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Why Tencent Is Buying 10% of Universal Music

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China is seeing a rise in streaming entertainment—from esports to music streaming. And Tencent (TCHEY) is the biggest beneficiary. It’s one of the country’s leading tech companies, and it has many subsidiaries in digital services. Plus, it’s already trying to gain a foothold in the esports streaming business. And now, Tencent hopes to expand its music streaming business as well by purchasing 10% of Universal Music.

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What investors need to know about the Tencent–UMG Deal

On New Year’s eve, Tencent Holdings (TCHEY) officially announced that it would purchase a 10% stake in Universal Music Group (UMG) along with some co-investors. The purchase consideration for the acquisition is 3 billion euros. Universal Music Group is a subsidiary of the French mass media company Vivenda, and it has contracts with many well-known artists.

One of the investors in the consortium is Tencent’s subsidiary Tencent Music Entertainment Group (TME). Tencent Music Entertainment Group is a joint venture between Tencent and Spotify (SPOT), founded in July 2016. TME creates dedicated music content for Chinese audiences. So the Tencent-UMG deal could help Tencent expand its music library with more media content.

Tencent’s initial discussions for a UMG stake

Reuters reported initial reviews of the deal back in February 2019. At that time, Tencent was planning to buy half of the stake in UMG from its parent company Vivendi. According to Reuters, American private equity company KKR & Co. was also eyeing UMG. The report, citing unknown sources, stated that UMG had an estimated value close to 20 billion euros.

Reuters also quoted JP Morgan analyst Daniel Kerven, who felt the music company’s business valuation should be around 44 billion euros. Also, Kerven felt that Universal Music is “a unique asset – under-monetized” and that its content has the potential to entertain global audiences. He continued to express that UMG holds a lucrative opportunity for tech companies hosting streaming music.

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Why Tencent’s deal values UMG at 3 billion euros

Tencent values a 10% stake in Universal Music at 3 billion euros on a fully diluted basis. Based on the acquisition amount, Universal Music’s total value stands at 30 billion euros. However, the deal closure is subject to customary closing conditions and regulatory approval from China and the US. The release suggests that the agreement could come to a close sometime in the first half of this year.

In addition to the 3 billion euro purchase, the consortium led by Tencent will also have an option to increase its stake by an additional 10% at the same value. But this option will mature on January 15, 2021. and Tencent Music Entertainment is considering acquiring a minority stake at the same valuation. TME’s interest lies in Universal Music’s business in Greater China. But there’s no further information about the direct agreement between these two subsidiaries.

UMG and the music industry

Universal Music ranks among the top industry leaders. It competes with the likes of Sony Music and Warner Music. Universal Music reports its earnings in its parent company Vivendi’s consolidated financials. In Vivendi’s Q3 2019 financial release on October 17, 2019, the French company reported 3.9 billion euros in revenues. Of this total, Universal Music contributed around 45%. During the first nine months of the year, Universal’s revenues grew at an organic rate of 17.5% year-over-year. In the third quarter alone, its organic growth rate came in at 15.7% year-over-year.

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Like all other business sectors, reliance on technology in the music industry is rising. The IFPI (International Federation of the Phonographic Industry) is a body that represents interests of the Global Recording Industry. In its Global Music Report 2019 released in April, IFPI stated that paid subscribers to streaming music grew 33%. Meanwhile, download and physical revenue declined by 21% and 10%, respectively. The growing adoption of streaming music worldwide is a big driver of revenue growth.

According to the IFPI report, Asia and Australasia collectively ranked the second-highest revenue growth. IFPI estimated a 12% rise in revenues, including both physical and digital revenues. Among the top ten markets in 2018, China ranked seventh on the list. The Global Music Report also claimed that China is becoming a hotspot for music and that Western artists are keen on touring China. Tencent could capitalize on all of these drivers through the UMG deal.

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Is the deal a good call for Tencent?

Based on the drivers we’ve discussed above, Tencent could make a significant breakthrough in music streaming services to Chinese audiences. And the company’s strategic decision to buy this stake in UMG will have a triple impact on its financials.

The first factor is a 10% collective share purchase. Then the second factor is the option to exercise an additional 10% purchase at the same valuation. And the third factor is a potential minority interest purchase by Tencent Music Entertainment Group.

Investors could see this move to expand in the music industry as a play to help Tencent gain popularity—particularly among the Chinese fanbase of UMG artists. In its last quarterly release, TME’s paid user count surpassed 35 million, a 42% year-over-year increase. Also, its quarterly revenues came in at approximately $910 million.

Finally, according to research from Statista in November 2019, music streaming revenues in China will grow at a compound growth rate of 8% from 2020 to 2024. So this deal looks like a step in the right direction.

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