NetEase steps up Tencent challenge with music-streaming unit IPO

NetEase Inc. is preparing to list Cloud Village, its music-streaming unit, potentially giving the Chinese company greater firepower to exploit an opening in the market as leader Tencent Music Entertainment Group faces regulatory scrutiny.

Cloud Village plans to use proceeds from its Hong Kong share sale to purchase music rights, work with independent artists and promote its brand among young users, according to a May 26 exchange filing. The listing could raise $1 billion, according to a Bloomberg News report.

The stake sale may help Cloud Village to expand its catalog at a time when regulators are seeking to strengthen music-streaming competition. Tencent Music's use of exclusive agreements with the likes of Warner Music Group Corp. and Universal Music Group Inc. helped the company amass 622 million users by the end of 2020, compared to Cloud Village's 180.5 million users.

"Cloud Village's IPO proceeds will give it a war chest," Ke Yan, lead analyst at DZT Research, said. "It will have more titles for distribution and paying users will increase."

Tencent Music and NetEase did not respond to requests for comment from S&P Global Market Intelligence.

Tencent Music confirmed during a May earnings call that it is facing heightened scrutiny from Chinese antitrust regulators. Tony Yip, Tencent Music's chief strategy officer, said the company has been "actively cooperating" with the relevant authorities. The State Administration for Market Regulation is planning to order the company to divest rights to certain music labels, according to a July 12 Reuters report.

In May, Sony Music Entertainment Inc. said it signed a digital distribution deal with Cloud Village, ending the exclusive nature of its agreement with Tencent Music. Sony also extended its partnership with Tencent Music.

"Western labels will now have to sell to NetEase, under Chinese regulators' instructions," Charlie Chai, equity analyst at 86Research, said. Asia-Pacific labels will also likely start pursuing deals with both NetEase and Tencent Music in order to maximize revenue, he explained.

Cloud Village may also try undercutting Tencent Music in order to grow user numbers, analysts said.

In the past, Cloud Village has partnered with other platforms to offer discounted subscription packages, leading to a significant improvement in its number of paying users, Shifara Samsudeen, equity analyst at LightStream Research, said. Cloud Village's proportion of paying users is expected to reach 27% in 2025, after rising to 8% in 2020 from 2% in 2016, according to the filing. Around 9% of Tencent Music users pay to use the service.

The listing will not change the fact that Cloud Village is pre-profit, which means the company many not have free rein over how to spend the proceeds. "Ultimately, Cloud Village will need to focus first on improving its profit margins before it gets the budget to spend on content," Chai said.

The unit incurred gross losses of 595.3 million yuan, 1.1 billion yuan and 1.3 billion yuan, in 2020, 2019 and 2018, respectively, according to the prospectus. Cloud Village said its content service costs increased in 2020, leading to a rise in the cost of revenue, due to an increase in payments to music labels and independent artists.

Allocating some of the proceeds to independent artists will help Cloud Village to attract younger listeners and differentiate itself from Tencent Music, Chai said. Music by non-label artists made up over 45% of streams on Cloud Village's platform in December 2020, according to the filing.

Such deals could be key in boosting Cloud Village's number of paying users. "Even a 1% difference in the number of copyrights can decide whether a significant amount of users [will choose one streaming service over another]," Shawn Yang, an analyst at Blue Lotus, said.