Tencent Music's Dominance and the Evolving Chinese Music Landscape

Tencent Music Entertainment Group (NYSE:TME) is China's largest online music and audio entertainment platform, boasting a diverse portfolio of popular apps including QQ Music, Kugou Music, Kuwo Music, and WeSing. Despite facing revenue declines in recent years, the company has achieved record earnings in fiscal year 2023, driven by expanding gross margins and improved operational efficiency. However, TME's significant valuation premium over other Chinese ADRs raises concerns about potential downside risks due to geopolitical factors.

Unlocking the Potential of China's Booming Online Music Market

China's Online Music Market: A Rapidly Expanding Landscape

According to a report by CIC (China Insight Consultancy), China's online music market experienced a 33% increase in 2023, reaching approximately RMB 32.2 billion (.5 billion). The market is expected to continue its growth trajectory, projected to reach RMB 49.5 billion (.9 billion) by 2025, driven by higher penetration rates and increased average revenue per user (ARPU). The report also estimates that China has 744 million online music users, with only 150 million paying users, representing a significant untapped potential for growth.

TME's Dominant Position in the Chinese Music Landscape

Tencent Music Entertainment Group (TME) has firmly established itself as the dominant player in China's online music market. Statista estimates that TME holds a market share of around 60% in terms of monthly active users (MAU) as of February 2024. Furthermore, according to another report, TME's market share of the paid online music market is even higher, exceeding 70%.

Tencent's Playbook: Replicating Success in the Music Industry

Investors familiar with Tencent Holdings (OTCPK:TCEHY) may recognize the company's playbook in its core gaming business, which it has replicated in the music industry. Tencent's strategy involves internal competition, acquiring the best global game developers, and leveraging its channel dominance. Similarly, with TME, Tencent has followed a similar path, developing its flagship QQ Music app and subsequently acquiring Kugou Music and Kuwo Music to form the China Music Corporation (CMC), which became the dominant player in the Chinese online music market.

The Turning Point: Crackdown on Piracy and the Rise of Exclusive Licensing

The turning point for the industry came in 2015, when Chinese regulators cracked down on online music copyrights, requiring the removal of all pirated music content from major online music apps. This led to a significant increase in copyright prices, and in 2016, Tencent acquired CMC and merged it with QQ Music to form the Tencent Music Entertainment Group (TME). In 2017, TME reached a strategic agreement with Universal Music Group, becoming its exclusive copyright licensee in mainland China. This move effectively monopolized the market, as TME secured exclusive music copyrights from the world's three largest music labels (Universal, Sony, and Warner) in China.

The Break-up of TME's Monopoly: Regulatory Intervention and Market Dynamics

TME's monopolistic reign did not last long, as the Chinese government became increasingly alert to the rapid growth of platform companies such as Alibaba (BABA), Baidu (BIDU), and Tencent itself. In November 2020, China's State Administration for Market Regulation (SAMR) issued guidelines to prevent and address monopolistic behavior in the platform economy, ultimately ordering TME to give up its exclusive rights to music labels within 30 days.The end of TME's exclusive rights has had a surprising impact on the market. Instead of weakening TME's position, it has actually helped the company improve its margins. The bargaining power of the big three music labels (Universal, Sony, and Warner) has weakened, as they now have to negotiate with both TME and NetEase Cloud Music. This has led to a decline in content acquisition costs for both TME and NetEase Cloud Music, resulting in improved gross margins. TME's gross margin has increased from 30% in 2021 to more than 35% in 2023, while NetEase Cloud Music's gross margin has risen from a mere 2% in 2021 to 26.7% in 2023.

Monetization Strategies and User Engagement: Driving Growth

The end of TME's exclusive rights has also had a positive impact on user monetization. Both TME and NetEase Cloud Music have seen an increase in their average revenue per user (ARPU). NetEase Cloud Music disclosed that its monthly ARPU has increased from RMB 6.6 at the end of 2022 to RMB 6.9 at the end of 2023. Similarly, TME's monthly ARPU has increased even more, from RMB 8.9 at the end of 2022 to RMB 10.7 at the end of 2023. This suggests that users are more willing to pay for the content, further enhancing the companies' revenue streams.

Financial Projections and Valuation Considerations

In my financial projections, I assume that TME's revenue will grow by 3% in 2024 and 8% in 2025, in line with sell-side estimates. I also expect TME's margins to continue expanding in the coming years as the company optimizes its operations. Based on these assumptions, I estimate that TME's net income will reach ,066 million by 2025.However, despite the company's strong financial performance, TME's significant valuation premium over other Chinese ADRs poses a risk of potential downside. To reflect the China risk, I have applied a 15x trailing-twelve-month (TTM) price-to-earnings (PE) multiple, which is a significant discount to TME's current multiple. This suggests that TME may have at least 30% downside risk at its current price.