Tencent Music’s US IPO: everything you need to know

Tencent Music’s IPO is set to be one of the biggest listings by a Chinese company on a US stock market this year, boasting huge growth potential and a market-leading position. But can the firm’s unique business model win over investors?

Joshua Warner @JoshWarner_IG
Analyst, London

Publication date : 2018-10-05T18:17:30+0100

Source: Bloomberg

Tencent Music Entertainment is set to be the latest Chinese tech stock to list in the US, seeking access to international capital to build on its ambitious plans to dominate China’s online music entertainment space.

The business has been automatically thrown into the same pool as music streaming services like Apple Music and Spotify, the latter of which listed in New York earlier this year, but Tencent Music is a very different business operating in a very different market. It is more a blend of music streaming, video content and social media – combining characteristics shared by firms like Spotify, YouTube and Facebook.

Although Tencent Music boasts a leading position in a market that has only just started to take off, there is considerable risk in its strategy. Some have raised their eyebrows at the fact that parent company Tencent Holdings, the Internet giant, is hyping up and spinning off its music arm only weeks after unveiling a huge restructuring that is centred on growth from business customers, not the music listeners and karaoke singers that Tencent Music attracts. Some query the motive behind Tencent Music’s separation, particularly when its platforms are so heavily intertwined with the parent company’s messaging and social media services, as well as its IT infrastructure.

We have a look at Tencent Music and how it operates, and whether it will be able to hit the right tune with investors.

What is Tencent Music and how does it make money?

Tencent Music dubs itself as an ‘all-in-one music entertainment destination’ boasting over 800 million monthly active users (MAUs) to make not only the biggest platform of its type in China, but in the world. Although it is easy to start drawing comparisons to Western peers like Spotify, the company is very different, as is the market it operates in.

Tencent Music has four core platforms under its belt: QQ Music, Kugau, Kuwa and WeSing. Broadly speaking, it has four revenue streams to match:

Online music services: this is the element where Tencent Music is comparable to Western peers like Spotify. Through three leading platforms – QQ Music, Kugou Music and Kuwo Music – the company offers 20 million tracks secured through 200 labels, including the ‘Big Three’ (Sony Music Entertainment, Universal Music Group and Warner Music Group). It also has Emperor Entertainment Group and China Record Group on board, which are big players in the domestic market.
Online karaoke: this is where it starts to get a little different and the part where some US and European investors may become befuddled. It cannot be understated how big karaoke is in Asia. China, Japan and South Korea are rife with karaoke rooms and the area is a big business. In its simplest form, users can record their own performances and watch others on the WeSing platform, but at its heart this is a social network built around karaoke that encourages users to challenge one another to sing-offs and hold online parties in virtual karaoke rooms. Tencent Music claims it had a staggering ‘40 billion connections’ between users of WeSing at the end of June. The content produced here is then made available on its other platforms, bolstering its music library for QQ, Kugou and Kuwo.
Live music streaming: this element sees performances by artists streamed live primarily through Kugou Live and Kuwo Live, which in turn compliment the online music services
Social entertainment: bundling this music-centric social network together then provides further opportunity to flog virtual products – emoji hearts and online gifts for example – that users purchase and send to karaoke or live performers. Tencent Music then shares a slice of the virtual sales with the artists or users that receive them, increasing engagement and providing income for content providers.

Surprisingly, Tencent Music currently makes over 70% of its revenue by selling virtual gifts and premium memberships. The other 30% comes from its online music services, which operate under a similar model as Spotify by offering ad-supported tiers and ad-free subscriptions.

This shouldn’t be the case longer-term, as the core subscription element of the business should grow in what is a very immature Chinese market, but this is not to say that selling virtual gifts and the like will not remain a fundamental part of the business in the future. For Tencent Music, all of its services form one ‘virtuous cycle of value creation’ – a flywheel that sees its music library attract users, which in turn encourages them to engage and provide further content that helps make its platforms even more attractive to new users.

Why is Tencent Music listing and why is it being spun out of Tencent?

Tencent Music is being spun out of its parent company Tencent Holdings, the Chinese giant dominating internet gaming and operating the country’s largest mobile messaging service WeChat. The music industry in China had, until Tencent began consolidating the market and bundling them all into Tencent Music, been highly fragmented.

Tencent is a hugely diverse company with fingers in all sorts of pies helping support their growth, and it seems to be the right time for Tencent Music to go it alone. The parent company’s e-book company China Literature listed in Hong Kong earlier this year and soared after joining the market and food delivery service business Meituan Dianping, backed by Tencent, earned a valuation of $53 billion to become one of China’s most valuable tech firms.

However, not all have been successful, with Chinese electric car maker NIO having experienced a tough start to life as a public company after listing in the US.

Learn more about NIO and what you need to know

Why is Tencent Music listing in the US?

Tencent Music is listing in the US to access global capital markets outside of China and gain recognition in financial markets. Listing in the US will bring it to the attention of analysts and investors, and listing alongside the likes of Spotify will help support its valuation - the Swedish firm has soared over 27% since listing in early April 2018 and currently boasts a valuation of $30 billion.

What is Tencent Music likely to be valued at?

Tencent Music will be one of the biggest US listings by a Chinese company this year but the price of the initial public offering (IPO) has not yet been confirmed. Reports suggest the company will look to join the market with a valuation of between $29 billion to $31 billion – matching Spotify’s current worth. Based on the middle of the reported valuation range, Tencent Music would be worth about 18 times its annual sales last year when it joins the market.

For registration purposes it has set a placeholder amount of $1 billion, which should be regarded as a minimum target considering the firm is reportedly aiming to raise closer to $2 billion. That would be only half the rumoured $4 billion figure circling earlier this year, although the valuation has remained stable to suggest it now plans to sell fewer shares under its IPO than before. That would be understandable considering it has over $1.4 billion in the bank following positive cash flow and significant fundraisings this year.

The IPO price per share will be higher than what existing investors have paid and with that in mind, Tencent Music this year has sold off 67.4 million shares for $239 million to new strategic investors at an average price of around $3.50 and 52 million shares for $210 million to existing investors for about $4 per share.

Tencent Music IPO: parent company to retain ultimate control

Tencent Music has filed for a possible IPO in the US involving the issuance of American Depositary Shares (ADS) but has not yet decided whether it will list on the New York Stock Exchange (NYSE) or Nasdaq. However, like many tech giants that come to market over the years the company will ultimately remain under the control of the parent company Tencent Holdings, which owns 58% of Tencent Music pre-IPO. How much control Tencent Holdings will retain after the IPO is not yet known, but it will hold a majority of the voting power.

The support from Tencent Holdings has been invaluable, not only aiding the music arm financially but also in vital areas including traffic acquisition, advertising and IT infrastructure, demonstrating how Tencent Music’s reliance on its parent firm goes far beyond money.

The lead sponsors of the Tencent Music IPO are Bank of America, Deutsche Bank, Goldman Sachs, JPMorgan and Morgan Stanley.

Is Tencent Music profitable?

Tencent Music is not only in the black but delivering sustained levels of profit growth, making it one of the only upcoming tech giants to go public without accounts awash in red ink. What’s more interesting is the reason why, unlike Spotify, it has been able to remain profitable while rapidly growing - in the first half of 2018 pre-tax profit quadrupled year-on-year (YoY), operating cash flow rose 6% and total net investment was almost two-thirds lower.

Tencent quarterly growth chart

(RMB, millions)	Q316	Q4	Q117	Q2	Q3	Q4	Q118	Q2
Online music service revenue	585	749	719	645	737	1048	1254	1299
Social entertainment revenue	890	1252	1386	1735	2173	2538	2862	3204
Gross profit	430	684	679	703	1034	1394	1683	1795
Pre-tax profit	(47)	201	251	227	472	647	925	998

This profitability has come down to its success not as a music streaming service provider but as a social network. ‘Social entertainment’ – the virtual gifts and so on purchased by users to show their appreciation to karaoke and live performers – is not only the fastest growing revenue stream of the business but also offers considerably higher margins, flogging things that are practically free to create. This also adds an important volume-based income for a business operating in a market where most of its peers are reliant on fixed monthly subscriptions that make it difficult to grow how much each of its users spend, placing more pressure on adding new paying users.

The success in the social network arena has come down to the unique access it has to its parent company’s market-leading social network. WeChat (note that it’s on brand with WeSing) has over one billion of China’s 1.4 billion people signed up, and this has formed the strongest possible foundation for Tencent Music to build upon.

At the bottom line: music is at the heart of the business, but social media is where Tencent Music’s strengths lie. This is why, amongst other things, its likeness to Spotify or other streaming services like Apple Music is in fact very limited.

Still, those that choose to invest should not necessarily expect profit growth to continue, or possibly even profit at all. The proceeds from the IPO will be spent on new content (40%), product and service development (30%), marketing (15%), and on potential acquisitions (15%). Moving forward the company has warned it plans to spend big to license music content and innovate its technologies, ‘which requires us to obtain additional equity or debt financing’ in the future. And in the final quarter of 2018 it will report an overall loss after issuing 68.1 million shares to Warner Music and Sony Music under a deal signed earlier this year worth $200 million – equalling about $2.93 per share.

Increased expenditure and less reliance on its parent company suggests the future financial performance of Tencent Music will be drastically different to the results it has produced in its relatively short history.

Tencent Music vs Spotify: how do they compare?

With over four times as many users than the Swedish company and profit flowing into the business Tencent Music looks to outrank Spotify at first glance. But, while social media and virtual products have kept Tencent Music in the black, it is nowhere near as successful at monetising the online music business, with Spotify boasting 2.5 times as many paying subscribers.

Spotify vs Tencent Music: Q2 2018

(As at the end of June 2018)	Spotify	Tencent Music
MAUs	180 million	800 million
Paying/Premium users	83 million	32.8 million
Paying ratio	46%	4.1%
Quarterly revenue	$1.27 billion	¥4.5 billion ($655m)
Quarterly gross margin	25.8%	39.9%
Quarterly pre-tax profit (loss)	($392 million)	¥998 million ($145m)

Despite their different approaches to the market the pair already have ties to one another following an equity swap agreement struck last year that today means Spotify owns about 9% of Tencent Music and Tencent Holdings owns about 7.5% of Spotify. This of course means Spotify has the potential to benefit when the Chinese music business lists as it will have the market and therefore the option to sell its holding should it require any liquidity, but only after the lock-up period expires at the start of 2021.

What does Tencent Music’s growth look like?

Tencent Music has delivered substantial growth in its overall user numbers over the past two years and while maintaining that growth will remain important the real challenge comes down to monetising its services. China’s music streaming market is nowhere near as developed as those in Western markets: US consumers spend 45 times more on music streaming than Chinese consumers and while over 800 million people use its services just 3.6% of them pay, compared to Spotify which boasts a paying ratio of over 46%.

Tencent Music growth vs penetration chart

(millions, unless stated)	Q316	Q4	Q117	Q2	Q3	Q4	Q118	Q2
Total online music MAUs	579	589	607	606	609	603	625	644
Paying online music service users	12.2	13.5	15.3	16.6	18.3	19.4	22.3	23.3
Paying ratio: online music	2.1%	2.3%	2.5%	2.7%	3%	3.2%	3.6%	3.6%
Monthly ARPPU: online music (RMB)	8.6	9.3	9.5	8.7	8.5	8.7	8.4	8.7
Total social entertainment mobile MAUs	144	151	180	200	214	209	224	228
Paying social entertainment service users	2.9	4.2	6.2	7.1	8	8.3	9.6	9.5
Paying ratio: social entertainment	2%	2.8%	3.5%	3.5%	3.7%	4%	4.3%	4.2%
Monthly ARPPU: social (RMB)	100.7	99	74.5	81.6	90.8	101.9	99.5	111.8

The need to convert more users into paying customers is only likely to rise as Tencent Music is running out of new free users to attract. Its links to China’s favourite social media networks through its parent company have been fundamental in acquiring the 800 million users it has at present, but that is not too far off the estimated one billion users of WeChat, suggesting that the company has already acquired most of the users it can and now has to get them to pay rather than look for new ones. This is also important because the Chinese firm’s ad-supported tier is less aggressive than Spotify’s.

All Spotify customers tend to go through the same journey, signing up for the free service and eventually upgrading to a premium subscription to get rid of the adverts that pop up. However, Tencent Music’s advertising methods are limited so it can offer an ‘uninterrupted online music entertainment experience, in order to retain its market-leading position. This not only dampens the appeal of the platforms for advertisers, which will not see their brands gain as much exposure compared to alternative ones, but also provides less incentive for free users to upgrade if they can use the services with minimal interruption already. Plus, Tencent Music’s engagement level with its user base is already high, raising questions about what else it needs to do to get customers to pay – its users spend an average of 70 minutes a day on its platforms, considerably more than the 50 minutes or so users spend on Spotify and Facebook, according to data from Statista.

How fast is China’s music and online entertainment market growing?

The investment case for Tencent Music comes down to its leading role in a fragmented and early-stage market that is still far from reaching its full potential. Paying for music is still a relatively new concept in China where both music and film piracy has remained rife, but the amount spent on recorded music is forecast to quadruple between 2017 and 2023.

Chinese music and online entertainment market growth forecasts

Tencent Music does intend to move toward a subscription-based model but is aware that it might not take off as fast (or at all) as it has done in Western markets, although it has already demonstrated the ability to source income from its music-centric platforms without subscriptions so far.

What challenges face Tencent Music?

Although Tencent Music has a unique blend of music streaming, user-generated content and social media the company has a long way to go in monetising its huge user base. Although this is a great position to start from it will have to significantly increase spending before reaping the rewards and, less reliant on Tencent Holdings and more on public markets and commercial banks, this means the company’s profitable history is by no means a signal of its future performance.

There are some other significant points that should be considered going forward:

China’s regulatory regime for the Internet and online music is changing

The regulatory environment for online music entertainment is only beginning to be moulded in China, particularly over exclusive licensing and sublicensing. Tencent Music has warned that the government has guided the industry to ‘avoid acquiring exclusive music copyright’ and indicated that they should also not engage in activities involving ‘collective management of music copyright’. The company’s model therefore, could have to change depending on what the government ultimately introduces as legislation.

In addition, the reliance on virtual gifts and products puts it under the virtual currency spotlight. Tencent Music’s business means it is technically selling virtual currency for cash (a token) which are then used to purchase the virtual products in its e-shops, but believes it does not fall under the remit as these cannot be traded between users nor traded for cash. The threat here is that it has to significantly shake-up its business if it is decided the company is providing both a transaction service (issuing virtual currency) and the platform by which they are traded (such as the shops), which is banned under law.

Copyright issues and legal claims are likely to remain rife

There were over 900 lawsuits filed against Tencent Music at the end of June, carrying total potential damages of about $7 million, primarily in relation to copyright infringement. The nature of the music market in China means the ownership of the vast array of music, both domestic and foreign, is not as concentrated as it is in the West. In fact, Tencent Music openly admits it only has licenses for 85% of its existing music library, stating it is still trying to find who actually owns the rights to the rest.

Another big issue is its corporate structure, which could pose problems far beyond copyright and licensing issues. The units that actually operate its platforms are not owned by Tencent Music but are under contractual arrangements. These partners, not subsidiaries, own some of Tencent Music’s licenses covering its libraries.

The other possible hurdle comes down to its karaoke arm and how it ensures people can use artist’s songs without infringing on any copyright issues. Tencent Music says its content partners are ‘silent on our rights to use the accompanying music for our online karaoke services, partly due to the relatively novel nature of online karaoke services and lack of industry standard on the applicable royalty arrangements’. But with this set to be the fastest growing segment of the market and core to Tencent Music’s business content, providers will eventually demand a slice of the action if they can, it just isn’t worth doing until the market has truly taken off. Without any sort of framework its content partners and the record labels have the ability if not the desire to cancel karaoke night.

The challenge in creating a valuable marketplace for artists and advertisers

Having noted the potential problems in attracting advertisers by prioritising the user experience the other element the company may struggle with is creating an effective marketplace for artists, particularly the ones not covered by the deals it has with the big record labels.

Currently, the live performers and karaoke singers are incentivised to use the platform because they get a share of any virtual products sent their way by fans. This is a model that Tencent Music has less control over compared to paying for content under large deals, as it comes down to the willingness of customers to buy these virtual gifts and then give them away. It may seem odd for customers to effectively pay amateur singers using emojis and whatnot rather than the cash that I’m sure the performers would prefer, but it all boils down to the social media element of its platforms and how performers and users interact with one another online rather than squeezing cash out of fans. Still, the ultimate risk is that any slump in demand for virtual products will hit the income of performers and make the platforms less attractive – the company claims it has a flywheel in effect, that new growth creates even further growth, but that also means it works the other way and a downturn in one area will quickly start to unravel the rest of the business.

Growth and record label deals to weigh on margins

Tencent Music has managed to deliver sustained profit growth, but margins will come under heavy pressure as it ramps-up investment and its arrangements with the big record labels start to kick in. It currently has to make minimum guaranteed payments to some of its copyright partners, heightening the need to convert more users into paying customers.

Details about these arrangements are not crystal clear, but Tencent Music says the deals containing minimum guaranteed payments typically last for two to three years and that next year’s sum of ¥3.1 billion ($450 million) will be considerably higher than the minimum ¥1.8 billion ($262 million) to be paid in 2018.