analysis of warner music group

Performance Measurement

Assignment 1

Analysis of Warner Music Group

Group 4

Alessia Bianchi (1381946), Valentina Chiarini (1573971), Claudia Klapproth (1574367), Federico Nardini (1343623), Andrea Padovani (1347780)

Critical Success Factors

Profitability Analysis

Efficiency Analysis

Liquidity & Solvency Analysis

Future ROE: Risks and Prospects

Unusal or Non-Recurring Items

Potential Investment

1. Critical Succes Factors: SWOT Analysis


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Strengths

• Artist & Repertoire Section: able to attract, develop and retain main artists

• Highly diversified revenue base• Leader in downloading services,

like digital subscription services• Experienced, stable management

team

Opportunities

• More revenues in digital market• Expand the non-traditional recording

music business (e.g. fan clubs)• Enter to expanded-right deals: closer

relationships with artists• Agreements with major companies in

industry (Universal Group, EMI, Sony BMG) create entry barriers

Threats

• Decline of physical music industry• Digital piracy: loss in sales due to

illegal downloads • Highly competitive industry –

competing on artists• Downward pressure on prices due

to substitute goods and small number of online stores

Weaknesses

• Reliance on only one single company as the primary supplier (Cinram)

• Difficult to get additional financing due to substantial leverage

• Limited flexibility in operating business due to debt agreements

• Controlled by Current Investor Group

WeaknessesStrengths

Opportunities Threats



Efficiency Analysis





1. Critical Success Factors: Porter‘s Five Forces Analysis

Group 4 3


• Highly competitive market: 4 majors competing on artists and customers (sales revenue)

• High entry barriers: market is dominated by 4 major players making it difficult to enter

• Illegal downloads• Blueray disc• Legal online access:

e.g. Youtube

• High bargaining power due to customer taste being key success factor

• Willingness to pay is decreasing due to downloading opportunities

• Artists: Bargaining power increases with popularity

• Cinram: High bargaining power as it is only supplier for manufacturing, packaging &physical distribution

Suppliers Customers

Rivalry

Substitutes

New Entrants



Efficiency Analysis





2. Profitability Analysis: Most Suitable Ratios

• Return on assets (ROA) is the most suitable profitability ratio in the music industry.

• Especially intangible assets are crucial for a firm operating in the music industry.

• Warner‘s strategy: the maximization of its music assets seeking to exploit the potential of previously unmonetized content

– in new channels (online physical retailers like Amazon and other digital sources)1,

– with new formats and product offerings (premium price album bundles, full track video and downloads on mobile phones etc.)2

• Assets in Warner‘s two core businesses as major revenue sources

– Recording Music• Long-term assets are exploited year after year – more profitable than new

releases in this industry.3

• Warner‘s strategy: creation of a specific division (Rhino) to acquire licensing rights from catalog artists to exploit long-term assets4

– Music Publishing• In the matter of intangible assets, royalties play a fundamental role, especially

the mechanical ones, way more profitable then the others because not affected by piracy.5


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Efficiency Analysis





2. Profitability Analysis:Ratios

• ROE = Net Income/Sales x Sales/Assets x Assets/Equity = Net Income/Equity

– Because equity is negative, the ROE cannot be used to evaluate the profitability of the company.

– Given that the equity is negative, we already have an indication that the financial position of the company is problematic: There are more debts than assets. Dividends cannot be paid out to shareholders. If all assets were sold, shareholders would owe money instead of getting a return.

• ROA = EBIT/Sales x Sales/Total Assets = EBIT/Total Assets– ROA 2010: 90/3,779* = 0.024 = 2.4%– ROA 2009: 135/4,063* = 0.033 = 3.3 %– ROA 2008: 207/4,526* = 0.046 = 4.6 %

The return on assets ratio shows profitability in terms of how efficiently assets are managed to produce profits. The ratios seem rather small and, moreover, the ROA is declining in the past years, thus profitability is decreasing.

• ROS = EBIT/Sales– ROS 2010: 90/2,984* = 0.030 = 3.0%– ROS 2009: 135/3,198* = 0.045 = 4.5 %– ROS 2008: 207/3,506* = 0.06 = 6.0 %

The return on sales ratio indicates a low profitability of sales, declining over time. The profitability of sales will be further investigated by looking at the composition of sales revenue in the following slide.


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*Figures: million dollars



Efficiency Analysis





2. Profitability Analysis: Sales Revenues

• Total sales revenues are largely

affected by the decline in sales of

physical/mechanical content, due to

a declining demand for phyiscal

products in the industry

• Reasons are piracy but also a shift

in demand from physical to digital

content

• Thus, sales from digital content are

increasing.

• No significant change in revenue

from licensing

• Performance sales are only

decreasing due to timing of cash

collections and Warner‘s decision not

to renew low marging deals in this

business area

% of Total Sales 2010

Change2010 vs. 2009

Change 2009 vs. 2008

Total Sales 100% -7% -9%

Recorded Music Total 82% -7% -9%Physical and other 51% -15% -14%Digital 24% 9% 10%Licensing 7% -2% -3%Music Publishing 18% -4% -7%Mechanical 6% -8% -15%Performance 7% -8% -7%Synchronization 3% 5% -2%Digital 2% 9% 35%Other 3% -15% -38%

Decrease in total sales has negative effect on profitability (ROA and ROS) and efficiency in use of assets (asset turnover)

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Efficiency Analysis





3. Efficiency Analysis:Asset Turnover

ROA = EBIT/Sales x Sales/Total Assets

• Total asset turnover:

Sales/Total Assets 2,984/3,779* = 0.79

As part of the ROA, asset turnover is measuring the firm‘s efficiency in using its assets: for every dollar in assets, Warner is selling $ 0.79 worth of products. This ratio seems rather small, equivalent to the overall result of the ROA.

• Inventory asset turnover:

Sales/Inventories 2,984/37* = 80.65

Inventory turnover, as part of the total asset turnover, is not a problematic measure for Warner, on the contrary, Warner is handling its inventories efficiently.

However, looking at the balance sheet, it is obvious that the assets that are affecting total asset turnover to be low are the goodwill and the intangible assets.Group 4 7

Efficiency Analysis




Efficiency Analysis





3. Efficiency Analysis:Main Operational Assets

• Goodwill– In 2010, goodwill was accrued primarily due to the acquisition of

Roadrunner Music Group, a touring company, and a production music company.1

– These investments are necessary in order for Warner to pursue its expanded-rights deals strategy: building closer relationships with recording artists and diversify revenue streams such as merchandising, fan clubs, sponsoring, and touring.

• Intangible Assets– Are comprised of the record music catalog, music publishing

copyrights, artist contracts, trademarks and other intangible assets.2

– These assets are the most valuable assets for the company3, but they do not seem to be used efficiently.

– The company searches to exploit the assets through a variety of distribution channels, formats and products in order to generate revenue

– A major reason why these assets are currently not being used efficiently is the decrease in revenues accounted from the selling of physical products such as CDs (see slide 6)

– However, non financial performance measures for intangible assets, we can conclude that Warner is performing very well in terms of number and quality of artists

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The amount of assets is necessary in this industry, especially in terms of intangible assets. The decreasing sales in terms of

physical products affect asset turnover negatively. Sales need to be increased to make asset use more efficiently.

Efficiency Analysis



Efficiency Analysis





4. Liquidity Analysis: Ability to Pay Short-Term Debt

• Current Ratio = Short-Term Assets/Short Term Liabilities– Current Ratio 2010: 1,129/1,721* = 0.656– Ratio is less than one, thus firm is not in a good

position, because its ability to repay liabilities in the short run is poor. (benchmark: should not be lower than 1, but above 2)

• Quick Ratio = Short-Term Assets – Inventories – Prepaid expenses) / Short-Term Liabilities– Quick Ratio 2010: (1,129 – 37 – 143) / 1, 721* = 0.551– Taking into account only the most liquid assets: The

result is far from 1 (benchmark value), so short-term liabilities exceed short-term liquid assets, entailing a high amount of debt for the firm and a low capacity to repay it.

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Liquidity Analysis

The firm’s ability to repay its short term debt is very low.




Efficiency Analysis





4. Solvency Analysis: Ability to Pay Long-Term Debt• Debt-Equity Ratio = Total Liabilites/Equity

– Debt Equity Ratio 2010: 3, 990 / (-211)* = -18. 91– Benchmark: should be positive and as low as possible. However,

the ratio is negative indicating that the firm´s net worth is negative, meaning that its debt is not matched by its ability to cover it. If all assets were sold now, investors would be left with debt.

– The result was expected due to the fact that liabilities exceed assets and thus equity is negative.

• Time Interest Earned Ratio = EBIT/Interest Expenses

– Time Interest Earned Ratio 2010: 90 / (-190)* = -0.474– The ratio suggests that the company is not able to repay interest

in the medium and long run.

In the following slide, the effect of the interest expenses will be shown, thus the effect of the large amount of debt.

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Solvency Analysis

The firm’s ability to repay its long-term debt is very low.




Efficiency Analysis





4. Solvency Analysis: Interest Expenses

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Solvency Analysis

Warner’s last gains were in 2008, since then the company is increasingly making losses.

Year EBIT*Interest Expenses EBT

2008 207 180 27

2009 135 195 -60

2010 90 190 -100

2008 2009 2010

-150

-100

-50

0

50

100

150

200

250

EBIT Interest Expenses

EBT

• EBIT is steadily declining due to declining sales revenues• Interest expenses are stable, but very high due to the large

amount of debt ($ 3,990 million in 2010)• Due to this, EBT is declining and therefore also net income




Efficiency Analysis





5. Future ROE:Possibilities to Increase

(1) Net Income/EBT: Net income and EBT are both negative due to high interest expenses. No EBT is kept in the company. EBIT is not high enough to cover Interest expenses due to a decrease in sales .

(2) EBT/EBIT: Effect of interest: interest expenses are so high, that no EBT is retained by the company, the company is making losses.

(3) EBIT/Sales: ROS is declining due to decline in sales that is also affecting EBIT

(4) Sales/Assets: Assets efficiency is likely to stay low if sales continue to decline, as current intangible assets are being kept.

(5) Total Assets/Common Equity: Effect on leverage: negative ratio due to negative equity. Accumulating new assets will be difficult as there is a large amount of debt.

ROE = Net Income/Equity

ROE is possible to be increased by changing: Net Income: should be increased to be positive and large

Increasing sales – since market is decreasing, sales cannot increase by focusing on the physical sales. By increasing digital sales, overall sales can be increased

Cost savings – Warner is determining contracts with artists of low revenue and focuses on smaller number of high quality artists. Moreover, shift from physical to digital products will entail cost reduction.

Decreasing debt – debt has to be paid back in order to decrease interest expenses. This can only be done if sales increase to then pay back debt.

Equity: should be increased to be positive by repaying the company’s debt

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Future ROE



Efficiency Analysis





5. Future ROE:Prospects and Risks

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Future ROE

Prospects Risks

• Push sales of digital content by focusing on that sector which is increasing

• Costs savings- Focus on few but popular

artists instead of investing in new emerging artists

- Push digital sales which are less costly than physical sales

• Combat piracy- If Warner‘s strategy to

combat piracy pays off, sales could be improved

Decline of music industry continues

Downward pressure on prices

Failing to identify new artists due to attempt to save cost

Debt agreements contain restrictions that limit its flexibility in operating business

Overall, it will be difficult for Warner to increase the ROE due to the market characteristics and its currently financial

position with a lot of pressure due to difficulty to repay debt.



Efficiency Analysis





6. Unusual or Non-Recurring Items

• There are no unusual or non-recurring items in 2010 that need to be included in the analysis.

• There are no discontinued operations are shown in Warner’s income statement for the year 2010 (the company only discontinued their Bulldog operations in 2008 losing $21 million1)

• Thus, earnings are persistent and of high quality. The company does not rely on unusual items to make earnings.

• However, since Warner is afflicted by a big amount of debt (and in consequence by a big amount of passive interest), its income statement results in a net loss.

• Quailty of Earnings are high, but not high enough to cover the interest expenses resulting from the large amount of debt.

• Quality of Earnings Ratio = Cash Flow from Operating Activities / Net Income

– Quality of Earnings Ratio = -12 / -143* = 0.0832

– Ratio cannot be used due to the fact that both cash flow from operating activities as well as net income are negative.

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Unusual/Non-Recurring Items

Earnings are persistent and regular (but decreasing due to decreasing sales). Due to high interest expenses and the resulting loss, quality of earnings cannot be calculated.




Efficiency Analysis





7. Potential Investment

• Based on the analysis, regarding the ROE and ROA and the overall trend of the industry, Warner Music Group is not a company potential investors are likely to invest in.

• This is not necessarily due a poor management but rather due to the problems that the music industry is facing in general (e.g. piracy).

• As already mentioned, the company‘s equity is negative, which is a warning sign for potential investors. With the negative equity, Warner is not able to pay its shareholders dividends and if all assets were sold, shareholders would not receive any compensation for the investment. The equity is even worsening over the past years (last year equity was positive was in 2006):

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• However, if there was still a potential investor interested in investing in the Warner Music Group, the most necessary information for him to be found would be the share prices and possibilities to invest

• In the investor relations section of the company‘s website, potential investors find all necessary information in a well structured way.

2006 2007 2008 2009 2010

-300

-200

-100

0

100

Equity1

Equity is steadily declining by large

amounts over the years

analysis of warner music group

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