Warner Music Group Corp (WMG) 2008 Q2 法說會逐字稿

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  • Operator

  • Welcome to the Warner Music Group's fiscal second quarter earnings call for the period ending March 31, 2008.

  • At the request of Warner Music Group, today's call is being recorded for replay purposes.

  • (OPERATOR INSTRUCTIONS) Now, I would like to turn today's call over to your host, Ms.

  • Jill Krutick, Senior Vice President of Investor Relations and Corporate Development.

  • You may begin.

  • Jill Krutick - IR

  • Thank you very much.

  • Good morning, everyone.

  • Welcome to Warner Music Group's fiscal second quarter 2008 conference call.

  • This morning, we issued a press release announcing our results.

  • If you haven't already seen them, both the press release and our form 10-Q are available on our website at wmg.com.

  • Today, our Chairman and CEO, Edgar Bronfman Jr., will update you on the business performance, strategies, and suspension of our regular quarterly dividend, also announced today, and our EVP and CFO, Michael Fleisher, will discuss financial results for the quarter.

  • Then Edgar will wrap up before we take your questions.

  • Before Edgar's comments, let me remind you that this communication includes forward-looking statements that reflect the current views of Warner Music Group about future events and financial performance.

  • Words such as estimates, expects, plans, intends, believes, should and will, and variations of words or similar expressions that predict or indicate future events or trends, or do not relate to historical matters, identify forward-looking statements.

  • Such statements include, but are not limited to, estimates of our future performance, such as the success of future album sales, projected digital sales, increases and declines in physical sales, expansion of the online marketplace, success of strategic actions we are taking to accelerate our transformation as we redefine our role in the music industry, market share gains, our expected income tax expense for fiscal 2008, our intentions to deploy our capital including the level of and effectiveness of future A&R investments, and our intentions with respect to dividend policy.

  • All forward-looking statements are made as of today, and we disclaim any duty to update such statements.

  • Our expectations, beliefs, and projections are expressed in good faith and we believe there is a reasonable basis for them.

  • However, there can be no assurance that management's expectations, beliefs, and projections will result or be achieved.

  • Investors should not rely on forward-looking statements because they are subject to a variety of risks, uncertainties, and other factors that can cause actual results that differ materially from our expectations.

  • Information concerning factors that could cause actual results to differ materially from those in the forward-looking statements is contained in our earnings press release and form 10-Q, and other SEC filings.

  • We plan to present certain non-GAAP results during this conference call.

  • We have provided schedules reconciling these results to our GAAP results in our earnings press release posted on our website.

  • With that, let me turn it over to Edgar.

  • Thank you.

  • Edgar Bronfman Jr. - CEO

  • Thanks, Jill.

  • Welcome everyone.

  • Thanks for joining us.

  • Let me start by saying Warner Music Group had a strong operating quarter and again, out performed our competitors as we continue to execute on our strategy of becoming a broad-based music business with more diversified revenue strength.

  • Physical recorded music sales continue to decline industry wide and slowing ring tone growth as well as the softening broader economy, are also negatively impacting the recording music industry.

  • However, despite these challenges, Warner Music continues to affectively steer through difficult times, and is best-positioned to take advantage of the opportunities offered by the music industry's on-going transformation.

  • We continue to have a strong track record of out performing our peers in the tumultuous music marketplace, due to in large part to the excellent returns we have consistently generated on our A&R investments.

  • As the challenges in the recorded music industry persist, we recognize that the global economy has weakened and credit markets have deteriorated dramatically, making the choice to be even more fiscally prudent and add more financial flexibility to our balance sheet, a high priority.

  • As we've previously discussed, our board and management regularly evaluate our balance sheet and use of capital to enhance shareholder value, how best to maintain our financial flexibility while continuing to out-perform competitively and derive equity appreciation for shareholders has always been of paramount importance to us.

  • As a result of our analysis, we have decided to suspend our dividend.

  • Given the current state of both the economic and music markets, this action will provide us the flexibility we need to remain conservative in the management of our balance sheet while sustaining our level of A&R investment as a key ingredient to our continuing to achieve superior competitive results and investment returns.

  • Further in pursuing this path, we feel confident that when the economic environment ameliorates, and as the recorded music industry transformation advances, we will be best-positioned to seize even greater opportunities within the recorded music industry.

  • Now let me describe to you, some of our recent achievements and on-going initiatives aimed at positioning us for further growth.

  • Highlighting the success of our focused investment in A&R, marketing and promotion, we continue to discover and develop successful artists.

  • In our second quarter in the U.S., Warner Music was the only music major to grow, gaining 2% while the industry declined 5% in track equivalent album unit sales.

  • Warner Music gained 1.2 percentage points of market share in the quarter, more than any music major, ending the quarter at 20.2%.

  • This is the fifth consecutive quarter for which we have grown sound scan U.S.

  • track equivalent album share on a year-over-year basis.

  • Second, in the important digital arena, we continue to be a leader in shaping the future of the music industry.

  • Our quarterly digital revenue was 21% of total revenue, up from 14% in the December quarter.

  • For U.S.

  • recorded music, our digital revenue reached an all time high of 34%, up from 22% in the December quarter.

  • And we sustained our competitive digital lead into the March quarter, with the greatest U.S.

  • digital album share advantage over physical album share of any of the music majors.

  • Third, as part of our transformational effort to expand our role in the music business, we continue to expand our rights and recording agreements with new artists around the world, giving us a presence in the broader music business that will be increasingly meaningful to us going forward.

  • Fourth, we continue to bolster our music publishing business by strengthening our artist roster and catalog, and expanding our digital presence while delivering consistent results.

  • Now let me provide you with some detail about these achievements.

  • A&R marketing and promotion remain at the the heart of our business activities.

  • Our success in these areas over time, is best measured by our ability to grow our margin and market share.

  • In fact, According to sound scan, we have increase our U.S.

  • album share in 11 of the 12 quarters that the Company has been publicly traded, and we have grown that share by nearly 5 percentage points since our team acquired Warner Music in March 2004.

  • This was the first quarter since we have been public that we gained U.S.

  • album share year-over-year in all of the top five musical genres.

  • While we've accomplished all of the above, based on available reported margin data, we continue to manage our business at margins that we believe are equal to or superior to those of our much larger competitors.

  • In the March quarter, our international recorded music business rebounded solidly, while the U.S.

  • recorded music business turned in weaker results.

  • Despite our relative U.S.

  • out performance as measured by SoundScan, our results which are based on shipments, reflect the timing of releases and efforts by retailers to more actively manage their inventory levels.

  • Michael will address this more fully in a moment.

  • We continue to see a pick up in our UK business, led by sales from Nickelback, Michael Buble, Muse, and REM.

  • Most of the other key European markets benefited from stronger releases and comparisons to our softer prior year quarter.

  • We had another excellent quarter in Japan, gaining nearly 2 points in sound scan album share year-over-year over in the world's second largest recorded music market.

  • Results were driven by strong momentum from local artists, such as multi-platinum seller, Kobukuro.

  • We remain committed to growing our digital recorded music revenue, first, to compensate for and then to overtake the decline of the physical recorded music business.

  • This quarter produced stellar online digital results helped by the [mexit] releases and post-holiday gift card activity.

  • While ring tone sales remain pressured in the U.S.

  • and Europe, we believe the success of Japan's mobile music business can been looked at as a indicator of where the mobile music business is heading outside of Japan.

  • Japan's digital music business is almost entirely driven by mobile, given faster networks, advanced hand sets, superior user interfaces, flat rate data plans, and more complete catalog offerings.

  • In 2007, according to the Recording Industry Association of Japan, Japan's digital music business grew 41%.

  • Full-track downloads showed the greatest growth, rising 91% over the previous year and accounted for one-half of overall mobile music revenues.

  • While often extremely small base, we are seeing full-track mobile downloads growing rapidly on other markets, including the U.S.

  • As new mobile products and developing mobile business models spread worldwide, we believe mobile growth will accelerate in the U.S.

  • and Europe, as it continues to do in Japan.

  • Warner Music had quarterly digital revenue of $164 million, a sequential improvement of 16% and a 48% gain, compared to the same quarter last year.

  • As I mentioned, this quarter, our digital revenue was a record 21% of our total revenue, and was 34% of our U.S.

  • recorded music revenue.

  • These are very significant percentages and provide insight into how quickly our business is evolving.

  • This quarter, we again demonstrated both the success of our digital strategy, including our on-going supremacy in the sale of premium album bundles on iTunes and the strength of our content.

  • Atlantic Records artist, Flo Rida, broke several chart records.

  • Flo Rida's single, Low, set the record for most consecutive weeks as the number one ring tone in the U.S.

  • on the Nielson ring scan chart.

  • Flo Rida's also the first ever day new artist to have two top ten songs on Billboard's hot digital song's chart prior to an album release.

  • While we will see the results in our third quarter, in March Warner Music began implementing a progressive global marketing campaign for Madonna's eleventh Warner Brothers studio album, Hard Candy released ten days ago.

  • We entered into a series of carefully crafted digital partnerships with Vodafone, Samsung, Verizon, and Microsoft, each of which is individually designed to raise awareness and drive Madonna's record sales.

  • For example, an exclusive global pre-launch from Vodafone offered it's subscribers one new track from Hard Candy each day, counting down the week before the album was first made available, resulting in a single four minutes, becoming Vodafone's best selling track ever.

  • Collectively, tens of millions of dollars in advertising was spent by our digital partners, contributing to Hard Candy, debuting at number one in 28 countries around the world.

  • Hard Candy is one of Warner Music's most successful pre-released album bundles on iTunes in the U.S.

  • During the pre-release period, the premium version of Madonna's Hard Candy at $13.99 outsold its standard $11.99 version 8 to 1.

  • In December, we began offering DRM free audio downloads on the Amazon MP3 digital music store, which allows every track and album purchased to be playable on practically any digital device, including iPods.

  • MPB's research as found that digital sales through Amazon are enlarging the digital business, rather than cannibalizing sales from iTunes, and that Amazon sells a much higher proportion of albums to singles than iTunes, both encouraging developments for our industry.

  • Expending the strategy, Warner Music has announced a series of MP3 deals in recent months with partners who have agreed to support our project management strategy, promote pricing flexibility, and meet our technology initiatives.

  • We remain focus on monetizing the broad reach of our digital offerings.

  • One of our key priorities has been to unlock the value of music in the context of social media and online communities.

  • For example, we continue to develop new partnerships and business models in the online community space, potentially one of the industry's greatest growth opportunities.

  • We've approached the social networking landscape through investments and partnerships with selective companies.

  • You've heard us speak in the past about our deal with Imeem, the fastest growing social network today, to which we've recently licensed the rights to our music publishing catalog, in addition to our recorded music catalog.

  • However, nothing we have done in the past has been anything like the scale of the deal we recently announced with MySpace.

  • The new joint venture which we be called MySpace Music will offer DRM free digital downloads, and supported audio and video streaming, ring tones and other mobile products, as well as merchandise, concert tickets, information, and all kinds of ongoing interaction between artists and fans, on the world's largest social network.

  • We will be participating in a fully-integrated music offering, making use of our large library of recorded music and music publishing content.

  • We see this as a powerful way to monetize our content on a platform that has the broadest possible reach.

  • This consumer offers strengthened in it's breath of repertoire, by the participation of Sony BMG and Universal Music Group.

  • Creating and developing new digital business models to accelerate our business transformation remains a top strategic comparative.

  • We recently entered into a content agreement with TDC, a leading telco in Denmark, which established some key parameters for future business development initiatives.

  • TDC launched a new ground breaking service that offers its mobile and broadband customers unlimited access to tethered music downloads without additional charge.

  • We believe that packaging unlimited music in the mobile services possesses an attractive value proposition for subscribers, as well as a significant opportunity for us to monetize consumer behavior across cash networks.

  • We will continue to explore and develop these types of models around the world.

  • As we push to increase our digital revenues, we recognize that we must also transform our business within the music value chain.

  • As we have mentioned, we are continuing to enter into expanded rights deals with recording artists that provide us participation in growing areas of the music business, such as sponsorship, fan club merchandising, touring, ticketing, and artist management.

  • Through a broadening partnership between artists and their label, both parties' interests are aligned to nurture and grow all aspects of a artist's career.

  • We are entering into new deals at a rapid pace all around the world.

  • We are moving aggressively to establish a best-in-class skill set beyond our core recorded music and music coalition expertise, so that we can optimize our offerings to artists and broaden our revenue mix.

  • This process should largely be accomplished by organically growing the businesses we acquired in the last few years, and through small incremental moves, strategically designed to enhance our overall results.

  • In February, we acquired a controlling stake in an Italian touring company founded by executives from friends and partners, Italy's leading touring company.

  • This transaction will provide Warner Music Italy with a strong entry into the concert and booking business with local Italian artists, facilitating our efforts to broaden our artist relationships and adding proven touring management to our team.

  • One of our strategic goals has been to drive the performance of the uniquely valuable WarnerChappell music publishing business which is the world's third largest music publisher.

  • Warner/Chappell enjoys a stable, diversified revenue stream from its extraordinary library and has delivered improved performance over the past year.

  • As we've noted in the past, we have a global multi-pronged plan to drive long-term growth at Warner/Chappell.

  • We intend to make the necessary content investments to support our growing production music business, new song writer discovery, and catalog development, develop new exploitation opportunities to expand the value of our existing catalog, expand our leadership position in digital music by playing the key role in industry initiatives, platform development, and standard setting, such as our recent Pan European digital licensing efforts, and broaden our international reach and deepen our global content offerings.

  • We continue to make progress against these initiatives.

  • The recent U.S.

  • Federal Court decision on music publishing performance rates for internet streaming by AOL, Real Networks and Yahoo was an important victory for the music publishing industry, ASCAF, and Warner/Chappell .

  • The new rate was set at 2.5% of revenue until 2010, and will be retroactive to the launch of these streaming services in 2002.

  • While the decision is subject to appeal, it establishes the clear, well-reasoned framework for properly evaluating musical compositions in the digital world.

  • Furthermore, on the digital front, in addition to agreements with MySpace and Imeem, Warner/Chappell has also now concluded licensing agreements with online radio players, Slacker, and with the web-based ad supported music service base biofrog.

  • The Warner/Chappell will continue to be aggressive in developing a winning digital music strategy.

  • We continue to see great potential here.

  • Warner/Chappell's A&R efforts identify some of the brightest talents in the business.

  • In February, Warner/Chappell announced a worldwide publishing agreement with singer/songwriter duo, Glen Hansard and Marketa Irglova, winners of the best original song Academy Award for Falling Slowly from the acclaimed independent Irish musical film, Once.

  • Highlighting the success of our Warner/Chappell artists, songwriter/producer Timberland earned the ASCAP Songwriter of the Year title for his contributions to nine award-winning songs.

  • Prior to receiving this award, Timberland was twice recognized by ASCAP as Rhythm and Soul Songwriter of the Year.

  • In addition, Warner/Chappell music writers, Burt Bacharach and Rodney Robertson, were awarded lifetime achievements awards for their artistic contributions to the recording medium at the recent Grammy Awards.

  • We look forward to updating you on Warner/Chappell's continued progress.

  • Now, I would like to turn the call over the Michael for a run through of

  • Michael Fleisher - CFO

  • Thank you, Edgar, and good morning, everyone.

  • Let me begin by covering some of the key financial highlights for the quarter.

  • Looking at the income statement for the three months ended March 31, 2008, we reported revenue of $800 million, which declined 4% on a constant currency basis.

  • All the revenue data that I'm about to discuss is on a constant currency basis.

  • All the margin data, for purposes of comparisons between periods, will account for the prior-year quarter's $16 million restructuring related charges in connection with the Company's fiscal 2007 realignment initiatives.

  • Domestic revenue fell 14% while international revenue grew by 7%.

  • We saw revenue gains in Europe, Asia Pacific, Canada, and Latin America.

  • Overall, total quarterly digital revenue growth outpaced the market, growing 48% to $164 million or 21% of total revenue, up from $111 million or 14% of total revenue in the prior year quarter.

  • This spike upwards of 7 percentage points sequentially, came as a result of the release schedule, post-holiday gift card activity, and the general consumption shift from physical to digital.

  • We expect to continue to see fluctuations quarter-to-quarter in the digital revenue percentages, driven by our release schedule and seasonality, and format mix.

  • Approximately 65% of our total digital revenue was generated in the U.S., and 35% in the rest of the world.

  • Our worldwide digital revenue stands at about 70% online, and 30% mobile.

  • In both the U.S.

  • and internationally, online is a larger share of our digital business than mobile.

  • Mobile remains soft as ring tone sales fell year-over-year in the U.S., and remained flat sequentially internationally in the quarter.

  • Newer mobile products such as ring back tones, full-track downloads, and other more innovative offerings remain too small as yet, to meaningfully impact mobile results.

  • Though the overall recorded music business may take some time before it returns to growth, we continue to develop our digital business and broaden our approach to the recorded music business, in order to mitigate our exposure to current industry trends while delivering profitability through the focus on financial discipline.

  • While transforming our business mix, we remain vigilant about managing our costs, even as we make the investments necessary to lay the foundation for future growth.

  • Our operating income before depreciation and amortization or OIBDA from continuing operations was flat year-over-year, and our OIBDA margins were also relatively stable.

  • Now, let's look at our different business segments.

  • Quarterly recorded music revenue fell 4% to $652 million.

  • Major sellers in the quarter included REM, Simple Plan, Kobukuro, Nickelback, and the Juno soundtrack.

  • We saw growth in our international physical recorded music business and our global digital business.

  • We had revenue gains in the UK, Germany, France, Canada, Latin America, and Japan.

  • Overall, international recorded music revenue rebounded 10% while domestic recorded music revenue fell 17% year-over-year.

  • The timing of our release schedule and continued contracting demand for physical product, led to weak domestic recorded music results.

  • In the U.S., retailers are more actively managing their inventory levels in response to the tougher economy and credit markets, as well as the changing underlying demand for physical product.

  • We are expect this realignment process to continue.

  • Reportedly, as evidenced by SoundScan which measures over-the-counter unit sales, consumer demand for physical product including catalog, hasn't changed substantially over the past several quarters.

  • As a result, the variance between our U.S.

  • shipments and the SoundScan reports are primarily due to timing differences and retailer inventory levels.

  • We are unwilling to cut our prices just to ship product into retailer inventory.

  • Ultimately, this retailer process will lead to a healthier physical marketplace with retailers better managing their physical music business.

  • Partially offsetting the physical declines, recorded music digital revenue grew 48% from the prior year quarter to $155 million or 24% of total recorded music revenue, up from 16% in the same period last year.

  • Domestic recorded musical digital revenue grew 31% to $101 million with 34% of total domestic recorded music revenue, compared to 22% in the same period last year.

  • Quarterly recorded music OIBDA from continuing operations was flat year-over-year.

  • Moving now to our music publishing business, in comparison to the same quarterly period in 2007, music publishing revenue of $155 million was flat.

  • Music publishing revenue grew 5% domestically, offset by a 3% decline internationally.

  • Total music publishing revenue benefited from gains in digital and performance revenue, offset by declines in both mechanical revenue, and to a lesser extent, synchronization revenue.

  • Sync revenues continue to feel the impact from the recent Writer's Guild of America strike.

  • Music publishing OIBDA was $54 million.

  • OIBDA and OIBDA margins for music publishing were flat year-over-year, excluding a $1million favorable impact of foreign currency exchange rates.

  • As for out cash management in our balance sheet, we ended the quarter with a cash balance of $249 million.

  • Total net debt amounted to approximately $2 billion, which reflects total debt less cash.

  • As we indicated last quarter, our cash and net debt balances reflect a reversal of the timing related increase in net accounts receivable from the holiday period.

  • For the quarter, we had positive free cash flow of $99 million, primarily due to working capital improvements from the timing of sales.

  • Our free cash flow is calculated by taking cash from operations of $132 million, less capital expenditures of $13 million, and net cash paid for investments of $20 million.

  • For the three months ended March 31, 2008, we had net cash taxes of $9 million and a provision of $13 million, on a pretax loss from continuing operations of $21 million.

  • As we have discussed before, our income tax expense is primarily based on income earned by our foreign affiliates.

  • In addition, our income tax expense includes withholding taxes paid to nonU.S.

  • countries where we generate royalty income from sales of repertoire outside the U.S.

  • Our income tax expense fluctuates based on the mix of income or loss, and the different applicable tax rates within each foreign jurisdiction.

  • We expect our tax expense for fiscal 2008 to be about the same as the prior year level of $49 million, depending on our geographic profit mix.

  • For the quarter, regenerated a net loss from continuing operations of $34 million or $0.23 per diluted share, including a $0.09 per share tax impact on results.

  • We will continue to press ahead with our transformational initiatives, but as previously mentioned, the M&A investments over the remainder of this fiscal year should be nominal, as we build cash and effectively reduce our net debt, preserving financial flexibility.

  • We will continue to exercise financial discipline around all of our A&R investments.

  • We also expect that we will continue to invest in A&R at the same level as the last few years.

  • As we have consistently said, we do not manage our business for any single quarter.

  • We strive to release the right content, at the right time, in an effort to maximize fiscal year profit potential and artist career development.

  • As a matter of policy, we do not provide financial guidance to the investment community, given that quarterly fluctuations from our music release schedule and associated marketing and promotional expenses, are normal.

  • While recognizing the challenges ahead, we are confident in our future.

  • Now, I would like to turn the call back to Edgar for some closing remarks.

  • Edgar Bronfman Jr. - CEO

  • Thank you, Michael.

  • Over the course of this year, we plan to work towards optimizing, evolving, and transforming our business.

  • In doing that, we will stay vigilant in managing costs and investments, while generating significant free cash flow as we adopt a prudent approach to our balance sheet in this uncertain economic environment.

  • We will enhance our digital leadership, doing innovative models while transitioning the recorded music industry back to a growth trajectory.

  • We will to continue to enhance the value and progress of Warner/Chappell.

  • We will broaden partnerships with artists and build relationships with consumers to add new revenue streams from growing segments of the music business.

  • And we will increase market share, while maximizing on margin potential.

  • Recognizing that we have an aggressive agenda, we are confident that we have the right strategy and team in place.

  • Our goal is to drive shareholder value over the fiscal year and beyond, as we evolve our business model and take advantage of opportunities in the rapidly transforming music industry.

  • We look forward to answering your questions.

  • Thank you.

  • Operator, if you would open it up to Q&A.

  • Operator

  • (OPERATOR INSTRUCTIONS) Please stand by for the first question.

  • The first question is from Bishop Cheen with Wachovia.

  • Bishop Cheen - Analyst

  • Thank you, Edgar, Michael, Jill.

  • Let me focus on the balance sheet, Michael.

  • You have a covenant step down to 4.25 times in your credit facility.

  • And then it goes down I think to 4 times at October 1st.

  • So with these step downs and with your new approach cutting the dividend, et cetera, it looks to be a little tight.

  • Is the definition of that ratio net of cash?

  • And if so, can you then continue to buildup cash to meet those covenants?

  • Edgar Bronfman Jr. - CEO

  • It's Edgar.

  • First of all, the definition does include cash on the balance sheet and I don't think it's tight and I don't intend to let it get tight.

  • And I want to be very clear.

  • We feel totally comfortable that we have complete financial flexibility we need to meet our covenants going forward.

  • In addition, we feel great about our competitive performance and our ability to continue to generate excellent returns on our A&R investments.

  • And those constants we don't expect to change.

  • What has changed is the economy has weakened.

  • The credit markets have deteriorated incredibly and we are grappling with a recorded music industry that is in the middle of a transformation.

  • As a result, we decided to suspend the dividend in order to take a more conservative approach to cash management that allows us to reduce the net debt while maintaining our level of A&R investment, and we think that's the best combination of policies to create equity appreciation for shareholders.

  • Bishop Cheen - Analyst

  • Understood, and you have been very articulate about that.

  • Just a quick follow up.

  • As you look forward in these investments in A&R, do you expect you will see the lift from your A&R investments continue throughout '08 and into '09?

  • Or is it something that is just going to rachet up a year from now?

  • How long does it take to cook this uptick?

  • Edgar Bronfman Jr. - CEO

  • Bishop, first of all, as Michael indicated, we intend to invest in A&R at approximately the same levels that we have in the past.

  • You can see what's happened to, as we've explained, our market share, which continues to grow both internationally and particularly in the U.S.

  • over the past four or five years.

  • And the fact that as I mentioned we manage our business at margins which we believe are greater to or better than our much larger competitors.

  • You got to take the view that our A&R investments resulted and continue to result in good returns for -- or outstanding returns for investors and we see no reason why that should change.

  • Bishop Cheen - Analyst

  • Thank you for the color.

  • Operator

  • The next question is from Mike Clarfeld from ClearBridge Advisors.

  • Mike Clarfeld - Analyst

  • Just following up on the first question.

  • Could you talk more about your policy on cutting the dividend?

  • Are you doing that because you're concerned about your ability to meet your debt covenants going forward?

  • Edgar Bronfman Jr. - CEO

  • We are not concerned about our ability to meet our debt covenants.

  • I can't underline that strongly enough.

  • Given the uncertain economic environment, as we look at what levers do we want to pull to make sure that as we sail our ship no matter what currents run under the water, no matter what winds blow above the water, we are going to be nowhere near the shoals or the rocks that we don't anticipate.

  • There are a lot of different levers we can pull.

  • We felt that cutting or simply suspending the dividend was the best of those levers, but I do feel quite confident even if we had not done so we would not have a debt covenant issue.

  • Mike Clarfeld - Analyst

  • Thank you.

  • Operator

  • The next question is from Doug Mitchelson with Deutsche Bank.

  • Doug Mitchelson - Analyst

  • Thanks, good morning.

  • Edgar, you went through a awful long list of things you're going on digital to grow revenue, reinvent the business model, both different business models domestically and internationally.

  • What would be helpful is -- which of those would have the greatest impact on your business this year, which will have the greatest impact on your business next year?

  • What would you point us to in terms of will actually hit the financials over the next year or two?

  • Edgar Bronfman Jr. - CEO

  • Look, I think I'd frame it the following way, Doug, without trying to be too specific as to what timing will be.

  • I will try and give some color to that as well.

  • Over time, you're going to see four income streams largely emerge from the digital arena.

  • Those are going to be continued purchase of music.

  • Advertising based revenue, subscription based revenue and what I will call accessed base revenue.

  • Those four buckets are largely to be the largest buckets in digital revenues as our business models evolve.

  • Clearly for some time the purchase bucket is going to be the largest of those.

  • There is increased traction around subscription.

  • And I think access and advertising will follow.

  • I think when you look at -- and then of course beyond that, we think that we will have revenue streams from businesses that are affiliated with but are not specifically recorded music such as merchandise, ticketing, fan clubs, subscriptions, et cetera, as we expand our partnerships with our artists going forward.

  • Doug Mitchelson - Analyst

  • Can I follow up with Michael -- on the A&R investment, I understand you're not going to give us return that you think you've earned so for or what your return hurdle on A&R might be.

  • But can you give us a sense of how returns have been changing?

  • Have they been improving, or deteriorating?

  • Obviously there is competition for some of the bigger artists out there -- that is relatively new.

  • On a blended basis, how are returns trending on A&R?

  • Michael Fleisher - CFO

  • Doug, we just completed work looking at A&R returns over the last three or four years since we took over the company and comparing those to the A&R returns in the past.

  • Our A&R returns have held quite steady, we had better returns in the last couple of years on our A&R investments as our management teams have been stable and had good longevity and been able to build artists over time.

  • So when we look at the vintages of our releases going through '05, '06, '07, we continue to see fabulous returns on A&R and that's the reason we are going to continue to invest against it.

  • Edgar Bronfman Jr. - CEO

  • If I can give color to that, we did finish that study, but I don't think Michael made enough of the point that our returns on A&R have dramatically improved since 2004 when we acquired the company versus the A&R investments made prior to 2004.

  • Much of that of course has to do with making those A&R investments over a smaller overhead base.

  • Within the four year period that we've owned the business, investment returns on A&R have actually improved in the last two years versus the first two years, much of that because of the Atlantic/Electra restructuring and the resuscitation of the [Ars] rosters on the East Coast.

  • The last point I would make is as I said many times before, the overinvestment in chapter two or chapter three of a major artist's career has historically been a poor return for the recorded music industry, and the industry is replete with examples and I won't go in to them.

  • We continue to exercise a very high degree of financial discipline so that our investments do return superior results.

  • Whether it's in a new artist or established artist, it is almost always because we simply make an investment decision not to proceed with a project or deal that we feel will not return according to the standards that we insist upon.

  • Doug Mitchelson - Analyst

  • Great, thanks.

  • Operator

  • The next question is from Ingrid Chung from Goldman Sachs.

  • Ingrid Chung - Analyst

  • Good morning, thank you.

  • So two questions, to start off -- to use a baseball analogy.

  • Which inning do you think you are in, in terms of the investment cycle for A&R and also to become a 360 Music company, or is it more of an ongoing investment?

  • Number two, can you talk about the tighter retail management of inventory?

  • Seems like it has had -- almost looks to me like a 1,500 basis point impact on your domestic growth.

  • When do you see that returning back to normalized levels?

  • Edgar Bronfman Jr. - CEO

  • I will let Michael do the second part of your question.

  • It was interesting to at least see your note earlier this morning.

  • So let me try and answer some of the questions that you just asked and you posited in your note as well.

  • A&R investment is a continuing investment.

  • As we tried to indicate in our prepared remarks and previous answers, we don't expect our A&R investment to increase or decrease.

  • We think we got the right level of A&R across the right level of overhead, and based on the extensive studies we have done, those investments return very well for shareholders.

  • So I don't see that cycle increasing or decreasing -- it's more of a constant.

  • In terms of the 360, we have made a series of investments, and as we indicated in prepared remarks, we expect going forward that our business will benefit from monetizing those investments rather than making incremental investments.

  • Lastly I would say we had enormous success in the U.S.

  • and globally in signing new recording artists with significantly broadened rights without significantly increased investment to obtain those rights.

  • So we think that will continue.

  • And so I guess I would say we don't expect significant M&A activity to broaden our 360 platform.

  • We think we will continue to do that organically and with the M&A activity that preceded us and A&R remains a constant rather than a cycle.

  • Michael Fleisher - CFO

  • On the question of retailers and how they are managing inventory, our view is that especially coming off of the holiday season, when inventory levels are extraordinarily higher for retailers, they're intentionally growing inventories through the holidays up to and including through the holidays.

  • And so as we went into the first calendar quarter, our physical retailers -- smartly for their businesses by the way -- chose to work down the inventory levels.

  • One of the practices in our industry historically has been in those kinds of quarters to discount dramatically, particularly around catalog product, in order to push inventory from our loading dock into the inventory of our physical retailers.

  • And we have been quite clear we're not going to bow to the pricing pressure, particularly in catalog where we know that catalog will sell through, because when a consumer is looking for a piece or particular catalog product, they are happy to pay full full retail price for it.

  • I suspect we will continue to see physical retailers trying to manage inventory better or smarter -- we're actually proactively working with a number of retailers to do that in concert with each other.

  • We have a pretty good handle on it.

  • They have an okay handle on it.

  • Together we can create a better inventory pattern for both of us.

  • I would expect that to continue.

  • It has been happening over the last year -- it will continue over the next year.

  • I think there was a bigger impact this quarter largely because of the holiday inventory buildup.

  • Ingrid Chung - Analyst

  • Great, thanks.

  • Operator

  • The next question is from Jessica Reif Cohen from Merrill Lynch.

  • Jessica Reif Cohen - Analyst

  • I have one clarification and two questions.

  • On the clarification, back to the balance sheet -- can you tell us what the current net debt to EBITDA position is under the covenant's definition?

  • The two questions are, what are your digital margins now that 34% of U.S.

  • sales and 21% overall of your sales come from digital?

  • And secondly, more on timing, when do you expect to see some meaningful benefit from MySpace music?

  • Edgar Bronfman Jr. - CEO

  • Let me start with MySpace.

  • I will ask Michael to clarify the balance sheet issue and the digital margin question.

  • MySpace music I think is going to launch probably around September time.

  • I would expect if it launches in September, I hope it will have a strong December quarter.

  • Then we think it can and will gain momentum beyond that.

  • I wouldn't see anything meaningful from MySpace until our '09 year.

  • Then obviously we would hope that given the breadth of the offering we believe MySpace music will have for consumers -- we hope that will become a important contributor as the years go on.

  • Nothing I don't think of size, but all in '08.

  • Michael Fleisher - CFO

  • Jessica, on your question on the ratios, we don't disclose the ratio.

  • The calculation is relatively straightforward.

  • There are addbacks for things like noncash charges, FAS 123, et cetera.

  • What I can say is that certainly the ratio at March 31st, where we had to be at under 4.5, we were very comfortably under that number.

  • On the digital margins, I'm not sure I fully understood your question.

  • We clearly get a margin benefit from digital sales versus physical sales.

  • Jessica Reif Cohen - Analyst

  • Just wondering if you could elaborate.

  • You said that.

  • Now that it's becoming a meaningful contributor to revenue?

  • Michael Fleisher - CFO

  • It's becoming a meaningful contributor to revenue and a meaningful contributor to our profitability.

  • I would expect that to continue.

  • We're not going to give any greater detail.

  • We have said in the past that there is a substantial margin benefit from digital and we will continue to see that benefit as the digital business grows.

  • Jessica Reif Cohen - Analyst

  • Thank you.

  • Operator

  • Your next question comes from Jason Bazinet of Citigroup.

  • Jason Bazinet - Analyst

  • I think the amount of money you paid for acquisitions stepped down in the quarter, but when I go back over the last four quarters, if I'm doing the math right, you spent $317 million on acquisitions.

  • When I look at the numbers you're reporting on year ago revenue, I think you're reporting the numbers pre any of that M&A.

  • I was wondering, is that right?

  • Will we ever get a sense of pro forma clean numbers after the acquisitions?

  • Thanks.

  • Edgar Bronfman Jr. - CEO

  • I guess I'm not sure of the question.

  • I'm not sure I understand on the reporting.

  • As we acquire businesses, we add them in to the revenue and profit mix.

  • That is true of all the businesses we acquire where we are consolidating them.

  • Some are more substantial investments -- as an example, Front Line -- are not being consolidated.

  • So we are only picking their profitability up below the line, our share of their profitability.

  • When you look at the dollar value of those investments, you do need to sort of reverse out of that some of those that aren't contributing to the revenue line at this point in time.

  • Jason Bazinet - Analyst

  • When I look at the March '07 number that you put on the release, those numbers are not pro forma, correct?

  • Are those revenues you do consolidate?

  • Edgar Bronfman Jr. - CEO

  • Correct.

  • Jason Bazinet - Analyst

  • Will you ever disclose those?

  • Edgar Bronfman Jr. - CEO

  • We don't have any intention to.

  • Jason Bazinet - Analyst

  • Thank you.

  • Operator

  • The next question is from Rich Greenfield of Pali Capital.

  • Rich Greenfield - Analyst

  • Hi.

  • Couple of questions.

  • One, when you -- just to follow up on Jason's question, you commented in the past about the relative impact of acquisitions.

  • If your revenues were down 4% on a constant currency basis, can we assume similar to last quarter you were down several more points, possibly in the area of 7 to 10% if you remove the impact of acquisitions year-over-year?

  • And then two, you've got a couple of big artists currently in the process of contract negotiations in terms of Nickelback and Metallica, and wondering what you could tell us in terms of where that stands?

  • I know Nickelback relates to Roadrunner, which you bought last year.

  • That contact I assume expires before they have to deliver their next album.

  • Any clarity would be great on that.

  • Lastly, given that you're cutting the dividend, why did you actually make the acquisition of Front Line?

  • It's a nonconsolidated acquisition.

  • That would have saved you over $100 million and allowed you to pay the dividend for a good while longer.

  • Just trying to understands what the rationale for that acquisition was.

  • Thanks.

  • Edgar Bronfman Jr. - CEO

  • Rich, the old thing -- you grant a premise, you can win any argument.

  • You've got so many premises there that are wrong.

  • I will try and take them one by one.

  • Michael can do, and I'll ask him to do a better job on the acquisitions.

  • Your premise there is in terms of what the revenue would have been is wrong.

  • In terms of the artists' contracts, just to be clear, the Nickelback contract does not expire.

  • When we purchased Roadrunner, we have two additional Nickelback studio albums and a greatest hits to come under the contract when we purchased Roadrunner.

  • So there is no pressure on us to negotiate to get additional Nickelback albums, unless of course we did so on a improved financial basis.

  • But there is no urgency for a Nickelback renegotiation other than to improve our financial position if we chose to do that.

  • Metallica is at the end of their contract.

  • It's been a long and great association, we have an album due from Metallica to go before the end of that contract.

  • We don't comment specifically on artists' negotiations beyond that.

  • Again, I just wanted to be clear about your notion there.

  • Michael, do you want to give any color on the acquisition?

  • Michael Fleisher - CFO

  • What I'd say on the acquisitions is that most of the acquisitions that are generating incremental revenues, we sort of passed their anniversary or three quarters through their anniversary.

  • I don't think there is -- of the consolidating acquisitions that we are doing, I don't think there is a meaningful year-over-year revenue impact if you look at this quarter versus the previous quarters.

  • Edgar Bronfman Jr. - CEO

  • On Front Line, first of all, Front Line was a large unconsolidated investment.

  • Smaller but still meaningful ones that would also be included would be Imeem and Lala.

  • A fair amount of money that Jason described is going to unconsolidated investments.

  • We think all of those will bear significant fruit, which is why we made them.

  • Front Line continues to be an expanding and very profitable business and gives us a tremendous insight into the management business and the artist perspective on revenue streams they are able to generate, and significantly enhances, I believe our ability to both sign and properly exploit the revenue streams we are bargaining for in new contracts, as well as giving us an insight and background in to how to respond to changes in the industry, while being an accreting asset for shareholders.

  • With regard to Imeem and Lala, we have a lot of faith in those businesses.

  • If you look at what is happening with Imeem right now, based on its fund [rates], I would suggest that our investment is worth a great deal more than we paid for our original investment.

  • We make accretive acquisitions where they can benefit the company, where they can further a business model we think is helpful and trading a dividend for Front Line investment in my view is a good trade.

  • Michael Fleisher - CFO

  • We have time for one more question.

  • Operator

  • The last question is from Tuna Amobi from Standard & Poor's.

  • Tuna Amobi - Analyst

  • Thanks a lot.

  • I guess my first question is on the mp3 deals that you guys made the past couple of -- over the past year, you have gotten aggressive in the deals, this year seems like it's been on an inflection point for the industry in terms of the newer services that we have seen.

  • So I guess the question there is do you think that this market -- this digital market for mp3 can coexist side by side with the DRM and if so, how do you think they play off of each other?

  • Any potential that we're going to see overall growth of the digital music market?

  • Are the ties going to grow, or is there potential for cannibalization there?

  • Edgar Bronfman Jr. - CEO

  • I think you're going to continue to see a mix of DRM and DRM free product in the marketplace.

  • Certain business models like subscription require some levels of DRM.

  • Other kinds of business models such as purchase don't absolutely require it.

  • I think as business models evolve you will see a mix of DRM and DRM free.

  • Clearly, the digital music market continues to grow.

  • It continues to grow at a strong pace.

  • And I think my hope is that that growth will accelerate as the business models significantly expand.

  • Remember that today our digital revenues really are a function of iTunes principally and ringtones.

  • That's a narrow base for a very very broad opportunity.

  • Those opportunities will come online.

  • We will see additional business models.

  • We will see additional retailers.

  • We will see social networks begin to play an important role.

  • We will see advertising begin to play a important role.

  • We will see ISPs begin to play an important role.

  • And so the source of funds in digital will continue to grow, and as they do, it is my hope that the business' growth itself will accelerate over the next few years.

  • Tuna Amobi - Analyst

  • On the digital growth you just alluded to, of those four buckets that you had earlier identified, where do you see the greatest growth coming from.

  • And also on digital, when you do these expanded 360 deals, I presume digital licensing is a core part of the deals?

  • Am I correct or not?

  • Edgar Bronfman Jr. - CEO

  • Let me answer the second question first.

  • Digital rights for recorded music is something that we have in all of the contracts and have had in all of the contracts.

  • There is nothing new there.

  • Clearly as we have expanded rights with artists in terms of fan clubs or merchandise or ticketing or touring or those kinds of things, some of those apply to the digital world as well.

  • Some of those like touring apply less to the digital world.

  • In terms of the -- but clearly where we have rights, we have them in both the physical and digital world.

  • In terms of where those four buckets are going to come from if you think of them as a purchase model, an advertising model, a subscription model, and an access model, and you say which is going to be of the largest -- assuming they all come on and are all robust, I suggest the access model as the best opportunity to be as large or larger than the purchase model just given the base of mobile subscribers at about 3 billion.

  • Not to say that model will come onstream early or will end up being robust.

  • But I think as you look at the general buckets and opportunity, there is purchase, there is access, there is subscription, and there is advertising.

  • But unlocking the value of mobile networks and mobile consumers remains the industry's largest opportunity, just given the vast numbers of consumers who now have access to a product they never had before.

  • Tuna Amobi - Analyst

  • Thank you very much.

  • Edgar Bronfman Jr. - CEO

  • Thanks everyone.

  • Operator

  • That concludes today's conference.

  • You may disconnect at this time.