IPO Update: Tencent Music Entertainment Files Terms For $1.1 Billion IPO

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About: Tencent Music Entertainment Group (TME), Includes: BABA, BIDU, NTES, TCEHY
by: Donovan Jones
Summary

Tencent Music Entertainment and selling shareholders intend to sell $1.1 billion of ADSs in a U.S. IPO.

The firm provides a range of digital audio streaming entertainment and related services to Chinese consumers.

TME has grown rapidly but I question whether it can sustain that growth.

The Spotify IPO earlier in 2018 has resulted in a lackluster performance for the stock post-IPO.

I'll be watching the TME debut and looking for a lower entry point after the IPO.

tencent music entertainment ipo

Quick Take

Tencent Music Entertainment Group (TME) and selling shareholders intend to raise $1.15 billion in a U.S. IPO of ADSs representing Class A ordinary shares.

The company provides Chinese consumers with streaming audio services.

TME has grown rapidly, but I have doubts as to whether it can continue that growth. Valuation isn’t cheap, and the Spotify IPO is a cautionary example of an interesting company but disappointing stock performance.

Company & Technology

Shenzhen, China-based Tencent Music, previously known as China Music Corporation, was founded to enable people to create, enjoy, share and interact with music on an online music entertainment platform.

Management is headed by Director and CEO Cussion Kar Shun Pang, who has been with the firm since 2014 and was previously Corporate Vice President at parent firm Tencent (OTCPK:TCEHY).

Tencent Music has developed a digital music entertainment platform that allows users to seamlessly engage with music in many ways, including discovering, listening, singing, watching, performing and socializing.

Social interactions such as sharing, liking, commenting, following and virtual gifting, are integrated into its products, enhancing its user experience, engagement, and retention.

Below is a brief explainer video for Tencent Music:

Source: UDtech

Customer Acquisition

Tencent Music is part of Tencent’s larger internet ecosystem.

Tencent, the company’s controlling shareholder, is a leading provider of internet value-added services in China, offering a broad range of internet services.

Sales and marketing expenses as a percentage of revenue have been essentially flat, per the table below:

Selling & Marketing

Expenses vs. Revenue

Period

Percentage

To Q3 2018

8.6%

2017

8.3%

2016

8.4%

The firm’s average revenue per paying user rose dramatically in 2017, but has dropped slightly so far in 2018:

Average Revenue Per Paying User

Period

ARPC/U

Variance

To Q3 2018

$56.84

-1.5%

2017

$57.73

54.6%

2016

$37.33

Sources: Company Prospectus, IPO Edge

Market & Competition

According to a market research report by Statista, the total digital music market in China has been growing at a CAGR of 6.7% during the period between 2013 and 2018, starting from $6.42 billion in 2013 to $8.91 billion in 2018.

Major competitors that provide digital music services in China include:

  • Ali Music Group (BABA)
  • NetEase Music (NTES)
  • Baidu Music (BIDU)

The company also faces competition from online offerings of other forms of content, including live streaming, karaoke, radio services, literature, long- and short-form videos provided by other online service providers, and games.

The social integration between Tencent’s social graph and Tencent Music’s platform gives the company an advantage over its competitors due to low cost and wide distribution and machine-learning data processing to optimize marketing placement for maximum consumer adoption.

Financial Performance

TME’s recent financial results can be summarized as follows:

  • Strong topline revenue growth, but at a decelerating rate
  • A sharp increase in gross profit, but also at a decelerating growth rate
  • Continued growth in gross margin
  • Strong growth in cash flow from operations

Below are the company’s financial results for the past two and ¾ years (Audited PCAOB for full years):

Source: Company Prospectus

Below are relevant metrics from the firm’s most recent registration statement:

TTM Revenue

Period

TTM Revenue

% Variance vs. Prior

To Q3 2018

$ 1,978,000,000

76.5%

2017

$ 1,599,000,000

142.0%

2016

$ 660,757,576

Gross Profit (Loss)

Period

Gross Profit (Loss)

% Variance vs. Prior

To Q3 2018

$ 792,000,000

116.4%

2017

$ 555,000,000

197.3%

2016

$ 186,666,667

Gross Margin

Period

Gross Margin

To Q3 2018

40.0%

2017

34.7%

2016

28.3%

Cash Flow From Operations

Period

Cash Flow From Operations

% Variance vs. Prior

To Q3 2018

$ 539,000,000

29.2%

2017

$ 485,878,788

175.2%

2016

$ 132,272,727

Sources: Company Prospectus, IPO Edge

As of September 30, 2018, the company had $1.7 billion in cash and $811 million in total liabilities. (Unaudited, interim)

Free cash flow during the nine months ended September 30, 2018, was $525.2 million.

IPO Details

TME intends to sell 41.0 million ADSs and selling shareholders will sell 40.9 million ADSs at a midpoint price of $14.00 per ADS for gross proceeds of approximately $1.15 billion, not including the sale of customary underwriter options.

PAG Capital and CICFH International are the two selling shareholders.

Parent company Tencent will own 61.6% of Class B shares providing it will 61.5% of voting power post-IPO.

Assuming a successful IPO at the midpoint of the proposed price range, the company’s enterprise value at IPO would approximate $21.2 billion.

Excluding effects of underwriter options and private placement shares or restricted stock, if any, the float to outstanding shares/ADSs ratio will be approximately 5%.

Per the firm’s most recent regulatory filing, it plans to use the net proceeds as follows:

approximately 40% for investment to enhance our music content offerings to improve the variety, quality and quantity of content on our platform;

approximately 30% for product and service development to expand and enhance our current product and service offerings, as well as to develop new products and services to further enhance user engagement;

approximately 15% for selling and marketing, including marketing and promotions to strengthen our brand and grow our paying user base; and

approximately 15% for potential strategic investments and acquisitions and general corporate purposes.

Management’s presentation of the company roadshow is not available.

Listed underwriters of the IPO are Morgan Stanley, Deutsche Bank Securities, Goldman Sachs [Asia], J.P. Morgan, Allen & Company, BOCI, CICC, China Renaissance, Credit Suisse, HSBC, KeyBanc Capital Markets, and Stifel.

Final Thoughts

Tencent Music is the dominant audio streaming provider in China and that management appears to be asking investors to pay a premium for that market-leading position.

While historical financial metrics are impressive, the main question for investors is to what degree that growth can continue.

I don't think it can continue at the previous rate. I suspect TME has already picked the 'low-hanging fruit,' and that further significant top-line revenue increases will be more difficult and costly to acquire.

The Spotify IPO, which occurred earlier in 2018, is also instructive. The firm generated a lot of hype and public interest, but since the IPO the stock has performed in a lackluster and low-growth manner.

While TME has further growth ahead of it, I believe that nimble and patient investors may be rewarded with a lower entry point in the weeks or months after the IPO.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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