Social entertainment services dominate Tencent (NASDAQOTH:TCEHY) Music's financials, which is a key contributor to the company's profitability. What's less clear is how quickly Tencent Music can grow its user base in the years ahead, as there are plenty of Chinese consumers who have to get online. In this episode of Industry Focus, Dylan Lewis is joined by Motley Fool contributor Evan Niu to look at Tencent.

A full transcript follows the video.

This video was recorded on Oct. 12, 2018.

Dylan 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."

Evan 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.

Dylan Lewis owns shares of Tencent Holdings. Evan Niu, CFA owns shares of Spotify Technology and Tencent Holdings. The Motley Fool owns shares of and recommends Tencent Holdings. The Motley Fool has a disclosure policy.