Tencent Music Entertainment (NYSE:TME), the largest streaming music company in China, recently posted mixed third-quarter numbers. Its revenue rose 16% year over year to 7.58 billion yuan ($1.12 billion), missing estimates by $10 million. But its adjusted net profit rose 9% to 1.35 billion yuan ($198 million), or $0.12 per ADS, which beat expectations by a penny.

Tencent Music's headline numbers look stable, but its social entertainment business, which hosts its WeSing karaoke platform, remains unstable. That raises a red flag since WeSing was once considered TME's core growth engine.

A woman listens to music on her headphones.

Image source: Getty Images.

What happened to the social entertainment business?

Tencent Music's social entertainment revenue rose 13% year over year to 5.25 billion yuan ($773 million), or 69% of its top line, during the third quarter.

The platform's average revenue per paying user (ARPPU) rose 32% to 166.7 yuan ($25.17), as its paying users spent more money on virtual gifts on WeSing and its live-streaming platform. It also attributed that growth to upgrades to WeSing's news feed and recommendation algorithm, which drove viewers to watch more ads instead of simply buying virtual gifts for their favorite broadcasters.

However, the platform's total number of mobile monthly active users (MAUs) still fell 6% year over year to 235 million, marking its second straight quarter of declining MAUs. Its number of paid users declined 15% to 10.5 million, due to fewer promotions and incentives for new users.

Tencent Music's chief strategy officer Tony Yip declared the company would "proactively tackle the competitive pressure" during its conference call, but didn't call out any competitors by name. However, WeSing's ongoing loss of users indicates rival short video apps -- including ByteDance's Douyin (known as TikTok overseas), Kuaishou, and NetEase's (NASDAQ:NTES) Yin Jie karaoke app -- could be gaining ground.

That's troubling when we consider that Tencent Music's social entertainment business generated nearly 18 times as much ARPPU than its online music business, which offers streaming music subscriptions and a la carte downloads.

Can the online music business pick up the slack?

Tencent Music's online music business was formed by the merger of China's three largest streaming music platforms -- QQ Music, Kugou, and Kuwo.

A music streaming app on a smartphone.

Image source: Getty Images.

The segment's total revenue rose 26% year over year to 2.32 billion yuan ($342 million), or 31% of TME's top line, during the quarter. Within that total, its music subscription revenue rose 55% to 1.46 billion yuan ($215 million), while the rest came from digital downloads, online ads, and music sublicensing agreements with smaller streaming services.

The platform's total number of mobile MAUs dipped 2% year over year to 646 million, which also marked a sequential loss of 5 million MAUs. That decline suggests Tencent Music could be losing listeners to smaller platforms like NetEase Cloud Music and Alibaba's (NYSE:BABA) Xiami Music.

But on the bright side, the online music platform's number of paid users surged 46% year over year to 51.7 million as it added more online concerts to its TME Live platform and more licensed music and long-form content like podcasts and audiobooks to its streaming library.

As a result, the online music platform's ARPPU rose 6% to 9.4 yuan ($1.42). That progress is encouraging, but the segment is still mainly supported by its growth in total paid users instead of its low ARPPU.

A difficult balancing act

Looking ahead, Tencent Music will likely focus on boosting the social entertainment segment's ARPPU, which could become increasingly difficult if it continues to lose mobile MAUs and paid users. The online music business looks healthier, but it still needs to focus on converting free users to paid ones as its mobile MAUs peak.

Accomplishing those goals will likely throttle its gross margins. Tencent Music's gross margin already contracted 160 basis points year over year to 32.4% during the third quarter, due to its higher investments in TME Live, long-form content, and higher revenue-sharing fees with broadcasters and musicians.

The sublicensing unit's higher-margin revenue has also been declining ever since regulators forced Tencent Music to reduce its fees in response to price gouging complaints from its competitors. A related antitrust probe against the sublicensing business was suspended earlier this year, but it's doubtful TME will ever meaningfully raise its licensing fees again.

In short, Tencent Music needs to pull off a tough balancing act. It needs to invest in new services that boost its ARPPU as its overall audience shrinks, but those investments will inevitably weigh down its margins and earnings.

Tencent Music didn't provide any guidance, but analysts expect its revenue and earnings to rise 20% and 7%, respectively, for the full year. Those growth rates are stable, but investors are likely expecting more from a stock that trades at nearly 30 times forward earnings.

The bottom line

Tencent Music generates most of its revenue and profits from its social entertainment unit, and this segment's audience is shrinking. It's unclear if it's losing users to other streaming video apps or people are just getting tired of smartphone-based karaoke stars -- but it's a problem TME desperately needs to fix. Until that happens, investors should stick with simpler streaming music players like Spotify.

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.