Warner Music Group Corp. — Q3 FY2018 Form 10-Q
Business context and period. Warner Music Group operates Recorded Music and Music Publishing businesses. This unaudited quarterly report covers the three and nine months ended June 30, 2018; the company notes the quarter’s fiscal period ended June 29. Comparisons are with the corresponding 2017 periods. The company is privately held, with all common stock owned by Access Industries affiliates.
Financial results and liquidity
| Metric | Q3 2018 | Q3 2017 | Nine months 2018 | Nine months 2017 |
|---|---|---|---|---|
| Revenue | $958 million | $917 million | $2,966 million | $2,659 million |
| Operating income | $28 million | $51 million | $201 million | $223 million |
| OIBDA (non-GAAP) | $99 million | $115 million | $406 million | $413 million |
| Net income attributable to WMG | $320 million | $141 million | $321 million | $182 million |
| Operating cash flow | Not stated for quarter | Not stated for quarter | $265 million | $309 million |
- Revenue and mix: Q3 revenue rose 4%; digital revenue after intersegment eliminations rose 16% to $576 million, or 60% of consolidated revenue. Recorded Music revenue increased 4% to $802 million and Music Publishing increased 6% to $159 million. For the nine months, revenue rose 12%, with digital revenue up 20% to $1.656 billion.
- Margins: Q3 operating margin was approximately 2.9% versus 5.6% a year earlier; OIBDA margin was approximately 10% versus 13%. Nine-month OIBDA margin was approximately 14% versus 16%. SG&A increased to $343 million in Q3 and $1.013 billion for nine months, outpacing revenue growth.
- Cash and liquidity: Cash and equivalents were $905 million at June 30, 2018, versus $647 million at September 30, 2017. Current assets were $1.585 billion and current liabilities $2.287 billion. Nine-month operating cash flow was $265 million; investing activities provided $451 million, primarily reflecting investment-sale proceeds; financing activities used $453 million. Management said existing cash and other liquidity sources were expected to support operations over the next 12 months.
- Debt: Reported debt was $2.814 billion, approximately flat with September 2017; net debt was $1.909 billion versus $2.164 billion. No revolving loans were outstanding; the facility had $180 million of commitments, less about $12 million of letters of credit. The company reported covenant compliance. Its stated leverage ratio was 2.26x, based on covenant-defined pro forma EBITDA that includes a substantial Spotify-related gain and permitted adjustments.
Material changes and unusual items
- Q3 net income benefited substantially from selling all Spotify shares for $504 million in cash proceeds. The company recorded an estimated $378 million pretax gain, net of estimated artist royalties and related costs, in other income. The gain is not representative of recurring operating performance. The sale also drove the increase in investing cash flow.
- Despite revenue growth, Q3 operating income fell 45% and OIBDA fell 14%, primarily as SG&A rose. Costs included higher variable compensation under the Senior Management Free Cash Flow Plan, severance and restructuring, transformation initiatives, and overlapping Los Angeles office leases. The nine-month OIBDA decline was smaller, at 2%.
- Streaming growth was the principal revenue driver, including continued streaming expansion and strong releases. Physical Recorded Music revenue continued to decline; digital downloads also decreased. Artist-services and expanded-rights revenue fell in Q3, partly reflecting the absence of prior-year France tours.
- Debt transactions included issuing $325 million of 5.50% notes due 2026 and $320 million of supplemental term loans, while redeeming $635 million principal of 6.75% notes. Nine-month debt-extinguishment losses were $31 million; net interest expense declined to $105 million from $112 million.
- Cash dividends paid during the nine months totaled $425 million. Subsequent to quarter-end, on August 7, the board declared an additional $500 million special dividend, payable August 10. This is a material post-period cash distribution.
- The Tax Cuts and Jobs Act affected tax expense and deferred-tax balances. The company recorded $132 million of tax expense for nine months versus a $132 million benefit in 2017; it described certain tax amounts as provisional.
Outlook, risks and contingencies
- No specific revenue or earnings guidance is provided in the filing. Management cited streaming and digital distribution as growth opportunities, while noting that results may fluctuate with releases, artist popularity and touring schedules.
- Key risks include dependence on digital music services and their pricing, piracy and intellectual-property enforcement, competition, artist and songwriter retention, foreign exchange and international-market exposures, leverage and debt-service requirements, and the ability to sustain digital growth as physical sales decline.
- The company uses foreign-exchange forwards and interest-rate swaps but cautions that hedges may not fully offset market movements. At June 30 it had $1.326 billion of variable-rate principal debt and $320 million of pay-fixed/receive-variable swaps.
- The long-running digital-download pricing litigation was dismissed with prejudice in May 2018. A dispute with Sirius XM over licensing rates for pre-1972 recordings remained in arbitration-related proceedings; the company sought a separate New York arbitration. Other legal accruals were described as immaterial, but the company could not estimate reasonably possible losses beyond accrued amounts.
- The company planned to adopt ASC 606 on October 1, 2018 using the modified retrospective method; it expected the most significant effect to be a change in timing of Music Publishing revenue recognition. Management said its assessment was not complete.
Most important facts for investors to verify
- How much reported earnings growth depended on the Spotify sale and other non-operating items, versus recurring operating results.
- Whether streaming-led revenue growth can offset physical and download declines, and whether operating margins recover as elevated SG&A costs change.
- The cash and leverage impact of the $500 million post-quarter dividend, alongside debt maturities and covenant calculations.
- The final effects of the Tax Act and ASC 606 adoption, particularly on deferred taxes and Music Publishing revenue timing.
- Developments in the Sirius XM licensing arbitration and other legal proceedings, as well as foreign-exchange and interest-rate exposures.