Tencent (NASDAQOTH:TCEHY) Music is kind of like the Spotify (NYSE:SPOT) of China, if Spotify was profitable and also part live-streaming platform. In just a few weeks, you'll be able to buy shares of the spin-off.

In this episode of Industry Focus: Tech, host Dylan Lewis and Motley Fool contributor Evan Niu explain what the company does, its biggest opportunities, and some risks investors should watch out for. Curious about how audience tips and gifts made up a huge chunk of Tencent's revenue? Wondering how a music-streaming platform is churning out revenue in the first place? What's the growth runway really like for the biggest music-streaming platform when it already has 800 million users? Why was the IPO delayed, and for how long? What can Tencent Music tell us about Amazon's (NASDAQ:AMZN) Twitch? Tune in and find out.

A full transcript follows the video.

This video was recorded on Oct. 12, 2018.

Dylan Lewis: Welcome to Industry Focus, the podcast that dives into a different sector of the stock market every day. It is Friday, October 12th, and we're talking about one of the biggest tech IPOs of 2018, and why investors are going to have to wait just a little bit longer for it. I'm your host, Dylan Lewis, and I'm joined on Skype by senior tech specialist, Evan Niu. Evan, what's up?

Evan Niu: Not too much.

Lewis: We have done a lot of shows on the ____ of China. We have another business that we are going to be talking about today that fits that bill. That is Tencent Music.

Niu: Right. You could call it the Spotify, you can also call it the Twitch of China. Both fit that fun little ____ of China.

Lewis: Y alluded to that there, there's kind of a hybrid business model that we'll get into. Some of it is going to be very familiar to people that follow Spotify and the streaming music space. Some of it is going to be very familiar to people that follow the Twitch and gaming space here. It's a fun one for us. This is a company that was supposed to be going public relatively soon. More on that later. Those plans have changed. It is the largest online music platform in China, over 800 million mobile active users across its four properties. You mentioned, it's the Spotify of China, kind of. We have this conventional streaming content approach. This is music, video, studio, live music recordings. That all happens within some of these portfolio products they have -- QQ Music and KuGou Music platforms. It looks a lot like Spotify, Evan.

Niu: I would also mention that at 800 million users, that makes them not only the biggest service in China, but also the world. If you compare that, their online music, they have about 650 million users, of which 25 million are paid. For reference, Spotify has 100 million free and 85 million paid. Apple Music, of course, has no free tier. They only have a paid version, which they have 40 million. Tencent Music is enormous, in terms of users. 

Lewis: This is the part of the model that will feel familiar to most folks. It's paid subscriptions, digital music sales, and online advertising. They also have something that is quite a bit different than what we think of with the online music space. That is their social entertainment services. When I think of this, it's primarily the Wesing platform that they have.

Niu: This is things like karaoke and little live music performances. Tencent Music mentioned in their F-1 registration statement that the Chinese market for live offline music performances has always been very small because it hasn't been very accessible compared to the U.S. Here, we like to go out and see shows and see bands pretty commonly. It's a pretty big industry here. Over there, the market is just so small. That's created this alternative market, demand for live streaming online performances instead. 

Lewis: As for what this experience looks like, it's video sharing, it's karaoke parties, it's virtual karaoke rooms, and I think even some duets with celebrities. Kind of unlike anything we have here in the United States. But, it's very similar, if you port over to the gaming side of things and think about Twitch and the idea of this shared experience, even though it's a digital experience, doing video game walkthroughs with people and watching people play. The monetization for this type of business is very similar to Twitch. Its paid subscriptions, its gifts, its online mini payments, the way you would almost have with a video game.

Niu: Right. On Twitch, people might not be familiar with how Twitch works. It's predominantly video games and e-sports. You're live streaming yourself playing a game and you have these viewers that will contribute cash donations as well as, like you mentioned, these virtual gifts or paid subscriptions to their channels. Basically, instead of just video games over in Asia, they have all sorts of different types of ways to create this entertainment with these live streaming platforms. For example, in Korea, people in Korea like to watch people eat. People live stream themselves eating. In China, it's karaoke and other live music performances. 

Lewis: This is not a small portion of the pie for Tencent Music. In 2017, 71% of the company's top line came from the virtual gifts and premium membership segment, which is to say that 30% came from the streaming music operations that are familiar to us when we think Spotify. It's a very different model than what I think a lot of people are expecting when they hear "the Spotify of China."

Niu: Right. The business is really built on this social entertainment part of the business. And as we've talked about before, Spotify has to pay these huge royalty costs. They're unprofitable. But Tencent Music is very profitable. They had about a 20% net margin the first half of the year. To put some more numbers to it, the social entertainment user side, they have about 230 million users, of which 10 million pay. If you look at the average revenue per user on each side of this business, on the music side, converted roughly from yuan, it's about $1.27. Average revenue per user on the social entertainment side is $16.28. That's almost 13X greater than the music side. We're talking about half as many users on the social entertainment side contributing, as you mentioned, 70% of revenue. It's just a huge, huge business for them.

Lewis: Right. When we started doing our digging on this company, I was thinking, "OK, here comes another high-growth platform tech company. It's not going to be profitable." The thing I was most immediately struck with was $1.6 billion in revenue and a profit. $240 million in profit in 2017. So far, for the first half of 2018, the company's put up $1.3 billion in sales and already topped their 2017 net income figure. This business scales a lot better and a lot more immediately than what we see here in the U.S. with Spotify.

Niu: Right. The cost structure is totally different. If you look at Spotify's numbers, 70-80% of their revenue goes toward royalty costs. On Tencent Music, I would imagine their music business is roughly the same, since they also have to have similar licensing agreements. But on the social entertainment side, which, as we talked about, is much bigger, their main costs are revenue sharing arrangements with the content creators and things like that, so you don't have as much royalty burden.

Lewis: It's rare to get a bundle of high-growth company, profitable, still a pretty big growth runway in front of it. It seems like that's what we have here. But I think it's important to understand what's going on and where the growth levers really lie for this company. When I look at their growth figures, about 650 million monthly active users on the online music services. You mentioned before just over 200 million monthly actives on social entertainment. The growth rates for them have been relatively low as of the most recent quarters. For the online music services, it's the low single digits. I believe social entertainment was somewhere around 14% year over year recently. We think about the 1.4 billion number for the Chinese markets, but I still think that a lot of this has been realized already. I think there's already some market saturation happening with their user base.

Niu: I do think that in the longer-term, they still have plenty of upside. Internet penetration in China is still around the 40% level. Like you mentioned, at 1.4 billion total population in China, and I think the total internet users in the country are somewhere around 800 million. You still have hundreds of millions of people that have to get online. How fast that happens, of course, is a little bit harder to predict. But I do think, over the long-term, they should have no shortage of users to keep getting on this platform. 

Lewis: Yeah. That's definitely more of a short-term outlook for me. The next couple of years, I think for the most part, a lot of the growth that we see with them, particularly on the top line, is going to be driven by its existing user base. Right now, their pay rate among users is very low. 3.6% pay for online music services. 4.2% pay for social entertainment services. That's a huge opportunity for them, but I think it also speaks to the customer expectation and the dynamic. Both of those rates have been growing over time, but they are low when you consider the overall base of users they have.

Niu: One quick note that I think is worth acknowledging is that the way that they report their paying users is, they only count people that have subscriptions. If you have an à la carte purchase of some digital music, they actually don't count you as a paying user, even though you actually are paying, obviously. It is something interesting there in how they report. It's another thing for investors to keep an eye on.

Lewis: That is why you have to read the prospectus, Evan. Great point there. I think, looking at these numbers, the challenge for them is going to be getting more users to pay for the service, and getting users to pay more once they are paying for the service. So, that is their average revenue per paying user number. It has generally been up on the social entertainment side. Streaming music has been all over the place for them on an ARPU basis. I'm not really sure what's going on there. There's been no consistency on a year over year or sequential basis, in terms of growth.

Niu: Right. Generally speaking, a lot of Chinese consumers, part of the mentality is, they don't really like paying for things online. But, when you talk about the entertainment experience part of it, I think there is greater propensity to actually open up the walls and contribute to these performers that are actually providing entertainment to them. So, I do think it is a pretty stark contrast. And you can see it played out in the ARPU numbers, too.

Lewis: Evan, as the company name might suggest, Tencent Music has a pretty big strategic partner as it looks at the mobile space in China.

Niu: Right. They're owned by parent company Tencent, which owns about 60%, I think 58% of outstanding shares. They're obviously going to have majority control, pretty much determine the strategic direction of this company. You have company insiders owning another 8%. Also, Spotify owns about 9% of this company, because Spotify and Tencent Music did an equity swap in December 2017, where they exchanged stock for positions in each other. So, they can also advise each other on strategic matters and learn from each other, give each other tips.

Between all that, that's about 75% of all shares that'll be locked up by these entities. That means, whenever the stock actually goes public and starts trading, your float is going to be 25% or less. 

Lewis: Yeah. This gives them a lot of different strengths. It gives them some stability. It has a lot of people that are really bought in to the success of the business. I think in the case of Tencent, it gives them access to this massive platform. They have, over a billion monthly active users on its apps. Having access to that, from a strategic perspective, access to the social graph there, and understanding some of the user data on that side, will be incredibly beneficial for them as they're trying to grow their user base.

Niu: Right. They'll definitely have all these different types of cross-selling, cross-advertising, cross-promotion, all sorts of things. Tencent owns WeChat, which is just enormous and completely ubiquitous in China. It's everywhere. Being able to really tie into those services, I think, is a huge advantage.

Lewis: Within the space, we touched on it before, but it's worth bolding and underlining, it is the largest platform in the market when you combine all of its apps' users. It's also the largest in the world. To your Spotify comparison earlier, not on the paying side, but in its general presence. And the users are highly engaged. Every daily active users spends an average of 70 minutes per day on the platform. That's engagement that is pretty hard to match. So, I think there are a lot of really good things going for this business right now.

Niu: I like it, actually, a lot more than Spotify, which I actually own stock in. There's a lot of things that I do like about this business and the numbers that they're putting up already. 

Lewis: Now, of course, with all those strengths, there were some concerns about market volatility recently. We've had some pretty big sell offs, particularly in the tech space. This was an IPO that was slated to happen at some point in the next few weeks, and it seemed like the book building was in process pretty much. Recent news indicates that that's going to be delayed a bit.

Niu: Right. The markets have been pretty choppy the past couple of weeks, particularly with the massive sell-off that you mentioned this week that wiped off three or four months of gains in the major indices. And, yeah, tech took it pretty hard, especially. But there's been some concerns about rising interest rates, etc. So now, Tencent reportedly wants to wait a little bit longer to go public, at least until November, even though it already filed its F-1 registration statement at the beginning of October. It was previously expected to do a roadshow as early as next week, and they'd go public by the end of the month. 

But if you think about it, it makes sense. This was going to be one of the biggest IPOs of 2018, valuing the company somewhere between $25-30 billion. That's a pretty huge valuation, especially for a Chinese company going public in the U.S. Besides, that deal could be a risk, specifically as it relates to the IPO pricing. IPOs are priced based in part on investor demand. If all this recent volatility has dampened the market's appetite for risky stocks, and all IPOs are fundamentally very risky, then you can see how they'd be a little bit worried that if there's not enough demand, pricing could get hurt, and that ruins your positive headlines and big presence in celebration of this huge deal. 

Lewis: Yeah, it is not unprecedented for a big IPO to be delayed. This is something we've seen in the past before. To your point earlier about this being a pretty appealing offering, I'm with you. I think this is a very interesting stock to watch, and certainly a company that I am interested in.

You look at that valuation range they were targeting, $25-30 billion, that puts them at something in the neighborhood of 10X sales, give or take, if they continue on the run rate that they've been on for the first half of 2018. And they're already profitable. The path to long-term profitability, the path to them being a successful, sustainable business, is already there. It's not something that you have to bet on. And it seems like there's still a lot of growth built into this business. 

Niu: Yeah. I'm definitely interested. I'm not sure what I'm going to do quite yet. But it actually makes me very curious about Twitch. Amazon bought Twitch several years ago for about $1 billion before they really had a lot of these monetization strategies in place. I'm very curious how big the Twitch business has grown for Amazon. Amazon doesn't really disclose anything about Twitch. When you see the success of Tencent Music, which, as we've mentioned, is this hybrid model between Twitch and Spotify, with the vast majority of the money coming from the live streaming side, it makes you wonder about how the Twitch business is going for Amazon, too.

Lewis: Yeah. We might actually have to do a show on HUYA down the road. It's kind of considered the Twitch of China. That is a comp for Twitch and maybe a little bit of an insight into what's going on on the books there. I guess that will be our next ____ of China show, Evan.

Niu: [laughs] There's no shortage of ____ of China.

Lewis: [laughs] We'll keep them coming. Evan, thanks for hopping on this show! Listeners, that does it for this episode of Industry Focus. If you have any questions, or if you just want to reach out and say hey, you can shoot us an email at industryfocus@fool.com, or you can tweet us @MFIndustryFocus. As of this week, you can also find all these podcasts segments on YouTube. Check them out at youtube.com/themotleyfool. If you're looking for more of our stuff, subscribe on iTunes or check out The Fool's family of shows over at fool.com/podcasts

As always, people on the program may own companies discussed on the show, and The Motley Fool may have formal recommendations for or against stocks mentioned, so don't buy or sell anything based solely on what you hear. Thanks to Rick Engdahl for all his work behind the glass today. For Evan Niu, I'm Dylan Lewis. Thanks for listening and Fool on!

John Mackey, CEO of Whole Foods Market, an Amazon subsidiary, is a member of The Motley Fool's board of directors. Dylan Lewis owns shares of Amazon and AAPL. Evan Niu, CFA owns shares of AAPL and Spotify Technology. The Motley Fool owns shares of and recommends Amazon and AAPL. The Motley Fool has the following options: long January 2020 $150 calls on AAPL and short January 2020 $155 calls on AAPL. The Motley Fool has a disclosure policy.