The Ledger: Tencent Music Highlights Risks of Doing Business in China

Doing business in China got tougher in 2021 after government agencies handed down new rules and levied fines against some well-known companies. For evidence this has made investing in Chinese companies more complicated, look no further than Tencent Music Entertainment’s annual report released Tuesday.

All publicly traded companies’ financial statements include risk factors mandated by the Securities and Exchange Commission to help investors understand companies’ unique challenges and possible negative outcomes if things go south. TME’s previous annual reports have listed numerous risk factors, ranging from licensing third-party content to its corporate structure. It’s a long list that just got longer.

The new risk factors in TME’s 2022 annual report are further evidence of the challenges facing both TME and its investors. Two topics dominate the new disclosures: The People’s Republic of China government’s heightened regulations and new U.S. legislation. These risks were previously known and helped TME’s share price drop precipitously in the past year. Still, TME’s detailed explanations underscore the seriousness of the threats.

TME’s annual report also includes several mentions of the risks related to the Holding Foreign Companies Accountable Act, a U.S. law passed in 2021 that requires foreign companies listed in the U.S. to submit to audits by the Public Company Accounting Oversight Board. The PRC government does not want a U.S. regulator to have access to Chinese companies’ sensitive financial information – even though “that could deprive investors of the benefits of such inspections.”

Running afoul of the PCAOB could have serious consequences. TME states its “ADSs may [be] delisted and our ADSs and shares prohibited from trading in the over-the-counter market under the Holding Foreign Companies Accountable Act” if the PCAOB is unable to inspect or fully investigate auditors located in China.

What’s more, pending legislation titled Accelerating Holding Foreign Companies Accountable Act, “would decrease the number of non-inspection years from three to two,” potentially quickening a delisting, according to the annual report. The early-stage bill was referred to in the House Committee on Financial Services on Dec. 14, 2021.

On July 24, 2021, the PRC government’s State Administration for Market Regulation penalized Tencent Holdings — now TME’s majority shareholder — regarding the acquisition of China Music Corporation in 2016. At the time, Tencent operated QQ Music, while CMC operated two competing music streaming services, Kugo Music and Kuwo Music. (Tencent spun off TME in 2018.) According to a legal analysis, SAMR found that Tencent and CMC were the top two parties in the music broadcasting platform market and owned an 80% market share — above the threshold for notifying regulators, which Tencent did not do. SAMR found the CMC acquisition reduced competition and increased barriers to entry after the larger company signed exclusive licensing deals with record labels and paid high advances its competitors might not be able to afford.

As a penalty, and to encourage competition, SAMR forced TME to relinquish its exclusive licensing deals with record labels. Tencent was also fined 500,000 RMB ($76,000).

The National Copyright Administration held meetings with “a number of music industry players” on Jan. 6, 2022 about banning exclusive music copyright agreements, “except under certain circumstances,” and develop an internal copyright management system, according to the report. TME says it is pursuing “exclusive collaborations” with copyright holders but cannot assure all the licenses that were once exclusive will be available at reasonable royalty rates, the annual report states. What’s more, TME acknowledges that losing exclusive licensing agreements “may potentially lower” competitors’ barriers to entry. Right on cue, Douyin – ByteDance’s China-specific version of TikTok – launched a beta version of a music streaming service,  Qishui Yinyue, targeted specifically to the Chinese market.

The annual report also lists a new risk factor about the PRC government’s oversight and scrutiny of live streaming platforms and performers. In Nov. 2020, the National Radio and Television Administration handed down the Circular 78, which set requirements on users’ spending on virtual gifts as well as restrictions on minors from virtual gifting and content tagging, among other things. Any limitation on virtual gifting may hit TME’s revenues and hurt the engagement of live-streaming performers.

TME, and other Chinese tech companies, could receive a reprieve from the PRC government. According to numerous reports on Friday, China will convene a symposium with some leading tech companies – including Tencent Holdings, TikTok owner Bytedance and e-commerce giant Alibaba Holdings Group – “to assure business executives that regulators will no longer demand rectifications or impose surprise fines,” according to the South China Morning Post. That wouldn’t change regulations already enacted for licensing music or affect U.S. laws aimed at Chinese companies, however.

Famed U.S. investor Warren Buffet is known for his thorough readings of the annual reports of companies he might acquire or invest in. He reasons that tracking management’s comments and strategies over multiple years will provide a good sense of how a company is run. Reading just two years of TME’s annual reports is enough to give Buffet the impression that a Chinese streaming company is an uncertain, risky investment in 2022.

STOCKS

Through April 29, the % change over the last week, and the year-to-date change.

Spotify (NYSE: SPOT): $101.65, -7.8%, -56.6% YTD
Universal Music Group (AS: UMG): 22.29 euros, -5.8%, -10.0% YTD
Warner Music Group (Nasdaq: WMG): $29.77, -5.0%, -31.1% YTD
HYBE (KS 352820): 251,500 KRW, -1.2%, -27.9% YTD
Live Nation (NYSE: LYV): $104.88, -1.0%, -12.4% YTD
SiriusXM (Nasdaq: SIRI): $6.00, -1.4%, -3.0% YTD
Tencent Music Entertainment (NYSE: TME): $4.25, +4.2%, -38.0% YTD
Cloud Village (HKE: 9899): 63.10, -5.0%, -59.9% YTD

NYSE Composite: 15,615.10, -2.8%, -9.0% YTD
Nasdaq: 12,334.64, -3.9%, -21.2% YTD

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