Tencent Music Entertainment: Staying On The Sidelines

Elevator Pitch

I rate Tencent Music Entertainment Group (NYSE:TME) (1698:HK) stock as a Hold. In my previous January 31, 2023 write-up, I touched on TME's efforts to optimize its topline mix and improve its profitability.

With this latest update, I explain that TME's post-Q1 2023 results share price outperformance was unsustainable because of its profitability outlook and unappealing valuations. I am staying on the sidelines with respect to TME for now, unless the stock suffers from a substantial valuation de-rating or new catalysts emerge. As such, a Hold rating for Tencent Music Entertainment is justified.

Post-Earnings Stock Price Rise Wasn't Sustained

On May 16, 2023, Tencent Music Entertainment reported above-expectations Q1 2023 financial results with its earnings press release, and it offered upbeat guidance at its first quarter results briefing.

Revenue for TME expanded by +5.4% YoY from RMB6,644 million in the first quarter of 2023 to RMB7,004 million for Q1 2023. This was the first quarter of positive YoY topline growth for Tencent Music Entertainment, following five consecutive quarters of sales contraction between Q4 2021 and Q4 2022. Tencent Music Entertainment's actual Q1 2023 topline was +1.4% higher than the sell-side analysts' consensus revenue forecast of RMB6,905 million (source: S&P Capital IQ). TME's headline net income attributable to shareholders surged by +88.5% YoY to RMB1,148 million in Q1 2023, which translated into a +17.1% earnings beat as per S&P Capital IQ data.

In terms of the financial outlook, TME guided at its Q1 2023 earnings call that 2023 will be "a year of positive growth for both topline revenue as well as bottom line net profit."

On the back of its better than expected first quarter financial performance and encouraging full-year guidance, Tencent Music Entertainment's stock price rose by +8.3% from $7.67 as of May 16 to end the May 17 trading day at $8.31. A May 17, 2023 Seeking Alpha News article also cited multiple Wall Street analyst upgrades as a key factor supporting TME's share price surge on May 17.

But the good times didn't last long for Tencent Music Entertainment shareholders. TME's stock price subsequently declined by -3.7%, -2.4%, -2.2%, and -3.5% on the 18th, 19th, 22nd, and 23rd of May, respectively. Tencent Music Entertainment's shares last traded at $7.78 as of June 9, 2023, which is just slightly above TME's May 16 stock price of $7.67.

In my view, there are valid reasons for TME's share price pullback in the time period between May 18, 2023 and May 23, 2023, if one looks beyond the headline results beat, as detailed in the subsequent sections.

Further Profitability Improvement For TME Might Be Limited

The current sell-side analysts' consensus normalized net profit margin estimates for Tencent Music Entertainment suggest that the company is unlikely to improve its future profitability by a meaningful extent going forward.

According to data sourced from S&P Capital IQ, the consensus Q2 2023, Q3 2023 and Q4 2023 normalized net income margins for TME are 21.5%, 21.4%, and 21.0%, respectively. Separately, the market sees Tencent Music Entertainment registering normalized net profit margins of 20.9%, 20.6%, 21.4%, and 21.2% for FY 2023, FY 2024, FY 2025, and FY 2026, respectively, In other words, it will appear that TME's profitability will peak in 2023 and its future margins are expected to be range bound.

The consensus profitability projections for Tencent Music Entertainment are aligned with management commentary at TME's most recent quarterly results call.

At the company's first quarter results call, TME noted its expectations that its "selling and promotion expenses and the G&A (General & Administrative costs) will be stable compared net of in Q1." It is reasonable to assume that Tencent Music Entertainment's expense optimization efforts have reached a point where benefits are maximized to a large extent.

Tencent Music Entertainment also guided at its Q1 2023 results briefing that its "revenue from online music services" is projected "to exceed social entertainment services to become a primary source of revenues." While this is positive from a revenue diversification point of view, the increase in revenue contribution from music is negative for TME's future profitability. I previously mentioned in my end-January article that "the online music services business boasts lower margins than the social entertainment business."

TME's Valuations Are Unappealing Based On A Peer Comparison

The market currently values Tencent Music Entertainment at a relatively higher forward Enterprise Value-to-Revenue multiple than Spotify (SPOT), even though the latter's topline growth prospects are better.

A Comparison Of Tencent Music Entertainment With Spotify

Source: S&P Capital IQ

Although Tencent Music Entertainment didn't manage to hold on to its +8.3% share price gain on May 17, 2023 results announcement, the company's stock is still up by approximately +75% in the past one year.

Considering both TME's valuations and its one-year price performance, it is understandable that Tencent Music Entertainment's shares have limited upside at this point in time.

Concluding Thoughts

It is fair to award Tencent Music Entertainment Group with a hold rating. On the one hand, TME's Q1 2023 results beat expectations and the company provided favorable FY 2023 guidance. On the other hand, there is limited scope for TME to expand its profit margins in a big way, and its current valuations aren't that enticing.

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