If you thought Spotify's (NYSE:SPOT) 180 million monthly active users (MAUs) were impressive, take a look at Tencent Music Entertainment's recent IPO filing with the SEC. The Tencent (OTC:TCEHY) spinoff boasts 800 million unique MAUs across its four apps: QQ Music, Kugou Music, Kuwo Music, and WeSing.

When it comes to paying subscribers, though, Spotify has Tencent Music beat. The Chinese company has just 23.3 million paying customers compared to 83 million paying Spotify on a monthly basis. And while paying subscribers are key to Spotify eventually turning a profit, Tencent Music is profitable already, and has been for the last two years. Here's how.

A woman listening to music from her smartphone.

Image source: Getty Images

All about social

Just 29% of Tencent Music's revenue comes from music services, which includes subscription packages, advertising, and digital music downloads. Historically, it's very difficult to convince Chinese consumers to pay for music due to a culture of piracy. Nonetheless, Tencent Music has managed to get 23 million people to pay for music, though the average customer pays just 8.7 RMB (about $1.27) per month. The basic subscription package is priced at 8 yuan per month.

But a few years ago, Tencent Music hit on a major cultural movement with WeSing, its virtual karaoke app. The company started offering karaoke via WeSing in September 2014, and it quickly expanded to the Kugou and Kuwo apps.

While users can sing karaoke and share videos and live streams with friends via Weixin (WeChat) for free, there are some paid features in WeSing that have been big revenue generators for Tencent Music. The primary source of revenue are virtual gifts users can send to live streamers and karaoke singers. Some of the revenue is shared with performers while Tencent Music keeps the rest.

Tencent Music's social entertainment services revenue grew from 2.2 billion RMB in 2016 to 7.8 billion RMB in 2017. Through the first six months of 2018, the company brought in 6.1 billion RMB, up 94% from the same period last year.

In the meantime, Tencent Music saw its overall gross margin climb from 28.3% in 2016 to 40.4% in the first half of 2018. By comparison, Spotify just posted a gross margin of 25.8% in the second quarter, and that's actually very encouraging for the company. But the higher gross margin at Tencent Music combined with relatively stable operating expenses as a percentage of revenue have enabled significant profit growth for the Chinese company. Tencent Music grew from just over break-even in 2016 to over 1.7 billion RMB ($263 million) in profits for the first half of 2018.

Can Spotify copy Tencent Music?

It's unlikely Spotify will be able to provide a karaoke service and suddenly turn a profit like Tencent Music. Tencent Music has quite a few advantages. First, it operates primarily in China, where karaoke is already very popular. Moreover, its relationship with Tencent, its controlling shareholder, provides unique access to its massive social networks, Weixin (WeChat) and QQ.

WeSing requires users to sign in using their Weixin credentials. That allows the app to tap into users' social graphs and find friends and performers they might be interested in. It also allows WeSing to post videos of performances to the Weixin feed, enabling greater discovery of the app. As a result, WeSing's user base has grown extremely quickly over the last four years.

Spotify doesn't have that kind of relationship with a global social network. And it's unlikely to form one anytime soon, especially considering the increased focus on data privacy following this year's events.

But Tencent Music's profitability is an encouraging sign for Spotify investors because it shows a two-sided music marketplace works. The Chinese music company effectively makes a profit by cutting out the middleman and giving creators direct access to the public. That's exactly the vision Spotify presented at its investor day before it made its public debut. In fact, it might be a borrowed idea considering Spotify is a major investor in Tencent Music.

Tencent Music's success could be a sign of things to come for Spotify.

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