are directly labeled with stagnant income growth, manifested by the valuation expanding with user growth and shrinking with user slowdown.

However, Tencent Music's performance in the past two years has demonstrated that in any market, any company, competitive advantage is the real pricing power. In the current stable competitive landscape, Tencent Music, as the absolute leader, is able to adjust the relationship between "quantity" and "price" more calmly to achieve sustained high revenue growth. For example, through some operational means, combined with user consumption habits, they adjust prices indirectly during peak seasons and promote customer acquisition through promotions during off-peak seasons.

Dolphin believes that the short to medium-term competitive environment still has a minimal marginal impact on Tencent Music, but the market expectations implied by the current valuation are not low either, corresponding to a 25-year performance P/E of 22x. A simple horizontal comparison shows that TME's valuation is relatively high among Chinese concept assets.

Although expanding usage scenarios such as in-car and tapping into the high-end demands of heavy users can further increase overall ARPPU, this growth narrative logic also helps support the current valuation in the short term. However, on the other hand, the user base for this demand group is relatively limited, and it is not easy to sustain subscription revenue growth of 15-20% for over three years. Even with a more optimistic long-term expectation from management (assuming 150 million users in three years, ARPPU of 15 yuan, combined with other music revenue of 10 billion, social music revenue of 7 billion, totaling 45 billion in revenue, with OPM increasing to 30% if the gross profit margin is optimized to 45%, 20x P/E, reaching 30 billion in the long term), discounted to the current market value of 23 billion, the upside potential is relatively limited.

Therefore, we have observed that some institutions have also started to incorporate expectations for the overseas market based on the guidance of the company's management. However, the industrial chain of the overseas digital music market differs significantly from that of the domestic market, and the competitive landscape is also different. Therefore, at a stage where valuation expectations are relatively full, we recommend paying more attention to potential marginal risks at this time, such as the impact of price increases on user retention and renewal rates, as well as the latest actions of competitors.

Here is a detailed analysis:

I. Monthly active users are still in a declining channel, focusing on the Tencent ecosystem + TME collaboration catalyst

In the first quarter, Tencent Music's online music monthly active users slightly increased to 578 million, with a loss of 14 million users year-on-year.

The rectification of live broadcasts began in early June 2023. Although it was a peak season in the first quarter, it may have been difficult to avoid the impact of short video competition, resulting in a further loss of 7 million users compared to the previous period.

From the perspective of third-party data, although the number of users for TTPod Music and Kuwo Music has not declined significantly compared to QQ Music, overall growth has also nearly stagnated. Compared to Tencent Music, the user base of TTPod Music and Kuwo Music still lags behind by a considerable margin.

Considering ByteDance's recent strategic focus not being on entertainment payments, TTPod Music is optimizing costs, so for Tencent Music, short-term competition is basically worry-free. In the medium term, attention needs to be paid to whether Kuwo Music will take further actions to attract traffic from Douyin, and whether TTPod Music will increase investment in copyrights.

In early February this year, Tencent Music tested the "Listen to Music" tab on WeChat, but based on the results from Q1, there is no immediate impact. However, the company has indicated in previous communications that by embedding into the WeChat ecosystem through testing, Tencent Music has reached some middle-aged and elderly users who are difficult to reach through traditional promotional methods.

Dolphin believes that although these middle-aged and elderly users may not spend a lot of time listening to music, they still have a demand for music scenes, especially the combination of WeChat + film and television + music (such as the old songs promoted by the drama "Blossoms"). The music consumed by middle-aged and elderly users often consists of classic old songs, which align with Tencent Music's library advantage in terms of song copyrights. Additionally, the cost of this part of the library may also be relatively low, whether Tencent Music chooses a fixed licensing fee or a revenue-sharing model, it is expected to increase user subscriptions, drive revenue growth, and bring higher profits.

To further confirm our logic, Dolphin will continue to monitor the traffic effect of the WeChat tab.

II. Live broadcasting adjustments have passed the worst stage

In the first quarter, social entertainment revenue continued to decline, reaching 1.76 billion, a year-on-year decrease of 50%, but showing a slight slowdown compared to the previous quarter. Although a significant decline is hard to avoid this year, considering that the number of paying users has stabilized and is no longer decreasing, we believe that the adjustments to live broadcasting have passed the most impactful stage. The subsequent increase in ARPPU will focus on further enriching member benefits, and a rebound is expected to be seen soon.

III. After raising prices and promotions, stimulating a record high net increase in paying users

Due to the ongoing pressure from the collapse of social entertainment, the company is motivated to continue promoting the paywall strategy, unlocking the growth potential of digital music payments in advance. During the Chinese New Year period, Tencent Music launched a large promotion, but due to the price increase at the end of last year (reducing discounts, joint memberships), although ARPPU decreased month-on-month, it was not significantly affected. Instead, this wave of operational activities brought about a record high increase in paying users.

At the same time, other online music revenues are still mainly driven by advertising business, including some splash screen ads, fixed page ads, free member ads on the app, as well as sponsorship revenue from hosting annual music events Online music revenue increased by 43% year-on-year, with a slight acceleration in the quarter-over-quarter growth.

Further breakdown reveals:

1. Subscription revenue increased by 38.5% year-on-year, with accelerated expansion driven by both volume and price increases. The number of paid users (+20% yoy) and average revenue per user (+15% yoy) both contributed to this growth. As of Q1, the penetration rate of music subscription payments reached 20%, with the company's medium to long-term goal aligning with the level of long videos, which is 25% to 30%.

1. Other online music services including digital copyright sales and advertising revenue saw a 56% year-on-year growth in the next quarter despite a high base, mainly driven by the release of advertising inventory.

IV. Continuous cost reduction efforts, solidifying profit margin improvement

Costs in the first quarter decreased by 15% year-on-year, maintaining the downward trend. Apart from the reduction in live broadcasting business and corresponding reward sharing, there may have been some optimization in copyright costs due to an increase in self-produced content. Therefore, with high revenue growth and costs shrinking in double digits, this ultimately reflects in the continuous improvement of gross profit margin. The 40% gross profit margin in the first quarter has already exceeded the company's medium to long-term target level (35%-40%), so it is worth paying attention to the new guidance from the management this time.

However, Dolphin believes that there may still be room for further optimization of gross profit margin while maintaining the platform's competitive advantage. In addition to increasing the payment rate, reducing discounts, and enriching the benefits of high-tier members to stimulate average user payment growth, copyright costs themselves can also be optimized through bargaining power in the industry chain, signing more favorable procurement contracts, and profit-sharing ratios.

Sales and administrative expenses in the first quarter exceeded our expectations, surprisingly accelerating their decline. In terms of magnitude, the decline in sales expenses was more pronounced. This further indicates the stability of the domestic digital music market competition and Tencent Music's leading position (TME can naturally attract users without additional promotion expenses).

With revenue expansion and expenditure reduction, the operating profit of the main business reached 1.64 billion in the first quarter, directly increasing the profit margin by 4 percentage points quarter-on-quarter to reach 24% If the impact of intangible asset amortization generated by acquisitions, equity incentives, and non-operating investment income is excluded, Tencent Music achieved a Non-IFRS net profit of 1.812 billion in the first quarter, a year-on-year increase of 24%. The difference between the growth rate of operating profit in the main business (+27% yoy) can be mainly attributed to the flat growth in amortization and the year-on-year decrease in SBC.

Dolphin Research on Tencent Music in the past year:

Earnings Season

March 19, 2024 Conference Call "Tencent Music: Early Year Promotions Exceed Expectations (4Q23 Conference Call)"

March 19, 2024 Earnings Review "Tencent Music: Leading with BUFF, Resisting Cyclical Price Increases"

November 17, 2023 Conference Call "There is still a wide space for music subscriptions (Tencent Music 3Q23 Conference Call Summary)"

November 14, 2023 Earnings Review "Tencent Music: Hidden by the Shadow of Live Broadcasting, Small and Beautiful"

August 15, 2023 Conference Call "Adjustments in live broadcasting expected to stabilize by the end of the third quarter (Tencent Music 2Q23 Conference Call Summary)"

August 15, 2023 Earnings Review "Tencent Music: Business Adjustments, Continuing to Grind the Bottom"

March 22, 2023 Conference Call "Performance guidance is not a major issue, just overly anticipated (Tencent Music 4Q22 Conference Call Summary)" March 21, 2023 Financial Report Review "Tencent Music: Without Growth, Can "Saving" Support the Big Dream of Music?"

November 16, 2022 Conference Call "Tencent Music: Open Source and Cost Reduction, Profit Margin Will Continue to Rise Next Year (3Q22 Conference Call Summary)"

November 15, 2022 Financial Report Review "Tencent Music: "Refining" Users, Squeezing Out Profits, Everything Focuses on "Money""

August 16, 2022 Conference Call "Tencent Music: Enriching Membership Privileges, Continuously Promoting Incentive Advertising (Conference Call Summary)"

August 16, 2022 Financial Report Review "Tencent Music: Easing Performance Decline, But Signals of Recovery are Premature"

May 17, 2022 Conference Call "Impact of New Live Broadcasting Regulations Will Emerge Throughout the Year, Cost Reduction and Efficiency Improvement is One of the Top Priorities This Year (Tencent Music Conference Call)"

May 17, 2022 Financial Report Review "Tencent Music: It's Still Early Spring, No Need to Worry About Grain"

In-depth

April 12, 2023 "TikTok and Tencent's Off-site Collaboration, Is There a Solution to the Dead End of Entertainment Payment?"

January 6, 2023 "Pan-Entertainment "Opening Red", Tencent, Bilibili, Whose Rebound is More Sustainable?"

Risk Disclosure and Statement of this Article: Dolphin Research Disclaimer and General Disclosure