Warner Music Group Corp

NASDAQ:WMG

Earnings Call Transcript 2018-Q1

[Operator]

Welcome to Warner Music Group's First Quarter Earnings Call for the period ended December 31, 2017. As a 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.

[James Steven, executive]

Good morning, everyone. Welcome to Warner Music Group's Fiscal First Quarter ended December 31, 2017, Conference Call. We filed our earnings press release and the Form 10-Q with the SEC this morning.

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, I'll turn it over to Steve Cooper.

[Stephen Cooper, executive]

Good morning, everyone. Thanks for joining us. We're still celebrating our spectacular showing at the Grammys. Atlantic, Billboard's label of the year, won more awards than any other record company. The icing on the cake was Bruno Mars winning all 7 that he was nominated for, including a sweep at the top categories, Album of the Year, Record of the Year and Song of the Year. We also had many other well-deserved wins across diverse genres for our recording artists including: Ed Sheeran, who took home 2 in Pop, including Best Pop Vocal Album; The War on Drugs’ for Best Rock Album; Dear Evan Hansen for Best Musical Theater Album; Kraftwerk for Best Dance/Electronic Album, Portugal; The Man for Best Pop Duo/Group Performance; Mastodon for Best Metal Performance; and Randy Newman for Best Instrumental Arrangement. Warner/Chappell songwriters also won in nearly all of the big publishing-related categories, including Song of the Year, R&B Song, Rap Song and Country Song. Kendrick Lamar swept the rap field, including rap/sung performance for his collaboration with fellow Warner/Chappell writer Rihanna. Our songwriters won in every country category with Chris Stapleton collecting 3, including Best Country Album. Just to get it said, this wasn't from our point of view, luck. When you pair the world's best operators with the world's greatest artists and songwriters, these are the results.

2018 is obviously off to a great start. Specifically, in the first quarter, we grew total revenue by 10% and digital revenue by 17%, with streaming up 27% and downloads down 17%. OIBDA was about flat, though this was largely due to onetime items, which Eric will discuss. For 3 years running, we've grown first quarter revenue by double digits. Our performance fueled a healthy jump in our cash balance, hitting a record $776 million at the end of the quarter. This gives us more than ample capacity to reinvest in our businesses and provide returns to our shareholders.

The industry outlook continues to be positive. Early data from trade sources for calendar '17 measuring the consumption of recorded music suggests that the rebound continues. Specifically, in the U.S., consumption rose 12.5%, with streaming up 43%; the U.K. grew 9.5%, with streaming up 51.5%. We also expect to see meaningful growth in other markets as more data is released over the next few weeks. As this trend continues, we're seeing the competition among digital music services intensify. In order to maintain our edge, our streaming partners are investing to expand their product offerings in geographical reach, which is good news for the wider music ecosystem. In the last few weeks, Apple Music passed through the 30 million subscriber mark and purchased the music discovery app Shazam. Spotify announced it had over 70 million subscribers and launched its Spotlight feature to add visuals to some of its audio experiences. Amazon Prime Music is now available in over 30 countries with Australia and New Zealand added at the beginning of the year. Deezer is now active in over 185 markets, making it the streaming platform with the widest global footprint. And we're hopeful that other subscription services will create new opportunities for our company, our artists and our songwriters.

As we said many times, our sustained success is based on having consistent flow of great new music. And we've once again seen a strong diverse mix of both established and developing artist contribute to our results. By a way of example, Liam Gallagher. Liam Gallagher's solo first album, As You Were, went straight to #1 in the U.K., impressively exceeding the combined sales of the next 15 albums on that week's chart. Emerging pop sensation Dua Lipa is also a standout. Her single, New Rules, went multiplatinum, reaching the top 10 on Spotify's global chart, helping to make her the most streamed female artist in the U.K. during 2017. Hip-hop has become the top genre for music in the U.S., and we have the hottest roster of urban talent in the world. Many of the most exciting new stars are signed to Atlantic, including Cardi B, Lil Uzi, A Boogie wit da Hoodie, DRAM and Gucci Mane to name just a few.

In the streaming world, we're seeing that the life of a hit album can be elongated. At the same time, a new version of a single can provide uplift to an artist's entire catalog. By way of example, Ed Sheeran released his new album ÷ in March of '17, which contains a solo version of the song Perfect. His duet of Perfect with Beyonce released in December has accelerated the momentum of ÷ and helped propel Ed's previous album x back into the top sellers list. Bruno Mars' 24K Magic, which launched over a year ago is again topping charts reinvigorated by a newly released nonalbum version of the song Finesse, which features another Atlantic star, Cardi B.

The hits keep coming in publishing too. Portugal. The Man is breaking chart records with Feel It Still. We're also having great success with Brody Brown, who wrote on Bruno Mars' album, rapper Logic, Scott Harris and Rag'N'Bone Man. We continue to invest in our existing talent and in bringing in new accent to the fold. In Nashville, we were honored to welcome superstar Kenny Chesney to the family, and we were delighted to re-sign Blake Shelton, whose album Texoma Shore marked his sixth #1 on the country album chart. Atlantic signed the pioneer of the Grime, Stormzy and partnered with his label, Merky. And at Warner/Chappell, we've signed recently songwriters, including rising star Moss Kena, multiplatinum selling songwriter Christman Hunt and Grammy-nominated producer Fred Ball, who is catalog includes collaborations with Rihanna, Zara Larsson and Little Mix.

Expanding our global presence remains a priority. Our international revenue grew 10% in the quarter, with standouts like Japan up 43%, Latin America up 28%, China up 21% and the U.K. up 15%. We continue to evaluate high-potential areas to build out our global footprint. We just launched Warner Music Middle East, and we'll open its Beirut headquarters in April. We've also recently entered into some new relationships with digital music companies in emerging territories: one with Anghami, the largest streaming service in the Middle East and North Africa; and another with Mdundo, a music service focused on the African market.

Following on from our Grammy success, we've got the bridge to look forward to later this month. Our artists and songwriters collectively have a total of 28 nominations or nearly 50% of the total. On the Recorded Music side, we have more homegrown talent up for awards than any other label, including Ed Sheeran and Dua Lipa, the male and female stars with the most nominations. We wish all of our nominees the best of luck at the show on the 21st.

We started off strong, and I'm looking forward to 2018 being another fantastic year for our company, our artists, our songwriters and their fans. We remain laser-focused on positioning ourselves for continued growth in the streaming age. With this in mind, we've taken strategic steps, such as divesting some of our touring businesses, reshaping our IT infrastructure and reducing the size of our organization related to the declining Physical business. We're committed to the continuous process of transforming our company and our global team is hard at work, ensuring we're leading the industry's evolution.

Before Eric covers our financial performance, I want to honor the memory of Johnny Hallyday. Known as the French Elvis, Johnny had an amazing career spanning 6 decades with the last 12 years spent as part of our family. A rock 'n' roll icon, Johnny leaves behind an incredible musical legacy. He will be deeply missed by millions.

And now over to Eric.

[Eric Joshua Levin, executive]

Thank you, Steve, and good morning, everyone. We're pleased to share our first quarter performance as it is further evidence of our ability to sustain strong results. In fact, this marks the first time in over 10 years that we had quarterly revenue in excess of $1 billion. Revenue, again, rose double digits, up 10% in constant currency and 14% on an as reported basis. Furthermore, there are 2 factors which affected the numbers, such that our underlying momentum is even stronger than it appears. First, in last year's Q1, we booked $18 million of revenue related to the Pandora pre-'72 settlement, which impacted growth by 2%. Second, you'll recall that late last year, we completed the PLG-related asset sales, which, along with some noncore concert promotion assets, had about a 2% impact on our revenue growth for the quarter. The effects will be felt for the balance of the year.

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 $13 million of onetime expenses, up from $4 million in the prior-year quarter. These expenses relate to costs from our corporate headquarters moving L.A., relocation of our shared service center to Nashville, costs associated with management changes and restructuring costs as we optimize the business. Q1 adjusted OIBDA rose 4.3% to $168 million. The improvement was driven by revenue growth. Adjusted OIBDA margin declined 1.5 percentage points to 16.1%, due primarily to higher variable compensation expense, investment in A&R and the impact of the pre--- of the Pandora pre-'72 settlement in the prior-year quarter. Variable compensation expense was $23 million, up from $10 million in the prior-year quarter. As a reminder, this is largely a deferred cash expense attributable to our long-term incentive plan, the value of which is tied to the increase in the value of our company.

In Recorded Music, first quarter revenue was up 10%, with digital revenue up 17%, driven by a 27% increase in streaming. Streaming growth was still strong, but comparisons were impacted by the Pandora settlement in the prior-year quarter. Excluding this, our streaming revenue would have been up 34%. Physical revenue declined 6% as new releases from Liam Gallagher, Kelly Clarkson and Sia helped to moderate against the ongoing industry decline. Licensing revenue rose 15%, aided by higher broadcast fee income and increased sync activity. Artist services and expanded-rights revenue rose 11%, benefiting from higher merchandise revenue and ticket sales from U.S. artists and successful tours in France and Japan, offset by a decline in Italy related to strength of the prior-year quarter. Recorded Music adjusted OIBDA grew 8.9% to $183 million driven by revenue growth. OIBDA margin declined 0.9 percentage points to 20.2% related to higher variable comp expense, investment in A&R and the impact of the Pandora settlement in the prior-year quarter.

During the quarter, Music Publishing revenue rose 12% with growth in every segment, digital rose 18%, performance rose 13%, with continued strength in the U.S. and a benefit from timing of distributions. Sync rose 4% and mechanical was up 13%, which was related to timing of payments. Music Publishing OIBDA rose 6% or $1 million to $17 million. OIBDA margin declined 1 percentage point to 11.9%, driven by higher A&R and the impact of revenue mix. Our operating cash flow in Q1 was $136 million versus $156 million in the prior-year quarter. This change was largely due to improved operating performance, offset by timing of working capital.

CapEx was $16 million, up from $8 million in the prior-year quarter. The increase was driven by higher investment in IT. For full year 2018, we continue to expect CapEx of about $90 million, which includes about $40 million in onetime spend related to the build-out of our L.A. office. 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. As a result, in mid-January, we declared and paid a $125 million dividend to our shareholders. While this is higher than our recent dividends, so is our cash balance. Subsequent to quarter-end, we also paid out annual bonuses to our employees. As a result, we are focused on -- I'm sorry, as always, we are focused on optimizing our capital structure, such as with our term loan amendment late last year and new revolving credit facility, which we closed at the end of January. We'll continue to evaluate options as appropriate.

Before concluding, I want to make a quick note on the impact of tax reform in the U.S. During the quarter, we took a $27 million noncash charge in the P&L related to revaluation of net U.S. deferred tax assets or the impact of the U.S. tax change from 35% to 21%. Given that we are a fiscal year filer, other tax reform changes are not effective until our fiscal 2019 which begins on October 1, 2018. We are in the process of evaluating the future impacts of U.S. tax reform, such as the new minimum tax, which could require us to pay cash taxes. We will update you accordingly. Our momentum is strong, and we're proud of the results being delivered by our teams around the world.

With that, operator, please open the lines for questions.

[Operator]

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

[David Farber, analyst]

Congrats on crossing the billion-dollar mark. That's a good number to have. I have couple questions. I guess, I wanted to quickly touch on the CRB, because we're getting a number of questions on it. And I guess, I want to understand, there seems to be, I guess, a meaningful increase in streaming royalties. So given the Publishing business and the Recorded business and the mix there, can you maybe just talk a little bit about how that will impact Warner? How we're supposed to think about that in terms of P&L? And then I had a couple follow ups.

[Eric Joshua Levin, executive]

Thanks, David. So the CRB does have an increase, you are correct. It phases in over 5 years. So the impact in the short term, we expect to be modest. It's come out relatively recently just in the past few days. We're still analyzing the specific impact. But I would expect it to phase in over time and initially be modest.

[David Farber, analyst]

Is the expectation that -- I guess, I'm trying to understand from the -- like I assume maybe there's some upside from the Publishing side weighed against the Recorded Music. Do you think net-net...

[Eric Joshua Levin, executive]

No.

[David Farber, analyst]

Is this incremental expense? Is it potentially incremental benefit?

[Eric Joshua Levin, executive]

It's certainly incremental to the Publishing side, that's what the ruling dictates. How it plays out overall in negotiations, we'll play out over time, and I wouldn't want to speculate specifically.

[David Farber, analyst]

Okay. So I guess, the takeaway is that you expect this to be relatively small in totality for the time being?

[Eric Joshua Levin, executive]

In the short term, yes.

[David Farber, analyst]

Okay. You talked about this -- your global footprint and mentioned, I think, perhaps the Middle East and markets in Africa. I guess, I'm just trying to get a better sense for if you could touch upon how you're doing that? Are these outright acquisitions? Are they JVs? I'd just like to get a better sense of how you're structuring these deals or how you're thinking about them and the economics involved, that'd be helpful? And then I just had one follow up.

[Stephen Cooper, executive]

Well, it's a -- it's anywhere from our own stand-alone investments, David. So by way of example, Warner Music Middle East is one of our own internal operations. It's similar to our other -- it will be similar to our other Warner Music operations in other parts of the world. The streaming services, those are just counterparty deals that we've initiated for the Middle East and North Africa and the balance of the African continent. So I should note, we have a wholly owned operation also, Warner Music South Africa. So based upon the nature of the markets and where we want to plant our flag, so to speak, we go anywhere from a direct investment and building the market with our investment organic, so to speak, and organic with streamers in those areas.

[David Farber, analyst]

So they're more -- so there's no necessarily more acquisitions you're making. You're just sort of trying to plant your flag in other areas where perhaps streaming is less of an option today with the hopes it'll become more viable down the road, is that the right way to think about it?

[Stephen Cooper, executive]

Well, we expect it to be viable as we step onto the road. But we are also still in the acquisition business. We look at acquiring businesses that we think fit nicely with the Warner Music Group as long as we can do it on a sound-economic basis. I think we've indicated before that we don't find acquiring market share at a loss to be a good long-term strategy.

[David Farber, analyst]

Okay. And Eric, you mentioned some of the cash flow pieces. I just want to make sure I had it right. So there were -- subsequent to the quarter, there was $125 million dividend plus cash bonuses to the employees, is that right? I just want to make sure I have that correct.

[Eric Joshua Levin, executive]

That is correct.

[Operator]

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

[Aaron Watts, analyst]

Couple questions for me. I wanted to start with a question on EBITDA margins. And Eric, understanding there's some noise these past couple quarters from the Pandora payment and some of the asset sales you mentioned. But as we think about the different buckets within both Recorded and Publishing, digital, physical, artist services, licensing, for instance. How should we think about the margins of each of those buckets? And I know from quarter-to-quarter, you talk about mix. What -- which are those kind of tends to bring in higher margins and which tend to be a little bit lower margin?,

[Eric Joshua Levin, executive]

So on Recorded Music, and generally speaking, digital will have somewhat of a higher margin than physical related to really not having the manufacturing, production, distribution requirements that allow that to perform at a higher margin. So as digital continues to grow and physical continues to decline, you'd expect moderate margin accretion over time. What you're seeing against that when we report in this quarter somewhat lower margins are onetime events like Pandora, which was in the prior-year quarter creating a significant benefit, and you're also seeing some of our spend against restructuring and continued improvement of our business, which again, is generally onetime in nature, whether it's the move to Nashville or consolidating our L.A. offices. And once you clear out those adjustments, our margins are actually quite healthy and continue to grow. On the Publishing side, we generally expect margins to be somewhat to be stable. We are continuing to invest in growth and sometimes on the incremental deal on growth, the incremental deal may have a lower margin. And so you may see, as part of the growth trajectory, incremental margin decretion, but the underlying business remains quite stable.

[Aaron Watts, analyst]

Okay. That's helpful. And then just kind of secondly, as you think about the cash balance even after paying the dividend and your cash bonuses and priorities for that cash, understanding you have, maybe, a potential to optimize your capital structure again in the near term with your unsecured notes, any thought to using some of that cash to pay down debt, mixed in with kind of refinancing with additional debt or how are you thinking about the priorities there now?

[Eric Joshua Levin, executive]

So -- thanks, Aaron. So with cash, we generally think about our priorities kind of are waterfall in kind of this way. So first is about investing in our business, continuing our momentum and growth, whether it's organic investment or an M&A investment. As Steve was talking about before, we see a terrific growing market, and we continue to reinvest in driving the future of the business. So long as it meets the return on investment profile, and we're very financially disciplined in our investment, but that's priority 1. Priority 2, as you talked about, Aaron, is continuing to optimize our capital structure. We've made a series of steps updating our term loan and revolver, and we'll continue to look for ways to optimize our capital structure, reducing our net cost of interest and making sure that's sufficient as it can be. Third, and from cash available, we'll continue to evaluate dividends after meeting the first 2 goals and from cash available. So that's kind of our set of priorities, Aaron.

[Aaron Watts, analyst]

Okay. And Last one for me, maybe back to Stephen. As you think about your flow of new music, any particular releases we can look forward to in calendar 2018 that you want to highlight today?

[Stephen Cooper, executive]

Well, I think you can look forward to a steady flow of great releases. But as always, Aaron, we don't get into specifics, primarily because while we're very confident of what they will be and when they come, there is always the probability that they can shift. So while not talking to that, we will continue to have a steady stream of great stuff for the remainder of our fiscal year, I mean, really great stuff.

[Operator]

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

[Stephen Cooper, executive]

Well, thanks so much, everyone, for joining us, again, and enjoy this bright sunny groundhog day. Talk to you soon

[Operator]

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