The death of cultural transmission

Alphaville recently read Eamonn Forde's new book "Selling the Pig”, which deals with the disastrous leveraged buyout of now-defunct major record label EMI by Guy Hands' private equity group Terra Firma.

It's a story of debt, Radiohead and an industry gasping for breath under the turbulent waters of digital disruption, and we think Alphaville readers will enjoy it.

The penny dreadful got us thinking about another major deal for a music label that's been on the table since last summer: namely, Vivendi's plan to sell up to 50 per cent of Universal Music Group (UMG). And in particular, the price a potential bidder might pay for its assets.

The valuations thrown about so far for the home of The Beatles, Rolling Stones and U2 are extreme. UBS reckon its worth between €22bn to €26bn, Deutsche Bank €29bn, Morgan Stanley up to €37bn, and JPMorgan, up to €44bn. Take UMG's ebita last year of €902m, according to Vivendi's annual report, and we're talking multiples of anywhere between 24 to 48 times. For comparison, PitchBook estimated the average private equity multiple in 2018 was 11.2x for a plus-$250m deal.

Part of this is down to potential suitors. Mooted strategic buyers, such as a Google or Spotify, may be more willing to pay for the benefits of owning the business than a private equity house, given the potential synergies.

But even then, Alphaville reckons there's a set of assumptions underpinning these valuations which don't quite add up. Let us explain.

First, a bit of background. Since the nadir of 2011, when the global recorded music market reached a bottom 41 per cent below 1999's high, revenues have recovered to $18.8bn, according to a report by Mark Mulligan at MIDiA research. And the growth is set to continue, with UBS forecasting a market size of $38bn by 2027.

Streaming, via platforms such as Spotify and Apple Music, has been the driving force. In 2018, according to Mulligan, the medium accounted for 162 per cent of the market's entire 7.9 per cent growth. As you might imagine from these numbers, no one is buying CDs any more.

Hone in on UMG, and the figures are even better. In 2018 it increased revenues 10 per cent, in constant currency terms, to €6bn, according to Vivendi's financials, with streaming now representing just over half of its sales. It's dominance in the US charts — eight out of ten of 2018's most popular artists, according to Rolling Stone, were signed to UMG — also underlines its strength as a maker, as well as a repositary, of talent.

In total, recorded music was 80 per cent of UMG's sales, with music publishing — the business of licensing songs for films, television and advertising — contributing nearly all of the rest.

So valuing UMG's recorded music catalogue — the largest in the world at over 3m items — is therefore crucial for anyone looking to bid for a stake in the business.

Despite the prominence of new music, established artists are still fundamental to recorded music's success. According to a report by BuzzAngle Music, in 2018 songs released over 78 weeks ago (somewhat arbitrary, we know, but a lifetime in the music industry), made up 62.1 per cent of all streams.

So let's think about these golden oldies as assets. Assets whose appeal has, arguably, only been heightened by the advent of streaming which, with its recurring revenues and growing audience, has made recurring payments from established acts even more bond-like in their cash flow consistency. (Readers may recall David Bowie sold the rights to his royalties in bond form for $55m. So the comparison is apt.)

But like fixed-income assets with long durations, these cash flows are also sensitive to the smallest assumptions about their future viability. Assumptions which are not as rock solid as some investors might imagine.

We're going to use The Beatles as a point of reference here, as "The White Album" was UMG's fourth best-selling album last year.

If you're asking “why The Beatles?” Well, Alphaville likes The Beatles, sure. (The Fab Four could easily be replaced by its other legacy acts, such as Queen and Nirvana).

But the problem for a prospective buyer is why we're a fan. To put it simply: we had no choice. We were indoctrinated.

On a long car journeys to coastal summer holidays, or at home on a knackered JVC stereo, we, like many of our friends, were limited to a dozen or so records. One of which, inevitably, would be some form of John, Paul, George and Ringo (and George).

Call it the cultural transmission effect. Music would be passed on generation to generation, amplified by the relative scarcity, physical space constraints and high prices of recorded media.

This provided a boon for the major labels as it not only meant lower marketing costs but reissues, limited editions, and remasters became an easily repeatable trick, as younger generations grew up to become consumers themselves.

The Beatles' recent release history is a great example. In 2000, EMI released The Beatles "1" album — a compilation, unsurprisingly, of all of their number one singles — it went on to be the bestselling album of the decade in the US. Not content with its success, EMI released a remastered, multiple edition version of the entirety of the Fab Four's back catalogue in 2009. It even came with a limited edition USB flash drive (peak noughties). This was the sixth release of the Liverpudlian's oeuvre in history.

(To boot, last year UMG released a super deluxe version of the "White Album", hence its streaming performance.)

Streaming, however, poses problems to this pattern of releasing the same stuff over and over again with additional gimmicks, and then selling boatloads of it to an indoctrinated public.

The first is obvious. The format is set, and unlikely to be bettered in the next couple of decades. We've arrived at the era of instant music, assuming you have either phone signal or internet. It's hard to imagine it getting any more convenient for consumers, and it's therefore even harder to induce a normal Beatles listener to part with $200 for new vinyls (which carry much better margins) if it's also available on streaming platforms.

The second is more of a thought experiment, and one that was put to us by MIDiA Research analyst Zach Fuller: what if the smartphone has disrupted the effect of cultural transmission?

As Alphaville mentioned before, we loved The Beatles because we had no choice. By the time we were adults, the songs were scratched into our souls.

Smartphones, and readily accessible digital media, might have changed this. Cars now regularly feature television screens in the back to wist children away to Frozen lands, so parents can listen to Bon Jovi, or bicker, in peace. The bedroom, for the majority, was once a place where only reading or listening to music (via radio or CDs) could be done in privacy. It's now a space to watch Netflix, play Fortnite or follow Swedish racists on YouTube. It is not tenuous to suggest that in this environment, it is unlikely that “Eleanor Rigby” will be the go-to entertainment.

Of course, there are other ways to bring the classics into vogue. The recent spate of passable music biopics — such as the Queen film Bohemian Rhapsody — can help revive the classics for a few months. But these bumps in streams are not only unpredictable, as demonstrated by the flop that was the Tupac Shakur film All Eyez on Me, they're also one-offs. Arguably the culture transmission effect requires constant exposure, not just 90 minutes in the cinema. (Artist scandals also help, if the recent action of R Kelly's streams are anything to go-by, but they're also harder to engineer. We guess.)

With all the hype about new content in television industry, some may think we're over-emphasising the declining value of the back catalogue. Surely Taylor Swift can pick up where the Stones left off right? The problem is finding new Taylor Swifts if the cash flows from the catalogue begin to decline. In the 2017 financial year, UBS estimated that UMG funded its €1.3bn of artist and repertoire (read: artist search) and marketing costs out of its €1.7bn of back catalogue profits. So there's an indisputable chicken and egg problem.

Maybe we're overstating the issue. The Beatles, Rolling Stones and Bob Marley are after all, great artists. Their music will live on. But that's not the question for a perspective investor.

The question is: to what degree will the royalties from these artists continue to flow? Assume Sir Paul and Sir Ringo will continue to grow exponentially richer off the back of streaming, and perhaps the quoted multiples don't look quite so mad. In this age it's hard to find assets which both grow, and have semi-predictable cash flows.

But if the next generation doesn't hold the same affinity to the artists which defined the first fifty years of the pop era, where does that leave the labels' back catalogues? May we suggest: in a tougher spot than most imagine.

Related Links:
Money for nothing: copyright law, YouTube, and the future of music [Part I] - FT Alphaville
Money for nothing: copyright law, YouTube, and the future of music [Part II]
- FT Alphaville

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