Tencent Music Entertainment (NYSE:TME), the top music streaming company in China, went public in late 2018 and its stock currently trades nearly 20% above its IPO price. That's a decent return, but its Swedish counterpart Spotify (NYSE:SPOT) has nearly doubled in value since its direct listing in early 2018.

Back in June, I explained why investors favored Spotify over Tencent Music: Spotify generated stronger growth in revenue and paid users, operated a simpler business model that didn't rely on live videos, and faced fewer regulatory challenges than Tencent Music.

Tencent Music's recent second-quarter earnings report didn't bring back the bulls. The company's revenue rose 18% annually to 6.93 billion yuan ($981 million), but missed expectations by $1.5 million. Its non-GAAP net income rose 2% to 1.15 billion ($163 million), or $0.10 per ADS -- which beat estimates by a penny. Those headline numbers were solid, but Tencent Music's stock probably won't generate Spotify-like returns until three things happen.

A young woman listens to music on her smartphone.

Image source: Getty Images.

1. Tencent Music stabilizes its social entertainment business

Unlike Spotify, Tencent Music is consistently profitable by both GAAP and non-GAAP measures. Those profits mainly come from its "social entertainment and others" segment, which generates most of its revenue from live-streamed karaoke videos on its WeSing platform. Viewers purchase virtual gifts for their favorite broadcasters, who receive a cut of each sale.

This business grew rapidly in the first half of 2019, but it's stalled out over the past two quarters. Its mobile monthly active users (MAUs) declined 3% annually in the fourth quarter, rebounded 13% in the first quarter during the COVID-19 crisis, but cooled off again with a 2% drop to 236 million MAUs in the second quarter. That slowdown wasn't surprising, since locked-down users streamed more music at the height of the pandemic in the first quarter. It was also partly offset by its growth in paid users, which rose 12% annually to 12.5 million.

However, the unit's monthly average revenue per paid user (ARPPU) declined 3% annually to 125.6 yuan ($18.07), marking its second straight quarter of year-over-year declines. Its ARPPU grew 13% sequentially, but it faced an easier comparison to the first quarter when cash-strapped viewers purchased fewer virtual gifts.

In the end, the unit's growth in paid users offset its declining MAUs and ARPPU, and its total revenue rose 9% annually and accounted for 68% of Tencent Music's top line. Unfortunately, the bulls will likely stay away until all three metrics stabilize.

2. Tencent Music proves the online music business still has room to grow

Tencent Music's online music business, which sells streaming subscriptions and digital downloads across three core platforms (QQ Music, Kugou, and Kuwo), fared better during the second quarter.

A young woman listens to music on her phone.

Image source: Getty Images.

The platform's mobile MAUs dipped 0.2% annually to 651 million, but its number of paid users surged 52% to 47.1 million as its ARPPU rose 8% to 9.3 yuan ($1.34). Tencent Music attributed those higher monetization rates to live events featuring famous musicians, better personalized recommendations, robust sales of digital albums, and an expanded library of anime, comics, and gaming (ACG)-related media for Gen Z listeners, along with new audiobooks, talk shows, and music videos.

Tencent Music's monetization strategies are aggressive, but its decline in MAUs suggests its platforms -- which already control nearly 80% of China's music streaming market -- could be running out of room to grow. If that happens, Tencent Music will need to convert its free listeners to paid ones at an even faster rate.

For now, the unit's growth remain stable. Its revenue rose 42% annually, thanks to a 65% jump in subscription revenue, and accounted for the remaining 32% of Tencent Music's top line.

It also recently signed a new multi-year licensing agreement with Universal Music Group (UMG), which it owns a stake in, to form a new joint venture in China. That joint venture, along with Tencent Music's existing deals with Sony Music and Warner Music, could strengthen its sub-licensing business (which licenses tracks to China's other streaming platforms) and reduce its own content licensing fees.

3. Tencent Music needs to overcome its regulatory challenges

Lastly, Tencent Music needs to overcome regulatory headwinds in both China and the U.S.

Last year, China's antitrust regulators forced Tencent Music to lower its sub-licensing fees to rivals following complaints of unfair markups. Chinese regulators also probed Tencent Music's deals with UMG, Sony, and Warner Music for over a year before suspending the investigation in February during the pandemic. It's unclear if the regulators will restart that probe, but it's casting a dark cloud over its online music business.

Tencent Music faces two major challenges in the U.S. First, a recently passed Senate bill could force all U.S.-listed Chinese companies to delist their stocks if they don't comply with new regulations. Second, the Trump administration recently targeted Chinese tech giant Tencent (OTC:TCEHY), which still holds a majority stake in Tencent Music, with a ban on its popular messaging app WeChat. An escalation of that battle could spell trouble for Tencent, and all its related companies.

The key takeaway

Tencent Music's stock could still head higher, but its near-term gains will be limited by these three challenges. Investors looking for a simpler streaming music play should stick with Spotify instead.