Warner Music: Suspending Dividend, But Everything's Cool. Really (WMG)

Murmurs about Warner Music Group’s (WMG) ability to handle its $2 billion+ debt got louder today, after the company suspended its dividend. But Edgar Bronfman Jr, , asked repeatedly about it during his 2Q earnings call, insisted that everything’s fine, that the company is in no danger of violating its debt covenants. And that they wouldn’t be even if they kept handing out the dividend. Not sure that’s going to quiet the peanut gallery, though.

The rest of the business? More or less the same: Physical sales still falling, digital growing but not enough to compensate.

What will change that? New digital revenue streams that WMG and the rest of the industry have been waiting on for some time. Among the ones they’d love to see: Signficant download revenue from somebody other than iTunes (AAPL), and mobile sales that aren’t ringtones, which have been flattening.

Revenue: $800M, up 2% y/y vs. consensus of $776M. But take out the weak dollar and things look less optimistic: Revenues declined 3.6% on a constant currency basis. Domestic revenues down 13.8%; international up 19.9%, but only 6.7% on constant currency.

OBIDA: $96M, up 20% y/y consensus of $92M

OI: $28 million, up 47% y/y

EPS: loss of 23 cents; consensus of -$0.13. The 23 cent loss doesn’t include another 2 cent loss from discontinued operations. WMG blames miss on tax issues, and tacitly castigates the Street for not understanding them.

Digital revenue: $164 million, up 48 y/y, up 16% sequentially. 21% of total revenue.

The explanation for the dividend suspension, via CFO Michael Fleisher:

“We regularly evaluate our capital deployment strategy. Our Board and our management believe it is sensible to maximise capital flexibility, given the vagaries of both the economy and recorded music market, by suspending our dividend to build cash reserves and reduce net debt. This action will give us the freedom to maintain our level of A&R investment, while enhancing shareholder returns over time.”

Immediate speculation will centre on whether the move means Warner is worried about servicing its $2.27 billion in debt. Now we’re hearings grunts and hints that the EPS shortfall is a tax issue, and that debt service isn’t a problem. We’ll hear more about it during the call.

Earnings call:

Edgar Bronfman Jr:

Strong operating quarter, outperformed competitors. Physical down, slowing ringtone growth, lousy economy. But steering through difficult times. On dividend: “provides flexibility” to manage balance sheet, continue to spend on A&R. As economy gets better, and business gets better, we’ll be even stronger.

WMG market share up, 5th consecutive increase in US market share. Pointing out digital revenue increase. 34% of recorded music revenue. Margins equal to our superior to much larger competitors.

“Stellar” digital results. Ringtone sales “pressured” in US and Europe, but mobile business in Japan is great, and we think that’s precursor for rest of industry. Full track mobile downloads growing rapidly in other markets (off of small base). Supremacy in premium bundled sales on iTunes. Pushing Madonna’s last WMG album with digital deals with Vodafone, Samsung, etc. “Tens of millions” of ad dollars spent by partners to promote album. $13.99 premium CD outsold $11.99 version 8 to 1.

Recapping MP3 deals with Amazon (no sales details) and others. Social media, online important. Mentions imeem again. Nothing we’ve done in the past has been anything like the scale of the joint venture we’re doing with MySpace (and Sony BMG, and Universal).

More “expanded rights” (“360”) deals with artists. Entering into these deals at a rapid pace, all around the world. Deal with Italian concert/promotions company.

Publishing: Stable, diversified revenue stream, which has improved (per earnings note – mechanicals (CD sales) and sync rights (TV shows) down, digital and movies up).

CFO: Rereading earnings release. All data on constant currency basis. Digital: 65% in US, 35% Intl. 30% Mobile, rest online. Most of mobile is ringtones, rest (full track downloads, etc) not meaningful yet.

Blames weak US results on release schedule and crummy overall business. Mentions US retailers “realigning” shelf space. “We are unwilling to cut our prices just to ship product into retailer inventory.”

Taxes: As we have discussed before, income tax primarily based on income earned by foreign affiliates, and other issues related to withholding, etc outside of us. Income tax will fluctuate, but we expect our tax expense for FY 08 to be same as last year, depending on product mix. (CFO speaks clearly and slowly on last sentence, trying to contain fury at Street for getting EPS estimates wrong).


4.25 covenant step down in credit facility, then 4x October 1st. Even with dividend cut, “looks a little tight,” no? EBJ: “I don’t think it’s tight” and I don’t want it to get tight. What has changed? Economy weakened, credit markets tanked, industry troubled. So we think dividend cut helps us there (repeat of what WMG has said three times now).

A&R investments paying off throughout 08 or 09, or later? “How long does it take to cook?” We’ll keep investing in A&R as we have in the past, and our increasing market share shows that it’s paying off. We manage our business at margins that are better than our competitors. “So we see no reason why that should change.”

Concerned about debt convenants? EBJ: “We’re not concerned about our ability to meet debt covenants. I can’t highlight that strongly enough.” Lots of levers to pull. Suspending dividend was the best choice, but even if we had not done so, we wouldn’t have debt covenant issue.

Which digital products, initiatives most important now, later? Broad answer about purchase, subscription, access, purchase, advertising. “Purchase” bucket most important now, subscription gaining traction, access and advertising down the line.

A&R returns trending up, down? Deal prices going up? EBJ: Returns on A&R have dramatically improved since we bought company in 2004 (in part because we’ve been making those returns with lower overhead). Overinvestment in chapter 2 or chapter 3 in artist career has been a problem for the industry. We continue to exercise high degree of discipline when it comes to that. Translation: Big debut album or single? Don’t expect huge payout from us.

Use the baseball analogy: What inning are you in? Also, please talk about retail inventory management?

EBJ? Referring to Goldman note. A&R investments staying steady. 360 deals will start paying off. Enormous success getting more 360 deals without paying more for them. Don’t expect significant M&A activity to increase 360 platform (not buying more concert, t-shirt companies, etc.).

During Christmas season, retailers tightened inventory, and normally when that happens our peers cut prices, but we won’t. We think physical retailers will try to manage inventory smarter and better, and we’re working with them on it.

What is net debt to EBITDA margin? What is digital margin? When do you expect to see meaningful benefit from MySpace?

MySpace Music I think will launch probably around September. I would expect strong December quarter, think it gain momentum until that. So nothing meaningful until 09. Nothing of size at all in 08.

Won’t disclose ratio, but calculation is relatively straightforward. But we were “very comfortable” under our 4.5 ration at end of March, as we had to be.

Won’t disclose digital margins except to say that it’s meaningful and better than physical. Why not cought it up? Non-answer doesn’t please Jessica Reif.

More visibiity into performance of acquisitions, JVs, etc? Nope.

Can we assume that if you take out acquisitions, etc, that revenues were down even more? Also what’s up with Nickleback, Metallica deals? Also, if you’re cutting dividend, why did you bother to acquire Frontline (Irving Azoff’s management company).

EBJ: You’ve got so many premises that are wrong. You’re wrong about our revenues. Nickleback contract doesn’t expire soon. Have two more albums and greatest hits to come. So no pressure on us to get another deal from them unless it’s a good deal. Metallica is at end of contract. We have an album due to go, and we don’t comment on artist negotiations.

We think our Front Line deal was a good one. In addition to financial benefit, gives us good insight into industry changes, trends. And is accretive asset to our shareholders. imeem deal already worth more than what we paid for it based on their fundraising activity.

Confusing question about MP3, DRM. EBJ tries: Will see mix of MP3 and DRM. Clearly, the digital music market continues to grow. Continues to grow at strong pace. Hope is that it continues to accelerate. Digital revenues right now basically iTunes and ringtones. So that’s a very narrow base for a very broad opportunity. (Can’t argue with that).

Assuming that all digital avenues work, over time the “access model” (this is the much-hyped non-plan WMG’s Jim Griffin is pursuing) has opportunity has biggest opportunity to overshadow purchase market.

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