Should You Buy Tencent Music After Its IPO?

Tencent Music (NYSE: TME) went public on Dec. 12 at $13 per share, at the bottom of its $13 to $15 range, and raised $1.1 billion. The stock finished the first trading day at $14, giving it market valuation of $21 billion -- which was well below the $25 billion to $30 billion valuation it previously targeted. The company originally planned to go public in October, but it postponed its IPO due to unfavorable market conditions.

Tencent Music's market debut was stable, but Chinese stocks are still on shaky ground due to unresolved trade issues and a weak yuan. Can Tencent Music win over investors in this hostile environment? Let's take a closer look at the company to find out.

What does Tencent Music do?

Tencent Music is China's largest online music-streaming platform with over 800 million monthly active users (MAUs). Its ecosystem merged the music apps QQ Music, Kugou, and Kuwo with the karaoke platform WeSing -- which together control about 75% of China's streaming music market.

Its daily active users (DAUs) spend over 70 minutes per day on the platform, which has access to over 20 million songs from over 200 domestic and international music labels. Unlike its smaller rivals, Tencent Music holds exclusive deals with many Western artists.

How does Tencent Music make money?

Tencent Music's revenue nearly doubled year over year to $2 billion during the first nine months of 2018, and its net income more than tripled to $394 million.

Seventy percent of its revenue comes from its social entertainment services, which include virtual gifts on WeSing (where fans purchase for their favorite singers) and premium memberships -- which grants them access to live-streaming concerts. The social platform's paying users grew 24% annually to 9.9 million during the third quarter, giving it a paid ratio of 4.4%, while generating 118.5 yuan ($17.22) in average revenue per paid user.

The remaining 30% of its revenue came from its online music services, which include paid subscriptions to its ad-free platform, a la carte music sales, and ads for free listeners. The unit's paid users rose 36% annually to 24.9 million during the third quarter, giving it a paid ratio of 3.8% -- which Tencent Music admits is "very low compared to online games and video services in China and online music services globally." The unit brought in only 8.5 yuan ($1.24) in average revenue per paid user during the third quarter.

Simply put, Tencent Music generates most of its revenue from a small (but growing) sliver of paid users instead of free ad-supported tiers. The addition of WeSing's social platform makes it more profitable than Spotify (NYSE: SPOT), which rigidly generates all of its revenue from premium subscriptions and ad sales.

How will Tencent Music keep growing?

Tencent (NASDAQOTH: TCEHY), which retains over 60% of the voting power in Tencent Music, will still integrate the music platform into its expanding ecosystem -- which is rooted in WeChat, the top mobile messaging app in China. Tencent's continued support could help Tencent Music hold smaller rivals like NetEase Cloud Music at bay.

Tencent Music plans to spend about 40% of the cash raised from its IPO on expanding its music catalog, 30% on product and service development, 15% on sales and marketing, and the remaining 15% on strategic investment, acquisitions, and other corporate uses.

For now, its primary goal will be to expand its base of paid users instead of growing its total MAUs. In fact, investors should hope that Tencent Music can continue growing its paid user base at a faster rate than its total MAUs -- otherwise licensing fees and royalties for ad-supported free listeners could throttle its bottom-line growth.

Should you buy Tencent Music?

Tencent Music looks like a more promising long-term investment than Spotify (which also owns a big stake in the company). However, the stock isn't cheap at 13 times last year's sales. Spotify, which has a slightly higher market cap, trades at just 4 times sales. Investors might be reluctant to pay that premium until the trade issues between the U.S. and China are resolved.

Tencent Music also faces some legal headwinds. There are over 900 pending lawsuits against it in regard to allegations of copyright infringement, and the company even admits that about 15% of the music on its platform isn't fully licensed. A Tencent Music executive is also being sued by an early investor who claims that he was coerced into selling an early stake in the company ahead of its IPO.

These issues make it tough to recommend Tencent Music for now. The market still seems allergic to Chinese growth stocks, so I wouldn't buy this pricey stock until it posts a few more quarters of consistent growth and resolves its legal issues.

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Leo Sun owns shares of Tencent Holdings. The Motley Fool owns shares of and recommends NetEase and Tencent Holdings. The Motley Fool has a disclosure policy.