Tencent Music Stock: Bullish on Positive Earnings Despite Regulatory Problems (NYSE: TME)

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Tencent Music Entertainment (TME) just released its latest quarterly result to beat EPS expectations, while revenues are in line with market estimates. The bar has been set low for the stock, which has been nothing short of a disaster for shareholders, down nearly 75% this year from highs in the first quarter. Recognized as China’s leader in online music and audio entertainment, the company has been caught in the country’s regulatory crackdown, straining sentiment and clouding the outlook. While TME shares remain in the speculative category, we believe the sell-off more than rated stocks negative while the long-term outlook remains positive. Rising profitability and a rock solid balance sheet put TME in a good position for a rebound until 2022.

(Seeking Alpha)

Summary of TME Benefits

In the third quarter, TME hit EPS of $ 0.09, $ 0.02 ahead of expectations. Revenue of RMB 7.8 billion grew 3% year-on-year, coming against the backdrop of a difficult comparison period in 2020, when online services were boosted during the phase home care services for the pandemic. The challenge has been declining margins given an ongoing shift in the business mix, with music streaming gaining in importance over more profitable entertainment services. The gross margin fell to 29.6% against 32.4% in the third quarter of 2020. Similarly, the increase in general and administrative expenses led to a decrease in the operating margin to 11.8% against 16.6% for the period of last year.

(The source: Company RI)

The most encouraging part of the story was the strong momentum in paid online music users which reached 71.2 million, up 37.7% year-on-year. This offset a 4.8% drop in payers for social entertainment which includes platforms like live streaming and online karaoke.

(source: RI company)

Part of the dynamic here lies in efforts by the Chinese government to directly impose time limits on minors to play online games. The effect has been increased competition from other types of platforms, including games and short-lived video social media, adding to the volatility of user metrics. Management commented on these trends in the earnings press release:

In the third quarter, our online music services recorded healthy growth, driven by strong subscription dynamics, as users continued to be drawn to our improved music streaming experience. As the online music industry in China adapts to regulatory changes and faces competition for time spent on short video services, we will continue to differentiate our online music and social entertainment services and ” execute our dual-engine content and platform strategy.

The company ended the quarter with 24.5 billion RMB or $ 3.8 billion in cash and cash equivalents, compared to $ 799 million in long-term debt. We consider the balance sheet to be a strong point of the company’s investment profile. Notably, Tencent Music Entertainment repurchased approximately $ 239 million of shares under its existing share repurchase program.

Forecast of TME actions

The regulatory change in China has impacted Tencent Music Entertainment in several ways. In July, the company was directly targeted for perceived anti-competitive practices due to its effective monopoly based on exclusive content deals with major music labels. The company had 30 days to release control of its contrast, allowing competition from other Chinese platforms. Separately, other government efforts, including restrictions on collecting user data usage, have also limited a potential source of revenue for the company.

The stock’s volatility dates back to the first quarter following the high-profile collapse of hedge fund Archegos Capital Management which had built highly leveraged positions in several Chinese tech stocks, including TME, which resulted in a sell-off. massive when the fund was forced to liquidate its positions. These developments largely explain the weakness of the title over the past year compared to the strong momentum of the fourth quarter of 2020.

(Seeking Alpha)

The financial impact for society can be seen in the downward trend in consensus estimates for the current year and through 2022. From the chart below, the trend has been a steady stream of revisions to declining outlook for earnings and EPS.

Data by YCharts

The market currently predicts 2021 revenue to reach $ 5 billion, a 10% increase from 2020. The EPS estimate of $ 0.39 if confirmed would represent a 15% decline from 2020. compared to last year’s result. Even though revenue growth is expected to remain close to double digits through 2023, the market expects stable profits next year given cost pressures limiting margins. Nonetheless, it is important to remember that the business remains profitable with a financial outlook supported by a strong balance sheet.

(Seeking Alpha)

While the loss of exclusive music license agreements is a setback, our view is that it doesn’t necessarily jeopardize the long-term prospects of the company. Consider that the TME ecosystem has over 800 million monthly active users on a suite of apps and entertainment products. There is no indication that these users will be migrating en masse to another startup music service, especially as Tencent has a significant lead in terms of cutting-edge technology and platform.

(The source: Company RI)

Q3 figures showing strong growth in the number of paid music users highlight what is a positive wind for the company as the Chinese consumer becomes increasingly comfortable paying for premium services beyond the versions supported by the addition. Continued innovation with new forms of interactive music and audio entertainment, including live streaming and podcast-style content, remains only in the early stages of its potential monetization.

In terms of valuation, the consensus EPS for 2021 implies that the stock is trading at a forward P / E of around 20x or a forward sell multiple of 2.7x. For the context, Spotify Technology SA (SPOT) remains unprofitable but is trading at a forward sales multiple of 5x, or nearly double the premium of TME. We believe Tencent’s current valuation is attractive for a technology leader against the backdrop of positive earnings and at least stable growth prospects.

Is TME a buy, hold or sell?

When it comes to Chinese tech stocks, the segment has almost become taboo given this year’s deep underperformance relative to global markets. We argue that now is the time to take a contrarian stance with the massive sell off creating a new buying opportunity. From a high level, positive macroeconomic growth prospects with the global economy entering the next stage of post-pandemic recovery in 2022 may also support economic activity in China as a positive operating environment for all businesses.. For TME which is currently trading below $ 8.00, the reward versus risk setup now looks more compelling than when the stock was trading above $ 30 earlier this year.

We rate TME shares as a buy with a price target of $ 12 representing a multiple of 30 times EPS of the 2022 consensus. The bullish case for Tencent Music is that the company is ultimately outperforming expectations by driving organic growth through stronger engagement on its platform.

The risks here cannot be underestimated. Tencent is particularly exposed to other regulatory measures not only in its music streaming business, but also in the headlines against its parent company Tencent Holdings Limited (OTCPK: TCEHY). Concerns over Chinese companies’ foreign listing requirements on a US stock exchange with potential SEC enforcement action could end up putting pressure on sentiment and pushing TME shares lower. Over the next several quarters, user trends and weaker-than-expected subscriber metrics remain key watch points.