Universal Music Group: Sweet Spot In Low-Cost Entertainment, Catalyst-Rich Market Dynamic

Company Description

Universal Music Group (OTCPK:UMGNF) - Consumer Discretionary - Entertainment

Formed in 1996, Universal Music Group ("the company") is one of the world’s major music entertainment companies with a family of iconic record labels, including Def Jam Recordings, Republic Records, and Island Records. It operates in three integrated segments: Recorded Music, Music Publishing, and Merchandising:

• Recorded Music segment (77.0% TTM) - it involves selling, marketing, distributing, and licensing the recorded music produced by the Company’s recording artists. Recorded Music derives revenue from three main sources: digital, physical, licensing and others.
• Music Publishing segment (17.1% TTM) - it involves signing, acquiring, and administering rights to musical compositions and licensing them for use in multiple formats. Music Publishing derives revenue from five main sources: performance, digital, mechanical, synchronization, and others.
• Merchandising segment (5.9% TTM) - it involves the creation, design, production, and distribution of various consumer products related to music artists and their brands. Merchandising derives revenue from four main sources: touring income, retail, licensing, and E-commerce/DTC.

Investment Thesis

Universal Music Group is a cash-flow generative, capital-light business that is trading at a significant discount to its intrinsic value.

Music is that kind of low-cost entertainment that is a "must-have" to many and thanks to the Digital Service Providers (DSPs), e.g., Spotify (SPOT), consumers can have instantaneous access to a catalog of millions of songs. In my opinion, the streaming era opened the door to a decades-long runway for growth. In fact, according to the International Federation of the Phonographic Industry, from 2017 to 2022, the global recorded music revenue grew at a CAGR of 10.5% as opposed to streaming revenue CAGR of 23.1%.

Moreover, with most of the streaming revenue (80%+) coming from premium subscriptions, it makes the business less cyclical and moves the business model toward a recurring one. However, ad-supported streaming may be more volatile, especially during a macro backdrop.

I expect streaming to represent a major growth opportunity for the business. In my opinion, we are still in the early cycle of the streaming adoption. According to Musical Pursuits, in 2021, global premium music subscribers totaled 524M (+26.4% vs. 414M in 2020). Even if the number seems huge, it still represents less than 10% of the 5.25B global smartphone users in 2021, according to Oberlo. It also represents a small fraction of the user base of DSPs such as Facebook (META) and YouTube (GOOGL) (GOOG).

There is also a pricing, not only volume, opportunity. In my opinion, the audio streaming industry is under-monetized, as opposed to SVOD (e.g., Netflix (NFLX)), but going forward I expect the price increases to be more regular. This will directly benefit UMG's subscription revenue growth rate.

In addition to streaming, the rise of short-form video, live-streaming, and in-game experiences (e.g., virtual concerns on platforms like Fortnite) are driving new opportunities.

Business Performance

Cycle - Mature Growth - Stalwart (i.e., Peter Lynch classification)

Universal Music Group is a high-quality business, capital-light (i.e., EBITDA factor of 1.21x TTM) with an outstanding business performance profile.

Recently, gross margins have been under pressure due to rising artist costs, however, now the costs are normalizing, and the gross margins have started to invert this trajectory. FCFF margin is stable at 14.0% TTM, and ROCE is at 35.6% TTM which is well above the Company's cost of capital of 9.52% and the fact that in the last years, the average ROCE increased significantly suggests that the company's returns on new investments are above norms. This underlines how high-quality the business is.

ROE keeps improving, and it currently stands at 47.5% TTM, although it presents some volatility due to net margin delta, driven by improving total assets turnover and deleveraging process.

The balance sheet is solid with a Net-debt/EBITDA of 1.25x and with interest coverage of 8.23x TTM. The cash conversion cycle is extremely negative, driven by the company's business model that "collects now, pays later". Cash realization is at 129%, which underlines the strong cash position.

Valuation

Universal Music Group trades at a discount to its intrinsic value.

Under my conservative scenario, and incorporating a margin of safety of 15%, it suggests a target price of €30.79/share or a discount of 28.17% vs. the current price of €24.08/share. The current valuation gives an opportunity to purchase a cash-generative, capital-light, and dividend-paying company at a very attractive price.

However, once we compare Universal Music Group to its closest peer, Warner Music Group (WMG), the company seems to be less attractive. In fact, it currently trades at an FWD P/E of 26.74x vs. Warner Music Group's FWD P/E of 22.94x. In my opinion, investors are willing to pay more for each €1 of the earnings of Universal Music Group rather than Warner Music Group because it represents a higher quality investment. Warner Music Group's ROCE is 19.9% TTM with a cost of capital of 12% and FCFF margin of 10.6% TTM vs. Universal Music Group's ROCE of 35.6%, cost of capital of 9.52% and FCFF margin of 14.0% TTM. Moreover, the latter also has a bigger music catalog, and if it decides to normalize its spending on artists & repertoire (A&R) toward Warner Music Group's level, it would immediately experience a margin boost in my opinion.

Catalysts

In my opinion, the following should represent a potential tailwind

1 - Expanded Connectivity: I do see the proliferation of connected devices (e.g., smart TVs, connected cars, etc.) as a tailwind for driving customer acquisition and retention. This in turn allows it to expand the current total addressable market.

2 - Expand Global Presence: The company seems well aware that the real growth lies in emerging countries, and it is moving in the right direction to capitalize on it. In India, for example, Universal Music acquired a majority stake in TM Ventures to strengthen its position in a high-growth market with a favorable demographic distribution as well as a rising penetration of smartphones.

3 - Price Increase: I do expect the audio streaming industry to follow a similar path to SVOD. This will benefit the top-line growth and coupled with operating leverage, it will drive margin improvement as well.

Risks

However, in my opinion, there are also a series of risks on the downside which we should consider:

1 - Artificial Intelligence: investors seem to be overly concerned about the impact that AI may have on the music industry. In my opinion, the music industry is well protected not only by copyright laws (i.e., companies have to obtain permission to use copyrighted content for AI training) but also by protection of commercial DSP agreements (i.e., DSPs must ensure that their service is not used by an unauthorized third party with the aim to train generative AI models).

Moreover, in my opinion, AI should be seen not only as a threat but also as a potential tailwind for the music industry. Giles Martin, for example, used an AI-powered audio source separation process to remix The Beatles, Revolver. Hence, this type of technology may drive a resurgence of iconic back catalogs.

2 - Interest rates: High-interest rates lead to a higher discount rate, hence making the present value of future royalty payments lower.

3 - Macroeconomic Headwinds – macroeconomic headwinds are leading to a decline in DPS ad revenue, which is putting pressure on Universal Music Group's revenue. However, this risk is likely to be short-lived.

4 - Do DPSs represent a potential threat? Can they create their own record label? In an interview, Steve Stoute, a record executive, stated that Spotify has an agreement with major labels under which it is stated that if Spotify were directly to compete with them (i.e., by starting its own label) they would pull all their music from Spotify.

Technical Analysis

From a technical analysis point of view, in my opinion, a cup and handle pattern is forming which suggests a potential short-term target at €27/share, which is curious as it corresponds to its historical peak.

The pattern will be broken if the price action breaks the support line at €22.6/share.

Final Remarks

In my opinion, Universal Music Group represents an appealing investment as it does offer enough margin of safety.

In the long term, the analysis suggests that the company is well-positioned to capitalize on the secular growth opportunity driven by the streaming era, and the potential catalysts outweigh the potential risks. In Peter Lynch's classification, Universal Music Group can be classified as a "stalwart", hence, active management is required and the average ROCE should be tracked to make sure that the management is not engaging in some "diworsefication".

Editor's Note: This article discusses one or more securities that do not trade on a major U.S. exchange. Please be aware of the risks associated with these stocks.