Why Tencent Holdings Is a Better Investment Than Tencent Music

Tencent Holdings (TCEHY 3.56%), one of the top tech companies in China, only trades in Hong Kong and over-the-counter markets. But last December, Tencent spun off its majority-owned music streaming unit, Tencent Music (TME 4.76%), in an IPO on the New York Stock Exchange.

Tencent's stock has risen less than 10% since Tencent Music's public debut, but Tencent Music currently trades slightly below its IPO price of $13. Some investors might still consider Tencent Music a value play, especially after its solid third-quarter report last month, but I'll explain why Tencent Holdings is actually a safer investment.

Image source: Getty Images.

A better-diversified business

Tencent Music owns the largest streaming music platform in China. Last quarter, it generated 72% of its revenue from its social entertainment business, and the remaining 28% came from its online music business.

Its social entertainment business provides live karaoke streams that can be shared with other users, and viewers can buy virtual gifts for their favorite performers. Its online music unit provides free ad-based streams, paid ad-free streams, and digital downloads to listeners. This unit also sub-licenses its music rights to other streaming platforms in China.

Tencent Holdings' business is more complex. Its three core growth engines -- its online gaming, advertising, and fintech and business services unit -- generated 29%, 19%, and 28% of its revenue, respectively, last quarter. It also holdsinvestments in a long list of companies, including Tencent Music, Activision Blizzard, JD.com, and Tesla Motors.

Tencent is the world's largest video game publisher by annual revenue. It owns WeChat, the top messaging app in China with 1.15 billion monthly active users (MAUs); the older messaging platform QQ, which reaches another 731 million MAUs; and WeChat Pay, the country's most widely used digital payments platform. It's also the fourth-largest digital advertising company in China.

Tencent also owns Tencent Video, one of the top video streaming platforms in China; Tencent Cloud, the second-largest cloud infrastructure platform in China after Alibaba Cloud; and a growing list of short-video and news apps.

In short, Tencent is a well-diversified company that leads many of its core markets. Tencent Music leads China's streaming music market, but it faces tougher headwinds in that narrow market.

More tailwinds than headwinds...

Tencent Music's revenue rose 31% annually last quarter, as its social entertainment and online music revenues grew 36% and 26%, respectively.

The social entertainment unit reported accelerating growth in mobile MAUs and paid users, but its growth in ARPPU (average revenue per paid user) and total revenue decelerated slightly, indicating that the average viewer was buying fewer virtual gifts.

Its online music unit reported accelerating growth in paid users, subscription revenue, ARPPU, and total revenue. However, its growth in higher-margin licensing revenue hit a brick wall after Chinese antitrust regulators probed the business over allegations that it intentionally overcharged its domestic competitors. That probe is disrupting Tencent Music's plans to acquire a 10% stake in Universal Music Group -- which would have given it exclusive songs, lowered its licensing fees, and boosted its sublicensing revenue.

Image source: Getty Images.

Tencent Holdings' revenue rose 21% annually last quarter, as its gaming, advertising, and fintech and business services revenues grew 11%, 13%, and 36%, respectively. Its growth in gaming revenue accelerated, thanks to the strength of top-tier games like Honor of Kings, PUBG Mobile, and Peacekeeper Elite.

Its advertising revenue decelerated due to the economic slowdown in China, but still fared better than those of other advertising platforms like Baidu and Weibo. Its fintech and business services unit remained its fastest-growing business, thanks to the growth of WeChat Pay and Tencent Cloud. In other words, Tencent arguably faces fewer direct headwinds than Tencent Music.

Better margins and profit growth

Tencent Music is consistently profitable, thanks to the growth of its higher-margin social entertainment unit. However, the aforementioned loss of its higher-margin sublicensing revenue is weighing down its gross margins, while higher marketing and R&D costs are reducing its operating margins. As a result, its non-GAAP net income grew just 8% annually last quarter.

Tencent's non-GAAP net income rose 24% annually last quarter. Its gross margins held steady and its operating margins expanded slightly, indicating that its stronger businesses were offsetting the softer spots in its ecosystem like digital ads. It also indicates that Tencent's ongoing ecosystem war with Alibaba and Baidu isn't denting its adjusted profits.

Tencent Music and Tencent Holdings both trade at 26 times forward earnings. Investors should always take analysts' forecasts with a grain of salt, but Tencent Holdings looks slightly cheaper relative to its bottom-line growth:

Source: Yahoo Finance, Dec. 12.

Both are good investments, but one is better...

Tencent Music and Tencent Holdings are both promising long-term investments. But if I had to choose one over the other, I'd stick with Tencent Holdings because it has a more diversified business, bigger growth engines, higher margins, and better profit growth. In addition, you'd still gain a slice of Tencent Music through Tencent's investments.