Warner Music Group Corp. (WMG) Q2 2017 Earnings Report, Transcript and Summary

Welcome to Warner Music Group's Second Quarter Earnings Call for the period ended March 31, 2017. At the request of Warner Music Group, today's call is being recorded for replay purposes, and if you object, you may disconnect at any time. [Operator Instructions] Now I would like to turn today's call over to your host, Mr. James Steven, Executive Vice President, Communications and Marketing. You may begin.

Good morning, everyone. Welcome to Warner Music Group's fiscal second quarter ended March 31, 2017, 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 and CFO, Eric Levin, will discuss our financial condition and results. And then we will take your questions. Before Steve's comments, let me remind you that this communication includes forward-looking statements that reflect the current views of Warner Music Group about future events and financial performance. All forward-looking statements are made as of today, and we disclaim any duty to update such statements. Our expectations, beliefs and projections are expressed in good faith, and we believe there is a reasonable basis for them. However, there can be no assurance that management's expectations, beliefs and projections will result or be achieved. Investors should not rely on forward-looking statements because they are subject to a variety of risks, uncertainties and other factors that can cause actual results that differ materially from our expectations. Information concerning factors that could cause actual results to differ materially from those in the forward-looking statements is contained in our earnings press release, our Form 10-Q and Form 10-K and other SEC filings. We plan to present certain non-GAAP results during this conference call. We have provided schedules reconciling these results to our GAAP results in our earnings press release posted on our website. Also, please note that all revenue figures and comparisons discussed today will be presented in constant currency unless otherwise noted. With that, let me turn it over to Steve.

Good morning, everyone. Thanks for joining us today. I'm very, very pleased to say that we're sustaining our momentum around the world in both Recorded Music and Music Publishing. In our first and second quarters, as well as in the comparable prior year quarters, we've reported double-digit growth. Specifically, in the second quarter, we grew total revenue by 13%, digital revenue by 23% and OIBDA by 11%. It's been a full year since streaming become largest source of Recorded Music revenue, and the gap has become even more pronounced. Streaming revenue is twice that of physical and 3x the size of downloads. In publishing, where performance is currently the largest source of revenue, digital is about to take over. Already, streaming revenue and publishing has tripled the size of downloads and it continues to grow. Clearly, the industry's streaming growth is contributing to our results. FP data for calendar '16 showed an increase of 6% for the global Recorded Music business. While physical revenue was down 8% and downloads fell 21%, those declines were more than offset by a 60% jump in streaming, accelerating from 45% last year. Those industry trends are continuing in calendar '17. During the first 3 months of the year, on a consumption basis, the U.S. rose about 6% driven by a 35% increase in streaming. The U.K. rose 11% with streams up over 55%. Even so, it's important for us to remember that we've only had 2 full years of industry growth after 15 years of contraction. We can't afford to take growth for granted, and we must instead take the necessary steps to control our future. We need to be careful in managing the ongoing transition to streaming around the world. In calendar '16, according to IFPI, the Recorded Music industry's top 15 markets saw wide variations in a percentage of revenue coming from streaming. For example, China was at 81%, while Japan was at 7%. And even though digital finally exceeded 50% of global industry revenue for the first time, 2 of the top 5 markets, Germany and Japan, are still predominantly physical. Furthermore, it would be unwise to believe that the transition to streaming represents any sort of final evolution for the music business. So while we're working to improve monetization and accelerate the adoption of streaming, we're also exploring many different revenue drivers and future revenue sources. Some of the areas we're currently excited about include high-res audio, live streaming, voice activated services, and both augmented and virtual reality. While some of these technologies -- with some of these technologies, the business models are nascent, but it's very encouraging to have so many possibilities ahead of us. We never forget, though, that all of this innovation and change will come to nothing unless we're releasing great music. That's why I'm pleased that during the second quarter, our Recorded Music revenue rose 13% globally and publishing was up 16%. Alongside strong carryover sales from artists such as Coldplay, twenty one pilots and Gucci Mane, our highlights this quarter included fantastic music from 2 of the world's biggest superstars. Ed Sheeran's third album, ÷, went straight to #1 in 30 markets, obliterating streaming records and becoming the U.K.'s fastest selling album of all time by a male solo artist. Ed's single, Shape of You, went #1 in over 25 countries, hitting the top of the U.S. and U.K. charts for 14 weeks and the top of the Australian charts for 16 weeks. Bruno Mars' third album, 24K Magic, hit the top 10 album charts in 26 countries, and his latest single, That's What I Like, recently claimed the top spot on 4 Billboards U.S. singles charts, including the Hot 100. Meanwhile, our artists and songwriters continue to be awarded prestigious honors. Our Grammy winners this year included twenty one pilots and Sturgill Simpson, who both took home their first wins. Among the Warner/Chappell songwriters, recognized was Beyoncé, who added 2 awards to her record breaking Grammy tally. At the ASCAP Latin Music Awards, our songwriters picked up top honors, including Song of the Year for Silverio Lozada, and long overdue it's fantastic news that Warner/Chappell songwriter, Jay-Z, will be the first rapper inducted into the Songwriter's Hall of Fame. We continue to invest in local A&R, and look for smart ways to expand our global operations. This quarter, we launched 2 new labels in the U.K., Black Diamond, which will focus on new talent, and Artists to Watch Records, which will identify singles that have potential as global streaming hits. We expanded our presence in South Korea, where we are partnering with hip-hop label, Brand New Music. We launched Run Out Groove, an imprint, which will find new audiences for out-of-print vinyl gems from our music catalog. And in publishing, we recently opened a new office in Berlin to get us better access to the rapidly growing German songwriter community. All of this momentum is evidence of our focus on 3 strategic priorities: a consistent flow of great new music, international expansion and commercial innovation. Our strategy continues to pay off as we continue to outperform the industry. We expect music and copyright data for 2016 to show again that we have the largest worldwide Recorded Music share gain of any major, and that Warner/Chappell took share in publishing globally. IFPI 2016 figures show that last year we had more albums in the global top 10 and top 50 lists than any other music company. I'd also like to note that Atlantic and the Warner Bros. affiliated, OVO Sound, were the only labels featured in this year's fast company list of most innovative companies in music. This is fantastic recognition of our industry-leading approach to bridging art and technology, developing amazing artists and fighting inventive ways to reach fans While I'm pleased with our progress, we're only getting started. There's always more to do and things we can improve. We recently announced that in October, Max Lousada will be promoted to CEO of Recorded Music. Max' vision and drive have transformed our U.K. company over the last 3 years, consistently growing our market share and helping our artists achieve global, record-breaking success. He will be tasked with finding new ways to turbocharge our worldwide labor operations. With Max as CEO of Recorded Music, and Jon Platt as CEO of Warner/Chappell, we will have 2 great music executives driving our creative operations. While Recorded Music and Music Publishing are 2 distinct businesses, Max' appointment will further improve collaboration and communication between our divisions. The continued cross-pollination of best practices will benefit our artists and songwriters as well as their fans, our people and our partners. The Warner Music Group team is stronger than ever, and I know we can accomplish even more together. With fantastic music, tenacious focus and an incredibly talented team, we're determined to sustain our success. With that, I'll now turn the call over to Eric.

Thank you, Steve, and good morning. Our trends are inspiring across key metrics, and I remain confident in our formula for sustainable growth. In the quarter, total revenue of 13% came on top of 13% in the prior year quarter. Currency had a 2-point impact, so as reported revenue grew 11%. As we've indicated in recent calls, PLG-related asset sales are moderately impacting our revenue growth as the results are being affected by the sale of certain noncore assets, such as some of our European concert promotion businesses. The aggregate impact of these in Q2 was 2% of revenue. We continue to expect asset sales to have a modest impact on growth for the full 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 $5 million of nonrecurring expenses versus the prior year quarter when we had $2 million. The adjustments in the quarter relate to costs from the move of our shared service center, shared service center to Nashville, which ultimately will deliver net savings and to PLG-related assets sales. Adjusted OIBDA, which excludes nonrecurring expenses, rose 13% to $146 million. Adjusted OIBDA margin rose 0.4 percentage points to 17.7% due to revenue growth and revenue mix. Note that this year, higher variable compensation expense partially offset our margin growth due to an increase in deferred compensation expense. As our operating performance and cash generation improves, our variable comp could also continue to increase. Recorded Music revenue was up 13%. Digital revenue increased 24% driven by 47% growth in streaming, which more than compensated for a 17% decline in downloads. Our physical revenue this quarter was down 4%, reflecting industry trends, somewhat offset by strong physical-centric releases such as Ed Sheeran's ÷. Licensing revenue rose 3%. Artist service and expanded rights revenue rose 5%, driven largely by higher merchandising revenue in the U.S. Recorded Music adjusted OIBDA was up 22% to $116 million, and Recorded Music adjusted OIBDA margin was up 1.6 percentage points to 16.9%. Margin benefited from revenue growth. Music Publishing revenue rose 16%. Digital grew 30%, benefiting from streaming. Performance revenue rose 14%, which was due to U.S. market share increases and timing of distributions. Mechanical revenue was flat, and sync rose 10%. Music Publishing OIBDA rose 7% to $58 million driven by revenue growth. Margin declined by 2.5 percentage points to 40%, driven by revenue mix. We had operating cash flow of $70 million, down from $111 million in the prior year quarter. This was the result of an increase in receivables due to higher operating performance. Importantly, working capital was a source of cash for the first half of the year. CapEx came in at $10 million, a bit below the prior year quarter, but spend is likely to increase for the fixed fiscal year as we start ramping up the build-out of our new LA offices. Total capital expenditures associated with this are expected to be in the $40 million to $50 million range over the next 2 years, but the majority will flow in fiscal '18. In January, we paid the previously announced $54 million dividend. Based on our performance, we will periodically evaluate issuing additional dividends to be funded out of cash. Our cash balance was $476 million as of March. This compares favorably versus a balance of $359 million at the end of fiscal '16 and $316 million at the end of the prior year quarter. We'll remain opportunistic with regard to further optimizing our capital structure. Given our strong operational performance, we are on track to further reduce our leverage ratio this year. Before concluding, I wanted to let you know that we plan to reverse a portion of our U.S. deferred tax asset valuation allowance in the second half of the year, which will result in a sizable onetime tax benefit to earnings. This is triggered by having cumulative net income versus prior years of losses, and is a sign of our upward trajectory and profitability. There is no associated cash impact. With 7 quarters in a row of year-over-year impact revenue growth, we keep setting the bar higher. Our team is hard at work to drive revenue, profit and cash flow. And while tough comparisons make for a more challenging second half, I'm confident we'll have another great full year. With that, operator, please open the line for questions.

[Operator Instructions] Your first question comes from the line of Aaron Watts with Deutsche Bank.

Just a couple of questions. I'll start with the margin improvement. As you see streaming continue to grow as a percentage of revenue and downloads and physical continue to become a smaller portion of your revenue, should we expect to continue to see margin improvement going forward?

Aaron, I appreciate the question. I would say, yes, we would expect modest continued margin improvement over time, obviously. But not every quarter is the same. Different artists have different structures and relationships, and different forms of revenue. Sometimes we have concert revenue that performs better, which is lower. So it's not linear quarter-to-quarter. But over time, with the big picture, as we move from physical revenues more to digital revenues and specifically, streaming, you would expect to see some margin uptick, yes.

Okay. And as we think about this year, I know that the late great Prince, you have some efforts around releases with him. Should -- is that going to affect your trends in physical at all as we think about that?

Well, I would say that there's still -- our Purple Rain rerelease that we're working on. Note, we've also released Prince's music in streaming in February. I would say that every year, we work really diligently on looking at both our catalog and new releases for key parts of the world, where physical is still strong, and make sure that we maximize that opportunity of physical. Prince and the opportunities there are clearly are part of that, but I wouldn't say that it would distort the trends that we continually to work on, and make sure we're maximizing year in and year out.

Okay. And one last one for me. I think recently you struck a new deal, or at least, an extension with YouTube, vis-à-vis licensing. Can you maybe talk about, if not specifically with that deal, but more generally, what are some of the terms that you're hoping to attain in those agreements? And as you go forward, what would make you happy with how those deals shake out, versus -- I think I saw some commentary around -- you weren't totally pleased with this particular extension?

Yes. Aaron, this is Steve. We don't comment on confidential deal terms. I'll simply say that we negotiated for an extended period of time. We fought for and got the best possible deal for our artists and songwriters, given the current environment. As we and the company said and as I've said many times, including on these calls, we strongly, strongly believe in the need for legislation. That would mean, actively managed user uploaded services no longer can take advantage of the safe harbor laws. Those laws create fundamental market distortions, and they skew competition. And that has been and remains our position.

And your next question comes from the line of David Farber with Crédit Suisse.

I had a couple of questions. So first quarter, digital growth, obviously improved nicely, and is now, I think, north of 50% of the company, so congrats on that. I know it's been a big area of focus. My question is, perhaps maybe, can you provide some additional thoughts on where that growth is largely coming from in terms of the distribution platform, whether it be a Spotify, or Apple, or maybe some thoughts around that. And then separately, if you separately can discuss the YouTube deal, I think there was some commentary around the length of it. So I guess, I'm curious to hear if you could sort of just talk us through the length of this versus the prior deals? And then I had a couple of follow-ups.

Sure. So, thanks, David. So on digital growth, I think, the way I would answer that, and I think what the key there is the paid subscription services which continue to rapidly grow, whether it's Spotify, Apple Music -- Amazon has entered the space, as have others, continues to be the best monetizing and fastest-growing part of the digital and streaming business. And that is really helping to drive those numbers. On the YouTube deal, Steve has already answered I think, the question to the best of our ability, and we don't respond to specific terms of any deals.

Okay. And then I'll leave that as it is. On the working capital side, you talked a little bit about that in the prepared remarks. I guess, I was just curious, what drove the larger usage? And would you expect that to reverse, perhaps, in the back half? And then can you just remind us a little bit on the dividend, and whether we should be thinking about that as more of a special onetime in nature or something you'd consider more of an ongoing basis? And then that it's for me [ then ].

Yes. Thanks, David. I'll answer both. So on working capital, in this quarter, in our second fiscal quarter, we had some strong releases towards the end of the quarter, some of which were physically oriented, or had a strong physical presence. That will -- that has caused an increase in our receivable, which will be collected in our current quarter, Q3. So that really drove the use of working capital, that's obviously short time in nature and will reverse quickly. If you look at the first half of the year, working capital has actually been a benefit, so we've managed working capital quite diligently here, and make sure that we're managing each of the underlying components of working capital. On dividend, I guess I would answer that with the bigger picture first, which really are our prioritization. So first, we focus and make sure we're investing and looking at ways to invest our capital to help drive the business growth, whether it's investing in A&R and organic growth, or continuing to look at strategically aligned M&A that has a strong return on investment and could be rapidly accretive. We continue to look at and focus on ways to optimize our capital structure and continue to reduce our leverage ratio. After we accomplish with those things, we will, based on cash available, continue to periodically revisit dividends. So that is something that is part of our balanced portfolio, but again, as part of the overall portfolio of priorities that we have.

And your next question comes from the line of Julien Roch with Barclays.

The first question is on whether there was any exceptional revenue in the last quarter. Last year, you had the Sirius settlement in fiscal Q2, so I wanted to know, you gave revenue at constant currency but whether we could get a clean picture if there was any exceptional? That's the first question. The second one is, can you remind us how much was the Sirius settlement last year in fiscal Q2? And the third question is on margin. And I know you said that you are expecting modest margin improvement over time, not a linear progression. But streaming went from 33% to 44% year-on-year in the quarter, but the gross margin in Recorded Music was broadly flat, it only went up by 1 point, and I would've thought that, that streaming has a high gross margin. So on the margin question, if you could focus on gross margin, do you expect gross margin to go up? Or is the margin improvement will only come from operational gearing on the fixed cost?

Thanks, Julien. So as far as exceptional revenue this quarter, really, there was nothing. So I think from the perspective that if I understand your question, it could look like as a pretty kind of clean quarter. SiriusXM, a year ago, the overall cumulative revenue from that settlement was $33 million, but the initial period of recognition was $24 million of revenue, okay, a year ago. And on your last question for streaming, the margin is up 1-point, and actually, we think that's a pretty reasonable, healthy increase. Remember, the growth is a portion of a very large revenue stream, and across the broad Recorded Music revenue stream, a 1-point growth is actually fairly substantial. And as we transition from physical to streaming, the margin uptick from each of those, we generally say is double-digit. But remember, there's still a reasonably healthy margin on physical, so it's not 100% of margin increase, it is a continued steady, modest margin uptick that we expect over time.

Your next question comes from the line of Lisa Yang with Goldman Sachs.

This is Se Park for -- on for Lisa. Just not to belabor the point of margins, but could you maybe quantify the magnitude of operating leverage embedded on the streaming side, especially how margins differed to download side of the business? And just a second point, in terms of how the streaming platforms are segmenting the market and trying to maximize the value per artist and in turn for the labels as well, could you just discuss how the discussions have been going with the streaming platforms on that end?

Sure. As far as I understand the operating leverage, you're now asking specific margin streaming versus download. Look, streaming and downloadable are digital services that in general have similar margins. We should note that every artist deal and relationship we have, have some very different margins, so depending on an individual release, things can be different. But in general, streaming and download, as both digital services have similar overall margins. As far as I think you were asking about -- what was the second question?

I guess, as opposed to the currently existing, like the $10 per month kind of ARPU model, right.

Well, overall, we've been very supportive of our distributors, evaluating and trying different models to connect with consumers and expand the category. There are different price points being used by whether it's Amazon, Pandora, Spotify, Apple, so that they can reach different customer segments and maximize the community. We wouldn't comment on discussions we're having with current distributors, but obviously, you could see what's come in the market even just over the past 6 months and the different price points that are emerging and obviously, we've been supportive of that because we've licensed that.

And we have no further questions at this time. I'll turn the call back over to the precentors.

Thanks, everyone, for your time this morning. Have a great spring, and we'll talk to you in a few months.

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