Warner Music Group Corp. (WMG) Earnings Call Transcript & Summary

Good afternoon, everybody. I'm Sebastiano Petti. I cover the media and communication services space at JPMorgan. I want to introduce Eric Levin, CFO of Warner Music Group. Eric, thanks for joining us.

Thank you for having me, Sebastiano. Great to be here and good to see everyone.

So Warner Music is closing in on 2 years a public company. A lot has happened since that time. How is the team positioned WMG for the long-term success against this evolving backdrop?

So when we went public, was right in the middle of COVID and right at the beginning, really, of COVID when everything was in lockdown. And our IPO really, I think, helped open up the IPO markets and even during COVID, we had this very strong belief in the power of music where digital was going, streaming and beyond and really the growth vectors in the future. Even while COVID was happening, 2 years later we feel even stronger about that. We've used the last 2 years to invest in our infrastructure and business to help a more diversified array of growth beyond streaming, areas like sync, even physical are in growth mode now, and that is something that is additive to the story of streaming, continue to power through continuing to grow high teens when we think it's early innings with more developed and emerging subscriber growth to come potentially price increases to come, which we've been pushing hard for as well as in emerging forms of streaming and Web3 promises to be additive to that. So we're really excited about the future of the industry. We're really excited about what's happening at Warner. We focus not just on growing with the industry, but growing of the industry. Last year, the industry grew globally 18.5%. We grew 2 points higher than that. And that's part of our objective as we continue to reinvest in our business to drive rapidly accretive growth.

Great. And a lot of stuff I want to come back to there, starting with streaming. Underlying recorded music streaming continues to grow, as you said, in the high teens, but it's been a little bit of noise around a reported basis. You have the DSP renewal, Russia, FX as well as some difficult comps. Can you just take us through the DSP renewal announced at the beginning of the year again? What changed? How will this renewal impact results through year-end?

Sure. So we had a DSP whose prior DO, which recently expired was actually higher than a market rate deal. That was renewed to a market rate deal and market rate really is where the -- all of our significant DSPs lie. Is a very tight band now that everyone is in. Previously, they were the one outlier. So in comparison, that is a downward reduction, but a downward reduction to what is a stable market rate that will continue. So once we lap the anniversary of that renewal, which will be our fiscal Q1 2023, all of our growth vectors and metrics will start to normalize and map against market growth, whereas this year because we have that negative comparison on the surface, it shows less than market growth, but fundamentally an operating basis, we're still growing consistently or even better in some cases than the market.

So the renewal rather than larger [indiscernible] fears just the one off versus the longer term.

It's anomaly one-off. And once we lap the anniversary, we fully expect our growth rates to match that -- to map perfectly to that of the industry.

So again, as you lap the DSP renewal, get back to a more normalized level of growth, take us through what underlies this confidence, right? You talked about a little bit high level, but also just thinking about the paid versus ad supported side.

Yes. So I think what you're asking about is more of the confidence of the growth of the streaming business. So we look at streaming in a couple of components. First is developed markets and their ability to continue to grow, most developed markets, or I should say, developed markets on average are penetrated in the 30s -- 30% to smartphones. We've seen research that indicates consumer interest in upwards of 70%. So there's still a lot of room to grow. There are new demographics to reach, new marketing programs to embark on to tap into those demographics. And in developed markets, essentially, prices haven't gone up in a decade. If you think about inflation even before now where there's higher inflation over the past decade. Those prices, if they kept up with inflation would have gone up something like $3. So there's a lot of room to catch up to where market pricing, we believe, should be. And we think the music price value is extraordinary relative to other forms of media, and we've been advocating for price increases for a while, Spotify has done a nice job last year of starting to raise rates. Last quarter, they reported a 3% increase in ARPU without any noticeable increase in churn. We think that's incredibly encouraging. And we've encouraged other DSPs to take notice. We're not a retailer, so we don't make the decision, but we do get to be an advocate. Emerging markets are just the earliest stage. They're single-digit penetrated still. So there's massive upside and there's major streaming services, both global services and local services in every market and they're prime to grow. And last or the emerging forms of streaming, whether it's social, fitness, gaming and now everything that we see and that we're deeply involved with Web3, we think there's an enormous amount of growth there and a lot of new business models coming online all the time that unlock future growth. 4 years ago, I didn't -- I don't know if anyone did, I didn't see TikTok as being an enormous player. And enormous player in the music market comes out of nowhere, but comes fast. It just shows how new models can unlock consumer interest spend and create a new revenue model. And we look forward to working with partners to unlock the models of the future and unlock new revenue growth. So we see a lot of growth, and we see it coming from a lot of places.

So just to finish up on that. I mean I think we estimate global page streaming subscriptions of about $550 million today going to, call it, $1.7 billion in '23 and 2030, about 20% penetration or so. Does this seem aggressive just given the DM opportunity upside opportunity? And just the nascent?

Here's how I think about it. So penetration to smartphones is somewhere in the neighborhood of 10%, 11% now. The $1.7 billion in 2030 is relative to projected smartphone market of about $8 billion. It's in the neighborhood of 20% penetration. To me and to many that are doing forecast, I don't do quick forecast, but just as someone that's deeply involved, that doesn't seem like a very aggressive assumption. It seems like a normal trajectory of growth that you'd see as smartphone -- as streaming continues to roll out deeper into demographics and developed markets and really start its more substantial rollout globally in emerging markets, $1.7 billion doesn't sound in that context very aggressive. Clearly, it's a big number. But music fans all over the world are just starting to come into streaming, especially in emerging markets, and we see these numbers as numbers that we're looking forward to supporting the industry to strive to attain, or if possible.

So going back to price increases. You've been pretty open about your view, and I think we can all agree that the utility of paid subscriptions is not fully reflected ARPUs out there. But on a near-term basis, as you look at the macro backdrop, as the window for price increases closed?

No. We think the window for price increase is wide open. We think it's a decade in the making. We view it as catching up to where the price used to be and should be. Other industries because of some of the inflationary issues or many industries are raising rates. We don't see why music would be excluded from that. We understand that there are pressures, and we understand where the wholesaler, not the retailer and the DSPs, the retailers to make their own decisions. But we think that music is an extraordinary price value, and there's plenty of room as Spotify has shown to raise rates continue to grow your subscribers, not increased churn and get rates back to a place that we think is more appropriate to the value it provides consumers. So no, we remain strong advocates and we even think with the difficult macro environment, music remains extraordinary value. And I would make one other point. If you compared us to video, which a fair amount of people have done, we think there are huge differences. In video, many people who subscribe to streaming services may have 2, 3, 4 services with differentiated content, which means instead of 4, you may be could skinny it down and pay for 2 and still have the content you prefer the most. In audio, you likely only have 1 service because every service has the same content. It has all content. It has content ubiquity. So that one service you have has an incredibly high utility, it has all the personalization you've built into it, your playlists, et cetera, your favorites, the algorithms know your taste. So we think the friction to disconnect for audio is high, and we think the ability to keep one low relatively low-priced audio service within the framework of what you're paying for is very strong. So believe very strongly in the value of music subscription and do all we can to continue to put out great music to make it better and better all the time.

Do you think there's also similar to sticking with the video analogy, opportunities to create a rate ladder and different features and functionality. I mean you're seeing some of that already.

Sure. So some of the services, Amazon, Title have high-resolution tiers. Look, there are tiers that are above the 99 tier and there are tiers that are below. We have always been supportive of different but having different strategies, different strategies to onboard sub, different strategies to have different content and feature mixes to meet consumers where they are. We have always been fine, always been supportive. Our job is to help each distributor find their differentiated each and be successful. Obviously, we want to make sure that the pricing is appropriate relative to their usage of content and we're getting the fair value for our music. But we've always supported -- we don't want to have DSPs that all look exactly the same. They have largely the same content. So the way they market and promote and differentiate features can be important. And we support that. And also that can -- you could even bring ad-supported and subscription in those mix of how those work together in the discussion as well. And again, we've been supportive each of our distributors in helping them find their niche.

So the emerging streaming platform revenue bucket increased to $345 million on an annualized basis in the second quarter, about 10% of total company streaming revenue. This steady growth is consistent with expectations outlined just more steady growth move to different models here. So is it more reflective of just more consumption-based or versus buyouts? Or is there -- what drove that growth, addition deals as well?

Yes. So what's happened in the past, and if you look back to 2021, that number was jumping by leaps in 2021. When we saw it in the past jump by leaps, generally that reflected the renewal of what we're in that category, major service deal renewals. This year, because our deals tend to be 2 to 3 years in length. There really haven't been any major renewals. So what you've seen in increases quarter-to-quarter in '22, but more modest and that's because the renewals we've had have been smaller services, not larger services, plus you also see the addition of new entries into the space or new entries to doing their first music licenses within the drill space. So you're seeing smaller additions. At some point in the future, what will happen will be a few things that will continue to drive, we believe, really strong growth in the category. One is the major services in that category will renew. And I should note, in the past, we've done generally fixed price deals where they've done buyouts. They've done buyouts. And I'd say the largest reason is because these aren't audio streaming services that are designed to solely sell and track the consumption of audio. These are almost all multimedia services. These are social services that may pair video with audio or graphics with audio and their systems aren't designed to track audio consumption and report audio consumption on a stream-by-stream level. So it's easier to do a buyout than something within perfect data. We'd like to pay our orders with perfect data so that they know exactly what was consumed. So we've generally done buyouts. We've encouraged these companies to develop the system so we can do consumption-based deals. So some of the larger renewals when they come up, will move to consumption based, some won't be ready, most still do buyouts. What consumption base means is as opposed to having stepwise growth when it's renewed, we can start to grow in line with their platform in a more linear fashion. We prefer that. It's more reflective of earnings in that period, but we have to have data to do that. So those are the things we expect to drive growth in emerging streaming and the category. And the one thing I'd add would be Web3. We've been really active in the Web3 space. Every quarter, we have new announcements of partnerships that we've made, whether it's in Dapper Labs or OneOf, NFT companies and other NFT company pull out Genie is an Avatar company. And what we're doing is trying to build best-in-class partnerships. So we can work with them to develop the best sustainable music executions in the web3 space. And our goal not to make a quick buck. We could make a quick buck. But the goal is not to make a dollar off music fan or more and then have them have something that may not be valuable or doesn't have a recurrent benefit to their life. Our goal is to build fandom in a sustainable way, where they love their favorite artists and love their music and content and come back for more in part of their lifestyle in a way that's incredibly positive to them. So we're trying to find those models that really take fandom to the next level respect fandom, build more fans, connect artists and fans in deeper ways. And we're going to be doing -- and we're already starting, but we're going to be doing a serious experiment over the next block of time, whether that's 1 year, 1.5 years, 9 months to work to find that sustainable business model. And then when we do, we'll be doubling down and making it a meaningful ongoing part of the screen, but we're really excited about it. We're excited about what we're working on with our partners and more to come on that as we earnestly to develop really the future of, or a future component of growth in the music industry.

So it sounds like the pipeline is pretty robust, and we're just scratching the surface here.

That's how we feel. I mean we even before COVID, but honestly, I think COVID, with the lack of ability to tour artist become even more interested in digital executions of the their brand, their content, allowed an acceleration from the artist side. Clearly, the development, innovation of product and content and product type in digital format has accelerated over the past several years as well. And music is integrated into so many different of these product types. It's becoming massive. I mean we've gone from a company that's had, say, tens of digital licenses just a few years ago, we now have hundreds and continuing to grow every quarter. So the number of services and geographies where we're getting revenue from is just exponentially expanding on an ongoing basis.

And is there any risk of increased competition as other labels pursue these emerging platform opportunities.

So it's a really good question. And what we would say is, just like we described with DSPs, we always expect a service or a product we're doing business with to license all the content. It's generally been where music has gone. The consumer wants equity, access to all the content, all their favorite artists in one place, and we're highly -- when we do deals with these services, we're often first because we want to be a leader and an innovator, but it's not to become exclusive and to create a product that leaves others out. The reason we go early is we want these services to have a music partner at the table that can help them experiment, give them access to artists content, but also that they have -- so we have music at the table with them, helping provide input in shape and sculpt this. So it's the best interest, the artists, the fans and creates the best product. So we won't part of the experiment to get to the best outcome, but not so it's only to our benefit, we know it will benefit the whole industry. But we've always been an entrepreneurial, innovative mindset at Warner Music Group. And so we try to be first where we can, but it's to help the industry grow faster. We don't expect it to be exclusive.

And so if you had to just -- what inning are we in, in the...

Well, it's early innings. So what we would say is if we took streaming, we've broken into pieces. Developed markets are penetrated, call it, in the 30s, and we've seen consumer research saying there's consumer interest up to the 70s. So you'd say that might be the middle of the ballgame, but really hasn't been other than Spotify last year to a degree during price really hasn't been price increases and prices have actually fallen behind. So we think there's a significant opportunity there. So if you'd say the middle in I'd say that move it back to slightly earlier in the game. In emerging markets, it's probably the first or second inning. We're talking about single-digit penetration. And if you look over time and say, can they catch up to develop markets, well they should be trying, certainly with the middle classes. And that's just getting started. And when it comes to emerging streaming and web3, I think we're in the very, very early stages and web3 has an opportunity to be really substantial. So I'd say kind of tip of the iceberg, very early innings. So we think in streaming in general and emerging streaming, there's massive opportunity in front of us.

Why investors perceive Web3 is maybe a long-term threat?

So I actually had this conversation. We get that question a lot. So -- and I can answer it kind of here's my thought. But what I did is I went to the General Manager of Atlantic Records Atlantic Records is -- I think it's the largest label in the world and ask them that question. And he had been -- he's been in Atlantic for 20 years, and he kind of looked at me and said, Eric, I've been hearing that question for 20 years. And we sat down and he started describing a series of innovations and how it's perceived but then what it really meant. And the consistent theme was every time there's a new capability, the perception is that the artists can go directly to the fan and then what do they need the label for. And what he said is, although that's true for an individual platform, we actually now connect artists and fans because there's so much innovation in music and so many digital products across so many geographies, you literally, to break an artists, have to be working across hundreds of services simultaneously. It's like it is. So, Paul is his name, said, although we can work with an artist or an artist can work directly on one platform with their fans, that's a very narrow strand of an entire fan base. In order to reach the entire fan base, you have to work across hundreds of platforms. You can't do that without infrastructure. You can't do that without a team, you can't do that now without technology that is able to keep up with the pace of change in content flow. And you can't do it without tracking how things move, the way a social platform works 6 months ago and the content that's cool. 6 months is totally different. So if you're 6 months behind, you won't see modern and relevant anymore. So what he basically was saying is that the scale, reach, complexity, the number of services, the pace of change, the need for team, infrastructure globally and tools to keep up is so complex and layered. Every time one of these changes happen, it's just other brick being added. It doesn't change or move the wall. It just builds it bigger and makes the need for the label even more valuable than ever. So each service is perceived as threat but the reality is it just becomes part of a bigger, more complicated ecosystem that's needed to break artists and connect to their fans on a going basis.

All right. it's a valid point. I mean just a greater complexity of web3. So margins expanded at a very robust pace during the pandemic driven mainly by revenue mix. On the second quarter call, you reiterated the company's long-term margin target of mid-20% range, how should we think about Warner's margin trajectory over the next year or so as low margin revenue streams continue to recover?

Yes. So consistent with what we've been saying over the past several quarters and really once it became clear that the impact of COVID was going to last longer than a few months at the time of the IPO. No one thought it would be 2 years of dealing with no touring, which is what happened. So when we went public 2 years ago, what we said was we expect our margin to increase about a percentage point a year. And on a fundamental operating basis, that's been exactly what's happened. And that's roughly what we expect to have and go forward to continue to grow margins. What's happened on top of that is that in 2021, our Artist Services business which is our concert promotion businesses and our tour merch business have -- I mean, I don't know what the right word is kind of been on hey, it is because of COVID. If artists weren't touring, not making that revenue, those happen to be our lowest margin forms of revenue. So if you're a lower-margin forms of revenue are on hiatus, if your operating margins are growing by 1 point, then the impact of COVID is going to take it up more. So we kind of were growing our margins the last 2 years about 2 points a year. But only 1% of that was really going to be sustainable ongoing. Now that artist services are coming back, which we saw in the past quarter, concerts are coming back, that revenue and the merch is coming back. What you see is they start to -- is they have a dampening effect because they're coming back faster than our overall revenue growth. So this year and absent to next year, you might see more flattish curve, even though our underlying operating margins continue to grow about 1 percentage point a year. So you see that kind of offset, which is just the short-term impact from COVID and then the recovery from coveted artist services, what is kind of masking an underlying continuing fundamental trajectory of margin growth.

So 100 basis points is the right way to think about the business over the long term. But maybe a little bit more flattish through -- over the next -- into '23?

I think that's probably about right. It's hard to predict exactly the pace the artist services revenue will come back, the ballpark, that's about right. And fundamentally, we have a strategy that just continues to focus on fundamentally growing our margins, and it starts with a continued shift from physical formats to digital formats, digital revenues are our highest margin forms of revenue and continuing to manage cost control. We've got a transformation office that is consistently looking at tools and technologies to help us automate, standardize and centralize capabilities where we can, and that includes our financial transformation, which will deliver -- it will be delivered in waves, but start to deliver in '23, and that will generate $40 million -- $35 million to $40 million a year of annualized savings. So we have a program to continue to make sure we're pushing the curve so we can continue to drive underlying margin growth.

Even if we think about flattish through next year, whatever. But just given the pace of margin expansion, I mean and initiatives you just kind of outlined and your focus on efficiency -- it seems like mid-20s percent margins maybe not that...

No. But we're not afraid of saying mid-20s. Look, we're already almost you mean we're in the low to mid-20s now. And so we want to keep pushing that. And even once we hit mid-20s, we're going to be looking at our formula and say, how do we keep pushing that lever and keep growing. We don't see margins as a momentary thing. We see it as something that we are continually striving to push forward and continue to grow.

So it could be upside longer term.

We're certainly focused on that.

Can you update us on the deal or catalog pipeline, the reports you and WMG are competing for the Pink Floyd catalog. How is the team thinking about the deal environment overall and how will higher cost of capital, the COVID unwinds expect impact deal velocity from here?

Yes. So we don't talk about individual deals, so won't talk about Pink Floyd or any other deal. We can't talk about the category. So I think -- what we saw happen during COVID were a couple of things. One is interest rates got incredibly low. Financial players entered the field and we're with very low cost of capital bidding on music catalogs. Also, artists weren't able to tour, which meant a significant portion of their revenue streams temporarily dried up and sell catalogs represented a potential significant income stream. So there was really this confluence of events that really accelerated the rate of actions. Now we're seeing an environment that's changing in the opposite direction. Touring is coming back. Those revenues are coming back and interest rates are going up. So the cost of financial players, capital, and therefore, the pricing would logically be affected by that. So it's reasonable that to think that there'd be a more normalized environment for deals coming up. That said, we're not particularly affected by that. First, our debt structure is locked through 2028. Our cost of capital is 3.3%. The majority of that is fixed debt. So our cost of capital is pretty secured for quite some time. Two is, although we invest in acquisitions, including catalogs, it's not our focus. Our focus is we're an operating company that invest cash in a variety of different ways to drive the growth of our business within our strategic areas of focus. If a catalog acquisition is both a good fit, we can add operational value that drives up the returns for us more than it would be for a financial player, and it's well priced, it generates a good return, we'll take it very seriously. But if we don't see things that fit that, we'll just invest organically into new IP, expand into new markets because we have a variety of ways to drive growth, but we look at those deals, acquisitions of catalog acquisitions, but we're very disciplined if it doesn't meet our financial criteria, and we can't add operational value, we move on. So we expect to see that market start to change as the factors, as we described earlier, start to change, but we're not going to change our discipline at all because we have multiple to drive growth, and that is just one -- it's just one leg of several.

Moving to another leg of growth. A lot of focus on A&R investments, advances, evolution of artist deals, I understand these are largely opportunistic, but how should we be thinking about the near term and longer term, perhaps impacts on free cash flow?

Well, so we've always said that -- our first focus is to drive the growth of our business and drive our free cash flow growth with it. We've then said once we have that capital, the first place we look to deploy our capital, if it meets our return threshold and is a strategic fit is back into our business to drive future growth. As I said earlier, first of all, that is consistent with how we have driven our market share growth. As I said earlier in 2021, the global music industry grew 18.5%, we grew 2 points higher than that. And the way you do that is you deploy your capital smartly with meeting our financial return thresholds to continue to drive growth, both in developed and strategic emerging markets that we're trying to lean into. So that's the first place we deploy our capital. And if we run out of opportunities to deploy it there, obviously, we return capital to shareholders. We've increased our dividend. But we continue to focus and see great opportunities to drive our business even faster than the market. And when we see that, we've not been afraid to pull the trigger and accelerate our own growth.

Any way to think about perhaps payback periods as we're thinking about some of these investments?

So a few things. One is when we deploy our capital into advances, they're advances, they're recoupable, they come back to us. So when we deploy our working capital into our own growth, it's just a matter of timing. It's not a permanent outflow. The deal is accretive both to revenue earnings, but also cash flow just in a matter of time. Now how long does it take? What we'd say is we tend to do is our focus to develop career long relationships with our artists. Artists rarely leave Warner Music Group. So what we focus on is very long-term deals with artists that we believe in their careers and in the era of streaming, deals pay off for a long time as long as music is streaming, including their catalog, which can be for decades. Now we don't do deals that take decades to recoup, but in the old days where it was physical and it recouped all in the first couple of quarters, now it's different, now something can recoup over a couple of years. So the extent of which something recoups can be longer than it was, but the earnings power of the music because the industry is growing so quickly is much higher than it's been in decades.

Well, right on time. Eric, thank you so much for joining today.

Thank you, Sebastiano. And thank you, everyone, for joining us. I appreciate the time and appreciate the interesting questions. Thank you.

Great. That's good.