Earnings Call Transcript - TME Q2 2020

Operator, Operator

Ladies and gentlemen, good evening and good morning, and thank you for standing by. Welcome to the Tencent Music Entertainment Group 2020 Second Quarter Earnings Conference Call. Today, you will hear discussions from the management team of Tencent Music Entertainment Group, followed by a question-and-answer session. Please be advised that this conference is being recorded today. Now I will hand the conference over to your speaker host today, Ms. Millicent T. Please go ahead, ma'am.

Millicent T., Speaker Host

Thank you, operator. Hello, everyone, and thank you all for joining us on today's call. Tencent Music announced its quarterly financial results today after the market close. An earnings release is now available on our IR website at ir.tencentmusic.com as well as via Newswire services. Today, you'll hear from Mr. Cussion Pang, our CEO, who will start the call with an overview of our recent achievements and our growth strategies. He will be followed by Mr. Tony Yip, our CSO, who will offer more details on our operations and business developments. Lastly, Ms. Shirley Hu, our CFO, will address our financial results before we open the call for questions. Before we proceed, please note that this call may contain forward-looking statements made pursuant to the safe harbor provisions of the Private Securities Litigation Reform Act of 1995. These forward-looking statements are based on management's current expectations and observations that involve known and unknown risks, uncertainties and other factors not under the company's control, which may cause actual results, performance or achievements of the company to be materially different from the results, performance or expectations implied by these forward-looking statements. All forward-looking statements are expressly qualified in their entirety in the cautionary statements, risk factors and details of the company's filings with the SEC. The company does not assume any obligation to revise or update any forward-looking statements as a result of new information, future events, changes in market conditions or otherwise, except as required by law. Please also note that the company will discuss non-IFRS measures today, which are more thoroughly explained and reconciled to the most comparable measures reported under the international financial reporting standard in the company's earnings release and filings with the SEC. You are reminded that such non-IFRS measures should not be viewed in isolation or as an alternative to the equivalent IFRS measure, and other non-IFRS measures are not uniformly defined by all companies, including those in the same industry. With that, I'm now very pleased to turn over the call to Cussion, CEO of Tencent Music. Cussion?

Cussion Pang, CEO

Thank you, Millicent. Hello, everyone, and thank you for joining our call today. As the industry leader of China's online music market, we continue to shape the development and fostering of the music industry by the continuous promotion of the pay-for-streaming model, deeper cultivation of indie musicians, further expansion of our capabilities to promote digital albums and our innovative online concept, TME Live.

Tony Yip, CSO

Thank you, Cussion. Hello, everyone. Apart from the key developments discussed by Cussion just now, I would like to add that our overall promotional capabilities have been expanded, and our enhanced, personalized recommendation analytics continue to contribute to improved user experience. In the second quarter, the DAU penetration ratio of personalized recommendation further increased sequentially, and personalized recommendation accounted for an increasing proportion of streaming volume on our platform. Furthermore, as a pioneering product in creating a whole new experience to live concerts by bringing them online, our TME Live has gained tremendous recognition, making significant social impact and propelling the industry to flourish. In the second quarter, we successfully organized 9 influential Ultra Live performances for well-known global artists, such as Mayday, Wu Yuè Tian; and Hanazawa Kana, Hua Zé Xiangnài, which have earned TME Live a strong brand name. In July, we went one step further by introducing extended reality technology to online live performances, the first in the industry to do so, which truly demonstrates our commitment to embracing technology and innovation. As we continue to build our TME Live pipeline, we are exploring different service models for users to enjoy our high-quality live shows, including VIP packages, virtual gifting and others, taking another step to unlock the massive value and market potential for online live performances.

Shirley Hu, CFO

Thank you, Tony. Hello, everyone. Next, I'll discuss our results from a financial perspective. Overall, I'm very pleased with our second-quarter financial results. We achieved strong growth in online music services, particularly in music subscription revenues as well as healthy growth in the social entertainment business. Our total revenues were RMB6.9 billion, up 17.5% year-over-year. Online music revenues were RMB2.2 billion, up 42% year-over-year driven by music subscription revenues, digital album sales and advertising revenues, despite a decrease in sublicense revenues. In particular, our music subscription revenue was RMB1.3 billion, up 65% from the same period last year. On a year-over-year basis, paying users and ARPPU grew 52% and 8%, respectively, resulting from user retention improvements and effective paywall strategy implementation, as Cussion discussed earlier. Additionally, we saw strong growth in both advertising revenues and digital album sales. Advertising revenues continue to be an important growth driver for us. We are optimistic about the growth potentials in this area and are proactively taking steps to grow the advertising business effectively. Growth in digital album sales in this quarter was driven by new digital platform releases from a few very popular artists. Social entertainment services and other revenues were RMB4.7 billion, up 9% year-over-year driven by growth in online karaoke and live streaming services. Paying users grew 12% year-over-year. ARPPU decreased 3% year-over-year but increased 13% quarter-over-quarter as we continued to recover from the COVID-19 situation. Our gross margin was 31.3% in Q2 2020 and decreased 1.6% from 32.9% in the same period of last year. The gross margin decrease was mainly the result of investments in new products such as long-form audio as well as higher revenue sharing fees in social entertainment to strengthen our platform's competitiveness. Online music services had a positive impact on overall margin in Q2 2020, and this trend is expected to continue as our subscription revenues continue to grow while licensed content costs are gradually stabilizing as our music industry evolves. Now moving on to operating expenses. Total operating expenses for Q2 2020 were RMB1.3 billion and were 18.8% as a percentage of total revenues, representing an increase of 1% compared to the same period in 2019, with promotion expenses and R&D employee-related costs being the largest drivers. During the quarter, we incurred expenses to promote new products such as long-form audio, Kugou Changchang and the TME Live that are still ramping up in terms of revenue generation. But we are investing for their long-term growth potential. We also increased the promotional spending for existing products to strengthen our products competitively. Additionally, we continue to invest in R&D for product investment and technology innovation, leading to higher employee-related costs in R&D. Our net profit attributable to equity holders of the company was RMB0.9 billion, non-IFRS net profit attributable to equity holders of the company was RMB1.15 billion, and the non-IFRS net profit margin was 16.7%. As of June 30, 2020, our combined balance of cash, cash equivalents and term deposits was RMB22.3 billion, representing an increase of RMB0.4 billion from Q1, which was primarily driven by cash flow generated from operations of RMB1.44 billion and the cash paid for investments. In conclusion, we continue to be optimistic about the future of the broad music industry and are confident in the overall ecosystem and the product pipelines that we are building in the long run. We will continue to focus on enhancing and expanding our product and service offerings such as long-form audio, Fanlive, and the TME Live while maintaining core company investments.

Operator, Operator

Your first question today comes from Eddie Leung with Bank of America Merrill Lynch.

Eddie Leung, Analyst

Just wondering if you could share a bit of color on the MAU trends happening into the summer. We probably understand that the decline year-on-year in the same quarter partly because of people getting back to work. So just wondering how the trend is going as we hit summer. And then just a quick follow-up. Wondering if you could address some investors' questions on any measures to mitigate the risk of a delisting of ADL from the U.S.

Tony Yip, CSO

Thank you, Eddie. Your first MAU question, I suppose it relates to music. Actually, in the second quarter, we saw a very mild year-over-year drop of 0.0% in music MAU, and that's actually not because of people getting back to work. Because as you know, when people return to work during their commute, they tend to listen to more music. So that's actually a positive factor for us. The offsetting factor is more a result of the younger demographic going back to school. When younger demographics are locked down at home, they spend more time on music and karaoke, but when they go back to school, they actually spend less time. And that's actually the main reason we saw a small decline in the music MAU. Additionally, we do expect the MAU in Q3 to see some growth. Given the sheer size of the music MAU at around 650 million, our focus is very much on growing the paying penetration and monetization and engagement as opposed to growing that user base significantly. In terms of social MAU, we saw a sizable increase in the first quarter, especially due to COVID, as more users had more time to spend on karaoke and live streaming at home. However, in the second quarter, when the lockdown ended, the younger users returning to school caused a decrease in social MAU. This is the first factor. The second factor affecting our social entertainment MAU is continued competition with short video apps for user time, particularly WeSing. While we expect that competition to continue, we do anticipate seeing some improvements in core metrics as we roll out a number of product enhancements that we talked about in WeSing relating to reducing usage barriers and increasing video features and social elements.

Cussion Pang, CEO

He also talked about delisting.

Tony Yip, CSO

In terms of the second question about delisting, first of all, I think just to take a step back, the executive order that was provided, or actually, it's not an executive order. The recommendation by the President's Working Group is just that—a recommendation. The President and the White House have not officially come out with an executive order yet regarding that recommendation. We do believe that it is premature to speculate on how that will evolve. Secondly, I want to stress that delisting is not the only option because if you look at the recommendation paper submitted by the President's Working Group, it outlines alternative options, for example, co-audit between a U.S. auditor and a Chinese-based auditor. So that is also a potential option. We are evaluating all options and ensuring that when further policies come out, we will act in the best interests of our shareholders to protect long-term value.

Operator, Operator

Your next question comes from John Egbert with Stifel.

John Egbert, Analyst

Great news about the UMG deal. Aside from the obvious change that this is a license for TME services only, can you talk about some of the primary objectives you're most excited about accomplishing in the new deal? And perhaps, is there anything related to TME's promotional capabilities, given Universal's adoption of marketplace services as part of its new deal with Spotify?

Cussion Pang, CEO

Thank you so much, John, for your questions. We are very excited to enter a new deal with UMG. As I have mentioned, this relationship is not just starting today; we have had a very good history of working with UMG and other leading music labels around the world for many years. We have done a great job protecting the IP rights, which has been fully appreciated by them. Additionally, we have laid a solid foundation in promoting the music industry together. This time, as we renew our contract with Universal, we are pleased that the outcome is a new multiyear agreement, which we believe is a truly win-win situation. Unlike the last agreement, which was effectively more like a fixed-cost contract, the new one has a reasonably fair minimum target level so that both parties are incentivized to work together to see revenue sharing kick in. The new deal aligns both parties' interests and motivates us to cooperate closely to better serve each other. Moreover, Universal has selected us to form a new joint venture music label in China, focusing on nurturing some of the new younger generation artists. I think this is another truly win-win situation because Universal Group excels in ANR and music production, while TME serves a vast user base in China and understands user preferences and how to effectively distribute content. This collaboration is crucial for us, and I am really looking forward to this joint music label.

Operator, Operator

Your next question comes from Binnie Wong with HSBC.

Binnie Wong, Analyst

It's Binnie here, and I have a couple of quick questions on the user engagement strategy. I noticed that you have various new innovative features, including TME Live and long-form video. In QQ Music, we also observed there's a new user feature called the Putong Community. Is it somewhat similar to a Weibo style that promotes more interaction between singers or streamers and users? Any metrics on how users are converted into subscribers would be helpful. Also, what are your plans for monetization on these new features? Do you see a need to monetize beyond your core subscription and live streaming? Do you think advertising would be something that we would be introducing soon or perhaps doing more?

Tony Yip, CSO

Yes, I'll address the first part of your question regarding engagement and monetization, and then I'll let Shirley take the margin question. We are pleased to announce several product enhancements focused on increasing user engagement. For example, TME Live, the Putong Community, and increasing video enrichments across all our apps, including QQ Music, Kugou Music, and WeSing. In WeSing 7.0, we enhanced the interactive features and increased the adoption of online singing rooms, promoting more publishing activities by our KOLs and ordinary users. All these efforts build a long-term, sustainable, and healthy platform, from which there will obviously be a plan to monetize. We are seeing good metrics; for example, DAU penetration for the Putong Community is increasing and the total number of songs reviewed has exceeded 1 million in a short span of time. Regarding the video enrichment in QQ Music and Kugou Music, we are experiencing increasing video content and DAU consumption penetration. We see very exciting growth in online karaoke in terms of video publishing activities. All these metrics indicate a healthy trend for the platform's long-term growth. Regarding monetization, you're correct; we view advertising as the third major revenue source, behind subscription and live streaming. In fact, we mentioned last quarter that we are actively hiring to boost our team and enhance our advertising products and technology. Expect to see more actions in the second half, with advertising revenue ramping up substantially next year.

Shirley Hu, CFO

Regarding the gross margin, we expect it to remain stable in the second half of this year compared to the first half, potentially with a slight increase. In the first half of this year, revenue-sharing fees placed some pressure on margins, which we will monitor in the second half to improve this aspect. The growth of online music revenues will positively impact our gross margin because of the rapid growth of our subscription model, and the cost structure of online music will be evolving in the next quarters and years. We will also need to invest in new products like long-form audio and Kugou Changchang, so costs will increase in those areas. In summary, we expect overall gross margin to stabilize in the second half compared to the first half of this year.

Cussion Pang, CEO

I just want to add a little more context about the advertising business you mentioned earlier. During the pandemic, our advertising business was impacted significantly, especially the data we obtained in Q1. However, we believe we are on the recovery path. In Q2, our advertising revenue recorded an impressive 52% year-over-year growth. We are performing well in this area for several reasons. Firstly, we will continue to enhance our user experience, perhaps by adding more advertising while also providing users the chance to access premium content. Secondly, we can apply advertising in different scenarios. For instance, in our IoT business, providing in-car music services is a good context for incorporating audio advertisements. As mentioned, we are heavily investing in developing a long-form audio business, which will also naturally support a combined subscription and advertising model.

Operator, Operator

Your next question comes from Alex Poon with Morgan Stanley.

Alex Poon, Analyst

Congratulations on good results. My first question is related to the new agreements with UMG. Is there anything you can share from this agreement that affects your gross margin for music services? Can you also comment on the music gross margin in the second quarter and the anticipated second-half trend? My second question regards your thoughts on competition with NetEase in the long term since they signed a UMG agreement today. Both companies have a large user base, but the paying ratio is low, indicating that everyone is still growing nicely. How do you see the competition play out in the longer term, and what are your reactions?

Tony Yip, CSO

Regarding the UMG contract renewal, we are very pleased with the outcome. The structure of the economics within the contract is a win-win situation, with a reasonably fair minimum guarantee level, which incentivizes both parties to exceed it. We foresee that we should be able to exceed it based on our subscription growth trajectory. Another point is that as part of our agreement with UMG, we intend to add UMG content behind our pay-for-streaming paywall. You may have already seen some UMG content behind the paywall already. This addition will positively drive revenue growth for paid subscriptions derived from this UMG partnership. Regarding competition with our peers, we will not comment directly on their actions. However, we are pleased to observe that the industry is progressively moving towards supporting paid music. This movement is important for users to understand the value of music. Overall, we see significant growth potential in the music subscription market.

Cussion Pang, CEO

Additionally, regarding the content from UMG, there isn't much difference compared to the past. TME and other platforms have had access to UMG content under the master licensing arrangement for a while now. However, the crucial point is that we have reached a new milestone in transitioning to a more cooperative phase with UMG. We are no longer merely content distribution partners; we are collaborating as business partners, which signifies a major advancement and highlights the trust that UMG places in TME. We believe we are their preferred partner, and we will remain focused on maximizing value and quality music for our users.

Operator, Operator

Your next question comes from Alicia Yap with Citigroup.

Alicia Yap, Analyst

My question relates to social entertainment. Are there any updates regarding competition and regulatory aspects that might affect growth outlook for social revenue for the second half or even 2021? What is management’s view on the industry prospect? Are there concerns about market saturation? Additionally, will game broadcasting become a more critical user engagement and monetization driver in the future?

Tony Yip, CSO

In terms of overall outlook, I want to start with our total company revenue. We expect the year-over-year revenue growth rate for the second half to be similar to the first half, around the mid-teens level. For social and music revenue, we anticipate continued strong growth in subscription revenues, while non-subscription revenues may decline due to sublicensing and normal fluctuations in digital album sales, especially after a robust Q2 performance. For social entertainment revenue in the second half, we expect year-over-year growth to exceed the first half, reflecting a healthy recovery from the 6% growth seen in the first half, although macroeconomic factors may impact some users’ willingness to spend on virtual gifts. Regarding competition, we continue to face competition from short video platforms, which is one of the primary factors affecting social MAU this quarter. Nonetheless, we've invested significantly and will continue to roll out multiple product enhancements to strengthen the WeSing platform, with optimism that social MAU will stabilize from Q3 onward. In the online karaoke segment, we command a significant lead with over 200 million MAU, and we foresee further monetization potential rather than much growth in the user base.

Cussion Pang, CEO

Moreover, concerning the future entertainment business, we hold a competitive advantage over other live broadcast applications due to our music-centric social entertainment focus. This synergy is crucial, particularly through programs like the Tencent Musician program. Young musicians can conduct live broadcasts while engaging their friends on our platform. TME Live, which launched during the pandemic, has received excellent feedback from artists. Although currently focused on top-tier artists, we envision extending our reach to various artist levels, resulting in improved user outcomes. Positive feedback comes from both users and business partners, illustrating the potential we have in the overall music ecosystem we are creating.

Tony Yip, CSO

To add on that, we successfully launched QQ Music's live streaming service in June, which is our Fanlive service. We are pleased to see this initiative gaining traction since launching. It's still in its early stages, having debuted in the second quarter, but it's designed to provide a differentiated experience with innovative features that let music fans interact. We expect revenues to gradually increase in Q4 and contribute meaningfully to revenue growth in 2021.

Operator, Operator

Your next question comes from Wendy Chen with Goldman Sachs.

Wendy Chen, Analyst

My question is about the paywall process. Can we get a quick update on the percentage of songs that we are moving behind the paywall so far? With the renewal of UMG, to what extent can we expand the paywall beyond the previously mentioned 20% full-year target? Additionally, can we have an update on how management foresees the growth of paying subscribers for music in the second half? Will we see further acceleration compared to the first half?

Tony Yip, CSO

Regarding the paywall, we are on track to reach the 20% target by year-end that we discussed previously, and we might exceed that a bit. In Q2, we had a balanced portfolio of overseas major labels and domestic labels go behind the paywall. In our service, you'll see that many songs from the big three, including Universal and Warner, are already behind the paywall, and that process will continue. This will be an essential driver for strong growth in our paying user numbers. We expect our paying users to keep growing robustly; indeed, in Q2, we achieved a 52% year-over-year growth in paying users, which is our fastest growth reported in any quarter, adding about 4.4 million paying users this quarter. While we may see some quarterly fluctuations in net additions, our overall expectation is for continuously rapid growth.

Operator, Operator

Your next question comes from Thomas Chong with Jefferies.

Thomas Chong, Analyst

Just two quick questions. First, regarding our outlook for 2021. Given that our online music services have strong momentum, and our social entertainment should rebound from a relatively lower base in 2020, along with Q2 live streaming, should we anticipate revenue to accelerate and margins to improve year-over-year next year? My second quick question pertains to our long-form audio content. How should we think about competition on this front?

Tony Yip, CSO

We will discuss the 2021 outlook more as we approach the year-end, so we won't be addressing that directly here. Regarding long-form audio, we are happy with the development of our long-form audio service. User penetration has significantly grown, with our MAU effectively more than doubling year-over-year. We rapidly expanded our long-form audio content on a quarter-over-quarter basis and are actively working on securing popular audio production licensing while adapting top IPs into long-form audio. We are engaging with podcasters to include premium UGC content. There is a long runway for monetization, starting with cross-selling subscription strategies that have proven successful.

Shirley Hu, CFO

On the margin side, we expect revenue from long-form audio and Kugou Live streaming to materialize in 2021. We predict margin recovery and improvement over this year.

Operator, Operator

Your next question comes from Rob Sanderson with Loop Capital Markets.

Robert Sanderson, Analyst

Perhaps for Cussion or Tony. Just going back to the IPO, your original expectation was that digital music subscriptions would begin to accelerate in 2021 and then in the 2022 timeframe as you plan to tighten the paywall gradually and encourage behavioral changes, etc. But we're seeing acceleration now, and growth is up significantly in each of the past three half-year periods and continues to grow. What is developing differently than your earlier expectations? Are you leaning into a more accelerated use of the paywall? Are consumers more responsive than you expected? Or do you still see potential for an inflection in the years ahead? That's part one. If we look at the other subscription media markets, are there many examples of streaming music services around the world, or Internet video in China? Which example of pay ratios do you think will align more with what you'd expect for your business over the long term?

Cussion Pang, CEO

Firstly, I think we're doing excellent on online music services, particularly according to our plans laid out during the IPO. The paying ratio this quarter stands at 7.2%, up from 4.8% a year ago, and we expect this trend to continue. However, we want to strike a balance; it's not just about continually pushing for a higher-paying ratio but also caring about user experience. During the IPO period, we noted that the Chinese music industry had a perfect music experience, where everything was free. We're in a long-term education process, and our hard work over the last four to five years is paying off. We're not rushing; we will continue to ensure we strike the right balance. At the right time, we will achieve the inflection point. There's still plenty of room to grow the paying ratio compared to global leaders like Spotify or the long-form video industry. We will grow in a similar fashion, albeit a couple of years behind.

Tony Yip, CSO

The only point I'd add is our comparison with online video subscribers. Users in that space often pay for the latest content, while in music, consumers might pay for even the oldest songs if they are fans of the artist. We believe this reflects a more sustainable long-term prospect for our subscribers compared to other sectors.

Operator, Operator

Your next question comes from Zhijing Liu with UBS.

Zhijing Liu, Analyst

Congratulations on the great result. I have only one question. How should we think about potential revenue from advertising for music? How do you perceive competitive factors concerning our advertising strategy?

Tony Yip, CSO

There's a lot of potential for our advertising revenue growth, which currently comprises a low single-digit percentage of total revenue. We have not aggressively pursued ad loads across our app yet. This will change, especially in 2021. We will start taking some steps in the second half. Our advertising strategy will be complementary to the paywall strategy. For example, we may allow users to watch video or listen to audio ads to redeem access to songs behind the paywall, which enables us to monetize users who are challenging to convert otherwise. This extends our revenue opportunities.

Cussion Pang, CEO

Moreover, users on our platform are not just paying for content; they are investing in their overall user experience. We consistently emphasize the importance of personalized recommendations to help users discover new music, rather than simply searching for songs in a library. Socialization is equally crucial. We emphasize creating a new Putong society and singing rooms on the WeSing platform, allowing users to share their music preferences and experiences, interact with each other, and showcase user-generated content.

Operator, Operator

Your next question comes from Alex Liu with China Renaissance.

Alex Liu, Analyst

Just one question. How should we think about TME's value proposition regarding audience reach and content promotion, especially given that some non-music platforms have recently invested in music content and celebrities? Can you help us understand if there is any overlap between their content agreements and ours?

Tony Yip, CSO

Sorry, could you clarify your question? Was that about audience reach and promotion?

Cussion Pang, CEO

Yes, thank you for your question. The TME platform can work synergistically with video platforms, as you noted. Video platforms also serve as a channel for content promotion. For example, on Tencent Video, many singers promote themselves or their songs. We must look at this holistically. For instance, if there is a music variety show on Tencent Video where the artist performs, audiences may want to hear that song again on our music platform. It's valuable for users to revisit the song post-show. We aim to work with video platforms, having co-produced music variety shows and engaged in joint promotions. We also see younger musicians seeking more exposure across different platforms and collaborating with Bilibili to nurture them. Hence, while video platforms can promote music, we believe the music platform retains its unique positioning.

Operator, Operator

Thank you. That concludes our question-and-answer session. We will now turn the call over to your speaker host today, Ms. Millicent T., for closing remarks.

Millicent T., Speaker Host

Thank you, Ashley, and thank you, everyone, for joining us today. This concludes today's call, and we look forward to speaking with you again next quarter. Thank you and goodbye.

Operator, Operator

The conference call has now concluded. Thank you for attending today's presentation. You may now disconnect.