2023-03-10 01:08:35 ET
Summary
- If you look at what is priced in, the growth rates do not justify the current share price.
- An increasing number of people are releasing music without the major labels, so it will be interesting to see how this develops.
- And what kind of impact will AI Music have on the music industry?
Thesis
Many people argue that companies like Warner Music (WMG) and Universal Music Group (UMGNF) are a better bet in the streaming market than Spotify (SPOT). They say that these companies have pricing power over the rights that streaming companies use from them. On the one hand that is true, but I think a lot of people overestimate the pricing power and more and more artists are doing it without a major label. And furthermore, Warner is completely overvalued at the moment if you look at the business metrics. Let me explain why in the next few chapters.
Short Introduction
Warner is one of the three major labels and currently has 2 divisions. Recorded Music, where they discover, develop and market artists. And Music Publishing, where they market, promote and distribute music.
Analysis
Normally I am not a big fan of using normalized or adjusted earnings, but in this case Warner has every right to do so. They changed their reporting periods so they had 1 week less in the last quarter and over such a short period of time 1 week can really have an impact.
But they have also adjusted for currency movements over the last few months and I think that is part of the business so you should avoid adjusting for that because currency movements are going to happen all the time. Sometimes in your favor and sometimes not. In actual terms, the decline would have been -8% and even if we take into account the one week less they had this quarter, it would have been flat at best. This is partly because they have their major releases scheduled for the second half of 2023, and the last few months have been challenging from a macro perspective.
On the positive side, they actually improved their FCF by 98% to $188m and guided to improve overall margins by 0.5-1% per year. They also reduced the average weighted cost of debt from 4.0% to 3.7% and extended the average debt maturity from 5 to 7 years.
They currently have 720m in cash and 3.9b in debt with the nearest maturity in 2028. But if we look at Warner's historical financials , we see that their debt is growing every year. This is something we should watch.
Looking ahead, they mentioned in their Q1 earnings call that they see the potential for higher prices for music streaming subscriptions in the future. Some companies such as Apple (AAPL), Deezer and Amazon (AMZN) have already done so. And if we compare this with the increases for Netflix (NFLX), for example, we can see that there is still a lot of room for price increases.
And if we take a look at their latest annual report , we see that music streaming is still in its infancy, and a growing market + potential price increases have the potential for nice revenue growth. And there are good growth opportunities in emerging markets, particularly in China and India.
If you just look at the streaming revenue, it had a CAGR of 27% and if you compare the number of streaming users to companies like Insta or TikTok, which have a billion monthly users, you can see the growth opportunity.
They have also appointed a new CEO , Robert Kyncl, who is a very experienced manager. He worked as CBO at YouTube and was President Content Acquirer at Netflix. With his experience from the other side of the business, he could really help them improve. But time will tell how that will play out.
The actual market situation is that Universal dominates the market by a wide margin. Warner improved their market share from 16.06% to 19.05% this year, but a big part of that is that they included ADA, which distributes a lot of independent labels, for the first time. So, the actual market share gain is much smaller.
Over the last 3 years, Warner has failed to land any of their artists in the top 5 most streamed list. And if we look at the all-time rankings , we see Ed Sheeran at number 4, Coldplay at number 14 and David Guetta at number 23 and Bruno Mars at number 26 as their top selling artists in the streaming business. So it is safe to say that the other 2 major labels have a slightly better roster at the moment.
The input for the reverse DCF to see what is currently priced in is as follows: TTM EPS of $0.92 and a 15x multiple. With these inputs we get that they need to grow by 21% over 10 years to justify the current share price. That is a really tough ask to meet. So the share price looks overvalued to me at the moment. When we combine this with the current EV/EBIT of ~28 and a return on capital that has averaged below 10% over a 5 year period, it is really hard to justify this share price.
On the plus side, they have increased their dividends every year and could therefore be of interest to dividend growth investors.
Risks
Spotify reported their annual results recently and indicated that the share of streams attributed to major labels head again declined by another couple of 100 basis-points. And I'm curious, how you view that information?
This was a question posed by Michael Morris on their recent earnings call, and today it is easier than ever to do it without a label. Many artists are building their own audiences before A&Rs even notice them. Social media has changed the game in this regard and perhaps this will weaken the market power of the major labels. They noted that there are many more platforms than Spotify, but at the moment Spotify is the most important music streaming platform. So that's something you're going to want to be thinking about.
The debt situation is also something to look at because total debt is growing year on year and growing debt is always something to watch. Too much leverage can quickly become a problem.
Because of the hype around OpenAi, AI has gotten a lot of coverage in the last month or so, and there are a couple of companies where you can create AI music. Especially on YouTube, there are a lot of channels where people are using the music they have created with AI and monetising it. So how will this affect the major labels? It will probably make it even easier for some people to release music without a major label.
Conclusion
The major labels have a nice catalogue of music that they own and can monetize. But at the moment it does not look like a very high margin business. And with companies like Apple, Google and Spotify, you can almost guarantee that it will be a tough and competitive market. I mean, just look at the Apple Store Tax and how they are trying to make as much money as they can.
Apart from that, if you look at the EV/EBIT and sales growth rates or the reverse DCF, the actual valuation is not in line with reality. So I would not say that Warner is a better bet in the music streaming market than either Spotify or Universal at this point in time.
For further details see:
Warner Music Group: The Price Is Too High For What You Are Getting