Chinese tech giant Tencent (OTC:TCEHY) is in talks to buy a 10% stake in Universal Music Group (UMG) from French media conglomerate Vivendi (OTC:VIVHY). The proposed deal, which values UMG at 30 billion euros ($33.6 billion), would also grant Tencent the right to purchase an additional 10% of UMG within the first year.

UMG, Sony (NYSE:SONY) Entertainment, and Access Industries' Warner Music are the three largest record labels in the world. Tencent holds licensing deals with all three companies, and it spun off its streaming music unit, Tencent Music (NYSE:TME), in an IPO last December.

Sony and Warner Music already own stakes in Tencent Music, so Tencent's investment in UMG would expand its web of cross-investments to the last of the "big three" labels.

Let's see how those investments might help Tencent and Tencent Music.

A young woman listens to music on her headphones.

Image source: Getty Images.

Tencent holds the keys to the Middle Kingdom

Tencent Music was created by merging three of China's top music streaming platforms: QQ Music, Kugou, and Kuwo. That ecosystem controls about three-quarters of China's streaming market, and its total number of mobile MAUs (monthly active users) rose 5% annually to 654 million in the first quarter.

The big three labels signed licensing deals with Tencent to tap into that massive market. The terms of those deals weren't disclosed, but royalty payments to record labels are usually the top expense for streaming music companies.

Tencent Music expects to pay 4.37 billion RMB ($620 million) in royalties to record labels this year, which translates to just over $1 per existing user per year. That's a surprisingly low rate, and indicates that Tencent likely convinced Sony, Warner, UMG, and other labels to lower their royalty rates to reach its massive base of listeners. Tencent Music's streaming music subscribers only paid an average of 8.3 RMB ($1.18) per month last quarter, but that equals about $14 per year, which easily covers its anticipated royalty fees.

Tencent Music's number of paid mobile streaming music listeners grew 27% annually to 28.4 million last quarter, but that represented just 4% of its total mobile MAUs. As a result, most of Tencent Music's streaming revenue still comes from lower-margin ads instead of higher-margin subscriptions.

However, Tencent Music complements the growth of its streaming business with its social entertainment unit, which includes its karaoke app WeSing. That diversified business enables Tencent Music to remain consistently profitable -- something Spotify (NYSE:SPOT) (which also owns a stake in Tencent Music) still can't achieve. Tencent already holds the rights to sub-license UMG's music to other platforms in China thanks to a deal struck two years ago, so lower licensing fees could boost its sub-licensing division's profits.

A woman sings a song into her smartphone.

Image source: Getty Images.

How does this deal help Tencent?

We should note that Tencent, not Tencent Music, wants to buy a piece of UMG. Tencent remains the controlling stakeholder in Tencent Music, and the platform remains tethered to other apps like WeChat and Tencent Video.

Tencent's relationship with Tencent Music is comparable to Baidu's (NASDAQ:BIDU) relationship with its video platform iQiyi, which was also spun off in an IPO. Tencent Music and iQiyi both function independently, but their former parent companies (and majority stakeholders) still cover some of their content licensing expenses.

Tencent generates most of its revenue from video games, online ads, and its newer cloud and fintech businesses. However, Tencent's streaming music and streaming video platforms link together different parts of that ecosystem and widen the company's moat against rivals like Baidu and Alibaba, which both integrate their streaming music and video platforms into other services.

Simply put, Tencent's investment in UMG is focused more on expanding its ecosystem than boosting its near-term revenue. An investment in UMG also complements its other music-oriented investments, which include Tencent Music, Spotify, and India's Gaana. Tencent also owns the Asian streaming app Joox. All those musical investments could strengthen Tencent's position against ByteDance's TikTok, the popular lip-syncing app which topped 500 million MAUs last year.

The key takeaway

Tencent is spreading out its bets across the music industry. With UMG, it gains a stake in a top record label. With its stakes in Tencent Music and other platforms, it remains invested in the streaming market. The UMG investment probably won't move the needle for Tencent or Tencent Music, but it will reinforce the company's dominance of China's evolving digital music market.

This article represents the opinion of the writer, who may disagree with the “official” recommendation position of a Motley Fool premium advisory service. We’re motley! Questioning an investing thesis -- even one of our own -- helps us all think critically about investing and make decisions that help us become smarter, happier, and richer.