Universal Music Group Q4: Time To Trim (Rating Downgrade)

Investment Thesis

I continue to see Universal Music Group (OTCPK: UMGNF) (“the company”) as an exceptional investment, which is likely to continue to outperform the market in the long term. With that in mind, I downgrade the company to “Buy” as I do believe that from the valuation point, it is no longer asymmetrically skewed to the upside but at a more “neutral” point.

In my previous article back in September 2023, I argued that Universal Music Group was significantly undervalued, backed by a compelling valuation, a strong value proposition, and a dominant position in a low-cost entrainment industry.

Since then, the stock performance has been positive, able to deliver alpha relatively to the S&P500:

4Q23 Results Overview

After Universal Music Group reported the 4Q 2023 fiscal results, the market reacted with shares rising ~5% in response to such developments.

For Q4, revenues came in at €3.21B, and at €11.1B or up by about ~7.4% on a full-year basis, with all three operating segments showing continuous strength, in particular physical and merchandising (up ~ 14.2%) driven by global superstars like Taylor Swift.

In the near term, I do expect the top line to be mainly volume rather than price-driven, as consumers are highly susceptible to further increases, with Universal Music’s initiatives such as expanding its global presence (especially in China) and investing in local labels, among others, being the key drivers.

That said, the margins look healthy, despite input inflation biting into some of the business profits.

Gross margins decreased to 44.1%, due to higher artists’ costs and the Physical and Merchandising lower margin segment, taking a greater share of total revenue. Operating profit showed a less rosy picture, due to higher stock-based compensation expenses, however, this is no longer going to be a headwind in 2024, and once we account for Universal Music’s cost savings plan, the tailwinds are there.

On the FCFF side, there are no particular headwinds to underline, but there is a potential long-term tailwind that could boost Universal Music’s cash flow position. I am referring to the company’s acquisition of the 25.8% stake in Chord Music Partners, at an EV/EBITDA of ~17.0x. In my opinion, this vehicle will provide greater financial flexibility when acquiring “expensive” music catalogs, hence boosting FCF’s profile.

Finally, the balance sheet remains healthy, boasting a Net Debt/EBITDA of ~0.9x, an interest Coverage ratio of 34.75x 2023A, and an average maturity of ~ 5 years. For this reason, I don’t see any risk on this front in the foreseeable future.

Valuation And Risks Update

I decided to downgrade the company from “Strong Buy” to “Buy” at this stage, with a fair value of €30.79/share. The downgrade reflects the change in the valuation profile, which is no longer asymmetrically skewed to the upside but at a more “neutral” point. Universal Music Group trades at a P/FCFF of 31.86x, slightly above the historical average, but still well below the historical high of 42.18x.

Having said that, my long-term thesis remains intact, as I do believe that the company will be able to capitalize on the secular growth opportunity driven by the streaming era.

I want to provide an update on the risk side, particularly regarding Artificial Intelligence and the break-up between Universal Music Group and TikTok.

First, regarding Artificial Intelligence. The management started to take the first steps in making sure that the company’s IP is well protected against illicit use, and well compensated in case it occurs. As stated during the 4Q23 earnings call:

Instead of waiting for AI to take hold and then trying to figure out business models that will fairly compensate artists and music companies. We got ahead of the game this time. We formed a historic relationship with our long-time partner YouTube, whereby we and our artists have a seat at the table to help shape the technology development and determine how to harness and monetize it for the benefit of the entire creative community.

Second, regarding the break-up between Universal Music Group and TikTok. In the letter, Universal Music Group pointed the finger at TikTok claiming that TikTok is allegedly not enforcing issues around AI, as well as not paying a fair revenue share for Universal Music Group’s artists. This is a risk for a simple reason: TikTok thanks to its global user reach was providing significant visibility to the company’s artists. This is no longer the case.

In my opinion, this may be an issue in the short-term, but I don’t see a relevant impact in the long-term, as the consumption shifts to other short video platforms that are likely to offset the impact. Moreover, I do believe that later in the year we will see them reengage on a deal structure, since the break-up is likely to damage TikTok more than Universal Music Group (which is clearly in a dominant position).

Final Remarks

Universal Music Group is an exceptional investment opportunity with a compelling valuation, strong cash flow generation, and potential catalysts for market share expansion and margin improvement.

The management is continuing to execute well, addressing the risk related to artificial intelligence and taking a proactive approach in trying to mitigate a headwind related to the break-up with TikTok. That said, I do expect the company to keep to its track record, however, based on the current valuation I decided to trim my position by 30%, as I do believe that we may experience some downside volatility in the short term.

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