Warner Music Group Corp. (WMG) Q2 2018 Earnings Report, Transcript and Summary

Welcome to Warner Music Group's Second Quarter Earnings Call for the period ended March 31, 2018. At the request of Warner Music Group, today's call is being recorded for replay purposes, and if you object, you may disconnect at any time. [Operator Instructions] Now I would like to turn today's call over to your host, Mr. James Steven, Executive Vice President, Communications and Marketing. You may begin, sir.

Good morning, everyone. Welcome to Warner Music Group's Fiscal Second Quarter ended March 31, 2018, Conference Call. Both our earnings press release and the Form 10-Q we filed this morning are available at our website. Today our CEO, Steve Cooper, will update you on our business performance and strategy; our Executive Vice President and CFO, Eric Levin, will discuss our financial condition and results, and then we will take your questions. Before Steve's comments, let me remind you that this communication includes forward-looking statements that reflect the current views of Warner Music Group about future events and financial performance. All forward-looking statements are made as of today, and we disclaim any duty to update such statements. Our expectations, beliefs and projections are expressed in good faith, and we believe there is a reasonable basis for them. However, there can be no assurance that management's expectations, beliefs and projections will result or be achieved. Investors should not rely on forward-looking statements because they are subject to a variety of risks, uncertainties and other factors that can cause actual results that differ materially from our expectations. Information concerning factors that could cause actual results to differ materially from those in the forward-looking statements is contained in our earnings press release, our Form 10-Q and Form 10-K and other SEC filings. We plan to present certain non-GAAP results during this conference call. We have provided schedules reconciling these results to our GAAP results in our earnings press release posted on our website. Also, please note that all revenue figures and comparisons discussed today will be presented in constant currency unless otherwise noted. With that, let me turn it over to Steve Cooper.

Good morning, everyone. Thanks for taking the time to join us. We're having an excellent year so far, and we continue to build global momentum in both Recorded Music and Music Publishing. Specifically, in the second quarter, we grew total revenue by 10%, digital revenue by 20% and OIBDA by 8%. These results, coupled with our financial discipline, contributed to our cash balance of $612 million at the end of the quarter. Subsequent to quarter-end, we sold about 75% of our Spotify equity for approximately $400 million. Over 2 years ago, we were the first major music company to announce that we would share proceeds with our artists from the sale of equity in digital services, in this case, Spotify. As we said, we'll share these proceeds on the same basis as we share revenue from actual streams and so-called digital breakage. In addition, we will be sharing equity proceeds with distributed labels if included in their agreements with us. Just so there won't be any misinterpretation about the rationale for our decision to sell, let me be clear, we're a music company, and not by our nature, long-term holders of publicly traded equity. This sale has nothing to do with our view of Spotify's future. We're hugely optimistic about the growth of subscription streaming. We know it has only just begun to fulfill its potential for a global scale. We fully expect Spotify to continue to play a major role in that growth. Our view of the continued health of the music industry was borne out last month when IFPI announced its worldwide recorded music revenue figures for calendar '17. Revenue rose 8%, marking the third consecutive year of growth and the biggest year-on-year increase in roughly 2 decades. Paid subscription streaming was the driver, growing 46%, with paying subscribers soaring 57% to $176 million. As the IFPI report shows, the recorded music industry's transformation is nowhere near complete and there are stark differences in trends across the globe. In aggregate, the increase in streaming revenue more than compensated for a 5% revenue decline in physical and a 21% decline in downloads. However, there are still many markets around the world where the streaming business is still in its infancy. As an example, in Japan, the second-largest recorded music market, revenue declined 3%, and in Germany, the third largest market, revenue fell by 1.5%. In both cases, an increase in streaming revenue wasn't enough to offset the declines in those largely physical markets. This contrasts with a market like the U.S., where streaming represents a majority of revenue and total revenue grew a substantial 13%. Regardless of industry trends, it's imperative that we chart our own course. I'm pleased that 2017 is the fourth year running that we've outperformed the industry by having the largest recorded music market share gained of any major. In order to sustain this growth, we're committed to continue investing in our impressive roster of artists and songwriters as well as in exciting new technologies that will help us drive change and transform our business. Our top sellers this quarter reflected our ability to champion artists across almost every genre and at all stages of their careers. From local chart toppers such as the Japanese punk rock band, WANIMA, to global blockbusters like The Greatest Showman Soundtrack, from Warner Brothers' pop sensation Dua Lipa, to Atlantic's rapper Cardi B, who recently made history by breaking Beyonce's record for the most simultaneous entries by a female artist on the Billboard 100. We're also seeing very strong carryover sales for superstars like Bruno Mars and Ed Sheeran, who was officially named the biggest artist in the world by IFPI. Our direct artist investments are complemented by our expansion of ADA, our indie artist and label services division. ADA had a great quarter and recently celebrated #1 hits from Jason Aldean, on Broken Bow in the U.S. and Kylie Minogue on BMG in the U.K. In publishing, we have a fantastic range and diversity of songwriters who are driving our results. We are pleased that the creative resurgence at Warner/Chappell is going global, as our success in the U.S. is now being mirrored in much of Europe and Asia. The talented songwriters contributing include Logic, MNEK, Ali Payami, Josh Miller, Justin Tranter, Sasha Sloan and Ian Kirkpatrick to name just a few. We're always exploring ways to sharpen our competitive edge in the race to discover the superstars of tomorrow. We recently acquired Sodatone, a Canadian startup that uses data and machine learning to identify emerging artists with big potential. A&R expertise has always been informed by different types of data, but today, tech tools are bringing deeper insights to our decision making. We're just as focused on commercial innovation as we are on the magic of music making. We're constantly exploring new ways for our artists and songwriters to make an immediate and lasting global impact. In March, we signed a licensing deal with Facebook, paving the way for fans to create, upload and share videos with music from their favorite artists and songwriters across the Facebook, Messenger, Instagram and Oculus platforms. We see this partnership as a way to expand the universe of music streaming and provide additional revenue for artists and songwriters. Fan-created video is one of the most personal and popular ways that music is enjoyed, and we are very focused on improving its monetization. Earlier in the quarter, Atlantic Records launched an in-house podcast initiative with its own dedicated production team and recording studio. These podcasts will give listeners a unique look behind the scenes and encourage fans to explore our catalog more deeply. It's moves like these that are behind Atlantic being named for the last 2 years one of the 10 Most Innovative Companies in music by Fast Company. As the pace of change in the music business accelerates, we're committed to the rapid transformation of our business so that we continue to be well positioned to add real value to artists, songwriters and music fans. As I mentioned last quarter, we're already taking steps, including divesting certain noncore touring businesses in Europe; reshaping our IT, data and analytics infrastructure; consolidating our local footprints and building state-of-the-art facilities such as our L.A. office and studios; and rightsizing our physical operations. Some of these initiatives have a financial impact, which Eric will address. I want to mention that after our spectacular showing at the 2018 Grammys, our artists also had a record-breaking year at the Brits, where we won 6 out of the 8 domestic awards. Dua Lipa and Stormzy each took home 2 awards, and Ed Sheeran and Gorillaz also celebrated wins. At ASCAP's 26th annual Latin Music Awards, Warner/Chappell won the title of Publisher Of The Year. In total, Warner Chappell won 12 Most Performed Song awards, with songwriter Eduardo Cabra being honored with prestigious ASCAP Vanguard Award. I'll now turn the call over to Eric.

Thank you, Steve, and good morning, everyone. The second quarter was very strong, and I'm proud of our performance. Revenue was up 10% in constant currency and 17% on an as-reported basis. Excluding the impact of divestitures, including PLG-related asset sales as well as noncore concert promotion assets, our revenue growth was even higher by about 1 or 2 percentage points. From an OIBDA perspective, certain adjustments are necessary to make the year-over-year comparisons more meaningful. The details are in our press release. But in the quarter, we had $29 million of onetime expenses, up from $5 million in the prior year quarter. The biggest driver of the increase was restructuring costs related to strategic initiatives such as rightsizing the physical business, which Steve talked to earlier. Q2 adjusted OIBDA rose 24% to $181 million. The improvement was driven by revenue growth. Adjusted OIBDA margin improved 1.1 percentage points to 18.8%, due primarily to the benefits of revenue mix. On -- our Recorded Music, second quarter revenue was up 9%, with digital revenue up 18%, driven by a 33% increase in streaming. In the quarter, streaming revenue was nearly 6x that of downloads and 3x as big as physical. Physical revenue declined 5%, as strong sales of The Greatest Showman soundtrack helped to moderate industry physical trends. Licensing revenue rose 20%, aided by higher broadcast fee income and increased sync activity. Artist services and expanded-rights revenue declined 16% due to higher concert promotion and merchandising activity in the prior year quarter as well as the impact of concert promotion divestitures. Recorded Music adjusted OIBDA grew 32% to $153 million, driven by revenue growth. Adjusted OIBDA margin improved 2.4 percentage points to 19.3%, related to the benefits of revenue mix. For the quarter, Music Publishing revenue rose 14%, with growth in every segment. Digital rose 30%, performance rose 7%, with continued strength in U.S, sync rose 6% and mechanical was up 11%, which was timing related. Music Publishing OIBDA rose 3% or $2 million to $60 million. OIBDA margin declined 5.5 percentage points to 34.5%, driven by the impact of revenue mix. I'd like to make 2 comments about our publishing results going forward. First, we will be adopting the new revenue recognition standard, ASC 606, in fiscal 2019. While still evaluating the final impact on our financial reporting, we currently believe the most significant change will be timing, as we switch from a cash basis to an accrual basis for our publishing business. As such, while there should be no impact over an entire fiscal year, there will be lumpiness in quarterly comparisons in the first year of adoption. We do intend to provide pro forma figures to aid in performing like-for-like analysis. Second, I want to mention margins. We have been investing in a growing market, which is clearly paying off with double-digit revenue growth, but that increased investment is putting pressure on publishing margins, and it is possible this dynamic will continue. Our operating cash flow in Q2 was de minimis versus $70 million in the prior year quarter. The change was largely due to movements in working capital related to payment of annual bonuses and other variable compensation and timing of royalty payments. CapEx was $13 million, up from $10 million in the prior year quarter. The increase was driven by spend related to the buildout of our new L.A. office and ongoing investments in IT. While we continue to believe that appropriate run rate CapEx for our business is in the $40 million to $50 million range, total CapEx in both '18 and '19 could be about $90 million, reflecting the strategic focus Steve mentioned in his commentary. Specifically, the increase relates to spend behind major improvements in IT and the buildout of our new L.A. office space, which will contain cutting-edge recording studio facilities. Investing in our business remains our top priority for cash. We have more than ample funds to do that while still being able to issue dividends. During the quarter, we previously announced $125 million dividend to our shareholders. Our cash balance at the end of last week was in excess of $900 million. As a result, subsequent to quarter-end, we declared an additional dividend in the amount of $300 million to be paid on May 11. Over the past few months, we refinanced $635 million of 6.75% unsecured notes through a combination of using $325 million in new unsecured notes at 5.5% and increasing the size of our term loan from $1 billion to about $1.3 billion. We also executed a 5-year interest rate swap on a portion of the term loan to offset the variability in LIBOR rates. Our overall blended cost of debt is currently 4.6% compared with 4.9% a year ago and close to 6% just 3 years ago. I am pleased with our performance, and while there may be more difficult quarterly comparisons in the second half, our outlook is bright for the full year and for years to come. With that, operator, please open the line for questions.

[Operator Instructions] Your first question comes from the line of David Farber with Crédit Suisse.

The business, obviously, continues to perform quite well. But I wanted to briefly touch on the restructuring charges you mentioned. And I guess, I wanted to understand a little bit what you think the right expectations are for when some of these charges, and I'm talking just specifically on the income statement, will likely be done, because I would've expected some of them to roll off by now. So I guess, I was just -- wanted to get a little smarter on that. And then I had a follow-up on Spotify.

Great. So the restructuring charges this quarter are related to a program in Recorded Music, where we're looking at some bolder skill sets in businesses that are declining, most notably physical, and streamlining that operation so that we can exploit the long tail at physical as it declines. So that's what this one is. This is majority of this restructuring expense. There will be, in subsequent quarters, smaller amounts related to this, but this is the predominance of this restructuring. We will, going forward, continue to look at areas that we can streamline and get more efficient, sometimes using technology, sometimes just looking at the scale of business. So it is possible there'll be future restructurings. And if there are, we expect commensurate benefits to come from them going forward.

And just in terms of magnitude though, are you expecting -- like thinking about bridging sort of adjusted EBITDA from the covenant EBITDA? Do you expect the required bridge to be smaller as you move forward? Or do you think the magnitude like this quarter will continue? And then I did wanted the ask the Spotify one.

We think the magnitude should be reducing over time, however, there will be periodic restructurings that are reviewed. Remember, this restructuring will have expense, but over time, and over time really means over subsequent quarters and certainly next year, there could be commensurate savings that really offset the charges and bridge the gap.

Okay. And then on Spotify, you mentioned in the prepared remarks, and I see it in the Q, so I'm trying to just get up to speed. But just understanding the fact, it appears you sold $400 million of shares and subsequently, dividended $300 million of the proceeds to shareholders. So is the takeaway that post the quarter, you effectively kept a $100 million within the company and still own 25% of your original shares? Is that the right way to think about it? And then secondarily, given where it was in the company, does this impact restricted payments capacity at all?

So with respect to Spotify, obviously, as Steve said, we're not long-term holders of equities. So we've been able to take advantage of the fact that they've listed and sell a portion -- or the majority of our shares. From a dividend perspective, we worked very hard operationally to drive our business and generate significant cash flow. We've been able to do that over the past few years and continue to do that. Those cash flows supplemented with the Spotify cash flow gave us sufficient capacity for a dividend. And obviously, given that we had roughly $900 million of cash flows -- significant cash flow for an expanded dividend. So we feel pretty comfortable with that, and our cash flow continues to be at a very solid level where we can, not only run our business, but continue to invest in growth, both organic and M&A, as we have and continue to execute our strategy of growth. From our peak capacity, we don't disclose what it is, but it is something that can be calculated. Our commitment, or really our focus, I should say, that we're paying dividends out of cash available without sacrificing our growth strategy, and we continue to focus on that.

Yes. I guess, I was curious if the asset sale of Spotify, if it was part of the borrower and therefore, maybe it was something to be considered with the restricted payments. And then just lastly, so what do you -- if you could answer that. And then separately, what do you own left in Spotify, and how should we think about that?

Well, we've sold the majority, roughly around 3/4, so one can glean based on market prices, which move day-to-day, what's left. And we continue to monitor the markets, and we'll determine our best action going forward with them.

Your next question comes from the line of Aaron Watts with Deutsche Bank.

Eric, one clarifier real quick. Your cash balance, you said it was $900 million prior to paying that $300 million dividend. Did I hear that right?

That's correct. That's correct, Aaron.

Okay. Got it. And then I had a question on kind of the monetization of free subs and the conversion rate you're seeing from where you sit, on those free subs to pay, maybe versus what you were seeing in the past. Are you have happier today with the efforts on some of the various services' part to push those free users to paying? And are you making any more off the free users than you were in the past, whether it's through advertising or other means?

So -- thanks, Aaron. So on the monetization of free subs, look, we continue to be supportive of our partners developing their funnels in the different forms to create trials of their services. Generally, we've seen solid results in upgrading those to premium. Those are, by platform, different. And there are different platforms, experiment with different free or trial-type offers. We continue to monitor the performance of each. But generally, paid streaming subscribers have been coming online at a solid rate. And so we continue to be supportive, so long as their conversion rates are solid, and their conversion focus is our commitment. On -- we do see an uptick in some of the -- so how are some of the nonsubscription platforms monetizing. We do see an uptick in advertising sales, and we do see that those revenue streams are growing solidly. So although we see, generally, free as a pathway to paid subscription, the advertising on the -- on those platforms continues to grow solidly as well, Aaron.

Okay. Got it. And then just one last kind of bigger-picture strategic question for you. Spotify, obviously, is now a public company, wondering -- there's been reports of one of your peers considering a public float. So just thinking about where Warner Music is headed, can you maybe talk a little bit about how you think and maybe your owner thinks about public versus private? You've obviously been able to take cash out, you spoke about the dividends. But as you think ahead and looking at the valuations that are out there, how do you consider the options now?

Well, I think at the moment, the -- our valuation reflects what we believe is fair. The speculation about Universal remains speculation at the moment, Aaron. And with respect to public versus private, to the best of my knowledge, Access prefers private. So I think that, while we're seeing a lot of interesting movement in the world of music, the only one that's really materialized, at least at this point in time, is Spotify. And that valuation that they received was expected and good for them.

[Operator Instructions] Your next question comes from the line of Davis Hebert with Wells Fargo Securities.

First, I just wanted to ask about the Music Modernization Act. Do you have any official position on this or any other regulatory developments on Capitol Hill?

We're highly supportive of the Music Monetization Act (sic) [ Music Modernization Act ]. Obviously, it has more steps to go through Congress before it gets enacted. But there are several key areas that we're supportive of, including developing a licensing system that gives proper credit to mechanicals and tracks it properly. The CLASSICS Act, which in part includes defining the monetization for pre-'72 repertoire, and making sure that recording professionals receive compensation for their work. So this is something that we've been highly supportive of, Davis.

Okay. And then is there anything to think about, now that your balance sheet has delevered nicely, you're sitting on a lot of cash? I mean, is there any game-changing or transformative M&A that's out there, that you would consider, whether on the publishing side or recorded music?

Well, we don't talk to -- we don't speculate about potential deals. But what we would say is, we think you're right, kind of structurally, that we are certainly in a position if a larger deal was both strategic and met our financial return criteria that we could consider it. And that if something comes up, we certainly look at things, but there's nothing really specific to talk about today.

Okay. And then last question, you talked about the opportunity for streaming, converting more people to paid subscribers. On the YouTube side, I mean that seems to be more advertising driven, I think they have a new deal with Vevo. Do you think that is a -- or we hitting the tip of the iceberg on the advertising piece of that?

So YouTube, I think, has multiple prongs. So certainly, they have consolidated their 2 premium tiers, and they do have a premium tier, and that is a part of their equation and our monetization. Obviously, YouTube is quite substantial, and so the advertising there is a meaningful piece. We continue to view that as a growth platform. And again, the -- as we have said before, the advertising portion of the business has been growing nicely. Although again, our focus was to make sure that those subs are managed to paid, and YouTube, Google, does have a paid platform that we think and expect they'll continue to focus on converting to.

Great. I'm actually going to ask one more big picture for Steve. In the increasingly digital world, how do you think the barriers of entry in the record label business have changed, if at all, now that we are more of a streaming-dominant music industry?

Well, I think that there still are -- there are no barriers of entry, really, anymore by way of putting your music up. And that's been true since the iTunes Store first started in business. You could upload your music to the iTunes Store, and you could make it in your garage and -- or your home studio, whatever. So those barriers have fallen. The trick, though, is because you can't spread talent like peanut butter, you need vehicles such as the Warner Music Group or ADA, Sony and Universal for that matter, to take really extraordinary talent and globalize it. My own personal view is you can't democratize talent. And if you look at the statistics, something like 80% or 90% of all of the tracks that were on the iTunes Store or the overwhelming majority of the tracks on Spotify or Apple Music have never been listened to. And it's because, I think, that while there are no barriers of entry, really, anymore by way of getting your music up there, there are barriers by way of separating truly great music from just music that doesn't meet that standard.

We have no further phone questions in the queue at this time. I'll turn the call over to Steve Cooper for closing remarks.

Well, thanks again for joining us today. I hope everybody has a wonderful spring and summer. Have a great Memorial Day, and we'll talk to you in a few months. Bye-bye.

And this concludes today's conference call. You may now disconnect.