We exited our position in TME in early Q3. Here's why.
The original story
When we invested in Tencent Music about a year ago, we said the following:
With over 800m users across its many apps, Tencent Music is the primary way that people in China interact with online music. Today, the majority of revenue comes from virtual gifts sent to streamers in its “Social Entertainment” segment, which has grown revenue from $300m in 2016 to $2.9b in 2020. Within this segment, the most popular app is WeSing, a karaoke app with hundreds of millions of users in China. While competition from platforms such as Douyin (the Chinese version of TikTok) is increasing, WeSing continues to generate substantial profits for TME.
The smaller segment (by revenue) is a subscription-based business similar to Spotify, utilizing a “freemium” model and providing Chinese users access to millions of songs. Their apps Kugou, Kuwo, and QQ Music have more than 600m users, but as of Q2 2019 more than 95% of them were on the free tier. Since then an aggressive effort has been made to grow subscription revenue, and 30% of songs are now behind a paywall. This shift has driven rapid growth in paid users, and today almost 11% of users pay for access to these songs. The size and consistency of this segment’s growth is extremely impressive. How many other companies can add 5m paid users per quarter?
The theory was that the Social Entertainment segment, with EBIT of more than $500m, seemed to fully support the $8b enterprise value of the company. Separately, TME’s music subscription business was already doing around $1b of sales despite just having begun on their journey to monetize >600m unpaid users. This resulted in substantial upside should the growth of subscriptions materialize as we projected and the Social Entertainment business continued to throw off profits.
However, our thesis failed on multiple fronts.
As a result, TME has generated large shortfalls in operating income relative to our projections. While we thought the business would grow, profits are actually down around 40%.
The problems at WeSing
The decline in the Social Entertainment segment was the primary cause of the TME earnings drop, and this decline was driven by a fall in active users, which were down 27% over the past year.
Prior to our investment, MAU’s had been moving lower, but we were able to convince ourselves that these were normal fluctuations around a base of 200-250m active users. But since we’ve invested, TME has posted another 3 straight quarters of user declines, making it 5 in a row on a QoQ basis.
ARRPU (average revenue per paying user) growth could not overcome this, and revenues in the segment declined materially.
We think this decline may be inexorable. While TME blames the drop primarily on “macro and industry” factors, not all streaming businesses in China are experiencing such declines. For example, Kuaishou grew DAUs by 17% YoY in Q1 2022. TikTok/Douyin almost certainly grew users in China, and Alibaba’s China Commerce (which includes live streaming platform Taobao Live) business grew users by 10% YoY. Netease Cloud Music – a key competitor which we will discuss later – grew paying users for their live streaming business by 61% YoY. So this is a TME / WeSing specific problem, and we don’t see why it would go away. It seems that users have simply begun to prefer other live streaming apps, and the platform's network effects may be working in reverse. YoY user declines have been accelerating, from the single digits a few quarters ago to 27% in Q1 2022.
But even if the decline slows from 27% in Q1 2022 to 10% annually for 2023-2026, revenues would fall from 19b Yen to <10b yen. The graph below shows how our forecasts for this segment have changed.
We think this implies just 1b Yen per year of operating profit from the SE segment in 2026. If the rest of the business is not profitable by that point (as it stands today), the company may only do 700 or 800m Yen of net profit, which is less than $200m USD.
This figure does not compare favorably to TME’s $8b market cap. It doesn’t even look cheap against the current $4b current Enterprise Value, which subtracts the $4b of net cash and investments. Paying 20x five-year-out earnings is not a recipe for success.
Online Music - will it ever be profitable?
When we originally invested in TME, we expected the online music business to become profitable over time. But we did not invest in the company simply on this speculation; the valuation appeared well supported by profits in the SE segment. But with profits from that business collapsing, the long-term margins in the Online Music segment take on much greater importance.
While the segment has been growing paid users, the other key input to revenue, ARPPU has disappointed materially. While we assumed 1% annual growth in ARPPU, it actually declined by 11% in the past year.
While the company says that they expect ARPPU to increase going forward, with “Q1 2022 as a base”, they also implied that this may come at the expense of paid user growth:
This is not a good sign. It implies that paid users are very sensitive to price, which is understandable but not what we had been expecting for a near monopoly. We had also assumed that the low absolute price of 9 RMB per month would allow for both user growth and ARPPU growth.
One possibility is that we simply underestimated the strength of the competition, namely Netease Cloud Music (NCM). We assumed that a two-company market would act oligopolistically, and allow greater profits than the four-way slugfest between Spotify, Google, Amazon, and Apple in developed markets. But perhaps two aggressive competitors with a commodity product and a digital (ie, mostly fixed) cost structure is sufficient to create a race to the bottom in terms of pricing and profitability.
NCM’s most recent quarterly results show that the company is in fact operating in a fairly aggressive manner. Paying users were up 50% YoY, to about 37m, and ARPPU fell from 7.1 RMB/mo to 6.4 RMB. In other words, NCM has dropped their effective pricing to a level that is 20% below TME’s.
Here’s what NCM said about their decline in ARPPU:
While both companies have an 8 RMB/mo bottom tier of pricing, NCM’s promotions may continue to exert downward pressure on TME’s pricing and/or user growth.
Given this level of competition from NCM, it may be that TME’s long-term margins on the subscription business will not be materially different from Spotify's. This would be disastrous, since Spotify remains unprofitable on $12b of 2022e revenue.
Even if Spotify eventually raises their margins, as their valuation implies they can, following in Spotify's footsteps would mean a very long road to profitability for TME's subscription business. By then, the Social Entertainment business may have withered to almost nothing.
Given what we know now, our current model for TME assumes the following:
With these assumptions, the stock would generate a mere 7-8% IRR from current prices. Not terrible, but we have better opportunities.
Due to geopolitical tensions, regulatory concerns and valuation compression, Chinese ADRs have taken a beating over the past year. The KWEB ETF, which tracks Chinese internet companies, is down nearly 70% from its peak. And even if we exclude the blowoff / Archegos top of Q1 2021, the index is still down 50% since late 2020.
Some of these companies now trade at very attractive earnings multiples. As long-term value investors, this gets us excited.
If management believes earnings are sustainable, they should use this dislocation to buy back shares at a discount. Buybacks would be very accretive to shareholders, and could catalyze a valuation rerating from the market. The question is: will management step up and pull the trigger? Or are they just as scared as the market?
This is their moment of truth, and the firepower of these companies to do something is substantial:
Some of these firms are taking action and have announced buyback plans. However they are generally quite small relative to the size of the net cash balances. Not a single one (that I’ve found) has announced a buyback that amounts to more than half of their net cash balance.
Tencent Music (one of our largest positions) said they’ve completed $553m of a $1b buyback that was authorized in 2021, and they will complete the rest in 2022. Still, this buyback is for less than a third of their net cash balance.
Alibaba has increased their buyback plan from $15b to $25b. Still, this also amounts to less than a third of their net cash balance and less than a tenth of their market cap.
Baidu announced that it repurchased $1.2b worth of shares in 2021, but has not updated the size of their buyback program (previously disclosed as $4.5b in total). To date their buyback pales in comparison to their gross cash of $27b and net cash of $14b.
JD upsized its buyback program in December 2021 to $3 billion, but again this is tiny relative to $22.7b of net cash.
PDD does not appear to have ever repurchased shares or commented on a buyback program, unless I’ve missed it. This is despite their net cash balance of $12b (21% of market cap).
While we are heartened by the fact that companies like TME and BABA are making moves in the correct direction, all of these companies could go much bigger. Large buybacks could be a powerful signal that management believes earnings are sustainable, and a powerful catalyst for shareholders to realize the inherent value. Only time will tell if these companies will muster the courage to do so.
Bollore is a French conglomerate controlled by Vincent Bollore. We have been shareholders for years and wanted to send out some updated thoughts. First, some background.
Bollore's primary assets are Vivendi (29% stake worth around 4b EUR), Universal Music Group (18% stake worth around 8b EUR), and 100%-owned operations in African Logistics, Freight Forwarding and Electric Batteries. For more detailed thoughts on the individual segments, please see our full writeup from 2019.
The market has never given Bollore full credit for these assets, even when those assets have been publicly traded. Today, Bollore's ~12b EUR worth of Vivendi and UMG almost gets you to more than the entire market capitalization of the firm when netted against ~4b EUR in Bollore-level debt. Essentially, the market is saying that Bollore's other businesses have no value. The "conglomerate discount" thus swallows up businesses which appear likely to do more than 900m EUR of EBITDA in 2021.
There are a number of academic theories as to why the conglomerate discount exists. One driver is the principal-agent problem: management (the agent) simply has different incentives than shareholders (the principal). Management is incentivized to ensure and grow their own compensation, which may mean building an empire of diversified businesses rather than pursuing a higher-returning, more focused strategy. And just as important, management is incentivized to retain excess capital as opposed to paying it out as dividends.
Inefficient conglomerates may be the result, and such firms trade a discount due to the implication that capital will be poorly reinvested. Academic research has found typical conglomerate discounts to be in the range of 10-15%. But of course the proper discount should vary based on the quality of management.
Some conglomerates overcome the pull towards bad decision-making. Signs of this include:
1) Buying back stock when it is cheap
2) Paying large, chunky dividends
3) Selling off businesses when you get a good price
4) Spinning off key subsidiaries
IAC Corporation (some background here) is a great example of this. Over the years, Chairman Barry Diller has maximized shareholder value at IAC, outperforming the S&P 500 and generating his multi-billion dollar net worth. IAC has executed more spinoffs than any other firm, and their progeny include such well-known businesses as Home Shopping Network (later QVC), TripAdvisor, Ticketmaster, Hotels.com, Expedia, Match, Vimeo and others. So when you own IAC, you know that the CEO (who answers to Diller) is not pursuing deals simply to increase the size of his empire -- he is going to spin them to you at the end of the day.
Bollore is no stranger to spinoffs, with Bollore-controlled Vivendi recently issuing one of the largest in recent history. While the UMG spin was done downstream of Bollore itself, it indicates Vincent Bollore's willingness to shrink the fiefdom of his son Yannick, the Chairman of Vivendi. While Bollore still owns 18% of the company, UMG is now totally independent and no Bollore family members are involved in its operation. That business could be acquired at any time.
But the most interesting move came more recently, when the family put its African Logistics business up for sale, hiring Morgan Stanley in October 2021. This resulted in a Christmastime offer of 5.7b EUR from MSC Group. This sale would be a massive change to the Bollore business, with the company's logistics arm exiting an entire continent. It requires the sale of a stable, profitable business which the family painstakingly grew over a period of decades.
The price for this transaction seems to be quite good - about 20x EBIT. Not bad for something which is valued at zero by the stock market. It will be interesting to see what happens to this large chunk of capital should the deal come to fruition.
Today, we think the total value of Bollore's assets is about almost 17b EUR today or 12 EUR per adjusted share. This implies a conglomerate discount of more than 50%, a level which is completely out of line with historical precedent. It also gives the Bollore family zero credit for the shrewdness of their recent moves nor their willingness to cede control of businesses when the time is right.
We think Bollore stock will substantially outperform the market from current levels.
The history of Tencent Music is one of exponential growth, having increased revenues from 4.4b RMB to 32b RMB over the past 5 years. Today they dominate the online music business in China, with 800m users across multiple platforms. But despite generating nearly $5 billion in revenue, their subscription business has barely begun to scratch the service in terms of monetization.
The stock price has collapsed in recent months, first with the liquidation of the Archegos fund -- a major shareholder -- and more recently with the decline of all stocks related to the Chinese internet sector. We think investors worried about the regulation of these companies are falling prey to narrative bias, attributing all actions by the Chinese government to a ruthless power grab. A deeper look reveals a government that is just reining in practices that would’ve been banned in Europe a long time ago. This is exactly the type of investor bias that we seek to exploit in our Fundamental Value strategy.
The stock trades at a record low of just 14x ‘20 EBITDA and 17x ’21 EBITDA, a pedestrian valuation for a company that is likely to double its revenues over the next 6-7 years. We think investors buying today, at a stock price of less than $8, will generate an IRR of more than 15% over that time period.
Famed podcast host Bill Brewster noted on twitter that he was worried about customer concentration at a company he was researching. The company had 30% of its revenues coming from a single firm.
In many cases, a 30% customer has tremendous power over its suppliers. Let's consider some examples.
Walmart v Blendco
For most consumer product companies, Walmart is a major customer, often 10-20% of sales. Walmart uses this fact to its advantage, resulting in headlines like this:
This is part of Walmart's moat: their scale results in a positive feedback loop between low prices, customer traffic, and supplier negotiating power.
Low prices —> High customer traffic —> Power over supplier —> Supplier cuts prices —> Lower prices
To show how this works in practice, let’s war game a conversation between Walmart and a supplier of say, blenders:
Walmart: We need you to lower your prices
Blendco: We don’t want to
Walmart: If you don’t, we will bring in another supplier of blenders
Blendco: But our products are unique. People will be up in arms if you don’t carry our blenders! You will lose traffic! Our loyal customers will go online to buy our blender anyhow!
Walmart: I don't think so
Walmart's success in this negotiation hinges on customers not caring much about differences in blender design. They may have a slight preference, but most wouldn’t notice if Blendco’s products disappeared from Walmart's shelves forever. In contrast, Blendco cannot recover this revenue. So most of the time, Blendco caves and offers Walmart a slightly lower price.
But not all large customers have this type of power.
Spotify v UMG
For music labels, Spotify is an even larger customer than Walmart is in the consumer products world. For example, payments from Spotify constitute roughly 20-30% of Universal Music Group (UMG) revenue. This was the inspiration for Bill Brewster's tweet.
The idea is that Spotify may be able to leverage this position and its "ownership of the customer relationship" to retain more value for themselves over time.
The "customer ownership" theory appears to rely on experience from other online media businesses, where such ownership was key to long-term success. The obvious example is Netflix, where the relationship with its ever-expanding set of consumers has created the industry's largest budget for exclusive content, improving the product dramatically relative to competitors and driving even more subscriber signups.
The problem with this analogy is that Netflix has always had a differentiated product relative to peers. Much of their content is unavailable to be streamed elsewhere, and they've always had far and away the most scale.
Spotify has none of these advantages. In music, it has ~zero exclusive content, and while it does have the largest subscriber base, their scale advantage is modest relative to Netflix's.
We think a hypothetical negotiation between Spotify and UMG would look like this:
Spotify: We need you to lower your take rate
UMG: We don’t want to
Spotify: If you don’t we will bring in another supplier of Drake and Taylor... ok we can’t do that. Well, we will just drop your songs from Spotify completely. Our consumers won’t care. Maybe we can lower our prices.
UMG: You don’t think your customers will jump to Apple Music or YouTube Music if you don’t have Taylor Swift, Billie Ellish, Drake, The Weeknd, The Beatles, Post Malone, Lady Gaga, and Ariana Grande?
In this negotiation, the fact that Spotify provides 30% of UMG’s revenues is almost irrelevant. While Spotify appears to own the customer relationship, at the end of the day it is a music app. The music is really what owns the relationship with consumers. Yes, there may be some consumers who feel locked in to Spotify due to playlists they’ve shared or followed. But for most people, the loss of UMG artists would would far outweigh other considerations. They would simply switch apps.
Daniel Ek is too smart to take that kind of risk.
Musicians v UMG
What then, about the stars? Can't they use their leverage to get a bigger slice of the pie?
The short answer is that they will try to, and they do have some leverage. After all, these stars control important music: their yet-to-be-recorded albums, at least those that are not under existing contracts. The back catalog will be owned by UMG regardless, but many stars have woken up to the long-term value provided by streaming and want to have greater ownership over their future music. They will be tough negotiators when current contracts run out.
But wasn't this dynamic true before streaming? It has always taken a lot of money to retain hit musicians with expiring contracts. Somehow this fact has not crushed the economics of labels historically and I don’t see why streaming changes the picture, other than giving both sides a larger pie to split.
Stars going independent
What about the artists building an audience on social media and then going completely independent?
This could happen, to be sure. But the evidence shows that artists continue to value working with the major labels. And why wouldn't they? The music industry is notorious for creating one-hit wonders. The real skill is in turning one hit into two, three, and four hits. That is what makes a career in the music industry and labels still bring considerable expertise to bear on this effort.
Consider Lil Nas X. He uploaded the original Old Town Road track in December 2018. Note the request in this tweet:
The song went viral on TikTok and elsewhere a few months later. He had all the attributes of an act that could've gone independent:
1) He produced his own music
2) He uploaded his songs to streaming services using an independent distribution provider
3) He gained traction on social media before signing anything
All of this gave Lil Nas X leverage. Theoretically, he could have just uploaded his music to Spotify using something like CD Baby and raked in the $$$ without splitting it with a traditional label. But he didn't. He decided to sign with Columbia Records. In fact, he appears to have turned down a $1m+ offer from his original distribution platform / independent label Amuse.
So far, this decision appears to be working well for him.
After all, it was Columbia Records head Ron Perry that contacted Billy Ray Cyrus about appearing on a version of the song. That "remix" is now the official version, the one that broke the record for longest run at #1 on the Billboard charts.
I don't think Lil Nas X is regretting his decision.
While we have no doubt that some artists will go the independent route, and that social media will help them do so, we think the majority of breakout artists will want help. And that help is likely to come from the labels with the best track record of creating stars, with UMG at the top of the list.
All of this being said, we continue to think that the best way to get exposure to UMG is through the extremely-discounted stock of Bollore.
I did two podcasts over the past month talking about our Q4 letter. We discuss my background, poker, statistical value investing, current market conditions, and a few investment ideas. Enjoy!
Acquirer's Podcast w Tobias Carlisle
This Week in Intelligent Investing w Elliot Turner
It is very common for gamblers to learn lessons.
It is easy to see why: there is so much data for the gambler to consider. In roulette alone there are all the numbers... are they low numbers? Red numbers? Numbers divisible by three? What color shirt is the dealer wearing? There are so many opportunities to learn lessons if you are looking for them!
Almost all of these lessons are nonsense.
Rational people understand this because the randomness in a casino is very explicit: an equal-weighted die, a well-spun wheel, or a shuffled deck of cards. For these games, anything except a mathematical analysis of optimal play -- based solely on the rules of the game -- is irrational. It is superstition.
In the real world, the lines are more blurred between what is random and what is not.
One could even argue there is no such thing as randomness at all. Was the person that took a job at a future unicorn the beneficiary of chance, or just prescient? If you were smart enough -- or perhaps had a computer in your shoe -- couldn’t you predict where the roulette ball would land? Is it lucky that the Pfizer / BioNTech vaccine works so well, or is it the result of decades of scientific research? Cleary there are opportunities in this world to sift through randomness and find truths which can be exploited. At the very least, there are opportunities to tilt the odds in our favor.
The world of investing, though, is a particularly difficult place to spot such truths. Yesterday's “truth” may merely be noise. Or, if enough people are aware of it, yesterday’s truth will become today’s random walk. There is still an active debate about whether skill exists at all in investing.
I do believe there is skill in investing. As a former poker player, however, I am acutely aware that small sample sizes can be misleading. This applies to investors, strategies, or simple rules of thumb like “sell in May and go away”. And learning too much from small sample sizes is particularly dangerous for bottom-up stock pickers.
Some quick math will help us see why. Let’s say you are a fairly concentrated portfolio manager that typically holds 20 positions. If you turn over 5 positions per year that means over a period of 10 years you will own 70 stocks (the 20 you start with and 10 x 5 new ones). If you do a good job, maybe 10-15 of these stocks show losses over your 4-year average holding period. Perhaps 5 of them will suffer large losses of >50%. If you throw in thematic errors of omission like “missing out on the SAAS rally”, you may have ten total mistakes to analyze.
Is it possible to learn anything from these ten mistakes?
The answer is likely no. There is just too much randomness involved. Unless you can identify an underlying causal factor which is applicable across market cycles, taking lessons from such a small number of cases is a fool’s errand. It leads investors to double down on today’s hot strategies and divest from what is underperforming. If enough market participants invest based on these “lessons”, price movements can become self-fulfilling and move towards extremes.
Below is a partial list of market “lessons” that have been learned by investors over the years:
1960s: only invest in the largest fifty companies
1970s: don’t invest in bonds
1990: don’t invest in banks
1999: buy anything tech, stay away from value
2002: don’t buy anything tech
2005: invest only in value stocks, especially banks
2007: commodities and resource stocks are an asset class
2017-today: bitcoin is an asset class
2010-today: valuation doesn’t matter, #neversell, only buy growth stocks
Of course, all but the final two “lessons” have proven to be mirages.
These mirages are top of mind for me when people on twitter ask what lessons we have learned from our past mistakes. Are people really learning the right lessons from their own small sample size? And further, have the past ten years really been a good teacher, or are all of these *lessons* merely a reflection of larger market trends?
On the long side, the lessons being learned are obvious: Always invest in electric vehicle IPOs. Make sure not to pass on Special Purpose Acquisition Companies. You can’t lose money on SAAS stocks. 30x sales is still cheap for a “good business”. And the most frequent lesson of the past decade: never sell based on valuation.
The opposite lessons are also being learned: you can’t make money in stocks that don’t grow. There is no such thing as a mediocre company being “too cheap”. Don’t invest in banks, cyclicals, or energy, because “bad” industries should be avoided altogether.
The performance of the Vanguard Energy ETF demonstrates how long investors have been trained to avoid bad industries:
As we mentioned earlier, these "lessons" can become self-fulfilling, as more and more investors "learn" them. This dynamic can cause trends to stray beyond pure randomness, and even beyond what is warranted by underlying industry dynamics. If they go far enough, they can create opportunities for investors who pay attention to valuation and are willing to look into the future rather than the past. These are the investors that buy 30 year bonds in 1982 or value stocks in 2000.
Perhaps the right approach to the "lessons learned" question is to invert it:
What lessons are investors learning today that aren’t based on any fundamental truth?
In other words, what does the market know for sure that just ain’t so?
This is where you will find the real opportunities.
Given that Warner Music Group has recently had an IPO, I thought it would be interesting to compare the company to privately held UMG, which we own via Bollore. UMG and Warner, along with Sony, make up the "big three" music labels owning 80-90% of revenue-producing music.
History of Warner Music
In 1957, an actor for Warner Brothers movies made a hit song for an independent record company. Sensing a missed opportunity, Warner created Warner Bros. Records in 1958. This served as a platform for numerous acquisitions, including Atlantic Records. Atlantic paved the way for WMG's success, and during the 60s and 70s became the home of hit artists such as Ray Charles, Aretha Franklin, Led Zeppelin, Bette Midler, Neil Young, and Cream. Today, WMG traces its roots back to 1811 via their Chappell and Co subsidiary, which was purchased in 1987. That firm was once called "one of the best publishers" by Beethoven himself.
Uniti Group is a weird little company that trades 9x EBITDA and arguably a ~20% free cash flow yield to the equity.
The company owns fiber optic cables and copper wires and leases them to ISPs, mobile wireless providers, and businesses.
Owning fiber-optic cables can be a good business. Fundamentally, they are the key asset behind a roughly $70b market in the US - fixed broadband internet (and increasingly important in mobile wireless as well). Once deployed, fiber is costly to compete with: the only real way to do so is to “overbuild” your own fiber. Estimates of the cost to run fiber to one household varies between about $700 for telcos to wire existing customers to $1250 per home for a near-nationwide build-out. Costs are even higher in some rural areas where homes are far apart.
Insurance is a strange business, because unit costs are not known ahead of time and are different for every customer. Sometimes these costs are not fully known for decades, such as when asbestos claims surfaced in the 1970s and resulted in hundreds of billions of dollars in liability for manufacturers and insurance firms.
Not only are costs not known ahead of time, but they are different for each customer. In some cases the factors most heavily influencing claims are random. Who can know which coastal town in Texas is more likely to be hit by the eye of a hurricane? For car insurance, though, the customer is in much more control. While there is certainly still lots of randomness to car insurance claims, an aggressive driver has a much different risk profile than a conservative one.
Since this factor -- how someone drives -- is both heavily correlated to insurance risk and knowable ahead of time, car insurance companies make a big effort to quantify it. In the early days of auto insurance, this was pretty tough. Insurance companies had to make an educated guess based on age, gender, and driving history (tickets, accidents, insurance claims). Over time, though, insurance companies have gotten more sophisticated at collecting data.
What this is
Informal thoughts on stocks and markets from our CIO, Evan Tindell.