Warner Music Group Corp. quarterly report, Q3 FY2012

Warner Music Group Corp. — Form 10-Q Summary

Reporting period: Fiscal third quarter and nine months ended June 30, 2012. Dollar amounts are in millions unless stated otherwise. The company operates Recorded Music and Music Publishing businesses.

Comparability: The 2012 Successor financial statements reflect acquisition-method accounting following Access Industries’ July 20, 2011 acquisition; 2011 Predecessor statements use historical-cost accounting. The company cautions that these periods are not directly comparable.

Financial performance and position

Metric	Three months ended June 30	Nine months ended June 30
Revenue	$654, down 5% from $688	$2,061, down 4% from $2,150
Operating income	$7, versus $10	$68, versus $53
OIBDA	$66, down 14% from $77; margin 10% versus 11%	$250, versus $249; margin 12% in both periods
Net loss attributable to Warner Music Group Corp.	$32, versus $46; basic and diluted loss per share $0.30 versus $0.68	$94, versus $102
Interest expense, net	$56, versus $47	$169, versus $141
Operating cash flow	Not presented for the quarter	$107 provided, versus $18 used
Cash and equivalents	$219 at June 30, 2012, versus $154 at September 30, 2011
Total debt / net debt	$2,209 / $1,990 at June 30, 2012; net debt was $2,063 at September 30, 2011
Total current assets / current liabilities	$798 / $1,475 at June 30, 2012

Quarterly gross margin, calculated from reported revenue and cost of revenues, was approximately 46%, versus approximately 45% in the prior-year quarter. Cost of revenues was $356, down 6%; SG&A was $244, up 3%.
Quarterly digital revenue after intersegment eliminations rose 13% to $230 and represented 35% of revenue, versus 30%. Physical revenue fell 15% to $188; artist services and expanded-rights revenue declined 25% to $58.
For the nine months, physical revenue fell 12% to $696, while digital revenue rose 12% to $642. Digital revenue after eliminations was $684, or 33% of consolidated revenue, versus $610, or 28%.
Segment results: quarterly Recorded Music revenue was $518 and OIBDA $56, down 5% and 33%, respectively. Music Publishing revenue was $140, down 4%, while OIBDA rose 18% to $26. Nine-month Recorded Music revenue and OIBDA were $1,682 and $206; Music Publishing revenue and OIBDA were $391 and $98.
Nine-month investing cash outflow was $36, including $24 of capital expenditures and $21 for publishing rights, offset partly by $12 from a building sale. Financing cash outflow was $2. Cash increased $65 over the period.
Debt consisted principally of 9.5% secured notes due 2016, 11.5% unsecured notes due 2018, and 13.75% Holdings notes due 2019. The weighted-average debt interest rate was 10.5%, versus 8.9% in the prior-year comparison. No revolving-credit borrowings were outstanding; the facility provides up to $60, less approximately $1 of letters of credit.
Management reported a 4.56x leverage ratio under the revolving facility’s defined calculation. Its springing leverage test applies when borrowings exceed $5; the stated fiscal 2012 maximum is 6.25x. Debt agreements contain other restrictions, including limits on distributions, additional debt, liens, and asset sales.

Changes, outlook, risks and unusual items

Quarterly revenue declined mainly from weaker concert-promotion/touring-related artist services, lower physical sales, and foreign exchange; digital growth partly offset these declines. Excluding currency effects, quarterly revenue fell 1%. Nine-month revenue fell 3% excluding currency effects.
Management attributed the nine-month Recorded Music trend partly to a light post-holiday release schedule, physical-market decline, and touring-schedule timing; Michael Bublé’s “Christmas” was a significant offset. International revenue was particularly pressured in France and the U.K. Publishing weakness reflected lower mechanical and performance income, including U.S. radio licensing and U.K. market declines.
Quarterly net loss narrowed despite lower operating income and higher interest expense, mainly because the company recorded an $11 tax benefit versus a $15 tax expense in the prior-year quarter. Nine-month net loss also narrowed, with operating-income improvement and a tax benefit partly offset by higher interest expense.
Reported results include nonrecurring or timing-sensitive factors: the prior-year period included a $12 LimeWire settlement benefit; 2012 included severance charges of $17 for the quarter and $28 for the nine months, Access management fees of $2 and $6, respectively, and EMI-related professional costs. The company reported $53 of merger transaction costs in 2011, including $7 in the nine-month comparison.
Management said it expects existing cash sources to support operations over the next fiscal year and debt service, working capital, and capital expenditure needs for the foreseeable future. It targeted $50–$65 of cost savings over the nine fiscal quarters after the merger, but cautioned that savings may not be fully achieved. No specific revenue or earnings guidance was provided.
Management views digital distribution and expanded-rights/artist-services activities as potential growth and diversification opportunities. It noted that digital and artist-services growth has not yet fully offset physical-sales declines; future outcomes depend on consumer adoption, release schedules, margins, and execution.
Key risks include substantial leverage and high interest costs; ongoing recorded-music industry contraction and piracy; dependence on a limited number of digital retailers and their influence on pricing; talent and release-cycle uncertainty; foreign exchange; possible impairment of goodwill and intangible assets; and restrictive debt covenants.
Supplier continuity is a notable operational risk: Cinram, the company’s primary physical manufacturing and distribution supplier in North America and parts of Europe, faced financial distress and a court-supervised sale process. Warner gave notice terminating its agreements in June 2012 but continued under transition terms; alternate capacity had been integrated but used only to a limited extent.
Contingencies include digital-download pricing litigation, with claims remaining for internet-music purchasers, and five artist suits alleging underpayment of digital royalties, consolidated in California. The company said it could not predict outcomes; recorded accruals in pending proceedings were not material and excess reasonably possible losses could not be estimated. The merger-related shareholder settlement awaited court approval and included no class monetary payment, but up to $0.5 in plaintiffs’ counsel fees.
Other developments: Warner announced in July 2012 an acquisition of Miramax film-music assets. Sony’s acquisition of EMI Music Publishing closed in June 2012, subject to divestitures; Warner identified the changing competitive landscape as a risk. The company reported no interim goodwill-impairment indicators.

Important facts for investors to verify

Assess the limitations of Successor-versus-Predecessor comparisons and distinguish operating trends from purchase-accounting effects, currency movements, release timing, and one-time items.
Track whether digital growth can sustainably offset physical declines, and whether Recorded Music margins recover as concert-promotion and touring revenue fluctuate.
Review cash generation and working-capital movements, especially the large current-liability balance, accrued royalties, and the extent to which the $107 nine-month operating cash flow reflects timing.
Monitor debt service capacity, refinancing options, covenant headroom, and the availability of cash across subsidiary and holding-company structures; verify the facility leverage-test trigger and calculation.
Follow Cinram transition and replacement-supplier readiness, litigation developments and potential exposure, and the effects of EMI/Miramax transactions and associated costs.
Note that Warner’s common stock had no public market, all 1,000 outstanding shares were owned by Access affiliates as of August 9, 2012, and public-equity investor liquidity was unavailable.