Anatomy of a good company: Universal Music Group (UMG)

 

Key Takeaways:

 

• Universal Music Group (UMG) is one of the world’s largest music companies. In Recorded Music, its principal activity, UMG is the market leader, with a 32% market share and 8 of the top 10 global artists in 2021 signed to its labels.
• Since 2015, the global recorded music market has recovered significantly, with growth attributable to the rise of streaming and rising smartphone penetration. Streaming transforms the user experience, giving users access to a catalogue of tens of millions of songs at their fingertips either through a paid subscription or ad supported service.

 

There tend to be many features that most good companies have in common, but there are myriad characteristics and features to analyse that will be unique to each and every business. By undertaking a detailed analysis of the 50 or 60 companies we have on our radar (a portfolio of ~40 positions and a watch list of 10-20 names), we try to ascertain whether a business is a good business and if so, whether now is the right time to be invested or not.

Universal Music Group (UMG) is one of the world’s largest music companies. In Recorded Music, its principal activity, UMG is the market leader, with a 32% market share and 8 of the top 10 global artists in 2021 signed to its labels. UMG’s top artists include Taylor Swift, Drake and The Weeknd, among other household names. In Recorded Music, UMG discovers, develops, and markets new artists as well as owning rights to a back catalogue of older artists, including ABBA, The Beatles and Elton John. UMG is also active in Music Publishing, where it monetises rights to musical compositions and lyrics and has a small Merchandising business. In the streaming era, UMG generates the majority of its revenues when its songs are played on a Digital Streaming Provider (DSP) such as Spotify or Apple Music, generating a subsequent royalty for the business and the artist.
 

Digital Streaming has transformed the music industry from a structural loser to winner

 

The music industry has undergone a significant turnaround following a decade of structural disruption. Between 1999 and 2013, the music industry lost circa 45% of its value due to the rapid erosion of music sales (e.g. CDs, Vinyl) as the rise of digital and growth of the internet created an easy route to piracy. However, since 2015, the global recorded music market has recovered significantly, with growth attributable to the rise of streaming and rising smartphone penetration. Streaming transforms the user experience, giving users access to a catalogue of tens of millions of songs at their fingertips either through a paid subscription or ad-supported service.

Streaming significantly improves the quality of earnings for music companies and has increased the business model’s appeal to our quality-focused investment strategy. It has resulted in a move away from one-off sales of singles or albums to mostly subscription-based revenues from streaming platforms. This moves the music industry away from developing ‘hits’ to fuel sales of a physical single or album to a more reliable revenue stream from an existing talent pool and catalogue that increases earnings visibility over time and improves business quality. Additional sales do not come with the risk of additional variable costs associated with physical media, such as making more CDs and paying for more distribution if they think an album is going to be a hit. Streaming costs are more fixed, which means that as listener numbers grow, margins for UMG will increase, demonstrating attractive operating leverage with the business model.
 

Music has unique appeal amongst digital media

 

In music, the content ownership business (e.g. UMG) is highly consolidated, with the top three music companies owning nearly 3/4s of all music in circulation. This gives them a strong negotiating position with content distribution partners (e.g. Spotify), a part of the market that is more fragmented and their services less differentiated. In addition, streaming services need music from all three major music companies (Universal, Warner Media and Sony) to have a viable value proposition for consumers, who typically only pay and use one music service.

By contrast, video services such as Netflix compete with rivals with different catalogues and invest heavily in their own exclusive content. For example, a consumer might want to watch a popular new show, and that could mean purchasing a new subscription to access it. They may also have to keep other subscriptions to access their other favourite shows. This means a consumer can end up paying for multiple video subscriptions every month, representing a larger share of their disposable income. Conversely, if a consumer wants to listen to a new album from a UMG artist, it is likely to be available on all the main music streaming platforms. Combined with ad-supported or free services, streaming music is generally more affordable than video. In an inflationary economic backdrop with pressure on consumer spending, we think this gives UMG more defensive revenue characteristics than businesses engaged in video.

The value of the music back catalogue is also higher than video and gives music a unique appeal amongst other types of digital media. It is likely you have listened to your favourite artist or album hundreds of times. With film and TV, you may have watched your favourite film only a handful of times. This has injected older music which was more difficult to monetise in the physical era with greater value in the streaming era. By contrast, there is more significant pressure for video companies to constantly invest in new ‘hits’ to maintain interest in their platform, as the value of the back catalogue is lower for customers.
 

UMG has strong structural growth drivers

 

Paid streaming is the cornerstone of growth for the modern music industry. Given a large and expanding smartphone userbase of >3bn today, paid streaming penetration of 15% is still low compared to other on-demand products such as video streaming. Streaming penetration in developed markets such as Germany, France and Japan still lags early adopters of streaming such as the US and UK, which continue to observe a strong pace of new additions. In 2021, for example, Spotify grew its premium subscription users by 16% to 180 million from 155 million in 2021 and is expected to continue growing at a strong rate in 2022. Other platforms are also accelerating, such as YouTube and Apple Music. For UMG, growth in all digital platforms is positive for its top line, as they have similar royalty agreements with each platform.

Another source of growth in developed markets is price increases. Spotify, for example, has charged $9.99 for its standard premium subscription since the platform launched in 2011, as it has sought to build out the user base for the platform. This is despite the value for the user increasing significantly over this time with 82 million tracks and 4 million podcasts titles now available from a few million at launch. As developed markets mature and disposable income increases, music streaming companies may follow video streaming services in raising prices for their core product which will benefit UMG’s revenues.

Emerging Markets also represent a significant opportunity for UMG. In the physical era, UMG and other major labels could only address a small part of the global population as the distribution of their physical music products was constrained. However, with the transition to digital and the emergence of local streaming partners such as Tencent in China, UMG has easier access to these emerging markets. Today, paid music penetration is just 6% in China and 5% in other emerging markets, but as smartphone penetration accelerates, labels invest in domestic artists and disposable income increases, this will grow to represent a more significant area of growth for the major labels from a low base today.
 

Ad-supported and alternative revenue streams present opportunities

 

UMG also benefits from the growth of ad-supported streaming. Spotify, for example, had 236m active ad-supported users in 2021. Currently, the Average Revenue Per User (ARPU) for an ad-supported user is <22x smaller than for paid users, and DSPs have struggled to monetise these users. However, ad-supported services often serve as a gateway to premium subscriptions. Adding more exclusive premium features and artists can ultimately hasten the conversion of ad-supported users to premium subscriptions.

For UMG, all of the premium platform investment and marketing would be funded by DSPs like Spotify, but UMG would benefit from the upside without having to invest itself. In addition, there are several smaller but rapidly growing business models open to UMG, including integrating into social media platforms, digital fitness, and gaming, all of which are under-monetised today. On social media platforms such as Tik Tok and Instagram, for example, music plays a crucial role in driving user engagement and is becoming more essential for supporting growth for these platforms. Overall, we consider UMG to have very exciting growth prospects over the medium term.
 

UMG is a high growth, high margin and high ROIC business.

 

UMG is a high growth, high margin, and high Return on Invested Capital (ROIC) business. From 2019-21, UMG has delivered double-digit revenue growth on average and expanded EBITDA margins from 17.7% in 2019 to 20.2% in 2021. We calculate ROIC at 21%, growing to 25-30% over the medium term. Looking forward, we expect growth will largely be driven by the continuing penetration gains/subscriber growth in streaming. Margins are high because of UMG’s powerful position in a consolidated content-ownership market and are likely to increase as music revenues grow with a limited step-up in corresponding cost (high operating leverage). Returns for UMG are high because of the high margin nature of the business together with limited physical asset intensity. The vast majority of invested capital lies within the content assets, which includes artist advances (paying artists upfront to produce music) or catalogue investments (buying rights to a music back catalogue).
 

What are the risks to the business?

 

As the streaming era has transformed the attractiveness of Recorded Music and Publishing contracts, the music industry has seen an influx of new capital looking to sign artists and purchase the most popular back catalogues. This has driven up the cost of royalty advances to new artists and increased the valuation of catalogue investments being bought and sold in the market. Despite this, we continue to see UMG’s position as well entrenched. For a new artist, signing a contract with a major label like UMG presents a compelling value proposition (distribution scale, production and song writing talent) compared to smaller labels or other financial vehicles that do not have the same scale to develop and market the artists. On the catalogue side, valuations have increased, but catalogue investments have significant recurring value over multiple decades, and large music companies like UMG are uniquely placed to monetise these catalogues.

UMG also faces the risk of weakening consumer budgets, potentially resulting in a slowdown in DSP subscriber growth. Netflix, for example, recently reported a subscriber decline which led to a significant fall in its share price. However, for UMG and the music labels, we consider this risk to be more manageable, given lower differentiation amongst DSPs (consumers likely to own one music streaming service vs multiple video services).

While Universal Music Group is used solely as an example here, it highlights some of the topics addressed when building an investment thesis for Henderson EuroTust, assessing quality, valuation, and momentum. The thorough ongoing analysis of every business under consideration is part of a distinctive offering with a focus on identifying those businesses generating high and sustainable returns that do not seem to be accurately priced in (or with unpriced optionality), or businesses where there is a specific catalyst that could transform the returns generated over time.