Tencent Holdings (OTC:TCEHY) recently led a consortium of companies, including Tencent Music Entertainment (NYSE:TME), in acquiring a 10% stake of Vivendi's (OTC:VIVHY) Universal Music Group for $3.4 billion.

Before the deal closes in the first half of 2020, Tencent Music is expected to enter a second deal to acquire a minority stake in UMG's Chinese business. Furthermore, the deal gives the consortium the option of buying an additional stake of up to 10% in UMG by Jan. 15, 2021.

A young woman listens to music on her headphones.

Image source: Getty Images.

Tencent Music is already the top online streaming company in China, but these deals will improve its access to UMG's lineup of artists, which includes Taylor Swift, Lady Gaga, and The Beatles.

It will also likely lower Tencent Music's licensing fees for UMG songs, and bolster its sub-licensing business, which licenses its tracks to other Chinese streaming music platforms. This deal clearly benefits Tencent Music, but it could also hurt NetEase (NASDAQ:NTES) Cloud Music, Alibaba's (NYSE:BABA) AliMusic, and other rivals in several ways.

The 800-pound gorilla just gained weight

Tencent Music owns the three most popular music streaming apps in China -- QQ Music, Kugou, and Kuwo. These three apps control about three-quarters of China's music streaming market, while the rest of the market is fragmented among smaller players.

NetEase and Alibaba are two of the market's more resilient underdogs. To challenge Tencent Music, the two companies pooled parts of their streaming libraries in 2018. Alibaba also acquired a $700 million stake in NetEase Cloud Music last year.

However, Tencent Music's clout still helped it secure more exclusive deals with the three largest record labels in the world: Access Industries' Warner Music, Sony Music Entertainment, and Vivendi's Universal Music Group. Those deals caused NetEase, Alibaba, and other companies to file complaints with China's antitrust regulators, which subsequently forced all Chinese streaming platforms to share their licensing rights with their rivals via sub-licensing deals.

Tencent Music complied and licensed its songs to rival platforms, but a Bloomberg report last year claimed that TME's sub-licenses could be "twice as expensive" as direct licenses from record labels. That practice sparked an antitrust probe of Tencent Music last year and forced it to cut its sub-licensing fees.

A streaming music app on a phone.

Image source: Getty Images.

Some investors believed that the probe could derail Tencent's Tencent's talks with UMG, which started last summer. However, the deal was still approved -- and will likely allow Tencent Music to license songs at lower royalties from UMG, then sub-license them back to rivals like NetEase and Alibaba at current rates for higher profits. To add insult to injury, Tencent Music will also reap profits from NetEase and Alibaba's direct licensing payments to UMG.

What does this mean for Alibaba and NetEase?

Tencent's UMG deal won't threaten Alibaba or NetEase's core businesses, since neither company relies heavily on streaming music revenue. Alibaba generates most of its revenue from its core commerce business, while NetEase makes most of its money from video games.

However, the deal makes it harder for both companies to gain ground in China's streaming music market. Alibaba operates AliMusic as part of its digital media and entertainment unit, which has been an unprofitable money pit ever since its IPO in 2014.

NetEase opened up Cloud Music to nearly a dozen external investors since 2013, but it still maintains a majority stake in the unit. NetEase doesn't disclose if the unit is profitable, but recently warned that it mostly relies on non-exclusive deals, and that the "competition in China for exclusive or non-exclusive licenses to distribute music content is fierce."

Moreover, maintaining a streaming music platform contradicts NetEase's strategy of streamlining its business with the divestments of its online comics unit and its e-commerce platform Kaola, as well as the spin-off of its Youdao education unit over the past year. This suggests that NetEase will prioritize the growth of its core gaming business over its music streaming business in the future.

The key takeaways

Tencent Music's investors should expect the UMG deal to stabilize the company's gross margins, which were weighed down by lower sub-licensing fees in recent quarters. It should also reinforce its position as China's streaming music leader.

However, the deal will make it tougher for Alibaba, NetEase, and other smaller rival Chinese stocks to keep pace with Tencent Music. These smaller players probably can't count on China's antitrust regulators to throttle Tencent Music's growth, or prevent the company from making additional investments in other big record labels in the future.