Fitch Ratings has affirmed China-based Tencent Music Entertainment Group's (TME) Long-Term Foreign- and Local-Currency Issuer Default Ratings (IDRs) and senior unsecured rating at 'A'.

The Outlook is Stable.

The affirmation reflects the company's strong linkage with its parent, Tencent Holdings Limited (A+/Stable). We rate TME on a top-down basis, notching the IDRs by a single notch below Tencent's IDR on strong linkages, as assessed under our Parent and Subsidiary Linkage Rating Criteria. TME's Standalone Credit Profile (SCP) of 'bbb+' is underpinned by its strong market position as China's largest online music platform, a solid net cash position and low EBITDA leverage, despite near-term pressure faced by its live streaming business.

Key Rating Drivers

Strong Linkage: We believe Tencent has a 'Low' legal incentive, 'Medium' strategic incentive and 'High' operational incentive to support TME. Tencent owns 52.5% of TME and controls 92.6% of the voting rights. TME is Tencent's only online music subsidiary in China and a core unit in Tencent's social network services, accounting for 24% of its social network revenue in 2022. TME is an integral part of its parent's content ecosystem. TME's user base is an important online community to Tencent and overlaps with Tencent's Weixin and QQ smart-device users.

TME's operations are deeply integrated with that of Tencent. TME shares the parent's audio and video service permit. The web portals of TME's music streaming service, QQ Music, and online karaoke service, WeSing, are fully integrated under Tencent's www.qq.com domain. TME also collaborates closely with Tencent across multiple business units, including Weixin Video Account, Tencent Video, Tencent Picture, Tencent Games, Qzone and China Literature Limited.

Solid Market Position: TME's SCP is underpinned by its market position as China's largest online music platform, with the largest revenue share in the country's paid digital-music market in 2022. TME has benefited from Tencent's shared mobile ecosystem, including its Weixin, QQ and Qzone communication and social platforms, which should help TME defend its market position.

Small Decline in Revenue: We expect 2023 revenue to decline by 2%-3%, before recovering by 2%-3% in 2024 (2022: 9% decline), due to lower revenue from TME's social entertainment services - which contribute 40%-46% of group revenue. However, TME's online music services should expand by 15%-21% in 2023-2024 (2022: 9%), driven by rising paying users and upgrades to pricier subscription packages as the company adds more privileges to these packages.

We believe online music services will be the company's key revenue driver in the medium term. This should mitigate our expected 10%-20% drop in social entertainment service revenue, as TME removes content that may not comply with regulations on host behaviour and users' virtual gifting in live streaming.

EBITDA Margin to Improve: We expect TME's Fitch-defined EBITDA margin to improve to 21%-22% in 2023-2024 (2022: 19%) on better monetisation of music subscription services, a recovery in advertising revenue along with tight operating cost control. We expect the company to keep its selling and marketing expenses low, at around 4% of revenue in 2023-2024 (2022: 4%; 2021: 9%), as it targets growth in paying users rather than promotions to further acquire customers, including free users.

Long-Form Audio Potential: TME is well-positioned to capture the rapid growth in long-form audio services in China, as the format complements the content and services provided to music users. TME has been investing in audiobooks and podcasts over the past three years and acquired Lazy Audio to complement its existing long-form audio business. The company also works closely with publisher, China Literature, and other members in Tencent's online entertainment ecosystem to broaden audio categories.

Solid Net Cash; Low Leverage: We expect TME to maintain its solid net cash position of around CNY22 billion in the medium term (2022: CNY22 billion). We also expect the company to generate around CNY4 billion-5 billion of free cash flow (FCF) per year, while maintaining a conservative capital structure with low EBITDA leverage of 0.9x in the medium term (2022: 1.0x). The company does not intend to add borrowing in the medium term; it only has an outstanding USD800 million in bonds that it issued in 2020.

Manageable Regulatory Risk: TME's IDRs reflect our expectation that the company will continue its healthy relationship with the Chinese government and regulatory authorities. Any change in this position could affect TME's credit strength, due to government restrictions on foreign ownership of domestic internet companies. TME does not have equity control over its onshore operating companies, such as Guangzhou Kugou Computer Technology Co., Ltd., or other consolidated affiliated Chinese entities with which it only has contractual relationships.

TME has an ESG Relevance Score of '4' for Exposure to Social Impacts due to heightened regulatory risk as the Chinese government is focusing on antitrust enforcement and strengthening control of content and behaviour on the internet, which has a negative impact on the credit profile, and is relevant to the ratings in conjunction with other factors.

Unless otherwise disclosed in this section, the highest level of ESG credit relevance is a score of '3'. This means ESG issues are credit-neutral or have only a minimal credit impact on the entity, either due to their nature or the way in which they are being managed by the entity. For more information on Fitch's ESG Relevance Scores, visit www.fitchratings.com/esg1.4

Derivation Summary

TME's SCP is underpinned by its leading market position in China's online music entertainment industry and solid financial profile. Its SCP is stronger than that of most 'BBB' rated internet peers, given its dominant position in China's digital music market, steady FCF generation and solid net cash position.

TME warrants a better business risk profile assessment than Vipshop Holdings Limited (BBB/Stable). TME has a stronger market position in its respective market segment; Vipshop is a leader in the niche discount apparel market, but only has a low single-digit percentage market share in China's ecommerce B2C market, which is dominated by Alibaba Group Holding Limited (A+/Stable) and JD.com Inc. The ratings of both companies benefit from low EBITDA leverage and net cash positions.

TME's SCP is weaker than that of Baidu, Inc. (A/Stable), as China's search-engine market is significantly larger than the online music market. Baidu also has stronger cash generation.

Key Assumptions

Fitch's Key Assumptions Within Our Rating Case for the Issuer

Continued market leadership in China's online music subscription market with an improving market position in long-form audio services

Revenue to decline by 2%-3% in 2023, before recovering by 2%-3% in 2024

Fitch-defined EBIT margin to widen to 17%-18% in 2023-2025 (2022: 15%) on better monetisation of the music subscription and long-form audio businesses and tighter control over operating expenses

Capex/sales ratio of 4% in 2023-2025 (2022: 4%)

No cash dividends in the medium term

Share repurchase of around USD500 million in 2023-2024

RATING SENSITIVITIES

Factors that could, individually or collectively, lead to positive rating action/upgrade:

Positive rating action on Tencent

Strengthened incentives for Tencent to support TME

Factors that could, individually or collectively, lead to negative rating action/downgrade:

Negative rating action on Tencent

Weakened incentives for Tencent to support TME

Best/Worst Case Rating Scenario

International scale credit ratings of Non-Financial Corporate issuers have a best-case rating upgrade scenario (defined as the 99th percentile of rating transitions, measured in a positive direction) of three notches over a three-year rating horizon; and a worst-case rating downgrade scenario (defined as the 99th percentile of rating transitions, measured in a negative direction) of four notches over three years. The complete span of best- and worst-case scenario credit ratings for all rating categories ranges from 'AAA' to 'D'. Best- and worst-case scenario credit ratings are based on historical performance. For more information about the methodology used to determine sector-specific best- and worst-case scenario credit ratings, visit https://www.fitchratings.com/site/re/10111579.

Liquidity and Debt Structure

Strong Liquidity: We expect TME to maintain a large net cash position for the next few years. It had readily available cash of about CNY31 billion at end-June 2023, against total debt of CNY5.6 billion, consisting of USD300 million of notes due in 2025 and USD500 million of notes due in 2030. We expect TME to generate steady annual FCF of about CNY4 billion-5 billion in the next few years. In addition, TME has strong access to banks and capital markets, given its strong ties with Tencent.

Issuer Profile

TME is majority owned by and deeply integrated with Tencent. TME is China's largest online music and music-centric social entertainment platform, and it operates the country's highly popular music apps; QQ Music, Kugou Music, Kuwo Music and WeSing. It also offers long-form audio services via Kuwo Changting and Lazy Audio.

REFERENCES FOR SUBSTANTIALLY MATERIAL SOURCE CITED AS KEY DRIVER OF RATING

The principal sources of information used in the analysis are described in the Applicable Criteria.

Public Ratings with Credit Linkage to other ratings

Fitch rates TME on a top-down basis one notch below Tencent's IDR.

ESG Considerations

TME has an ESG Relevance Score of '4' for Exposure to Social Impacts, due to regulatory risk, as the Chinese government is focused on antitrust enforcement and strengthening its control over content and behaviour on the internet. This has a negative impact on the credit profile and is relevant to the ratings in conjunction with other factors.

The highest level of ESG credit relevance is a score of '3', unless otherwise disclosed in this section. A score of '3' means ESG issues are credit-neutral or have only a minimal credit impact on the entity, either due to their nature or the way in which they are being managed by the entity. Fitch's ESG Relevance Scores are not inputs in the rating process; they are an observation on the relevance and materiality of ESG factors in the rating decision. For more information on Fitch's ESG Relevance Scores, visit www.fitchratings.com/topics/esg/products#esg-relevance-scores

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