Fitch suggests potential sale, acquisition of EMI for Warner Music Group as negative outlook for WMG reflects company's slowing digital revenue performance over last two years, decline in non-digital revenues

Andrew Rogers

NEW YORK , April 21, 2011 (press release) – Fitch Ratings discussed various strategic options Warner Music Group (WMG) could pursue regarding its business and assets, in a previous comment on Jan. 25, 2011. To date, the company has not made any strategic announcements. Fitch is providing its observations on the following strategic options: a potential sale of WMG and the acquisition of EMI.

SALE OF 50% OR MORE OF WMG:
The Change of Control (CoC) put across all bonds at WMG Acquisition Corp. (WMG Acquisition) and WMG Holding Corp. (WMG Holding) would be triggered at 101%, if 50% or more of WMG's equity was bought by a third party. This could provide downside risk protection for bond holders.

A purchase by a financial buyer that used incremental leverage would likely result in a downgrade of the existing ratings.

WMG ACQUIRES EMI:
It is likely that certain publishing and/or recorded music assets would have to be sold due to the significant market share, if WMG were to acquire EMI. Management would have some flexibility in deciding which assets to hold on to and which ones to sell, maximizing their market share. Based on available information, Fitch values EMI in a range of $2 billion to $2.8 billion. It is possible that any sale of WMG would change Fitch's valuation of EMI.

Fitch believes it is possible to finance an acquisition of EMI without violating any covenants, based on Fitch's analysis of the existing governing indentures. Fitch believes this transaction could be financed using a combination of:

--Non-recourse acquisition financing (a debt limitation covenant carve out under the indentures);
--Additional debt under the fixed charge coverage incurrence test of 2.0 times (x) (Fitch estimates that there is approximately $300 million in capacity under this carve out); and
--Proceeds from asset sales.

A downgrade of the rating could occur depending on the level and/or structure of debt incurred to finance an acquisition of EMI. Cost synergies could potentially provide an offset.

Fitch does not believe that this scenario would have a material impact for the existing senior secured bond holders at the WMG Acquisition level, given that their seniority and security package remain unchanged. However, Fitch does believe that this could be detrimental to the current Subordinated note holders at WMG Acquisition and the note holders at WMG Holding. Any new debt at WMG Acquisitions would likely rank ahead or pari passu with the WMG Acquisition subordinated notes and may reduce any potential recovery prospect for these series of notes.

It is possible that the issue ratings on the subordinated notes and notes at WMG Holding could be downgraded, even if the structure of the transaction did not lead to the downgrade of the Issuer Default Rating (IDR).

The preceding discussion regarding Fitch's conclusions are based on Fitch's interpretation of the current loan documents across WMG Acquisition and WMG Holding.

LIQUIDITY AND LEVERAGE:
Fitch calculates WMG's metrics as of Dec. 31, 2010, as follows:
--Cash interest coverage at 2.2x;
--Free cash flow (FCF; before dividend and acquisitions) of $51 million. Fitch expects WMG to generate FCF in the range of $100 million to $125 million range in 2011;
--$263 million in consolidated cash and cash equivalents (including $164 million of cash at the parent holding company);
--Gross leverage at approximately 5x and net leverage at 4.7x (excluding parent company cash). Fitch expects leverage to remain near these levels in 2011.

The FCF and leverage expectations do not take into account any transactions discussed above.

The Negative Outlook reflects the company's slowing digital revenue performance over the last two years and the accelerating pace of declines in nondigital revenues. The outlook does not reflect any potential strategic option WMG may pursue.

A rating downgrade may occur if the company is unable to maintain cash interest coverage above 2.0x and/or FCF in excess of $100 million on a sustainable basis. In the event of a downgrade of the IDR into the 'B' category, Fitch would perform a bespoke recovery rating analysis. Fitch notes this recovery analysis may cause a wider dispersion between the issue ratings.

Fitch currently rates WMG and its subsidiaries as follows:

WMG
--IDR 'BB-'.

WMG Holdings
--IDR 'BB-';
--Unsecured notes 'B'.

WMG Acquisition
--IDR 'BB-';
--Secured notes 'BB';
--Subordinated notes 'B+'.

The Rating Outlook is Negative.

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