HPGSF - Hipgnosis Songs: Wide Trading Discount Offers A Margin Of Safety

Summary

• Growth from streaming expected to continue boosting revenues.
• Sector regulatory tailwinds from recent settlement of CRB rulings.
• Valuation fears are likely to be overplayed with inputs appearing to be conservative.
• Trading discount means the company cannot raise equity in the near term, however its debt facility has a remaining life over 4 years.

Hipgnosis Songs Fund Limited’s ( HPGSF ) objective is to provide shareholders with an attractive and growing level of income, together with the potential for capital growth, from investment in songs and associated musical intellectual property rights. Cumulatively, the company owns 146 catalogues with c.65k songs. The company is currently trading at a c.48% discount (at last close price) to its operative NAV, with a c.6% dividend yield. We think that at a discount of 48% to NAV, there is sufficient headroom baked in, with a surprise to an upside more likely rather than towards the downside.

Music as an asset class

Music intellectual property rights only had in the past 5 to 6 years started being considered as an asset class. Since then, there have been an influx of investment from large institutional players like Blackstone and Brookfield investing substantial amounts into this industry. The biggest attraction of this rising asset class is: i) increasing prominence of streaming revenues, ii) recurring revenue potential and iii) Low correlation to economic activity.

Streaming has brought greater stability to music royalty cash flows. Digital streaming has driven the growth in global recorded music revenues after 15 years of declines caused by piracy and the decline of the physical album. As a result, there is now greater confidence in owning music intellectual property assets and the royalty income derived from them.

At a song level, new music royalty income generally sees its greatest income within a year after release. Income then typically decays until the 5 ^th year mark, which then becomes relatively stable thereafter.

Music spending has historically shown little correlation to broader economic activity. According to Goldman Sachs research, music spending and its associated royalties typically held up well relative to other industries during past recessions and most recently during the Covid-19 pandemic. The following chart highlights this lack of correlation by comparing the recorded music industry’s 15-year decline due to piracy and its subsequent streaming-driven rebound against personal consumer expenditures. Recorded music spending has outgrown personal consumer expenditure growth by a factor of 2.4x since 2016.

In its recent earnings, Spotify, the leading streaming service, beat expectations with year-on-year premium subscriber growth of 13% to 195m. This is in contrast with Netflix, which have suffered a fall in subscriber numbers since early 2022.

Sector regulatory tailwinds

After a lengthy appeals process, the Copyright Royalty Board ((CRB)), which sets royalty rates for the United States had rejected the appeal of CRB III brought by some streaming companies. As a result, CRB III, will increase statutory minimum rates for streaming paid in the US from 10.5% to 15.1% in 2022, an overall 44% increase.

The CRB IV ruling, which will begin in 2023 will further see the headline royalty rate for streaming in the US rise further from 15.1% to 15.35%, phased in over the five-year term from 2023-27. We believe this is a positive announcement for the music royalty industry, and Hipgnosis will stand to benefit from higher revenues and an increased NAV from increased future expected revenues.

Why don’t I buy a bond?

Objectively, a music royalty asset could be thought of as a bond with a long-dated income stream. However, we highlight the key difference is the possibility of growth embedded into music royalties, from streaming growth and active management of the assets.

Once a song catalogue is acquired, management will then find creative licensing opportunities in film, TV, advertising, cover songs and video games. The rise of social media platform TikTok has provided an interesting opportunity for song owners to capitalise on its growth. One of Hipgnosis’ recent success was "Talking to the Moon by Bruno Mars", which was released in 2011. Ten years on, due to a viral TikTok post, they have successfully garnered 500m cumulative song streams across 2021.

Active management also involves decreasing cost and payment timing of royalty collections. Historically, the flow of funds from end consumers to music rights owners is complex and often involves many “middlemen,” such as collection societies and agencies. Payment timings between these collectors and rights holders can take 6-12 months, or even potentially longer. Labels, publishers, and royalty funds, will look to minimize the time lag between payments in order to maximize cash flow available to shareholders.

Valuation inputs

With the recent rising interest rates, there have been increased scrutiny in the discount rates used in the valuation of real assets. Hipgnosis had used a discount rate of 9% since it first launched in 2018, and had reduced its discount rate to 8.5% in 2019, subsequently continuing to hold the discount rate steady to date. Per management’s disclosures, the inputs could be broken down into a cost of equity of 10.2% and a cost of debt of 6.9%, which they believe to be conservative. Cost of equity could be further broken down into risk free rate of 4.9%, beta of 0.96 and equity risk premium of 5.5%. Furthermore, management stated that there have been recent transactional evidence within the private markets, valuing song catalogues at discount rates of 7 to 8%.

We value Hipgnosis using a DCF model with an average revenue growth rate of c.5%, stable EBITDA margin, terminal growth of 2% and WACC of 9%, which indicates an upside of c40%. The implied terminal EBITDA multiple is 16x, which is fairly in line with the company’s historic acquisition multiple on average. We believe the intrinsic value of the company is not sufficiently too far off its NAV to warrant a trading discount of c.48%.

Risks

Hipgnosis has a revolving credit facility of $700m, with c$607m drawn at 30 September 2022. Its interest rates are largely hedged, with $340m fixed at 5.67% until 30 September 2027, and a further $200m hedged until 3 January 2026 at a fixed rate of 5.89%. Nevertheless, net debt stands at a 25.7%, which is somewhat high, given the interest payments that are close to c6%.

Furthermore, as the share price is trading at a discount, the company cannot raise equity as it will dilute the existing shareholders. Given the bearish equity performance, it may be a while before the share price trades at a premium again. Although, there is some comfort that the debt facility would only need to be repaid in September 2027, giving it a breathing space of over 4 years to raise additional equity funding.

Conclusion

The music royalty asset class is set to continue enjoying the strong industry tailwinds through streaming growth and increased royalty rates in the recent ruling. A potential recession would likely not be costly for song owners due to the lack of correlation with economic activity. We think that at a discount of 48% to NAV, valuation and recession fears have sufficient headroom baked in, with a surprise to an upside more likely rather than towards the downside. As characterised by one of Hipgnosis’ songs in its catalogue, “Don’t stop believin’ by Journey”, we remain optimistic on the music royalty sector and believe that Hipgnosis is well placed to capitalise on its growth.

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