NetEase (NASDAQ:NTES) is China's second-largest video game publisher after Tencent (OTC:TCEHY). It generated nearly three-quarters of its revenue from online games like Invincible, Onmyoji, and Sky last quarter.

However, NetEase's "Innovative Businesses and Others" segment, which generated over a fifth of its revenue during the quarter, houses its secondary growth engine: NetEase Cloud Music, China's second-largest streaming music platform after Tencent Music (NYSE:TME).

A young woman listens to music on her smartphone.

Image source: Getty Images.

NetEase repeatedly attributed the growth of its Innovative Businesses segment to NetEase Cloud Music in recent quarters, but it's been cagey with the exact details. Let's review what NetEase has revealed so far about its streaming music platform.

What do we know about Cloud Music?

NetEase launched Cloud Music in 2013. Its free streams are supported by ads, while paid subscribers gain access to ad-free streams and additional content. It also generates revenue from live video streams for musicians.

The platform's number of registered users hit 300 million in 2017, doubled to 600 million in 2018, and hit 800 million in 2019. However, NetEase has never disclosed its number of monthly active users (MAUs).

Tencent Music, which merged three leading music platforms (QQ Music, Kugou, and Kuwo), has nearly 650 million mobile MAUs. Tencent Music's three platforms control over three-quarters of China's streaming music market in terms of spending, according to the latest industry estimates, while NetEase Cloud Music ranks a distant second with a share of about 10%.

Partnering with Alibaba to counter Tencent

Alibaba (NYSE:BABA), which ranks third in the streaming music market, acquired a fifth of NetEase Cloud Music for $700 million last year. That investment, which was paired with Alibaba's $2 billion takeover of NetEase's cross-border marketplace Kaola, lowered the barriers between the two streaming music underdogs.

This summer, NetEase offered Cloud Music's annual subscription, which usually costs 179 yuan ($27), as a free perk for top-tier members of Alibaba's 88VIP loyalty program. It also integrated its streaming services with Alibaba's Youku Tudou video platform and its affiliated Alipay payments service.

Tencent Music holds exclusive contracts with many of the world's top record labels. NetEase, Alibaba, and other smaller players need to sublicense that content from Tencent Music. Tencent Music lowered its sublicensing fees in response to price gouging complaints and an antitrust probe last year, but the two underdogs still pay substantial licensing fees to their biggest rival.

How fast is NetEase Cloud Music growing?

NetEase's Innovative Businesses and Other segment generates most of its revenue from its e-commerce platform Yanxuan, its online advertising business, and NetEase Cloud Music. The segment's top-line growth has accelerated over the past year, but its gross margins remain wobbly:

Period

Q3 2019

Q4 2019

Q1 2020

Q2 2020

Q3 2020

Revenue Growth (YOY)

4.5%

17.9%

28%

38.7%

41.6%

Gross Margin

15.2%

20.6%

15.8%

18.5%

16.8%

YOY = Year-over-year. Source: NetEase.

Over the past year, NetEase repeatedly cited Cloud Music as the segment's main growth engine. It claimed its Cloud Music revenue rose by the "triple digits" year-over-year in the first and second quarters of 2020, with "record high" membership revenue -- but it didn't reveal any exact numbers.

NetEase didn't claim Cloud Music was still generating triple-digit growth in the third quarter, but said it was still "growing rapidly," with a rising ratio of paid members. It attributed that growth to its partnership with Alibaba, and noted the platform now hosted over 200,000 independent artists -- up from 100,000 in 2019 and just 20 million back in 2016.

NetEase Cloud Music is likely growing faster than Tencent Music, which grew its total revenue 16% year-over-year last quarter, but we can't draw any direct comparisons until NetEase reveals some concrete numbers.

We also don't know if Cloud Music is profitable yet, though CFO Charles Yang noted its licensing fees were still at an "irrationally high level" during last quarter's conference call -- which indicates the government's actions against Tencent Music haven't significantly helped NetEase and Alibaba.

Will NetEase Cloud Music keep growing?

NetEase Cloud Music is rapidly expanding, and the accelerating growth of the innovative businesses segment indicates it's becoming a major growth engine alongside its core gaming business.

For now, NetEase will likely focus on expanding its scale, tightening its partnership with Alibaba, and attracting more independent artists to reduce its overall dependence on large record labels and Tencent Music.

It also plans to nurture Cloud Music's growth as a social networking platform, which could boost its stickiness and counter Tencent Music's WeSing, which generates most of the company's profits with live karaoke streams.

Tencent Music had 51.7 million paid users on its online music platform last quarter. If NetEase Cloud Music can sign just 20 million of its 800 million users onto annual subscriptions, the business could generate about $540 million in subscription revenue -- or roughly 5% of its estimated sales next year.

Investors should keep an eye on NetEase's innovative business segment, and see if Cloud Music maintains its momentum and it reveals clearer metrics for this high-growth business. If it does, it could offer investors even more reasons to own NetEase's rising stock.