[00:02:21] Shawn O’Malley: In exchange, labels get the copyrights to a certain number of recordings, maybe three or four albums, and then each recording has two copyrights. The master recording, which is the actual song recording, and the song composition, which is like the sheet music version of the song with the notes and lyrics.

[00:02:38] Shawn O’Malley: Some people also refer to these composition rights as publishing rights. Copyright laws differ by country but can last up to 70 years or more after the author’s death. Universal, which I’ll also refer to by its stock ticker UMG, owns a collection of more than 3 million song recordings and splits around 15 25 percent of its royalty revenue with artists.

[00:02:59] Shawn O’Malley: While music labels earn less per song or album than they might’ve in the pre streaming days, the difference now is that their entire back catalogs can be monetized. Before, in the days of CDs or iTunes, revenue mostly came from new hit songs. So, music monetization was front loaded, and artists and labels made most of their money within the first year or two of a release whenever people bought records, CDs, or paid to download a song.

[00:03:25] Shawn O’Malley: Now, the majority of music label revenue from recorded music comes from streams of old songs rather than new ones, since it’s so much easier now to access all of an artist’s past work. This has made music royalties much more of an annuity like business. Songs are released, and then they may steadily generate revenues for decades from streaming.

[00:03:44] Shawn O’Malley: Yet the music industry remains under monetized compared to its peak in 1999. On a per capita basis, and after adjusting for inflation, annual spending on music has fallen over 50%. As streaming grows, music labels will receive a further boost if platforms like Spotify are able to considerably raise prices to reflect the value they create for users.

[00:04:06] Shawn O’Malley: That’s because labels like UMG have a claim on the total pot of revenue that streaming platforms generate from ads and paid subscriptions. Roughly speaking, every time Spotify earns an additional dollar from paid subscriptions or from advertising, 70 cents gets paid out to music rights holders.

[00:04:23] Shawn O’Malley: Streaming has ultimately helped make UMG more profitable. From 2015 to 2021, Universal’s operating margin rose 6 percentage points as streaming became a larger part of its business. It’s little surprise that private equity and other investment firms have taken such an interest in buying up the rights to music catalogs too.

[00:04:42] Shawn O’Malley: Recent examples range from a Carlyle Group backed firm buying up Katy Perry’s music catalog for over 200 million to Wiz Khalifa’s catalog selling to Harborview Equity Partners. Others like Neil Young, Bob Dylan, and Stevie Nicks sold their catalog several years ago. Sometimes it’s the publishing and composition rights being sold, other times it’s the actual master recordings.

[00:05:04] Shawn O’Malley: Altogether, investment firms are spending billions of dollars each year on both types of music rights. Usually it’s the publishing and composition rights being sold though, not the recording rights that labels retain. Whereas the labels are making more off recording rights for music streaming, these investment firms buying up publishing rights get a smaller cut of streaming royalties, but cash in on broadcast music or when another artist performs a cover of their songs or uses them in a remix.

[00:05:32] Shawn O’Malley: When music is broadcast on radio stations, TV networks, and even at bars and restaurants, those businesses pay for that privilege, and U. S. copyright law dictates that those royalties go to the publishing rights holders, not recording rights holders. Same with live concerts, royalties from touring go to the owners of publishing rights.

[00:05:50] Shawn O’Malley: But a key difference between publishing rights and recording rights is that recording rights seem to be more economically resilient. COVID lockdowns, for example, stopped music tours and closed bars worldwide, taking a chunk out of the publishing industry’s revenues. Yet, streaming only gained in popularity as people were trapped at home.

[00:06:07] Shawn O’Malley: It’s probably the same in less extreme examples too. If there’s a recession, people may cut back on spending to go to concerts, which would hurt publishing rights holders, but they’re less likely to stop streaming music. If anything, they might stream music more to make up for not being able to afford to see live concerts.

[00:06:24] Shawn O’Malley: Not being able to buy tickets to Taylor Swift’s Era’s tour has only boosted the number of people listening to her music. Streaming is sort of the next best thing in that case. All in all, these private equity music deals are a testament generally to just how valuable different types of music rights are.

[00:06:40] Shawn O’Malley: And I tend to think that from an investment perspective, the recording rights that labels like Universal own are likely more valuable than the publishing rights. Because the music business is such a winner take all industry, where just a small handful of the biggest artists generate almost all of the revenue, being the biggest music label as UMG is, comes with a lot of advantages.

[00:07:00] Shawn O’Malley: For example, they have the largest budget to spend on acquiring the rights to these big names who move the needle most. That also means they can afford to take more risks in trying to find the next big star. Another advantage is that Universal’s primary focus as a company is the music industry. Whereas with Sony, at least its music label represents a small double digit percentage of its overall business as a large conglomerate.

[00:07:24] Shawn O’Malley: This focus combined with already being the biggest label positions Universal well to maintain its market share going forward as it continues to be the first choice for top artists. In recent years, UMG’s revenue has compounded at more than 13%, boosted largely by streaming revenues, which have grown by more than 20 percent a year since 2015.

[00:07:44] Shawn O’Malley: Those streaming revenues are broken down by revenue connected to paid subscriptions on platforms like Spotify, and revenue from ad supported streaming. Over 75 percent of UMG’s streaming related revenues comes via royalties from paid subscriptions on apps like Apple Music and Spotify, which makes the revenue streams much more stable.

[00:08:03] Shawn O’Malley: Most people do not cancel their subscriptions from month to month and because music is such an important part of their routines It’s likely highly recession resistant My guess is that people would rather cut their spending at the grocery store or on other apps before they downgrade their Premium music streaming account back to an ad supported tier Once you get used to not having ads, it’s just hard to go back, and again, it goes without saying that music consumption is a core part of people’s lives.

[00:08:30] Shawn O’Malley: People worldwide listen to 20. 7 hours of music per week. That’s over 18 percent of their waking hours spent listening to music, and 71 percent of people say music is important to their mental health. That engagement transcends geography and demographics too. Everyone, everywhere, loves music. And with Gen Z listening to roughly 20 percent more music than other generations, per capita music consumption seems destined to continue rising.

[00:08:56] Shawn O’Malley: At the same time, as we discussed with Spotify last week, an important part of the thesis for both is that streaming penetration is still rather low worldwide. There are over 9 billion people on this pale blue dot in space that we live on, and 60 percent of them have smartphones, which has doubled from 10 years ago and will probably rise to almost 100 percent in our lifetimes.

[00:09:18] Shawn O’Malley: Yet only a small fraction of all global smartphone users have music streaming subscriptions, just 11 percent at the end of 2021. And the vast majority of the recorded music revenues for the major labels come from developed market countries where higher percentages of people pay for music streaming subscriptions, leaving a ton of room for growth as streaming services become more widely adopted in emerging markets.

[00:09:42] Shawn O’Malley: 75 percent of Universal’s revenues last year came from the U. S., U. K., Japan, Germany, and France. Although I’m focusing on Universal specifically, I’d find it hard to argue against the case for owning Warner Music Group as well, since they’re also a pure play on the music label industry and enjoy similar results to Universal.

[00:10:03] Shawn O’Malley: Sony, on the other hand, is harder to use as a comparison, since the company does much more than act as a music label. To zoom in more on where Universal’s revenues come from, the biggest chunk is digital music, so basically streaming services. Another chunk comes from physical sales, like vinyl records and CDs, which are still surprisingly popular among parts of the population.

[00:10:25] Shawn O’Malley: On top of that, they earn revenues from the additional services they facilitate for artists, like helping them earn sponsorships, manage their websites, concert tours, brand management, and so on. Universal also generates revenue from music publishing rights, such as when an artist’s music is used in TV shows, movies, video games, commercials, on the radio, etc.

[00:10:45] Shawn O’Malley: Universal’s music publishing business deploys vast teams of songwriters who earn composition credits and royalties on the hit songs they help produce, which represents a bit less than one fifth of Universal’s total revenues. At the same time, revenues from all of these are increasing in aggregate as the recorded music industry more broadly returns to steady growth thanks to streaming.

[00:11:08] Shawn O’Malley: Earnings from recorded music grew quickly through the mid-1980s into the late 1990s as CD adoption picked up, but that positive momentum came to a dead stop amid the early days of the internet. As you’ll remember from last week’s episode, music piracy websites made it incredibly easy to suddenly get music at zero cost, which sent the industry into a sharp decline.

[00:11:29] Shawn O’Malley: While the rise of iTunes reduced the sting, it wasn’t really until Spotify went mainstream in around 2014 and 2015 that the downtrend in revenue from owning music rights reversed. Recorded music revenues had fallen more than 40 percent in 15 years. Where investing in Spotify is a more narrow bet on their specific opportunity to add more subscribers over time.

[00:11:50] Shawn O’Malley: A bet on Universal is largely a bet on the recorded music industry continuing to grow irrespective of whether that listening is occurring on YouTube, Amazon Music, Tik Tok, Spotify, or some future disruptor that takes market share from all of them. Spotify also now effectively subsidizes Universal’s customer acquisition costs, where labels had to spend more on marketing in the past to drive CD and record sales for their artists, Now Spotify takes on the burden of driving society to engage more with music through streaming, which ripples through to benefit UMG.

[00:12:23] Shawn O’Malley: Spotify has spent over 7 billion on sales and marketing in the last 5 years to boost streaming consumption. In total, according to the Digital Media Association, music streaming services retain around 32 percent of streaming revenue, while 68 percent is paid to music rights holders. Most of that money specifically goes to the labels who own the rights to the recorded music.

[00:12:45] Shawn O’Malley: Other music rights holders, like publishers, only receive about 13 percent of the total pie from streaming revenue. To be cliche, as the old saying goes, in a gold rush, it’s best to be selling pickaxes. While Spotify is chasing the gold, Universal is selling the pickaxes. It’s mostly agnostic about who gets the gold.

[00:13:04] Shawn O’Malley: That is, which streaming platform wins the music streaming wars. Rather, as long as people keep looking for gold here, Universal is positioned to do quite well as the rights holder for recorded music. I think that metaphor holds up well, but I will say that music labels aren’t just these passive entities collecting checks on music rights.

[00:13:23] Shawn O’Malley: Obviously, a lot of work goes into adding value for artists such that each new generation of talent is still drawn to working with labels. Beyond that, like everyone these days, labels rely heavily on data. Using data analytics, labels try to find the next big stars earlier on in their journey, which typically leads to more favorable deals for the labels.

[00:13:43] Shawn O’Malley: One off stars find success going direct to market occasionally, but most find it helpful to work with labels, especially early on in their careers. Analytics is also helping to make Universal’s business much more predictable with tons of data about people’s latest listening preferences. They can in theory, make better bets on talent.

[00:14:02] Shawn O’Malley: They also can increase their value proposition to artists with data. A label might be able to help an artist maximize touring revenues by tracking on a city by city level which places enjoy their music the most and therefore where that artist would be most likely to sell out shows. It’s one of many illustrations of why, in theory, most artists will say they don’t want to work with labels but ultimately end up signing if offered.

[00:14:26] Shawn O’Malley: Universal’s music talent is also quite globally distributed. Yes, there’s the big names like Taylor Swift, Drake, and the Rolling Stones, but there are also huge K pop bands in their portfolio that you might have never heard of. Universal’s fourth and fifth top sellers last year were the South Korean artists Jungkook and Stray Kids.

[00:14:45] Shawn O’Malley: Last year, 9 of the top 10 IFPI global recording artists were Universal clients, while 13 of the top 20 most streamed songs globally on Apple Music belong to Universal. From France to Indonesia, many of the top artists and songs worldwide are tied to Universal each year. This begs the question of, if you’re some mega celebrity like Taylor Swift, why do you even need a label, right?

[00:15:09] Shawn O’Malley: With 283 million followers on Instagram alone, why does she need any help promoting herself? One simple explanation is that she wants to be a singer and songwriter, not run a huge global marketing business. There’s an element of financial risk, too. A label can support artists by funding the money to pay the recording studios, the techs, the mixers, the engineers.

[00:15:30] Shawn O’Malley: They can front the money for tours, do the distribution, and assist with the Grammy and award nomination process. An artist also probably wants someone to front the money to make all the CDs and vinyl records and distribute them to retailers or to help negotiate with the touring company and venues.

[00:15:46] Shawn O’Malley: Universal, for example, held launch parties worldwide for Taylor Swift’s recent albums. Having teams and offices globally enables Universal to do that. It would be very costly and difficult for an artist by themselves to try and coordinate a huge launch. Universal’s distribution network also ensures that her songs are uploaded onto platforms like Spotify and YouTube while helping produce merchandise and music videos, provide administrative and legal support, and more.

[00:16:11] Shawn O’Malley: On that point about merchandise, Universal owns a full service merchandising business through Bravado. Bravado supports 220 top artists and end to end merchandising from creation and design to distribution for everything from t shirts to toys, home goods, accessories, and even food. And it might sell those products on tour, to retailers, or directly to consumers online while also licensing merchandising rights to third parties.

[00:16:36] Shawn O’Malley: The merch business generated well over 700 million in revenue last year and grew more than 14 percent from the year prior. At the heart of this merch business are superfans, who are music consumers who Universal defines as spending 80 percent more per month on music than the average listener. So there are many different ways that labels can add value, and the relationship may be different on an artist by artist basis.

[00:17:01] Shawn O’Malley: Labels run much of the underlying business on behalf of artists, and artists can focus on recording new music, touring, making public appearances, and so on, rather than being directly responsible for managing teams of people or personally financing anything. As artists get bigger though, there are definitely examples of some choosing to build the business empire themselves and launching their own label, while others are more than happy to work with the major labels and negotiate more generous terms due to their star power.

[00:17:30] Shawn O’Malley: So, Universal’s collection of labels have their own star power too, in a way. You’re probably familiar with some of the ones they own, like Def Jam Records, Capital Music Group, and Motown, or Universal’s legendary recording studio, Abbey Road. Last year alone, Universal signed stars like Lana Del Rey, Sabrina Carpenter, Niall Horan, Ice Spice, and Jack Antonoff.

[00:17:50] Shawn O’Malley: As part of a new strategic organizational redesign, Universal is looking to further expand its relationships with artists. While the strategic redesign will include employee layoffs and other operational efficiencies meant to drive over 250 million a year in cost savings by 2026, much of this new strategy includes expanding partnerships with artists across new areas, leaning more into social media, gaming, and health and wellness.

[00:18:17] Shawn O’Malley: The hope, according to 2023’s full year financial report, is to quote, provide our labels with unprecedented capabilities to deepen artists and fan connections via new experiential commerce and content offerings. To step back a bit and get the full picture of Universal, we need to look at a French company known as Vivendi.

[00:18:36] Shawn O’Malley: Universal Music Group began in 1898 with the founding of Music Corporation of America. After decades of twists and turns through the 90s and early 2000s, Vivendi ultimately gained full ownership of UMG in 2006. Up until 2020, Vivendi owned 100 percent of Universal. Then, over the next year, the Chinese firm Tencent acquired around 20 percent of Universal at an enterprise valuation of 30 billion euros.

[00:19:02] Shawn O’Malley: With that valuation set, after years of shareholders in Vivendi pressuring management to spin off Universal, they finally did. Vivendi made a special dividend in 2021 to distribute 60 percent of its Universal shares to Vivendi shareholders while listing the new stock to trade publicly on an exchange in Amsterdam.

[00:19:20] Shawn O’Malley: With 60 percent of the company handed over to Vivendi shareholders and 20 percent held by Tencent, the famous hedge fund manager Bill Ackman joined in to invest ahead of the spinoff with a 10 percent stake in Universal, leaving the remaining 10 percent in Vivendi’s hands. So, Universal’s ownership base is split up across a few big global players, from Tencent to Vivendi to Bill Ackman’s Pershing Square.

[00:19:45] Shawn O’Malley: And then as mentioned, the other 60 percent of shares were given out to Vivendi’s shareholders and made available to trade in Amsterdam. As a standalone company, UMG has traded publicly for less than three years now, but it made a big splash when it first listed. It hit the market with a roughly 53 billion valuation amid a 36 percent surge as investors piled in to get their hands on the company that is arguably positioned the best to continue profiting from increasing music streaming globally.

[00:20:13] Shawn O’Malley: Despite Vivendi still holding sizable stakes in Universal, their involvement has been pretty hands off. Universal’s CEO, Lucian Grange, is a legend in the music industry, and he’s done an excellent job continuing to run the business, both as a subsidiary of Vivendi and now as an independent company. It’s not uncommon for people to refer to Lucian as arguably one of the great CEOs in history across any industry.

[00:20:40] Shawn O’Malley: While on the topic of Universal’s biggest shareholders, let’s look at Bill Ackman and his firm Persing Square, where UMG is their largest portfolio holding and Ackman also sits on Universal’s board. We can’t discuss Bill Ackman and Universal though without mentioning Artificial Intelligence. Ackman has been quite outspoken about his lack of concern for AI negatively disrupting business for music rights holders.

[00:21:05] Shawn O’Malley: Imagine a world where the pop stars of tomorrow are not human, but rather AI powered virtual characters with their own profiles and branding. Or maybe even AI powered robots one day. As music production costs come down dramatically, almost anyone can use AI to churn out music, leading to a much more fragmented recorded music industry.

[00:21:27] Shawn O’Malley: For example, why go back and listen to Tupac’s catalog when you can use AI to create new versions of Tupac’s music? Maybe you want to use AI to create a Tupac and Biggie crossover. Some see this all as a nightmare scenario for music labels and artists alike. A world where the human value is drastically diminished, and music and intellectual property rights are kicked to the curb.

[00:21:49] Shawn O’Malley: That would clearly be bad for artists, but also for labels who manage artists. On the one hand, you can call me old fashioned, but I do think people will always be interested in art created by real people. In a sea of new music, I think it’ll be hard for AI generated music to stand out among the millions of songs published each year.

[00:22:07] Shawn O’Malley: An artist’s story is often what fans fall in love with and what causes them to share their music, and AI generated music is obviously disadvantaged in that way. Shortly after ChatGPT first hit the world last year and began generating buzz about AI, an analyst on Wall Street famously double downgraded his outlook for Universal Music Group based on disruptions from AI.

[00:22:29] Shawn O’Malley: Whether that means people will stop streaming old Fleetwood Mac songs is another question entirely, though, in my opinion. Bill Ackman disagrees with the AI concerns as well. To quote him directly, Ackman said to shareholders in his investment firm, we believe that investor concerns about AI displacing major labels and artists are misplaced.

[00:22:48] Shawn O’Malley: Rather, we believe that AI represents a significant opportunity for the company. Ackman sees Universal continuing to grow revenue by at least 10 percent per year for the next decade. Meanwhile, he argues that the vast majority of AI created audio tracks will never be heard and will not displace legitimate artists work.

[00:23:06] Shawn O’Malley: Despite hundreds of thousands of AI tracks being created, Universal’s global market share in the industry has remained steady at 30%. To quote him again, AI has the potential to make UMG’s current roster and vast catalog even more valuable by allowing the company and its artists to involve fans with user generated content and monetize old music in new and revolutionary ways.

[00:23:29] Shawn O’Malley: So, on the one hand, labels have the opportunity to be defensive, working with platforms like Spotify to remove AI generated songs if they’re believed to violate copyright laws, while also licensing its content to earn new revenue streams from applications that allow users to use AI to create new versions of past songs.

[00:23:47] Shawn O’Malley: In other words, an offensive strategy would involve licensing existing music catalogs to people interested in sampling or deriving new music from past hits. I’d imagine the sky is the limit to how creative people might get with this, but these AI tools are already being developed at places like YouTube and they’re working closely with labels to do so in a way that is reportedly protective of artists and labels alike.

[00:24:11] Shawn O’Malley: After its Q1 earnings in 2023, Universal’s Chief Digital Officer addressed AI concerns pretty squarely. He says that quote, sophisticated AI that’s enabled by large language models, which trains on our IP violates copyright law in several ways. Companies have to obtain permission to use copyrighted content for AI training or other purposes.

[00:24:32] Shawn O’Malley: He says that beyond copyright laws, they have an additional negotiated protections with streaming DSPs like Spotify and Apple Music, and that they own all sounds captured in a sound recording. In October, UMG showed the potential for AI by using the technology to help produce the last quote unquote new Beatles song that will ever be released.

[00:24:52] Shawn O’Malley: Four decades after being originally written, John Lennon’s AI generated voice brought life to the song. This was an example of artists and labels working together to use AI to overcome mortality. Deceased band members are not necessarily an obstacle to creating new music now, especially if music rights holders and remaining band members sign off.

[00:25:12] Shawn O’Malley: I wouldn’t be surprised at all if bringing back the stars of yesterday in a way that complies with music rights laws is the next big growth driver for the big three labels and the music industry more broadly. Another area of drama and investor angst comes from TikTok. Universal flexed its muscles a bit in February of this year by pulling all of its music off of TikTok.

[00:25:34] Shawn O’Malley: Universal’s concerns ranged from fair compensation to artists, to protections from AI content abuses, and general online safety for TikTok users. Universal alleged that TikTok paid a fraction of the royalty rates that other social media platforms did. After a three month dispute, the two sides reached a new licensing agreement that surprised Wall Street.

[00:25:53] Shawn O’Malley: According to the Wall Street Journal, Taylor Swift’s album launch for the Tortured Poets Society brought both sides back to the negotiating table, and TikTok also pledged to work with UMG to remove unauthorized AI generated content. Meanwhile, TikTok has bigger battles to fight. As you probably know, TikTok is facing a ban from the U.

[00:26:11] Shawn O’Malley: S. if it doesn’t sell its U. S. operations to an American company. Amid band concerns, it’s plausible that bad PR from the fallout with Universal convinced them to commit to a more favorable deal for artists sooner rather than later. Although TikTok contributes to a small percentage of Universal’s revenues, it does help expose hundreds of millions of users to new music that they may end up streaming elsewhere.

[00:26:33] Shawn O’Malley: However, TikTok by itself might not be that critical. If TikTok were to get shut down altogether, Universal executives expect that most of those users would find their way to Instagram or YouTube where Universal already has established licensing agreements. Ultimately, UMG gets paid regardless of which short form video people scroll through.

[00:26:51] Shawn O’Malley: And the recent drama with TikTok is, in my opinion, at least evidence of the considerable leverage they have. While UMG could absorb a loss of revenue from TikTok, and really any social media platform, TikTok couldn’t. Social media is driven by pop culture, and it’s not easy to stay relevant if your platform can’t use music from many of the most popular artists in the world.

[00:27:12] Shawn O’Malley: In 2023, TikTok tested this in Australia by pulling top artist music only to confirm what should be obvious. Excluding popular licensed music annoys content creators and reduces user engagement. Whether TikTok, Spotify, or anywhere else people consume music, their expectation is to have the entire catalog of recorded music at their fingertips.

[00:27:32] Shawn O’Malley: Whereas many people subscribe to multiple video streaming services, they only use one music streaming app. So, Music streaming services need to have all recorded music available, not just most of it, making it impossible to imagine ever cutting out a given record label from a service over contract negotiations.

[00:27:50] Shawn O’Malley: That gives labels a ton of leverage. Can you imagine staying subscribed to Spotify or Apple Music if they didn’t have The Beatles, The Rolling Stones, or Billie Eilish? An area that Universal is leaning into that might be less intuitive is health and wellness. The company wants to pioneer a new category called prescription music.

[00:28:09] Shawn O’Malley: It sounds a bit out there, and I’m not qualified by any means to say whether it’s realistic or not, but the company claims that there’s research suggesting certain types of music can be used to treat health conditions ranging from stroke to traumatic brain injury, Alzheimer’s, anxiety, and even some sleep conditions.

[00:28:26] Shawn O’Malley: The company, Med Rhythms, is leading in this space, using music it licenses solely from Universal and its FDA licensed N Tandem device, which aims to help stroke victims walk again. This is apparently the first prescription digital therapeutic product that uses music. Again, I will be the first to say I’m skeptical here.

[00:28:46] Shawn O’Malley: It’s not controversial to acknowledge that music can help us feel better, but it’s harder to say to what extent it can be used as a serious medical treatment. I wouldn’t put much stock into this idea when valuing universal, but it does offer some optionality. As companies at least experiment with using music as a medical treatment, UMG will be a beneficiary of those new licensing agreements.

[00:29:10] Shawn O’Malley: Signing exclusive arrangements with wellness and fitness services like Peloton are probably more tangible ways to create value in the space, but if music as a medical treatment gains broader acceptance, health could become a more meaningful revenue stream for UMG. Spotify’s negotiating power in music rights royalty contracts may continue to increase over time as Spotify grows bigger and bigger.

[00:29:33] Shawn O’Malley: That said, even if rates come down modestly, the boost to overall consumption of recorded music that Spotify brings to the table may more than offset lower royalty rates. So, it’s sort of a win win for both. A slightly smaller share of a much bigger pie would still leave Universal and other labels in pretty good shape.

[00:29:51] Shawn O’Malley: It’s also possible that the value that labels bring to artists could decline over time. This is a risk, but one that doesn’t keep me up at night. Most artists forego owning their music exclusively to work with labels who can help them garner much greater exposure. Labels provide the industry know how and artists provide the talent.

[00:30:08] Shawn O’Malley: To what extent that changes in a world of growing streaming and TikTok still remains to be seen. Some artists may find it much easier than it used to be for them to be discovered by themselves. Still, while the barriers to entry to becoming a recording artist have fallen, it remains very difficult to break through, short of hoping that you go viral on the internet, which isn’t a legitimate strategy.

[00:30:29] Shawn O’Malley: For context on just how hard it is, more than 60, 000 new songs are uploaded on a Spotify every single day. What are the odds that a single artist can stand out? Not very high, even if you’re in the top 1 percent of music talent globally. Connections to songwriters, producers, distribution partners, and so on can really elevate emerging artists.

[00:30:49] Shawn O’Malley: Labels may spend between 500, 000 and 2, 000, 000 helping artists get mainstream attention. Another challenge, connecting back to the idea that growth in streaming in emerging markets is fundamental to the picture here for platforms like Spotify and for labels, Universal faces the challenge of having much smaller market shares in emerging markets.

[00:31:08] Shawn O’Malley: For Universal, continued growth will not only depend on deeper streaming penetration globally, but also on its ability to gain market share in new corners of the world. On that point, Universal has had some success of late. Bloomberg reported in April that Universal had signed a handful of popular artists in China this year through an agreement with the company TF Entertainment.

[00:31:28] Shawn O’Malley: Groups like TF Boys, which aren’t well known outside of China are hugely popular within it and will now join Universal’s roster of talent. On Chinese social media apps like Weibo, the boy band TF Boys has more than 250 million followers, while their live streams alone have brought in millions of viewers.

[00:31:46] Shawn O’Malley: In 2018, the group’s commercial value was estimated at over 400 million dollars. Deals like these and new markets with their own stars and even their own social media apps and streaming services are likely where most of Universal’s growth will come in the future, as it uses its vast resources to go up against local competition.

[00:32:04] Shawn O’Malley: Universal has made similar acquisitions in India and Nigeria. UMG maintains an exclusive partnership with the management company, UM India, which helped produce one of India’s biggest hits of 2023 with over 12 billion total views. In Nigeria, Rima became the first African artist to lead a track with over 1 billion streams on Spotify.

[00:32:27] Shawn O’Malley: His hit song, Calm Down, was released through Universal’s label, Maven Records, and distributed globally by Virgin Music Group, another subsidiary of Universal. Meanwhile, in Thailand, Universal acquired RS Group, which holds Thailand’s second largest music catalog with over 10, 000 master recordings. Now I want to dive into everyone’s favorite part of discussing potential stock investments, valuation.

[00:32:51] Shawn O’Malley: In contrast with my valuation of Spotify last week, Universal is very stable and profitable. Still, artist and product costs consume about 56 percent of the company’s revenue right off the top. So while most of Spotify’s costs come from sending around 70 percent of their revenue as royalties to music rights holders, over half of Universal’s revenue goes towards splitting those royalties with artists, financing their recordings, and paying to market and promote them.

[00:33:18] Shawn O’Malley: It’s also worth considering that the assets UMG invests in are very long lived. Whereas video content on Netflix, with the exception of a few hit shows and movies, really only has a shelf life of a few years or less. Songs from top artists have nearly indefinite lifespans. In fact, most of the company’s recorded music revenues come from songs that are more than three years old.

[00:33:40] Shawn O’Malley: So Universal spends up front to develop and promote music, and then those songs can generate cash flow for decades to come. There are essentially no marginal costs for these catalogs of music either, except for splitting royalties with artists and songwriters. After accounting for artist costs, product costs, and overhead expenses, including the company’s new share based compensation plan, Universal earned a 1.

[00:34:01] Shawn O’Malley: 5 billion operating profit in 2023. I’ll focus on operating profit because the company’s actual net income numbers are pretty skewed by its investments in Spotify and Tencent Music Entertainment. Even if Universal hasn’t sold any of its stakes in those companies, fluctuations in their market value are recorded on its income statement.

[00:34:22] Shawn O’Malley: In 2022, a selloff in tech companies wiped out over $600 million worth of the market value of, um, G’S investments in Spotify in Tencent music, which subtracted from net income in 2023. Things went the other direction and gains from Spotify in Tencent added $450 million to Universal’s net income. The issue here is that this distorts the company’s actual income from operations in a given year.

[00:34:46] Shawn O’Malley: Swings in the value of its Spotify Intents and Investments are paper gains and losses that aren’t impacting the cash that flows in and out of Universal, at least not until they sell those positions. Any attempt to value Universal based on its earnings then needs to adjust for this accounting headache.

[00:35:02] Shawn O’Malley: In his 2021 presentation on valuing Universal Music Group, Bill Ackman asks the audience, how much would you pay to own one third of the global music industry with an added growth engine that continues to acquire new talent? He compares the company to Walt Disney, another iconic brand that owns much of the world’s most valuable entertainment content.

[00:35:22] Shawn O’Malley: Yet in market capitalization terms, Universal is valued at around one third of Disney. In 2021, UMG was valued at about 21 times operating profits, which Ackman saw as quite undervalued. Today, Universal’s valuation is closer to 38 times operating profits, so in the last three years, investors clearly came to recognize the company’s quality and bid up its price accordingly.

[00:35:45] Shawn O’Malley: That puts its valuation, in terms of a multiple of operating profits, roughly in line with Netflix, which is a company that must pay considerably more to acquire or produce content for TV shows and movies. This content also has a vastly shorter lifespan. You may watch a TV show or movie once, perhaps re watch it twice, but you’ll stream the same music for years, if not decades.

[00:36:06] Shawn O’Malley: So, Universal is a very, very high quality business. After rising something like 40 percent in the last year, though, it’s hard to argue that the stock is still dirt cheap. Generally speaking, Universal’s moats are strong enough and its industry is growing fast enough that even at a valuation that is much closer to fair value than when Ackman first got in, the company should keep compounding and deliver above average returns long term.

[00:36:30] Shawn O’Malley: The bull case for UMG over the next few years primarily boils down to a belief that streaming platforms create enough value for customers that they can routinely raise prices at an average of 60, 000. per year, which would feed into the company’s profits at a gross margin of more than 60 percent for recorded music on the fringes of bullish speculation are also hopes that labels can leverage AI to create new royalty streams while the adoption of streaming and emerging markets picks up at faster than expected rates.

[00:36:59] Shawn O’Malley: Compared to Warner, the other pure play of the big three labels, Universal should probably trade at a relative premium for being the market leader, which it does, in addition to its better track record and stronger balance sheet. On that last point, Universal’s ratio of operating income to interest costs on debt is roughly twice that of Warner’s, leaving them with more of a financial cushion.

[00:37:20] Shawn O’Malley: Because of its better financial health, the credit rating agency S& P gives Universal a triple B investment grade rating on long term borrowing while giving Warner a double B plus junk bond credit rating. UMG spends around 45 percent of its revenue on developing existing talent and on acquiring new talent, compared to around 33 percent for Warner.

[00:37:41] Shawn O’Malley: Lowering that spending to match that of Warner’s in terms of percentages of total revenues would quickly boost earnings per share by something like 40%. But this extra spending should largely be seen as a necessary cost for defending and deepening its moats in the music industry as it invests more in keeping its existing talent happy and in finding new talent.

[00:38:02] Shawn O’Malley: One more factor in comparing Universal to Warner that makes Universal arguably more attractive is that Warner has a large billionaire controlling shareholder with super voting shares that effectively gives them a 98 percent voting interest in the company. In other words, all the other shareholders have no say over the company’s future.

[00:38:21] Shawn O’Malley: This implicitly boosts the case for Universal, assuming you’re interested in the music label industry generally, and are picking between the two companies. Another detail worth mentioning is that Universal has a dividend policy that requires the company to pay out at least 50 percent of its profits each year to shareholders.

[00:38:37] Shawn O’Malley: So it’s a cash producing machine for investors. Because the dividend policy doesn’t define some nominal amount that must be paid out and is derived from its net income, that should mean that the dividends aren’t hindering the company’s ability to reinvest in future growth. That would happen further up on the income statement.

[00:38:54] Shawn O’Malley: And from my perspective, the policy primarily aims to ensure that the company doesn’t build up cash on its balance sheet. That isn’t going to a good use on that note about reinvestment. UMG treats acquisition of music catalogs as a form of M and a while expensing artists costs paid in advance for new talent and.

[00:39:10] Shawn O’Malley: capitalizing costs on its balance sheet connected to proven talent where its spending is more certain to pay off down the road. And because streaming has breathed new life into music catalogs from the 70s, 80s, and 90s that would have largely been forgotten otherwise, or at least wouldn’t be generating much from new album sales, the real value of Universal’s balance sheet has appreciated considerably in the last decade.

[00:39:32] Shawn O’Malley: Accounting depreciation of these music rights has already subtracted from net income, yet the depreciation schedules used may not reflect the increase in value of older music assets brought on by streaming. Because these catalog assets are appreciating stores of value, this further justifies Universal’s premium valuation since its future earnings power may be understated.

[00:39:54] Shawn O’Malley: Consider how special it is for products from over two decades ago to still represent more than 20 percent of a company’s sales. And rather than decline, those products are actually earning a growing share of industry revenues. Few other examples come to mind, yet this is exactly the case for Universal.

[00:40:11] Shawn O’Malley: As new generations discover older music, those catalogs continue to earn streaming revenues. Universal could probably ride earnings from its catalog rights for years and still do quite well without spending anything on acquiring rights from new artists. Even better, these catalog assets sell themselves.

[00:40:27] Shawn O’Malley: Elton John or Neil Diamond don’t need much help marketing their music. They’re established artists with enduring hits that generate their own buzz and attention fanbases. So margins on music catalogs are very high. Universal valuation then should primarily be seen as a growing annuity stream discounted back to today.

[00:40:49] Shawn O’Malley: In simpler terms, that means that Universal generates a very steady series of growing future earnings available to shareholders in the company, and after accounting for the time value of money and risks to UMG’s business model, we can quote unquote discount those cash flows into a present value. What I’m describing here is the technique of discounting future cash flows to shareholders and valuing a company.

[00:41:11] Shawn O’Malley: Investors use this technique for most mature businesses, but the difference with UMG, in my opinion, is that it offers a far greater degree of certainty to pay out those cash flows. With more certainty should come a lower discount rate, everything else equal, which significantly increases UMG’s intrinsic value today and the price per share investors are willing to pay to own it.

[00:41:31] Shawn O’Malley: Unlike a more typical company, Universal doesn’t experience much volatility in its operating costs, but it also doesn’t have much direct pricing power either. Universal’s pricing power comes implicitly through streaming platforms who, for their own reasons, want to raise prices. When valuing Universal’s royalty annuity stream, the discount rate you use makes a huge difference in what you think the company is worth, as well as your projections for how much those annuities will grow due to greater streaming adoption and price increases.

[00:41:59] Shawn O’Malley: and the lifetime value of its catalog of music from yesterday’s biggest stars. If past artists hits continue to retain or grow their share of total streaming activity, then the present value of those artists royalties rises materially. While I don’t intend to explicitly compare investing in Universal to investing in a corporate bond, because bonds offer very different legal protections, The point of comparing Universal’s earnings to an annuity, similar to the cash flows offered by Bonds, is that there is a very high certainty to these earnings.

[00:42:29] Shawn O’Malley: We roughly know how much music will be streamed in five years and can predict with a high degree of confidence how much Universal will earn from that. We also know that these music catalogs have driven over 60 percent of UMG’s recorded music revenue in recent years. To my previous comments on the discount rate you use, if you use one closer to the 6 percent yields offered on investment grade corporate bonds to value the operating profits from the long term annuity stream of catalog revenues, then you can justify a valuation twice as high for Universal, which for the record is not just me saying that, but an opinion expressed by analysts who cover the company on wall street.

[00:43:04] Shawn O’Malley: Carving out Universal’s catalog business alone and valuing it with this lower discount rate captures most of Universal’s current enterprise valuation, which doesn’t account for the value that will be created from royalties generated by new artists signed going forward. It also doesn’t include Universal’s smaller business units either, like its merchandising subsidiary.

[00:43:23] Shawn O’Malley: If you’re less confident that Universal’s music catalog will retain the same relevancy as it has, or are particularly concerned about AI or whatever it is, you’d want to use a higher discount rate when valuing the company, probably between 8 and 10 percent or higher, which is more common for discounted cash flow valuations of large companies.

[00:43:41] Shawn O’Malley: These more conservative discount rates suggest Universal is roughly fairly priced today. Over the next decade, I’d expect with a relatively high degree of confidence that Universal should deliver a total return, including dividends, that’s in line with market averages with less risk, thanks to its valuable music catalogs.

[00:43:58] Shawn O’Malley: There’s also some additional upside unlocks new ways to monetize music rights, or if the economics of streaming monetization improve faster than projected. Universal is by no means a get rich quick kind of investment, but it is a company that offers an unusually high amount of certainty for its future cash flows and therefore is an excellent addition to balance out a portfolio.

[00:44:22] Shawn O’Malley: With all of that being said, I do not think that Universal is cheap, and its current price is probably pretty close to fair value. But the best businesses are rarely ever cheap. In the long run, the companies that generate above average returns on capital, while not taking on enough debt to threaten their viability, tend to be the ones that generate the most wealth for shareholders.

[00:44:42] Shawn O’Malley: Universal seems very likely to continue being one of those high quality companies for a long time to come. So Universal is another company on my watch list alongside Spotify. And when Mr. Market panics the next time, I’ll be looking to build up a position in the company with the hope of owning it forever.

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