My investment rating for Tencent Music Entertainment Group (NYSE:TME) [1698:HK] Stock is a hold.
I have provided an overview of Tencent Music Entertainment’s earnings for the second quarter of this year with my previous write-up of August 19, 2022. In this article, I preview TME’s upcoming third quarter 2022 financial results, which are expected to be released in Mid November. Given that I expect Tencent Music Entertainment’s third-quarter earnings to be consistent with no surprises and its valuations in-line with its peers, I see no reason to change my “Hold” rating on TME.
Completion of listing in Hong Kong
Before previewing TME’s third quarter results, it’s important to discuss a key development for the company.
On September 20, 2022, Tencent Music Entertainment announced that its shares were “successfully listed on the Hong Kong Stock Exchange.” Notably, in the announcement, TME emphasized that the company’s Hong Kong-listed shares, with ticker 1698:HK, are “fully interchangeable with NYSE-listed ADSs (American Depositary Shares)”.
I have already highlighted in my previous article for TME on August 19, 2022 that the company “faces the risk of having to be delisted from the US stock exchange in the future provided it is unable to support the Holding Foreign Companies to comply with the Accountable Act”. PricewaterhouseCoopers chairman was quoted as saying in a statement dated October 4, 2022: Reuters News article mentioning that “it could be months before the conclusions are known” regarding “US regulatory inspections of audits of “US-listed Chinese companies”.
In other words, there is still significant uncertainty as to whether Chinese companies like TME can remain listed in the US. Therefore, the success of Tencent Music Entertainment’s Hong Kong listing is crucial to mitigate the risk of a US delisting.
Third quarter financial results preview
I mentioned in my previous update for Tencent Music Entertainment, released in August 2022, that “the near-term outlook for TME is mixed, with revenue declines expected to be offset by higher profit margins.” This is exactly what is reflected in the sell-side consensus financial forecasts for Tencent Music Entertainment.
Related to S&P Capital IQ’s According to consensus data, Tencent Music Entertainment is expected to post revenue of RMB7,118 million in the third quarter of 2022, down -9.9% year-on-year in RMB terms. Still, this represents an improvement compared to TME’s year-on-year revenue declines of -15.1% and -13.8% for Q1 2022 and Q2 2022, respectively.
In terms of profitability and bottom line, analysts believe that TME should be able to deliver higher profit margins and robust earnings growth in the third quarter of the year. Taken from consensus financial estimates S&P Capital IQ point out that Tencent Music Entertainment’s normalized net profit margin improved to 16.3% in the third quarter of 2022 from 13.5% in the first quarter of 2022 and 14.9% in the second quarter of 2022. This is expected to result in TME normalized earnings per share growth of +16.0%y/y (in RMB terms) to RMB0.71 in the third quarter.
In my opinion, the consensus financial estimates for TME for the third quarter of 2022 are reasonable and realistic. In particular, I think cost optimization will be the key factor that will help Tencent Music Entertainment achieve profits in line with market expectations. TME stressed in its Q2 2022 earnings call in mid-August that it would implement “cost controls in areas” such as “content royalties,” “personnel costs,” and “marketing spend” going forward.
In the next section, I review the prospects for TME’s online music services and social entertainment services businesses.
Strength in online music is offset by weakness in social entertainment
I’m positive about TME’s online music services business, but I’m much less optimistic about the prospects for its social entertainment services business.
I expect Tencent Music Entertainment’s online music services business to grow strongly in the future.
There is scope for TME to increase the number of paying users. The music store’s paid users grew a strong +25% qoq to 82.7 million at the end of Q2 2022, representing about 13.9% of monthly active users in the most recent quarter. As TME intends to put more content behind the paywall over time, this should strengthen the music business’s paying user base going forward.
On the other hand, the short-term performance of TME’s social entertainment services business is expected to be weak.
Live streaming services in particular are facing significant regulatory headwinds. According to a June 23, 2022 South China tomorrow post Article “China enacted new regulation for live-streaming industry, listing 31 prohibited conducts,” seen as “the government’s latest effort to regulate booming digital economy.” Tencent Music Entertainment cited “industry adjustments” as a factor negatively impacting its social entertainment services business at its second-quarter 2022 earnings review, which I take as an acknowledgment of the regulatory challenges.
In summary, I think the short-term strength related to Tencent Music Entertainment’s online music services business is offset by weakness related to its social entertainment services business.
My rating for TME remains Hold. I don’t expect Tencent Music Entertainment to report a significant earnings decline or loss when it reports its third-quarter 2022 results in mid-November. In addition, TME’s ratings are reasonably fair. TME currently trades at 1.04 times consensus enterprise value to next 12 month revenue S&P Capital IQ Data approximately equal to 1.09x Spotify (SPOT).