Tencent Music (TME -4.32%) recently issued its first earnings report as a public company, but the market didn't exactly sing its praises, sending shares down over 10% the next trading day. Still, Tencent Music's stock remains about 28% above its December IPO price of $13, so it's not as if early investors should be disappointed.

So is the post-earnings drop just a temporary setback for a stock that's already had a big run, or is it a sign that something's amiss? Delving into the quarterly results, it appears to be the former.

A young woman listens to music on headphones attached to her smartphone.

Tencent Music's growth story is still intact. Image source: Getty Images.

Spend money to make money

Tencent Music is a young, high-growth company, so it would be a concern if revenue were falling short; however, the company actually beat analysts' revenue expectations last quarter. While its 50.5% year-over-year growth did mark a deceleration from the 83.7% year-over-year revenue growth it chalked up during the first nine months of 2018, that's still a healthy number, and again, ahead of analyst expectations. The fourth quarter is also a seasonally slower quarter for Tencent Music, as more listening and online karaoke occur during the summer months, according to management.

The problem appears to be on the spending side. Licensing fees paid to labels and revenue-sharing fees to karaoke performers increased by 62.5% against the prior-year quarter. Selling and marketing expenses grew 51.4%, and general and administrative expenses were up 63%. All expenses grew faster than revenue, causing Tencent Music's margins to compress, though non-IFRS (International Financial Reporting Standards) earnings still grew by a pretty decent 37.3%. While the company officially posted a net loss, this resulted from a one-time accounting expense due to shares issued to Warner Music and Sony (SONY -1.34%) Music Entertainment in conjunction with the IPO.

Widening its moat

Of course, if there's a time for Tencent to invest heavily in its future, it's now. The company has a big lead over rivals with roughly 76% of the Chinese music streaming market. In contrast to many other streaming platforms, the company is actually profitable, and it just raised an additional $1.1 billion in its December IPO. Since it's flush with cash, now is the time for Tencent Music to extend that lead.

And spend it did. The company is rolling out a number of new tools and features to the service. Among them are the following:

  • New video content, including a music chart countdown show, a music variety show called Produce 101, and live-streamed music talk shows
  • Short video features for social media
  • Long-form radio shows
  • New tech tools to help young artists and singers, including a new autotune capability
  • New data analytics tools to help unsigned niche artists grow and market their music

These tools, among others, have helped increase Tencent Music's user engagement. Paying streaming users increased by 39.2%, from 3.2% of total monthly average users (MAUs) in the year-ago quarter to 4.2% last quarter. Given that only 4.2% of MAUs pay for music subscriptions, there's still lots of room to grow.

In addition, the company's main profit center, its social entertainment segment, saw a 22.9% increase in paying users, to 4.5% of total social entertainment users, up from 4% one year ago. And the average revenue per social entertainment user grew 24.3% on top of that.

The two big takeaways from these figures are that user engagement continues to increase, and penetration of paying subscribers relative to overall users is still relatively low. Just as today's leading video streaming companies spend all they can on content to drive subscriptions, often running at low or no profits, Tencent Music should likewise invest in content and features that will drive future-user and paying-user growth.

Check out the latest earnings call transcripts for the companies we cover.

Investments, or just higher costs?

While management is portraying these spending increases as investments rather than just elevated costs, investors should monitor these costs going forward. As my colleague Leo Sun pointed out, there are some outstanding lawsuits against Tencent Music for streaming unlicensed music. However, the number of outstanding lawsuits over licensing seems to have fallen to just 58 as of December, down from 900 in June, with potential aggregate damages of only $2.6 million. Still, investors should make sure engagement and paying users continue to grow as a result of these investments and that licensing costs don't get out of control.

Overall, it's good to see management investing in the company's long-term health rather than worrying about quarter-to-quarter profitability at this stage. Given that Tencent Music is still growing faster than the other major streaming services and continues to be profitable, even with these elevated investments, the future appears bright for this leading Chinese streamer.