Tencent Music’s Relentless Acquisitions: Building a Borderless Music Empire?

The long-rumored acquisition of $Tencent Music(TME.US) - Ximalaya has come to a conclusion, indicating that it has passed the relevant approvals for business concentration. Coupled with recent investment news in SM, Dolphin Research discusses the recent surge of the domestic digital music giant.

1. Acquisition Price Shows "Full Sincerity"

The acquisition of Ximalaya was finalized at a price slightly higher than the rumored $2 billion, with $1.26 billion in cash + nearly 5.6% of TME shares, totaling $2.7 billion based on the current market value of $29 billion.

But TME can be said to be full of sincerity. After all, at its peak, Ximalaya was valued at RMB 30 billion during the 2021 bull market, equivalent to just over $4 billion, which is a 30% discount. Compared to its Chinese counterparts at the same time, only a few have returned to 70% of their 2021 highs.

Moreover, Ximalaya, besides being a "short video victim," is also surrounded by competitors in the industry. Ahead is Lazy Listening (which embraced the Penguin ecosystem first), and behind is Tomato Listening, backed by Douyin, advancing rapidly.

In this situation, Ximalaya, facing a survival crisis, aggressively monetized (advertising + paid memberships), but its MAU has been declining. At the beginning of the year, it was estimated to have less than 200 million users (75 million on QM mobile, assuming a 4:6 ratio for in-car IoT), down by a third compared to 2023. But these fewer than 200 million users can be said to be Ximalaya's loyal long-audio fans cultivated over the years.

2. "Price Increase Logic" Has Been Traded for a Long Time — Short-term Saturation

Tencent Music is willing to pay a high price to acquire the "declining" Ximalaya for its consideration. Having ample funds is certainly a reason, but the management has repeatedly mentioned their strategic plan to focus on long audio during conference calls. Just as Spotify bets on podcasts, TME bets on long audio, although slightly different, both are based on the consumption needs of their main user base.

What is more similar between the two is the core of their business model — enhancing membership conversion rates through rich copyrighted content, including the development path of upgrading VIP to SVIP.

As of Q1, over 10% of regular members have actively upgraded to SVIP, with ARPPU jumping from 11 yuan to 17-18 yuan, which is one of the driving forces for future gross margin improvement. Since the Q1 financial report, the market has been continuously trading this price increase logic. Price increases by leading streaming media are the favorite assets of most foreign investors, as seen with Netflix and Spotify.

However, compared to Western streaming media, TME has a fatal flaw — difficulty in expanding overseas, with stagnant growth in the entire ecosystem's traffic. Therefore, the conversion and upgrade of existing users are the core driving forces for maintaining growth.

Based on the current valuation of $29 billion, it has essentially entered a "fully loaded state" subscription ecosystem:

——15 yuan ARPPU (ordinary VIP: SVIP=1:1), nearly 30% payment rate, with a 30% operating profit margin, 15% tax rate, P/E=20x, it already has a slight premium as a quality asset among current Chinese stocks.

3. "Cost Reduction Logic" Not Fully Priced — Long-term Slow Burn

However, today we also want to mention another long-term logic — "cost reduction".

After the regulation of exclusive music copyrights, Tencent Music's cooperation with top labels has shifted from focusing on "minimum guarantee fees" to a model of "minimum guarantee fees + revenue sharing," and gradually formed a cooperation model mainly based on "revenue sharing, with further reduction of minimum guarantee fees."

Of course, during the painful period for TOP labels, they naturally choose to expand more distribution channels (Cloud Music, Douyin, Kuaishou, Bilibili, Qishui, etc.), which also leads to the weakening of Tencent Music's advantage in copyrighted tracks and the continuous loss of ecosystem traffic.

But from the changes in market supply and demand structure, and from the profit distribution conflict between platforms and labels, the rise of niche music and the weakening of copyrighted music is a major trend. With the migration of traffic, top labels stubbornly hold onto 50 %+ of the total revenue share (millions to tens of millions of dollars in minimum guarantee fees + 50% revenue share), which is quite unappealing.

For the platform to further drastically weaken the label's share, it is not easy in the short term (one method is to invest in upstream labels, such as the recent investment in Korean entertainment giant SM, which is expected to reduce transaction costs while binding copyrights), especially since TME also needs to balance its copyright advantage among peers, but the long-term trend will not change.

Therefore, this is also why we believe the current market has not, or, more accurately, does not dare to factor in this expectation yet. As for how much the share ratio can be reduced and when it can be achieved, we might as well make an optimistic "five-year (i.e., 2030) assumption":

(1) The aforementioned demand-side operational goals remain unchanged, i.e., the "ideal state" revenue scale remains unchanged (15*12*1.5=RMB 27 billion subscription revenue + RMB 10 billion other online music + RMB 5 billion live streaming = RMB 42 billion)

(2) If the copyright cost ratio to subscription revenue can decrease from the current 55% to 40% (comparable to Netflix's cost rate, game content development share ratio), the group's gross margin can reach 55 %+, compared to the current increase of 11 %+

(3) Expense rate remains normally optimized, tax rate 15%.

According to an 11.2% discount rate, the DCF calculation yields an optimistic price of $35.3 billion, which is nearly 25% higher than the current $29 billion (after deducting the dilution impact from the acquisition, which is less than 20% space). But it should be noted that this is a relatively ideal operational goal, and achieving it requires "taking it slow."

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