Chit Chat Stocks - Warner Music (WMG) | Not So Deep Dive

Episode Date: August 30, 2022

Warner Music Group operates as a music entertainment company in the United States and internationally. The company focuses on two segments: Recorded Music and Music Publishing. Listen closely as Brett and Ryan go through the history, financials, and future prospects of Warner Music. Enjoy the show! Is this episode locked? Access our “Not So Deep Dive” episodes by signing up for CCM+. Sign-up directly through Spotify or Apple Podcasts. If you listen on another podcast player, use this link and create a private RSS feed: https://anchor.fm/chitchatmoney/subscribe Need more information? Check-out our launch newsletter: https://chitchatmoney.substack.com/p/welcome-to-chit-chat-money-plus  Want updates on future shows and projects? Follow us on Twitter: https://twitter.com/chitchatmoney Contact us: [e-mail] Timestamps Company Background | (3:23) Industry | (11:45) Management & Ownership | (16:02) Earnings | (22:16) Balance Sheet | (27:03) Valuation | (29:20) Our Analysis | (31:58) Disclosure: Chit Chat Money hosts and guests are not financial advisors, and nothing they say on this show is formal advice or a recommendation. Brett Schafer and Ryan Henderson are general partners and portfolio managers at Arch Capital. Arch Capital and its partners may hold securities discussed on this show. Learn more about your ad choices. Visit megaphone.fm/adchoices

Welcome to Chit Chat Money. On this show, host Ryan Henderson and Brett Schaefer interview industry experts and riff on the world of investing. As a quick reminder, Chit Chat Money is a CCM Media Group podcast. Ryan and Brett are also general partners at Arch Capital, and Arch Capital may have positions in the securities discussed in this podcast. Anything discussed on Chit Chat Money by Ryan or Brett or any other podcast guests is not formal advice or recommendation. Now, please enjoy this episode. Welcome in. This is the Tuesday Not So Deep Dive episode on Chit Chat Money. This is the episode solely available each week for Chit Chat Money Plus or CCM Plus subscribers. And today we're

going to be talking Warner Music Group to finish up our audio theme. I should warn you, uh we're doing themes now on a month-to-month basis we're going to be putting out actually a schedule so stay tuned for that actually might be out before you're listening to this but either way right around now we're going to be planning our schedule more to hopefully for anyone that's subscribing to understand what you're going to get and we're also going to thematically move them with our arch capital episodes ryan let's tease the themes okay so the uh for let me make sure i get it right um for the month of september we're going to be doing gaming so we're each going to pick a it depends how it works out but we're each going to pick a few companies and then

we're going to end with and we've kind of tried to structure these a little bit around the arch capital episodes which we're going to do at the start of every month so actually the end now but yeah they're at the end of every month now so the that first month september is going to be gaming We're going to end it with Electronic Arts, which we currently own. And then October will be Housing. We'll end it with Consorcio Aura, which we own in the fund. And then November will be Engineering Software. There's a couple of companies we were able to choose from there.

That will end with Autodesk. And then the last one, December for 2022, we're going to end with Website slash Ecommerce Software. So those are your themes. And the company we'll be talking about in December will be Wix. Well, I guess they'll probably be January, but that's kind of to lay it out. We'll have a nice little graphic that we're working on, throw it up on the Twitter so you can kind of follow along with all the companies so you know what you're going to be getting for the remainder of the year. That's enough of that, right?

Or is there anything else? As always, if you subscribe to through Apple podcast, please email us the right email to sign you up for the premium newsletter that goes along with CCM Plus. that does not have anything super different than the actual show except really has our show notes charts and all the research we use in written format instead of audio format so it's a great supplement to the audio show they're listening to right now if you don't want it that's fine however it is a part of the ccm plus subscription and we think it's really a great combination to have the written stuff along with the audio some of you that have subscribed on apple podcast just looking at the number of emails we have from apple podcast versus the number of total

subscribers through Apple Podcasts. We don't have all of you yet. That's fine. But again, email us and the email is chitchatmoneypodcasts at gmail.com. That will be in the show notes as well. All right. Let's not delay any further. We're talking Warner Music Group, one of the largest labels in the world. However, that is a bit of a black box. So Ryan, why don't you introduce the company and explain what they actually do? Yeah. Warner Music Group is, you kind of described it there, one of the largest music entertainment companies in the world. They are uh according to some sites the second largest in revenue behind sony music entertainment oh but well universal is the largest though right so this website was wrong that website yeah

universal if we're gonna once we get an industry and market share universal is the largest um but that's that kind of shows how much of a black box some of this stuff is where no one no one really knows they're all mysteries but uh warner there's there's plenty of information So it is the basics of the business or that they own a bunch of different record labels. So WMG, which maybe just to abbreviate it, we're going to go with WMG for the episode, is that they're home to more than 100,000 artists and composers and more than a million compositions. So I guess maybe we'll go with Warner. Warner houses a bunch of iconic artists such as Ed Sheeran, Bruno Mars, Dua Lipa. uh basically pick your favorite artist there's a good chance that they're with warner music

um i don't need to go on and on i know they they touted lizzo a lot in their financial filings that's like the new i think that's their newest hit artist so yeah yeah either way uh they've had plenty of famous artists uh go through there and they have rights to a lot of those compositions but they generate revenue in pretty much two ways so there's recorded music revenue and then there's music publishing revenue. And this is, um, it's, it's a little complicated, but I'll try to describe it the best I can. So recorded music comprises more than 80% of Warner's overall revenue. And it refers to the actual sound recording component of a song. So this is, they also call this the master. Um, and the way it works is the way revenue collection works is

that distribution or streaming platforms like Spotify or radio stations sign contracts with warner for the use of their musical compositions then depending on particulars from the contractor depending on um listen numbers they ultimately get this royalty pool or uh royalties uh up front it really depends on the contract but for the bulk let's go with the streaming platforms as an example there will be a royalty pool based on the plays uh of certain songs that they own rights to So about 80% of that revenue gets paid to the owner of the recorded music and the remainder gets paid to the publisher for the use of the composition. So I'm going to talk about the publishing revenue here in a second. But the way I would just think about it is the recorded music revenue refers to the actual sound recording.

The music publishing revenue refers to the IP or the actual composition. So the lyrics and the actual publishing. um am i am i kind of blanking on anything there would you describe it any differently that sounds fine to me okay and then warner generates revenue from various channels but the channels are pretty similar between recorded and publishing and so 62 percent of their revenue comes from streaming and 46 percent or i should say about three quarters of that streaming revenue subscription the remaining quarter is about roughly a quarter is ad supported so those two comprise the streaming aspect 19 still come from physical revenue that includes cd sales vinyl

cassettes and records vinyl has had 14 years of growth if i saw it correctly 14 straight years yeah it's a nice little niche that has been growing recently so that other physical that's the only one that's really keeping it alive cds are you know pretty much dead now cassettes dead but yeah over time this will probably continue to trickle down although you know with antique stuff and collectibles stuff like that people kind of like the vinyl and have you ever used vinyl no not really my my sort of hobby i'm not really i don't care too much for music so well i mean i listen to it but you know i'm not a giant fan of very many people so yeah all right well but anyway it is a hobby for people yeah 19 comes from physical sales and then 11 is performance

rights so broadcasters and public venues stuff like that and then six percent is downloads and other digital i believe this is probably referring to itunes and anything that's basically digital but non-streaming and then two percent is other this includes gaming films advertisements anytime they use the the song recording in something that that let's say a movie uses it in their background they're gonna end up paying for that and so then the the other segment is that music publishing revenue, which I referred to earlier, that is more focused on the IP. It's the actual monetization of, or it's the monetization of the actual musical composition, not the sound recording. And then in exchange for helping in the actual publishing process. So think like

promotional activity, marketing, actually helping to create the song, the label shares or Warner Music in this case, shares the publishing revenue with the artists. So they are, if we're thinking what value do the labels provide today? If you're an artist, you can get help from some of the best genre-specific producers by being connected with the label. You can get help with branding, help with marketing, help with helping with PR, helping to get on the right distribution channels. Basically, you are growing your audience because the label is helping you do that. They really understand the business side. If you are a singer or an artist, because I know we actually have a few musically talented people that listen to the show and we're getting anything

wrong. Please feel free to correct us. But I believe that's pretty much the gist of it. It's kind of a just the promotional and the distribution side have changed over the years, but labels still provide value in that, even though the distribution channels are a little different. And then as far as history goes, well, there's a ton of different record labels within warner music group and the oldest one dates back to 1811 um which is probably the earliest company we've ever studied the earliest origins good bet good bet kind of hard to beat that but that's chapelle and co and then um but like i said there's tons of different record labels so they all have their own origins but the actual formation of warner music group didn't really

come about until 1958 so about a couple years prior to 1958 one of the warner brothers or Warner Bros, which was a film studio, one of their actors produced a hit song, but Warner had no record label at the time. So the actor had to go to a subsidiary of Paramount Pictures, who was a competitor with Warner Bros, basically to get help publishing his music. And Warner didn't want to lose this business. This is kind of their lesson learned. They didn't want to lose business on talent that they'd already gone out and acquired. So they opened up Warner Bros records in 1958. Five years later, they acquired Frank Sinatra's struggling record label Reprise Records. I'm not going to go through every single transaction because there's been a ton of them, but Warner's been – not only have they acquired a ton of labels, but they have been bought by other companies and sold on several occasions.

In the last 20 years, for reference, Warner Music Group was sold by its parent company, Time Warner, in 2004 to a group of private equity firms. It was then brought public a year later. Then in 2011, it was once again acquired this time by Access Industries for $3.3 billion. Fast forward 10 years and WMG or Warner Music Group has gone public again. However, Access still owns a large chunk, which Brett's going to talk about here. So it's changed hands a lot today. It's a publicly traded company. Access still owns and still controls the business predominantly um but yeah it's it's one of the biggest uh record labels they have a very expansive catalog of music that they own the rights to um you want to talk industry and landscape yep let's get into it global recorded music industry and this is

excluding music publishing so there's two different categories i know it's confusing but ryan i think introduced it so the global recorded music industry is estimated to be about 25.9 billion dollars in 2021 and has really been growing at about a 15 to 20 rate with the rise of streaming music subscriptions and a lot of um not backlash but defeating piracy in a lot of markets i know they've defeated piracy which is just you know illegally downloading music for free on the internet they've defeated that in a lot of western markets mainly north america and europe but that is expanding globally. And that's along with streaming, along with the streaming music subscriptions and then advertising support of streaming as well as kind of give them a

consistent tailwind the past, say, five to 10 years. WMG, I'll probably call them WMG, they've been steadily rising this wave. And if we look at the global music publishing industry, that's estimated to be around $6 billion. It's a bit smaller, but still sizable and should grow really along with streaming as they get a percentage of that revenue as well um competitors pretty easy to see this you know landscape it's not too difficult you have universal music which has about an estimated 32 percent market share and this is according to uh warner music groups uh 20 well they have a weird fiscal year their fiscal year that ended in september 2021 their annual report so we're in a bit of unfortunate timing here where they're about to report

in two or three months now, their next annual report. So some of this stuff might be slightly dated, but the industry isn't too dynamic. So things won't change that much. But Universal Music has an estimated 32% market share. Sony has 21% market share. And then Warner Music Group has an estimated 16% market share. So they're the smallest of the big three music labels, but still one of the big three with a big chunk of the overall market. And then if we look at artists that are not at a major label basically just taking 100 minus the sum of those three numbers that is 32 market share so a decent amount of people are not at one of the big three but still 68 of the total um artists in the world or the total revenue for music recording i'm getting

that right yeah for the music recording part the largest part are at the big three labels now if we look at another competitor because they're competing with you know universal sony they competed with them for other forever but a rising competitor is investment funds buying music catalogs for example um i saw that blackstone is getting into the business with a partnership with this company or investment fund called hip genosis it's h-i-p-g-n-o-s-i-s strange name but they're about they're estimated to deploy around one billion dollars in investments into music catalogs we love there was actually a recent story this week while we're recording this about the pink floyd catalog going for an estimated say like 500 million dollars something like that so

that's a rising threat because a part of warner music's strategy is to invest in new you know artists new catalogs new music and if the cost of these catalogs is going up um that's just something to watch out for and i'm sure we're going to discuss that more later and to to kind of butt in here on the i don't know if i did a great job breaking out the recorded music and publishing segment the reason those two are often separated is that it isn't always the same party so um the publisher there might be someone else that gets credit for the lyrics and the writing of the composition whereas the artist might be the singer so this is kind of a way to credit both sometimes it's uh it's the same party doing both um but that's why they break it out into those two

yeah yeah there's been all the legal stuff around publishing um rates going higher for streaming i don't think we need to get to those details but that has benefited i guess the labels a bit where they get a higher rate from the streaming companies but yeah there's a difference between a lot of the major artists i think as listeners will know don't write all of their music sometimes there's you know right i read it said it's a team effort or something like that uh but let's move to management ownership interesting one here i think the most important thing any investor needs to know from what I read through the proxy statement and just kind of reading about the company is that WMG is majority controlled by Access Industry Holdings. So Access Industries was started by

Len Blavatnik. He is a Ukrainian, I believe, kind of from the ex-Soviet Union, came to the US, I believe in the 80s, he got citizenship, but it is a private US-based investment group that has been running for decades. And Blavatnik was born in the Ukraine. He's estimated to be worth about $33.2 billion. So one of the richest people in the world. And he still sits on the WMG board and is essentially the one that controls this company.

Now, if we look at the executive team, Stephen Cooper, age 75, is the current CEO. He might be Stephen. Stephen or Stephan? Stephen? I'm guessing that's Stephen. PH would be Stephen. People spell Stephen that way.

How do you know? I guess there's no way to know unless you listen to an autopilot. How do you spell Stephan then? I know. I've seen people spell Stephan. It's either Stephan or Stephen. S-T-E-F-A-N. S-E-T-F-A-N.

Yeah, that's true. That's true. All right. Stephan Cooper. I'll just call him Cooper. He's the current CEO. He's been the CEO since 2011. So he's been there since Axis Industries took over.

He has a ton of different experience across finance and managerial roles. He was actually a temporary CEO of Enron after the bankruptcy. So he came in to right the ship, although it was probably a ship that was doomed to fail anyways. One interesting thing that investors should watch out for is that he announced he will be resigning by the end of 2023, and they're looking for a new successor by then. And that leads to the next most important person at the company. That is Max Posada, who is age 48.

He is the CEO of Recorder Music and has been in charge of that segment since 2017. before this role he was the ceo of warner music uk for four years so what would that be 2013 he's been in charge of some form of recorded music statement and it's apparently had quote record-breaking success that was in the proxy statement so i believe this means they have you know they have a lot of top uk artists like ed sheeran at wmg um that have done quite well for the company he is rumored although not confirmed to be the leading candidate to get cooper's role But nothing has been announced. There's just some interesting succession stuff here that we might want to plan to.

All right. And then we'll move into compensation. Nothing too big here. I mean, total director for the board of directors compensation was only 0.08% of gross profits. So really fine there. No concerning stuff on paying their board too much money. And then executive compensation was about 1.23% of fiscal year 2021 gross profit. Again, not too big concern.

And there wasn't any huge notable things about their compensation plan. No big red flags or really positives from my regard. I mean, they do a standard annual salary, annual bonuses and long term equity incentives to compensate employees. We've talked about the upsides and downsides of these standard strategies quite long before, or sorry, a lot of times before, but they really seem to have the standard stuff here. I mean, the annual bonuses and long-term equity incentives, they said they're generally discretionary. So there's no, say, target, I guess, they have to hit or no things set in advance where the bonus is calculated if they hit some hurdle rate on revenue or their profitability metrics. They do have a strange what they call free cash flow plan, where you can get compensated based on a percentage of free cash flow generation, but it looks like one person was possibly using it. Again, not the preferred method. They were just giving out discretionary RSUs generally for their equity compensation.

If we look at their shareholder list, it's pretty basic. You have Axis Industries that own 73.3%. We'll put out a good chart here for the newsletter in conjunction with this. There's two classes of stock here, and they own all the B stock, and they've been converting some to A, I think, to sell off some of their stake. And they own 73.3% of total shares outstanding. So it'll be interesting to see if Access Industries, you know, they took this company public. They really made a strong investment buying this for only $3.3 billion. And as we can see, it's been quite a good investment for them.

I don't know what their plan is because they have converted some Class B to Class A. Maybe they're going to sell some stuff off. But again, they own the majority. And if we're looking at voting power, because it's Class B and it has 10 times voting power, they own 98% of the voting rights. So even if they continue to sell some stuff, they can still majority own this business. If you look at other ones, they got some standard hedge funds and Vanguard owning here. Cooper owns actually, and that's the CEO again, for reference, owns about 2.3% of the company. So pretty good skin in the game.

However, a little bit of a low light seeing that he was still getting compensated in RSUs, especially because he already announced his retirement and owns a huge stake. so kind of a downside there that he would still take that but not a huge red flag and then lasada actually owns 0.71 of the company so decent skin in the game he's been around the company for a long time and maybe he'll be the one to take over seems like he's kind of a lifer there and i did like that he's only 48 years old um so maybe he's still got a couple decades left yeah everything looks pretty good in terms of management and compensation yeah no no big red flags i didn't think any huge positives but really really boilerplate stuff i mean there might be that risk

of the i don't think bovatnik i mean he's been the u.s citizen for a long time but he might get associated with that you know ex-soviet union oligarch stuff there could be stuff complications with ukraine that we're unaware of but i don't know you know they're self-sustaining business so who knows what will happen with that but it's just interesting that you know this ukrainian oligarch kind of owns the majority of this company yeah it's hard to say how that would trickle down to the the actual business yes people are still going to be listening to whatever happens with with him all right i'll talk earnings and i kind of want to i know we throw a lot of numbers at listeners during this segment so just to kind of understand the goal

when we talk earnings i'm trying to give listeners context of the size of the business and then also a snapshot of what's going on at the current moment. For the last 12 months, they've generated just under $6 billion in revenue. That's growing at about 15% from the 12 months before. They have 48% gross margins. It tends to be pretty steady there. Most of their cost of revenue comes from royalty payments to artists. If you ever looked at Spotify, the majority of their cost of revenue goes to labels. The majority of the labels cost of revenue goes to the artists. It's this trickle down effect back to the artists um and then different uh stakeholders take a little piece of the pie along the way and then apparently no one is happy with their situation which i always

think is quite funny yeah no and then uh about 432 million dollars in free cash flow over the last 12 months from what i've seen it looks like they're tend to stay right around or just under 10 free cash flow margins um and that's so that that's last 12 months figures most recent quarter there was about $1.4 billion in total revenue. That was up 7% year-over-year. It was up 12% in constant currency, but they obviously do business globally and report in dollars. So a bit of a lapse there.

Constant currency, foreign exchange was a big headwind for them. And then the recorded music business was up 3% and the publishing revenues were up 30%. Yeah, the publishing was interesting. I think they had that revised rate that a lot of the – Yeah, there was that ruling. We don't need to go into the details of that, but just the rate they're getting from the streaming services

is higher now on the publishing stuff. Okay, and then the cash flow, $128 million of free cash flow, about 9% free cash flow margin. They've had pretty lumpy cash generation. I think it's always been a little bit under their operating income that figure that they report. They use OIBDA, operating income before depreciation and amortization, as sort of a proxy for profitability.

Yeah, the management did say at a conference that they're like, yeah, we should expect consistent needed to convert about 50% to 60% of that to free cash flow. And I was like, well, maybe it's not the best profitability metric then if you're only converting 50% to 60% of it to actual cash. But sorry, continue.

And then so about 16% oil margin. But like I said, focus on that free cash flow figure. And then in terms of just like providing some context for the quarter digital revenue actually as a percentage of overall revenue declined for the first time in a while and part of that well it was almost entirely driven by higher artist services and expanded rights revenue so concerts started to come back in a big way artist services revenue was up 56 percent that kind of offset or had an outsized impact on it grew as a percentage of overall revenue but it's coming off a low comp because concerts were kind of destroyed over the

last two years. And then artist services is a lower margin business. So it had a bit of an impact on that OIBDA margin for, or just consolidated margins for Warner Music Group. Then the other thing that's worth noting here, revenue is a little bit slow. Revenue growth was a little bit slow because they are also impacted by the advertising slowdown that we've kind of seen over the last quarter. So with an ad slowdown, the ad supported revenue from a lot of their streaming partners um creates a smaller royalty pool which means revenue collection for them is going to be slightly lower um and then they also pushed a few big album releases to q4 so some sometimes it's it's almost like game video game companies

where uh it can have to do with the timing of the release occasionally um yeah apparently uh they're new well we're in q4 and they said something about cardi b's album doing well that was the big pushover so i mean either way it's kind of a timing thing yeah i mean that's also kind of an interesting note is that you have the ability to kind of track if you know who their artists are you can kind of track what their revenue share could potentially be by by following how popular some of those songs are yeah and when i don't think i've made this chart yet but when we put out the newsletter i'm going to make sure to go back because they have to state it in their annual reports the market share of them universal and sony as as a percentage of total recorded

music i believe it's been pretty stable over time um i don't know i think that's just a good number to look at because if it's been super stable you can kind of maybe make a prediction that it can be stable in the future as well right and then balance sheet and liquidity um kind of an interesting note here access industries since taking over they've really improved proved warner's debt structure over the last decade. Now, part of that is the streaming industry has brought on a bit of stability. So it's a little easier to get better terms on your debt. But not only have they improved the credit rating for Warner Music Group and extended the maturities, but Warner Music Group's weighted average interest rate declined from 10.5% in 2011 to just over 3% today.

Beautiful debt strategy. Yeah, yeah. It's been pretty impressive. And then in terms of the actual debt today, There's about $3.8 billion in long-term debt. It's comprised of both senior notes and one senior term loan. And the earliest maturity is 2028, and the weighted average interest rate is 3.4%. Really long-term debt, stable cash flows, and low rates. Pretty impressive all around. That was the downside of where they're pouring that cash into, but the debt side looked very strong.

Yeah. And then in terms of the, I guess, assets and cash flows, cash and equivalents was $345 million. So they use that cash pretty, they don't store up a whole bunch of cash on the balance sheet. They run the balance sheet pretty lean. And then over the last 12 months, they've generated just over a billion dollars in adjusted EBITDA. So their leverage ratio stands at just over three times. This is a pretty predictable business, especially now. I think we can, during the piracy run, it was probably a little harder to predict. But with just how dominant streaming is as a percentage of their revenue, it's fairly predictable. So that allows them to kind of lever a bit and add some debt to the balance sheet, which they've done over the last 10 years. Yeah. And I should mention before we forget, they do pay out a dividend as part of their capital allocation strategy and is yielding approximately 2% as of this writing. So looking at, you know, when we talk valuation, they're not a big buyback company, but they do return capital to shareholders in the form of dividends. Not really good history on whether they're going to increase that over time. We'll see what their strategy continues to be because they just went public kind of under, you know, now they're in the public markets, but we'll see. all right let's move to valuation pretty quick here as again you'll be able to check the dynamic valuation we don't do complicated valuation work so this isn't a huge part of every show

i know we're kind of just looking at basics on the trailing 12 month and actually when i'm doing these numbers on some fiscal year 2021 i would you know maybe would like to do go into like the trailing 12 month where the business is so predictable that i think there's honestly other metrics that you would want to follow for tracking kind of the success of this company and looking at their enterprise value to blank. It's not the best metric, but we're going to do it anyways. It'll be quick. So their market cap, just to give you a size reference, is about $14.8 billion. Add on to that debt, and it's $18.3 billion for their enterprise value. And if you look at the two metrics, I think are interesting to follow is just enterprise value to OEBIDA, and that is

enterprise value divided by their trailing OEBIDA. And that is 20 right now. So very close to the market average. I don't know if that's high or low, but if we look at their conversion to free cash flow it isn't that high we'll talk about that later the downsides of sort of their business model where they're not getting the cash up front compared to the streaming services and possibly the artists but their enterprise value to free cash flow is much higher at 38 but a bit lumpy if we look at on the charts here and i don't even know if this is the best way to look at it let's look at their conversion to free cash flow it was we look at fiscal year 2018 to 2021 the conversion of free cash flow from Owebida was 69%, 10%, 888%,

which is just weird because Owebida was almost close to zero, and then 53%. So they got it to about 50% to 60% conversion. So that's kind of what I'll be modeling when I do both the bull and the bear case because there's not much you would think that would change to affect that. If it's due to the streaming companies holding on to...

those accounts payable, essentially. It's their receipts. Yeah, it's Warner Music's receivables. That OI, OI BIDA, or whatever you want to call it, is actually probably a better proxy

than I would have thought. Yes, it's decent. That's why I like to look at both from what I was looking at. How is this business actually making money? I think looking at both OI BIDA and free cash, but looking at both of those is probably the best two metrics.

So, I mean, And depreciation and amortization, you know, there's going to be some capex here, which is basically acquiring new music catalogs, reinvesting in new artists, stuff like that. But the depreciation and amortization can be fairly high. And yeah, it is nice. All right. Let's move to Angle Evidence. Not a consumer-facing company, so a tough one here.

Not true. What? What do you got here? I've listened to their songs. Sure. Yeah. Okay. I don't know.

Ed Sheeran's not, you know, everyone loves Ed Sheeran. Sure. It's consumer-facing. No. The results of how many people listen to their songs directly impacts their financials.

Sure, the artists are consumer-facing. The artists are. Yeah. It's their music. Yeah. In some cases. Water music is not

interacting with consumers. Right. All right. Yeah, no. It's not really the anecdotal evidence people would want either, but

the way I kind of understand their role in the music landscape it feels labels generally feel irreplaceable not only do they provide value on the actual business side and i'm sure that's extremely valuable to artists there's sort of this reputational thing where like it's validating if you sign with a label you know or signing with a big agent something like that yeah so like if you're an artist it's Like I just signed with the big label.

It kind of creates this incentive to sign with them instead of going individual, which is probably a harder, it might give you a bigger take-home rate, but one, the pie might be smaller. You might not reach as far as you could with the help of the labels, but also you kind of get some social clout when you sign with them. So I see, I imagine a lot of young up and coming artists will sign solely for that reason. Yeah.

And the new artists is, yeah, it seems like the labels have a lock on that. The complications of getting yourself distributed to all the different digital platforms, getting any sort of music recouped from, they talk about, you know, social platforms and even places like Peloton or exercise places where if you're on your own, that's quite difficult to do. The labels can help you with that. They have the infrastructure to do that. and and the creative teams to build or help make better songs exactly and it seems like again

anecdotally they've managed to keep their market share fairly well they actually bragged about gaining market share although it was only a couple not too many basis points was like 50 basis points or something like that so i wouldn't really toot my horn too much but again they've retained their market share which is great the only thing i worry anecdotally is and this is different than new artist is the cat is out of the bag with the value of music catalogs yeah um that feels like a commoditized market now i just you see blackstone you see all these different funds going in there there's only a limited amount of places i mean yeah these you know catalogs can be quite valuable people listen to old music and if it's on streaming it's sort of

an annuity but especially if especially on the older catalogs like i guess you kind of just said that but the streams on older catalogs have to be pretty stable i'd imagine oh yeah i mean growing growing because we grow up the stream yeah they're quite i mean they're they're it's pretty yeah unless you're neil young and you take your well he uh yeah i guess you can't take uh the the owner of the content that makes the decision but yeah all right let's move to future growth opportunities ryan looks like you have the standard one here but it is kind of a boring you know it is what it is it's gonna be the most important one yeah i mean growth isn't really up to warner music i mean they can obviously acquire new talent but growth they're just sort

of a byproduct of the overall industry growing i think and basically just getting their content onto all the possible channels and seeing how the industry evolves is is basically their growth strategy and so i'm picking streaming as uh as sort of my growth avenue um there's not really a whole lot they have to do here, but it's obviously been a boost to the business over the last decade. And there's ways I think that, so I've kind of contemplated this idea of, all right, distribution's easier than it's ever been. Getting popular or having a viral song is kind of easier than it's ever been with the onset of like TikTok and stuff like that. And you can get into different playlists and you can kind of get popular on social media, that kind of thing.

but it's also probably more competitive than it's ever been. And so being able to leverage expertise in the industry when it's hyper competitive, getting yourself on streaming playlists or whatever, you know, you can't, it's a lot harder to do that on your own. Warner music has that relationship with Spotify,

Apple, YouTube, you know, and they'll take advantage. Yeah. And even, all right. I saw that songs are getting shorter because they're trying to get more

uh virality via these short form video clips and there's incentive because you get paid on a per stream basis on streaming so there's kind of incentive you don't need that eight minute song anymore you would rather have three you know three minute songs right and so not only giving some expertise in sort of the creative process to the artist to kind of say like this is what's popular right now this is how we can benefit the most financially but then also saying we know we have the relationships with the radios or we have we know how to get you onto the right playlist we know how to do uh promotional activity on spotify with those marquee promotions and basically knowing the proper promotional strategy i think being being the most digitally inclined and and

kind of knowing that world and knowing the streaming world and knowing how to take advantage of it is going to be a big asset for them in uh helping talent and growing growing the lessons of their catalog yeah and attracting new artists because that is that is very important if the catalog is kind of competitive for new you know i mean they'll have like there's a difference between they have their existing catalog which is not anything we've really talked about because that's just you know occurring i mean it's a hundred percent mode it's a lock it's monopoly on that catalog for however many years the ip is but i think it's almost 100 years they have a lot on that and the old catalogs that are kind of up for sale are highly competitive the way to grow

is to acquire new and upcoming artists and that could be the easiest way if they have that sort of marketing push people would be convinced to sign with them now i'll move to mine and it's within digital but it's different it's called the what they call emerging segment they haven't outlined this in every quarterly report so you kind of have to go through what they say recently but they did say something in june of this year which is nice to see so this is revenue and that doesn't come from streaming services and this includes some place like peloton tiktok and meta actually just signed a new deal with meta that apparently will boost this segment so the numbers i say here will apparently get even better and that i mean is facebook so instagram

whatever instagram reels probably is yeah stuff like that you know facebook live whatever whatever facebook watch i can't remember what they call that stuff but at a june investor conference an executive mentioned that this segment is at a run rate revenue of only $100 million when they went public two years ago, but is it now at $345 million? I think if this rapid trajectory continues and music royalties around the world start to get paid out across all these consumer internet platforms, not just dedicated music services, it could turn into a meaningful driver for the digital segment. If we look at their fiscal 2021 revenue, it was $5.3 billion. So if this gets to a billion dollars i mean it can be pretty pretty sizable for them um it's not small right now and

there's only there's only upside because basically a lot of these places are technically pirating the music and water music can kind of go in and say look what's you're kind of a non-compliant customer of us let's sign a deal with you it might not be as lucrative as a streaming deal but you got to give us some money and yeah you know the large platforms will be willing to all right highlights of always ryan what'd you like about this business it's pretty simple uh they can pretty much skate wherever the puck goes they don't even need to skate no yeah they can grow without doing a whole lot uh well in some regards in some regards they had to do a lot to help with their artists but yeah but let's say you just took management out

of the equation and you just bought the whole content library the whole catalog that would grow yeah listen listens would grow yeah without yeah like you have to you know you had to work with artists that are coming out with new stuff but the old stuff i mean it's just it's an annuity yeah um also i mean really it's kind of industry highlights here music is becoming increasingly accessible to people around the world um and just like so many songs at their fingertips uh more and more people are adopting smartphones it just seems to get easier and easier um there's also that reputational advantage that i talked about of signing with a label i don't see a world where the labels are not a crucial part of the the music ecosystem in

five ten years um especially just given the fact that they own all uh all of the all of their catalogs and and very valuable music um low lights for me though i don't see what sort of a competitive advantage they have in acquiring or identifying new artists compared to other labels it feels to me and this is probably where maybe my naivete comes into play because i don't i'm not an artist but what value do they provide over universal i think it would be similar honestly i tend to think i would like like if i was an artist i feel like i would want to go to universal to be honest because they're the largest like you got if you're a hip-hop artist you see drake or whoever at universal you're like okay if i want to be like him i go there it's sort of yeah but i feel like there's

diminishing effects after a while i mean there's ed sheeran yeah i don't think it's a huge deal i think honestly the big worry there is you like they over the long term warmer music's unit economics will the artists be able to keep better deals as a lot of the stuff we've seen kanye west kind of go crazy with uh from time to time about the artist stuff and it sounds like he's kind of talking i don't know you know like kanye west but the uh they're the deals could skew favorably towards the artists as or if

the labels become more of a commodity because they can play everyone back and forth sort of like I honestly think it's sort of similar to a sports station where they don't get that much of the revenue because they provide a good amount of value

but it's almost a commodity service that they're kind of just taking care of. Yeah. I mean it kind of my other low light i guess i'll say is maybe there's with distribution being easier with being able to advertise directly with spotify there's the two-sided marketplace um i know a lot of people go through the labels to do that i wonder if there's a world where the value that the labels provide just kind of starts to shrink over time

it's not quite as valuable as it used to be um so i just i don't know if like the increasingly digital nature is helpful or hurtful for them in the future and so i guess that's kind of a risk for me but they've they've weathered it so far and it's helped their business yeah yeah exactly and it's interesting to think whether they have been okay so streaming has been growing since say like as a meaningful part of it doesn't say like 2012 2013 or something like that from then until now have they been basically getting free advertising and now a lot of the companies like say spotify has especially talked about this but all the other streaming services are probably going to want to you know not really promote people anymore where i think spotify

highlights that their consumers or users discover like 16 billion artists i believe that that's the number 16 billion new artists every month and a lot of that they've basically done for free because they want to improve their service but that is a ton of value getting provided to the labels and the artists that they're essentially doing for free and actually they're paying the majority of the revenue they earn off of that to the labels i just worry that the union economics and maybe our spotify bull bull uh bias is coming in here but i worry that there could be more pay it probably comes down the line yeah there's not that many low lights across the board like the the big low light for me is that like it's really predictable which makes me think that

it's pretty easy to value which means maybe the returns aren't going to be that great for investors that's a good point that's a good point it's probably the biggest low light yeah no differentiated viewpoint although too durable that everyone knows it yeah i don't know that's tough but you kind of wrap your brain in a pretzel when you think like that but it could be true here what about you yeah i mean industry durability is a huge positive for me i mean i've had money that humans are going to be listening to music regularly in 2030 2040 probably 100 years from now um other highlights the intellectual property advantage gives them really strong moat you know with the existing catalog yeah you know there's been a lot of talk

about artists trying to retain their masters and that could still be a big threat but i kind of look at say taylor swift who had a huge problem with that we don't need to go into that whole story i think it's kind of complicated i don't know the exact details but she re-signed with universal and she maybe is the biggest artist in the world i don't know exactly but either way like top five or something like that globally if she's signing with universal or she's signing with a label um it feels like they got to provide value to people that are small in that as well they can provide value to an artist of all size um either way the intellectual property stuff is just huge advantage because it's you're not a no one can compete uh and then second the streaming

market still looks like it's it's very early innings small penetration rates around the globe digital revenue has compounded at 16 since 2018 through the end of fiscal year 2021 2021, I don't think it's like overestimating to say that same exact growth rate or somewhere between 15% to 20% will continue for the next three to five years, which is great. I mean, they can just ride that wave. Now, lowlights that you haven't talked about, Ryan, poor cash conversion on earnings. So they have streaming services that have that accounts receivable stuff that we talked about. Cash advances to artists. So they're paying cash to artists upfront to sign with them right but they're recouping that in streaming mainly streaming now almost as an

annuity over a long period of time but they're not you know they're not getting that back cash back immediately yeah you know there could be positive uh basically thinking of it like a loan like lifetime value of that but still it's bad organ capital dynamics or however you want to describe that and second there is going to need to be a reinvestment into new music catalogs and artists meaning a lot of the earnings the oe vida don't actually show up consistently as cash in the balance sheet because they have to consistently reinvest uh however that means i think it's just it gives them a tougher path with the business model for consistently returning cash to shareholders nothing they can really do about that it's just a lie for the business in general

um second one acquisitions seem unwarranted and strange they've acquired quite a few different companies they acquired a company called uproxx it's a website about music i think maybe they do other stuff i would rather see the company focus on what it does best and then return cash to shareholders every time i looked at their cash flow statement it was acquisitions of you know business combinations or whatever that line is was consistently there and yeah i'm looking at uprox right now what the hell's the point of this i know it's i mean why why did they need to own it yeah it's in the music industry um it's all the culture of now i know it's so they can own so they can own the media around their own brands i guess i would love them to just that just

concerns me a bit because media companies have a history of buying assets i don't know there's just poor you know capital destruction from acquisitions that we talked about and then lastly let's see we talked about you know promotional stuff it could be a low light and then uncertainty around deals so i think that's i think that's it let's move the bull case brian what do you think go right here they continue to grow their catalog and the overall industry growth continues all right that sounds simple but that's all you really need i mean isn't that kind of exactly what's going to happen it feels like yeah you need conversion to cashflow though yeah as long as they don't do stupid things with their capital yeah i mean uprox

they're still generating a fair amount of cash yeah the conversion does concern me i mean we talked about a lot but yeah i mean top line growth feels very very predictable um i'll hit mine i mean you know they have their infrastructure advantage they have their reputation advantage and they already have ip advantage i think they'll be able to retain market share and their margin structure so i think that's the two things they retain market share and their margin structure basically with the continued the same relationship with the streaming services and the same relationship with the artists uh financially the good thing about um i think you mentioned that the two-sided marketplace is by definition margin destructive for the labels but if they choose

to take that compression on margins they're expanding the potential nominal profits by creating a bigger audience so if margins decrease you could see an inflection in growth uh like like nominally so it feels kind of like a even though what i'm trying to say is like you could lose one and grow the other and you'll still be all right and you can also see a world where streaming services start raising prices which warner music executives obviously they're talking their book discuss a lot when i was reading their conference calls and investor conferences they talk about how the streaming services have they're like we tell them they have a ton of room to raise prices but they won't yet and i think a lot of that is because they're big tech and they're

trying to subsidize a lot of stuff but still if the streaming companies could say in a scenario raise prices but have um basically deal with the labels where they pay out their revenue shares just slightly lower for the labels as they raise prices just because for whatever reason And that's part of the leverage they have on that deal. That would mean Warner Music Group's margins might go down, especially if they had to pay more for promotional stuff, but it could still be gross profit, creative. I mean, if we look at all that stuff,

basically at current prices, current valuation, if margins, if the industry continues to grow and margins are fairly consistent, you probably get good returns here. But let's move to the bull case. What do you think you're on? The bear case. I should also say

I think the bull case I think it's sort of a narrow range of outcomes I don't think the bull case is that great I think you can get good returns but I don't think there's going to be valuation coming into valuation as a part of it top line growth isn't going to be

insane I could definitely see a path to like double digit free cash flow growth on a percentage basis for the next 5 to 10 years just literally riding the tail

or riding the wave of streaming and those returns will be fine but I don't know do you see this being like you could like a multi-bagger? Yeah it depends what your terminal multiple is

on an OEBDA or free cash flow Bear case for me it's just that the values the value that the labels provide decreases over time and while they might be able to still kind of i mean they'll still own their content so the bear case is limited but if the value they provide over time shrinks i have to imagine that eventually that's going to show up in their margins yeah now at least in mine too it's just my bear case was margin

deterioration i think ryan just described why that would happen they have worse deals with streaming services worse deals with artists and then the commodification of the catalog business and then combine that with poor cash conversion you you know it's hard to see where you get returns if that happens um i really think it does count to come down to consistent margins because industry growth feels pretty easy to it's gonna happen right yeah but it just depends on who is keeping I think it's just a big question who is keeping

like their share of the pie the artist the consumer facing companies and the labels those three how does that shift alright more or less interested Ryan more

maybe not as an investment I don't think I think you're paying for a lot here and you're maybe getting mediocre returns

at today's price like it's a premium valuation any way you look at it and I was kind of thinking through this in my mind

it's 20 times earnings a premium multiple it's a bad little company yeah I don't know I mean

there's just something about it that's like too easy yeah it feels well I think a 20 times

multiple with that cash conversion is premium for sure. Yeah. Let's say it's like 30 times, but let's meet it, meet the multiple halfway 30 times, say Stan multiple year free cashflow kind of look, you know, right. Yeah. It doesn't entice me too much, but it's, it's like, I think audio is in my wheelhouse. I, I, I love that we've done these episodes cause we did serious last week and it's starting to give a better grasp on the overall landscape it's worth tracking just to see like if in five years

nothing's changed maybe i'm wrong like maybe it's just just go along the content owners yeah if they retain that market share and they retain those margins i think yeah i'm more interested i would like to see what happens with the new ceo because i think that's important because cooper's been there for over a decade and i just think that's really important uh to leave the charge there they have been the management concerns me a bit just with their acquisitions they are hyping up a bunch of web free stuff uh which concerns me but besides that i mean very good business say one last time the big concern is the cash conversion and the relationships with some of their constituents but that means it's an interesting business for sure if you're riding

a tailwind and you're you have the ip advantage there's got to be something in track there's it's attractive just depends on what price it's like a lot of gaming companies over the last decade yeah exactly it could be could be a similar analogy there like call of duty and it takes less capital intensity to build the games but to build the games or to build the games than to build a song sure yeah but you know the brands that were dominant seem to have stayed pretty dominant yeah maybe i'm wrong on some but like you know if you're older you listen to rock music you're listen to rock music for the next 30 years yeah that's a streaming annuity all right and even a little more staying power because you know you're willing to play old songs as opposed to like

playing old games that's exactly the people still listen to uh what you call it classical that beethoven catalog you know i wonder how that's done for that uh all right stock for next week this will tease out the new schedule we're putting out so i'm sure we might link it in the show notes, although maybe not. But either way, if you follow us on social, on the newsletter, or whatever, go check out the schedule. But, Ryan?

We are kicking off the video game month of September with Ubisoft. Ubisoft. Yep. That's a good one. I think we have all game... Oh, no. We're doing Xbox as a special one. But besides that, I think it'll be all publishers or developers, which I guess is really the entire industry.

Alright, that's going to do it for this episode. Remember, we are not financial advisors. Anything we say on the show is not formal advice or recommendation. We are general partners at Arch Capital and clients may hold securities discussed in this podcast. Thank you all for listening and subscribing as CCM Plus members. We'll see you next time.