Fitch Ratings has affirmed the following Issuer Default Ratings (IDRs) and outstanding debt ratings on Warner Music Group Corp. and its subsidiaries:
Warner Music Group
--IDR at 'BB-'.
WMG Acquisition Corp
--IDR at 'BB-';
--Senior secured at 'BB';
--Subordinated at 'B+'.
WMG Holdings Corp
--IDR at 'BB-';
--Senior unsecured at 'B'.
The Rating Outlook is Stable.
In addition, the ratings on the company's Term Loans and Revolving Credit Facilities have been withdrawn.
The ratings are supported by WMG's strong market share, global footprint, and diversified and established content library. Credit concerns include substantial challenges facing the recorded music industry related to continued declines to its physical unit sales. The Stable Outlook is supported by WMG's adequate liquidity position, scaleable cost structure, and WMG's position as one of the top global music publishing businesses.
The music industry continues to deal with declining physical sales that have not been fully replaced by digital sales in most markets. Year-to-date Aug. 16, 2009, album units including track-equivalent album sales (giving 1/10th credit for digital singles) have decreased 8.9% according to Nielsen SoundScan. Fitch believes these decreases are predominantly the result of continued piracy and copying, and proliferation of alternative entertainment activities and products. Digital tracks and digital albums combined now account for approximately 40% of total adjusted albums. In addition, while both digital products continue to grow (year-to-date up 12% and 18%, respectively, according to Nielsen) it has been at a decelerating rate and still unable to offset the impact from physical sale declines. While Fitch is cautiously optimistic regarding the continued roll-out of cellular music products including over-the-air downloads, Fitch expects a mid-to-high single-digit negative trend on track-equivalent albums to continue during this transition.
Specifically related to WMG, total revenue decreased 2% in the most recent quarter on a constant-currency basis due to general secular trends, as well as difficult international comps and release schedules. Additionally, U.S. physical retailers continue to manage down their physical inventory levels. While the conservative inventory management by U.S. physical retailers has essentially cycled through a material phase, Fitch expects continued pressure in this area for the industry. Fitch believes similar behavior by foreign physical retailers has also been occurring over the last few years. Digital revenue for WMG increased 11% from the prior year and 2% sequentially on a constant currency basis. Digital revenue represented 23% of total revenue for the most recent quarter for WMG.
Fitch currently estimates that nearly 50% of U.S. track-equivalent album sales for the industry are from emerging platforms (iTunes, Amazon physical, etc.) with the other 50% from platforms that will be in permanent decline (physical retailers). This mix continues to shift and the key for the music industry will be to continue to manage their cost structure down with the transition to the emerging platforms which should ultimately gain market share above 75% over the next few years. Given the company's variable cost structure (royalties, physical distribution, etc.), Fitch expects the company to be able to successfully handle this transition.
Fitch continues to believe WMG's push into 360-degree relationships is prudent. As demonstrated over the last few years, there does not appear to be material risk related to the major labels pursuing high-priced established artists in these agreements. Instead, Fitch expects WMG and the other labels to continue to push these agreements with new artists and that the recording industry will have significant leverage regarding deal terms due to the oligopoly structure of the industry combined with the virtually limitless supply of aspiring musicians. Further upside to operations could be realized through radio royalty fees that are currently being considered in Congress, as well as progress related to the ISP's monitoring piracy.
As of June 30, 2009, WMG's gross leverage was approximately 4.6 times (x) and net leverage approximately 3.9x. Pro forma for the recent bond offering, Fitch expects cash interest coverage to be slightly below 3.0x. Including cash interest from the HoldCo notes that become payable beginning in 2010 brings the cash interest coverage ratio to just under 2.5x per Fitch's calculations. Relative to the 'BB-' rating category, the company's free cash flow-to-debt metrics are strong at approximately 15%, due to limited capital expenditure requirements. Fitch assesses the company's negative working capital generally as a permanent position given the timing of receivables versus the royalties paid to artists and Fitch's long-term expectations for the industry. Including the company's $700 million negative working capital deficit as debt still results in free cash flow to debt above 10%.
Fitch assesses WMG's liquidity position based on the operating entity, WMG Acquisition Corp. As such, liquidity is adequate and comprises $247 million of cash as of June 30, 2009. The company no longer has a credit revolver. The previous revolver went unused for its entire existence. Liquidity is also supported by ongoing free cash flow which Fitch estimates will be in excess of $200 million per year. Pro forma for the recent bank amendment and bond offering, the company's maturity schedule is manageable with no maturities until 2014 when $876 million of subordinate notes come due. Fitch believes these maturities could be handled organically through cash on hand and expected free cash flow. Remaining maturities consist of $1.1 billion of senior secured notes due 2016.
WMG's release schedule for the remainder of fiscal 2009 includes Madonna's greatest hits and Paramore, as well as some key Japanese releases from artists that have been top sellers in the past.
For additional information related to WMG and secular trends facing the music industry, please see Fitch's report on Warner Music dated October 2008 and available at 'www.fitchratings.com'.
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Rolando
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kevin.duignan@fitchratings.com
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