Kuke Music Holding (KUKE) operates in a growing market and shows significant gross profit margin. There are several risks that investors need to understand. The company has one large supplier, which I don’t appreciate. I also believe that the recent acquisition made by KUKE was too expensive. Hence, in my opinion, this is a company that only institutional investors will study. In my view, KUKE will most likely trade with a total valuation of $74-$300 million. I would buy if the market capitalization crosses the $74 million mark.
Kuke Music Holding offers classical music licensing and subscription in China. According to Frost & Sullivan, the company is one of the largest classical music subscription providers in China. Taking into account only this fact, I think that the company will be very interesting for institutional investors:
Powered by our rich and diverse content offerings, we were the largest classical music licensing service provider and the second largest online classical music subscription service provider in China in 2019, according to Frost & Sullivan, representing 46.6% and 13.8%, respectively, of the market share in terms of revenue. Source: Prospectus
Kuke Music Holding appears to be having good relationships with some of the most well-known music labels in the world. We are talking about Naxos, which helped Kuke create what appears to be the largest library of classical music content in China. The company owns exclusive rights of over 1.8 million music tracks.
The number of Kuke’s clients also appears very overwhelming. As of September 30, 2020, the company reported 743 743 institutional subscribers with 444 universities in China.
With regards to Kuke’s target market, the company is operating in a growing industry. The global music streaming market was valued at USD 20.9 billion in 2019, and is expected to increase at a CAGR of 17.8% from 2020 to 2027.
If we talk about the market in China, the numbers are also beneficial. Digital music is expected to show a growth rate of 12.3% CAGR from 2020 to 2025. I would expect the company’s sales growth to be close to this figure:
Specifically, the classical music market in China is expected to grow at a CAGR of 9.3% from 2020 to 2025. If the company performs better than the market, Kuke could be delivering sales growth of more than 9.3% y/y. However, I don’t believe that most investors will expect Kuke to do much more than that. Notice that the company did not deliver organic sales growth in 2019.
Its market size, as measured by total revenue generated from classical music licensing, paid subscription of online classical music subscription service providers and box office receipts of classical music performances, grew from RMB1,040.4 million in 2015 to RMB1,738.4 million in 2019, at a CAGR of 13.7%, and is expected to reach RMB2,396.6 million by 2025, at a CAGR of 9.3% from 2020 to 2025. Source: Prospectus
Large Gross Profit Margin
Kuke does not report sales growth, but it does report massive gross profit margin. In 2019, the gross profit margin was equal to 66%, which is quite large as compared to other companies. The gross profit margin of Spotify (SPOT) is close to 21%:
As far as the balance sheet is concerned, in 2020, Kuke enhanced its financial shape quite a bit. The total amount of assets increased by 56% in the 9M 2020. At the same time, total liabilities decreased by 14%. With that, certain shareholders may not appreciate the transactions that generated such impressive financial gain.
I like the fact that Kuke has not increased its liabilities in 2020. The financial debt has also not increased because the company is making acquisitions with its own shares. It appears to be a very smart corporate move. Notice that the asset/liability ratio is at more than 4x. I don’t expect any financial advisor to be afraid of this ratio.
Financing Of Kuke Music And The M&A In 2020
According to Crunchbase, Kuke Music received funding from one entity in 2014. It had only one investor:
The most interesting transaction was executed in 2020. Kuke Music issued shares to acquire Rosenkavalier for RMB284 million:
The Company issued 4,856,273 ordinary shares as non-cash consideration for the acquisition of Rosenkavalier. The shares issued had a total estimated fair value of RMB284,000,000, based on the preliminary fair value of the Rosenkavalier Group as at the date of acquisition measured using income approach. Source: Prospectus
Rosenkavalier had RMB67 million in assets when it was acquired. The company reported a goodwill of RMB216 million. I am not in the music industry. However, the goodwill appears significant. The industry does not seem to be growing that much to justify such increase in the value of the assets:
I could also find the assets acquired from Rosenkavalier. Intangible assets were equal to RMB20 million. Notice that the company increased the valuation of those intangibles to RMB53 million when the company was acquired:
I believe that investors need to know about Kuke’s main supplier. Naxos provides 95% of the total amount of content offered by Kuke. In my opinion, some investors will believe that there is a risk here. If Naxos decides to increase its prices or stop working with the company, shareholders may have an issue:
Our content providers include renowned music labels, publishing houses and artists. In particular, content licensed from Naxos, our largest content provider, accounted for over 95% of our content offerings as of September 30, 2020. Source Prospectus
I researched Naxos a bit. According to Crunchbase, it is a private company, and a subsidiary of Hnh International Limited. Hnh International Limited, the owner of Naxos, is a company based in the United States. Zoominfo says that Hnh International Limited reports a revenue of only $4 million. It has branches all over the world. So, I believe that the sales figure given is that of the branch in Hong Kong:
There is something else that investors need to get to know. The CEO of Kuke Music Holding owns a controlling state in Naxos. I don’t really like this. Notice that the CEO appears to be both buyer and seller in the acquisition of content from Naxos:
Our Chief Executive Officer and Chairman of the Board, holds 75% of the equity interests in Naxos. Naxos is our largest content provider and contributed to over 95% of our content offerings as of September 30, 2020. Source: Naxosmusiclibrary
Use Of Proceeds
Kuke Music Holding expects to use the proceeds to increase the company’s music education services and enrich content. I appreciate that the company does not intend to acquire shares from existing shareholders or reduce debt:
Approximately 70% to enhance and diversify our smart music education service offerings, expand the geographic coverage of our smart music education services and strengthen our technological capabilities;
Approximately 15% to enrich our content offerings, reinforce our content leadership and explore additional content monetization opportunities;
Approximately 5% for working capital and other general corporate purposes. Souce: Prospectus
Competition And Valuation
Kuke Music Holding has not given the name of any competitor in the productus. The company appears to be competing with other music licensing providers and providers of education:
We face competition from other classical music licensing service providers for licensees, other online classical music subscription service providers for subscribers, other smart music education service providers for student enrollment and the sale of our Kuke smart pianos and Kuke smart music teaching systems, and other live classical music event organizers for audience and sponsorship. Source: Prospectus
Let’s use the valuation of SPOT to value Kuke Music. SPOT traded at 2.4x-6.9x sales with revenue growth of 24% and gross profit margin of 21%. If we assume sales of $31 million in 2021, Kuke Music Holding could trade at a maximum of $74-$213 million. If we use the EV sales ratio of 10x sales given by TAL Education (TAL), the market may give a valuation of $310 million. In my view, any valuation larger than $300 million will not represent a sell opportunity. I may be buying shares at less than $74 million.
Source: Ycharts – TAL
Kuke Music Holding offers investment exposure to a growing market in China. The company’s sales gross profit margin is very significant. With that, the company is still very small, which is always a risk. Also, I don’t like the fact that Kuke has one very significant supplier. I would be buying a small position at a total valuation mark of less than $74 million. I recommend investors to do extensive due diligence on the company before buying any share. There may exist risks that I may have not identified.