Warner Music Group Corp. (WMG) Q2 2012 Earnings Report, Transcript and Summary

Welcome to Warner Music Group's Second Quarter Earnings Call for the period ended March 31, 2012. 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. As a reminder, there will be a question-and-answer session following today's presentation. [Operator Instructions] Now I would like to turn today's call over to your host, Mr. Will Tanous, Executive Vice President of Communications and Marketing. You may begin.

Good morning, everyone. Welcome to Warner Music Group's Fiscal Second Quarter 2012 Conference Call. Both our earnings press release and the Form 10-Q we filed this morning are available on our website. Today, our CEO, Steve Cooper, will update you on our business performance and strategy; our Executive Vice President, CFO, Brian Roberts, will discuss our financial results and then both of them 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 could cause actual results to 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 and Form 10-Q and other SEC filings. We plan to present certain non-GAAP results during this conference call. Revenue data we provide on today's call will be on a constant currency basis. We have provided schedules reconciling these results to our GAAP results in our earnings press release posted on our website. With that, let me turn it over to Steve Cooper.

Thanks, Will. Good morning, everyone. Welcome to our Second Quarter Earnings Conference Call. Thanks for joining us today. I appreciate you taking the time. This quarter, we achieved a number of positive metrics. Our cash balance and free cash flow both showed substantial growth, reflecting our continued focus on cash generation through disciplined A&R investment and operating cost control. We grew OIBDA, improved OIBDA margin also because of operating cost controls, and we've continued to grow digital revenues. We accomplished this even with the second quarter's anticipated light release schedule, which resulted in a decline in total revenue compared to last year's quarter. In the U.S., WMG's track equivalent album units were down 5% year-over-year, and track equivalent album share fell 1 percentage point to 18%. While our release schedule affected our results, we did see some noteworthy industry-wide performance trends, which could bode well for the future. In the U.S., the world's largest music market, track equivalent album units were up 2% for the quarter continuing the growth trends seen in calendar year 2011. Also, catalog album units grew for the fifth consecutive quarter, up 10%, and digital download unit growth remained strong at 11%. In other geographies where there is publicly available data, the industry picture was more mixed. In the U.K. for example, physical album sales continued to decline sharply, down 25% in the quarter. However, digital albums and tracks both showed upward momentum, up 20% and 4%, respectively. In Japan, the physical market held flat in the quarter but faced an easy compare as last year's quarter reflected the impact of the March 2011 earthquake and tsunami. And while iTunes continues to grow in Japan, the rest of the digital business has been weaker due to declines in the mobile ringtone business. There were several exciting developments in the U.S. digital space. According to the RIAA, U.S. digital subscription revenue for the industry grew 13% in 2011, and the number of subscribers grew 19% to 1.8 million. Growth in both digital performance royalties from sound exchange and in subscription service revenue indicates increasing consumer demand for music streaming models. New digital music services should also receive a boost from an agreement reached by the trade associations for record labels and music publishers and digital music providers regarding U.S. statutory mechanical royalty rates. This agreement should streamline the licensing process with respect to mechanical royalties. It creates rates and terms for new digital music service categories including various types of lockers, bundles and limited interactive services. This creates the potential for entrepreneurs to continue developing exciting new business models, a win for the consumers, the music community and new music services alike. And in another effort to further the growth of legitimate digital music, U.S. Internet service providers are expected to roll out their copyright alert systems later this year. This follows the July 2011 Memorandum of Understanding among a group of U.S. Internet service providers and content industry trade associations, which outlined a system for alerting subscribers of their copyright infringements and educating them on the importance of avoiding infringement, as well as on the availability of legal digital alternatives. For WMG, 2012 has already been a period of strong digital innovation. We were among the first partners for Spotify's new desktop apps. These enable labels to develop a wide range of music experiences for consumers. The Warner Sound app features songs, albums and playlists from our artists, and includes genre-specific and artist-curated playlists, among other features. In March, we launched The Warner Sound YouTube channel featuring original programming. Built around exclusive access to artists and celebrities, the site offers a mix of music-based, specialty-produced programs. For example, we launched a program called Staged, featuring comedy and drama based on our top artists lyrics. As always, we are working closely with a variety of new digital services to help broaden consumer access to music. As consumer tastes evolve, it is important for us to continue to enable and support innovation and experimentation in the digital space. Turning back to our results. Even in a light release quarter, both our Recorded Music and Music Publishing businesses delivered some strong metrics indicative of the continued transformation of our businesses. In Recorded Music, we grew digital revenue by 8%, and digital revenue represented 58% of U.S. Recorded Music revenue and 44% of worldwide Recorded Music revenue, both of which are our highest percentages to date. In Music Publishing, synchronization revenue grew 3%, OIBDA grew by 8%, and OIBDA margin expanded 6 percentage points to 42%. In that context, let's look at some of our recent successes. Breaking new artists remains at the core of our strategy. Pop rock band FUN is a '360' recording artist who is also signed to a publishing deal with Warner/Chappell. Their second album, "Some Nights", entered Billboard's top current albums chart at #2. "We Are Young", the first single from the album, was the top-selling track in the U.S. for the March quarter, had the #1 spot on Billboard top 100 for 6 weeks and hit #1 on the local charts in Canada, Australia and Ireland. To date, the track has global sales of over 5 million units. It also became the first track ever to launch 6 weeks of 300,000 units or more in U.S. digital sales. The Black Keys, El Camino, a Q1 release, continued to sell well globally in Q2. The album was certified gold in the U.S. a month after its release, and it's also been certified platinum in Australia and gold in France, Ireland and the U.K. The album currently has 2 singles in the top 10 at U.S. alternative rock radio, Lonely Boy and Gold on the Ceiling. And Gold on the Ceiling has received a number of sync placements including for the NCAA, Discovery Channel's Shark Week, CBS' CSI: Miami and Universal Pictures upcoming feature film Battleship. In Japan, a new English language album from Jin Akanishi, along with strong singles from 2 other local artists helped drive revenue and OIBDA growth. Under our new Warner Music Japan CEO, we are working to regain momentum in this important territory with a number of major releases slated for later in the fiscal year. I want to congratulate members of the Warner Music Group family who were recently inducted into the Rock 'n Roll Hall of Fame. These include Warner Bros. recording artists, Red Hot Chili Peppers and The Faces, Atlantic recording artist, the late Freddie King and Atlantic Records staff engineer and producer, the late Tom Dowd. In the remainder of this fiscal year, we have scheduled some exciting new releases. Warner Bros. records recently announced that Green Day is in the studio, finalizing the recording of 3 new albums, the first of which we are targeting for release in September. The 3 albums, Uno, Dos and Tre are produced by the band's longtime producer and Warner Bros. records chairman, Rob Cavallo. Also, Linkin Park has seen strong presales for their new album, Living Things, which will be released in June. Turning to Music Publishing, which continues to have a great year, Warner/Chappell was jointly named the 2012 Publisher of the Year at the ASCAP Pop Music Awards. Our songwriters collected 19 "Most Played Song of the Year" awards and the coveted Song of the Year award for Bruno Mars', Just the Way You Are. In addition to FUN's previously mentioned success, Warner/Chappell songwriter, Katy Perry, broke the record for most #1 singles, 6, from the female artist's album. And Wayne Hector co-wrote 2 songs that hit the top 5 of the Hot 100, The Wanted's Glad You Came and Nicki Minaj's Starships. Also in the quarter, Warner/Chappell continued to strengthen its catalog by signing extensions or expansions with a number of its top artists including Van Halen, Hayley Williams of Paramore, Michael Bublé and Bruno Mars. With our renewed focus on licensing tracks in which we have both Recorded Music and Music Publishing rights, we are pleased that Warner Bros. recording artist and Warner/Chappell songwriter, Van Morrison has 8 songs featured in Judd Apatow's new film, The Five-Year Engagement. Since we control both the sound recordings and musical compositions on 3 of these tracks, it's a double benefit to us. Finally, in April, we launched Warner/Chappell Production Music, which unites all of our production music businesses, including 615, Carlin, Non-Stop and Groove Addicts. Among the benefits this provides clients is a simple central point of access to our significant collection of compositions and sound recordings. We believe this platform will help us continue to enhance the performance of the investments we made in production music over the past several years. In sum, we remain optimistic with our plans and pleased but never satisfied with our progress. Given the release schedule, we knew this would be a softer quarter from a revenue perspective. Going forward, I'm confident that our strategy of sustained artist development, digital innovation, revenue diversification and careful cost management will continue to benefit us over the long term. With that, let me turn it over to Brian Roberts to detail our financial results.

Thanks, Steve, and good morning, everyone. This quarter demonstrates that even in a period with declines in revenue, we have the ability to grow OIBDA, improve OIBDA margin and generate meaningful free cash flow. Our cash balance improved by $104 million from December to $272 million, and free cash flow improved to $103 million from $46 million in the prior year quarter. Our improved free cash flow was largely related to an increase in OIBDA, the timing of our working capital requirements, the timing of our A&R spend and a decrease in cash paid for severance and acquisitions. As you know, our cash balance is also impacted by the timing of our interest payments. For example in the third quarter, we have a semiannual cash interest payment, which will make it tougher to build cash in the quarter. While our total revenue declined 7%, digital revenue continued to grow solidly, up 7%. We continue to see continued growth in international digital downloads particularly from emerging digital markets in Latin America and certain European territories and we're getting increasingly more revenue from streaming and subscription businesses. While subscription and streaming businesses account for less than 20% of our Recorded Music digital revenue in the quarter, this revenue is growing at a significantly higher rate than revenue from downloads. Partially offsetting this growth, ringtone revenue continued its multi-year downward trend. Additionally, digital revenue for Music Publishing declined, driven partially by a onetime settlement in the prior year quarter. The decline in digital revenue for Music Publishing was also due to the timing of collections, since this revenue, as with most of our Music Publishing revenue, is largely recognized on a cash basis. From a geographic perspective, revenue growth in Japan and other parts of Asia, Italy and Canada were offset by weakness in the U.S. and most of Europe, including the U.K. and France. Total OIBDA grew 4%, and OIBDA margin expanded by 2 percentage points, given our continued execution on our cost savings plan as well as a reduction in severance expense. We have recently executed on a number of initiatives including restructuring our international Recorded Music operations and recognizing -- reorganizing certain of our smaller labels. And we remain on track to achieve our targeted cost savings of between $50 million and $65 million over the ninth [ph] fiscal quarter period, which began July 2011. Additionally, we continued to identify incremental cost savings opportunities. In Recorded Music, this quarter's release schedule magnified the effect of the industry's physical declines. However, this was partially offset by our digital revenue growth of 8%. Digital revenue represented 58% of U.S. Recorded Music revenue in the quarter and 44% of worldwide Recorded Music revenue, both of which are our highest percentages to date. Top Sellers in the quarter included Skrillex, Black Keys, Bruno Mars, Ed Sheeran and FUN. '360' revenue, which includes revenue from concert promotion, touring and merchandising, grew 8% year-over-year and represented 12% of Recorded Music revenue in the quarter. This growth was largely driven by merchandising revenue from expanded rights deals in the U.S. and Japan as well as from our European concert promotion business. The Recorded Music OIBDA decline largely reflected the decline in revenue, partially offset by ongoing cost savings initiatives. In Music Publishing, the increase in synchronization revenue was more than offset by continued decline in mechanical revenue. The timing related decline in digital revenue and the decline in performance revenue, resulting largely from softness in the U.S. This softness related to an overall reduction in distributions made by U.S. performing rights societies with the Music Publishing industry, principally related to reduced radio license fees. Music Publishing gross revenue improved as cost of revenue declined, due to our focus on acquiring higher-margin assets. As a result, OIBDA grew 8% and OIBDA margin expanded 6 percentage points. Finally, I wanted to address 2 items that we have received a number of questions on. First, where our cash is located. While the picture will obviously vary quarter to quarter, as of March 31, more than half of our cash was on deposit in the United States or readily accessible through our intercompany cash pooling arrangements. Substantial portion of our remaining cash is owed to the U.S. by our foreign affiliates through intercompany debt. As a result, we have the ability to repatriate cash to the U.S. through the paydown of intercompany debt. Therefore, while we have significant foreign operations, the majority of our global cash is available to fund U.S. obligations. Second, as a matter of policy, we do not provide financial or release schedule guidance, given that quarterly variations in the timing of our music release schedule and associated marketing and promotional expenses are a normal part of our business. Overall, we are pleased with our cost management and margin expansion this quarter, although there is still a lot of work to be done. With that operator, please open the line for questions.

[Operator Instructions] The first question is from Aaron Watts from Deutsche Bank.

Brian, maybe just a couple of quick ones for you. In the Publishing segment, can you remind me what the amount of that settlement was in the prior year?

It was $1.6 [ph] million.

Got it. Okay. And on the cost side of the equation, I know you said I think 9 months from the time you guys stepped into the picture. So does that mean, in terms of -- thinking about the cost going forward that this was the last quarter where we're going to see as drastic year-over-year declines as we've seen. I think you had 10% decline in cost of operations and something close to that in terms of SG&A.

Yes. As we've said, we started that process of the cost savings back in July of 2011. We continue to rationalize different costs within the business. We just, in the recent quarter, did some label reorganization in the United States and Europe that we announced. And there are continuing changes in the international organization, all of which will have quarterly impact going forward, with the goal at the end to have this $50 million to $65 million. So from an overall percentage drop quarter-to-quarter, we can still see some changes against our prior year quarter G&A. The magnitude of which will unfold as we execute the plans and the timing of them as we roll things out. So you're still going to see some severance charges in our results. We'll identify those as those occur. And then really, in fiscal '13 and in the future you'll start to see the impact on a permanent basis going forward.

Okay. That's helpful. And Steve, maybe for you, with Spotify and other streaming services out there, can you maybe just give us an update on the success you're seeing in converting consumers to actually paying subscribers and perhaps how's that tracking against your initial expectations?

Well, I can't -- I'm not privy to all of this specific numbers, Aaron, but I believe Spotify has been satisfied with the conversion from premium to paid, to date, in the United States. And obviously, it's expanding nicely in Europe. They have looked at ways to increase their -- the size of their front end funnel, for lack of a better term, in order to expose more potential users to the service. And we continue to support them by way of hours of play and free play songs and so forth, to make the experience meaningful enough to the free users to convert to paying customers. So to date, we're very happy with the way Spotify seems to be gaining traction in the United States and with their continued expansion in both Western and Eastern Europe.

Okay. And then last one for me. Just, this has to do with -- I think next year, under the copyright act, some artists are going to begin to have the right to take their works back, the rights to their works back. And I was just curious if you put that in perspective for us or what it could mean for Warner Music and Warner/Chappell.

We're comfortable with our legal position regarding the termination provisions in the copyright act, and we believe that labels will continue to enjoy the full ownership of these recordings where their contracts so provide. We're actually talking this through with our artists and their representatives, and our intent is to work through any issues that are outstanding so that we can resolve these in a fair and amicable fashion. Obviously, as you know, when you sign recording, that is a work made for hire, the termination rate doesn't apply. And where termination rights do apply, only U.S. rights would be affected, x U.S. rights are not being affected. So it's something we're aware of, it's something we're cognizant of, and it's our intent, if and when we do have issues, to work through them in a very proactive, fair way with our artists, Aaron .

The next question is from Adam Spielman from PPM America.

I was just hoping to get your thoughts, how do you guys look at the cash generation goals or potential of the business? And I ask -- understand there's going to be a lot of movement quarter-to-quarter, and you've got some annual interest payments, but how do you guys target, do you look through those restructuring charges? Or how do you think about CapEx over the longer term, should the business generate cash flow?

Well, let me see if I can take each of those points. Obviously, both in the short, intermediate and long-term, Adam, the objective of the business is to generate substantial free cash flow, which we can utilize to either reduce debt, provide returns to our owners or to continue to make investments in the business. The fact of the matter is that as we generate more and more cash flow, obviously given our cost to capital, debt reduction is one of our priorities over time. That being said, we have in both the Recorded Music side of the business and in Music Publishing side, long-term views about what our expenditures should be, whether it's for A&R investment, both proven and unproven artists on both sides of the business, or the acquisition of complementary or supplementary businesses, both to Recorded Music and to Music Publishing. Now obviously, the rate at which we are able to reduce debt and the rate at which we are able to find good investments will indicate how, at the end of the day, we utilize that cash flow. But our goal is as much as possible, within the realm of reason.

All right. And just any comments on plans for the refinancing the 9.5% notes due 2016?

No, we have no comments on that today. Obviously, we keep an eye on our capital structure, which is relatively high cost capital structure. And we continue to keep a very close eye on our cash flows so that we balance the needs to service the capital structure with our needs to manage and invest in the business.

The next question is from Andrew Finkelstein from Barclays Capital.

First on Recorded Music, in the U.S., I thought at the beginning, did you guys say that, was it that units were down for you guys 5%, because I'm just looking at the revenue line in the back, and it looks like the U.S. Recorded Music line was down a lot more. So I was hoping maybe you could maybe bridge the 2 numbers or give us some more color.

Compared to the industry, Andrew, for our second fiscal quarter in the U.S., our total equivalent album unit sales were down 4.83% compared to the industry, which was up a couple points. The unit sales, so keep in mind, don't factor in any pricing considerations.

Okay. And is the 254 last year to 211 this year? I mean, is it just price or should there be something else I'm thinking about? It's just was a bigger drop, I guess, than expected given the units. I didn't think there was that material change in pricing across the industry.

Andrew, the units are based on Soundscan which is a measurement taken as -- at the retail cash registers or self-service scanners, whatever it happens to be. Whereas year-to-year, year-over-year revenue is based on shipments. And there is always a variation as to what's been shipped versus what's been sold. That's helpful.

Okay. So there could be some timing in that, is what it sounds like as well.

Yes, typically there is.

Okay. And obviously, it sounds like you expect the gaps to the industry sales, whatever, to close as your release slate picks up for the second half of your year?

Well, we -- I think at the end of the first quarter, we had mentioned that as we went into the second quarter, we were going to have a relatively light release schedule. And any comparisons of the Warner Music Group to the industry are obviously, it's very sensitive based upon the release schedule. We think we have a pretty good back-end of the year coming. I mentioned Green Day, I mentioned Linkin Park. While we don't publicly announce our release schedule, those have already hit various information mediums, but I'm hopeful that as we progress through the third and fourth quarter, that our showing, both year-over-year and against the industry, will be stronger.

Okay. And then just one more on the expense side, it's been pretty impressive. I mean, I guess do you think the A&R is where it needs to be to, I guess, really to maintain share? Or is there some maybe share that you don't want, if there is unprofitable business, it's obviously been impressive the further cost reductions that we've seen. Yet obviously, revenue continues to drop. So, are the spending cuts, I guess, hurting the top line or is it top line that you're willing to give up at this point?

Well, I think that on -- certainly on Music Publishing, I think the operating philosophy on the Music Publishing side is to give up very, very, very low margin revenue, where the cost of service at revenue doesn't warrant extension of that business. And that's pretty straightforward on the Publishing side. On the Recorded Music side, and incidentally on the Music Publishing side, the A&R budget is really, has 2 components: one, proven artists and the other, unproven. And the constraint is more our infrastructure and what we have by way of required artist support in any 12-month period for their releases for the marketing and promotion, and what that requires with respect to the A&R budget, Andrew, and then what we can devote to new artists. So the constraint is really the organization. What's on their plate at any given time and the rate at which we can essentially make those capital investments. During the budgeting process, we lay that out as effectively as possible or as effectively as we can, given our knowledge of what's happening at that moment. But as I'm sure you can appreciate in this business, things change during the year. And in some instances, we invest more capital against the budget and in other instances, less capital. Again, based upon the infrastructure's ability to handle the investments and what we see on the near, short-term horizon, Andrew, by way of artist support.

And on the Recorded side, do you have any thoughts?

Say that again?

On the Recorded side? That was very helpful on Publishing. On the Recorded side, do you have any thoughts on sort of A&R and the terms [ph] ?

Yes, the Recorded side is almost the same with the exception that typically more of their capital expenditures will go into unproven artists, new artists, than on the Music Publishing side. So the process is exactly the same. And it is in large part constrained by the ability of our organization, the infrastructure to invest that money, given all of their current expenditures and the commitment to support the artists with those current expenditures.

Okay. And then just last one for me along those lines, investing is down a lot, which you guys had said I think it would be down this year, or the 6-month level, is that a good thought for the rest of the year? I know things could change if something comes along but short of something different happening, is the level of CapEx and investing kind of similar to what you'd expect?

Andrew, you're right, it can vary based on where we are in the process with releases. And given the Q2 light release schedule, that's going to drive some of that investment. We have releases in the back end of the year in Q3 and Q4. I don't want to give you the thought that what we have in the first 6 months is really indicative to the back end of the year. You probably actually see some uptick there from a pure CapEx standpoint just in PP&E and things like that. I think we've said before, we laid that number out at around $25 million a year, and that's the number that we'll be at for the year. But on the investment line, you'll probably going to see some change there going out as the releases start to come.

The last question comes from Bishop Cheen from Wells Fargo.

Let me go back to 2 things. On the expense goals of $50 million to $65 million that began in the July quarter 2011, can you remind us again ballpark, where you are on that? In other words, how much, the way you count it, have you achieved so far?

Yes. We're roughly around $40 million through the process of that target of $50 million to $65 million.

All right. And then, on '360' revenue, which I think in this Q2 was about 12% of Recorded Music, all in, U.S. and domestic and international, can you give us a sense on where you think you'd like to take that? How far that can go as a percentage of Recorded Music?

We don't have a, Bishop, we don't have a goal in terms where we think that number is going to hit as it relates our total Recorded Music business. As we've said, there is some sort of variation to that number quarter-to-quarter, largely driven by our European touring and concert promotion business, which are driven by the underlying tours that we're promoting. So you're going to see some volatility in that on a quarter-to-quarter basis, as well as volatility around where certain things, like this quarter we had a good quarter in merchandising and some of the expanded rights deals that we have, simply because there were tours to support that. So you're going to see quarter-to-quarter volatility. We don't have a targeted percentage of that as it relates to our total Recorded Music business.

Okay, fair enough. And then, last one for me, I'll make this quick. Moving to your subscription business and streaming, can we think of this more as a cash business, or the way that you GAAP and recognize the revenue on this. Is this different than your physical business or any other parts of the business?

Yes. That element of our business is principally on a cash basis. So as we receive the royalties and the recordings from those services, we're recognizing the revenue associated with it. There's a piece of it that is based on an accrual, only because we have real visibility around what the collections are and what is going be paid to us based on the relationship we have with that collections society. But the lions' share of it is on a cash basis.

Okay, great. And then the Q, will you be filing that today?

Yes. It was filed this morning. You can pick it up off our website, Bishop, it's right there.

All right, everybody, thanks again for joining us this morning. I appreciate you taking your time, and we look forward to speaking with you again after the third quarter closes. Have a wonderful day, and have a wonderful Memorial Day weekend, and safe and happy summer. Bye.

That concludes today's conference. You may disconnect at this time.