We came across a bullish thesis on Tencent Music Entertainment Group (NYSE:TME) on ValueInvestorsClub by StockOperator. In this article, we will summarize the bulls’ thesis on TME. The company’s shares were trading at $11.14 when this thesis was published, vs. the closing price of $13.32 on Mar 07.

A person on a laptop in the night, listening to Arabic music through a streaming application.

TME operates online music entertainment platforms to provide music streaming, online karaoke, and live streaming services in China. It also sells music-related merchandise; and artist-related merchandise, such as branded apparel, posters and art prints and accessories.

Over the past 5 years, TME has increased its paying users from 34 million to 127 million, clocking a CAGR of 30%. The management is focusing on its core strength, the online music segment that saw revenue contribution from 30% to 75%. The ARPPU for this segment increased from $1.30 to $1.50 in the last 8 quarters. The paying ratio has also increased from 3% to 20% and is expected to remain increasing in the next few years. In terms of profitability, its operating margin increased from 15% in 2017 to 31% in the latest quarter even though the MAU declined by ~200 million.

TME enjoys a duopoly with NetEase and this should sustain the business growth and margin expansion. Spotify was able to increase its paying ratio to 45% by offering promotional discounts and while this rate seems far-fetched, 30% paying ratio can be considered reasonable if the economic environment improves.

The stock price has been volatile over the last five years due to regulatory concerns but this has now been resolved. The potential of TME lies in the online music segment which can account for 88% of the revenue (currently 75%). This will not only provide a stable and lean business but also improve the overall margin for the company. TME is also looking to monetize its investment in AI by building use cases of in-vehicle apps and audiobooks. The monetization strategy has enabled TME to increase its paying user base at the rate of 15-20 million/year since 2020. Consequently, the gross margin has expanded from 30% to 40%. The Super VIP Tier is another segment to look out for since it offers an opportunity to increase revenue by $3-5 per user per month.

Under the base case scenario, paying users is expected to increase annually by 13 million (9.75 million converting from free to premium and 3.25 from premium to Super VIP). The incremental revenue from this transition would be $390 million. The forecasted revenue for 2028 is $6.4 billion and with an operating margin of 31%, EBIT should touch $2.1 billion. An EV/EBIT multiple of 14x should value the stock price at $22.60, a potential 70% gain from its current level.

While we acknowledge the potential of TME as an investment, our conviction lies in the belief that some AI stocks hold greater promise for delivering higher returns, and doing so within a shorter time frame. If you are looking for an AI stock that is more promising than TME but that trades at less than 5 times its earnings, check out our report about the cheapest AI stock.

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Disclosure: None. This article was originally published at Insider Monkey.