In this episode of Industry Focus: Consumer Goods, Emily Flippen and Motley Fool contributor Jason Hall discuss the music publishing industry, and particularly a recent IPO that largely went unnoticed. Learn details about the IPO, how the music industry has changed over the years, how it's coping with coronavirus, and much more.

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This video was recorded on June 9, 2020.

Emily Flippen: It's Tuesday, June 9th, and I'm your host Emily Flippen. For today's Consumer Goods focused episode, I have Jason Hall back with me again to revisit a company that we discussed earlier this year, that recently made a successful debut as a public company. Jason, thanks for joining me again.

Jason Hall: Absolutely. It's interesting to circle back to this. It's weird, it seems like it's a year ago that we first -- I mean, COVID, I don't think was really been on our radar very much, and it was kind of a thing that was happening a little bit in China. And, man, woo! [laughs] here we are, three months later.

Flippen: Yeah. The last time we talked about Warner Music Group (NASDAQ:WMG), which is a stock we're going to be talking about today. I mean, it was only a few months ago, I think it was back in February, but the world has, huh! really changed since then.

Hall: It has. And I think it delayed the IPO a little bit. They, obviously, [laughs] waited for things to normalize a little bit. And this is one of the biggest IPOs of the year so far, right?

Flippen: Yeah. And actually, the last time we talked about Warner Music Group we were so concerned about the IPO landscape for [laughs] 2020 versus 2019 and that feels so trivial now.

Hall: Completely, it absolutely does.

Flippen: But, yeah, I guess throughout all this craziness, even though they did have to delay their IPO, Warner managed to get themselves out there on the public markets. And you know, I don't know if you agree with me, Jason, but I feel like this is one of those underreported or under-covered IPO stories; it's one of the biggest, but between all the news about COVID, market turmoil, the protest here in the United States, it feels like this just slid under the radar.

Hall: Yeah, it kind of did. You know, I haven't followed it super-closely since, you know, everything happened. I also cover the other oil and gas industry, and things have been in such turmoil there. And commercial real estate, things have been so bizarre, because a usually safe business has been flipped upside-down. That I kind of, to your point, because it is so under-covered, I was just, kind of, flipping through some trade journal websites that I try to visit a couple of times a month. And I saw the headline, like, the day before they IPO'd and I'm, like, "Wow! this is happening."

And I was actually talking to our colleague Dan Kline about The Rundown, one of the other TMF Live programs that he does, and he was looking for a spot, like a five-minute thing to talk about. And I said, "Hey, let's talk about it." And we talked about it the day before the IPO or actually it was the day of the IPO. And that's the same day that I messaged you and said, "Hey, this is happening." So, that was last week, you know, it happened. It seems like it went from just off the radar to, hey, this is done, it's happened. So, it's been really interesting.

Flippen: Yeah. And so, before we get into whether or not the IPO, I guess I'll say, met the expectations that you had and maybe had all the way back in February, for anybody who didn't listen to that episode, who is, you know, living under a rock and has no idea what music is, [laughs] maybe tell us what Warner Music Group does.

Hall: Yeah. So, the music publishing industry is giant and it's in every corner of the world, but in a lot of ways it's kind of dominated by just a few companies and Warner Music Group is one of the big three. It's the third largest record label in the world, behind Universal Music Group, which is wholly owned by Vivendi; which we'll talk about, there are some things going on there with Universal Music; and behind Sony Record. So, it's one of the big three. And its business is managing music content, selling it and signing artists to its various labels, and it takes a cut of everything that gets sold.

So, distribution is really, I guess, the best way to describe the majority of what it does. It's the business that gets the music to the various ways that we consume it, which is, as we know, more and more shifting toward streaming. So, you think about Spotify, Pandora, Apple Music, but also still few physical media sales. Vinyl is a big growing business, it has been for about five or 10 years, it's an interesting thing that's swung back. But this is the company that's in between us and the artists, I guess is the best way to put it.

Flippen: And before we came on and started to record this episode, Jason, I think you were having a conversation with Brian Feroldi. Brian asked you, "Okay, what's your favorite artist that's represented by Warner Music Group?" And you had a fun response, so I kind of want to give our listeners the opportunity to hear your take on some of their more popular or less popular artists.

Hall: Yeah, so the main thing that I told Brian was that the part of the business that I like a lot is Warner Chappell, which is kind of a collection of legacy older music. You know, I love the older stuff, but again, this is one of the third largest labels in the world. They have, yes, you think about Elektra Music, you think about Atlantic, you know, Atlantic Records. So, you think about some of those labels that have been around forever. So, Rhino is one. If you listen to OLDIES, it is full of some of the biggest names out there. You name five stars, and probably two of them are signed to Warner. It's a very, very -- again, it's one of the big three.

Flippen: Uh-huh. So, with that in mind, has this IPO maybe met the initial expectations that you had?

Hall: I think it did. If you look at where it IPO'd, I think the IPO price was $25/share, which was near the high-end of the range. And when your IPO price is near the high-end of the range, that's a successful IPO, right? Here's another way to look at it too, it was near the high-end of the range, but the price has actually, kind of, skyrocketed since then, it's over $32/share now. So, in a way, you could say maybe they underpriced it, right? Because that's a typical idea of, if the price quickly moves above or below the IPO range then the question is, did they really necessarily price it well? But I think in general they did, because this is a weird market, right, stocks just go up now, right? [laughs] So, there's a little bit of that, but I think in general it was. But again, you have to remember who benefited from the IPO, right?

Flippen: Yeah. And let's talk about that, because we mentioned it briefly when we talked about Warner Music Group back in February about why they were going public, and it was kind of a unique scenario.

Hall: Yeah. So, Warner Music has been publicly traded in the past. And it actually has continued to issue SEC filings, quarterly and annual filings, because it has publicly traded debt. But when it went private back in 2011, so about nine years or so ago, it was acquired by a company called Access Industries, which is a privately held company that's pretty broad-based, it owns companies in a lot of different businesses. [laughs] Not really a ton of stuff with entertainment, to be honest with you, so this was just kind of an outside of its normal ownership business. But the thing that's interesting about it is, that it's kind of a consistent cash flow business.

So, anyway, back to the question. The point of this IPO was not to raise money for Warner Music, it was a partial cash-in for Access Industries. So, the entire proceeds for this public offering went to Access Industries, which is almost entirely controlled by a single individual. And so, it was a successful IPO in terms of that cash-in in terms of raising capital for Access Industries.

But Warner Music is still completely controlled by Access Industries and its related parties that own, I think, around 87% of its shares. So, they still overwhelmingly control the company. They were able to, kind of, take advantage or monetize a small portion of that.

Flippen: And one could argue that this is becoming relatively normal in the music space right now, and you alluded to this earlier by mentioning Vivendi, but tell us what's going on with them and Universal Music Group.

Hall: Yeah. So, Universal Music Group is the largest record label in the world, it's the largest music company in the world. And it's wholly owned -- well, was wholly owned up until not very long ago -- by Vivendi, which is the largest French media company. And I think it's been more than a year, Vivendi has been working on trying to find a way to sell part of its stake in Universal Music Group. And it went through a long process, engaging a number of bankers. And my guess is they probably met with two or three dozen potential interested investors and they finally reached to group with Tencent, which is the Chinese company, to sell Tencent 10% of Universal Music Group. And I think that part of the idea there was, No. 1, they could monetize part of it, raise capital, because Vivendi carries a ton of debt and is very acquisitive, so additional capital they can get their hands on is handy. But also, because the idea is that with Tencent being a Chinese company, is to help leverage its presence to grow their Chinese business with Chinese artists and get more access to a market that has a massive, massive middle class that's growing very, very quickly.

Tencent actually has the option to buy an additional 10% and potentially up their stake to 20% of Universal Music Group. And it was valued at €30 billion enterprise value. So, that's the market capitalization plus debt. And I think right now the market value for Warner is, enterprise value is about $18.3 billion, or about $3 billion of that's debt. So, just for some context in terms of the relative size of the business.

But here's the big thing, Universal Music Group announced as part of the deal with Tencent, that in 2023 at the latest, they said by 2023 at the latest, that they intend to take Universal Music Group public, to IPO it. So, that's an interesting one. And since Vivendi is publicly held, my guess is, depending on how they structure the IPO, if they structure the IPO to spin part of Universal Music Group out, then shareholders of Vivendi would receive shares of Universal Music Group, it's a tax-free way to return value to Vivendi shareholders. But again, we don't know exactly how they're going to do it, they have a couple of years to figure it out.

But I think it's interesting, because it is part of a trend that we see where these companies that got absorbed and pulled private at some point, are now getting spun back out. And I think we're going to see a cycle of that, it's going to continue through perpetuity, it's just the nature of media companies.

Flippen: Uh-huh. And you mentioned briefly the enterprise values of these companies. And earlier you mentioned that it's possible that given the success of Warner Music Group's IPO that it's possible they just price themselves too low right now, but Warner Music Group is a $16 billion, in terms of market cap, business. But even though it's a big three player in the space, it's still pretty low margin. You know, there is a sense that you can only split a dollar so many ways, you're fighting over pennies after some point. But do you think this IPO is underpriced and it's just reflecting its true value or do you think that maybe the stock is reaching overvalue territory?

Hall: I would lean more toward it reaching overvalued. So, a couple of things. The music business has changed a little bit with the advent of streaming. You know, if you were to go back even to the last financial crisis that the world went through, a pretty large portion of music sales were still physical media, people were actually still buying albums, buying CDs. The Apple Store, what did they call it back then? That was you bought the iPod Store or whatever they called it, [laughs] I can't even remember back then, but you'd buy music from Apple, right, and you'd buy a song at a time. So, the key was, people were physically choosing to actively buy music versus the current model, which is streaming, which you can do, like, a Pandora or something that you don't have to pay anything for and you listen to ads, but then there's also Apple Music and Spotify where you pay a monthly subscription. So, I think the thing that's starting to shift is people are, I think, going to be less likely to cut that monthly subscription right now, because they still want to have their music, right? Entertainment tends to be, kind of, countercyclical in certain ways. So, I think maybe there's a little bit of a view that this is, kind of, a little bit of a flight to safety, because music should hold up well, and it's a pretty steady cash flow business.

The margins are slim. I think the gross margins over the trailing 12 months, or excuse me the profit margin was 3.5%. [laughs] So, it is a pretty thin low margin business, but in terms of operating cash flows, this is a company that can kick off between $400 and $500 a year in operating cash flow and turn part of that back into a dividend using the leverage of that debt balance to kind of create some additional operating leverage and then pay a dividend. The dividend yield is 1% right now based on the forward yield at recent prices. So, I do tend to lean more toward it being a little bit overvalued right now. Again, simply because I think there's been some flight to the perceived safety of this kind of business.

As far as, did they price it well? Yeah, I think so, it's just that it's hard to know right now; things are weird.

Flippen: Uh-huh. I see in my notes here that I wrote down; one of the questions I wanted to ask you was about COVID, and as you were speaking, I was thinking to myself, "Why did I write that down?" And then I remembered that explicitly in Warner's most recent filing they had mentioned that they did not expect to see any negative impacts as a result of this pandemic. And I remember thinking to myself, "I think this is the first company that has come out and said, nope, everything's the same for our business." So, do you agree, do you think that there's going to be no impact from COVID, or do you think maybe there's positive impact from this pandemic?

Hall: I do think that if there is anything on the negative side, it would be minimal and it would only be if we saw a really sustained, more permanent impact economically that affected even this kind of business that tends to be relatively countercyclical. And I do tend to think that there could be some positives, because, I mean, think about Disney+ as a product that was expected to do well when it was first announced, and when it first rolled out it did quite well. And then everybody in America was told, you have to stay home, and it blew up, the number of subscriptions just absolutely exploded. And I think, to a certain extent, you could see some potential uplift for the Warner Musics and the Universals of the world, simply because more people are going to be interested in subscribing to a music service.

I think the question is when you start thinking about the ad-supported music platforms, the economics change because companies aren't advertising right now. Ad spend dollars, if you're curious about that, read Alphabet's latest earnings and they talk about how ad spending dollars have changed. So, I think that could potentially underpin the economics of some of the streaming services, but for the paid services, yeah, I think it's a potential tailwind, I really do, and that carries back to, if you own the content or if you have the license for the content like Warner does, you're kind of in the winning position, right?

Flippen: Yeah. And you said you had talked earlier with Dan Kline on The Rundown about this IPO when you first realized that the company had in fact successfully gone public or is it planning to go public immediately. And it's funny, because I also had a conversation with Dan, which I'm sure a lot of our listeners are familiar with because Dan is a frequent visitor on Industry Focus: Consumer Goods. I should really call him the host, [laughs] that's how often Dan is on.

But when I told Dan that I was doing this episode with you, he was very negative, he had some very strong negative opinions about this portion of the music industry. And it reminded me a little bit of companies like Live Nation that have such a chokehold on live events and ticketing. But when push comes to shove, you're probably buying your ticket over Live Nation and paying the outrageous fee because what's your alternative? So, is Warner Music one of those businesses that genuinely has no real alternative or is this an industry that's ripe for disruption?

Hall: Yeah. So, I'm old enough to remember when Pearl Jam tried to do a worldwide tour without using Ticketmaster; I mean this is 25 years or so ago. And it was an absolute disaster, because the distribution is a key. If you're trying to attain access to a large market, scale is hugely important. And I think as much as technology has disrupted the music industry, you know, think about Apple or think about the iPod, think about how disruptive -- in a way, the technology disrupted the music industry and then Apple disrupted that technology to make music cheap and accessible versus all the IP theft that was going on before that. Making $1 you can buy a song and you don't feel bad; you're not stealing it anymore. So, technology kind of saved the labels.

But I think the way things are now, because of the scale of the industry, and if I'm Spotify, I have to have the big three. I can't -- because I'm not valuable as Spotify -- because if the music leaves, the listeners leave. The entire value of my platform is having access to music that people want to listen to, right?

So, I don't necessarily know that translates to pricing power for Warner, again, because it's the smallest of the big three, but it has a leverage to get on every single platform because it's the one that's in demand. I think where I'm negative on this industry as a group is -- it's kind of a microcosm of society in a way that you have thousands and thousands of artists who struggle to make ends meet, you know, they're making no money right now because they make money touring, they make money performing music, that's how they make a living. And distribution of their content is, kind of, how they create awareness, there's just not a lot of money.

If you're not in the Hot 100 on a regular basis, as an artist you're not making money on your music; that's just the way it works. And streaming has, kind of, exposed that even more. So, yeah, I don't love that about the business because it's basically these three companies that make the money on the music and the artists make their money when they go and perform.

Flippen: Yeah. And it's a hard sell to have someone be invested in a company that they may actively dislike, right? So, is it fair to say that you are not a shareholder, that you're not eagerly buying shares, or did I misinterpret?

Hall: No, I'm not a shareholder and I'm not particularly interested in buying. And it's not just because -- so, I'm a huge music guy, I love music and I like the idea of having an economic interest in some part of that value chain. But for me, the thing that I come back and struggle with is I think about, with Warner, you still, as an investor, you have essentially no say in the business, right? You know, private equity still owns very close to 90% of the business, 87% and change. So, you have no vote, you have no voice. And it's hard to say that your economic interests are going to be aligned with them.

And it creates the scenario where let's say something happens and cash flows change or they decide to add a little more debt and take on some leverage, and then the next thing you know, they're losing money and they cut the dividend, and shareholders sell, and the price falls. And it falls below the IPO price or it falls 25% to 30% from today's price. A couple of years go by, it's a muddling business, and Access Industries says, OK, we're going to buy back, we're just going to reacquire, they reacquire for below the IPO price, right?

There's just so many things that I don't like about, just everything about [laughs] the way that it's structured, it's just not particularly appealing. It doesn't offer prospects for high rates of growth, even though the streaming is going to grow. You think about Africa, India, China, these opportunities for middle class growth that could drive revenues growth over time and cash flow growth, it's just doesn't appeal me as a kind of investment that has the prospects to either outperform the market over the long term or offer some other meaningful benefit like a high dividend yield that I can count on to generate income. So, it's just not attractive -- it's elevator music, how does that sound?

Flippen: [laughs] Well, that sounds nice and it does feel like to me, as you were talking, that I could make a more compelling argument to own companies that I like more in other aspects of the value chain, companies like Spotify or even a Tencent Music Entertainment, which Tencent recently spun off, with the potential for that agreement with Vivendi to maybe result some tangible change in the music business in China. So, I agree, I'm not sure if 12% revenue growth is really going to do it for me here.

Well, Jason, thank you so much for joining me today. It's always a pleasure to speak with you. And, hey, maybe in a year will come back and we'll be totally wrong [laughs] about Warner, we'll have to do an update episode.

Hall: I'm willing to take that risk. I'm also interested to follow this Universal story too.

Flippen: Yeah, it's definitely an interesting industry to be watching right now.

Hall: You're singing my tune, Emily Flippen.

Flippen: [laughs] I wish I was full of good puns like you are, I'm not that quick-witted, unfortunately. Jason, thank you again. And listeners, that does do it for this episode of Industry Focus. If you have any questions or just want to reach out, you can always email us at IndustryFocus@Fool.com or tweet us @MFIndustryFocus.

As always, people on the program may own companies discussed in the show, and The Motley Fool may have formal recommendations for or against any stocks mentioned, so don't buy or sell anything based solely on what you hear.

Thanks to Austin Morgan for his work behind the screen today. For Jason Hall, I'm Emily Flippen, thanks for listening and Fool on!