Warner Music Group Corp. annual report, FY2012

Warner Music Group Corp. — FY2012 Form 10-K

Reporting period: Fiscal year ended September 30, 2012. The filing’s “2012 Q4” reference is not a standalone quarterly report; quarterly results are provided in the 10-K. Warner Music operates Recorded Music and Music Publishing businesses. Access Industries acquired the company in July 2011, and the company is privately held. Fiscal 2011 comparisons combine predecessor and successor periods on a non-GAAP basis and are not directly comparable with GAAP results.

Financial performance and position

Metric	FY2012	Comparable FY2011
Revenue	$2.780 billion	$2.867 billion
Operating income	$109 million; 4% margin	$32 million; 1% margin
OIBDA, a non-GAAP measure	$353 million; 13% margin	$290 million; 10% margin
Net loss attributable to Warner Music Group Corp.	$112 million	$205 million
Operating cash flow	$209 million	$(52) million
Capital expenditures	$32 million	$48 million

• Revenue fell 3% as reported, but only 1% excluding unfavorable foreign exchange. Recorded Music revenue declined 3% to $2.275 billion; Music Publishing declined 4% to $524 million. International operations generated 60% of revenue.
• Digital revenue after intersegment eliminations rose 13% to $925 million, or 33% of consolidated revenue. Digital was 38% of Recorded Music revenue. Recorded Music digital growth more than offset physical declines, but lower artist-services and expanded-rights revenue and licensing timing weighed on the segment.
• Cost of revenue declined 6% to $1.459 billion, or 52% of revenue versus 54%. Total SG&A was essentially flat at $1.019 billion and increased to 37% of revenue from 35%.
• Operating cash flow improved from the combined FY2011 outflow, reflecting stronger OIBDA, working-capital timing and lower cash interest paid. Cash and equivalents were $302 million at year-end, versus $154 million; total debt was $2.206 billion versus $2.217 billion, and reported net debt was $1.904 billion versus $2.063 billion.
• Current assets were $939 million and current liabilities $1.606 billion. The filing attributes liquidity primarily to operating cash flows, available cash and revolving-credit capacity and states existing sources should support operations over the next fiscal year.
• Interest expense was $225 million. The company reported a net loss despite positive operating income, largely because interest expense exceeded operating income.

Material changes and notable items

• Compared with FY2011’s combined, non-GAAP results, OIBDA increased 22% and operating income improved; the net loss narrowed. The comparison is affected by prior-year merger transaction and share-based compensation costs, so underlying improvement should be assessed alongside these items.
• Severance charges were $42 million in FY2012. The company also incurred approximately $14 million in professional fees related to the EMI sales process and regulatory review, and recorded $8 million of Access management-agreement fees plus approximately $2 million of related consultant expenses.
• Management had targeted $50–$65 million of cost savings over nine fiscal quarters following the 2011 merger and said a majority had been achieved by September 30, 2012, with additional opportunities identified.
• The November 1, 2012 refinancing replaced $1.25 billion of 9.5% secured notes due 2016 with $500 million of 6.0% secured notes and €175 million of 6.25% secured notes due 2021, plus a $600 million term loan and a $150 million revolving facility. Pro forma debt was $2.249 billion; a $31 million revolving-facility draw made at closing was repaid December 3, 2012. Management said annual cash interest payments would decrease. An approximately $83 million debt-extinguishment loss was recorded in FY2013, not FY2012.
• Management’s covenant calculation showed a 4.37x leverage ratio under the former facility and a 4.22x pro forma ratio under the new facility. The new revolver has a springing leverage test when borrowings exceed specified thresholds; covenant EBITDA includes adjustments and projected savings and is not a GAAP measure.

Outlook, risks and contingencies

• No specific revenue or earnings guidance was provided. Management expects digital distribution, streaming and artist-services/expanded-rights activity to support growth, but said these sources may not fully offset physical-sales declines. It cited release schedules, touring timing and consumer demand as sources of fluctuation.
• Key risks include continued recorded-music industry contraction and piracy; dependence on a small number of digital retailers, particularly Apple’s iTunes; pricing pressure and competition; artist and songwriter retention; foreign exchange exposure; and the impact of industry consolidation following EMI’s sales.
• Leverage remains substantial, with significant debt service, restrictive covenants and exposure to variable interest rates under the term loan and revolver. The company reported $232 million of talent commitments for the following 12 months, generally payable upon delivery and acceptance and typically cancellable at its discretion.
• Cinram, then a primary physical manufacturing and distribution supplier in North America and parts of Europe, had disclosed going-concern uncertainty and was selling operations. The company warned that service interruption or transition to alternate suppliers could disrupt customer fulfillment.
• Digital-download pricing litigation remained in discovery. Five consolidated artist class actions alleged underpayment of royalties on digital sales and were subject to mediation. The merger-related shareholder class-action settlement was approved with no payment to shareholders; the company paid $500,000 in plaintiffs’ counsel fees. The company said no accrual for pending proceedings was material and could not estimate possible losses beyond amounts accrued.
• In October 2012, a subsidiary settled FTC allegations of COPPA violations without admitting or denying them; the settlement included a $1 million civil penalty and other requirements. Goodwill impairment testing found no impairment in FY2012, but management noted that a 100–200 basis-point increase in discount rates could have reduced estimated reporting-unit values below carrying values.
• The company paid no dividends in FY2012 or FY2011; dividends are subject to debt covenants. There is no public market for its common stock, all of which is owned by Access affiliates, and the filing notes that the company is not subject to certain exchange governance requirements.

Investor verification priorities

• Reconcile the FY2011 predecessor/successor periods and non-GAAP combined comparison before interpreting year-over-year improvement.
• Review the refinancing’s final debt balances, cash-interest savings, fees and FY2013 extinguishment loss, along with covenant definitions and headroom.
• Test the durability of digital growth and whether it can offset physical declines, including dependence on major platforms and the economics of streaming.
• Verify progress and remaining costs for the $50–$65 million savings program, and separate recurring operating performance from severance, EMI and other unusual costs.
• Track the digital royalty and pricing litigation, COPPA compliance obligations, and Cinram supplier-transition risk; the filing does not provide a clear estimate of potential litigation exposure.