Warner Music Group Corp. — Q1 Fiscal 2017 Form 10-Q
Reporting period: Three months ended December 31, 2016 (the company notes its fiscal period ended December 30, 2016); compared with the three months ended December 31, 2015. Amounts are in U.S. dollars unless stated otherwise. Warner Music Group is a music-content company with Recorded Music and Music Publishing segments. Access Industries affiliates own all of its common stock; the filing states there is no public market for the shares.
Financial performance and position
| Metric | Q1 FY2017 | Prior-year quarter | Change |
|---|---|---|---|
| Revenue | $917 million | $849 million | Up 8% reported; up 11% excluding foreign-exchange effects |
| Operating income | $94 million | $62 million | Up 52% |
| OIBDA | $157 million | $137 million | Up 15%; margin 17% versus 16% |
| Net income | $24 million | $28 million | Down 14% |
| Net income attributable to Warner Music Group Corp. | $22 million | $27 million | Down 19% |
| Operating cash flow | $156 million | $61 million | Up $95 million |
| Capital expenditures | $8 million | $10 million | Down $2 million |
Cost of revenue was 54% of revenue, compared with 53% a year earlier; SG&A was 30% of revenue versus 33%. Gross margin was therefore approximately 46%, compared with 47%. Higher product costs, including costs from distributed-label sales and concert promotion, pressured margins. Interest expense, net, was $40 million, down from $45 million. Income tax expense was $17 million, versus a $3 million tax benefit.
Digital revenue across both segments, after intersegment eliminations, rose 28% to $444 million and represented 48% of revenue, versus 41%. Streaming revenue drove much of the increase: Recorded Music streaming revenue increased $99 million to $311 million, while digital downloads fell $18 million to $85 million. Physical revenue declined $21 million to $227 million. Recorded Music revenue increased 8% to $797 million; Music Publishing revenue increased 7% to $124 million.
At December 31, 2016, cash and equivalents were $455 million, total assets $5.340 billion, and total liabilities $5.200 billion. Current assets were $1.061 billion and current liabilities $1.944 billion. Debt was $2.755 billion on the balance sheet (principal debt of approximately $2.798 billion before unamortized discount and financing costs); reported net debt was $2.300 billion. Warner Music Group Corp. equity was $124 million, down from $195 million at September 30, 2016, in part reflecting a $54 million dividend and $39 million of other comprehensive loss.
Operating cash flow benefited from working-capital timing, including a $112 million increase in royalty payables. Investing activities used $12 million; financing activities used $38 million. Cash increased by $96 million during the quarter. The Board declared a $54 million special cash dividend, paid January 3, 2017.
Material changes versus the prior comparable period
- Revenue growth was led by digital streaming, successful releases and U.S. performance; foreign exchange reduced reported growth, particularly internationally.
- Recorded Music operating income rose to $123 million from $98 million; OIBDA increased to $165 million from $152 million. Music Publishing narrowed its operating loss to $2 million from $13 million, while OIBDA rose to $16 million from $5 million.
- Consolidated OIBDA and operating income improved, but net income declined because of higher tax expense and a $32 million debt-extinguishment loss.
- Cash from operations increased substantially, with the filing attributing the increase partly to operating performance and partly to working-capital timing.
- Debt refinancing replaced 2021 notes bearing 6.00% and 6.25% coupons with new secured notes due 2024 at 4.125% and 4.875%. The term-loan maturity was extended to 2023, subject to springing-maturity provisions. Weighted-average debt interest rate was 4.9%, versus 5.3% at September 30, 2016 and 5.6% a year earlier.
Outlook, risks, contingencies and unusual items
- Management provided no specific revenue or earnings guidance. It said existing liquidity sources were expected to support existing operations over the next 12 months and that operating cash and revolving-facility borrowings should fund debt service, working capital and capital expenditures for the foreseeable future.
- The $150 million revolving credit facility had no loans outstanding; approximately $13 million of letters of credit were outstanding. The company reported compliance with debt covenants. Its disclosed trailing-twelve-month pro forma Consolidated EBITDA was $585 million and leverage ratio 3.44x; the facility’s maximum ratio is 4.625x when revolving borrowings exceed $30 million at quarter-end.
- Management highlighted risks including the shift from physical sales to digital, dependence on digital platforms and their pricing, piracy, artist and songwriter performance and retention, competition, foreign exchange, international operations, intellectual-property disputes, and substantial leverage and debt-service requirements.
- The October refinancing and November partial note redemption generated a $32 million debt-extinguishment loss. Other income included foreign-exchange gains on euro debt and derivative assets, partly offset by losses on intercompany loans.
- A long-running putative class action concerning digital music pricing remains unresolved. The company said outcomes and any reasonably possible loss range could not be estimated; it intends to defend the claims. Other pending litigation accruals were described as not material, but additional loss ranges could not be estimated.
- The company received $18 million from the Pandora pre-1972 recordings settlement allocation and recognized it as revenue during the quarter. It also recognized $1 million of Sirius XM settlement proceeds in revenue; the remaining balance was to be recognized ratably over the next four quarters.
- Management said up to approximately $20 million of the reserve for uncertain tax positions could reasonably possibly decrease in connection with foreign audits and settlement discussions. Foreign currency translation produced a $37 million loss in other comprehensive income.
Important facts for investors to verify
- Whether growth in streaming revenue and successful releases is sustainable, and how ongoing download and physical declines affect revenue mix and margins.
- How much of the increase in operating cash flow reflects recurring earnings versus timing of royalty payables and other working-capital movements.
- The terms and refinancing benefits of the new notes and amended term loan, including springing-maturity provisions, debt-service burden and covenant headroom.
- Potential financial exposure and developments in the digital music pricing litigation and foreign tax audits or uncertain tax positions.
- The impact of the special dividend on liquidity and the company’s capacity to fund operations, investment and debt obligations.