Why Tencent Music Is Poised for Growth

Tencent Music (NYSE: TME) is more than simply "the Spotify (NYSE: SPOT) of China." The platform is a mash-up of music streaming and social networking, enabling users to listen to music, sing with friends, and buy digital merchandise. The company's relationship with Chinese internet giant Tencent (NASDAQOTH: TCEHY) has given it a leg up in attracting users, and the platform is the dominant online music service in China.

The stock recently had its initial public offering in the U.S. and could be a great long-term investment for growth-oriented investors. Not only does Tencent Music have a sensible strategy to increase monetization of its platform, but it also benefits from the growth of internet usage in China.

More than music

Tencent Music isn't a singular service for streaming music. The company owns the four most popular music-related apps in China, which collectively boast over 800 million monthly active users.

Tencent Music's Mobile Apps Description
QQ Music Music streaming, focused on promoting interactions between artists and fans
KuGou and Kuwo Music and live performance streaming (professional and amateur)
WeSing Karaoke social network enabling people to sing with each other online

One of the great things about Tencent Music is that it has the largest music collection among Chinese services, with over 30 million songs from artists around the world. The company has something for everyone and uses algorithms to customize playlists to individual tastes. This provides users with a better experience and keeps them on the platform longer, which increases the opportunity for Tencent Music to sell ads or services.

In China, music culture is highly social. Karaoke is a very popular activity, and many of the most popular TV shows are based around singing performances. It's not surprising then that some of the hottest music apps in China are used to watch other people perform or for singing with your friends.

Tencent Music is the dominant music-streaming service based on its user count and music catalog, but it has a lot more to offer than just listening. The ability to interact with celebrities and bond with friends over performance and karaoke has made it a vibrant social network as well.

Relationship with Tencent is a big advantage

Tencent Music's parent company and majority shareholder is Chinese internet conglomerate Tencent. Tencent operates WeChat, the single most popular online service in China. WeChat has been dubbed "China's app for everything" because it touches everything from social networking to payments. With over 1 billion monthly active users, virtually everyone on the internet in China uses WeChat.

Through its presence in the WeChat ecosystem, Tencent Music is able to easily and cheaply attract users from WeChat. There is significant cross-platform compatibility between WeChat and Tencent Music apps. WeChat promotes Tencent Music's apps by enabling its users to share music they are listening to, and Tencent Music pre-loads a user's WeChat connections on its app to make it easy to find friends.

Most online platforms pay large sums to search engines and sponsor free trials to acquire new customers. The ability to onboard users from WeChat has given Tencent Music a low cost of acquiring customers. Tencent Music will be able to maintain its relatively low customer acquisition costs so long as the broader Tencent ecosystem remains popular.

By piggybacking on WeChat, Tencent Music has amassed the largest user base among Chinese music platforms. This has helped create a network effect on the Tencent Music platforms because the fact that all of your friends and favorite celebrities are already on the platform makes it difficult to switch to a different platform.

Why Tencent Music is more profitable than other streaming companies

The music industry has always been a notoriously challenging industry to operate in. Music streaming, in particular, has been difficult because the streaming services have to pay hefty royalties to the artists and record labels who own the content. Pandora and Spotify have generally operated unprofitably; however, Tencent Music is actually profitable.

In addition to its ability to minimize its customer acquisition costs through its connection with WeChat, Tencent Music's profitability has a lot to do with how the platform is monetized. The company has a multifaceted monetization model, which includes offering premium membership subscriptions, selling songs digitally, and selling virtual items.

Tencent Music Segment 2016 Revenue 2017 Revenue 2018 Revenue
Digital music 2,144 million yuan 3,149 million yuan 5,536 million yuan
Social entertainment and other 2,217 million yuan 7,832 million yuan 13,449 million yuan
Total 4,361 million yuan 10,981 million yuan 18,985 million yuan

For the past three years, the overall growth rate of the business has been impressive; even more impressive is how fast the social entertainment and other revenue is growing. The company makes two-thirds of its revenue from services related to social entertainment.

Clearly, the key to Tencent Music's financial success is its social entertainment revenue, not its music services. Social entertainment and other revenue consists of premium memberships to the live streaming and karaoke apps and virtual goods bought on the platform. Users can purchase virtual goods for themselves or send them to friends or strangers as gifts to show appreciation for a live performance. And while the company needs to pay royalties to the artists for music played, the profit margin on a virtual good is essentially 100%.

Although Tencent Music is thought of as a streaming company in the likeness of Pandora, it's far from such. The company doesn't break out its profit by segment, but a logical guess would be that most if not all of the company's profits are generated by the revenue from social entertainment and other services. It's good news that the company has found success outside of the seemingly inhospitable music industry.

Strong growth trajectory

In 2018, Tencent Music saw revenue grow 73% over the prior year. Strong growth is expected to continue because the company has an opportunity to increase its revenue per user while benefiting from the overall growth of the internet in China.

There are roughly 800 million people on the internet in China today, meaning only 57% of China's 1.4 billion inhabitants are online. Improved access to internet-enabled smartphones and the declining price of computers will continue to bring hundreds of millions of consumers in China online over the next 10 years.

Tencent Music has a high penetration of Chinese internet users. The company's music services alone count 644 million monthly active users -- implying that over 80% of Chinese internet users are on its music service. The company's social entertainment apps count 228 million monthly active users. As the number of internet users in China grows, Tencent Music should be able to continue growing by maintaining its high penetration rate. The key is the popularity of WeChat; Tencent Music should be able to keep its high market share so long as the broader Tencent ecosystem remains popular.

Finally, Tencent Music can grow its revenue by improving its monetization per user. Only 3.8% of the company's music users pay for a premium subscription, a very low rate compared to other streaming services around the world or even compared to online video games in China. On the social entertainment side, 4.4% of users have paid for a virtual gift or non-music subscription. This area represents an attractive opportunity for the company to improve its revenue per user. Even if users do not pay directly for services, Tencent Music can harness its growing user base and data collected to sell more ads.

Tencent Music's high penetration rate gives the company a somewhat monopolistic position in online music and makes the company a good proxy on the growth in the Chinese internet sector. The company can flex its strong position to nudge more users to directly spend money on the platform or ramp up its advertising efforts. Either way, Tencent Music has multiple paths to continue showing strong top-line growth.

A high-quality growth business

Tencent Music's holds the pieces of a high-quality business with significant growth potential. The company's affiliation with WeChat is almost an unfair competitive advantage relative to other online platforms that has enabled it to amass the largest user base in the Chinese music industry. However, the key to Tencent Music's business model is the social aspect of its platform and how it monetizes social interactions between users. Turning a music service into a social networking experience with live streaming and karaoke has enriched the user experience and has been very good for business.

The company's stock has traded strongly since its IPO, where it priced at $13 per share. And it could continue rising because the company has a bright future ahead with healthy revenue growth and a uniquely profitable business model.

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Luis Sanchez has no position in any of the stocks mentioned. The Motley Fool owns shares of and recommends Tencent Holdings. The Motley Fool has a disclosure policy.