Warner Music just filed an S-1 with an intent to go public. Industry Focus: Consumer Goods host Emily Flippen and contributor Jason Hall share the positives and negatives they see so far and what to watch out for in the future. They guide us through the complexities of the music industry and how Warner is positioned to tackle them. Find out these and many other details in our complete breakdown of the details in the filing.
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This video was recorded on Feb. 11, 2020.
Emily Flippen: It's Tuesday, February 11, and I'm your host, Emily Flippen. 2019 seemed to be the year for IPOs, but after nearly a month and a half into 2020, there was very little excitement -- that was, until last week. Joining me today to talk about the latest and greatest S-1 filed is Motley Fool contributor Jason Hall. Jason, thank you so much for joining.
Jason Hall: I am happy to be on with you. This is the first time you and I have recorded a show together, so I'm pretty excited about that.
Flippen: It is. And I'm excited about the topic that we have today, because it's one that -- you know, any time you get a new S-1 filed, it's always really exciting for investors. And that S-1 is actually one of the world's leading music entertainment companies: Warner Music. They filed their S-1 -- which is essentially just a document outlining its intent to list as a public company -- and it's getting a ton of attention. So, it's fun to have you on and talk about that. But, Jason, do you think this is anything really to get excited about?
Hall: I mean, maybe, you know. Don't go on Twitter and start "at"-ing me about this for giving a definitive "maybe" answer here. Warner Music is one of the big three. They're one of the biggest record labels in the world; they have some of the biggest names in music entertainment signed on their label. There's a good chance, if you listen or if you stream music this week, you're probably going to hear -- you know, 15% of the stuff you listen to is probably Warner Music. So, I mean, this is a massive, massive label. And scale really matters in the industry right now.
But I think the reason I'm not really super gung-ho is the purpose for this IPO isn't to generate capital for Warner Music to use to pay down debt or to invest in growth; it's a cash-out for the private equity investors that own it now. So, that's where I'm a little bit iffy.
Flippen: Yeah, it's rare that we see companies filing just for the purposes of getting previous shareholders out. It means that there's really not going to be a lot of capital for Warner to raise from this to reinvest and grow the business. But I do have to think that there has to be some sort of tailwinds here for the music industry. Now, granted, there's a lot of intricacies in the industry, but as a company that generates a majority of its revenue from the sale of digital music, I'd have to imagine that the overall shift to digital music streaming must be a boon for a company like Warner, right?
Hall: Yeah, you're spot on. In the S-1, Warner mentions the word "streaming" -- they used the word "streaming" 143 times. So, there you go, right; that's a pretty significant thing. They said that the largest source of their revenues became streaming in 2016. They claim that they were the first major label that streaming became the majority of the revenue soonest. They said they were the first to get to streaming as being their biggest revenue, so they like to think that they're progressive and really going after this new revenue opportunity.
And, this is where consumers are going. There's a lot in the S-1 about the percentage of the population and markets that are paying for streaming, just looking at market penetration. So, it's kind of two things. It's the streaming, the growth of streaming, but it's also the growth of streaming in developing markets. China is mentioned over 30 times in the S-1. An interesting thing about this too, for anybody that's considering it, is you don't just have the S-1 to look at, this is a company that's reported quarterly earnings filings for a number of years because of the way part of its debt structure is a public debt. It still has to file some of these things with the SEC. So, you can go back and look at the past few years, and you can see that streaming-derived revenue consistently has grown at a higher rate than Warner's overall revenues.
Flippen: Yeah, when I hear you say that, Jason, I have to think that the flip side of that coin is that the handful of streaming music giants -- I'm thinking Apple iTunes or Spotifys, those types of companies -- would have a lot of control over, maybe, the pricing of Warner's music, right? So, if they're the only people that are really making streaming music accessible -- and a huge number of people are now streaming or digitally downloading their music -- do you think that that takes away some of Warner's pricing power?
Hall: No, really, I don't think so. And to the contrary, in the S-1, Warner talks about how rising prices down the road -- and I think part of it's going to be as we see more consolidation in the different streaming outlets -- is likely to be good for the company. And what you have to remember is at the end of the day, listeners, they're going where the music that they want is. And Warner has a massive library, some of the biggest musical acts in the world. If you think about older music, this is the Warner Chappell, they have this massive collection of really popular music from the past 80, 100 years.
So, I think a good industry to compare this to is, you look at Spotify, and Pandora, and Apple Music, iTunes -- they're distributors. So, it's kind of like Netflix, and kind of like Amazon Video -- Amazon's Prime Video service. And if you look at where Netflix and Amazon Prime have invested huge gobs of money over the past few years, they've invested in developing content that they control. So, you think about, for example, Disney -- which is maybe analogous to Warner Music -- Disney owns this massive amount of content, and now they're moving to launch a stand-alone streaming business. So, I think the point is that content is really king. And just as it is with video entertainment, it's the same with music.
The Spotifys of the world, I mean, they have to keep the content owners happy. I'm not saying -- that we're not going to see Spotify go spend billions of dollars to acquire exclusive content -- kind of like we've seen with the streaming distributors, with the Netflixes and the Amazons of the world. But the point is, the companies that have the best content are the ones with the leverage, not distributors. Again, you think about it, if you're Netflix, and you're losing [some] really popular streaming content, customers are going to leave your platform and go to where that content is, or maybe just subscribe to the content where it is. So, the leverage, again, is with the content owners.
Flippen: That makes a lot of sense. So, you know, I kind of want to move on, Jason, to what we're seeing in Warner's financials. Obviously, that's the big hot topic with this S-1 coming out. What were some of your, I guess, green and red flags you had when sifting through this S-1?
Hall: Yeah, I'm going to start with the red flags. And kind of the first one that jumps out at me is not a specific financial metric, but it's control. So, the short history behind Warner Music -- for a long time, Warner was publicly held. And then it went private, and then it went public again for a few years, from 2004 to 2011, or something like that. And then Access Industries, which is a private equity investor that buys and invests in multiple different industries, took it private in 2011. And essentially what's happening now is, I think they're looking to raise a couple hundred million dollars by selling an equity stake and taking it public, but they're going to create a dual share class. And Access Industries and its affiliates are going to retain complete control. So, the shares that you'll be able to buy, you're not going to be able to vote, to really make any change in the company.
And that's something -- it's a little bit concerning. Again, it's the owner is cashing out but still retaining control. So, that's not a great alignment with retail investors like us. So, I don't really love that about the way this is being IPO-ed.
The second thing that's -- it's more of a yellow flag, but it could be a red flag -- is leverage. The company has about $3 billion in long-term debt. And there's not a plan in place to pay that down or reduce it. To the contrary, if you read the S-1, it talks about debt. It's kind of vague. It's vague enough that -- I mean, my expectation, I would imagine -- because again, this is a growth industry -- I would imagine, the debt could go up before it goes down, hopefully, to fund growth initiatives. Again, debt isn't a bad thing on its own, but any company that has debt and uses a lot of debt leverage has a thinner margin of error. And investors could get burned if debt does become an issue.
This is a company that's planning to initiate a dividend. We don't know what the dividend is going to be at this point. So, those are things that you can kind of get hurt, if debt becomes a bigger issue, if the company is not generating enough cash to service the debt.
So, the third one, it's kind of 1-A really, because it's tied to the control. Again, the purpose of the IPO -- and I mentioned this on the outset -- Warner Music is not raising cash; Warner Music's investors are selling a stake for themselves to receive some cash proceeds. So, the company is not getting a cash infusion to do anything at all with, whatsoever. So, again, the purpose of this IPO isn't to put Warner Music in a better position, it's just to allow the current owners to capitalize on the value. But, again, they're not giving up any control in exchange for selling some of the equity stake in the company.
So, if you look at the green flags. I mean, there's a lot to like. As we've talked about, this is a growth industry. Revenues increased 12% in each of the past couple of years. As we talked about earlier, digital revenues like streaming are growing at a higher rate than consolidated revenues. There's a ton of -- think about the long-term trends, you know, the world is going to add about a billion people to the middle class over the next decade, and you can guarantee that a lot of those people are going to be paying for premium music streaming on their smart devices. So, this should be a really great long-term growth industry.
Also, we talked about it earlier, this is a company that's on the right end of the music value chain: It owns the content. It's in a position to remain profitable, while the distributors, all the streaming companies, while they fight the competitive battles for listeners. Think about it, do you really want to be the streaming service that doesn't have Ed Sheeran or Cardy B or Pink Floyd on your site? You can't -- you know that's the thing -- you have to have the best content. That's how you grow the number of subscribers on your platform. And, again, it's one of the big three. And scale really matters in this space. So, this is another really big green flag for me.
And again, it's not just that it has a big collection of western talents, it's not just the American music acts or European music acts; Warner Music has a big presence in developing markets like China, Middle East, Africa. As more of the world enters the middle class, people are going to want to hear artists who are popular where they live, not just Katy Perry, right? So, I think that's a really important thing.
And lastly, this is kind of a cash-cow business. It's consistently generated more than $400 million in operating cash flow in each of the past three years. And if this turned out to be a decent dividend stock, a dividend growth stock, you want a business that is consistently able to generate strong operating cash flow.
So, those were the four things that really stand out to me. The growth industry, it's on the right end of the value chain, it has the scale, and it's investing in markets where the growth is going to be, and it's a cash-generating business. So, I like those things about it a lot.
Flippen: Yeah. I don't want to downplay the importance of the moat that a company like Warner Media has in front of them. But at the same time, a lot of stuff you mentioned does rub me the wrong way. When you have yearly operating cash of around $400 million but $3 billion in long-term debt, especially in a low interest-rate environment like we're seeing today -- I mean, something about that just strikes me as strange.
And then, additionally, planning on paying out dividends instead of lowering the debt in case the interest rate environment changes. These are things that kind of make me wonder about management.
Hall: Yep. I think you have to be leery, and again, I think it's part of -- again, this is kind of the private equity mentality, right? You use leverage as best as you can. So, a good point. Really, really good point.
Flippen: Yeah. And when I think about the management -- and not to put too much emphasis on this, but I thought their CEO, Steven Cooper, was really interesting. So, he's been in place since 2011, [laughs] but at one point, he was the so-called turnaround man for Enron and seems to have no visible connection to the media space at all. How do you feel about, I guess, Warner's leadership?
Hall: Yeah, that's one thing that does kind of stand out a little bit. And you notice, he came in when Warner Music was taken private. He was kind of the guy that was brought in by the new ownership. And you know, I think it's OK. But if you look deeper into the company, past Cooper, and you look at the rest of their executives, you look at the CEOs of their various labels, and you look at their operations people, these are people that do have deep music industry background. And I think that maybe more important in the music industry than any other, that you have people with specific industry background, because it's such a relationship industry. People have to be connected to the music scene to find the new artists, to find up-and-coming artists to help sign and develop. So, it's really, really important. And I think that Warner does have that in spades.
So, I'm not overly concerned that Cooper is not somebody with 20 or 30 years in the music industry, I mean, he's been running Warner for going on a decade now. So, you know, at this point, if he's not seasoned, then it doesn't matter.
And again, I think a big part of this too is that, it gets back to the control aspect, right? This is still a company that's going to be controlled by a private equity investor, that's still going to have complete control over it. And their interests might not align with you as a common shareholder, so I think that's my bigger concern than anything.
Flippen: Yeah. And I don't want to get too existential on you here, but I guess I'm just kind of curious about how you feel about the music industry in general? From my perspective -- and granted I'm not somebody who does a lot of music streaming, so maybe I'm not the best audience, but I see Warner as being quite the legacy player. And sometimes when I look at the music business, it almost reminds me of used car sales and car dealerships. There's this kind of legacy way of purchasing vehicles. Regulations have kept the industry intact, despite the fact that everybody hates the process of having to buy a car. And I kind of feel like, maybe musicians hate the process of having to produce and sell music. And we've seen some players come out and change the game a bit, but how do you feel about Warner's legacy? Moving into the future, is this an industry that's ripe for disruption, or is this just a company that has an incredible moat that's going to persist for the foreseeable future?
Hall: So, I'm going to date myself a little, here. You know, I lived through the most serious existential crisis that the recording industry faced. So, almost 20 years ago, when the idea of online music first became a thing, and digital downloads, and this little website called Napster that almost killed the industry. Where, frankly, it was, you could go online and you could download this little app, and you could pirate music. And music piracy was a big thing, and it took the industry by surprise. And luckily, another little company (that's not so little anymore), called Apple, showed up with this great website where you could pay $1, and you could buy a song. And you weren't stealing anything. And that kind of brought things back, but a lot of labels really, really struggled, and artists also struggled.
But you fast-forward to today, and I think the industry is probably as strong now as it's ever been. And in a lot of ways, the current model is probably just going to get stronger, because, again, it gets back to scale really mattering. If you're an up-and-coming artist, signing with a big label is to your benefit, because it can expose you to markets that you simply couldn't have access to with trying to go on your own, or with a smaller independent label. The industry has changed so much because of streaming, right, you need access. And the big three, particularly, have massive access to all of the streaming platforms, to new markets. And I think that really matters a lot.
So, yeah, I think this is a great time to be in this industry. I think you can count on double-digit growth rates. We talked about some of the demographic trends. You think about the global middle class adding a billion people in a decade, that's a massive -- and then you start looking at the penetration rates, you know, how many people have cellphones, how many people have a music streaming app on their cellphone? All of those things are just going to go higher from here.
So, I definitely like the industry, I like the space, there's just not a lot of pure-plays ways to invest in it. And I think Warner is really looking to capitalize on that with this IPO, because it's going to be a relatively unique investment for retail investors to be able to participate in that opportunity.
Flippen: Yeah. I guess I'd just want to end off on one last question for you. And we kind of alluded to it earlier. But from 2004 to 2011, before the new CEO came in, Warner was an independent publicly traded company, and it did terribly for shareholders. So, do you think this is different over the next five to seven years? Is this an IPO that the average retail investor should be excited about?
Hall: I think it has the potential to be different, right. So, first of all, if we just think about the environment, if we go back to 2004 to 2011, first of all, that was kind of some of the worst of the piracy stuff was wrapping up in 2004. And then you fast-forward four more years, and then you've got the global financial crisis. So, the timing was not great. And at that point, Warner was still much like the rest of the other labels, trying to sell CDs, trying to make money that way, and it hadn't really fully embraced the way that consumers were moving and the way that consumers wanted to buy and consume music. And the other thing that's happened is, streaming has become mainstream now -- that's how people consume music, is through streaming apps.
So, I think there is certainly the potential for this to be a great investment, with the caveat that the S-1 that we have so far is very limited. We don't know what the IPO price is going to be, so we can't really ... determine what the prospects are. And then we also have to value-in, when we do get those things, what is the control premium, how much premium are investors not going to be able to get because the private equity that owns the company now is going to continue to have complete control. And whatever they chose to do may not be aligned with shareholders, they might sell part of their stake in a private deal, and investors don't realize any of the premium for that.
So, again, don't "at" me, anybody, but let's go back to my initial answer. It's decidedly "maybe." In other words, I think there's potential there, but until we know a little bit more, it's really, really hard to say. So, I think this is a great one to put on your watch list, read, study about it. And then as Warner starts giving us more information as they move closer to actually having an IPO, and we start having a price, then we can reevaluate.
Flippen: That makes sense. I can't wait to see where this one ends up. Jason, thank you so much for joining today.
Hall: This was fun.
Flippen: Definitely. Listeners, that does it for this episode of Industry Focus. If you have any questions, or just want to reach out, shoot us an email at IndustryFocus@fool.com, or tweet us @MFIndustryFocus.
As always, people on the program may own companies discussed on the show, and The Motley Fool may have formal recommendations for or against any stocks mentioned, so don't buy anything based solely on what you hear.
Thanks to Austin Morgan for his work behind the glass today. For Jason Hall, I'm Emily Flippen. Thanks for listening, and Fool on!