Tencent Music: How far can the price increase logic go?

On November 13th, Beijing time, after the Hong Kong stock market closed, $Tencent Music(TME.US) released its Q3 2024 financial report. Last quarter, due to issues with short-term user guidance, the market began to question Tencent Music's growth potential, especially regarding the sustainability of medium to long-term growth if it relies solely on increasing per capita payments in the current domestic consumption environment.

So how did the actual performance in Q3 turn out? What will drive Tencent Music's long-term growth in the future? The management has shifted from "user growth" to "price increases" (SVIP, in-car memberships, and other high ARPU products) to drive growth, a path that Spotify has been pursuing for nearly a year. Coupled with just crossing the profitability inflection point, its valuation has also risen significantly. Can Spotify's logic be applied to domestic streaming music?

We look for answers in the financial report:

1. Subscription expectations show "slowing growth": In Q3, online music subscription revenue grew by 21% year-on-year. Since the guidance from the previous quarter was quite specific, the actual performance was basically in line with market expectations. Growth was driven partly by an increase in the number of subscribers, but after a promotional boost during the Spring Festival at the beginning of the year, the momentum has gradually weakened in the second and third quarters.

On the other hand, the average revenue per paying user (ARPPU) continued to rise slightly. This is also a new narrative the company has begun to emphasize after converting users from 0 to 1 with its paywall strategy—digging deeper into the payment potential of existing "essential" users from 1 to 10. Currently, SVIP and in-car memberships are the key product types being promoted under this strategy.

Dolphin Jun believes that the overall payment rate is currently at 20%, still short of the 25% for long videos and 40% for Spotify. However, the management's short-term focus on ARPPU indicates that the conversion of users from 0 to 1 in the domestic market may have reached a "platform period" in the short term.

Dolphin Jun attempts to clarify the logic behind this:

(1) Currently, Tencent Music's two major music platforms, QQ Music and Kugou Music, have 50-70% of VIP tracks included in the paywall (with 50% of popular tracks behind the paywall), significantly higher than other peers, such as Cloud Music at about 35%, and Douyin's Soda Music being even lower. Therefore, forcibly increasing the "VIP proportion" affects user experience.

(2) Furthermore, even if Tencent Music forcibly raises the proportion of paywall tracks to 100%, theoretically, it is not impossible. However, in the current environment, Douyin's hit songs and grassroots musicians' niche music hold a certain market share, and the share of copyrighted music is showing a contraction trend. This means that the portion of copyrighted music available for free listening may inherently belong to long-tail demandIn this case, even if it is included in the paywall, the number of user subscriptions that can be driven may not be much.

Therefore, it is understandable to turn around and continue to explore more needs of core users. After all, the current average monthly membership fee of less than 11 yuan is not a high payment threshold for core users, leaving room for further improvement. As of the end of September, the number of SVIP users reached 10 million, accounting for only 8% of the total number of current subscribers.

2. Live streaming is gradually overcoming the adjustment gloom: In the third quarter, social entertainment is slowly overcoming the adjustment gloom, with revenue down 24% year-on-year, but starting to show a clear contraction. The growth performance of social entertainment is slightly better than market expectations, but Tencent Music's core logic has long switched to music subscriptions, so Dolphin believes that the beat of social entertainment is unlikely to bring much positive response to the market.

3. Advertising may be under pressure due to the macro environment: In the third quarter, the revenue growth rate of other online music businesses (licensing, digital albums, and advertising) also slowed to 18.5%. Since revenue from offline performances such as music festivals increased in the third quarter, the slowdown may mainly stem from the advertising segment. Currently, Tencent Music still relies mainly on brand advertising, and the revenue contribution from incentive ads that allow free music listening should be minimal.

In addition to the macro environment, the growth of brand advertising is closely related to the platform's traffic. In the third quarter, the online music MAU was 576 million, an increase of 5 million users quarter-on-quarter, but still a decline year-on-year. The social music MAU was 90 million, also declining both year-on-year and quarter-on-quarter. Therefore, when Tencent Music's platforms are presented together with Tencent's advertising system for advertisers to choose from, Tencent Music's advantages are not significant.

Currently, we view Soda Music, which is seen as a potential strong competitor in the future, with an MAU of over 50 million, equivalent to 1/10 of Tencent Music, and the average daily user duration is also significantly lower than that of Tencent Music, indicating that the music mindset has not yet formed. It is still too early to discuss competitive impacts, and continued attention is recommended.

4. Cost control nearing the end: Under revenue pressure, profit margins are improved through strict cost control, with the growth rate of core operating profit maintained at 65%. However, the profit margin of 25.3% has slightly declined compared to the previous quarter's 26%. Quarter-on-quarter, this is mainly due to an increase in operating expenses.

It is worth mentioning that although the overall profitability level is inline, combined with the situation where the low-margin social music revenue exceeded expectations, it implies that the profit margin level of online music should be roughly calculated by Dolphin to continue to improve quarter-on-quarter. Although the increase is not large, it still reflects the logic mentioned by Dolphin earlier that Tencent Music can utilize its bargaining advantage in the industry chain to steadily optimize upstream costs.

The considerable profit elasticity brought by reducing leverage is another reason Dolphin is optimistic about Tencent Music. Of course, this essentially reflects Tencent Music's advantages in the industry chain and among peers, as well as the positive cycle within the Tencent ecosystem, collectively enhancing the overall efficiency of the group.

5. Buybacks have resumed: In the third quarter, the company resumed buyback actions, repurchasing 9.9 million ADS at a cost of 100 million USD, with an average buyback cost of 10.1 USD per shareCumulatively, there is still $165 million left from the $500 million repurchase announced in 2023, and the overall dividend yield from repurchases and dividends is about 2%, which is not high.

As of the end of the third quarter, Tencent Music has net cash of 23 billion RMB (cash + short-term investments - short and long-term interest-bearing debts), equivalent to $3.2 billion. This means that Tencent Music is not short on cash, but it depends on when the management will loosen up and continue to increase shareholder returns.

7. Detailed Financial Report Data Overview

Dolphin's Viewpoint

The main "collapse" in last quarter's performance was due to the guidance on subscription user numbers for the second half of the year. This kind of information is generally only disclosed in small circles to institutions, so for retail investors, the sudden drop in performance valuation is quite confusing. Therefore, for the third quarter's basically inline performance, the key is still to see how the management guides for next year during the conference call, especially whether there will be any adjustments to the expectations for subscription user numbers after changes in the policy environment.

Streaming platforms with subscription revenue as their core business model have always been favorites among foreign investors. Whether it's Netflix or Spotify, their valuations are above a Forward P/E of 30x. Both of these companies have experienced sharp declines in their stock prices after earnings reports due to subscription numbers falling short of expectations, but the logic of price increases driving growth is somewhat recognized by the capital.

So what are investors worried about regarding Tencent Music?

Dolphin believes that, as a leading streaming platform, Tencent Music actually has a more prominent competitive advantage compared to Spotify in their respective main markets. The reason it cannot stabilize at 20x is due to the current macroeconomic environment and consumption trends in China, which are contrary to the management's direction of increasing ARPPU. The sustainability and potential of this "price increase" to drive growth in the domestic market remain questionable.

Therefore, with the "user growth" leg missing, Tencent Music indeed needs to cut its high valuation last quarter, especially during a time when other internet platforms' valuations are at rock bottom (previously, it reached 25-30x, significantly higher than other platforms' 10-15x valuations). However, apart from the two price increase strategies of "reducing promotions/directly raising prices + guiding users to switch to SVIP," last quarter's bundling strategy from Spotify also provided us with some insights:

For Tencent Music, the market seems to underestimate its ability to leverage its bargaining power in the industry chain to continuously optimize upstream costs or overall improve gross margins through 1) renegotiating agreement shares; 2) changing the forms of front-end products/services (such as bundling services). This is another hidden driving force for whether Tencent Music can hope to move from a P/E of 16x to 20x.The following is a detailed analysis

I. Ecological traffic continues to decline in the off-season, concerns about competitive threats are premature

In the third quarter, Tencent Music's monthly active users (MAU) for online music increased by 5 million to 576 million. Social entertainment, including live streaming, is still affected by regulatory adjustments; although there is support from the peak season, social entertainment's MAU still declined by 3 million quarter-on-quarter.

Currently, we view Soda Music as a potential strong competitor in the future, with an MAU of over 50 million, which is about 1/10 of Tencent Music, and the average daily user duration is also significantly lower than that of Tencent Music, indicating that the music mindset has not yet formed. It is still too early to discuss competitive impacts; we recommend continuing to monitor whether Soda Music has further initiatives for Douyin traffic diversion and increased copyright investment. Cloud Music, due to recent pressures from NetEase's gaming sector, has internal motivations for cost reduction and efficiency improvement, so it may be more inclined to maintain the status quo in the short term.

II. Can SVIP become a new story for subscription growth?

Due to pressures from social entertainment, despite a poor macro environment, Tencent Music continues to advance its paywall strategy, releasing the growth potential of digital music payments in advance. On the other hand, it is starting to convert paid users to SVIP users by adding more rights and services (such as exclusive digital albums, Dolby sound effects, online concerts, bundling with Tencent Video VIP, etc.).

Meanwhile, other online music revenues are still primarily driven by advertising, including some splash ads, fixed-position ads, and free member ads on the app, as well as sponsorship income from hosting offline music festivals and concerts.

Ultimately, online music revenue grew by 20.4% year-on-year, with a slight slowdown quarter-on-quarter. The sustainability of subscription revenue growth has been the mainstream story recognized by investors in Tencent Music over the past two years, so when user growth reaches a plateau, the impact on valuation will naturally not be small. Pay attention to the management's growth guidance for next year during the conference call; after changes in the policy environment, will it be relatively more positive?

Further breakdown shows that:

1) Subscription revenue grew by 21% year-on-year, with a slight slowdown quarter-on-quarter. Among them, the number of paid users (+16% year-on-year) and the average payment amount per user (+4.9% year-on-year) both saw slight slowdowns. As of the end of the third quarter, the music subscription payment penetration rate reached 20.7%, an increase of only 0.2 percentage points compared to the second quarter. The company's medium to long-term goal is to align with long video levels, which is 25% to 30%However, after a high from the Spring Festival promotions at the beginning of the year, there has been a gradual decline in the second and third quarters. The impact of the macro environment is one aspect, but there is also a situation where the effectiveness of the paywall strategy is indeed weakening.

1. Currently, the two major music platforms under Tencent Music, QQ Music and Kugou Music, have 50-70% of their VIP tracks included in the paywall (with 50% of popular tracks behind the paywall), which is significantly higher than other peers, such as Cloud Music at about 35%, and Douyin's Soda Music is even lower. Therefore, forcibly increasing the "VIP proportion" affects the user experience.

2. In addition, even if Tencent Music forcibly raises the proportion of paywall tracks to 100%, theoretically it is not impossible. However, in the current environment, Douyin's hit songs and grassroots musicians' niche music occupy a certain share, and the share of copyrighted music is showing a contraction trend, meaning that the currently free-to-listen copyrighted music may belong to long-tail demand. In this case, even if it is included in the paywall, the number of users that can be attracted to subscribe may not be much.

Therefore, turning back to continue exploring more needs of core users makes the logic behind this action understandable. After all, the average monthly membership fee of less than 11 yuan is not a high payment threshold for core users, leaving room for further improvement. As of the end of September, the number of SVIP users reached 10 million, accounting for only 8% of the total subscription users.

2) Other online music services, including digital copyright sales and advertising revenue, saw revenue growth slow to 18% in the third quarter. The increase in revenue from offline performances such as music festivals in the third quarter may be the main reason for the slowdown, primarily due to the advertising segment. Currently, Tencent Music still relies mainly on brand advertising, and the revenue contribution from incentive ads for free music listening should not be significant.

III. Social Entertainment: It has not actually warmed up yet, just gone through an adjustment period

In the third quarter, social entertainment revenue continued to decline by 24% year-on-year. After going through the adjustment period, the rate of decline has significantly slowed, slightly exceeding market expectations. However, Tencent Music's core logic has long switched to music subscriptions, and the significance of social entertainment is more about contributing cash flow. Therefore, Dolphin believes that the beat from social entertainment is unlikely to bring much positive response to the market.Analyzing the changes in volume and price relationships: Although the monthly active users continued to decline quarter-on-quarter in the third quarter, the number of paying users began to stabilize, showing no loss compared to the previous quarter, reflecting a certain seasonal effect. The average revenue per user decreased by 25% year-on-year, gradually moving past the adjustment period.

IV. End of cost control? Focus on long-term optimization potential of costs

In the third quarter, costs decreased by 5% year-on-year, and since the previous year's quarter was not high, the decline was relatively less than in the second quarter. In addition to the reduction in live streaming business leading to a decrease in reward sharing, estimates through Dolphin 君 suggest that while subscription revenue maintained over 20% growth, copyright costs may not have increased correspondingly. However, compared to previous quarters, offline music events brought some incremental copyright costs.

Ultimately, the gross margin further increased by 0.6 percentage points to 42.6%. Although the pace of increase has slowed, the bundling strategy of Spotify last quarter has also provided us with some insights: For Tencent Music, the market seems to underestimate its ability to leverage its bargaining power in the industry chain to continuously optimize upstream costs or overall improve gross margins through 1) renegotiating agreement shares; 2) changing the forms of front-end products/services (such as bundled services).

Although the operating expense ratio in the third quarter continued to decline overall, the fee rate has increased quarter-on-quarter. Marketing expenses began to recover, while management expenses continued to decline, mainly due to layoffs. Sales expenses are more about the company's proactive approach to maintaining high ROI in customer acquisition.

Ultimately, the operating profit of the main business reached 1.77 billion, with a profit margin of 25.3%, slightly declining quarter-on-quarter, mainly due to the slowdown in cost control.

Operating profit reached 2.144 billion, a year-on-year increase of 50%. The Non-IFRS net profit (original net profit excluding the impact of intangible asset amortization from acquisitions, equity incentives, and non-operating investment income) was 1.940 billion, a year-on-year increase of 29%. The gap between this and the operating profit growth rate of the main business (+65% year-on-year) was mainly due to the sharp increase in financial costs (interest expenses, exchange rate gains and losses) in the third quarter of this yearDolphin 君 tends to focus on the changes in the core operating profit of the main business mentioned earlier, which better reflects the company's performance in its main operations.