Warner Music Group: Not Enough Margin Of Safety (NASDAQ:WMG)

Company Description

Warner Music Group (NASDAQ:WMG) – Consumer Discretionary – Entertainment

Formed in 2003, Warner Music Group is one of the world’s major music entertainment companies which has under its umbrella a family of iconic record labels, including Atlantic Records, Warner Records, Elektra Records, and Parlophone Records. In addition, Warner Chappell Music, its global music publishing business, boasts an extraordinary catalog that includes timeless hits. It operates in two integrated segments: Recorded Music and Music Publishing:

• Recorded Music segment (82.5% of TTM sales) – it involves the sale, marketing, distribution, and licensing of recorded music produced by the company’s recording artists. The segment derives revenue from four primary sources: digital, physical, licensing, and other avenues.
• Music Publishing segment (17.5% of TTM sales) – it involves the processes of signing, acquiring, and managing rights to musical compositions, subsequently licensing them for use across various formats. The segment derives revenue from five primary sources: performance, digital, mechanical, synchronization, and other avenues

Business Performance

Cycle – Mature Growth

Warner Music Group is the world’s third largest pure-play music content company with a long-term track record of delivering robust operating performance.

Over the last four years, we have observed a positive business trajectory with sales growing at a CAGR of ~9.8%. Now that trend seems to be cooling, with sales being up a shy 0.5% on a TTM basis (recorded music down 1.2% TTM and music publishing up 9% TTM), reflecting ongoing weakness in the ad market and a lighter release schedule. However, some of the weakness seems to be easing, as underlined by Spotify (SPOT) during the 3Q23 earnings call:

Advertising business has improved throughout 2023. So we’re hoping that advertising can continue to be a driver in 2024 as well.

On the margins side, we can observe gross margins being under pressure due to rising A&R expenses and, operating margins being up driven by headcount reduction which translates into meaningful savings. FCFF margin stands at 10.6%, above the historical 4-year average, due to lower CapEx (CFI to CFO ratio stands at 0.22x TTM vs 0.88 4-year average). Warner Music Group’s ROCE stands at 19.9% TTM (above S&P 500 ROCE) which is well above the Company’s cost of capital of 11.44%. This underlines the fact that expansion creates value. ROE stands at 182.4% TTM, driven by interest-bearing debt expansion (Net D/E is ~ 12.35x TTM).

The balance sheet is stable with a Debt/EBITDA of 4.07x (net Debt/EBITDA of 3.5x) and interest coverage of 5.29x TTM. Such high debt/EBITDA is one of Moody’s red-flag for a potential rating downgrade:

Ratings could be downgraded if competitive or pricing pressures lead to a decline in revenue or higher operating expenses (e.g., increased artist and repertoire (A&R) investments), EBITDA margin contraction or sizable debt-financed acquisitions increases debt to EBITDA above 4x (Moody’s adjusted) for an extended period of time. There would also be downward pressure on ratings if EBITDA or liquidity were to weaken resulting in free cash flow to debt sustained below 7% (Moody’s adjusted).

Valuation

Warner Music Group trades slightly at a premium to its intrinsic value.

Under my conservative scenario, and incorporating a margin of safety of 20%, it suggests a target price of $30.84/share or a premium of 6.27% vs. the current price of $32.90/share.

Over the next 10 years, I assume sales will grow at a CAGR of ~10.17%, slightly above my expected growth for the overall industry, among others driven by greater device penetration, DSP price hikes, and global footprint expansion. On the profitability side, I expect the margins to improve and to converge towards that of Universal Music Group (OTCPK:UMGNF), which I see as the true market leader, driven by disciplined operating performance and higher operating leverage in streaming.

In particular, during the 4Q23 earnings results (expected to be announced on November 16th), a margin miss may result in a significant drop, as the Street expressed concerns about margin expansion reaching its peak during the 3Q23 earnings call.

Catalysts

In my opinion, the following should represent a potential tailwind

1 – DSPs price increases

2 – Stronger than-expected ad market

3 – Net/EBITDA convergence toward the optimal level (i.e., de-leverage)

Risks

However, in my opinion, there are also a series of risks on the downside that we should consider:

1 – Increase operating expenses (i.e., pressure on margins)

2 – Lower-than-expected monetization of new streaming opportunities

3 – Credit Rating downgrade (e.g., due to sizable debt-financed acquisitions)

Final Remarks

In my opinion, Warner Music Group is a great company which, however, does not offer enough margin of safety.

In the long term, the analysis suggests that the company is well-positioned to capitalize on the secular growth opportunity driven by the streaming era, however, it is not the champion I would bet on to capitalize on those opportunities. In my opinion, Warner Music Group’s price performance is likely to underperform those of Universal Music Group, as I outlined in my article, which I see as the true market leader due to higher margins, a stronger balance sheet, and greater scale.

Overall, I rate shares with a “Hold” rating and a fair value of $30.84/share.