Tencent Music: "Purify" users, extract profits, and focus on "money"

Hi guys, I'm Dolphin Analyst!

Following the Hong Kong stock market closing on November 15, Tencent Music Entertainment Group (TME) released its Q3 financial results. Overall performance was better than expected, with profits being the major highlight just like Q2. However, the downside remains the long-term growth of TME, as user loss caused by rivals is still prevailing.

The main points of the financial report are:

1. User loss continues due to intense competition: In Q3, TME's user index was lower than market expectations, with all other users except music subscribers experiencing user loss. What is more, social and entertainment users haven't demonstrated any peak season effect but rather show even more of a decline.

TME's inability to hold onto its user base implies the competition remains fierce. Other pan-entertainment platforms, especially short video platforms, are causing a product substitution blow to TME's social and entertainment user base. According to QuestMobile's data, short video users are still growing in Q3, with mature leader platforms Douyin and Kuaishou still expanding their monthly activity.

2. Decline in revenue slows down, stable increase of subscriptions, advertising recovery, and Jay Chou's album sells well: In Q3, TME's total revenue was RMB 7.365 billion, down 5.6% YoY, which is much less of a decline than Q2 (-13.8%). Even if we completely exclude the contribution of Jay Chou's album sales of RMB 210 million (7 million copies), an 8.3% YoY decrease can still see signs of rebound.

Dolphin Analyst believes:

(1) Apart from stable growth in subscription income, the recovery of advertisement revenue after the COVID-19 pandemic may also be a major driving force, as its advertisement was affected by the regulation rules of App by MIIT in the same period of last year's Q3.

(2) Social and entertainment business (live streaming and K song) declined by 20% YoY, with a slight easing of the seasonal effect but still not to the turning point, in comparison to last year's Q3 which has been seriously affected by regulatory and competitive factors. Hence, it can be seen from the user index that social and entertainment's active and subscribed users are still experiencing a continuous loss. Even though the market expectation for this business's income is lower, the user index reflecting the competition is overly optimistic.

Social and entertainment has always been the performance pillar of TME, despite having been in a slump for over a year. Nonetheless, as of Q3, social and entertainment revenue still accounts for 53% of the total revenue. Hence, in the short run, the decline in this pillar will put considerable pressure on TME's revenue.

Thus far, incremental growth brought by advertising has temporarily alleviated most of the pressure. Especially the function that was launched in the second half of last year, "watching ads to listen to music for free," should have made good progress. Management also mentioned last quarter that this feature contributed 10% to ad revenue. Referring to Spotify, Dolphin Analyst predicts that these ad revenues will help to promote more freeloaders to become advertising audiences, and these ad audiences will be more easily converted into subscribing users when the economy improves.

3. Profit still exceeded expectations mainly in cost optimization:

Like the second quarter, the highlight of the third quarterly report is still on the optimization of cost and expense. Cost reduction is a passive optimization, resulting from the decrease in income from high-scored live broadcasts and other social entertainment. Expense optimization reflects the proactive efforts of the company to improve its overall operating efficiency through methods such as layoffs and organizational structure adjustment. In addition, the decrease in sales expenses is related to the company's strategic adjustment, reducing customer acquisition costs and focusing on the conversion of existing users' payments. Ultimately, the gross profit margin and operating expense ratio in the third quarter both increased by 3 percentage points compared with the previous quarter, and the improvement in operating expense ratio was almost 1 percentage point.

4. Cash is still abundant:

As of the end of the third quarter, the company's cash-like assets balance was CNY 25.45 billion, which accounts for half of its total market value. With a profit of nearly CNY 1 billion per quarter, the company is able to create a positive cash flow. From the perspective of valuation, although the impact of competition is still ongoing, there is still potential to further explore the value of traffic. In addition, there is a margin for improvement in the macro environment, so Tencent Music still has some room for valuation repair.

Dolphin Analyst will share the summary of the phone meeting with the Dolphin user group through the Longbridge App. Interested users are welcome to add the WeChat account "dolphinR123" to join the Dolphin research group and get the summary of the phone meeting as soon as possible.

Dolphin Analyst Opinion

After the social entertainment income in the second quarter did not decline as much as expected and profits exceeded expectations due to cost optimization, the market was waiting for more signals of performance bottoming out and even returning to growth. If you delve into the logic behind it, what the market hopes to see is:

1. Tencent Music has a promising barrier to competition under the more prominent competitive pressure of the bad macro-environment.

2. Tencent Music can tap more realization value under the existing pool of traffic.

This quarter's report mainly confirms the second point, which is that the value potential of music assets has not been fully released and there is still considerable room for growth. At the same time, Tencent Music has also released more profits by using higher employee efficiency, which is what shareholders want to see. The only downside is that the impact of platform competition is still ongoing, especially in the user flow of social entertainment reflected in short videos.

In the short term, advertising revenue has resisted most of the pressure from the decline of social entertainment income due to competition, and with higher gross profit margin, it benefits the improvement of overall profitability. In addition, under the initiatives of cost optimization and layoffs, Tencent Music has resisted revenue pressure and released more profits.

In terms of the core operating profit indicators that Dolphin Analyst pays attention to, the profitability in the third quarter has returned to the level of 2020, even without the one-time benefits from Jay Chou's album sales, there are still obvious signals of recovery.Under the trend of marginal improvement in the macro environment, we can confirm that Tencent Music has passed the most difficult time in the short to medium term. With Tencent Music holding 25 billion and generating 1 billion in profits each quarter, and a market value of just over 50 billion, it is obvious that short-term valuation recovery has not yet been completed. In the medium to long term, whether the valuation can further open up requires more growth to be reflected. Relying solely on advertising to monetize existing users cannot fully compensate for the continuous loss of social and entertainment revenue in the long run.

Regardless of whether it is long-form audio, TME Live, or going overseas, the essential goal of finding a medium-to-long-term growth story is to reduce user churn and capture more new users. However, the results so far are limited. At least compared with the music streaming leader Spotify, which continues to expand its traffic, Tencent Music still has a long way to go.

Interpretation of this quarter's financial report

1. Users are still lost and competition continues

The user side of the third quarter still reflects the status quo of a peak inventory and gradual loss. The average monthly active users of online music continue to fall to 587 million, a decrease of 6 million compared to the previous month. Social entertainment monthly active users have quickly returned to their original state after losing the COVID-19 dividend, with a decrease of 11 million in the third quarter and only 155 million active users, reaching a new low.

The continued loss of users reflects Tencent Music's limited resistance in the face of competition. The "watch ads for music" function has only brought the benefits of monetizing inventory traffic value, but it has not helped Tencent Music obtain more traffic from outside the platform.

Online music continues to implement a subscription wall strategy. The net increase of subscription users in the third quarter was 2.6 million on a sequential basis, and the overall subscription users were 85.3 million, which was lower than the market's expectations. The payment of social entertainment users was more affected by the macro and competition, with a sequential decrease of 500,000, and the market originally expected that some users would return under the boost of the summer peak season effect.

The loss of social and entertainment users is the result of the competition from other pan-entertainment platforms such as short videos, which the company was basically unable to resist. However, after walking out of the Shanghai epidemic in the third quarter, the net increase in online music subscription users, which has always been strong, did not return to the guidance range of 3-4 million given at the beginning of the year. This is probably more due to the continued economic downturn. After all, the advantage of Tencent Music's music library is still significant for core users.Three

In addition, after more songs are included in the paywall, price-sensitive "non-loyal users" will continue to leave. This is also a foreseeable result for the management, but this year's strategic focus of the company is to improve services for "loyal users," explore more payment points, and help optimize the overall profit level.

Therefore, we can see that the ARPPU of subscription users in the online music business continues to increase from 8.5 yuan/month in Q2 to 8.8 yuan/month, but the increase in ARPPU of other online music in Q3 is mainly due to Jay Chou's album sales and the corresponding increase in the value of single users for advertising.

The single user payment ARPPU in social entertainment in Q3 continued to reach a new high of 177 yuan/month and did not decrease as the market imagined. Dolphin Analyst believes that this cannot reflect the increased payment power of social and entertainment users but is due to the repair of advertising revenue included in Kugou Live and Quanmin K Song. In addition, the high payment power of core users became apparent in the overall average ARPPU after low-paying non-core users stopped paying during the economic downturn.

Two

Behind the revenue recovery: steady subscription, advertising repair, and selling of popular albums

The total revenue in Q3 was 7.365 billion yuan, a year-on-year decrease of 5.6%, and the decline rate was significantly slowed down compared to Q2. In addition to the stable 15%-20% growth range of subscription revenue, Jay Chou's album as a hot-selling item, selling 7 million copies for 30 yuan each, also contributed 210 million yuan. However, after excluding this factor, the decline rate was still 8.3% YoY, which is much better than the 14% decline in Q2. Although the baseline of Q3 last year has been lowered, it is difficult to optimize more without considering the advertising revenue on QQ Music in the 20% drop in social entertainment.

Although advertising revenue can make up for the continuous decline of social entertainment in the short term, as social entertainment still accounts for over 50%, it may not be enough to make up for all the gaps solely relying on advertising in the face of short video competition and possible future declines:

Assuming 600 million users, 100 million paying and 500 million watching advertisements, with reference to Spotify's ARPU, which is about 10% of subscription ARPU, the estimated advertising monetization revenue accounts for about half of the payment revenue, that is, about 10-15 billion yuan/quarter, but the revenue scale of social entertainment is currently 4 billion yuan/quarter.

Therefore, before finding another growth path, the competition faced by social entertainment and when it will slow down will continuously affect Tencent Music's performance judgment.

Looking in detail:

1. Online music revenue was 3.44 billion yuan, an increase of 18.8% year on year. This comprises 2.25 billion yuan in subscription revenue and 1.178 billion yuan in other online music revenue (advertising revenue on QQ Music, digital album sales and copyright distribution).

   1. Subscription revenue maintained steady growth of 18% YOY, although net user growth was lower than planned at the beginning of the year. Management explicitly stated during the Q1 conference call that the primary goal will be overall revenue growth rather than net user growth, unlike in the past. Therefore, in a slow economy and with continuous competition, grasping the spending power of "loyal users" can optimize the profit model whilst achieving the ultimate revenue growth goal.

1. Other online music revenue included businesses that experienced adverse situations in Q3 of last year. App splash screen advertising was reformed, pink culture was regulated (fans were limited in the number of album purchases, reducing behavior of manipulating charts) and the impact of unbundling exclusive copyrights on copyright distribution all resulted in a lower base number last year.

In Q3 of this year, revenue includes sales of Jay Chou's new album and the recovery of advertising revenue. Compared with the significant decline in the first two quarters, this quarter achieved a YOY growth of nearly 20%.

As this business is not broken down into detailed items, Dolphin Analyst roughly separated the scale of advertising to judge the growth of advertising revenue. Although the value is not accurate, the trend can be seen briefly.

We predict that advertising revenue will account for 8.4% of total revenue in Q3, although Tencent Music's commercialization gap remains large compared with Spotify's current level of 12% and its medium- to long-term goal of 20-30%. Under the leadership of successful pioneers, the growth potential of Tencent Music's advertising is worth looking forward to.For example, the Dolphin Analyst's rough calculation of 1-1.5 billion/quarter still has room for further exploration compared to the current situation.

2. Social and entertainment single-quarter revenue continued to hit a new low within the past three years, with only 3.94 billion yuan and continued year-on-year decline of 20% due to direct competition from short videos, especially live broadcasts. This business is almost unable to defend itself against such competition, and can only reduce the direct loss of traffic through the company's ecological circulation.

Aside from competition, the regulatory standards (such as canceling rankings and head-to-head competitions) gradually implemented in June may also have an impact. However, according to Dolphin Analyst's observation, the various live broadcast platforms are progressing slowly, and have not yet been fully implemented. But according to feedback from industry experts, the final impact may not be as big as imagined.

But in any case, the peak of the live broadcast industry is a major trend. In the medium and long term, Tencent Music needs new growth business lines to make up for the loss in this area.

III.

Improvement in profits mainly comes from changes in business structure

Like the second-quarter financial report, the third-quarter profits are still the most eye-catching and main part that exceeds expectations. In which, the optimization of costs contributed more, and the gross profit margin in the third quarter reached 32.6%, an increase of three percentage points from the previous quarter. This is mainly due to the high-profit live broadcast business, whose revenue proportion has decreased, and the growth of high-margin advertising revenue has increased the contribution to total revenue.

On the cost side, it contributed one percentage point to the core profit margin (excluding non-primary-related income and expenses such as interest income and other gains and losses). This is mainly due to the reduction of layoff and customer acquisition expenditures, and the shift towards focusing on the conversion of existing users' payments.

The third-quarter sales expenses amounted to only 245 million yuan, a year-on-year decrease of nearly 60% and a decrease of 50 million yuan from the previous quarter. The absolute value has returned to the level of 2017, and it can be said that the company has tightened its belt to the limit. However, Dolphin Analyst believes that sales expenses of this level cannot be considered normal. When the economy turns better and growth is necessary, Tencent Music still needs to invest in customer acquisition to promote growth.

Finally, the adjusted net profit reached 1.4 billion yuan, a year-on-year increase of 32%. Although Dolphin Analyst believes that the profit level of the third quarter has short-term factors, the degree of profit release still significantly exceeded market expectations.The Dolphin Tencent Music: A Review of Relevant Research in the Past Year

Telephone Meeting on August 16, 2022: "Tencent Music: Enriching Member Privileges and Continuing to Promote Incentive Advertising (Telephone Meeting Summary)"

Financial Report Evaluation on August 16, 2022: "Tencent Music: Performance Decline Easing, but Signal of Recovery is Still Early"

Telephone Meeting on May 17, 2022: "New Live Broadcasting Supervision Effects Will be Evident Throughout the Year, and Cost Reduction and Efficiency Increase are One of the Priorities this Year (Tencent Music Telephone Meeting)"

Financial Report Evaluation on May 17, 2022: "Tencent Music: It's Still Early Spring and There is Plenty of Grain to Go Around"

Telephone Meeting on Month Day, 2022: "Tencent Music Telephone Meeting: Management is Honest and Transparent, and the Pressure in the First Quarter is the Greatest of the Year (Telephone Meeting Summary)"

Financial Report Evaluation on March 22, 2022: "Tencent Music: The Value of Music Below Zero, Needs to be 'Heard'"

Telephone Meeting on November 9, 2021: "After Copyright Loss, Competition Threats Intensify, Tencent Music Chooses to Embrace the 'Brothers' Thighs (Telephone Meeting Summary)"

Financial Report Evaluation on November 9, 2021: "Tencent Music: It's Not Easy to Protect the Family After the Copyright Era, The Reversal Still Needs to Wait"

Telephone Meeting on August 17, 2021: "Tencent Music Second Quarter Telephone Meeting Summary: More Attention to the 'Multiple Product, Multiple Brand Coordination' Strategy"

Financial Report Evaluation on August 17, 2021: "Without Exclusive Content, What Does Tencent Music Count On to Stand Out?"This article's risk disclosure and statement: Dolphin Research's Disclaimer and General Disclosure