Shares of Tencent Music Group (NYSE: TME) fell sharply on Wednesday after the company reported its first set of quarterly results since going public in December. Although the results were broadly in line with estimates and the outlook outlined in the company’s IPO prospectus, investors were spooked by sharply rising costs.

The share price had risen nearly 45% from the $11.81 price it traded at shortly after the IPO. There was little reason for such a dramatic rally, so Wednesday’s weakness wasn’t that surprising.

The company reported quarterly revenue of $785 million versus $779 million that analysts expected, and a loss of 8 cents per share, versus a 2 cent forecast. However, the loss was largely due to a one-off charge related to issuing equity to label partners Warner Music group and Sony Music Entertainment. When adjusted for those charges, EPS were 8 cents and 50% higher than the previous year.

Expenses rose 63%, reducing the gross margin from 38% a year earlier to 34%. This jump in costs appeared to alarm investors, and at least one analyst downgraded the stock.

 

China’s Version of Spotify?

TME is often compared to Spotify, the Swedish music streaming music platform that also listed on the New York Stock exchange in 2018. However, while TME does indeed offer subscription-based music streaming services, there’s far more to it.

TME, like most of the companies owned by company Tencent Holdings, consists of an ecosystem of related products with numerous methods of monetization. Besides music streaming, TME offers WeSing, an online karaoke app, album sales, and live music streaming.

In the last quarter, just 28% of revenue came from streaming music and album sales. The rest came from “internet services” which includes in-app purchases and virtual gifts that can be purchased for influencers. This uniquely Chinese business model is very different from Spotify which hasn’t really changed much since launching 10 years ago.

While the number of MAUs grew just 6.8% from the 4th quarter in 2017, the number of paying subscribers grew 39%.

The other difference is the number and makeup of subscribers. After 10 years in business, Spotify has around 200 million MAUs (monthly active users), of which a little fewer than 50% are paying subscribers. After just a few years in business, TME has 644 million MAUs – but only around 4% are paying subscribers.

While the number of MAUs grew just 6.8% from the 4th quarter in 2017, the number of paying subscribers grew 39%. The growth in paying users is impressive but comes off a low base and whether or not it is sustainable remains to be seen.

 

Lots of Unknowns

Tencent Music has shown incredibly strong growth in a short space of time. But, its ability to grow its user base is now somewhat limited within China, hence its modest growth in MAUs. To grow earnings from here it will either have to continue converting users into paying subscribers, grow its ecosystem to increase other sources of revenue, or expand internationally.

None of these avenues to further growth are out of reach, but just how successful they could be are impossible to foresee. Ultimately, earnings will depend on how many users can be converted, whether the business model will work internationally, and whether costs continue to rise.

Earnings will probably grow enough in the next few quarters to bring the current trailing PE of 60 down to more reasonable levels – but beyond that it becomes a guessing game. TME may well have blue sky potential, but with so many unknowns, it has to be considered speculative at current levels.