Tencent Music Stock: Undervalued and Undervalued Business

AntonioGuillem/iStock via Getty Images

The thesis in a nutshell

Tencent Music Entertainment (NYSE:TME)known as a Spotify music streaming competitor (NYSE: SPOT), is actually a social media company with a very sophisticated business model. TME has a dominant position 80% market share in China and a monthly asset 841m user base. Additionally, TME not only has untapped potential to monetize its current business, but also has a great opportunity to leverage its social music ecosystem in the metaverse.

Since its all-time high in March 2021, TME stock has sold more than 77%. Tencent Music appears to be extremely undervalued at the current trading price. A DCF valuation calculates a fair target price of $12.15 per share, implying 71% upside potential.

Understanding Tencent Music

Let’s start with a brief overview of Tencent Music Entertainment Group, as many Wall Street analysts seem to define the company’s value proposition narrowly.

Tencent Music Entertainment is the leading online music and audio entertainment platform in China, with a dominant music streaming market share of around 80%. The company operates 4 out of 5 most popular music apps in China, including QQ Music, Kugou Music, Kuwo Music and WeSing, and markets services such as online music, online karaoke and online concerts.

It is important to understand that these apps are not just focused on music streaming services but on a large community for music fans to discover, listen, sing, watch, play and socialize around music. Additionally, social interactions such as content sharing, likes, comments, follows, and virtual gifts are deeply integrated into TME products and highly complementary to the core music experience. TME describes himself as follows: “Our platform is an all-in-one music and audio entertainment destination that allows users to seamlessly engage with music in a highly social setting.”

So, in my opinion, TME should be considered – and potentially also appreciated – as a social media company.

As of September 2021, TME has a monthly active user base of 841 million.

Tencent Music Platforms

Presentation to TME Investors

A sophisticated business model

TME’s business model and monetization is very much in line with a social media business. While other music streaming platforms such as Spotify generate most of their revenue from online music services such as paid subscriptions, advertising and royalties, these companies only accounted for 1/3 of TME’s sales in 2021. In fact, most of TME’s revenue comes from social entertainment services (e.g. the culture of virtual gifts as promoted in other social media streaming companies).

The idea is this: TME’s business model acquires users through the provision of music downloads and streaming. Once users are in TME’s music ecosystem, the company monetizes its huge user base through offering various social entertainment services. Thus, TME not only provides a more comprehensive music experience than its global peers, but also benefits from cost-effective user acquisition coupled with higher value monetization.

As Tencent Music has already captured 80% of the relevant music market in China and the company’s MAU will likely stabilize at current levels, I expect TME to focus more on monetizing the business. And there are still many untapped opportunities for TME to monetize its music business. I attribute this argument to three facts: first, in November 2021, only about 11% of TME’s massive active user base are paid subscribers. Second, ad space on TME platforms could easily triple before ads negatively impact user experience. Third, broader integration with Tencent (OTCPK: TCEHY) ecosystem could generate new business opportunities. In this context, it should be noted that Tencent owns 51% stake in Tencent Music.

Moreover, I firmly believe that some chapters of Tencent Music’s growth and innovation story could still be written. With reference to the current entertainment and social music ecosystem of Tencent Music, the company has built incredible prospects to leverage its business in the metaverse.

Tencent Music business model

Presentation to TME Investors

Big finance

Whenever I make an equity investment, I need to be comfortable with the following three data points: growing income in the income statement, positive net operating cash flow, and a healthy balance sheet.

Let’s first look at the income statement. Between 2017 and 2020, revenues grew at a compound annual growth rate of 27.8%. Additionally, the business is profitable, with a net profit margin of approximately 12.3%.

Tencent Music income statement

Macrotrends – Income statement TME

Second, the cash flow statement shows that TME has strong operating cash flow. In fact, operating cash flow is higher than the bottom line, which I consider to be a very strong signal of a high quality company.

Tencent Music cash flow

Macrotrends – Cash Flow TME

Finally, let’s analyze the balance sheet. With $3.7b United States free cash, which accounts for more than 30% of the company’s market capitalization, Tencent Music is in a very healthy financial position. The company can certainly absorb some headwinds over several years, while making significant investments in long-term growth opportunities such as the Metaverse.

Given the healthy cash flow, strong balance sheet and low market valuation, a share buyback program is highly likely.

Tencent Music - Review

Macrotrends – TME Report

Now available at a great price

Every investment opportunity is a function of price. You can make a bad investment in an amazing company if you pay too much. Conversely, you can make incredible speculation in a near-bankrupt company, if you buy at a bargain price. So, for me, the price is very important.

Since its all-time high in March 2021, TME stock has sold over 77%.

TME share performance

Y-Chart TME Performance

But this sale is not linked to any fundamental change. As you can see in the following charts, the gap between stock performance and company performance has produced historically low valuation multiples such as the price-to-sales ratio and the price-to-earnings ratio. In my opinion, Tencent Music seems to be extremely undervalued at the current trading price.

TME Stock Performance %Off All-Time Highs

Y-Chart TME Valuation

Evaluation

TME therefore appears undervalued. But what would be a reasonable assessment? I constructed a DCF valuation with sensitivity analysis of key assumptions. The results of my analysis are called base, bearish and bullish cases. (Some assumptions for the analysis are listed under the respective case).

Valuation of the TME share

Authors’ calculations

As you can see, possible valuations for Tencent Music, given current knowledge of the company, should be between $6.91/share and $23.18/share. Given that TME’s last trading price was quoted at $7.10/share, the presented opportunity is biased towards a winning bet.

Risks and Challenges

While I think the market has already priced in a lot of negativity for TME, there are still risks. Besides the usual sources of possible challenges that can affect the profitability of each company, such as macroeconomic headwinds, industry competition or poor execution of strategy by management, I have identified three main possible sources of risks that are idiosyncratic for Tencent Music. .

Competetion. Some analysts believe that the music entertainment industry in China will become more competitive in the coming years. First, new entrants are trying to enter the market and, second, the Chinese government has removed exclusive content rights for Tencent Music. I believe, however, that due to TME’s huge scale advantage, the company should easily be able to maintain its current competitive edge. Additionally, synergies with parent company Tencent’s social media and a largely growing market also support its outlook.

Regulatory headwinds in China. Another major risk to TME stock is obviously a lawsuit Chinese government pressure. I don’t want to politicize the discussion, nor present myself as an expert on China, which is why I would like to encourage every investor to evaluate for themselves the risk/reward ratio of an investment in China. For me personally, valuations are pushed to such ridiculously low levels that I consider investing in China justified.

ADR delisting fears. This risk is closely related to the previous concern of regulatory headwinds. Personally, I’m not afraid of a ADR cancellationbut the negative market sentiment and associated fear could certainly keep the stock price depressed for some time.

Conclusion and recommendation

When I feel like a company is being cheaply valued, I like to wait for an additional 30% discount. If the extra discount never comes, I lose nothing, because opportunities come and go. If however, the target buy price is reached, the risk reward becomes very favorable.

When I first thought TME was cheap, the company was trading at $14/share. Thus, since my first assessment, TME has lost not 30%, but 50% of its market capitalization! At the current valuation level, I really think the company is cheap and I’m confident to take a long position in TME. I will keep the stock until the misunderstanding, undervaluation and undervaluation of Tencent Music is corrected.