Cloud Music Earnings: Improving Profitability Amid Growing Economies of Scale

No-moat Cloud Music’s 09899 first-half 2023 results exceeded our expectations. We lowered our 2023 revenue forecast on continued livestreaming weakness but upped our margin assumptions considering better-than-expected cost controls. Our longer-term earnings estimates remain largely unchanged. Overall, we are maintaining our HKD 130 fair value estimate, and we continue to believe the shares are undervalued. With $1.2 billion of net cash on its balance sheet as of the end of June 2023, Cloud Music is trading at an enterprise value/2023 sales ratio of just 0.5 times, significantly below the roughly 2 times EV/sales ratios of its peers Tencent Music and Spotify. We believe investors are underestimating the size of its long-term subscriber base and margin upside opportunities as the top line grows.

During the first half, revenue from social entertainment services declined 24% year over year. Like its peer Tencent Music, Cloud pre-emptively disabled features that contain games of chance across its mobile app in an attempt to manage potential regulatory risks. We estimate that these features contributed to a mid-single-digit percentage of the firm’s net profit in 2022, and the change in strategy translates to a permanent loss of earnings. That said, our assumptions have always assumed lackluster revenue from the social entertainment segment, so the resulting impact on our fair value estimate is negligible.

Moving to the online music services segment, we are encouraged by the 11% year-over-year growth in monthly subscribers despite the 5% increase in subscription cost. With the average monthly subscription cost standing at just CNY 6.8 ($0.93), we see significant room for the firm to increase subscription prices over the long term. Going into the rest of 2023, we expect continued increases in both subscribers and average revenue per subscriber.