Warner Music, Made Relevant By Spotify, Looks Fully valued

Warner Music Group (NYSE: WMG) went public earlier this month and the stock is up 30% from IPO levels, not much higher given the investor excitement towards anything new to the stock exchange, anything related to music streaming, and anything that can be compared to Spotify (Nasdaq: SPOT).

But the market is right to have tempered its excitement. Rise of music streaming has provided respect to music publishers once again; almost a decade after the business was pronounced dead with the rise of free file-sharing services.

No doubt, the franchise is strong, with the company owning major labels like Atlantic, Warner Records, and Elektra, music publishers like Warner Chappell, home to mega-stars like Cher, Led Zeppelin, Ed Sheeran and Cardi B, but as a public investor, you are more bothered about upside potential and valuation. Both of which are urging caution.

Music streaming services offered relevance

Out of the era that saw piracy and free downloads bringing music industry to its knees, streaming is booming and the music industry is once again celebrating this digital environment.

Up 20% is 2019, music-streaming services are booming and driving much of the music business sales, almost 80% in the U.S. according to the Recording Industry Association. There is little to suggest that the trend will abate anytime soon.

Please also read our note on Tencent Music (NYSE: TME), which we believe is doing a great job in monetizing digital music wave, more than just streaming services revenues.

As content becomes all-important, the threat of independent labels will rise

Artist and repertoire costs make up 33% of sales for Warner Music. Why is that a problem? Growth of digital music and proliferation of distribution avenues for artists has lead to supply constraints for the music rights acquisition industry participants, which is great for Warner Music’s inventory but the problem for its future growth and profitability.

Even from the demand side, is it all clear skies from here till eternity for music labels? Not so much, leading industry analysts have started to talk about the rise of independent labels, who don’t have the baggage of physical distribution that allows them to offer better deals to artists. Indeed, sales from digitally recorded music were just 54% of the total sales and 12% of sales still come from the physical sale of music for the company.

Poor growth momentum, near or far

From 2015 through 2019, sales for Warner Music grew 50%, nothing compared to Spotify but impressive for an old music company. More recently it seems the streaming wave has all but died down.

For the first half of this year, sales barely increased by 1%, before you blame it all on Covid-19, important to remember that sales for Spotify increase 22% during the latest quarter and more than 10% for Tencent Music during the same time. Even digital revenues for Warner Music grew at just 9% during the first half, suffering from decreases in physical and licensing sales. 

International markets that represent 57% of the total sales for Warner Music haven’t done much better either for the company, growing at 2% during the first half. Streaming services are growing internationally, but digital downloads are declining fast.

Industry analysts are expecting a rebound in the music business industry by 2021 and an average 6% growth in the music business over the next decade. If we go by those numbers, the case for Warner Music to grow much more than that is difficult to make.

Numbers

“Investments throw off cash flow for owners. Speculations do not. The returns to speculations depend exclusively on the vagaries of the resale market.” – Seth Klarman, Margin of Safety

 Next Yr PEP/ SalesMarket Cap (B)Gross margins 2019Operating expenseSales Growth 2019
Tencent Music 33 5.9 $2234%17%34%
Spotify Loss 5.1 $4226%25%26%
Warner Music 45 3.6 $1746%38%12%

As the chart above shows, the current stock price is not offering much margin of safety for investors joining in after the IPO, which is not surprising given the company was acquired by Len Blavatnik’s Access Industries for $3.3 billion, nine years ago and now trading at a value of $17 billion.

Warner Music Group   
    
 201720182019
Revenue Growth 12%12%
As % of Revenue   
Gross Margin46%46%46%
Selling, General and Admin34%35%33%
Amortization6%5%4%
Unimpressive operating leverage

Besides the current valuation, lack of operating leverage in the model, i.e. the company’s ability to drive profits faster than the sales growth, will soon start to bother the Street. As the chart above shows, much of the improvement seen at the operating margin level over the last 2 years was mainly due to the reduction in amortization expense.

This lack of leverage is mainly due to increasing competition to attract and retain talent in the industry, a trend that may only accelerate with the digitalization of the industry. The company also carries a debt of close to $3 billion, which may not bother investors right now, but if operating margins take a hit, interest expenses will have a disproportionately large impact on the net income line.

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