Description

I wrote this last week as my application idea. Up to then there was no write-up on the labels on VIC yet. Since then, Kerrcap published a good write-up on WMG and on the industry. Then on Monday, Apple Music announced its price increase, which pushed the valuation up a bit. But it is also strenghtend the thesis as further price increases at streaming services are becoming more likely.

Summary
You can buy Spotify (SPOT) for hope and dreams, or Universal Music Group (UMG) for free cash flow and returns. Music labels carry by far the best economics in the industry and are the best way to play the secular trends in the music industry. Despite this, there is only one write-up on the labels (WMG), while SPOT already counts five (three long/two short). UMG’s long-thesis summarized: the largest and best music label, monopoly-like content, high-margin royalty revenues, long runway of double-digit earnings growth with an underutilized balance sheet for 21x P/E.

Industry overview
In terms of content, music is a much better business than video. First, content is more concentrated with the big three labels representing close to 70% of the industry’s revenue. Second, distributors have limited exclusive/proprietary content. Third, catalog (songs that are three years or older) makes up >60% of revenue, making labels less dependent on new hits. Fourth, a distributor needs content from all the major labels, missing one, means your service sucks. Labels essentially have a monopoly on each of their artists. No matter which service will win ten years out, each of the labels’ content are a must-have.

The role of a label is to discover, sign and help artists to make it big. The label makes all the required investments in developing the artist and pays the bill for the related marketing, promotion and distribution expenses. This business is akin to venture capital, where the majority does not make it, but some will be a home run (e.g., Taylor Swift, Drake, Justin Bieber). In return, the label receives the copyrights to a certain number of recordings (4-5 albums). Each recording has two copyrights - the master recording (the original recorded song) and the song composition (the lyrics of the song). Labels typically own the master rights. They also own the majority of the publishing/composition rights. Copyrights differ per region, but generally last for 70 years after the author’s death. Labels monetizes these right and share ~15-25% of revenue with the artists.

Revenue in the industry is roughly split 80% recorded music and 20% publishing. In recorded music, UMG leads with 32%, followed by Sony Music Entertainment (SME) with 21% and Warner Music Group (WMG) with 16%. In publishing, SME has 25%, closely followed by UMG with 23% and WMG with 11%. The remainder consists of many small/local labels and Merlin who represents ~45% of independents.

Business overview
UMG owns a collection of >3m recordings that account for ~1/3 of the industry’s revenue. They also have the best artist & repertoire (A&R) platform in the industry, as evidenced by UMG’s track record in breaking artists. Their artists consistently represent 60-90% of the top artists/songs/albums on rankings from Spotify, IFPI and Billboard. This makes them the first choice for many upcoming artists.

In the pre-streaming era, labels earned the majority of revenue from new releases. Today, UMG generates ~60% of revenue from catalog. Profit wise this is somewhere between 75-85%, as the bulk of expenses relate to new artist/song development. Existing catalog needs little marketing, making it a high-margin and stable stream of royalties. Hence, private equity’s interest in this space. Artist development may be lower margin; however, it is the source of future valuable catalog revenue.

Scale is key in expanding your IP. UMG generates ~30%/~60% more revenues than SME/WMG. Providing UMG with more firepower to spend on A&R and catalog investments. For example, in FY21 UMG spent close to $4bn on A&R versus $1.8bn for WMG. Despite their smaller scale, WMG only spent 33% of revenue on A&R versus 45% at UMG. SME does not disclose this. Since SME only accounts for 11% of Sony’s revenue, it is fair to assume that they do not get the same attention as its pure-play peers. UMG continues to attract the best talent and generate the most valuable catalog. Since labels earn the majority of revenues based on their share of listening time, UMG continues to outgrow its peers. Over the past four years, UMG outgrew its peers by ~200bps per annum.

Streaming is the primary growth driver for the labels. Since 2015, streaming revenue grew at a ~25-30% CAGR. It went from 19% of UMG’s revenue to >65% today. This is higher on EBIT, as streaming carries higher margins. It is also higher quality revenue. More than 75% of streaming revenue comes from paid subscription, shifting the business away from its historical hit-driven business model towards a recurring one. I expect streaming to be resilient even during a recession. Music is one of the most consumed forms of entertainment and costs only ~$10 per month. I suspect that the majority of consumers rather cancel one of their SVOD subscriptions or forego other expenses before cancelling their music subscriptions. Ad-supported streaming may be more sensitive to macro, yet accounts for only <15% of UMG’s revenue.

I believe we are still in the early innings of the streaming adoption curve. Today, roughly 11% of global smartphone users have a music streaming subscription. This number is 34% in developed markets (DM) and 6% in emerging markets (EM). DM accounts for >80% of UMG’s revenue and will be the main driver going forward. There is still plenty of room for penetration rates in DM to climb upwards. We only have to look at Scandinavia, home of SPOT and the earliest adopters of paid music streaming services, where penetration rates are already at 56% and still growing. Nonetheless, the biggest subscriber count growth comes from lower ARPU EM countries.

There is also a huge pricing opportunity. Music is vastly undermonetized, especially considering that one music streaming service offers access to all music content instead of just a subset like in SVOD. While Netflix increased its US standard price by close to 80% since 2014 (~7.5% CAGR), SPOT’s US standard price remained flat at $10. SPOT already raised prices in 46 markets and did not see any meaningful impact on churn rates. They repeated many times that they have pricing power and hinted on this week’s earnings call that a price increase in the US is imminent. SPOT is not the only one. In April of this year, Amazon Music announced it’s first-ever price hike of 13% for the US, UK and Canadian markets. This week, Apple also announced its first price hike of 10% on subscriptions in their major markets (incl. US). This could be the inflection point of a series of price hikes, similar to Netflix in 2014.

In addition to streaming, music starts to play a larger role in non-traditional channels, such as social media, fitness, gaming etc. Four years ago, these emerging streaming platforms generated zero revenue, today it is ~5% of both UMG’s and WMG’s revenue. Sell-side expect this part of the business to grow at 30-40% CAGR over the next five years. The key takeaway is that monetization of music is ramping up, benefitting the ones with a large and growing catalog.

Valuation
UMG guides for high-single digit organic revenue growth with EBTIDA margins going from ~20% to mid-twenties in the mid-term. This excludes any price initiatives from the streaming providers. If these parties start to raise their prices by a few percentage points each year, organic revenue growth could easily hit 10%+ and earnings mid-teens for many years to come. UMG trades at 21x 2023 earnings, which is not demanding given its growth profile, monopoly-like position, resilient business model and strong balance sheet (1x ND/EBITDA).

UMG requires little capital to maintain its business. It even enjoys a working capital benefit (~3% of revenue), as UMG receives royalties from its customers and pays the artists with a delay. However, when UMG invests in new music, they pay artists advances that are recoupable from future revenue streams of the related recordings. Hence, this causes a timing-lag that more than offsets the working capital benefit. If you treat these advances as growth capex, FCF/NI conversion runs at >100%. If you treat it as regular capex, it is ~90-95%. The company uses its FCF to acquire catalog/local labels, pay a ~2.5% dividend yield and in the future likely buybacks as well. Without a re-rating, I expect an IRR of at least 15%.

UMG also looks attractively valued relative to WMG. UMG should trade at a premium to WMG to reflect its greater scale (market leader versus the number three), higher margins, better track record, a stronger balance sheet (1x ND/EBITDA versus 3x at WMG) and superior corporate governance (WMG is controlled by Access Industries that via Class B shares holds 98% of the voting rights). Despite all of this, WMG trades at 26x 2023 earnings (a ~20% premium to UMG). This is even more illogical, considering WMG’s focus on managing margins and free cash flow. Even with UMG’s scale advantages, WMG’s margins are close to those of UMG (18% vs 20%). The easiest way for a label to improve margins is to cut back on A&R. If UMG would lower its A&R spending from 45% of revenue to WMG’s 33%, it would instantly increase earnings by ~40%. This would bring UMG’s 2023 P/E to ~15x. I doubt UMG would do this, as it is run for the long-term. However, it does support the case that UMG should trade at a premium to WMG.

Why now?
There are two near-term catalysts that could unlock further upside.

Capital returns
Management said to be working towards a more optimal capital structure with the aim of returning more capital to shareholders. They are willing to increase leverage to 2.5x ND/EBITDA. UMG already has authorization to buyback 10% of its shares, but no plan in place yet. In a September conference call, management hinted that buybacks are on the agenda at the next board meeting in October. This is also the first meeting that Bill Ackman will attend, as a recently appointed board member. Pershing Square owns 10% of UMG and it is their largest holding (>25% of NAV). Ackman has been vocal on the potential for UMG to lever up and increase capital returns. If they would lever up to 2.5x and use the proceeds for buybacks, they can reduce their share count by ~10%. This reduces the multiple to ~19x.

US listing
UMG’s European listing is one of the main reasons for the discount to WMG. Similar to WMG, UMG is a US-headquartered company with half of its profits from the US. Ackman mentioned several times that the company could address this over time. He already held discussions with the NYSE about a potential dual listing. According to Ackman, the NYSE likes the idea of a UMG listing and have already pre-cleared the company. With Ackman now on the board and UMG being his largest position, I think it is a matter of when, not if. This should help narrow or even turn the discount to WMG into a premium.

Risks
There are several bear arguments on the labels, but they appear exaggerated and the current valuation more than compensates for them.

SPOT has the bargaining power
SPOT bulls claim that as SPOT grows bigger, they can negotiate a lower royalty share with the labels. I disagree. SPOT’s business model would not work without each of the three label’s content, while labels can easily survive without SPOT. If UMG would pull its music, SPOT’s offering would immediately be inferior to its peers. UMG would only see a brief 20% decline in revenue (SPOT’s share of UMG’s revenue), which it would likely recover quickly as consumers switch to an all content streaming service.

The value-add of a label declines in a streaming world
Streaming brought down barriers to entry for new artists, but raised barriers to success. There are >80m songs on SPOT with 60k added each day (up from 40k in 2019). Labels help promising artists to cut through the noise. The chances of succeeding without a label are one in a million. Labels have experience, connections with music producers/lyricists & distribution partners, and many data that all improve an artists’ chance of success. It typically requires $500k-2m to give a new artist a reasonable chance at “breaking through”. Try asking a bank for such a loan based on a demo tape. The combined market share of the three labels has been stable to slightly up since 2016, despite the rise in streaming. In the end, most artists rather have 20% of something than 100% of nothing.

Artists will negotiate a higher royalty share
The very few artists that are successful after their initial 4-5 album deals can generally negotiate better royalty share agreements for future recordings. This is only logical, as the royalty share with artists is an IRR exercise. Established artists are less likely to fail and hence deserve a higher share. If someone like Taylor Swift releases a new album, it sells itself with little risk of failure. Even if some top artists can negotiate better deals, UMG is not reliant on a small number of artist. Their top artists accounts for <1% of revenue and their top 50 for ~20%. Note that a higher royalty share agreement only applies for new recordings; the earlier recordings remain at the initial lower rates.

The key risk to UMG and the other labels is that we are further in the streaming adoption curve than we think. The data does not indicate this, but it is worth monitoring closely.

Catalyst

Initiation of a share buyback program, (dual) listing in the US and further price increases by streaming services. The first two can materialize as early as today (27 October) with their Q3 results.