Why Tencent Music Stock Crashed Today

What happened

Chinese music streaming service shares Tencent Music Entertainment Group (NYSE:TME) was caught in a landslide this morning, dropping as much as 21% in early trading, and still down around 19% as of 12:45 a.m. EDT.

And yet the only apparent news on the wires today is an announcement from HSBC bank that it is breeding its price target on Tencent Music stock at $35, nearly $10 above its current price.

So what gives?

Image source: Getty Images.

So what

After all, Tencent Music is now the top music streaming company in China, as my colleague Leo Sun pointed out last week. It released decent numbers in its latest financial report, meeting analyst expectations for sales ($1.28 billion) and earnings ($0.12 per share).

So why is the stock crashing?

We might find a clue in a report from China Renaissance Bank, which yesterday was the only analyst to downgrade Tencent stock after its earnings. Like TheFly.com reports, China Renaissance was happy to see “no signs of diminishing returns” as Tencent charges more for music, and the company has “revenue momentum” – sales are up 14% year over year in the fourth quarter, and online music streaming revenue was up 29%.

Nevertheless, the bank believes that the “rich valuation” of the title already takes this growth into account. Valuing Tencent at just $29 per share, it sees much less value in stock than HSBC does.

Now what

I somewhat agree with China Renaissance on this point. With $636 million in earnings, Tencent Music is now trading for a high valuation of 68 times earnings. Admittedly, free cash flow is probably better than that, with Tencent being a high-margin, asset-light company that generated $748 million in operating cash flow last year and typically spending less than $20 million dollars a year in capital expenditure.

Even if you assume that Tencent’s free cash flow number is, say, 15% higher than its reported earnings, that still brings the free cash flow stock price valuation down to around 58 only. For a 14% producer — or even a 29% producer if you’re focusing on the streaming business — that’s just too much to pay.

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Rich Smith has no position in the stocks mentioned. The Motley Fool has no position in the stocks mentioned. The Motley Fool has a disclosure policy.

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