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

Good afternoon, everyone. Next up, we have Eric Levin, the CFO of Warner Music Group. Eric, thanks for being here.

Meghan, it's my pleasure. Thank you for having me. Really appreciate the opportunity.

So I wanted to start with big picture and ask what are the top strategic priorities for the company as we sit here today?

Yes. Well, this is going to sound broad, but it's really growth in every direction of music. Last year, according to IFPI, and last year being 2021, the industry grew 18.5%, and we grew 2 percentage points more than that. We did that through a series of strategies that we continue to pursue. One, embracing innovation, music and the consumption of music is happening across more and more digital platforms all the time. And we want to be at the forefront of both licensing and sometimes helping even sculpt how they're incorporating music into their platforms. That's why we do so many partnerships and some investments. We're very focused on expanding our global footprint as music expands into emerging markets throughout the world. And obviously, we're always focused on artist development, both short but especially long term, helping build our roster all over the world to help us continue to push more and more great music into the ever-diverse, ever-complex, ever-broadening music ecosystem, and we are continually pursuing commercial success with that. We also see kind of back to basics. We see a lot of opportunity in the core streaming, developed markets, emerging markets, pricing opportunities, new platforms of digital, and we are driving all of these avenues. And we're doing it despite a complex macroeconomic background globally, where we are absolutely focused on driving music into what we believe is a very resilient music business, where the consumption of music keeps going up, even though there's a complex macroeconomic environment that we navigate like every other company.

Okay. Well, I think we're going to dig into more of those as we have -- go through the half hour. But I wanted to start with recorded music streaming revenue. It's your biggest revenue stream and it's obviously a big focus. COVID in the recovery has caused wild swings in this line and you have some unusual items. So I wanted to see if you could walk us through those and what growth looks like on a core basis.

Yes. So I mean it's absolutely true that COVID has created some issues over the past 2.5 years where certain revenue streams performed well. Others were affected by COVID and then come back. So there's definitely been some nonlinear trends that wouldn't have happened otherwise. Everything we see now is back on track from a streaming standpoint, certainly. We've had deal renewal dynamics and other comparability issues that create noise in our streaming numbers. Fundamentally though, on a core operating basis, our recorded music streaming growth has been very strong. In 2021, it grew approximately 21% driven by subscription streaming growth in the high teens, even higher ad-supported streaming growth as that business continues to grow organically, but there was also a recovery from COVID in the numbers as well as some very successful renewals and additions to our emerging streaming platforms bucket. In 2022, for the first 2 fiscal quarters, we've seen fundamental operating growth continuing to be in the high teens. It sounds like high teens is less than 20s, but obviously, as the denominator gets bigger, it creates -- mathematically, just the percentages get smaller, even with similar dollar value growth. So these fundamentals of streaming continue to be very, very strong. So we see the strong underlying growth. However, there are some things to really point out and focus to. They're the things that we live with and navigate. One is, the macroeconomic environment is something that we are affected by like any other business in the world. The Russia-Ukraine conflict, if we can call it that, the war is going to create about a $5 million headwind in Q3, obviously, lower on an OIBDA basis, but it's going to create some headwinds. It's a smaller emerging market, but there is some impact. And FX, foreign currency will create a 4% to 5% headwind in Q3 as well as we're a dollar-denominated company. And there are some company-specific items that affect year-over-year competitive -- comparability dynamics that we've been -- tried to be very straightforward about. Obviously, we've talked for the past 2 quarters about the DSP renewal that has had about a $30 million per quarter impact, simply an over-market deal that on its renewal cycle came down to market in a very tight band with every other significant DSP. We will lap that at the end of fiscal '22 and the comparison starting fiscal [ 1 ] '23 will be more apples-to-apples. We'll not be comparing an over-market deal to a market deal. It will be market-to-market. And we've had some smaller but nonrecurring items worthy of note. In our fiscal Q2, we had a nonrecurring true-up payment for an ad-supported streaming service, which affected comparability. And in Q3, we'll have about a similar size, $10 million or $11 million, an accounting change for a smaller DSP that will create some comparability issues for the quarter, small, but still worth noting. And that's a DSP that now has moved to normal accrual basis, but comparability in Q3 versus the prior year will show that dynamic. Again, the fundamentals are very strong, and we do want to say Q3 -- fiscal Q3 of '21 last year was an extraordinary quarter for streaming. Subscription grew more than 20%. Ad-supported, which was still recovering from COVID, grew more than twice that rate. And we had some -- very strong growth in our emerging streaming platforms with deal renewals of substance and creates a tough comp for Q3, even though the fundamentals remain strong. And in Q4 of 2022, we expect our year-on-year comparison to be stronger as ad-supported streaming had normalized in the prior year, and we had no large emerging streaming deals. So it's important to keep the comparisons year-on-year in context. And note that when you kind of work through it all, the fundamentals of streaming, both for the market but also for Warner Music Group continue to be very, very strong.

Just to clarify on those nonrecurring smaller items, $10 million to $11 million in F 2Q and 3Q, they were both benefits or headwinds?

They were benefits in '21 for non -- for items that effectively are not recurring in '22. In the case of the one we're talking about in '23, is a change of accounting where it was a smaller DSP that effectively was on a cash basis. But now we've just moved -- as it's become a more secure smaller distributor, we've just moved to accrual basis. So not really significant on an economic basis, more of an accounting policy change. That's why I just point out that the fundamentals of growth of the business remain quite strong and healthy, but there will be some noise around some of these onetime or accounting issues, even though they're relatively small in the big picture.

Okay. And the DSP renewal, we get the question all the time, why you're not -- why you're confident that's not going to happen again? Why you had this outsized deal? And just to be clear, how you're adjusting it. So when you talk about the 21% growth last year, that includes that deal and then the 16% this year is sort of your core growth that you're adding back currency or adjusting for currency, but you're not adding that $30 million a quarter back?

So if you take out the DSP renewal and the kind of -- in the last quarter, the onetime. Yes, in Q2, if you just take out the DSP renewal, we were at 15%. If you take out the DSP renewal and the onetime true-up payment, we're actually in the very high teens, above 16%.

And so -- and you're taking out the DSP deal from last year saying, okay, that if it wasn't in last year, this is what growth would be. Okay.

More of an operating basis for how the business is really growing, yes.

Right. Yes. Okay. So the Spotify Investor Meeting last week, they talked about the fact that they think they have pricing power, the churn is very low and that macro uncertainty -- they implied that price increases are not -- it's not the time. So is that frustrating? And do you think the DSPs are going to move off that $9.99 price for the individual plan?

So I want to be a little careful to start because it's not our decision to be the retailer. We're the wholesaler, we provide the content, it's the DSP's decisions. What I'd say is we have been for years and continue to be really strong advocates that the price value of music is extraordinary especially compared to other forms of streaming media. If you think about it in context of the last decade, where the $9.99 and other prices haven't gone up for a decade, while inflation was cumulatively 20% or 30%, prices just to keep up with inflation would have gone up $2 to $3 across the board. So we think this is always the right time to improve the price value of music and we advocate for that. So what we would say is we don't just talk to one distributor, we talk to all of them. And we do think that Spotify did something important by proving last year that price increases not just where possible, but worked and didn't increase churn. And we think that's an important message to the industry and that, not just Spotify, but others should take note and develop their own pricing plans. And we do encourage each individual distributor, and we hope the whole industry moves up in price. Again, it's outside of our control. But we certainly get to use our platform to promote that whenever we can, and we think there's a lot of pricing elasticity and upside from where we are today.

Understood. How is ad-supported streaming holding up given the macro uncertainty? And how much visibility do you have?

We don't necessarily have incredible visibility. Again, we're the wholesaler for the most part. We don't necessarily receive forward projections from our distributors on how ad-supported is going to perform in the future. But everything we've seen continues to show ad-supported holding up nicely. We have not seen softness. As we reported in Q2, the fundamentals of ad-supported streaming grew nearly 20%, if you adjust that onetime item. And so we continue to be very bullish on ad-supported streaming. Generally, ad-supported has grown right in line with subscription streaming, and we've not seen anything that has caused us to see any change in that dynamic. And quite frankly, as emerging markets roll out further and further, it just creates an even bigger opportunity for ad-supported to grow. So we're extremely kind of focused on that as an opportunity and see it as a substantial growth opportunity around the world.

And the emerging platforms are a new part of the story and most investors are trying to figure out how big these revenue streams can get and if they're truly incremental.

So yes, incremental. Let's start with what we've seen in the past 2 years. So when we went public 2-years ago this month, emerging forms of streaming were running at $100 million annualized. Now it's $345 million for us. And so it's increased really significantly over the past 2 years, one. Two is, during that period, subscription streaming has grown in the 20% range, which is what we would have expected had these new emerging forms of streaming not been as robust. So we have not seen these as being competitive but so much as being additive. We like to say that a home may have a streaming subscription and also a Peloton and the kids will use Instagram and TikTok, and the whole family will use Facebook or Meta. So we see these as additive consumption opportunities. The consumption of music is growing, which I think also helps validate that point. So we see these as generally additive. That doesn't mean that there aren't certain people in a home that you put more time into one platform versus another. But across an average home, we see this as really being complementary and allow music consumption grow and the different ways to explore music, both direct listening of music, but then also multimedia content that has the license music as part of the platform that's becoming a broader and broader part of how each household grows. We see the emerging forms of streaming at very early days. We know that the dollars have grown and the consumption has grown quite considerably, but we still see many of these categories as being early days of their growth cycle. And we see Web3 and all that comes with that tokenization, NFTs, metaverses, as really just at its infancy. And we are working with a series of leading companies across different components of Web3 and working on a series of experiments to help figure out what music fans really want, need and enjoy. So that when we commit to certain products or platforms, that it's not about making money, that it's about connecting with fans of music and tech building their relationship with their favorite artists and genres in music for the long term. So that we're building sustainable business models. And we think Web3 is a significant opportunity going forward that we're really leaning into.

So can you kind of talk about why these deals are structured differently? They're more sort of fixed-rate or buyout deals versus consumption-based? And what needs to happen for the next several years as you renew with these platforms?

Yes. So, great. So these platforms pretty consistently are not music-only platforms. They're multimedia platforms. It's music paired with video or paired with graphics or plugged into a game. And their infrastructure and systems of these companies were not designed from day 1 to track music per stream per point of consumption and report on a detailed usage basis. In order for us to do truly variable deals, which we prefer, these companies need the systems to track music at a fairly detailed level. We are encouraging our partners to do that. It will allow us to move to variable deals. When they don't have that, generally, we do kind of fixed-price buyout deals. When we do fixed-price buyout deals, especially for platforms that are new to music, where we don't necessarily have a history and a track record of the growth of consumption of music on the platform, the accounting standards generally push us to recognize that over the period of the deal on a straight-line basis. So we end up as deals that are straight line over their term. And when they're renewed, let's assume a renewal is also a buyout, then there's a onetime step up on renewal. But until there's a renewal, it's flat. That's why, in part, in 2021, you saw significant step-ups because we had significant renewals and thus far in '22, although there's been nice growth, it hasn't been as robust because there haven't been significant renewals. It's been more about adding smaller platforms into the equation. So that's kind of the dynamic. And again, we're working with all the platforms to really encourage them to develop the systems so we can migrate them to consumption-based deals, which will allow for a more linear growth of this revenue stream. Until then, it's going to be a bit of a mixed bag with some fixed deals and over time consumption-based deals rolling in.

So Spotify talked about the potential in their next renewal cycle for marketplace to play a bigger role. Do you agree with that premise? And are you spending on marketplace? And where would that be if you are?

Well, it would be booked in marketing. And we view it as one tactic on one platform. We are developing our marketing programs across dozens and dozens, if not hundreds of platforms with a series of goals. Some of the programs are designed to build awareness and connectivity to our artists and their music and some are meant to drive consumption. We see marketplace as a tool. It can be a useful tool. We've used it at times. And we'll continue to look at it on a campaign-by-campaign basis.

Let's switch to your other revenue streams like artist services, licensing. They were depressed during the pandemic. How is the recovery going in those lines?

The last 3 quarters have been really positive. Before the past 3 quarters, there was not really much happening in the artist services world. I mean concerts were on hold, which meant that both our concert promotion and tour-merch businesses were really, really quite limited. We've seen in the past 3 quarters them starting to recover. That's flowing through our numbers, there's been strong growth. We think that this is something that is ongoing. There is more recovery to come hopefully in the future over the next few quarters, but we're very encouraged by what we've seen in the past 3 quarters. And I would just note that this is positive to revenue, but these are lower-margin businesses. And as we've signaled over the past couple of years, that when artist services come back, it will start to moderate our margin growth or even flatten it out in the short term because when artist services went on hiatus in effect, our margins grew faster than they would have organically. We've kind of said that we thought margins would grow in the ballpark organically of a percentage point a year. We certainly -- that was consistent with the model at the time of our IPO. And we grew faster for the first 2 years post COVID. Operationally, we were right on plan, but the lack of artist services revenue kind of punched out margin. And now that's going to moderate back and we're going to be right back on the curve we always kind of expected and planned to be. So we're right about where we expect it to be just with a little bit of a sawtooth in there because artist services dissipated for 2 years, but it's now coming back.

And that's including some streaming pressure, right? So this year, the growth is -- had some slowdown, which impacts your margin because that's faster -- that's higher margin revenue that's [indiscernible]

Digital and streaming are higher-margin revenue. And so for sure, again, underlying operationally, our streaming growth is very, very strong. But yes, when you talk about the DSP renewal, that specifically is digital revenue with digital margins.

But you're still getting back to near in line with your projection?

Absolutely.

So how about e-commerce, how is that holding up given the macro environment? And remind us how big that business is?

So our category of advertising and e-commerce generated about $200 million, a little more than $200 million in the first 2 quarters of this year, e-commerce being the biggest component of that. There are other businesses in there that are ad-supported like UPROXX, Songkick, IMGN, which is social publisher, HipHopDX. And in COVID, the first 2 years of COVID, EMP or e-commerce -- European e-commerce division did incredibly well. It was growing in the 30% range, something that we never would have predicted, but the COVID really created an opportunity where people weren't going to stores to shop at retail, and they were moving to e-commerce and EMP got an incredible growth spurt and cycle out of it. We expect over the mid to long term EMP to continue to be a growth engine. We'd expect it to be more moderate in the kind of, call it, high single-digit, low double-digit range, 10%-ish. This year has been slightly challenging because of the war in the Ukraine has created some anxieties in Europe, but also because of the supply chain issues, getting goods, getting them on time requires a much heavier lift than it did in the past. The business continues to do solidly but is now having the complexities of 2022 and is in a position to continue to keep growing over the mid- to long term. So the e-commerce business is fine and healthy, but it's dealing with some of the macro issues that we're all facing, but is really well positioned for longer-term growth.

So we have about 5 minutes left. You had guided earlier, I guess, very beginning of this calendar year, I think, to double-digit revenue growth and margin expansion. Is that still on track? Or is the pressures that you're seeing taking a toll on that guide?

So we don't give guidance, but at the time of the IPO we put a model out there, which was double-digit revenue growth with continued margin expansion. That remains our outlook. We are on track with that. As a matter of fact, we're well ahead of schedule from '20 to '22. And '22 margins are likely to be flatter just because of -- as we talked about, before the return of lower margin artist services revenue, but continues to be on, if not above, the IPO model. And we haven't softened our views on growth or margin. We believe music is resilient and will continue to grow. We continue to focus on our formula to grow margins, which is a continued shift to high-margin digital revenue and managing our cost structure very tightly to maximize margins. So we continue to be focused on delivering on those plans.

So royalty advances have been a hot topic. And can you talk about the impact of streaming on the advances that you pay out and the recoupment process?

Yes. So great question. So royalty advances have been going up because the industry is growing. The industry grew somewhere close to 20% last year, which means music earns more and our ability to recoup is higher. So the first thing I'd say is we have been spending more in advances, and we have always signaled that our waterfall for use of cash, first, we grow our business and generate more cash. But if we see opportunities to reinvest in our business that generate a strong return and our strategic fit that, that will be our first deployment of cash to fuel future growth. And last year was a great example as we grew market share 2 percentage points higher than the overall market, and that requires resources to deploy into music and into globalization to drive that kind of upside. We believe when we invest in music, we analyze our music very tightly and we're investing in accretive deals. We are not investing for market share for the sake of market share. We're investing in accretive deals that help drive our market share. The second part of your question is recoupment. And so when we invest in [ artist ] deals, they are recoupable. And when we invest in proven artists, we capitalize it. We recoup those deals at very, very high rates. We have very modest write-offs. We used to recoup faster than we do now because in a physical and download world, music was paid for by consumers at the point of sale, one time upfront and then consumed over time, and there'd be no further competition. In a streaming world, we get compensated when the music is consumed over and over and over again for years and years and years to come. Well, that means that our recoupment cycle, which used to be short, let's call it, 1 year, now will be a couple of years. It will take longer, but we will recoup and do even better over the long term. So it's really just a matter of timing when we lay out advances. It is money that we recoup and get back. But as the recoupment time is extending as we go from a non-streaming point of purchase world to a streaming consumption world. And as the industry grows and as we are becoming more global, we are putting out more money in advances, but it just means we expect to get more revenue, more earnings and more cash flow from it going -- looking forward. So this really is part of the growth cycle.

How should we think of free cash flow generation then? Just last question.

So we're focused on growing our free cash flow and not every quarter will be the same. Sometimes, there are opportunities to invest in music. That, again, that take our fundamental operating capital and reinvest it back in music to fuel future growth. Other quarters, there aren't as robust opportunities and free cash flow will be higher and we'll save our powder for either investing in the future or for dividends as we've increased our dividends to shareholders as well as we've increased our investment in music. So we continue to focus on growing our business, which will have the effect over time to grow revenue, OIBDA, EBITDA and operating cash flow.

Okay. Well, I think we'll end it there. Thanks so much for being here, Eric.

Thanks, Meghan. Thanks, everyone, for listening. I appreciate the time.