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

Okay. Let's get started with our next session today. Thank you, everyone, for taking the time to join us. My name is Stephen Laszczyk, and I'm the lead analyst for the music sports semi-events sector here at Goldman Sachs. We are excited to welcome back to Communacopia this year. Steve Cooper, the CEO of Warner Music Group. Steve, thanks for being with us today.

Thank you. It’s a pleasure.

So Steve, earlier this summer, you announced that after 11 years, you'd be stepping down as CEO of Warner Music Group, and the Board will begin the process of searching for your success here. Could you talk a little bit about your decision to step down? What skills do you think are most important for future CEO? And what opportunities you believe are most critical for your successor to execute against?

Well, my decision to step down was pretty straightforward. I just think that after a certain amount of time, any business needs fresh eyes and 11 years seemed long enough. So that was pretty straightforward. I think that the Board will decide on all of the strengths that my successor has to have, but I think that certainly understanding of content and understanding the interface both with the existing and potential technology that will provide a greater expansion than we have today of opportunities for music will be necessary. So I think that, yes, those 2 content and technology.

Understood. We'll get a little bit deeper into content and technology. But first, I wanted to dive into some of the key debates on your stock, most notably with streaming, so paid streaming and ad-supported streaming have been the 2 primary growth engines of your business for the better part of the last decade. That said, traditional streaming growth of Warner has decelerated over the last year. Could you maybe spend some time talking about the factors behind this recent deceleration? And any expectations you have for growth reaccelerating over the next several quarters?

Well, let me take the last part first. We believe that streaming still has an enormous amount of runway. In fact, I think Goldman Sachs believes it’s streams has an enormous amount of runway. We see still tremendous opportunities for growth in mature economies in emerging economies in traditional streaming, in emerging streaming. And we're very confident that the Web2-oriented streaming opportunities are going to continue to grow. We also believe, and we've invested heavily in it. I'm absolutely convinced or Head of our peers in embracing the potential of Web3 that, that will also open up an enormous new array of opportunities for the utilization of music. So if you look at where we were 10 years ago, we were the industry, and Warner, we were in whatever the industrial juice squeezer was. And when I look at where we were then, where the industry's revenues had fallen by 2/3. Piracy was ramping and enormous industry consolidation and living on thin ice. Today, we are on very thick ice. We think the outlook is absolutely positive. And as Web2 continues to grow or the services provided through Web2 and Web3 comes on stream, we think that the outlook for the industry in Warner in particular, because we positioned ourselves for that is just great.

What about drilling down, I guess, into the recent deceleration and what it will take to get back to that long-term double-digit growth rate that we've seen historically and streaming? And other key things and investors should keep in mind and pay attention for the next couple of quarters?

Sure. Well, look, I think there's always hiccups. -- nothing is a perfectly straight line. I think that on the ad side, certainly, there's been an impact from macroeconomic influences. I think on the subscription side that business is very sticky. We had some white noise around our last quarter's reporting, which will clear out by the end of this quarter. But importantly, one of the things that we are beginning to see and hope to see on a regularized basis is price increases in addition to just the number of people that will still be signing up for either free or subscriptions in further penetration of smartphones. But I think between the normal growth between price increases that getting to and sustaining double-digit growth is highly likely.

You mentioned price increases coming from one part of the market, which is people up tiering and to pay subscription packages. I'm curious your price increases more broadly in some of the DSPs have selectively increased prices this year. So we've got to see the broad pricing increases that you and I think a number of other rights holders have been making the case for over the last few years. And could you maybe give us your thoughts, your latest thoughts on the opportunities, and potential timing of some of these broader price increases? And is there anything you're perhaps willing to do to help incentivize the DSPs to make that move?

Well, I think that one of the things the experiments have shown is that music subscriptions, a, are very sticky and b, they got enormous value. When you look at the value proposition in music versus video, it's -- that spread is unbelievable, which leads us to conclude that, that particularly with the stickiness and almost non-existent churn that services can easily raise the monthly subscription by a fraction, and they can do it on a regularized basis. We're hopeful that given historic, current and what I'm sure will be future discussions that the DSPs will ultimately see the need to raise prices, raise them regularly and have a more rational relationship between the price and the value that's being delivered.

Any sense on the potential timing of that? It seems like we're building momentum or have built some momentum over the last couple of quarters. Do you think we're at or close to a watershed moment for price increases?

Well, when I look at the DSP models, I would conclude fingers crossed that those increases will come sooner versus later.

Makes sense. I want to dig into the DSP economics splits a little bit a few quarters ago, you announced that you renegotiated a deal with one of your DSP partners, which resulted in a lower payout rate. I appreciate that this particular deal was perhaps a little bit unique, but I think it reignited some concerns out of the investment community that the economics within the industry could still shift. Are the economic splits between right holders and distributors still in flux? Or do you think they've reached an equilibrium?

There's a sold phrase, "no good deed goes unpunished." And we experimented on a deal. And the deal was designed to allow the other side of the experiment to be far more free and active by way of shaping your service and a quid-pro-quo was an economic package. The experiment didn't work as well as we hoped. But that being said, when we renewed the deal, it renewed within a very tight range of all of our other deals. We are currently in renewal processes with a number of DSPs. There's really little or no talk about economics. The talk is about functionality. The talk is about direction. The talk is about offering peripheral services. But I think economics in the main have settled, and I don't see much change, if any, in the splits for the foreseeable future.

You mentioned functionality and other services that could be provided. Could you maybe talk a little bit more about this?

Sure. I think that the Apple spatial sound has had a big impact on their service. I think others are looking at that with these new functionalities. We're looking at price points that will compensate content providers for these new technical services. We are talking to the services about different use cases for music by way of example, small clips. So as we look at this different functionality, as we look at different use cases, the economics within these narrow brands will be a little plus, a little minus. But settle, I think essentially where they currently are.

Understood. A little bit earlier ago, you mentioned some of the opportunities in emerging platforms and Web3, music's increasingly being incorporated into emerging services from social media, short-form video, connected fitness, NFTs, and so forth. Could you maybe talk a little bit more about how Warner's expecting to benefit from some of these trends and the evolution of these contracts with emerging streamers and how investors should expect that to play out in terms of the pacing of the emerging platform revenue growth?

Sure. So in Web2, and then I'll deal with Web3, in Web2, we have on an economic model basis, two primary models, putting aside ads. We've got the normal subscription, which we have it sloted by Apple, YouTube, whatever. And then we have what are essentially buyouts. And the buyouts are more closely associated with the emerging models on social platforms. Why buyouts? Because the platforms and we aren't sure about the breadth and depth of how music will be adopted, and we're not sure about the growth trajectory. So from our perspective, better to be safe than sorry. And hence, we lean towards the buyout model. As those models begin to mature, as we see the growth, as we see the trajectory, as we see the use cases, we will and they will collectively shift from a buyout to a use case model where we participate more directly in the growth of music on these emerging platforms.

Where are we at in terms of that cycle of switching from the buyout model to maybe more consumption or usage-based? And there's back-end tech infrastructure needs to be built at some of these platforms. Are we close to them being at the point where it has the possibility?

If I could answer that precisely. I'd be in a different business. But I think we've got a couple more turns at the buyouts before we see the social, the fitness and the other socially-oriented platforms have enough of a history and have done enough experimenting to really make that turn. So what you'll see is with the emerging platforms, we'll continue to see a step function. There will be a 2-year contract. It's a buyout then a step function on the next buyout. But ultimately, as we convert that, we'll see a line as opposed to a step.

Understood. Another key component of Web3 is decentralization and aims to shift ownership and economics away from digital platforms towards more individual creators. And I think for that reason, Web3 is viewed by some as a potential risk to write owners into platforms. Perhaps maybe you could talk a little bit about Web3 and decentralization and maybe how that applies to music labels and if you see it as a risk?

Well, we see it as an incredible opportunity and actually not a risk. It would be I think a lot of people when they hear the word decentralization, that to them means simplification. And it is anything but. So when you talk about these [ tower ] or these decentralized autonomous organizations, they require structure. They require interaction. They require the tokening or the tokenism within these communities. They require the rules and regulations around accretion of value, decretion of value. And when you bring in these decentralized worlds, people together, particularly creators and you look at moving them to success, it is anything other than a straight line. And because of the complexity, I mean, just by way of example, Web3 is going to be more complex than Web2 because Web3 is interactive and Web2 is essentially bilateral. In Web 2 today, on any given day of the week, roughly 100,000 tracks of music are uploaded to SoundCloud, Spotify, Apple, so on and so forth. The complexity of being able to separate one’s music from the other 99,999 tracks uploaded that date is incredibly complex, incredibly difficult. In Web3, it's going to become even more so because of the interactivity required in Web3 to bring a creator to prominence, to keep a creator prominent, to keep that content a live, active responsive on a 24/7 basis. Most creators don't have the capital, the skill levels, the expertise to do all of that and be successful. So we look at Web3 as tremendous opportunity. That's one of the reasons we've invested so heavily in it. And what we're doing is if you think of Web2 as one bucket and Web3 is another bucket, we're building these so that we can move our artists/creators, seamlessly between the 2 and seamlessly within all of the various worlds that are going to exist in Web3. And that isn't simple.

A lot of value being added by the label.

Yes. An enormous amount.

Let's shift and discuss some of the ways you're investing for growth and to build the pipeline of artists that can go into Web2 and Web3. And Warner has been very active on the A&R front this past year. Can you talk a little bit more about your A&R strategy from a holistic level, maybe the competitive environment that you're seeing for talent and the types of returns you expect to generate on the capital you're deploying today into A&R?

Sure. So I'll start with your last and work backwards. We put an enormous amount of resources into A&R. And our expectation is that we get on average because we run a portfolio, mid-to high-teen returns. In running that portfolio, what we've done over the last number of years is reduce our dependency on superstars because we do run a portfolio. And in reducing that dependency, it has allowed us to continue to reinforce our approach to A&R, which is long-term artist development. We try and find artists at the beginning of their career so that we can build their career with them, but build them on a set of economics that we believe are reasonable and rational as supposed to as opposed to economics that we often observe in other deals that, frankly, we don't understand. So philosophically, we find a new authentic emerging artists. We expect meaningful mid- to upper teen rates of return on average. With respect to the environment, people will ask are deals becoming more expensive. The answer is oftentimes yes, but they're becoming more expensive because we're generating more revenue. And obviously, we're growing our bottom line and our artists participate in that growth. As artists become more successful and are more important in driving growth with us, do we reevaluate the contracts and adjust? Absolutely.

It seems like there's been a step up in activity on the A&R front coming out of COVID. Is this in response to there just not being a lot of activity over the last 2.5 years during the pandemic? Or are we seeing a stair step higher and then the level of activity you expect on the A&R front?

No, we were very active during COVID in signing both artists and songwriters. I think there may be a little bit of an element of catch-up, but I don't see our A&R growing explosively over the next few years. I don't know about our competitors, but we try and be very, very thoughtful and very focused. And we don't chase -- we don't chase the heat. By way of example, when Taylor Swift moved from Big Machine to Universal. She got a monster check. She got a very, very skinny distribution charge. We don't do those deals. There is not, from our perspective, the right set of economics. And we don't chase big names to get a little bit of revenue and not make any money, that's crazy. So we don't do it.

Makes sense. Maybe shifting gears a little bit in terms of investments in the core business. You've also invested in growth by buying record labels recently, especially in emerging markets to help geographically diversify the business. Can you give us an update on your strategy for international expansion and how M&A plays a part in that today?

Sure. We follow markets that where we see legitimate distribution on the upswing, piracy on the downswing. And then we identify those markets where we see meaningful growth. When we go into those markets. We do it in a very deliberate fashion. We go in typically starting with commercial relationships and oftentimes a minority interest. In many of those markets, when we do that, we also negotiate but don't have to exercise a path to control. Why? A, we believe we've identified in those markets, the best partners by way of label, publishing, distribution, but we prefer to have a test period before we decide to exercise control. We did this strategy if you followed us closely, we identified a number of years ago, MENA, the Middle East, North Africa is an explosive area for growth. Population was growing rapidly. It's embracing the music. The economics were growing rapidly. So we -- with companies in those areas, we began to plant the seeds and between Chocolate City in Nigeria, Africori distribution in North Africa, our minority interest in Rotana and the acquisition of Qanawat, which we announced a quarter or 2 ago, we have taken our share in one of the fastest-growing markets in the world from roughly 10% to about 30%. And so we have built in that area in order to go back to a cold war phrase, an iron curtain where we have strategically built these opportunities to put an arm lock on that market. And that's how we do it. It's got to be commercial first, minority, path to control, testing the partnership, testing the relationships. It's just not about spending money to buy something and watch it go down a rat hole.

Is that the goal on the market share side to perhaps get from this 10% level today in newer markets up to 30% with these investments in emerging markets on average?

No. The goal is to invest very smartly and obviously to build market share, but not to have a predetermined view of what we need in a specific market because market shifts, technology shifts. And we want to maintain, which we've done over the last 5 or 10 years, the ability to be very agile to move quickly as we see opportunities and not embed ourselves too deeply that we find from a retrospective point of view that we overspent or overbuilt or overdeveloped in a market that's never going to provide the economics that we need by way of return.

Makes sense. One of the other key topics of conversation in the past year or 2 has been in the music royalty catalog space. And a lot -- you have been very active on this front of many other investors, especially those who have been more financially oriented, and it's, I think, attributed in multiples going higher in the space over the last number of years. Maybe could you just talk about why you're investing in music catalogs? Why do you think it's a good use of capital today? And how do these strategically fit into your business model?

So a couple of distinctions. We invest in catalogs we don't speculate in catalogs because I would argue that when you're talking about 30-plus multiples, and you're a financial investor, and you don't have the organization and the operation to manage that asset, you're speculating, you're not investing or you're just moving fixed income dollars from what is perceived as a bond to a quasi bond. When we look at catalogs because we're operators, we look at those catalogs and say, have they been undermanaged, have they utilized all of the things that, that catalog can utilize to make money and how do we rate them? If we see a well-managed catalog that is managed itself by way of ensuring that it's got a vibrant sync operation, ensuring that it has got the right metadata matching operations. So none of the revenue falls through the cracks that it did it, and they want 30x. We wish them the best of luck. When we see catalogs that we believe are under-managed, and we see substantial headroom for uplifting the revenue that has been historically generated, eliminating sub-publishers, putting a team together to manage sync, TV and film, live, so on and so on and so on. And we can get it at the right multiple, knowing that within 12 to 18 months, we can bring a multiple down from x to 0.5x or 0.6x. We make the investment. But we do that because we know how to activate the assets because we operate those assets. So for us, it's not -- for us, were strategic investors, not financial investors.

Understood. Let's shift for a moment and talk about margins. Last year at Communacopia, you stated that you saw scope for your adjusted EBITDA margin to expand into the mid-20s, which was an improvement from the guidance that you gave during your IPO of low 20% or the low 20% range by 2024. So what gives you confidence that you can achieve margins in the mid-20s and perhaps even greater over the long term?

Well, a, we believe some things we've already talked about that we'll see price increases across any number of our lines of business. We know what we're doing internally between our transformation activities, which are designed to make us more cost-efficient, cost avoidance. We know what we're doing with our fit program is going to generate substantial annual savings. And in addition to that, will allow us to hang on to those systems tools so that our ability to -- with these PORs around the world to match metadata to ensure that revenue doesn't drop through the cracks. All of that's in process. At the same time, we knew that there would be, for lack of a better term, a short-term plateau after -- we had hoped after COVID disappeared. But I guess as COVID dissipates or becomes less important, it is our lower-margin businesses that were tied to non-lockdown activities, live, merch, artist services would come back and would for a short period of time dampen the growth of our margins. That being said, it's all good news. I would rather have the core businesses that continue to grow at very robust margins and also have our other businesses returning to health because even though there is an intermediate-term where our margins are dampened, revenues going up, cash flow is going up, the bottom line is going up. And I would make that trade any day of the week.

Got it. You mentioned cash flow. Warner Music has historically converted about 50% to 60% of adjusted EBITDA into free cash flow. But recently, that conversions dipped given some of the elevated levels of investment that we just spoke about. How do you think about balancing opportunities between investing in the business over the near term and the goals of maximizing free cash flow generation over the long term?

Well, I think that 50% to 60% is something that should be expected and will be delivered on year in and year out. Our cash flow are flow in and our flow out from time to time is very lumpy. So when one looks at conversion on a quarter-to-quarter basis, can be either above or below, but when you begin to look at it over a 12-month period, it typically comes to roost in the 50% to 60% conversion ZIP code. And I think that's probably a very good range to think about our cash flow conversion in the future.

Got it. You made it pretty clear in the past that you do not expect Warner Music to delever the balance sheet. Do you anticipate being able to find enough good opportunities to invest back in the business over the long term? Or do you think capital returns to shareholders could become a bigger part of your capital allocation playbook over the next couple of years?

Well, I guess all things are possible. But our priorities are paid to reinvest in the business, and we have not seen any meaningful contraction of opportunity flow. In fact, we've probably seen an expansion. And I would think in certain categories as interest rates continue to climb, or as potential targets get buffeted by inflation that our opportunity set may well pick up. So at least as I see things today, our opportunity flow remains very, very robust. What we've always said is that's our first priority. Our second priority, if, in fact, those opportunities begin to shrink is to return capital to our shareholders. And our third option is to pay down debt, but the way we have historically in the way we will continue to delever is through growth. And so with our debt, it's a bit over 3% and I think most of our debt goes out to the late 20s. We see no reason, given our other optionality to actually write a check to pay that down.

Got it. Final question for me. Looking out over the next year, what do you think will surprise investors the most about Warner Music or the music industry more broadly during your last 12 months or so as CEO?

Well, I think that one of your first questions, I said the industry was in the manufacturing version of a juice press. I think we are well out of that. I think that I know at Warner, we are incredibly well positioned to take advantage of the opportunities that we see beginning to flow out of Web3. And so I think -- for me, it's an expectation that over the next 12 months, we’ll continue to grow at a very nice pace. Hopefully, that won't be a surprise to our investors. But I think that music, it's just -- it's entwined in people's DNA. And while there's always going to be bumps in the road. I think the resiliency, the utilization, the new opportunities that are going to be emerging for the use of music will surprise a lot of people. And we intend on being there as #1.

It's a great place to end it. Steve, thank you so much.

Thank you. Appreciate it.