Warner Music: I Do Not Like The Sound Of This

Summary

• Warner Music is a global leader which has seen impressive growth in recent years, having successfully made the move from physical to digital music.
• The company is now going public at quite a lofty valuation after being acquired for just $3 billion and change nearly a decade ago.
• I like the business and the music, yet find current valuations too high to create compelling risk-reward here.
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Amidst the impressive recovery of stock markets with COVID-19 concerns being put to the background, Warner Music Group (NASDAQ:WMG) made a successful public debut. I can see the reason why, as this is a blue chip company with actually some decent sales growth in recent years and diversified operations.

Market conditions have improved quickly and dramatically enough to allow high valued companies to go public again. The combination of a high valuation and modest growth seen in the long run prevents me from jumping aboard.

The Business, A Music Powerhouse

Warner Music hardly requires an introduction as it is one of the leading music entertainment companies. The company has well-known labels which include Atlantic, Warner, Elektra and Parlophone. Besides having signed up many large artists including the likes of Ed Sheeran and Bruno Mars, the company has a publishing business with a big catalog as well, including more than 1.4 million compositions.

The record music business makes up about 5/6 of total revenues, being a near $3.9 billion business, complemented by the music publishing business with more than $600 million in revenues per annum.

The company itself of course claims that its role is more important than ever as global barriers for widespread distribution have been erased. Not only are more tools available to create music, the entire world can easily be reached through digital platforms. This has a backdrop as well, as talent might find it harder to distinguish themselves, although that claim can be debated of course as real talent will still surface through such platforms.

The company was acquired by Access in 2011 for $3.3 billion from its former parent Time Warner, and in the near decade long period which followed, sales have steadily grown, among others, by the half a billion GBP purchase of Parlophone in 2013 in order to bolster European operations.

IPO And Valuation Thoughts

The selling shareholder Access initially aimed to offer 70 million shares in a price range between $23 and $26 per share. Solid demand meant that the offering was priced just above the midpoint of the preliminary range at $25, and that the size was upped to 77 million shares, translating into gross proceeds for the selling shareholder of just over $1.9 billion.

With 510 million shares outstanding, equity of the business was valued at $12.8 billion at the offer price of $25 per share, as the nature of the offering and dual class holdings still makes this a controlled company. This valuation even excludes a $2.5 billion net debt load assumed by the company as of March, boosting the enterprise value to $15.3 billion at $25 per share. Trading at $30 on their opening day of trading, the enterprise valuation comes in closer to $17.8 billion.

In exchange, it should be said that Warner has seen pretty solid growth, with sales increasing from $3.6 billion in 2017, to $4.0 billion in 2018 and $4.5 billion last year. For the first six months of the fiscal year of 2020, sales growth has come to a near standstill, up just over a percent.

For the year ending 2019, the company reported an operating income of $356 million, yet that was after already incorporating a $208 million amortization charges. If we adjust for this, adjusted operating income came in at $564 million, versus a reported "OIBDA" number reported by Warner of $625 million. The gap of $61 million is explained by depreciation charges, which is a real expense of course.

Working with the $564 million EBITA number, we can construct a sort of pro-forma P&L. With net leverage seen around 4 times based on the net debt load and OIBDA metric, I see interest charges at $125 million a year, assuming borrow costs around 5%. Working with a 15% estimated tax rate (by myself), I put net earnings potential at around $373 million. With 510 million shares outstanding, earnings potential runs around $0.75 per share, translating into sky-high and too high multiples in my book.

With shares moving higher to $30 on their opening day, it is clear to say that multiples have expanded rapidly to about 40 times earnings, despite a sizable debt load.

Final Thoughts

I have some real reservations about this public offering. Being impressed with the revenue growth displayed by the company in recent years, growth rates have leveled off. The big concern is that of a valuation at around 40 times earnings and leverage ratios being elevated around 4 times. Nonetheless, this is a very steady and stable business, yet the true long-term prospects for the business can be debated. Of course, one can argue if artists still require record labels the way they needed them in the past given the rise of platforms which can uplift artistic talent without requiring the services of record companies.

The good point is that a great part of transformation is handled well. The move from physical to digital has been more or less completed, as consumers use online platforms in greater numbers, while piracy is not such a big issue as perhaps feared.

While Warner seems quite proactive to fend off changes to its business model, and probably will do a reasonable job on that, I simply fail to see great appeal based on the simple observation of a 40 times earnings yield, in combination with a 4 times leverage ratio. Even as deleveraging might allow for some further earnings growth, I can only conclude that while I love the music of some of Warner’s artists, the same cannot be said for the stock.

Analyst’s Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.