Narrow-moat Tencent Music’s TME second-quarter earnings were in line with our and Refinitiv’s consensus expectations. Management lowered revenue guidance on continued livestreaming weakness but remains optimistic about margin expansion for the rest of this year. Overall, we are maintaining our $12.50 fair value estimate, and we continue to believe shares are undervalued. We think investors are underestimating the size of its long-term subscriber base and further margin expansion opportunities as the firm grows the top line.
During the second quarter of 2023, total revenue grew 6% year over year. This was led by a 37% increase in music subscription revenue but was partially offset by a 25% decline in social entertainment revenue, that is, livestreaming. Starting from the latter part of the second quarter of 2023, the firm pre-emptively disabled features related to gambling, to manage potential regulatory risks. We estimate that these features contributed to a high-single-digit percentage of Tencent Music’s net profit in 2022, and the latest adjustments translate to a permanent loss of earnings. That said, our assumptions have always assumed lackluster revenue from the social entertainment segment, so the overall impact on our fair value estimate is negligible.
Moving to online music services, we like the fact that despite a 14% year-on-year increase in the monthly subscription cost, paying users still grew 20%, underscoring the enduring value of Tencent Music’s products and network. With the average monthly subscription cost standing at just CNY 9.70 ($1.30), we see significant room for the firm to increase subscription prices over the long term.
Profitability was again a highlight this quarter, as gross margin clocked in at 34.3%, an improvement of 440 basis points on the same period last year. Management attributes the improvement to sales leverage and various cost-control initiatives, and they expect margin strength will continue into the rest of 2023.