TIVP039: Universal Music Group (UMG): Owning The World’s Music Catalog w/ Shawn O’Malley & Daniel Mahncke

27:51But even without betting on Spotify and Apple Music raising prices for subscriptions dramatically, we already know that streaming has helped make Universal more profitable. From what I can see here, from 2015 to 2021, Universal's operating margin rose six percentage points as streaming became a larger part of their business. But the big question, probably underlying all of this, is why do artists continue to use labels? I know you spoke to this a bit last time you covered the company, but I think it's still worth mentioning again, because initially a lot of people feel like you want to see the artist, they are making the music.

28:29Why is there a company in the background taking such a large chunk of their revenues? Just quickly on your point about streaming continuing to grow. I've seen some data that suggests Gen Z listeners consume about 20 % more music than other generations. So at the same time that per capita music spending has been declining, per capita music consumption really seems destined to continue rising, which is a good thing for UMG long term and offset some of those trends longer term and how per capita spending has declined. So to your question, it's one that a lot of listeners probably have on their mind.

29:09And really, I think in a lot of circles, music labels are almost vilified. There are probably some people that might be frustrated by the rosy picture of Universal that we're sort of painting. And some folks just find it completely distasteful that musicians don't get all of the revenue from the music they generate. but for better or worse that is just not economic reality if labels were truly only these middlemen that extracted profits without adding any value i can say pretty confidently they would have been displaced decades ago the fact that taylor swift herself is signed with a label which just so happens to be universal i think that should tell you that no artist is really big enough to bypass labels without taking significant risk and obviously if taylor swift is working with a label clearly they provide some kind of value.

29:56It's not me saying that out of wishful thinking. And that's because labels handle the business side of music. Being a pop star comes with really having a full enterprise around you. And just because someone is a great singer does not mean that they're equipped or even interested in overseeing an entire enterprise themselves while also touring, recording, and writing music. I mean, you're running a multi-million dollar, maybe billion dollar business if you're somebody like Taylor Swift. So it's just not possible to do all that and still be a top tier musician from booking venues and even planning tours to scheduling promotional interviews, sourcing and selling merch, uploading music onto music platforms globally, negotiating more favorable terms with streaming platforms, and then just simply overseeing kind of something that happens behind the scenes of the process of actually accounting for and collecting and properly distributing the dollars generated from royalties.

30:52I mean, all of those burdens and then a lot more will fall onto labels, which is why I say that they are so essential to the actual business of being a musician. And that's where they earn their cut of royalties because without them, it just the music industry would be completely different and artists would be taking a lot more burden than they currently do. So most noteworthy artists make the majority of their money from touring, usually. And streaming payouts tend to be very concentrated anyway. And according to Spotify last year, approximately 1 ,500 artists generated$1 million plus in royalties on the platform.

31:31So for the top 0.1 % of musicians, streaming can be a moneymaker. And they're splitting those royalties with the universals of the world. But for the vast majority, streaming payouts really only provide supplemental income at best anyways. Only 1 ,500 artists. I would have thought it would be, I don't know, the tens of thousands probably. That's a lot less than any, although you know all the headlines about artists kind of saying that Spotify pays them too little money. But that's a pretty substantial number. I mean, it's understandable at first glance that this might be frustrating for people.

32:05I mean, talent-wise, there may not be a huge difference between the 100s best singer in the world and the 1500s best singer, right? But one will make orders of magnitude more money than the other one. And over their career, I think that's kind of a given. It might feel arbitrary to some people, but that's kind of how the economics of the business works, right? No, you're right. I mean, this is a phenomenon that is not unique to the music industry. Whether you're talking about authors or pro athletes, there's a huge difference in earnings power from being in the top 1 % industry versus the top 0.1%, even though you still have to be insanely talented to be a pro athlete or to be a top 1 % musician.

32:46And something about it doesn't seem fair, but wealth in these kinds of industries is always concentrated. it. LeBron James and Michael Jordan alone, I'm sure, have earned more money in their careers on the court and off it, probably than the combined earnings of almost everyone who's ever played in the NBA that wasn't a superstar. I mean, I'm being serious. I mean, think about the Air Jordan brand alone, how much value that's created. So, I mean, that's just a guess off the top of my head, but you get the point. Even at the highest level, the best of the best of the best claim a disproportionate amount of the rewards.

33:21Well, you know me, Sean, I don't know too much about the NBA, but I think this might be accurate. I can only think of Cristiano Ronaldo, who just recently signed a new contract and including bonuses and everything else, he makes as much as $350 million a year. And that's probably more than the salaries of the entire Premier League combined. So to be fair, economic rationale doesn't play a big role in the Saudi League, but it proves again how much it's worth to be the best and not only top 1%. us in. Like any talent-based industry facing the masses, there is a power law in music. And like you said, the top performers will accrue most of the profit alongside the labels.

34:03While unfortunately the median artist struggles to pay the bills, just like how most startups fail and only a fraction of the bets adventure capitalists make work out. But when they do, they work out massively. I mean, that is what we're talking about here when we're talking about power laws. And it's even the same dynamic among podcasts, YouTube channels, and TikTok creators too. And so that's why I say it's maybe a little bit naive to hate on labels or think that musicians should own the rights to their music 100 % because the top echelon of artists really are the ones who hoard most of the royalties.

34:33And they also have the biggest businesses and they need the most help from labels managing those businesses. And so, I mean, that just ignores the fact that labels really do, again, generate value for artists and the industry more broadly. If a label is doing everything behind the scenes to help make someone into a star and manage the business of stardom for them why shouldn't they get a cut of the royalties so i think there's good reason for this status quo and this is not me trying to just defend everything that labels have ever done but i'm really just saying their role is more justified than i think most people think and maybe i'm making a straw man argument but like i said i just i think it's a fair exchange for the top talent, which is why I don't worry about the terminal value of Universal Music Group that much, because I don't think that labels are going to get displaced.

35:22I think if Taylor Swift is still working with music labels, that should tell you that they have a very real role in the industry, and it's not just a parasitic relationship on talent. And that's nothing to say of the financial risk that labels take either, right? I mean, those were risks that otherwise an artist needs to take, and maybe Taylor Swift could do that, but I think every single other artist on the world probably wouldn't like to have that burden on their plate as well. Yeah, I mean, they're taking a lot of risk up front. I mean, you can think of a music rights catalog business as almost an equity portfolio.

35:56You're buying a bunch of different streams of income and whether it's coming from classic equities or if it's coming from royalties on musical artists, I mean, that is the same kind of thing. And the labels typically are the ones who front the cost of production, marketing, distribution, and tour support. They're paying for all of that up front out of their own pocket. And then in exchange for that help and the financing, they get ownership of the master recordings or at least partial ownership. That is the deal. And without that financing, the tours across the country, the albums, the recording studios, I mean, all of that stuff would basically be impossible to do.

36:35I mean, can you imagine if you were, with the exception of maybe Taylor Swift, if you were an artist that had to fund your cross country tour just out of your own pocket? I mean, it just it wouldn't happen in the way that it's able to happen currently. You need those external financing partners so you're not taking on all that financial risk yourself. And again, you can focus on just being an artist. So, I mean, artists earn royalties based on their contracts. But this happens only after the label has recouped its upfront investment. And again, you can imagine that upfront investment matters a lot for first time artists because you might be totally broke.

37:09and now you're getting money to actually get an album recorded that you otherwise would really not be able to do. So UMG effectively acts as both a financier, a business partner, and a promoter and distributor for these artists. And it's not unlike a software business in some ways. They make upfront investments to create or acquire the content. And then they collect this long tail of royalty payments over time. And thanks to streaming, those royalties have become far more predictable and global than they were in the CD era. I think there's a very strong argument to make for why you need labels.

37:45And still, I think the business support they provide, the connections, the funding, all that can make or break artists. But today from something like SoundCloud to TikTok and YouTube, it has become significantly easier, probably easier than ever, to be an artist and to build your own following, perhaps without spending much money up front. So how do you see that impacting Universal in the future? There's definitely more opportunity today for independent artists to get discovered. A teenager can upload a song from their bedroom and wake up with a viral hit, but the barriers to sustained global stardom are still very high.

38:20You can get one song to go viral independently, but building a career, touring the world, running a merch business, negotiating licensing, navigating complex royalty structures, and then managing their branding. I mean, that is where a partner like UMG, who has been in the industry for decades, is absolutely necessary. The reality is that there are millions and millions of songs out there. I mean, hundreds of thousands of songs are published every single day on music streaming platforms. So it is just impossible to stand out. Everybody thinks they're great. Everybody thinks they're the next big star.

38:55But just statistically speaking, I mean, how do you get attention in that kind of competitive landscape. So for as much as the internet has democratized music, it has also increased the competition too by lowering the barriers to entry and really just make it easy for anyone to upload their songs and potentially be discovered. So if you are really serious about being a professional, I still think labels will take you further than a YouTube channel on average, which is not to say some people can't make a good living just by sharing singing-related content on their own. Obviously, there are a lot of people who have chosen the social media route and just do it themselves.

39:32But I don't think that is a viable option for most musicians at the top of their domains. What's interesting, and that is a bit of a tangent, but even the people who make it on YouTube most of the time do not stay solo. I mean, given that even people who made it their big time on YouTube and probably make enough money to finance most of the stuff they're doing, they're still managed by so-called influencer marketing firms, which at least to some extent do a similar job compared to a record label. I mean, there are differences, but I think the general setup is the same. And to me personally, that probably proves that there's just a need for that.

40:08Many people make fun of it, but every big influencer uses them. And there was no legacy structure as perhaps in Yuzik that basically forced them into working with them. So they seem to think that there is value they create and they kind of need them to be successful. So I think those are pretty strong arguments for why labels are just a necessity in the business. And to wrap up our convo on royalties for now, I did want to hear more about this new artist-centric royalty model that I've heard management mention in some of the calls. What should we know about that? What do you know about that? Can you paint a bit more light on that?

40:43Yeah, so there's certainly been a lot of tension around how royalties are allocated. Right now, most streaming platforms use a pro-rata model, which means all subscription revenue gets pulled and divided up based on the total number of streams across that platform. And that can disadvantage niche artists and lead to platforms prioritizing volume and virality over the quality or fandom depth that an artist has. And so, for example, last summer, I felt like Spotify was hellbent on serving me Sabrina Carpenter music at every possible opportunity. and you know it's okay but that to me is the perfect illustration of how these algorithms just get carried away with promoting the next big pop star even to people who are probably well outside of the target demographic and every time sabrina carpenter is recommended to me that's really just taking a possible stream from someone else and so yeah i mean there is an industry movement pushing for user-centric royalty models where each user's subscription fee is divided only among the artists they actually listen to.

41:46And in theory, that should be a more equitable approach and would likely benefit these fan-favorite artists with cult followings who don't have the largest total reach. And so it's hard to say how this will change the underlying economics, if at all, for UMG, though. And so, yeah, I mean, you'll hear UMG's CEO, Lucien Grange, who I should mention is really a pretty legendary figure, not just in music, but really he's one of the most assume CEOs and business history, honestly. And he'll mention what they call their artist-centric model 2.0. And that includes a few things, like what I mentioned a moment ago with these changes to how royalties are split up, but also working with Spotify to require that artists must generate at least 1 ,000 streams in the prior 12 months per track to accrue recorded royalties, which is meant to rule out a lot of the noise that can make royalty accounting very messy and also just demonetizing a lot of the spam that gets uploaded on the platform.

42:41And some of that spam, I mean, some of that stuff is just literally noise that people use to help them sleep. So like brown noise, cat's purrs, or the type of rain on leaves. And this maybe functional music, as you could call it, it does serve a purpose for people, but it really has nothing to do with recorded music. And yet it's eating into the overall pie and share of music rights. And so, you know, it does account for a vast portion of the streaming world. Spotify has said that white noise and ambient podcasts rack up 3 million hours of listens a day. And so that is part of what UMG has tried to address with the streaming app Deezer, changing the payout structure to favor professional human artists who are producing actual music.

43:29And Deezer for its part has actually claimed that they will be able to shift approximately 10 % of total royalties back to professional artists while helping cull tens of millions of these relatively low quality uploads that are otherwise distracting. To me, that sounds like universal benefits, not just from scale, but also from vertical integration to owning both the recording and the publishing, having merch layered in and having all of that monetized across a growing number of platforms as well. And I guess that makes the value add a lot more compelling. Yeah, and that vertical integration helps them strike better deals and invest in higher potential artists.

44:11So it's becoming a bit of a cliche to say on our show because we say so often, but there is a flywheel here that is reinforcing their advantages over time. As the biggest label, you have the most leverage over negotiating with streaming platforms, which means you can generate a higher total royalty payout for both artists and for themselves, which can then be reinvested into buying more catalogs and attracting new talent, which further entrenches them as an industry leader and so on. It also makes them a core partner to platforms like Spotify, which need access to the best content to stay competitive.

44:49If a music platform tried to cut out a label like Universal entirely, I mean, that would destroy the business overnight. The expectation today is that people want all of their music in one place unequivocally. If Spotify got into a tiff with Universal and pulled Universal's catalogs in some sort of nuclear option, they would immediately lose a third of the most popular music on their platform. and I think people would jump ship pretty quickly to Apple Music if that meant they could get all of Universal's catalog at the same price. I mean, not to keep invoking Taylor Swift, but if you suddenly couldn't listen to Taylor Swift on Spotify, you're telling me that there aren't millions of people that would cancel their subscriptions.

45:27I think that is just the reality. And so TikTok learned that lesson the hard way and pretty quickly relented last year when UMG actually did pull their catalog from the platform for a very short period of time. And as Spotify has grown, they certainly have increased their negotiating power more than what it used to be, since they're a bigger and bigger part of Universal's business as well, which we're showing in a chart on screen at the moment. But the idea is that Universal keeps on scaling too, and that reinforces their advantages on multiple fronts. And just to wrap up the power dynamics between labels and streaming platforms, it's hard to say which side definitely has more power in the relationship going forward, but it is a mutually beneficial and necessary relationship for both sides.

46:13We know that as a fact. I don't think there's a significant risk that Spotify is able to individually negotiate lower music royalty rates with labels. And I guess that there's a tacit understanding that the status quo is pretty good for everyone involved as the industry keeps growing. As a power user of Spotify, I think the worst thing that could happen is kind of seeing the same thing happening that was happening to Netflix, Disney +, etc., where you want to watch a certain show and you just have to click through all the different platforms because it's all split apart. I think, in my opinion, that probably means that Universal has maybe even the stronger hand in this negotiation.

46:53It's probably 50-50, but I think for both companies, it's best to just stick with the status quo for sure. And I think it's also really important for us today to understand the economics of streaming then, right? I mean, we will link to it in the show notes, but you did a great episode back in the day covering Spotify, not only Universal, going through the music industry's progression, Spotify's role in it, obviously, and also just really how streaming has completely reinvigorated the global music business with there being a lot more optimism that has kind of cleared the room for a pretty lengthy runway ahead.

47:27So with that entire backdrop, let's linger a little longer on streaming in particular and what role it plays for universal streaming is the engine that turned universal music group from a hit driven label into a cash flow machine i would say it's arguably the single most important structural shift in the company's modern history and back in the day music revenues were spiky you had to wait for a big artist to drop an album and you'd hope for strong cd sales and then you'd rinse and repeat and today streaming has just completely changed that dynamic. And now UMG earns money every single time someone plays a song, whether that song came out yesterday or 40 years ago.

48:09Streaming has made it far easier to monetize back catalogs, but also to make past music more discoverable. One of the things people love about Spotify the most is their recommendation engines for discovering new music. And that is ultimately a tool to keep people engaged with the app longer, which means listening to more music than they otherwise would and generating more royalty revenue for Universal. So you can almost think of it as Spotify is doing the work to market and grow the business on behalf of Universal. And Universal doesn't really have to do any of that on their own financial statements.

48:45And in 2023, streaming contributed over two thirds of UMG's revenue and streaming will only make up a bigger part of the business going forward. And just to say it Again, the model itself is relatively simple. Fans pay Spotify or Apple Music a monthly subscription fee or listen for free with ads. And then the streaming platform pays about 70 % of that corresponding revenue to rights holders, including Universal, who then is in charge of divvying that up between themselves and artists. It's such an interesting angle. I've never seen it that way, that Spotify is basically doing the marketing for Universal.

49:20I mean, when I look how I use Spotify, I'm way too lazy to actually have my own playlists I just go on a couple of songs that I like, and then I just go to the radio. And then basically Spotify is showing me all the new songs, and perhaps a lot of them are coming from Universal. So that's a powerful value proposition, I would say, that benefits Universal the most. And generally, you've got this dynamic where music streaming is structurally growing, especially in emerging markets where music consumption is much less saturated and has a much smaller percentage of the population paying for subscriptions like Spotify or like Apple Music, which is more than just common here.

49:55And yet the labels are still very much competing for their slice of that bigger and bigger pie. And I think the key point that you hit on is that streaming has made music consumption easier and more accessible all over the globe. And if I want to listen to music from the 80s, I don't have to make a commitment and go out to buy an album for, I don't know,$15 or tune into a radio station where I have no control about what they actually play next. And basically you have all the world's music available on demand and at your fingertips. And that's just a total game changer. I'm going to give you a stat that first blew my mind when I heard it.

50:31But more than 70 % of music streams today are catalog, not new releases. Just think about that. It means most people are listening to older music. And that older music is the most valuable asset on UMG's balance sheet. It has this interesting effect on its financials. how do you depreciate Fleetwood Mac's catalog value over time when there's a chance that the song Dreams will get featured in a viral TikTok of a man skateboarding while drinking cranberry juice and that could reignite the brand's popularity with a new generation? The short answer is there's no good way to. And yes, for anyone wondering, that is a real example.

51:10A single TikTok can lead to millions of new people discovering not only a new song, but a new band in a whole era of music at the same time that they might go down the rabbit hole for. And so this is what really gets me so bullish on the music industry going forward. Social media is just such an incredible tool for amplifying music catalogs and artist popularity. And Universal is the most obvious beneficiary of those trends with the least amount of business risk, I would say, because they're just taking a claim on music consumption. That's really all they're doing. They're not trying to innovate with technology and add the best features like Spotify and actively steal subscribers from Apple Music.

51:51They're just making sure that people continue to pay them for the music rights that they own. You just, you can't out-compete a back catalog, right? It's just not possible. I mean, sometimes I think back to music I used to listen to as a kid. And then just for fun, I look it up on Spotify. And I often see that these songs have tens of millions of streams. And I'm talking about, you know, German bands that stopped making music 15 years ago, but still have as many streams as some new artists. And then I'm always wondering, how is that possible? But now you're giving me that stat. So I'm not surprised that 70 % of streams are actually just catalog.

52:26And to summarize that dynamic, basically there's a certain but pretty large amount of stable consumption of catalog music that maybe slowly declines and needs to be offset by signing new talent with some embedded optionality in the catalog for labels with the chance that once popular artists can have resurgences basically at every point in time. Don't get me wrong, Fleetwood Mac getting dragged back to the top of the charts the way it was is an anomaly. but across a really deep music catalog you do get this almost annuity like revenue stream that's very passive and it just never sleeps it's true it reminds me a little of when we talked about in an episode on disney when you own a beloved character or in this case a beloved song you don't have to constantly reinvent the wheel to make money from that you just need to make sure it's accessible to be monetized make music widely available at a small cost how about we talk a bit more about the international picture for Universal since you mentioned having the rights to globally loved IP, pretty much like Disney, and that emerging markets are a source for growth in the music industry.

53:34How does it actually look with Universal's portfolio of, I don't know, let's say South American, Korean, East Asian, or even African artists? For everything we've talked about with how streaming has changed the music industry, as you're alluding to with your question here, streaming has also globalized the music industry in a way that was never really possible before but people in brazil are discovering k-pop american teens are listening to latin american hip-hop tracks a song from 1985 can break out in indonesia and what that means for umg as a business is that it can now monetize its catalog in markets where it had minimal distribution just a decade ago and you mentioned this earlier daniel but emerging markets are still in the early innings of streaming penetration.

54:19Markets like India, Southeast Asia, and Latin America have rapidly growing smartphone adoption and data access. And so there's a lot of room for these people to start demanding more ad-free music streaming. There are over 9 billion people on this planet, and only 60 % of them have smartphones, which has doubled from 10 years ago and will probably rise to 100 % in our lifetimes. But only a small fraction of all global smartphone users have music streaming subscriptions, just 11 % at the end of 2021. So streaming penetration worldwide is pretty low. And I'll just use some numbers from when I researched Spotify last summer to make the point further.

55:02Spotify has over 600 million total users, with around 60 % of those being free subscribers who just use the ad supported tier. and the remaining 230 million or so are premium subscribers who pay monthly to download music for offline listening and for no ads in that music and the average revenue per premium user is dramatically higher than what spotify makes off of the ad supported tier of users and in the u.s those premium subscribers might be on a solo plan for 11.99 a month a duo plan for 16.99 family plan for$19.99 or there's some student plan options for$5.99. And Spotify's prices vary around the world though.

55:42And so adjusting for the cost of living in different countries and the median incomes there. So like in developing countries like Nigeria, Egypt, and India, monthly costs for a premium subscription are just much lower, closer to one or two dollars. And for the rest of the world, it falls somewhere in between for the most part. Japanese users, for example, typically pay around$6.50 per month. And one of the core questions for Spotify and also UMG is whether you believe that over time, monthly subscription costs will converge on the higher rates that people across the US and Europe are willing to pay for on-demand ad-free music.

56:18And I tend to think the answer to that question is yes, because it's not like music is intrinsically worth more to Americans or Europeans. As incomes rise around the world, I suspect emerging market music monetization will at least trend closer toward that of developed markets, even if there is some gap that continues to persist for years to come. And Universal has actually been teasing for a while now that they think platforms like Spotify will eventually unveil super premium subscriptions that are targeted at these music super fans. And that would really help to further segment music listenership into different categories of monetization based on usage.

56:58So maybe you have ad-supported users that are just listening to music for free. You have the kind of status quo and premium subscriptions that we have today. Then you have another tranche of ultra-premium people who are paying considerably higher subscription fees for additional perks. And so according to management, their research suggests that one in five paid music subscribers today would be willing to pay for a super premium tier, potentially up to double the current standard price. I'm not sure what a super premium subscription would do, but considering I'm listening to music every day and for hours, every single day, I assume I would be the target audience for that.

57:40And I'm one of those five people who would definitely pay double the rate if they're actually good perks for that rate. And I would also be interested though, in the role hits play in all this. Now, I know we mentioned that the back color lock is incredibly important and all the royalties are kind of like an annuity for universal and that they also can get second lives, which kind of turns old music into a hit once again. But is there still the same incentive considering all of that to still invest in new artists and just go for hit potential and the future of the catalog? I think so. I mean, there still needs to be a growth engine that feeds the base of the business.

58:15When an artist breaks out, whether it's Billie Eilish, Post Malone, or Olivia Rodrigo, it creates a short-term revenue pop across streaming, touring, and merch but it also plants the seed for future catalog value if an artist has staying power their music becomes a part of this long tail of royalty revenue and that's why umg continues to invest in talent discovery and a and r i mean they're essentially underwriting future ip that could pay off for decades and we don't always know which artists will have that kind of payoff structure but we know that statistically speaking some percentage of the top talent that universal bets on will endure for decades.

58:53And now, because streaming data is so rich, they can be even more analytical in how they try to spot and develop that upcoming talent. And what do you think about AI? I know there's a lot of buzz around AI-generated music. Does it pose a threat? I'm already wondering if it's going to be like the pitch for Uber, where you actually believe that autonomous vehicles would boost Uber's business over time rather than being displaced by robot taxis. I think we talked about it a bit before the episode and was certainly a bigger topic two years ago than it is today. But I think it's still something worth mentioning and maybe for you to elaborate to us.

59:30Yes and no. On one hand, AI-generated music has already flooded streaming platforms with this low cost, non-licensed content. And that dilutes the attention pool. But on the other hand, UMG has taken a very proactive approach, I would say. They've partnered with YouTube on AI music tools, and they're working to protect artists' likenesses and vocal rights. And this stuff is essentially spam. And as long as Spotify can identify it, which I think they're incentivized to do, they can carve it out from their royalty pool, at least for stuff that violates copyrights and how it was trained and imitates existing artists or songs.

1:00:08Still, there have been a number of headlines recently about AI bands on Spotify, actually getting a good bit of attention. There's this one group called the Velvet Sundown that has more than 1 million monthly listeners on Spotify, but their entire album is AI generated. And it's kind of cool. When you read the group's bio on Spotify, it says the Velvet Sundown is a synthetic music project guided by a human creative direction and composed, voiced and visualized with the support of artificial intelligence. Not human, not machine. The Velvet Sundown lives somewhere in between. So kind of poetic. And I listened to some of their songs and I'd say it's not bad.

1:00:44And I also would have never thought it was AI. So it is a thought provoking example. And that is concerning, but who knows how much human direction there was versus true generative AI going into the development of this album. I mean, using AI as a tool in the music production process for humans is a very different thing than just having AI generate music on its own completely from scratch. And I did go down the rabbit hole a bit on this and read an interview with Ben Camp. And he is a music professor at Berkeley. And when talking about this, he said, quote, ghost artists have been part of music culture for generations.

1:01:21And AI is only the newest tool in that lineage. modern listeners already cheer for artists who hide their faces or even their human form the group gorillas present themselves as animated characters daft punk performed behind helmets mf doom rhymed in a mask hatsune miku is a vocaloid hologram who draws stadium crowds that sing along to all of her hits and none of these acts were produced by ai but again they all maintain some level of anonymity for the artists at the same time for what it's worth i think my opinion is that the value of human connection music is just hard to replicate people don't just listen to songs they connect with stories and personalities behind those songs and that's where i would think universal's roster of iconic artists gives them a mode that i just can't easily cross but i'm not sure i'm as confident about spitting that narrative into a long-term tailwind for UMG, like with Uber and Robotexies, for example.

1:02:22I think it's more clear there. Yeah, I mean, that's a reference to one of our portfolio companies, Uber, of course, and how there's this narrative that autonomous vehicles are going to destroy that business. And I have the contrarian view that they'll actually help the business. But yeah, not to go down that whole tangent. I mean, to the extent that AI can remix and reinvigorate past music with new artists, like, I don't know, creating a Tupac and Drake crossover, I mean, that would be interesting. but I have to say I'm kind of surprised that we haven't seen more of that kind of stuff going mainstream and being popular on TikTok we are a few years into this technology now and I would be a bit more concerned if some percentage of the top 100 songs were exclusively AI generated or if one of the top artists in the world was just a total AI creation and not even a human but I mean that's just not the case the Velvet Sundown I think is a really cool project on the margins but that's all it looks like to me.

1:03:17I mean, just something on the margins. And the difference is that people listen to their favorite artists and it can resonate for so many reasons. I mean, maybe it was their parents' favorite singer or a song that played at their wedding, or maybe they saw an artist on tour and an album just brings back those memories. There is a novelty value to AI generated music that can go viral on certain quarters on the internet, but I don't see it as a serious threat to displacing real musicians in the art form that is music. And so maybe it's a tool for ghostwriters and producers behind the scenes, but I really highly doubt our favorite artists in a decade from now will be AI agents.

1:03:56I'm still waiting for the metaverse to take over the world, right? I mean, I think Zuckerberg said a couple of years ago, we'd all be living there and I don't know, hasn't come to fruition yet. I think you would need to have basically an entire industry. I mean, just think about all the paparazzi and all of those people following your favorite artists and pushing stories of those. I think you would need all of that, even for an AI agent to just have a chance of creating somewhat of a sustainable hype. And I would honestly be more concerned if I was a ghostwriter rather than a singer, because music is a form of art.

1:04:27And I strongly believe, and I said it before, that humans want to see other humans perform art. We also talked about sports before. So that's another example where chess engines, for example, have no problem beating Martinus Carlsen, who is arguably the best chess player of all time and definitely currently, and they could beat them with ease, all of those grandmasters. And we still want to see Martinus Carlsen play and not Stockfish, which just for context is the best chess engine out there. And I think that will just persist for quite a long time. But anyway, how about we talk a bit about what Universal has done with their freedom as a public company and basically all this free cash flow that they produce, as you said, while it's an old company, it only IPO'd a couple of years ago.

1:05:10So what has that capital allocation looked like, especially if you compare to somewhat of a bond type investment? So they've been fairly balanced and pragmatic. UMG returns capital to shareholders via this consistent dividend that they currently pay out as about 51 cents per share annually, and that's in euros, which comes out to be about half of their total free cash flow. And they're also allocating some capital to acquire music catalogs. They've taken stakes in a few major publishers and catalogs in recent years, like buying a 25.8 % interest in a group called Chord Music Partners, which is a music-focused investment fund that has rights to songs by artists like The Weeknd, Lorde, Kid Cudi, Diplo, Ellie Golding, ZZ Top, John Legend, and then also 21 Pilots.

1:05:57And they also bought the majority share of Maven Global, which is an Afrobeats label in Nigeria, on top of buying out the entirety of RS Group, which owns the second largest music catalog in Thailand. So they've done a lot of these catalog and label acquisitions in just the last year or so, from the UK to Germany and Japan and everywhere in between. Beyond content, they're investing in the digital space as well. That includes artist analytics platforms, AI-enabled tools to scout talent and manage releases, and then pilot programs with platforms like YouTube and Deezer to test new royalty models like we kind of talked about earlier.

1:06:34So these aren't especially expensive initiatives, but they certainly signal that the company is proactively trying to prepare for the future of the industry. And I touched on it briefly earlier, but this is a company converting nearly 80 % of its operating profit into free cashflow. What that reflects is a business that isn't heavily encumbered by CapEx or content amortization, the way a Netflix or Disney might be. And most of the delta between operating profit and free cash flow comes from the timing of artists' advances, royalty payments, taxes, and some minor investments in physical infrastructure.

1:07:10But all of that is growth-oriented. When UMG pays in advance to secure an artist's next three albums or acquires a catalog that will produce royalties for another 30 years, I mean, that's capital being deployed into assets that will hopefully appreciate and generate long-term cash flows for shareholders. And what can you tell us about their executive compensation, especially for the last couple of companies? There was some interesting insights whenever we looked at the executive comp. So in this case with Universal, is it aligned with shareholders? What do you think of it? Do you think it's value accretive or not?

1:07:45In 2024, Lucian Grange earned roughly$45 million with about 20 % coming in fixed cash payments and then 80 % in performance-based incentives paid out in equity. And so in 2023, his pay was unusually high at over$150 million, mostly due to a one-time transition equity award as part of a deal where the company was essentially trying to move away from paying him in cash and reducing his yearly base salary. So on the bright side, I think it does reflect a shift toward more performance and equity-driven compensation structures for universal CEO, but it does come at a substantial dilution cost. And the way it works for him going forward is that he gets his three-year adjusted EBITDA targets, which have a 50 % weighting in his performance-based comp.

1:08:35And then he has three-year revenue growth targets that get a 25 % weight and then a total shareholder return target that gets a 25 % weight too. So about 40 % of his potential comp is a fixed cash salary and a cash bonus, with the other 60 % being split between stock-based comp, where half that is just simply based on his RSUs vesting, meaning that he just has to stick with the company for a certain amount of time to get paid. And then the other half of that is stock-based comp coming from the performance-based targets I just mentioned. And so if your head's spinning, long story short, his comp package has probably become better aligned with shareholders, but I still don't think it's great.

1:09:16I mean, And I would prefer it to be almost entirely based on five-year total shareholder return targets with cash bonuses that can then be used to purchase shares with, should he choose to do so. I feel like it's just too easy to throw around stock-based comp that seemingly has no cash cost to it, but it does come with a very real dilution cost for shareholders. And as you know, Daniel, at Berkshire, no one is paid in stock options. I mean, everyone is encouraged to use their cash bonuses to buy shares and become owners of the business themselves. but they're not just handed shares of stock. And I'd probably give this structure like a B minus grade.

1:09:50Honestly, it's not the worst I've ever seen. There's definitely room for improvement. And also there's just a reality that for someone as high profile as Lucian Grange, I mean, he gets mentioned in Jay-Z songs. This is a guy who probably deserves to get paid handsomely. And to some extent as shareholders, we sort of just have to accept that because I don't think I would want anyone else at the helm of the company. you'd probably rather overpay but have the perfect person on top than paying less but the person on top is just not the one you want for your company. I mean, I would say we've seen com structures that were more attractive for shareholders.

1:10:29I mean, with PayPal, for example, you have this total shareholder return-based compensation and I believe for a company, in their situation, it's probably the most fitting thing they could do. Another company that we covered and you talked about is LVMH And I think you mentioned that they actually compare their performance to a set of luxury competitors, which is also a great way to incentivize management. But as you said, if you have someone that great on the top of your company, you'd probably just want to hold on. So having said that, and with everything we talked about in today's episode still being on our mind, how should we value a company like this?

1:11:04How would you go about valuing Universal? I think it's a good time to take a step back and summarize the situation. And yeah, you've got a company in UMG that is the biggest player in an oligopolistic industry sitting at the intersection of culture, entertainment, and technology. Its revenues are diversified across recorded music, publishing, and merchandising. And within each of those, across thousands of artists and millions of songs. So this gives the business a ton of resilience. and in valuation terms, I mean, that means we can consider using a lower discount rate and margin of safety in the price we buy at because there's a lot of safety and diversification built into the business itself.

1:11:46I mean, we had this kind of conversation we were joking about before we started recording, Daniel, where we were saying, you know, is Universal Music Group safer or more risky than the MSCI World Index? And, you know, there's a lot of idiosyncratic risk with any given company. But at the same time, this is a company that really just owns millions of songs. And when you think about it that way, I mean, that is as diversified as it could possibly get. If a meteor took out the Universal Music Group headquarters and Lucian Grange fell off the face of the earth, they would still collect royalty payments for all their catalog music.

1:12:19So, I mean, it is a really safe business. And valuing it, though, it's really not just about slapping a multiple on current earnings per share or cash flow. It's about understanding the durability of those earnings and how long we think they can sustain growth, how wide the reinvestment runway is, and how much of today's economics can be preserved over a 5, 10 or 20 year time rise. And I mean, that is how I think about it. And as platforms like Spotify and Apple Music introduce price hikes like we saw last year, I mean, UMG stands to benefit almost dollar for dollar. They get a percentage of that increased revenue.

1:12:53And because most of their costs are fixed, that means higher incremental margins. I mean, almost all of that is just going to drop straight to the bottom line for them. And one other thing I should know is for anyone trying to value UMG, though, is that the company's net income has been consistently positive and growing. But free cash flow has occasionally lagged simply due to the nature of the music business. UMG has to frequently invest in content with advances to artists, marketing and occasionally acquisitions of song catalogs. But under accounting rules, many of these costs are capitalized as intangible assets to be expensed over time rather than being expensed immediately when the cash first goes out the door, which can inflate accounting earnings relative to free cash flows.

1:13:35And as such, I choose to mostly focus on free cash flow more than net income as being a better metric to really get a sense of what's going on with the business over time with. so you kind of elaborated on this already by now but what are the other key inputs then that you have to put into your valuation model and what assumptions matter most if you want to try and go ahead to value to value universal there are really a few levers that drive our expected returns top-line growth their ability to convert operating income into free cash flow reinvestment and capital allocation and then of course a terminal multiple and so first on revenue if you assume global music spending continues to grow in the highest single digits driven by streaming expansion, international market penetration, and then just improved monetization of the catalog.

1:14:22I mean, that gives you a solid base of projecting five to 7 % annual revenue growth with very, very high confidence. I mean, I would be almost shocked if that isn't what they achieved at a minimum on average over the next five to 10 years. And then secondly, you want to look at their margins and their ability to convert that revenue coming in into actual free cash flow, because that is what matters for long-term shareholders. UMG's operating margins do have some room for modest improvement. I think if they continue to scale the business efficiently. So I do think they can hit something like 17 to 18 % operating margins over the next few years, which is just a very slight improvement from what they currently average.

1:15:01And so it's not heroic, but it does reflect the fact that there's some continued operating leverage here. And I think they can continue, you know, and in a very stable way to convert operating profit into free cashflow. And then the third pillar is capital allocation that we talked about. UMG pays a really healthy dividend and they have this formal policy to pay out 50 % of adjusted earnings as dividends. So as the business grows as profits, we know that the dividend will grow proportionately too. We don't have to guess about whether management will consistently push through dividends. We know that capital will continue to be returned shareholders, but they also reinvest heavily into artist advances and catalog acquisitions as we've talked about.

1:15:41And I view those as a mix of growth investments and maintenance capex since they're offsetting some inevitable depreciation of chunks of their back catalog while also growing the total business. So this isn't a business that should grow dramatically on an organic basis. They are a serial acquirer of music catalogs and talent. And they have this really valuable asset base that I would say ages very slowly. there's one thing though that kind of came onto my radar and that's that we've seen private investors enter the market for music rights in force over the past few years and so as private equity has started to bid on these catalogs there is basically more competition for these rights which can drive our prices of course and i'm sure it will continue to be important for their long-term compounding that they can continue to make acquisitions at attractive prices but private funds focus on music rights now seemingly make that more difficult?

1:16:37Is that something that you would say in the long term could hurt them? Or is it something you do not worry about? I mean, you're right. And unfortunately, I think they're in a pretty strong position to be able to navigate this. I mean, private equity firms are tourists to the music industry bidding against Universal, who is really at the heart of it. So I tend to think that Universal will do a more reliable job of assessing attractive catalog value. And they have the balance sheet to opportunistically snap up music rights in a recession or financial market downturn, whereas private equity investors are kind of at the whim of their investees to some extent.

1:17:13And so, yes, I mean, more competition to buy rights is not making their lives easier, but they can also focus on primarily just signing up and coming talent too, if catalog music starts to get too expensive. And then lastly, going to my actual valuation, we've got to consider the multiple, right? I mean, that's where it always gets a little tricky and a little arbitrary. UMG, I should say, currently trades at around 26 times free cash flow per share, which personally I don't think is outrageous for a company of this quality, given the certainty of the earnings we know that they'll continue to produce.

1:17:43But I'm not going to sit here and say that 26 times earnings or free cash flow is dirt cheap because it's not. And so whether that's justified really depends on how confident you are in the stability and growth of the business over the next decade. And I happen to be of the view that it will be very stable. And I have to assume that part of your thinking there is probably grounded in what we've seen other IP driven businesses trade it. Right. I mean, Disney, of course, is currently a bit lower, but those are the type of businesses we usually take as comps here. No, those are probably the right peer comps.

1:18:16And if you look at Disney, Warner Music and LVMH, what they all share is pricing power, tons of IP and then pretty durable cash flow streams. And Disney and LVMH have both faced some major headwinds in China. and they're also much more capital intensive. LVMH is physically producing merchandise and running retail stores. And I mean, Disney, come on, theme parks just take a ridiculous amount of money to run. So they are flawed comparisons, but they both tend to trade with high teens, multiples of free cashflow. And I think with UMG being a more asset light business with much less cyclical financials, I mean, it does deserve to continue trading at a premium to those brands.

1:18:54And Warner Music Group is obviously the most pure comp since it's the only other public company devoted fully to music rights because Sony Music Group is just a small part of the overall Sony business. It's not a standalone company. And so when we do the comparison, it's pretty clear that Universal has tended to trade at even a premium to Warner, which again makes sense because UMG has higher free cash flow margins, has grown faster, carries much less net debt. And so with Warner trading at a median multiple of 25 times free cash flow, paying about the same or a little premium to that for Universal today seems very reasonable for me.

1:19:28And again, it's not screamingly cheap, but around 25 euros per share, it looks to me like a fair price for what is a wonderful company, as Buffett might say. Okay, so we've got a lot of background now. How about we now actually run the numbers? where did you actually land in terms of specific price targets for universal so we've got my price target on screen for people who are watching on spotify and youtube but in my base case i get a fair value of 24 euros and 50 cents using a seven percent discount rate so that's not far from the current market price of the shares actually which is why i say it's about fairly valued the thing we need to talk about though with universal is that universal doesn't quite meet our threshold for addition to the portfolio where we would normally look for an expected 12 % plus annual return over several years.

1:20:19And so that might be grounds for disqualification. But the thing is, I use a lower discount rate because we know this business has such high quality earnings. And this is that you could say with a lot of confidence how much free cash flow it will churn out for years going forward. And there's, of course, some uncertainty, but it's more like a utility than a growth bet. We know roughly how much music gets streamed, how much Universal makes from that streaming, and how quickly streaming is growing and being better monetized. So there's just not much of a risk of dramatic downside, in my opinion, unless you get a big contraction in the multiple, which would be hard to imagine why that would happen for a company of this quality.

1:20:55And so yet on the other side of the coin, you're also not going to get dramatic earnings growth either. And so it just reminds me a lot of one of the first companies we ever covered in VeriSign, which is like a toll road that gets paid by every website in the world that uses the dot-com domain. And you're trying to determine a fair price for this growing stream of annuity like cash flows. And the answer to that really depends on what you think a fair rate of return is for a given level of uncertainty here. And the point being, we're not hitting our typical return target, but we're also not taking on nearly the same risk.

1:21:28This business is pretty dang close to being a sure thing. And so if we can compound it maybe eight or 9 % a year with dividends from current prices, as opposed to earning 4 % in cash with a chunk of our portfolio, or just 5 % to 6 % in corporate bonds, I mean, I think that's actually a reasonable move for the amount of certainty. We're obviously taking on more risk with an equity, but we're not getting what I would say is a normal amount of equity risk, if that makes sense. I mean, just compare this business model to new bank or reddit just you could say with a lot more certainty what exactly the financials are going to look like over the next couple years there's a lot more certainty without any doubt in this case and we were kind of debating a bit before the call already and it might be a bit too much saying i'm a bit torn about this because i mean universal is such a great company and as you said it's about as close to a sure thing as you can get and we looked at a lot of companies by now so we looked at a lot nobody not nobody we looked at a lot and no other company except for perhaps verisign could actually deliver these returns with just that little risk and on the other hand the expected return is well below our usual threshold even after applying low and discount rate that we typically use which is mostly eight percent and we want to own businesses that can compound for a long time and while universal certainly fits that description.

1:22:53Its upside does appear to be limited. And again, on the other side, that said, I see it as a solid place to park capital just until we find more competing opportunities, perhaps at the more companies we look at. So given our still sizable cash position, I feel comfortable adding Universal just for that purpose. And who knows? I mean, a US listing could provide a meaningful boost to Universal stock, adding some extra upside to what otherwise at least functions like a bond-like investment. As you said, it's still 200 basis points higher than what we could expect from a corporate bond of the same quality.

1:23:29So the only other risk basically that we take with universal is perhaps currency risk. As long as it's listed in Amsterdam and therefore in Europe, that's something we have to keep in mind because the US dollar has been extremely weak in recent months and compared to the euro, that would have been great for US investors investing in euro-denominated equity. But if we see that reverse and the US dollar strengthens again, that would be bearish for US investors now investing. No, it's a great point. I mean, the currency factor is a real consideration for us. And I don't think we have a ton of euro exposure though.

1:24:01So getting some diversification across global currencies is maybe not a bad idea. And then on the idea of putting some cash to use, I mean, yeah, it's almost weird. I would almost put like a caveat on this position in the portfolio because it's not really a regular position. It is almost like an alternative placeholder to cash where I feel pretty comfortable saying that, you know, in five years from now, I suspect between the dividends and then the share price compounding, we should come out a lot better than if we just owned cash. And so I would propose though, I think we should add it as just a 5 % position just so we're putting some of our cash to work.

1:24:43And like you said, it's sort of a placeholder position where we can always trim it and reallocate to higher conviction bets as we find them. But then that also gives us some optionality that if for whatever reason, we see another crazy sell-off in universal music stock and the price of free cash flow goes from 25 times to 20 times, then the pricing and the valuation might actually look very, very attractive for the quality of the business. Assuming nothing has gone terribly wrong, which I don't expect that to happen. I have no reason to think that would happen. And so then we could actually think about dramatically increasing the position as a real bet where the expected returns are north of 10 or 12 percent.

1:25:20So that's just maybe some optionality for us where we could end up, you know, starting this as a placeholder investment. And if we get a chance to get a much better price on it, we can always act on it. And, you know, if the price moves in our favor and we get a real decent return in the short term, we can always just trim it and reinvest into opportunities that meet our normal threshold for investment decisions. I think optionality is a pretty good theme for this investment because as we talked about before the call, if you have a company that's the number one in an industry and you're pretty confident it will still be on that number one spot in 10 years from now, I think surprises tend to be to the upside and that's definitely a sign for us to just take that position.

1:26:02As we said, I think we still have a cash position of about 50%. So adding a high-quality company does not seem like we make a mistake. well there's been a lot to discuss today and it looks like maybe we just found a new position for the portfolio and of course we'll share more details on that in our intrinsic value newsletter which folks can sign up for but daniel how about you give us some hints for what you'll be pitching next week for the portfolio yeah i think it's fair to say that my next episode will be something completely different. Or well, in fact, you have covered such a company once before.

1:26:39It was the first company covered on the Intrinsic Value podcast. And as you can imagine, you know, I kind of have to bring a European flair into it. And I think it will be interesting. I'm quite confident that even all our American listeners will know this name. And I think that's all pretty vague. So perhaps one last hint. I mentioned Ronaldo today and he is linked to next week's pitch as well. And I think that should be enough to perhaps figure it out. All right. Well, let's leave on a quote from Lucian Grange as a fitting way to wrap up this episode. The quote is from 2017. Just as streaming was beginning to seriously uplift the music industry.

1:27:17And he said, when the industry wasn't doing so well, and let's face it, so many people from the outside thought it would be over. We didn't listen. We never listened. We always followed what we believed in, how important music is and how important our IP is. we continue to invest in great music, great artists, and great people. And for Daniel and I, that sounds like a great addition to our portfolio. With that, we will see you all next week.