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WARNER MUSIC GROUP CORP. - 10-K - MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS(Edgar Glimpses Via Acquire Media NewsEdge) You should read the following discussion of our results of operations and financial condition with the audited financial statements included elsewhere in this Annual Report on Form 10-K for the fiscal year ended September 30, 2012 (the "Annual Report"). "SAFE HARBOR" STATEMENT UNDER PRIVATE SECURITIES LITIGATION REFORM ACT OF 1995 This Annual Report includes "forward-looking statements" within the meaning of the Private Securities Litigation Reform Act of 1995, Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended. All statements other than statements of historical facts included in this Annual Report, including, without limitation, statements regarding our future financial position, business strategy, budgets, projected costs, cost savings, industry trends and plans and objectives of management for future operations, are forward-looking statements. In addition, forward-looking statements generally can be identified by the use of forward-looking terminology such as "may," "will," "expect," "intend," "estimate," "anticipate," "believe" or "continue" or the negative thereof or variations thereon or similar terminology. Such statements include, among others, statements regarding our ability to develop talent and attract future talent, our ability to reduce future capital expenditures, our ability to monetize our music-based content, including through new distribution channels and formats to capitalize on the growth areas of the music industry, our ability to effectively deploy our capital, the development of digital music and the effect of digital distribution channels on our business, including whether we will be able to achieve higher margins from digital sales, the success of strategic actions we are taking to accelerate our transformation as we redefine our role in the music industry, the effectiveness of our ongoing efforts to reduce overhead expenditures and manage our variable and fixed cost structure and our ability to generate expected cost savings from such efforts, our success in limiting piracy, our ability to compete in the highly competitive markets in which we operate, the growth of the music industry and the effect of our and the music industry's efforts to combat piracy on the industry, our intention to pay dividends or repurchase our outstanding notes in open market purchases, privately or otherwise, the impact on us of potential strategic transactions, the impact on the competitive landscape of the music industry from the sale of EMI's recorded music and music publishing businesses, our ability to fund our future capital needs and the effect of litigation on us. Although we believe that the expectations reflected in such forward-looking statements are reasonable, we can give no assurance that such expectations will prove to have been correct. There are a number of risks and uncertainties that could cause our actual results to differ materially from the forward-looking statements contained in this Annual Report. Additionally, important factors could cause our actual results to differ materially from the forward-looking statements we make in this Annual Report. As stated elsewhere in this Annual Report, such risks, uncertainties and other important factors include, among others: • the continued decline in the global recorded music industry and the rate of overall decline in the music industry; • downward pressure on our pricing and our profit margins and reductions in shelf space; • our ability to identify, sign and retain artists and songwriters and the existence or absence of superstar releases and local economic conditions in the countries in which we operate; • threats to our business associated with home copying and Internet downloading; • the significant threat posed to our business and the music industry by organized industrial piracy; • the popular demand for particular recording artists and/or songwriters and albums and the timely completion of albums by major recording artists and/or songwriters; • the diversity and quality of our portfolio of songwriters; • the diversity and quality of our album releases; 42 -------------------------------------------------------------------------------- Table of Contents • the impact of legitimate channels for digital distribution of our creative content; • our dependence on a limited number of online music stores, in particular Apple's iTunes Music Store, for the online sale of our music recordings and their ability to significantly influence the pricing structure for online music stores; • our involvement in intellectual property litigation; • our ability to continue to enforce our intellectual property rights in digital environments; • the ability to develop a successful business model applicable to a digital environment and to enter into expanded-rights deals with recording artists in order to broaden our revenue streams in growing segments of the music business; • the impact of heightened and intensive competition in the recorded music and music publishing businesses and our inability to execute our business strategy; • risks associated with our non-U.S. operations, including limited legal protections of our intellectual property rights and restrictions on the repatriation of capital; • significant fluctuations in our operations and cash flows from period to period; • our inability to compete successfully in the highly competitive markets in which we operate; • further consolidation of our industry and its impact on the competitive landscape of the music industry, specifically the acquisition of EMI's recorded music business by Universal Music Group and the acquisition of EMI's music publishing business by a consortium led by Sony Corporation of America; • trends, developments or other events in some foreign countries in which we operate; • our failure to attract and retain our executive officers and other key personnel; • the impact of rate regulations on our Recorded Music and Music Publishing businesses; • the impact of rates on other income streams that may be set by arbitration proceedings on our business; • an impairment in the carrying value of goodwill or other intangible and long-lived assets; • unfavorable currency exchange rate fluctuations; • our failure to have full control and ability to direct the operations we conduct through joint ventures; • legislation limiting the terms by which an individual can be bound under a "personal services" contract; • a potential loss of catalog if it is determined that recording artists have a right to recapture rights in their recordings under the U.S. Copyright Act; • trends that affect the end uses of our musical compositions (which include uses in broadcast radio and television, film and advertising businesses); • the growth of other products that compete for the disposable income of consumers; • risks inherent in acquisitions or business combinations; • risks inherent to our outsourcing of information technology infrastructure and certain finance and accounting functions; • the fact that we have engaged in substantial restructuring activities in the past, and may need to implement further restructurings in the future and our restructuring efforts may not be successful or generate expected cost savings; • the impact of our substantial leverage on our ability to raise additional capital to fund our operations, on our ability to react to changes in the economy or our industry and on our ability to meet our obligations under our indebtedness; 43 -------------------------------------------------------------------------------- Table of Contents • risks relating to Access, which indirectly owns all of our outstanding capital stock, and controls our company and may have conflicts of interest with the holders of our debt or us in the future. Access may also enter into, or cause us to enter into, strategic transactions that could change the nature or structure of our business, capital structure or credit profile; • our reliance on one company as the primary supplier for the manufacturing, packaging and physical distribution of our products in the U.S. and Canada and part of Europe; • risks related to evolving regulations concerning data privacy which might result in increased regulation and different industry standards; • changes in law and government regulations; and • risks related to other factors discussed under "Risk Factors" in this Annual Report. There may be other factors not presently known to us or which we currently consider to be immaterial that could cause our actual results to differ materially from those projected in any forward-looking statements we make. You should read carefully the factors described in the "Risk Factors" section of this Annual Report to better understand the risks and uncertainties inherent in our business and underlying any forward-looking statements. All forward-looking statements attributable to us or persons acting on our behalf apply only as of the date of this Annual Report and are expressly qualified in their entirety by the cautionary statements included in this Annual Report. We disclaim any duty to update or revise forward-looking statements to reflect events or circumstances after the date made or to reflect the occurrence of unanticipated events. INTRODUCTION Warner Music Group Corp. (the "Company") was formed on November 21, 2003. The Company is the direct parent of WMG Holdings Corp. ("Holdings"), which is the direct parent of WMG Acquisition Corp. ("Acquisition Corp."). Acquisition Corp. is one of the world's major music-based content companies. The Company and Holdings are holding companies that conduct substantially all of their business operations through their subsidiaries. The terms "we," "us," "our," "ours," and the "Company" refer collectively to Warner Music Group Corp. and its consolidated subsidiaries, except where otherwise indicated. Management's discussion and analysis of results of operations and financial condition ("MD&A") is provided as a supplement to the audited financial statements and footnotes included elsewhere herein to help provide an understanding of our financial condition, changes in financial condition and results of our operations. MD&A is organized as follows: • Overview. This section provides a general description of our business, as well as recent developments that we believe are important in understanding our results of operations and financial condition and in anticipating future trends. • Results of operations. This section provides an analysis of our results of operations for the successor fiscal year ended September 30, 2012, the successor period from July 20, 2011 to September 30, 2011, the predecessor period from October 1, 2010 to July 19, 2011 and for the predecessor fiscal year ended September 30, 2010. This analysis is presented on both a consolidated and segment basis. • Financial condition and liquidity. This section provides an analysis of our cash flows for the successor fiscal year ended September 30, 2012, the successor period from July 20, 2011 to September 30, 2011, the predecessor period from October 1, 2010 to July 19, 2011, as well as a discussion of our financial condition and liquidity as of September 30, 2012 (Successor). The discussion of our financial condition and liquidity includes (i) a summary of our debt agreements and (ii) a summary of the key debt compliance measures under our debt agreements. 44 -------------------------------------------------------------------------------- Table of Contents Overall Operating Results In accordance with United States Generally Accepted Accounting Principles ("GAAP"), we have separated our historical financial results for the period from July 20, 2011 to September 30, 2011 ("Successor") and for the period from October 1, 2010 to July 19, 2011 ("Predecessor"). Successor and Predecessor periods are presented on different bases and are, therefore, not comparable. However, we have also combined results for the Successor and Predecessor periods for 2011 in the presentations below, and presented them as the results for the "twelve months ended September 30, 2011" because, although such presentation is not in accordance with GAAP, we believe that it enables a meaningful presentation and comparison of results. The operating results for the twelve months ended September 30, 2011 have not been prepared on a pro-forma basis under applicable regulations and may not reflect the actual results we would have achieved absent the Merger and may not be predictive of future results of operations. Recent Developments 2012 Debt Refinancing On November 1, 2012, we completed a refinancing of some of our then outstanding Senior Secured Notes due 2016 (the "2012 Refinancing"). In connection with the 2012 Refinancing, we issued new senior secured notes due 2021 consisting of $500 million aggregate principal amount of 6.00% dollar notes (the "Dollar Notes") and €175 million aggregate principal amount of 6.25% euro notes (the "Euro Notes" and, together with the Dollar Notes, the "New Secured Notes") and entered into two new senior secured credit facilities consisting of a $600 million term loan facility (the "Term Loan Facility") and a $150 million revolving credit facility (the "New Revolving Credit Facility" and, together with the Term Loan Facility, the "New Senior Credit Facilities"). The proceeds from the 2012 Refinancing, together with other available sources of cash, were used to pay the total consideration due in connection with tender offers for all of our previously outstanding $1.250 billion of 9.50% senior secured notes due 2016 (the "Old Secured Notes") as well as associated fees and expenses and to redeem all of the remaining Old Secured Notes not tendered in the tender offers. We also retired our existing $60 million revolving credit facility (the "Old Revolving Credit Facility") in connection with the 2012 Refinancing, replacing it with the New Revolving Credit Facility. In addition, as part of the 2012 Refinancing, we commenced consent solicitations relating to our outstanding unsecured notes. On October 29, 2012, valid consents from unaffiliated holders of a majority in aggregate principal amount of the outstanding notes were received and we executed supplemental indentures to effect amendments to the related indentures to increase our capacity to incur senior secured indebtedness. See "Financial Condition and Liquidity" below for a further discussion of the 2012 Refinancing. Use of OIBDA We evaluate our operating performance based on several factors, including our primary financial measure of operating income (loss) before non-cash depreciation of tangible assets, non-cash amortization of intangible assets and non-cash impairment charges to reduce the carrying value of goodwill and intangible assets (which we refer to as "OIBDA"). We consider OIBDA to be an important indicator of the operational strengths and performance of our businesses, including the ability to provide cash flows to service debt. However, a limitation of the use of OIBDA as a performance measure is that it does not reflect the periodic costs of certain capitalized tangible and intangible assets used in generating revenues in our businesses. Accordingly, OIBDA should be considered in addition to, not as a substitute for, operating income, net income (loss) attributable to Warner Music Group Corp. and other measures of financial performance reported in accordance with U.S. GAAP. In addition, our definition of OIBDA may differ from similarly titled measures used by other companies. A reconciliation of consolidated historical OIBDA to operating income and net income (loss) attributable to Warner Music Group Corp. is provided in our "Results of Operations." 45-------------------------------------------------------------------------------- Table of Contents Use of Constant Currency As exchange rates are an important factor in understanding period to period comparisons, we believe the presentation of results on a constant-currency basis in addition to reported results helps improve the ability to understand our operating results and evaluate our performance in comparison to prior periods. Constant-currency information compares results between periods as if exchange rates had remained constant period over period. We use results on a constant-currency basis as one measure to evaluate our performance. We calculate constant currency by calculating prior-year results using current-year foreign currency exchange rates. We generally refer to such amounts calculated on a constant-currency basis as "excluding the impact of foreign currency exchange rates." These results should be considered in addition to, not as a substitute for, results reported in accordance with U.S. GAAP. Results on a constant-currency basis, as we present them, may not be comparable to similarly titled measures used by other companies and are not a measure of performance presented in accordance with U.S. GAAP. OVERVIEW We are one of the world's major music-based content companies. We classify our business interests into two fundamental operations: Recorded Music and Music Publishing. A brief description of each of those operations is presented below. Recorded Music Operations Our Recorded Music business primarily consists of the discovery and development of artists and the related marketing, distribution and licensing of recorded music produced by such artists. In the U.S., Recorded Music operations are conducted principally through our major record labels-Warner Bros. Records and the Atlantic Records Group. Our Recorded Music operations also include Rhino, a division that specializes in marketing our music catalog through compilations and reissuances of previously released music and video titles, as well as in the licensing of recordings to and from third parties for various uses, including film and television soundtracks. Rhino has also become our primary licensing division focused on acquiring broader licensing rights from certain catalog artists. For example, we own a 50% interest in Frank Sinatra Enterprises, an entity that administers licenses for use of Frank Sinatra's name and likeness and manages all aspects of his music, film and stage content. We also conduct our Recorded Music operations through a collection of additional record labels, including, among others, Asylum, East West, Elektra, Nonesuch, Reprise, Roadrunner, Rykodisc, Sire and Word. Outside the U.S., our Recorded Music activities are conducted in more than 50 countries primarily through our various subsidiaries, affiliates and non-affiliated licensees. Internationally we engage in the same activities as in the U.S.: discovering and signing artists and distributing, marketing and selling their recorded music. In most cases, we also market and distribute internationally the records of those artists for whom our U.S. record labels have international rights. In certain smaller markets, we license to unaffiliated third-party record labels the right to distribute our records. Our international artist services operations also include a network of concert promoters through which we provide resources to coordinate tours. Our Recorded Music distribution operations include WEA Corp., which markets and sells music and DVD products to retailers and wholesale distributors in the U.S.; ADA, which distributes the products of independent labels to retail and wholesale distributors in the U.S.; various distribution centers and ventures operated internationally; an 80% interest in Word, which specializes in the distribution of music products in the Christian retail marketplace and ADA Global, which provides distribution services outside of the U.S. through a network of affiliated and non-affiliated distributors. We play an integral role in virtually all aspects of the music value chain from discovering and developing talent to producing albums and promoting artists and their products. After an artist has entered into a contract with one of our record labels, a master recording of the artist's music is created. The recording is then replicated 46 -------------------------------------------------------------------------------- Table of Contents for sale to consumers primarily in the CD and digital formats. In the U.S., WEA Corp., ADA and Word market, sell and deliver product, either directly or through sub-distributors and wholesalers, to record stores, mass merchants and other retailers. Our recorded music products are distributed in physical form through online physical retailers such as Amazon.com, barnesandnoble.com and bestbuy.com and in digital form through online digital retailers like Apple's iTunes, online subscription services like Spotify, Rhapsody and Deezer, and Internet radio services like Pandora and iHeart Radio. In the case of expanded-rights deals where we acquire broader rights in a recording artist's career, we may provide more comprehensive career support and actively develop new opportunities for an artist through touring, fan clubs, merchandising and sponsorships, among other areas. We believe expanded-rights deals create a better partnership with our artists, which allows us to work together more closely with them to create and sustain artistic and commercial success. We have integrated the sale of digital content into all aspects of our Recorded Music and Music Publishing businesses including A&R, marketing, promotion and distribution. Our new media executives work closely with A&R departments to make sure that while a record is being made, digital assets are also created with all of our distribution channels in mind, including subscription services, social networking sites, online portals and music-centered destinations. We also work side by side with our mobile and online partners to test new concepts. We believe existing and new digital businesses will be a significant source of growth for at least the next several years and will provide new opportunities to successfully monetize our assets and create new revenue streams. As a music-based content company, we have assets that go beyond our recorded music and music publishing catalogs, such as our music video library, which we have begun to monetize through digital channels. The proportion of digital revenues attributed to each distribution channel varies by region and since digital music is still in the relatively early stages of growth, proportions may change as the roll out of new technologies continues. As an owner of musical content, we believe we are well positioned to take advantage of growth in digital distribution and emerging technologies to maximize the value of our assets. We are also diversifying our revenues beyond our traditional businesses by entering into expanded-rights deals with recording artists in order to partner with artists in other areas of their careers. Under these agreements, we provide services to and participate in artists' activities outside the traditional recorded music business. We have developed an artist services business to exploit this broader set of music-related rights and to participate more broadly in the monetization of the artist brands we help create. In developing our artist services business, we have both built and expanded in-house capabilities and expertise and have acquired a number of existing artist services companies involved in artist management, merchandising, strategic marketing and brand management, ticketing, concert promotion, fan club, original programming and video entertainment. We believe that entering into expanded-rights deals and enhancing our artist services business will permit us to better capitalize on the growth areas of the music industry and permit us to build stronger long-term relationships with artists and more effectively connect artists and fans. Recorded Music revenues are derived from four main sources: • Physical: the rightsholder receives revenues with respect to sales of physical products such as CDs and DVDs; • Digital: the rightsholder receives revenues with respect to online and mobile downloads, online and mobile streaming, and mobile ringtones or ringback tones; • Artist services and expanded rights: the rightsholder receives revenues with respect to artist services businesses and our participation in expanded rights associated with our artists, including sponsorship, fan club, artist websites, merchandising, touring, concert promotion, ticketing and artist and brand management; and • Licensing: the rightsholder receives royalties or fees for the right to use the sound recording in combination with visual images such as in films or television programs, television commercials and videogames. 47 -------------------------------------------------------------------------------- Table of Contents The principal costs associated with our Recorded Music operations are as follows: • Royalty costs and artist and repertoire costs-the costs associated with (i) paying royalties to artists, producers, songwriters, other copyright holders and trade unions, (ii) signing and developing artists, (iii) creating master recordings in the studio and (iv) creating artwork for album covers and liner notes; • Product costs-the costs to manufacture, package and distribute product to wholesale and retail distribution outlets as well as those principal costs related to our artist services businesses; • Selling and marketing costs-the costs associated with the promotion and marketing of artists and recorded music products, including costs to produce music videos for promotional purposes and artist tour support; and • General and administrative costs-the costs associated with general overhead and other administrative costs. Music Publishing Operations Where recorded music is focused on exploiting a particular recording of a composition, music publishing is an intellectual property business focused on the exploitation of the composition itself. In return for promoting, placing, marketing and administering the creative output of a songwriter, or engaging in those activities for other rightsholders, our music publishing business garners a share of the revenues generated from use of the composition. Our music publishing operations include Warner/Chappell, our global music publishing company headquartered in Los Angeles with operations in over 50 countries through various subsidiaries, affiliates and non-affiliated licensees. We own or control rights to more than one million musical compositions, including numerous pop hits, American standards, folk songs and motion picture and theatrical compositions. Assembled over decades, our award-winning catalog includes over 65,000 songwriters and composers and a diverse range of genres including pop, rock, jazz, country, R&B, hip-hop, rap, reggae, Latin, folk, blues, symphonic, soul, Broadway, techno, alternative, gospel and other Christian music. In January 2011, the Company acquired Southside Independent Music Publishing, a leading independent music publishing company, further adding to its catalog. Warner/Chappell also administers the music and soundtracks of several third-party television and film producers and studios, including Lucasfilm, Ltd., Hallmark Entertainment and Disney Music Publishing. In July 2012, we announced that Warner/Chappell had acquired the master and publishing rights with respect to film music owned by Miramax, which contains the film scores and certain masters from numerous critically acclaimed films. Our production music library business includes Non-Stop Music, Groove Addicts Production Music Library, Carlin Recorded Music Library and 615 Music, collectively branded as Warner/Chappell Production Music. Publishing revenues are derived from five main sources: • Performance: the licensor receives royalties if the composition is performed publicly through broadcast of music on television, radio, cable and satellite, live performance at a concert or other venue (e.g., arena concerts, nightclubs), online and mobile streaming and performance of music in staged theatrical productions; • Mechanical: the licensor receives royalties with respect to compositions embodied in recordings sold in any physical format or configuration (e.g., CDs and DVDs); • Synchronization: the licensor receives royalties or fees for the right to use the composition in combination with visual images such as in films or television programs, television commercials and videogames as well as from other uses such as in toys or novelty items and merchandise; • Digital: the licensor receives royalties or fees with respect to online and mobile downloads, mobile ringtones and online and mobile streaming; and 48 -------------------------------------------------------------------------------- Table of Contents • Other: the licensor receives royalties for use in printed sheet music. The principal costs associated with our Music Publishing operations are as follows: • Artist and repertoire costs-the costs associated with (i) signing and developing songwriters and (ii) paying royalties to songwriters, co-publishers and other copyright holders in connection with income generated from the exploitation of their copyrighted works; and • General and administration costs-the costs associated with general overhead and other administrative costs. Factors Affecting Results of Operations and Financial Condition Market Factors Since 1999, the recorded music industry has been unstable and the worldwide market has contracted considerably, which has adversely affected our operating results. The industry-wide decline can be attributed primarily to digital piracy. Other drivers of this decline are the bankruptcies of record retailers and wholesalers, growing competition for consumer discretionary spending and retail shelf space, and the maturation of the CD format, which has slowed the historical growth pattern of recorded music sales. While CD sales still generate a significant portion of the recorded music revenues, CD sales continue to decline industry-wide and we expect that trend to continue. While new formats for selling recorded music product have been created, including the legal downloading of digital music using the Internet and the distribution of music on mobile devices, revenue streams from these new formats have not yet reached a level where they fully offset the declines in CD sales on a world-wide industry basis. While U.S. industry-wide track-equivalent album sales rose in 2011 for the first time since 2004, album sales continued to fall in other countries, such as the U.K., as a result of ongoing digital piracy and the transition from physical to digital sales in the recorded music business. Accordingly, the recorded music industry performance may continue to negatively impact our operating results. In addition, a declining recorded music industry could continue to have an adverse impact on portions of the music publishing business. This is because the music publishing business generates a significant portion of its revenues from mechanical royalties from the sale of music in CD and other physical recorded music formats. Transaction Costs In connection with the Merger, we incurred approximately $10 million and $43 million of transaction costs, primarily representing professional fees, during the period from July 20, 2011 to September 30, 2011 (Successor) and for the period from October 1, 2010 to July 19, 2011 (Predecessor), respectively. These amounts were recorded in the consolidated statements of operation. Share-Based Compensation In connection with the Merger, the vesting of all outstanding unvested Predecessor options and certain restricted stock awards was accelerated immediately prior to closing. To the extent that such stock options had an exercise price less than $8.25 per share, the holders of such stock options were paid an amount in cash equal to $8.25 less the exercise price of the stock option and any applicable withholding. In addition, all outstanding restricted stock awards either became fully vested or were forfeited immediately prior to the closing; the awards that became fully vested were treated as a share of our common stock for all purposes under the Merger. As a result of the acceleration, Predecessor recorded an additional $14 million in share-based compensation expense for the period from October 1, 2010 to July 19, 2011 (Predecessor) within general and administrative expense. Prior to the Merger, Predecessor modified certain restricted stock award agreements which resulted in incremental share-based compensation expense of $3 million recorded within general and administrative expense for the period from October 1, 2010 to July 19, 2011 (Predecessor). 49-------------------------------------------------------------------------------- Table of Contents Severance Charges During the fiscal year ended September 30, 2012, we took additional actions to further align our cost structure with industry trends. This resulted in severance charges of $42 million during the fiscal year ended September 30, 2012 compared to $9 million and $29 million during the period from July 20, 2011 to September 30, 2011 (Successor) and for the period from October 1, 2010 to July 19, 2011 (Predecessor), respectively. Additional Targeted Savings As of the completion of the Merger on July 20, 2011, we had targeted cost savings over the next nine fiscal quarters following completion of the Merger of $50 million to $65 million based on identified cost saving initiatives and opportunities, including targeted savings expected to be realized as a result of no longer having publicly traded equity, reduced expenses related to finance, legal and information technology and reduced expenses related to certain planned corporate restructuring initiatives. Through September 30, 2012, we had achieved a majority of the targeted cost savings that we identified at the time of the Merger. LimeWire Settlement In May 2011, the major record companies reached a global out-of-court settlement of copyright litigation against LimeWire. Under the terms of the settlement, the LimeWire defendants agreed to pay compensation to the record companies that brought the action, including us. In connection with this settlement, we recorded a $12 million benefit to general and administrative expenses in the consolidated statements of operation for the period ended July 19, 2011 (Predecessor). These amounts were recorded net of the estimated amounts payable to our artists in respect of royalties. EMI Related Costs During the fiscal year ended September 30, 2012, we incurred certain costs, primarily representing professional fees, related to our participation in a sales process which resulted in the sale of EMI's recorded music and music publishing businesses and the subsequent review of the transactions by the U.S. Federal Trade Commission, the European Commission and other regulatory bodies. These costs which amounted to approximately $14 million were recorded in the consolidated statements of operation within general and administrative expense. Expanding Business Models to Offset Declines in Physical Sales Digital Sales A key part of our strategy to offset declines in physical sales is to expand digital sales. New digital models have enabled us to find additional ways to generate revenues from our music-based content. In the early stages of the transition from physical to digital sales, overall sales have decreased as the increases in digital sales have not yet met or exceeded the decrease in physical sales. Part of the reason for this gap is the shift in consumer purchasing patterns made possible from new digital models. In the digital space, consumers are now presented with the opportunity to not only purchase entire albums, but to "unbundle" albums and purchase only favorite tracks as single-track downloads. While to date, sales of online and mobile downloads have constituted the majority of our digital Recorded Music and Music Publishing revenue, that may change over time as new digital models, such as access models (models that typically bundle the purchase of a mobile device with access to music) and streaming subscription services, continue to develop. In the aggregate, we believe that growth in revenue from new digital models has the potential to offset physical declines and drive overall future revenue growth. In the digital space, certain costs associated with physical products, such as manufacturing, distribution, inventory and return costs, do not apply. Partially eroding that benefit are increases in mechanical copyright 50-------------------------------------------------------------------------------- Table of Contents royalties payable to music publishers which apply in the digital space. While there are some digital-specific variable costs and infrastructure investments necessary to produce, market and sell music in digital formats, we believe it is reasonable to expect that digital margins will generally be higher than physical margins as a result of the elimination of certain costs associated with physical products. As consumer purchasing patterns change over time and new digital models are launched, we may see fluctuations in contribution margin depending on the overall sales mix. Artist Services and Expanded-Rights Deals We have also been seeking to expand our relationships with recording artists as another means to offset declines in physical revenues in Recorded Music. For example, we have been signing recording artists to expanded-rights deals for the last several years. Under these expanded-rights deals, we participate in the recording artist's revenue streams, other than from recorded music sales, such as live performances, merchandising and sponsorships. We believe that additional revenue from these revenue streams will help to offset declines in physical revenue over time. As we have generally signed newer artists to these deals, increased expanded rights revenue from these deals is expected to come several years after these deals have been signed as the artists become more successful and are able to generate revenue other than from recorded music sales. While artist services and expanded rights Recorded Music revenue, which includes revenue from expanded-rights deals as well as revenue from our artist services business, represented approximately 9% of our total revenue for the fiscal year ended September 30, 2012, we believe this revenue will continue to grow and represent a larger proportion of our revenue over time. Artist services and expanded rights revenue will fluctuate from period to period depending upon touring and concert promotion schedules, among other things. We also believe that the strategy of entering into expanded-rights deals and continuing to develop our artist services business will contribute to Recorded Music growth over time. Margins for the various artist services and expanded rights Recorded Music revenue streams can vary significantly. The overall impact on margins will, therefore, depend on the composition of the various revenue streams in any particular period. For instance, revenue from touring under our expanded-rights deals typically flows straight through to net income with little cost. Revenue from our management business and revenue from sponsorship and touring under expanded-rights deals are all high margin, while merchandise revenue under expanded-rights deals and concert promotion revenue from our concert promotion businesses tend to be lower margin than our traditional revenue streams from Recorded Music and Music Publishing. The Merger Pursuant to the Merger Agreement, on the Merger Closing Date, Merger Sub merged with and into the Company with the Company surviving as a wholly owned subsidiary of Parent. On the Merger Closing Date, in connection with the Merger, each outstanding share of common stock of the Company (other than any shares owned by the Company or its wholly owned subsidiaries, or by Parent and its affiliates, or by any stockholders who were entitled to and who properly exercised appraisal rights under Delaware law, and shares of unvested restricted stock granted under the Company's equity plan) was cancelled and converted automatically into the right to receive the Merger Consideration. Cash equity contributions totaling $1.1 billion from Parent, together with (i) the proceeds from the sale of (a) $150 million aggregate principal amount of 9.50% Senior Secured Notes due 2016 (the "Second Tranche of Old Secured Notes") initially issued by WM Finance Corp., (the "Initial OpCo Issuer"), (b) $765 million aggregate principal amount of 11.50% Senior Notes due 2018 initially issued by the Initial OpCo Issuer, (the "Unsecured WMG Notes") and (c) $150 million aggregate principal amount of 13.75% Senior Notes due 2019 (the "Holdings Notes") initially issued by WM Holdings Finance Corp. (the "Initial Holdings Issuer") and (ii) cash on hand at the Company, were used, among other things, to finance the aggregate Merger Consideration, to make payments in satisfaction of other equity-based interests in the Company under the Merger Agreement, to repay certain of the Company's existing indebtedness and to pay related transaction fees and expenses. 51-------------------------------------------------------------------------------- Table of Contents On the Merger Closing Date (i) Acquisition Corp. became the obligor under the Second Tranche of Old Secured Notes and the Unsecured WMG Notes as a result of the merger of Initial OpCo Issuer with and into Acquisition Corp. (the "OpCo Merger") and (ii) Holdings became the obligor under the Holdings Notes as a result of the merger of Initial Holdings Issuer with and into Holdings (the "Holdings Merger"). On the Merger Closing Date, the Company also entered into, but did not draw under, the Old Revolving Credit Facility. In addition, approximately $30 million of shares of common stock of the Company owed by Parent and its affiliates were forfeited immediately prior to the Merger. In connection with the Merger, the Company also refinanced certain of its existing consolidated indebtedness, including (i) the repurchase and redemption by Holdings of its approximately $258 million in fully accreted principal amount outstanding 9.50% Senior Discount Notes due 2014 (the "Old Holdings Notes"), and the satisfaction and discharge of the related indenture and (ii) the repurchase and redemption by Acquisition Corp. of its $465 million in aggregate principal amount outstanding 7 3/8% Dollar-denominated Senior Subordinated Notes due 2014 and £100 million in aggregate principal amount of its outstanding 8 1/8% Sterling-denominated Senior Unsecured Subordinated Notes due 2014 (the "Old Acquisition Corp. Notes" and together with the Old Holdings Notes, the "Old Unsecured Notes"), and the satisfaction and discharge of the related indenture, and payment of related tender offer or call premiums and accrued interest on the Old Unsecured Notes. Management Agreement Upon completion of the Merger, the Company and Holdings entered into a management agreement with Access, dated as of the Merger Closing Date (the "Management Agreement"), pursuant to which Access will provide the Company and its subsidiaries with financial, investment banking, management, advisory and other services. Pursuant to the Management Agreement, the Company, or one or more of its subsidiaries, will pay Access a specified annual fee, plus expenses, and a specified transaction fee for certain types of transactions completed by Holdings or one or more of its subsidiaries, plus expenses. For the fiscal year ended September 30, 2012, such fee paid by the Company was approximately $8 million which includes the annual fee and reimbursement of certain expenses in connection with the Management Agreement, but excludes $2 million of expenses reimbursed related to certain consultants with full time roles at the Company. RESULTS OF OPERATIONS Fiscal Year Ended September 30, 2012 Compared with Twelve Months Ended September 30, 2011 and Fiscal Year Ended September 30, 2010 The following table sets forth our results of operations as reported in our condensed consolidated financial statements in accordance with accounting principles generally accepted in the United States of America ("GAAP"). GAAP requires that we separately present our Predecessor and Successor periods' results. Management believes reviewing our operating results for the twelve months ended September 30, 2011 by combining the results of the Predecessor and Successor periods is more useful in identifying any trends in, or reaching conclusions regarding, our overall operating performance. Accordingly, the table below presents the non-GAAP combined results for the twelve months ended September 30, 2011, which is also the period we compare when computing percentage change from prior year, as we believe this presentation provides the most meaningful basis for comparison of our results and it is how management reviews operating performance. The combined operating results may not reflect the actual results we would have achieved had the Merger closed prior to July 20, 2011 and may not be predictive of future results of operations. 52-------------------------------------------------------------------------------- Table of Contents Consolidated Historical Results Revenues Our revenues were composed of the following amounts (in millions): For the Successor Predecessor Combined Predecessor For the Fiscal From July 20, From Twelve For the Fiscal Year Ended 2011 through October 1, Months ended Year Ended 2012 vs. 2011 2011 vs. 2010 September 30, September 30, 2010 through September 30, September 30, 2012 2011 July 19, 2011 2011 2010 $ Change % Change $ Change % ChangeRevenue by Type Physical $ 966 $ 193 $ 839 $ 1,032 $ 1,295 $ (66 ) -6 % $ (263 ) -20 % Digital 864 147 621 768 713 96 13 % 55 8 % Total Physical and Digital 1,830 340 1,460 1,800 2,008 30 2 % (208 ) -10 % Artist services and expanded rights 244 75 235 310 233 (66 ) -21 % 77 33 % Licensing 201 41 191 232 218 (31 ) -13 % 14 6 % Total Recorded Music 2,275 456 1,886 2,342 2,459 (67 ) -3 % (117 ) -5 % Performance 202 41 173 214 207 (12 ) -6 % 7 3 % Mechanical 129 24 118 142 177 (13 ) -9 % (35 ) -20 % Synchronization 112 21 92 113 102 (1 ) -1 % 11 11 % Digital 67 15 45 60 59 7 12 % 1 2 % Other 14 3 12 15 11 (1 ) -7 % 4 36 % Total Music Publishing 524 104 440 544 556 (20 ) -4 % (12 ) -2 % Intersegment eliminations (19 ) (4 ) (15 ) (19 ) (27 ) - - 8 -30 % Total Revenue $ 2,780 $ 556 $ 2,311 $ 2,867 $ 2,988 $ (87 ) -3 % $ (121 ) -4 % Revenue by Geographical Location U.S. Recorded Music 909 175 781 $ 956 $ 1,043 $ (47 ) -5 % $ (87 ) -8 % U.S. Music Publishing 204 41 155 196 214 8 4 % (18 ) -8 % Total U.S. 1,113 216 936 1,152 1,257 (39 ) -3 % (105 ) -8 % International Recorded Music 1,366 281 1,105 1,386 1,416 (20 ) -1 % (30 ) -2 % International Music Publishing 320 63 285 348 342 (28 ) -8 % 6 2 % Total International 1,686 344 1,390 1,734 1,758 (48 ) -3 % (24 ) -1 % Intersegment eliminations (19 ) (4 ) (15 ) (19 ) (27 ) - - 8 -30 % Total Revenue $ 2,780 $ 556 $ 2,311 $ 2,867 $ 2,988 $ (87 ) -3 % $ (121 ) -4 % Total Revenue 2012 vs. 2011 Total revenues decreased by $87 million, or 3%, to $2.780 billion for the fiscal year ended September 30, 2012 from $2.867 billion for the twelve months ended September 30, 2011. Prior to intersegment eliminations, Recorded Music and Music Publishing revenues comprised 81% and 19% of total revenues, respectively, for both the fiscal year ended September 30, 2012 and the twelve months ended September 30, 2011. U.S. and international revenues comprised 40% and 60% of total revenues, respectively, for both the fiscal year ended September 30, 2012 and the twelve months ended September 30, 2011. Excluding the unfavorable impact of foreign currency exchange rates, total revenues decreased by $23 million, or 1% for the fiscal year ended September 30, 2012. Total digital revenues, after intersegment eliminations, increased by $105 million, or 13%, to $925 million for the fiscal year ended September 30, 2012 from $820 million for the twelve months ended September 30, 2011. Total digital revenue represented 33% and 29% of consolidated revenues for the fiscal year ended September 30, 2012 and for the twelve months ended September 30, 2011, respectively. Prior to intersegment eliminations, total digital revenues for the fiscal year ended September 30, 2012 were comprised of U.S. revenues of $526 million, or 57% of total digital revenues, and international revenues of $405 million, or 43% of total digital revenues. Prior to intersegment eliminations, total digital revenues for the twelve months ended September 30, 2011 were comprised of U.S. revenues of $471 million, or 57% of total digital revenues, and 53 -------------------------------------------------------------------------------- Table of Contents international revenues of $357 million, or 43% of total digital revenues. Excluding the unfavorable impact of foreign currency exchange rates, total digital revenues increased by $114 million, or 14% for the fiscal year ended September 30, 2012. Recorded Music revenues decreased $67 million, or 3% to $2.275 billion for the fiscal year ended September 30, 2012, from $2.342 billion for the twelve months ended September 30, 2011. U.S. Recorded Music revenues were $909 million and $956 million, or 40% and 41% of Recorded Music revenues for the fiscal year ended September 30, 2012 and for the twelve months ended September 30, 2011, respectively. International Recorded Music revenues were $1.366 billion and $1.386 billion, or 60% and 59% of Recorded Music revenues for the fiscal year ended September 30, 2012 and the twelve months ended September 30, 2011, respectively. Excluding the unfavorable impact of foreign currency exchange rates, total Recorded Music revenues decreased by $20 million, or 1%, for the fiscal year ended September 30, 2012. This performance reflected the ongoing impact of the transition from physical to digital sales offset by the current-year success of Michael Bublé's "Christmas" album and key local releases in Japan. In addition, growth in digital revenues more than offset physical revenue declines in our Recorded Music business. Artist services and expanded rights revenues decreased primarily due to a decline in concert promotion revenue resulting from a strong touring schedule in France in the prior year which was not duplicated in the current year. Licensing revenues decreased due primarily to timing. The increase in digital revenues was driven by continued success of streaming services, growth of digital downloads in the U.S. and in emerging digital markets in Latin America and certain European territories, partially offset by the continued decline in global ringtone revenue. Music Publishing revenues decreased by $20 million, or 4%, to $524 million for the fiscal year ended September 30, 2012 from $544 million for the twelve months ended September 30, 2011. U.S. Music Publishing revenues were $204 million and $196 million, or 39% and 36% of Music Publishing revenues for the fiscal year ended September 30, 2012 and for the twelve months ended September 30, 2011, respectively. International Music Publishing revenues were $320 million and $348 million, or 61% and 64% of Music Publishing revenues for the fiscal year ended September 30, 2012 and for the twelve months ended September 30, 2011, respectively. Excluding the unfavorable impact of foreign currency exchange rates, total Music Publishing revenues decreased by $3 million, or 1%, for the fiscal year ended September 30, 2012. The decrease in Music Publishing revenue was driven primarily by decreases in mechanical revenue and performance revenue, partially offset by an increase in digital revenue. The decrease in mechanical revenue reflected the ongoing impact of the transition from physical to digital sales in the recorded music industry and the decision to exit certain lower-margin administration deals. The decrease in performance revenue was driven primarily by a reduction in U.S. radio license fees and a market decline in the U.K., partially offset by a stronger advertising market, strong chart positions and recent acquisitions. The increase in digital revenue was driven by the growth of global digital downloads and the continued success of streaming services. 2011 vs. 2010 Total revenues decreased by $121 million, or 4%, to $2.867 billion for the twelve months ended September 30, 2011 from $2.988 billion for the fiscal year ended September 30, 2010. Prior to intersegment eliminations, Recorded Music and Music Publishing revenues comprised 81% and 19% of total revenues for the twelve months ended September 30, 2011, respectively, and 82% and 18% of total revenues for the fiscal year ended September 30, 2010, respectively. U.S. and international revenues comprised 40% and 60% of total revenues for the twelve months ended September 30, 2011, respectively, compared to 42% and 58% for the fiscal year ended September 30, 2010, respectively. Excluding the favorable impact of foreign currency exchange rates, total revenues decreased $194 million, or 6% for the twelve months ended September 30, 2011. Total digital revenues, after intersegment eliminations, increased by $61 million, or 8%, to $820 million for the twelve months ended September 30, 2011 from $759 million for the fiscal year ended September 30, 2010. 54-------------------------------------------------------------------------------- Table of Contents Total digital revenue represented 29% and 25% of consolidated revenues for the twelve months ended September 30, 2011 and for the fiscal year ended September 30, 2010, respectively. Prior to intersegment eliminations, total digital revenues for the twelve months ended September 30, 2011 were comprised of U.S. revenues of $471 million, or 57% of total digital revenues, and international revenues of $357 million, or 43% of total digital revenues. Prior to intersegment eliminations, total digital revenues for the fiscal year ended September 30, 2010 were comprised of U.S. revenues of $462 million, or 60% of total digital revenues, and international revenues of $310 million, or 40% of total digital revenues. Excluding the favorable impact of foreign currency exchange rates, total digital revenues increased by $44 million, or 6%. Recorded Music revenues decreased $117 million, or 5% to $2.342 billion for the twelve months ended September 30, 2011, from $2.459 billion for the fiscal year ended September 30, 2010. Prior to intersegment eliminations, Recorded Music revenues represented 81% and 82% of consolidated revenues for the twelve months ended September 30, 2011 and for the fiscal year ended September 30, 2010, respectively. U.S. Recorded Music revenues were $956 million and $1.043 billion, or 41% and 42% of Recorded Music revenues for the twelve months ended September 30, 2011 and for the fiscal year ended September 30, 2010, respectively. International Recorded Music revenues were $1.386 billion and $1.416 billion, or 59% and 58% of consolidated Recorded Music revenues for the twelve months ended September 30, 2011 and for the fiscal year ended September 30, 2010, respectively. Excluding the favorable impact of foreign currency exchange rates, total Recorded Music revenues decreased by $173 million, or 7%, for the twelve months ended September 30, 2011. This performance reflected the continued decline in physical sales in the recorded music industry and a more robust release schedule in the prior fiscal year, partially offset by increases in digital revenue, licensing revenue and revenue from our European concert promotion businesses. The increases in digital revenue had not yet fully offset the decline in physical revenue. Digital revenues increased by $55 million, or 8%, for the twelve months ended September 30, 2011, driven by the growth in digital downloads in the U.S. and International and emerging streaming services, partially offset by the continued decline in global ringtone revenue. Licensing revenues increased $14 million due to timing. The increases in our European concert promotion business reflected a stronger touring schedule in the twelve months ended September 30, 2011. Music Publishing revenues decreased by $12 million, or 2%, to $544 million for the twelve months ended September 30, 2011 from $556 million for the fiscal year ended September 30, 2010. Prior to intersegment eliminations, Music Publishing revenues represented 19% and 18% of consolidated revenues for the twelve months ended September 30, 2011 and for the fiscal year ended September 30, 2010, respectively. U.S. Music Publishing revenues were $196 million and $214 million, or 36% and 38% of Music Publishing revenues for the twelve months ended September 30, 2011 and for the fiscal year ended September 30, 2010, respectively. International Music Publishing revenues were $348 million and $342 million, or 64% and 62% of Music Publishing revenues for the twelve months ended September 30, 2011 and for the fiscal year ended September 30, 2010, respectively. Excluding the favorable impact of foreign currency exchange rates, total Music Publishing revenues decreased by $28 million, or 5%, for the twelve months ended September 30, 2011. The decrease in Music Publishing revenues was driven primarily by decreases in mechanical revenue, partially offset by an increase in synchronization revenue, performance revenue and digital revenue. The decrease in mechanical revenue reflected the ongoing impact of the transition from physical to digital sales in the recorded music industry, the timing of cash collections, an interim reduction in royalty rates related to radio performances in the U.S. and the prior-year benefit of $5 million stemming from an agreement reached by the U.S. recorded music and music publishing industries, which resulted in the payment of mechanical royalties accrued in prior years by record companies. The increase in synchronization revenue reflected the improvement of the U.S. advertising market and renewals on certain licensing deals. Performance revenue improved as a result of recent acquisitions, partially offset by our decision not to renew certain low-margin administration deals during the fiscal year ended September 30, 2010. The increase in digital revenue reflected growth in global digital downloads and emerging streaming services. Other music publishing revenue increased primarily as a result of higher print revenue in the U.S. 55-------------------------------------------------------------------------------- Table of Contents Revenue by Geographical Location 2012 vs. 2011 U.S. revenues decreased by $39 million, or 3%, to $1.113 billion for the fiscal year ended September 30, 2012 from $1.152 billion for the twelve months ended September 30, 2011. The overall decline in the U.S. Recorded Music business primarily reflected the ongoing transition from physical sales to digital sales and lower artist services and expanded rights revenues driven primarily by lower merchandise and ticketing revenue. The decrease was partially offset by the strong performance of Michael Bublé's "Christmas" album and an increase in digital revenue driven by growth in digital downloads and the continued success of streaming services, partially offset by the continued decline in global ringtone revenue. The overall increase in the U.S. Music Publishing business was primarily the result of the timing of collections, partially offset by mechanical declines exceeding digital revenue growth and a reduction in U.S. radio license fees. International revenues decreased by $48 million, or 3%, to $1.686 billion for the fiscal year ended September 30, 2012 from $1.734 billion for the twelve months ended September 30, 2011. Excluding the unfavorable impact of foreign currency exchange, international revenues increased $16 million, or 1% for the fiscal year ended September 30, 2012. This performance reflected the current-year success of Michael Bublé's "Christmas" album and key local releases in Japan. An increase in digital revenue, primarily as a result of growth in digital downloads and the continued success of streaming services was partially offset by the contracting demand for physical product and lower artist services and expanded rights revenues driven primarily by declines in concert promotion revenue as compared to results from the strong touring schedule in France in the prior year. Revenue growth in Japan, Germany and Italy was partially offset by weakness in France and the U.K. 2011 vs. 2010 U.S. revenues decreased by $105 million, or 8%, to $1.152 billion for the twelve months ended September 30, 2011 from $1.257 billion for the fiscal year ended September 30, 2010. The decrease in revenue for our U.S. Recorded Music business primarily reflected the ongoing transition from physical to digital sales in the recorded music industry, a more robust release schedule in the fiscal year ended September 30, 2010 and declines in ringtone revenues, partially offset by increases in digital revenue, licensing revenue and revenue from artist services and expanded rights. U.S. Music Publishing revenue decline was primarily due to a decrease in mechanical revenue which reflected the ongoing impact of the transition from physical to digital sales in the recorded music industry, an interim reduction in royalty rates related to radio performances in the U.S. and the prior-year benefit of $5 million stemming from an agreement reached by the U.S. recorded music and music publishing industries, which resulted in the payment of mechanical royalties accrued in prior years by record companies. The increase in digital revenue reflected growth in global digital downloads and emerging streaming services. Other music publishing revenue increased primarily as a result of higher print revenue in the U.S. International revenues decreased by $24 million, or 1%, to $1.734 billion for the twelve months ended September 30, 2011 from $1.758 billion for the fiscal year ended September 30, 2010. Excluding the favorable impact of foreign currency exchange, international revenues decreased $97 million, or 5%. Revenue growth in France was more than offset by weakness in the rest of the world, mostly in the U.K., Europe and Japan. An increase in digital revenue, primarily as a result of continued growth in global downloads and emerging streaming services and revenue from our European concert promotion businesses was more than offset by contracting demand for physical product, which reflected the ongoing transition from physical to digital sales in the recorded music industry and a more robust release schedule in the fiscal year ended September 30, 2010. See "Business Segment Results" presented hereinafter for a discussion of revenue by type for each business segment. 56-------------------------------------------------------------------------------- Table of Contents Cost of revenues Our cost of revenues was composed of the following amounts (in millions): Successor Predecessor Predecessor For the From Combined For the Fiscal From July 20, October 1, Twelve For the Fiscal 2012 vs. 2011 2011 vs. 2010 Year Ended 2011 through 2010 through Months ended Years Ended September 30, September 30, July 19, September 30, September 30, 2012 2011 2011 2011 2010 $ Change % Change $ Change % Change Artist and repertoire costs $ 969 $ 168 $ 834 $ 1,002 $ 1,018 $ (33 ) -3 % $ (16 ) -2 % Product costs 490 120 427 547 566 (57 ) -10 % (19 ) -3 % Total cost of revenues $ 1,459 $ 288 $ 1,261 $ 1,549 $ 1,584 $ (90 ) -6 % $ (35 ) -2 % 2012 vs. 2011 Cost of revenues decreased by $90 million, or 6%, to $1.459 billion for the fiscal year ended September 30, 2012 from $1.549 billion for the twelve months ended September 30, 2011. Expressed as a percent of revenues, cost of revenues was 52% and 54% for the fiscal year ended September 30, 2012 and the twelve months ended September 30, 2011, respectively. Artist and repertoire costs decreased by $33 million, or 3%, to $969 million for the fiscal year ended September 30, 2012 from $1.002 billion for the twelve months ended September 30, 2011. The decrease in artist and repertoire costs was driven by the decrease in revenue, the timing of our artist and repertoire spend and a cost-recovery benefit related to the early termination of an artist contract. Artist and repertoire costs as a percentage of revenues remained flat at 35% for the fiscal year ended September 30, 2012 and for the twelve months ended September 30, 2011. Product costs decreased $57 million, or 10%, to $490 million for the fiscal year ended September 30, 2012 from $547 million for the twelve months ended September 30, 2011. The decrease in product costs was primarily a result of a decrease in physical revenue in the current period and a decrease in artist services revenue from our European concert promotion businesses. Costs associated with our artist services recorded music businesses are primarily recorded as a component of product costs. Product costs as a percentage of revenues decreased to 18% for the fiscal year ended September 30, 2012 from 19% for the twelve months ended September 30, 2011. 2011 vs. 2010 Cost of revenues decreased by $35 million, or 2%, to $1.549 billion for the twelve months ended September 30, 2011 from $1.584 billion for the fiscal year ended September 30, 2010. Expressed as a percent of revenues, cost of revenues were 54% and 53% for the twelve months ended September 30, 2011 and for the fiscal year ended September 30, 2010, respectively. Artist and repertoire costs decreased $16 million, or 2%, to $1.002 billion for the twelve months ended September 30, 2011 from $1.018 billion for the fiscal year ended September 30, 2010. The decrease in artist and repertoire costs was driven by decreased revenues for the twelve months ended September 30, 2011, partially offset by the fiscal year 2010 impacts of a cost-recovery benefit related to the early termination of certain artist contracts. Artist and repertoire costs as a percentage of revenues increased to 35% for the twelve months ended September 30, 2011 from 34% for the fiscal year ended September 30, 2010. 57 -------------------------------------------------------------------------------- Table of Contents Product costs decreased $19 million, or 3%, to $547 million for the twelve months ended September 30, 2011 from $566 million for the fiscal year ended September 30, 2010. The decrease in product costs was driven by effective supply chain management and the continuing change in mix from physical to digital sales, partially offset by an increase in artist services revenue from our European concert promotion businesses. Costs associated with our artist services recorded music businesses are primarily recorded as a component of product costs. Product costs as a percentage of revenues were 19% of revenues for both the twelve months ended September 30, 2011 and for the fiscal year ended September 30, 2010. Selling, general and administrative expenses Our selling, general and administrative expenses are composed of the following amounts (in millions): Successor Predecessor For the Predecessor Combined From Twelve For the Fiscal From July 20, October 1, 2010 Months For the Fiscal 2012 vs. 2011 2011 vs. 2010 Year Ended 2011 through through ended Year Ended September 30, September 30, July 19, September 30, September 30, 2012 2011 2011 2011 2010 $ Change % Change $ Change % Change General and administrative expense (1) $ 574 $ 96 $ 450 $ 546 $ 583 $ 28 5 % $ (37 ) -6 % Selling and marketing expense 390 78 335 413 444 (23 ) -6 % (31 ) -7 % Distribution expense 55 12 46 58 68 (3 ) -5 % (10 ) -15 % Total selling, general and administrative expense $ 1,019 $ 186 $ 831 $ 1,017 $ 1,095 $ 2 - $ (78 ) -7 % (1) Includes depreciation expense of $51 million, $42 million and $39 million for the fiscal year ended September 30, 2012, the twelve months ended September 30, 2011 and for the fiscal year ended September 30, 2010, respectively. 2012 vs. 2011 Selling, general and administrative expense increased by $2 million to $1.019 billion for the fiscal year ended September 30, 2012 from $1.017 billion for the twelve months ended September 30, 2011. Expressed as a percent of revenues, selling, general and administrative expense increased to 37% for the fiscal year ended September 30, 2012 from 35% for the twelve months ended September 30, 2011. General and administrative expense increased by $28 million, or 5%, to $574 million for the fiscal year ended September 30, 2012 from $546 million for the twelve months ended September 30, 2011. The increase in general and administrative expense was driven by an increase in depreciation expense resulting from recently completed capital projects and purchase price accounting recorded in connection with the Merger, professional fees associated with our Management Agreement, costs related to the sale of EMI, an increase in variable compensation expense and the prior-year benefit for the LimeWire settlement, partially offset by the realization of cost savings from previously announced management initiatives and the prior-year charges for share-based compensation expense of $24 million. Expressed as a percentage of revenues, general and administrative expenses increased from 19% for the twelve months ended September 30, 2011 to 21% for the fiscal year ended September 30, 2012. Selling and marketing expense decreased by $23 million, or 6%, to $390 million for the fiscal year ended September 30, 2012 from $413 million for the twelve months ended September 30, 2011. The decrease in selling and marketing expense was primarily related to lower variable marketing expense as a result of our effort to better align spending on selling and marketing expense with revenues earned. Selling and marketing expense as a percentage of revenues remained flat at 14% for the fiscal year ended September 30, 2012 and for the twelve months ended September 30, 2011. 58 -------------------------------------------------------------------------------- Table of Contents Distribution expense decreased by $3 million, or 5%, to $55 million for the fiscal year ended September 30, 2012 from $58 million for the twelve months ended September 30, 2011. The decrease in distribution expense was driven by the ongoing transition from physical to digital sales. Distribution expense remained flat as a percentage of revenues at 2% for the fiscal year ended September 30, 2012 and for the twelve months ended September 30, 2011. 2011 vs. 2010 Selling, general and administrative expense decreased by $78 million, or 7%, to $1.017 billion for the twelve months ended September 30, 2011 from $1.095 billion for the fiscal year ended September 30, 2010. Expressed as a percent of revenues, selling, general and administrative expense decreased to 35% for the twelve months ended September 30, 2011 as compared with 37% for the fiscal year ended September 30, 2010. General and administrative expense decreased by $37 million or 6%, to $546 million for the twelve months ended September 30, 2011 from $583 million for the fiscal year ended September 30, 2010. The decrease in general and administrative expense was driven by a decrease in variable compensation, the benefit from the LimeWire settlement, the realization of cost savings from management initiatives and lower severance charges during the twelve months ended September 30, 2011, partially offset by an increase in share-based compensation expense of $14 million related to the payout for unvested Predecessor options and restricted stock awards as well as the modifications of existing restricted stock award agreements and an increase in merger and acquisition related professional fees. General and administrative expense as a percentage of revenues decreased to 19% for the twelve months ended September 30, 2011 as compared with 20% for the fiscal year ended September 30, 2010. Selling and marketing expense decreased by $31 million, or 7%, to $413 million for the twelve months ended September 30, 2011 from $444 million for the fiscal year ended September 30, 2010. The decrease in selling and marketing expense was primarily as a result of our effort to better align selling and marketing expenses with revenues. Selling and marketing expense as a percentage of revenues decreased from 15% for the fiscal year ended September 30, 2010 to 14% for the twelve months ended September 30, 2011. Distribution expense decreased by $10 million, or 15%, to $58 million for the twelve months ended September 30, 2011 from $68 million for the fiscal year ended September 30, 2010. The decrease in distribution expense was driven by the ongoing transition from physical to digital sales. Distribution expense as a percentage of revenues remained flat as a percentage of revenues at 2% for the twelve months ended September 30, 2011 and for the fiscal year ended and September 30, 2010. Merger transaction costs 2011 vs 2010 Merger transaction costs of $53 million for the twelve months ended September 30, 2011 were incurred in connection with the consummation of the Merger. These costs primarily included advisory, accounting, legal and other professional fees. 59 -------------------------------------------------------------------------------- Table of Contents Reconciliation of Consolidated Historical OIBDA to Operating Income and Net Loss Attributable to Warner Music Group Corp. As previously described, we use OIBDA as our primary measure of financial performance. The following table reconciles OIBDA to operating income, and further provides the components from operating income to net loss attributable to Warner Music Group Corp. for purposes of the discussion that follows (in millions): Successor Predecessor From For the From October 1, twelve Predecessor For the Year July 20, 2011 2010 months For the Year Ended through through ended Ended 2012 vs. 2011 2011 vs. 2010 September 30, September 30, July 19, September 30, September 30, 2012 2011 2011 2011 2010 $ Change % Change $ Change % Change OIBDA $ 353 $ 81 $ 209 $ 290 $ 348 $ 63 22 % $ (58 ) -17 % Depreciation expense (51 ) (9 ) (33 ) (42 ) (39 ) (9 ) 21 % (3 ) 8 % Amortization expense (193 ) (38 ) (178 ) (216 ) (219 ) 23 -11 % 3 -1 % Operating income (loss) 109 34 (2 ) 32 90 77 - (58 ) -64 % Interest expense, net (225 ) (62 ) (151 ) (213 ) (190 ) (12 ) 6 % (23 ) 12 % Other income (expense), net 8 - 5 5 (4 ) 3 60 % 9 - (Loss) income before income taxes (108 ) (28 ) (148 ) (176 ) (104 ) 68 -39 % (72 ) 69 % Income tax expense (1 ) (3 ) (27 ) (30 ) (41 ) 29 -97 % 11 -27 % Net loss (109 ) (31 ) (175 ) (206 ) (145 ) 97 -47 % (61 ) 42 % Less: (income) loss attributable to noncontrolling interest (3 ) - 1 1 2 (4 ) - (1 ) -50 % Net loss attributable to Warner Music Group Corp. $ (112 ) $ (31 ) $ (174 ) $ (205 ) $ (143 ) $ 93 -45 % $ (62 ) 43 % OIBDA 2012 vs. 2011 Our OIBDA increased by $63 million or 22%, to $353 million for the fiscal year ended September 30, 2012 as compared to $290 million for the twelve months ended September 30, 2011. Expressed as a percentage of revenues, total OIBDA margin increased by 3% to 13% for the fiscal year ended September 30, 2012 as compared to 10% for the twelve months ended September 30, 2011. Our OIBDA increase primarily reflected the prior-year charges for transaction costs incurred in connection with the consummation of the Merger and share-based compensation expense related to the payout for unvested Predecessor options and restricted stock awards as well as from the modification of certain restricted stock award agreements. Our OIBDA increase also reflected the strong current-year sales performance of Michael Bublé's "Christmas," which increased overall margin due to reductions in proportionate marketing spend, a strong back-end weighted release schedule particularly in Japan, the realization of cost savings from previously announced management initiatives and a cost-recovery benefit related to the early termination of an artist 60-------------------------------------------------------------------------------- Table of Contents contract, partially offset by the prior year benefit for the LimeWire settlement, increases in professional fees associated with our Management Agreement and costs related to the sale of EMI. In addition, our Music Publishing business has improved its OIBDA margin as a result of a disciplined A&R investment and acquisition strategy focused on higher margin assets. 2011 vs. 2010 Our OIBDA decreased by $58 million, or 17%, to $290 million for the twelve months ended September 30, 2011 as compared to $348 million for the fiscal year ended September 30, 2010. Expressed as a percentage of revenues, total OIBDA margin decreased from 12% for the fiscal year ended September 30, 2010 to 10% for the twelve months ended September 30, 2011. Our OIBDA decrease was primarily driven by the decrease in revenue, transaction costs incurred in connection with the consummation of the Merger, an increase in share-based compensation expense related to the payout for unvested Predecessor options and restricted stock awards as well as from the modification of certain restricted stock award agreements, an increase in merger and acquisition related professional fees, an increase in licensing costs as well as the prior-year impact of a cost-recovery benefit related to the termination of certain artist recording contracts and an adjustment in Music Publishing royalty reserves. The decrease was partially offset by reductions in artist and repertoire costs, product costs, distribution costs, selling and marketing expense, lower compensation expense, the benefit from the LimeWire settlement, the realization of cost savings from management initiatives taken in prior periods, lower bad debt expense in the current period and $16 million of lower severance charges in the current period as compared with the prior-year period. See "Business Segment Results" presented hereinafter for a discussion of OIBDA by business segment. Depreciation expense 2012 vs. 2011 Depreciation expense increased by $9 million, or 21%, from $42 million for the fiscal year ended September 30, 2011 to $51 million for the twelve months ended September 30, 2012. The increase was primarily due to recently completed capital projects and purchase price accounting recorded in connection with the Merger. 2011 vs. 2010 Depreciation expense increased by $3 million, or 8%, from $39 million for fiscal year ended September 30, 2010 to $42 million for the twelve months ended September 30, 2011, primarily due to recently completed capital projects and purchase price accounting recorded in connection with the Merger. Amortization expense 2012 vs. 2011 Amortization expense decreased by $23 million, or 11%, from $216 million for the twelve months ended September 30, 2011 to $193 million for the fiscal year ended September 30, 2012. The decrease was primarily related to purchase price accounting recorded in connection with the Merger which resulted in longer useful lives of our intangible assets, partially offset by additional amortization associated with recent intangible asset acquisitions. 2011 vs. 2010 Amortization expense decreased by $3 million, or 1%, from $219 million for the fiscal year ended September 30, 2010 to $216 million for the twelve months ended September 30, 2011. The decrease was primarily related to purchase price accounting recorded in connection with the Merger due to longer useful lives, partially offset by additional amortization associated with recent intangible asset acquisitions. 61 -------------------------------------------------------------------------------- Table of Contents Operating income 2012 vs.2011 Our operating income increased by $77 million to $109 million for the fiscal year ended September 30, 2012 as compared to $32 million for the twelve months ended September 30, 2011. Operating income margin increased to 4% for the fiscal year ended September 30, 2012, from 1% for the twelve months ended September 30, 2011. The increase in operating income was primarily due to the increase in OIBDA and the decrease in amortization expense, partially offset by the increase in depreciation expense as noted above. 2011 vs. 2010 Our operating income decreased $58 million, or 64%, to $32 million for the twelve months ended September 30, 2011 as compared to $90 million for the fiscal year ended September 30, 2010. Operating income margin decreased to 1% for the twelve months ended September 30, 2011, from 3% for the fiscal year ended September 30, 2010. The decrease in operating income was primarily due to the decline in OIBDA, the increase in depreciation expense, partially offset by the decrease in amortization expense, as noted above. Interest expense, net 2012 vs. 2011 Interest expense, net, increased $12 million, or 6%, to $225 million for the fiscal year ended September 30, 2012 as compared to $213 million for the twelve months ended September 30, 2011. The increase was primarily driven by our new debt obligations which were issued in connection with the refinancing of certain of our existing indebtedness in connection with the Merger at higher interest rates than the debt that was refinanced partially offset by tender/call premiums of $19 million incurred in connection with the debt obligations that were repaid in full during the twelve months ended September 30, 2011. 2011 vs. 2010 Interest expense, net, increased $23 million, or 12%, to $213 million for the twelve months ended September 30, 2011 as compared to $190 million for the fiscal year ended September 30, 2010. The increase in interest expense was primarily driven by the refinancing of certain of our existing indebtedness in connection with the Merger. The refinancing resulted in $19 million in tender/call premiums incurred in connection with the debt obligations that were repaid in full. In addition, the new debt obligations referred to above were issued with higher interest rates. See "-Financial Condition and Liquidity" for more information. Other income (expense), net 2012 vs. 2011 Other income (expense), net for the fiscal year ended September 30, 2012 and the twelve months ended September 30, 2011 included net hedging gains on foreign exchange contracts, which represent currency exchange movements associated with intercompany receivables and payables that are short term in nature, offset by equity in earnings on our share of net income on investments recorded in accordance with the equity method of accounting for an unconsolidated investee. The increase in other income was driven by payments received for tax indemnities related to tax matters in Germany and Brazil. 2011 vs. 2010 Other income (expense), net for the twelve months ended September 30, 2011 and for the fiscal year ended September 30, 2010 included net hedging gains on foreign exchange contracts, which represent currency exchange movements associated with intercompany receivables and payables that are short term in nature, offset 62 -------------------------------------------------------------------------------- Table of Contents by equity in earnings on our share of net income on investments recorded in accordance with the equity method of accounting for an unconsolidated investee. In addition, other income increased as a result of the settlement of an income tax audit in Germany reimbursable to us by Time Warner under the terms of the 2004 Acquisition. Income tax expense 2012 vs. 2011 We provided income tax expense of $1 million and $30 million for the fiscal year ended September 30, 2012 and for the twelve month ended September 30, 2011, respectively. The decrease in income tax expense primarily relates to the recognition in the fiscal year ended September 30, 2012 of deferred tax benefits for losses generated in various jurisdictions including the U.S. and the impact of tax rate changes in the UK and Japan. 2011 vs. 2010 Income tax expense decreased to $30 million for the twelve months ended September 30, 2011 from $41 million for the fiscal year ended September 30, 2010. The decrease in income tax expense primarily relates to a decrease in pretax earnings in certain foreign jurisdictions, and a valuation allowance reversal related to acquisitions during the twelve months ended September 30, 2011, offset by additional tax reserves. Net loss 2012 vs. 2011 Our net loss decreased by $97 million to $109 million for the fiscal year ended September 30, 2012, as compared to $206 million for the twelve months ended September 30, 2011. The decrease in net loss was driven primarily by the increase in operating income and lower income tax expense, partially offset by increases in interest expense, net as noted above. 2011 vs. 2010 Our net loss increased by $61 million to $206 million for the twelve months ended September 30, 2011, as compared to $145 million for the fiscal year ended September 30, 2010. The increase was a result of the decrease in our OIBDA and increases in depreciation expense and interest expense, partially offset by the decrease in income tax and amortization expense and the change in other income (expense) as noted above. Noncontrolling interest 2012 vs. 2011 Net income attributable to noncontrolling interests for the fiscal year ended September 30, 2012 was $3 million and net loss attributable to noncontrolling interests for the twelve months ended September 30, 2011 was $1 million. 2011 vs. 2010 Net loss attributable to noncontrolling interests for the fiscal year ended September 30, 2011 and for the twelve months ended September 30, 2010 were $1 million and $2 million, respectively. 63-------------------------------------------------------------------------------- Table of Contents Business Segment Results Revenue, OIBDA and operating income (loss) by business segment are as follows (in millions): For the Successor Predecessor Combined Predecessor For the Fiscal From July 20, From October 1, Twelve For the Fiscal Year Ended 2011 through 2010 Months ended Year Ended 2012 vs. 2011 2011 vs. 2010 September 30, September 30, through July 19, September 30, September 30, 2012 2011 2011 2011 2010 $ Change % Change $ Change % Change Recorded Music Revenue $ 2,275 $ 456 $ 1,886 $ 2,342 $ 2,459 $ (67 ) -3 % $ (117 ) -5 % OIBDA 283 48 234 282 279 $ 1 - 3 1 % Operating income $ 120 $ 17 $ 93 $ 110 $ 102 $ 10 9 % $ 8 8 % Music Publishing Revenue $ 524 $ 104 $ 440 $ 544 $ 556 $ (20 ) -4 % $ (12 ) -2 % OIBDA 152 51 96 147 157 5 3 % (10 ) -6 % Operating income $ 85 $ 39 $ 34 $ 73 $ 86 $ 12 16 % $ (13 ) -15 % Corporate Expenses and Eliminations Revenue $ (19 ) $ (4 ) $ (15 ) $ (19 ) $ (27 ) - - $ 8 -30 % OIBDA (82 ) (18 ) (121 ) (139 ) (88 ) 57 -41 % (51 ) 58 % Operating loss $ (96 ) $ (22 ) $ (129 ) $ (151 ) $ (98 ) $ 55 -36 % $ (53 ) 54 % Total Revenue $ 2,780 $ 556 $ 2,311 $ 2,867 $ 2,988 $ (87 ) -3 % $ (121 ) -4 % OIBDA 353 81 209 290 348 63 22 % (58 ) -17 % Operating income (loss) $ 109 $ 34 $ (2 ) $ 32 $ 90 $ 77 - $ (58 ) -64 % Recorded Music Revenues 2012 vs. 2011 Recorded Music revenues decreased $67 million, or 3% to $2.275 billion for the fiscal year ended September 30, 2012, from $2.342 billion for the twelve months ended September 30, 2011. U.S. Recorded Music revenues were $909 million and $956 million, or 40% and 41% of Recorded Music revenues for the fiscal year ended September 30, 2012 and for the twelve months ended September 30, 2011, respectively. International Recorded Music revenues were $1.366 billion and $1.386 billion, or 60% and 59% of consolidated Recorded Music revenues for the fiscal year ended September 30, 2012 and the twelve months ended September 30, 2011, respectively. Excluding the unfavorable impact of foreign currency exchange rates, total Recorded Music revenues decreased by $20 million, or 1%, for the fiscal year ended September 30, 2012. This performance reflected the ongoing impact of the transition from physical to digital sales offset by the current-year success of Michael Bublé's "Christmas" album and key local releases in Japan. In addition, growth in digital revenues more than offset physical revenue declines in our Recorded Music business. Artist services and expanded rights revenues decreased primarily due to a decline in concert promotion revenue resulting from a strong touring schedule in France in the prior year. Licensing revenues decreased due primarily to timing. The increase in digital revenues was driven by continued success of streaming services, growth of digital downloads in the U.S. and in emerging digital markets in Latin America and certain European territories, partially offset by the continued decline in global ringtone revenue. 64-------------------------------------------------------------------------------- Table of Contents 2011 vs. 2010 Recorded Music revenues decreased $117 million, or 5% to $2.342 billion for the twelve months ended September 30, 2011, from $2.459 billion for the fiscal year ended September 30, 2010. U.S. Recorded Music revenues were $956 million and $1.043 billion, or 41% and 42% of Recorded Music revenues for the twelve months ended September 30, 2011 and for the fiscal year ended September 30, 2010, respectively. International Recorded Music revenues were $1.386 billion and $1.416 billion, or 59% and 58% of consolidated Recorded Music revenues for the twelve months ended September 30, 2011 and for the fiscal year ended September 30, 2010, respectively. Excluding the favorable impact of foreign currency exchange rates, total Recorded Music revenues decreased by $173 million, or 7%, for the twelve months ended September 30, 2011. This performance reflected the continued decline in physical sales in the recorded music industry and a more robust release schedule in the prior fiscal year, partially offset by increases in digital revenue, licensing revenue and revenue from our European concert promotion businesses. The increases in digital revenue have not yet fully offset the decline in physical revenue. Digital revenues increased by $55 million, or 8%, for the twelve months ended September 30, 2011, driven by the growth in digital downloads in the U.S. and International and emerging streaming services, partially offset by the continued decline in global ringtone revenue. Licensing revenues increased $14 million due to timing. The increases in our European concert promotion business reflected a stronger touring schedule in the twelve months ended September 30, 2011. Recorded Music cost of revenues was composed of the following amounts (in millions): For the Successor Predecessor Combined Predecessor For the Year From July 20, From Twelve For the Year Ended 2011 through October 1, 2010 Months ended Ended 2012 vs. 2011 2011 vs. 2010 September 30, September 30, through July 19, September 30, September 30, 2012 2011 2011 2011 2010 $ Change % Change $ Change % Change Artist and repertoire costs $ 679 $ 131 $ 560 $ 691 $ 712 $ (12 ) -2 % $ (21 ) -3 % Product costs 490 119 428 547 566 (57 ) -10 % (19 ) -3 % Total cost of revenues $ 1,169 $ 250 $ 988 $ 1,238 $ 1,278 $ (69 ) -6 % $ (40 ) -3 % Cost of revenues 2012 vs. 2011 Recorded Music cost of revenues decreased by $69 million, or 6%, for the fiscal year ended September 30, 2012. Cost of revenues represented 51% and 53% of Recorded Music revenues for the fiscal year ended September 30, 2012 and the twelve months ended September 30, 2011, respectively. The decrease in product costs was primarily the result of the decrease in physical revenue in the current-year and lower artist services revenue from our European concert promotion businesses. Costs associated with our artist services businesses are primarily recorded as a component of product costs. The decrease in artist and repertoire costs was driven by the decrease in revenue for the current period, the timing of our artist and repertoire spend and a cost-recovery benefit related to the early termination of an artist contract. 2011 vs. 2010 Recorded Music cost of revenues decreased by $40 million, or 3%, for the twelve months ended September 30, 2011. Cost of revenues represented 53% and 52% of Recorded Music revenues for the twelve months ended September 30, 2011 and for the fiscal years ended September 30, 2010. The decrease in cost of revenues was driven primarily by decreases in artist and repertoire costs and product costs, partially offset by an increase in licensing costs. The decrease in artist and repertoire costs was driven by decreased revenues for the 65-------------------------------------------------------------------------------- Table of Contents current twelve months ended period, a cost-recovery benefit recognized in the prior year related to the early termination of certain artist contracts and a benefit from increased recoupment on artists whose advances were previously written off. The decrease in product costs was driven by effective supply chain management and the continuing change in mix from physical to digital sales, partially offset by higher non-traditional recorded music business costs related to the increase in revenue from our European concert promotion businesses. The increase in licensing costs was driven by the increase in licensing revenue. Recorded Music selling, general and administrative expenses were composed of the following amounts (in millions): For the Successor Predecessor Combined Predecessor For the Year From July 20, Twelve For the Ended 2011 through From October 1, Months ended Year Ended 2012 vs. 2011 2011 vs. 2010 September 30, September 30, 2010 through September 30, September 30, 2012 2011 July 19, 2011 2011 2010 $ Change % Change $ Change % Change General and administrative expense (1) $ 414 $ 74 $ 309 $ 383 $ 423 $ 31 8 % $ (40 ) -9 % Selling and marketing expense 385 77 330 407 436 (22 ) -5 % (29 ) -7 % Distribution expense 55 12 46 58 68 (3 ) -5 % (10 ) -15 % Total selling, general and administrative expense $ 854 $ 163 $ 685 $ 848 $ 927 $ 6 1 % $ (79 ) -9 % (1) Includes depreciation expense of $31 million, $26 million and $25 million for the fiscal year ended September 30, 2012, the twelve months ended September 30, 2011, and the fiscal year ended September 30, 2010, respectively. Selling, general and administrative expense 2012 vs. 2011 Selling, general and administrative costs increased by $6 million, or 1%, for the fiscal year ended September 30, 2012. Expressed as a percentage of Recorded Music revenues, selling, general and administrative expenses increased to 38% for fiscal year ended September 30, 2012 from 36% for the twelve months ended September 30, 2011. The increase in selling, general and administrative expense was driven primarily by the increase in general and administrative expense, partially offset by the decrease in selling and marketing expense and distribution expense. The increase in general and administrative expense was driven by an increase in severance charges and an increase in depreciation expense resulting from recently completed capital projects and purchase price accounting recorded in connection with the Merger as well as the prior-year benefit for the LimeWire settlement, partially offset by the realization of cost savings from previously announced management initiatives and a prior-year charge for share-based compensation expense. The decrease in selling and marketing expense was driven by our continued efforts to better align spending on selling and marketing expense with revenues earned. The decrease in distribution expense was driven by the ongoing transition from physical to digital sales. 2011 vs. 2010 Selling, general and administrative costs decreased by $79 million, or 9% for the twelve months ended September 30, 2011. The decrease in selling, general and administrative expense was driven primarily by decreases in selling and marketing expense, general and administrative expense and distribution expense. The 66 -------------------------------------------------------------------------------- Table of Contents decrease in selling and marketing expense was primarily as a result of our effort to better align selling and marketing expenses with revenues earned as well as lower severance charges in the current period. The decrease in general and administrative expense was driven by the benefit from the LimeWire settlement, lower bad debt expense, lower compensation expense, lower severance charges and the realization of cost savings from management initiatives taken in prior periods, partially offset by an increase in stock compensation expense related to the modifications of existing restricted stock award agreements. The decrease in distribution expense was driven by the ongoing transition from physical to digital sales. Expressed as a percentage of Recorded Music revenues, selling, general and administrative expenses decreased to 36% for twelve months ended September 30, 2011 from 38% for the fiscal year ended September 30, 2010. OIBDA and Operating income Recorded Music operating income included the following amounts (in millions): For the Successor Predecessor Combined Predecessor For the Year From July 20, From Twelve For the Year Ended 2011 through October 1, 2010 Months ended Ended 2012 vs. 2011 2011 vs. 2010 September 30, September 30, through July 19, September 30, September 30, 2012 2011 2011 2011 2010 $ Change % Change $ Change % Change OIBDA $ 283 $ 48 $ 234 $282 $ 279 $ 1 - $ 3 1 % Depreciation and amortization expense (163 ) (31 ) (141 ) (172 ) (177 ) 9 -5 % 5 -3 % Operating Income $ 120 $ 17 $ 93 $110 $ 102 $ 10 9 % $ 8 8 % 2012 vs. 2011 Recorded Music OIBDA increased by $1 million to $283 million for the fiscal year ended September 30, 2012 from $282 million for the twelve months ended September 30, 2011. Expressed as a percentage of Recorded Music revenues, Recorded Music OIBDA margin also remained flat at 12% for the fiscal years ended September 30, 2012 and the twelve months ended September 30, 2011. Our Recorded Music OIBDA results reflected the prior year benefit for the LimeWire settlement, a decrease in revenue, an increase in severance charges and an increase in costs related to the sale of EMI, offset by the strong current-year sales performance of Michael Bublé's "Christmas," which increased overall margin due to reductions in proportionate marketing spend, a strong release schedule in Japan, the realization of cost savings from previously announced management initiatives, the decrease in selling and marketing expense, a cost recovery benefit related to the early termination of an artist contract and prior-year share based compensation expense. Recorded Music operating income increased by $10 million, or 9%, due to a decrease in amortization expense driven by the extended useful lives of certain intangible assets recorded in connection with the Merger, partially offset by an increase in depreciation expense. Recorded Music operating income margin remained 5% for the fiscal year ended September 30, 2012 and for the twelve months ended September 30, 2011. 2011 vs. 2010 Recorded Music OIBDA increased by $3 million, or 1%, to $282 million for the twelve months ended September 30, 2011 compared to $279 million for the fiscal year ended September 30, 2010. Expressed as a percentage of Recorded Music revenues, Recorded Music OIBDA margin was 12% and 11% for the twelve months ended September 30, 2011 and for the fiscal year ended September 30, 2010, respectively. Our increased OIBDA margin was primarily the result of the realization of cost savings from management initiatives taken in 67-------------------------------------------------------------------------------- Table of Contents prior periods, the benefit from the LimeWire settlement, lower bad debt expense, lower compensation expense, lower severance charges, lower products costs and lower selling and marketing and distribution expense, partially offset by an increase in stock compensation expense related to the modifications of existing restricted stock award agreements. Recorded Music operating income increased by $8 million, or 8% due to the increase in OIBDA noted above, the decrease in amortization expense, partially offset by the increase in depreciation expense. Recorded Music operating income margin increased to 5% for the twelve months ended September 30, 2011 from 4% for the fiscal year ended September 30, 2010. Music Publishing Revenues 2012 vs. 2011 Music Publishing revenues decreased by $20 million, or 4%, to $524 million for the fiscal year ended September 30, 2012 from $544 million for the twelve months ended September 30, 2011. U.S. Music Publishing revenues were $204 million and $196 million, or 39% and 36% of Music Publishing revenues for the fiscal year ended September 30, 2012 and for the twelve months ended September 30, 2011, respectively. International Music Publishing revenues were $320 million and $348 million, or 61% and 64% of Music Publishing revenues for the fiscal year ended September 30, 2012 and for the twelve months ended September 30, 2011, respectively. Excluding the unfavorable impact of foreign currency exchange rates, total Music Publishing revenues decreased by $3 million, or 1%, for the fiscal year ended September 30, 2012. The decrease in Music Publishing revenue was driven primarily by decreases in mechanical revenue and performance revenue, partially offset by an increase in digital revenue. The decrease in mechanical revenue reflected the ongoing impact of the transition from physical to digital sales in the recorded music industry. The decrease in performance revenue was driven primarily by a reduction in U.S. radio license fees and a market decline in the U.K., partially offset by a stronger advertising market, strong chart positions and recent acquisitions. The increase in digital revenue was driven by the growth of global digital downloads and the continued success of streaming services. 2011 vs. 2010 Music Publishing revenues decreased by $12 million, or 2%, to $544 million for the twelve months ended September 30, 2011 from $556 million for the fiscal year ended September 30, 2010. Prior to intersegment eliminations, Music Publishing revenues represented 19% and 18% of consolidated revenues for the twelve months ended September 30, 2011 and for the fiscal year ended September 30, 2010, respectively. U.S. Music Publishing revenues were $196 million and $214 million, or 36% and 38% of Music Publishing revenues for the twelve months ended September 30, 2011 and for the fiscal year ended September 30, 2010, respectively. International Music Publishing revenues were $348 million and $342 million, or 64% and 62% of Music Publishing revenues for the twelve months ended September 30, 2011 and for the fiscal year ended September 30, 2010, respectively. Excluding the favorable impact of foreign currency exchange rates, total Music Publishing revenues decreased by $28 million, or 5%, for the twelve months ended September 30, 2011. The decrease in Music Publishing revenues was driven primarily by an expected decrease in mechanical revenue, partially offset by an increase in synchronization revenue, performance revenue and digital revenue. The decrease in mechanical revenue reflected the ongoing impact of the transition from physical to digital sales in the recorded music industry, the timing of cash collections, an interim reduction in royalty rates related to radio performances in the U.S. and the prior-year benefit of $5 million stemming from an agreement reached by the U.S. recorded music and music publishing industries, which resulted in the payment of mechanical royalties accrued in prior years by record companies. The increase in synchronization revenue results reflected the 68-------------------------------------------------------------------------------- Table of Contents improvement of the U.S. advertising market and renewals on certain licensing deals. Performance revenue improved as a result of recent acquisitions, partially offset by our decision not to renew certain low-margin administration deals during the fiscal year ended September 30, 2010. The increase in digital revenue reflected growth in global digital downloads and emerging streaming services. Other music publishing revenue increased primarily as a result of higher print revenue in the U.S. Music Publishing cost of revenues was composed of the following amounts (in millions): Successor Predecessor For the Predecessor Combined Twelve For the Year From July 20, From October 1, Months For the 2012 vs. 2011 2011 vs. 2010 Ended 2011 through 2010 ended Year Ended September 30, September 30, through July 19, September 30, September 30, 2012 2011 2011 2011 2010 $Change % Change $ Change % Change Artist and repertoire costs $ 309 $ 42 $ 288 $ 330 $ 334 $ (21 ) -6 % $ (4 ) -1 % Total cost of revenues $ 309 $ 42 $ 288 $ 330 $ 334 $ (21 ) -6 % $ (4 ) -1 % Cost of revenues 2012 vs. 2011 Music Publishing cost of revenues decreased by $21 million, or 6%, to $309 million for the fiscal year ended September 30, 2012, from $330 million for the twelve months ended September 30, 2011. Expressed as a percentage of Music Publishing revenues, Music Publishing cost of revenues decreased from 61% for the twelve months ended September 30, 2011 to 59% for the fiscal year ended September 30, 2012. The decrease was driven primarily as a result of a disciplined A&R investment and acquisition strategy focused on higher-margin assets, partially offset by a year-over-year increase in unproven artist spend. 2010 vs. 2011 Music Publishing cost of revenues decreased $4 million, or 1%, to $330 million for the twelve months ended September 30, 2011, from $334 million for the fiscal year ended September 30, 2010. The decrease in cost of revenues was driven primarily by a combination of lower revenues in the current year and lower costs associated with certain low-margin administration deals which we decided not to renew, partially offset by the timing of artist and repertoire spend as well as an adjustment to royalty reserves in the prior-year period. Music Publishing cost of revenues as a percentage of Music Publishing revenues increased to 61% for the twelve months ended September 30, 2011 from 60% for the fiscal year ended September 30, 2010, primarily as a result of a prior-year period adjustment to royalty reserves. 69-------------------------------------------------------------------------------- Table of Contents Music Publishing selling, general and administrative expenses were comprised of the following amounts (in millions): Successor Predecessor For the Predecessor From From Combined July 20, October 1, Twelve For the 2011 2010 Months For the Year 2012 vs. 2011 2011 vs. 2010 Year Ended through through ended Ended September 30, September 30, July 19, September 30, September 30, 2012 2011 2011 2011 2010 $ Change % Change $ Change % Change General and administrative expense (1) $ 67 $ 9 $ 58 $ 67 $ 67 $ - - % $ - - % Selling and marketing expense 2 1 1 2 2 - - % - - Total selling, general and administrative expense $ 69 $ 10 $ 59 $ 69 $ 69 $ - - % $ - - % (1) Includes depreciation expense of $6 million for the fiscal year ended September 30, 2012 and $4 million for the twelve months ended September 30, 2011 and the fiscal year ended September 30, 2010. Selling, general and administrative expense 2012 vs. 2011 Music Publishing selling, general and administrative expense was $69 million for the fiscal year ended September 30, 2012 and for the twelve months ended September 30, 2011. Expressed as a percentage of Music Publishing revenues, Music Publishing selling, general and administrative expense also remained flat at 13% for the fiscal years ended September 30, 2012 and for the twelve months ended September 30, 2011. 2011 vs. 2010 Music Publishing selling, general and administrative expense remained flat at $69 million for the twelve months ended September 30, 2011 and for the fiscal year ended September 30, 2010. Expressed as a percentage of Music Publishing revenues, Music Publishing selling, general and administrative expense also remained flat at 13% for the twelve months ended September 30, 2011 and for the fiscal year ended September 30, 2010. OIBDA and Operating income Music Publishing operating income includes the following amounts (in millions): Successor Predecessor For the Predecessor Combined Twelve For the Year From July 20, From Months For the Year 2012 vs. 2011 2011 vs. 2010 Ended 2011 through October 1, 2010 ended Ended September 30, September 30, through July 19, September 30, September 30, 2012 2011 2011 2011 2010 $ Change % Change $ Change % Change OIBDA $ 152 $ 51 $ 96 $ 147 $ 157 $ 5 3 % $ (10 ) -6 % Depreciation and amortization expense (67 ) (12 ) (62 ) (74 ) (71 ) 7 -9 % (3 ) 4 % Operating Income $ 85 $ 39 $ 34 $ 73 $ 86 $ 12 16 % $ (13 ) -15 % 70 -------------------------------------------------------------------------------- Table of Contents 2012 vs. 2011 Music Publishing OIBDA increased $5 million to $152 million for the fiscal year ended September 30, 2012 from $147 million for the twelve years ended September 30, 2011. Expressed as a percentage of Music Publishing revenues, Music Publishing OIBDA increased to 29% for the fiscal years ended September 30, 2012 from 27% for the twelve months ended September 30, 2011. The increase in OIBDA margin was primarily the result of a disciplined A&R investment and acquisition strategy focused on higher-margin assets, lower severance charges taken during the current period and the prior-year charge incurred in connection with the consummation of the Merger related to a change in control fee, partially offset by an increase in unproven artist spend. Music Publishing operating income increased by $12 million for the fiscal year ended September 30, 2012 due primarily to the increase in OIBDA noted above and lower amortization expense driven by the extended useful lives of certain intangible assets recorded in connection with the Merger, partially offset by the increase in depreciation expense. 2011 vs. 2010 Music Publishing OIBDA decreased $10 million to $147 million for the twelve months ended September 30, 2011 from $157 million for the fiscal year ended September 30, 2010. Expressed as a percentage of Music Publishing revenues, Music Publishing OIBDA decreased to 27% for the twelve months ended September 30, 2011 from 28% and for the fiscal year ended and September 30, 2010, respectively. The decrease in OIBDA was due primarily to lower revenues partially offset by lower artist and repertoire costs related to certain low-margin administration deals which we decided not to renew. Music Publishing operating income decreased by $13 million for the twelve months ended September 30, 2011 due to the decrease in OIBDA noted above and an increase in amortization expense related to additional amortization associated with recent intangible asset acquisitions. Corporate Expenses and Eliminations 2012 vs. 2011 Our OIBDA loss from corporate expenses and eliminations decreased $57 million to $82 million for the fiscal year ended September 30, 2012, from $139 million for the twelve months ended September 30, 2011, primarily as a result of the realization of cost savings from previously announced management initiatives, lower severance charges, prior-year charges for share-based compensation expense and transaction costs incurred in connection with the consummation of the Merger, partially offset by an increase in professional fees related to the sale of EMI and our Management Agreement. Our operating loss from corporate expenses and eliminations decreased to $96 million for the fiscal year ended September 30, 2012, from $151 million for the twelve months ended September 30, 2011. The decrease in operating loss was primarily driven by the decrease in corporate expenses noted above, partially offset by an increase in depreciation expense. 2011 vs. 2010 Our OIBDA loss from corporate expenses and eliminations increased $51 million to $139 million for the twelve months ended September 30, 2011, from $88 million for the fiscal year ended September 30, 2010. The increase in OIBDA loss from corporate expenses and eliminations was primarily driven by expenses incurred in connection with the consummation of the Merger, an increase in share-based compensation expense related to the payout of unvested Predecessor options and restricted stock awards as well as from the modification of certain restricted stock award agreements and an increase in merger and acquisition related professional fees, partially offset by lower compensation expense, the realization of cost savings from management initiatives taken in prior periods, lower bad debt expense in the current period and lower severance charges in the current period. 71 -------------------------------------------------------------------------------- Table of Contents Our operating loss from corporate expenses and eliminations increased to $151 million for the twelve months ended September 30, 2011, from $98 million for the fiscal year ended September 30, 2010. The increase in operating loss was primarily driven by the increase in corporate expenses noted above. FINANCIAL CONDITION AND LIQUIDITY Financial Condition at September 30, 2012 At September 30, 2012, we had $2.206 billion of debt, $302 million of cash and equivalents (net debt of $1.904 billion, defined as total debt less cash and equivalents and short-term investments) and $927 million of Warner Music Group Corp. equity. This compares to $2.217 billion of debt, $154 million of cash and equivalents (net debt of $2.063 billion, defined as total debt less cash and equivalents and short-term investments) and $1.065 billion of Warner Music Group Corp. equity at September 30, 2011. Net debt decreased by $159 million as a result of (i) a $148 million increase in cash and equivalents and (ii) a $12 million decrease in long-term debt related to the amortization of premiums on our Old Secured Notes partially offset by a $1 million accretion of the discount on our Unsecured WMG Notes. The $138 million decrease in Warner Music Group Corp.'s equity during the fiscal year ended September 30, 2012 included foreign currency exchange movements of $19 million and $7 million related to minimum pension liability and the $112 million of our net loss. Cash Flows The following table summarizes our historical cash flows. The financial data for fiscal year ended September 30, 2012 (Successor), for the period from July 20, 2011 through September 30, 2011 (Successor) and for the period from October 1, 2010 to July 19, 2011 (Predecessor) and for the fiscal year ended September 30, 2010 (Predecessor) have been derived from our audited financial statements included elsewhere herein. Successor Predecessor Predecessor For the From Combined For the Fiscal October 1, Twelve For the Fiscal Year Ended From July 20, 2011 2010 Months ended Year Ended September 30, through through September 30, September 30, Cash Provided By (Used In): 2012 September 30, 2011 July 19, 2011 2011 2010 (in millions) Operating activities $ 209 $ (64 ) $ 12 $ (52 ) $ 150 Investing activities (58 ) (1,292 ) (155 ) (1,447 ) (85 ) Financing activities (3 ) 1,199 5 1,204 (3 ) Operating Activities Cash provided by operating activities was $209 million for the fiscal year ended September 30, 2012 compared to cash used in operating activities of $52 million for the twelve months ended September 30, 2011 and cash provided by operating activities of $150 million for the fiscal year ended September 30, 2010. The increase in results from operating activities in fiscal 2012 reflected the increase in our OIBDA driven primarily by the absence of transaction costs in 2012 that were incurred in connection with the Merger during the twelve months ended September 30, 2011, the timing of our working capital requirements and the decrease in cash paid for interest of $17 million. The decrease in results from operating activities in the twelve months ended September 30, 2011 compared to the fiscal year ended September 30, 2010, reflected the decrease in our OIBDA driven primarily by transaction costs incurred in connection with the Merger, the increase in cash paid for severance, the increase in cash paid for interest of $41 million and the timing of working capital requirements. 72-------------------------------------------------------------------------------- Table of Contents Investing Activities Cash used in investing activities was $58 million for the fiscal year ended September 30, 2012, compared to $1.447 billion for the twelve months ended September 30, 2011 and to $85 million for the fiscal year ended September 30, 2010. Cash used in investing activities of $58 million consisted of $32 million to acquire music publishing rights, $32 million for capital expenditures and $8 million to acquire businesses, net of cash acquired, partially offset by $12 million received for the sale of a building and $2 million received for the sale of a recorded music catalog. Cash used in investing activities of $1.447 billion for the twelve months ended September 30, 2011 consisted of $48 million of capital expenditures primarily related to software infrastructure improvements, cash used of $62 million to acquire music publishing rights, $59 million to acquire businesses, net of cash acquired and $1.278 billion related to the purchase of shares of our common stock in connection with the acquisition of our Company by Access. Cash used in investing activities of $85 million for the fiscal year ended September 30, 2010 consisted primarily $51 million of capital expenditures primarily related to software infrastructure improvements, cash used of $36 million to acquire music publishing rights, cash used for acquisitions totaling $7 million, net of cash acquired, offset by $9 million of cash proceeds received in the connection with the sale of our equity investment in lala media, inc. Financing Activities Cash used in financing activities was $3 million for the fiscal year ended September 30, 2012 compared to cash provided by financing activities of $1.204 billion for the twelve months ended September 30, 2011 and cash used in financing activities of $3 million for the fiscal year ended September 30, 2010. Cash used in financing activities of $3 million for the fiscal year ended September 30, 2012 consisted of distributions to our noncontrolling interest holders. Cash provided by financing activities of $1.204 billion for the twelve months ended September 30, 2011 consisted primarily of a capital contribution received from Parent of $1.099 billion, net proceeds from the issuance of the Unsecured WMG Notes of $747 million, net proceeds from the issuance of the Second Tranche of Old Secured Notes of $157 million, proceeds from the issuance of the Holdings Notes of $150 million and proceeds from the exercise of stock options of $6 million, partially offset by full repayment of the Old Acquisition Corp. Notes of $626 million, the full repayment of the Old Holdings Notes of $258 million, deferred financing fees related to new debt obligations of $70 million and distributions to our noncontrolling interest holders of $1 million. Cash used in financing activities of $3 million for the fiscal year ended September 30, 2010 consisted of distributions to our noncontrolling interest holders. Liquidity Our primary sources of liquidity are the cash flows generated from our subsidiaries' operations, available cash and equivalents and short-term investments and funds available for drawing under our New Revolving Credit Facility. These sources of liquidity are needed to fund our debt service requirements, working capital requirements, capital expenditure requirements, strategic acquisitions and investments, and any dividends or repurchases of our outstanding notes in open market purchases, privately negotiated purchases or otherwise, we may elect to pay or make in the future. We believe that our existing sources of cash will be sufficient to support our existing operations over the next fiscal year. On November 1, 2012, we completed the 2012 Refinancing. As a result, our long-term debt following the 2012 Refinancing differs from the amounts described below as of September 30, 2012. The 2012 Refinancing, and resulting changes, are described further below. 73 -------------------------------------------------------------------------------- Table of Contents Existing Debt as of September 30, 2012 As of September 30, 2012 (Successor), our long-term debt was as follows: Revolving Credit Facility (a) $ - 9.50% Senior Secured Notes due 2016-Acquisition Corp. (b) 1,151 9.50% Senior Secured Notes due 2016-Acquisition Corp. (c) 156 11.5% Senior Notes due 2018-Acquisition Corp. (d) 749 13.75% Senior Notes due 2019-Holdings 150 Total long term debt $ 2,206 (a) Reflects $60 million of commitments under the Old Revolving Credit Facility, less letters of credit outstanding of approximately $1 million at September 30, 2012, which was replaced by the New Revolving Credit Facility. There were no loans outstanding under the Old Revolving Credit Facility as of September 30, 2012. (b) Face amount of $1.1 billion plus unamortized premium of $51 million. These notes were refinanced in connection with 2012 Refinancing. (c) Face amount of $150 million plus unamortized premium of $6 million. These notes were refinanced in connection with 2012 Refinancing. (d) Face amount of $765 million less unamortized discount of $16 million. Old Revolving Credit Facility In connection with the Merger, Acquisition Corp. entered into a credit agreement dated July 20, 2011 (the "Old Revolving Credit Agreement") for a senior secured revolving credit facility with Credit Suisse AG, as administrative agent, and the other financial institutions and lenders from time to time party thereto (the "Old Revolving Credit Facility"). We retired the Old Revolving Credit Facility in connection with the 2012 Refinancing and replaced it with the New Revolving Credit Facility as described further below. Old Secured Notes Acquisition Corp. issued $1.1 billion aggregate principal amount of its 9.50% Senior Secured Notes due 2016 (the "First Tranche of Old Secured Notes") in 2009 pursuant to the Indenture, dated as of May 28, 2009, among us, the guarantors party thereto, and Wells Fargo Bank, National Association as trustee. The First Tranche of Old Secured Notes would have matured on June 15, 2016 and bore interest payable semi-annually on June 15 and December 15 of each year at a fixed rate of 9.50% per annum. In addition, in connection with the Merger, the Initial OpCo Issuer issued $150 million aggregate principal amount of 9.50% Senior Secured Notes due 2016 (the "Second Tranche of Old Secured Notes" and, together with the First Tranche of Old Secured Notes, the "Old Secured Notes") pursuant to the Indenture, dated as of July 20, 2011, between the Initial OpCo Issuer and Wells Fargo, as trustee. The Second Tranche of Old Secured Notes would have matured on June 15, 2016 and bore interest payable semi-annually on June 15 and December 15 of each year at fixed rate of 9.50% per annum. As part of the 2012 Refinancing, we refinanced all of the Old Secured Notes. On October 17, 2012, we commenced tender offers and consent solicitations for any and all of the Old Secured Notes. On October 29, 2012, we received consents from holders of at least a majority of the outstanding aggregate principal amount of the Old Secured Notes and entered into supplemental indentures with the trustee for each of the indentures pursuant to which the Old Secured Notes were outstanding to eliminate certain restrictive covenants contained in those indentures. On November 1, 2012, we accepted for purchase in connection with the tender offers and related consent solicitations such notes as had been tendered at or prior to 5:00 p.m., New York City time, on 74-------------------------------------------------------------------------------- Table of Contents October 31, 2012 (the "Consent Time"). We then issued a notice of redemption relating to all Old Secured Notes not accepted for payment on November 1, 2012 (such notes the "Remaining Notes"). Following payment for the Old Secured Notes tendered at or prior to the Consent Time, we deposited with the Trustee for the Old Secured Notes funds sufficient to satisfy all obligations remaining under the indentures with respect to the Old Secured Notes not accepted for payment on November 1, 2012. The trustee then entered into Satisfaction and Discharge of indentures, each dated as of November 1, 2012, with respect to each indenture governing the Old Secured Notes, discharging our obligations under the Old Secured Notes. The Remaining Notes were redeemed on December 3, 2012. Unsecured WMG Notes On the Merger Closing Date, the Initial OpCo Issuer issued $765 million aggregate principal amount of the Unsecured WMG Notes pursuant to the Indenture, dated as of the Merger Closing Date (as amended and supplemented, the "Unsecured WMG Notes Indenture"), between the Initial OpCo Issuer and Wells Fargo Bank, National Association as trustee (the "Trustee"). Following the completion of the OpCo Merger on the Merger Closing Date, Acquisition Corp. and certain of its domestic subsidiaries (the "Guarantors") entered into a Supplemental Indenture, dated as of the Merger Closing Date (the "Unsecured WMG Notes First Supplemental Indenture"), with the Trustee, pursuant to which (i) Acquisition Corp. became a party to the indenture and assumed the obligations of the Initial OpCo Issuer under the Unsecured WMG Notes and (ii) each Guarantor became a party to the Unsecured WMG Notes Indenture and provided an unconditional guarantee of the obligations of Acquisition Corp. under the Unsecured WMG Notes. The Unsecured WMG Notes were issued at 97.673% of their face value for total net proceeds of $747 million, with an effective interest rate of 12%. The original issue discount (OID) was $17 million. The OID is the difference between the stated principal amount and the issue price. The OID will be amortized over the term of the Unsecured WMG Notes using the effective interest rate method and reported as non-cash interest expense. The Unsecured WMG Notes mature on October 1, 2018 and bear interest payable semi-annually on April 1 and October 1 of each year at fixed rate of 11.50% per annum. Ranking The Unsecured WMG Notes are Acquisition Corp.'s general unsecured senior obligations. The Unsecured WMG Notes rank senior in right of payment to Acquisition Corp.'s existing and future subordinated indebtedness; rank equally in right of payment with all of Acquisition Corp.'s existing and future senior indebtedness, including the New Secured Notes and indebtedness under the New Senior Credit Facilities are effectively subordinated to all of Acquisition Corp.'s existing and future secured indebtedness, including the New Secured Notes and indebtedness under the New Senior Credit Facilities, to the extent of the assets securing such indebtedness; and are structurally subordinated to all existing and future indebtedness and other liabilities of any of Acquisition Corp.'s non-guarantor subsidiaries (other than indebtedness and liabilities owed to Acquisition Corp. or one of its subsidiary guarantors (as such term is defined below)), to the extent of the assets of such subsidiaries. Guarantees The Unsecured WMG Notes are fully and unconditionally guaranteed on a senior unsecured basis by each of Acquisition Corp.'s existing direct or indirect wholly owned domestic subsidiaries, except for certain excluded subsidiaries, and by any such subsidiaries that guarantee other indebtedness of Acquisition Corp. in the future. Such subsidiary guarantors are collectively referred to herein as the "subsidiary guarantors," and such subsidiary guarantees are collectively referred to herein as the "subsidiary guarantees." Each subsidiary guarantee ranks senior in right of payment to all existing and future subordinated obligations of such subsidiary guarantor; ranks equally in right of payment with all of such subsidiary guarantor's existing and future senior indebtedness, including such subsidiary 75-------------------------------------------------------------------------------- Table of Contents guarantor's guarantee of the Existing Secured Notes, indebtedness under the Revolving Credit Facility and the Secured WMG Notes; is effectively subordinated to all of such subsidiary guarantor's existing and future secured indebtedness, including such subsidiary guarantor's guarantee of the Existing Secured Notes, indebtedness under the Revolving Credit Facility and the Secured WMG Notes, to the extent of the assets securing such indebtedness; and is structurally subordinated to all existing and future indebtedness and other liabilities of any non-guarantor subsidiary of such subsidiary guarantor (other than indebtedness and liabilities owed to Acquisition Corp. or one of its subsidiary guarantors), to the extent of the assets of such subsidiary. Any subsidiary guarantee of the Unsecured WMG Notes may be released in certain circumstances. The Unsecured WMG Notes are not guaranteed by Holdings. Optional Redemption Acquisition Corp. may redeem the Unsecured WMG Notes, in whole or in part, at any time prior to October 1, 2014, at a price equal to 100% of the principal amount thereof, plus the applicable make-whole premium and accrued and unpaid interest and special interest, if any, on the Unsecured WMG Notes to be redeemed to the applicable redemption date. On or after October 1, 2014, Acquisition Corp. may redeem all or a part of the Unsecured WMG Notes, at its option, at the redemption prices (expressed as percentages of principal amount) set forth below plus accrued and unpaid interest and special interest, if any, on the Unsecured WMG Notes to be redeemed to the applicable redemption date, if redeemed during the twelve-month period beginning on October 1 of the years indicated below: Year Percentage 2014 108.625 % 2015 105.750 % 2016 102.875 % 2017 and thereafter 100.000 % In addition, at any time (which may be more than once) before October 1, 2014, Acquisition Corp. may redeem up to 35% of the aggregate principal amount of the Unsecured WMG Notes with the net cash proceeds of certain equity offerings at a redemption price of 111.50%, plus accrued and unpaid interest and special interest, if any, to the applicable redemption date; provided that: (1) at least 50% of the aggregate principal amount of Unsecured WMG Notes originally issued under the Unsecured WMG Notes Indenture remains outstanding immediately after the occurrence of such redemption; and (2) the redemption occurs within 90 days of the date of, and may be conditioned upon, the closing of such equity offering. Change of Control Upon the occurrence of certain events constituting a change of control, Acquisition Corp. is required to make an offer to repurchase all of Unsecured WMG Notes (unless otherwise redeemed) at a purchase price equal to 101% of their principal amount, plus accrued and unpaid interest and special interest, if any to the repurchase date. Covenants The Unsecured WMG Notes Indenture contains covenants that, among other things, limit Acquisition Corp.'s ability and the ability of most of its subsidiaries to: incur additional debt or issue certain preferred shares; pay dividends on or make distributions in respect of its capital stock or make investments or other restricted payments; create restrictions on the ability of its restricted subsidiaries to pay dividends to Acquisition Corp. or make certain other intercompany transfers; sell certain assets; create liens securing certain debt; consolidate, merge, sell or otherwise dispose of all or substantially all of its assets. 76 -------------------------------------------------------------------------------- Table of Contents Events of Default Events of default under the Unsecured WMG Notes Indenture are limited to: the nonpayment of principal or interest when due, violation of covenants and other agreements contained in the Unsecured WMG Notes Indenture, cross payment default after final maturity and cross acceleration of certain material debt, certain bankruptcy and insolvency events, material judgment defaults, and actual or asserted invalidity of a guarantee of a significant subsidiary subject to customary notice and grace period provisions. The occurrence of an event of default would permit or require the principal of and accrued interest on the Unsecured WMG Notes to become or to be declared due and payable. Consents On October 22, 2012, we commenced consent solicitations (the "Consent Solicitation") relating to the outstanding Unsecured WMG Notes and the Holdings Notes. We entered into supplemental indentures to the indentures governing the Unsecured WMG Notes and the Holdings Notes, as applicable, after the requisite consents with respect to the applicable consent solicitations were received. The supplemental indentures amended the applicable indentures to permit us to incur additional secured indebtedness under certain circumstances. Holdings Notes On the Closing Date, the Initial Holdings Issuer issued $150 million aggregate principal amount of the Holdings Notes pursuant to the Indenture, dated as of the Closing Date (as amended and supplemented, the "Holdings Notes Indenture"), between the Initial Holdings Issuer and Wells Fargo Bank, National Association as Trustee (the "Trustee"). Following the completion of the Holdings Merger on the Closing Date, Holdings entered into a Supplemental Indenture, dated as of the Closing Date (the "Holdings Notes First Supplemental Indenture"), with the Trustee, pursuant to which Holdings became a party to the Indenture and assumed the obligations of the Initial Holdings Issuer under the Holdings Notes. The Holdings Notes were issued at 100% of their face value. The Holdings Notes mature on October 1, 2019 and bear interest payable semi-annually on April 1 and October 1 of each year at fixed rate of 13.75% per annum. Ranking The Holdings Notes are Holdings' general unsecured senior obligations. The Holdings Notes rank senior in right of payment to Holdings' existing and future subordinated indebtedness; rank equally in right of payment with all of Holdings' existing and future senior indebtedness; are effectively subordinated to the Existing Secured Notes, the indebtedness under the Revolving Credit Facility, and the Secured WMG Notes, to the extent of assets of Holdings securing such indebtedness; are effectively subordinated to all of Holdings' existing and future secured indebtedness, to the extent of the assets securing such indebtedness; and are structurally subordinated to all existing and future indebtedness and other liabilities of any of Holdings' non-guarantor subsidiaries (other than indebtedness and liabilities owed to Acquisition Corp. or one of its subsidiary guarantors (as such term is defined below)), Existing Secured Notes, the indebtedness under the Revolving Credit Facility, the Secured WMG Notes, and the Unsecured WMG Notes, to the extent of the assets of such subsidiaries. Guarantee The Holdings Notes are not guaranteed by any of its subsidiaries. Optional Redemption Holdings may redeem the Holdings Notes, in whole or in part, at any time prior to October 1, 2015, at a price equal to 100% of the principal amount thereof, plus the applicable make-whole premium and accrued and unpaid interest and special interest, if any, on the Secured WMG Notes to be redeemed to the applicable redemption date. 77 -------------------------------------------------------------------------------- Table of Contents On or after October 1, 2015, Holdings may redeem all or a part of the Holdings Notes, at its option, at the redemption prices (expressed as percentages of principal amount) set forth below plus accrued and unpaid interest and special interest, if any, on the Holdings Notes to be redeemed to the applicable redemption date, if redeemed during the twelve-month period beginning on October 1 of the years indicated below: Year Percentage 2015 106.875 % 2016 103.438 % 2017 and thereafter 100.000 % In addition, at any time (which may be more than once) before October 1, 2015, Holdings may redeem up to 35% of the aggregate principal amount of the Holdings Notes with the net cash proceeds of certain equity offerings at a redemption price of 113.75%, plus accrued and unpaid interest and special interest, if any, to the applicable redemption date; provided that: (1) at least 50% of the aggregate principal amount of Holdings Notes originally issued under the Holdings Notes Indenture remains outstanding immediately after the occurrence of such redemption; and (2) the redemption occurs within 90 days of the date of, and may be conditioned upon, the closing of such equity offering. Change of Control Upon the occurrence of certain events constituting a change of control, Holdings is required to make an offer to repurchase all of the Holdings Notes (unless otherwise redeemed) at a purchase price equal to 101% of their principal amount, plus accrued and unpaid interest, if any to the repurchase date. Covenants The Holdings Notes Indenture contains covenants that, among other things, limit Holdings' ability and the ability of most of its subsidiaries to: incur additional debt or issue certain preferred shares; create liens securing certain debt; pay dividends on or make distributions in respect of its capital stock or make investments or other restricted payments; create restrictions on the ability of its restricted subsidiaries to pay dividends to Holdings or make certain other intercompany transfers; sell certain assets; consolidate, merge, sell or otherwise dispose of all or substantially all of its assets; and enter into certain transactions with affiliates. Events of Default Events of default under the Holdings Notes Indenture are limited to: the nonpayment of principal or interest when due, violation of covenants and other agreements contained in the Holdings Notes Indenture, cross payment default after final maturity and cross acceleration of certain material debt, certain bankruptcy and insolvency events, and material judgment defaults, subject to customary notice and grace period provisions. The occurrence of an event of default would permit or require the principal of and accrued interest on the Holdings Notes to become or to be declared due and payable. Consents On October 22, 2012, we commenced the Consent Solicitation. We entered into supplemental indentures to the indentures governing the Unsecured WMG Notes and the Holdings Notes, as applicable, after the requisite consents with respect to the applicable consent solicitations were received. The supplemental indentures amended the applicable indentures to permit us to incur additional secured indebtedness under certain circumstances. Guarantee of Holdings Notes On August 2, 2011, the Company issued a guarantee whereby it agreed to fully and unconditionally guarantee (the "Holdings Notes Guarantee"), on a senior unsecured basis, the payments of Holdings on the Holdings Notes. 78-------------------------------------------------------------------------------- Table of Contents Guarantee of Acquisition Corp. Notes On December 8, 2011, the Company issued a guarantee whereby it agreed to fully and unconditionally guarantee (the "Acquisition Corp. Notes Guarantee"), on a senior unsecured basis, the payments of Acquisition Corp. on the Old Secured Notes and the Unsecured WMG Notes. Guarantee of New Secured Notes On November 16, 2012, the Company issued a guarantee whereby it agreed to fully and unconditionally guarantee (the "New Secured Notes Guarantee"), on a senior secured basis, the payments of Acquisition Corp. on the New Secured Notes. Dividends In connection with the consummation of the Merger and the related transactions, cash on hand at the Company was used, among other things, to finance the aggregate Merger Consideration, to make payments in satisfaction of other equity-based interests in the Company under the Merger Agreement, to repay certain of the Company's existing indebtedness and to pay related transaction fees and expenses. See "Overview-The Merger." Refinancing of Old Secured Notes On November 1, 2012, we completed the 2012 Refinancing. In connection with the 2012 Refinancing, we issued new senior secured notes consisting of $500 million aggregate principal amount of dollar notes (the "Dollar Notes") and €175 million aggregate principal amount of euro notes (the "Euro Notes" and, together with the Dollar Notes, the "New Secured Notes" or the "Notes") and entered into new senior secured credit facilities consisting of a $600 million term loan facility (the "Term Loan Facility") and a $150 million revolving credit facility (the "New Revolving Credit Facility" and, together with the Term Loan Facility, the "New Senior Credit Facilities"). The proceeds from the 2012 Refinancing, together with other available sources of cash, were used to pay the total consideration due in connection with the tender offer for all of our previously outstanding $1,250 million of 9.50% senior secured notes due 2016 (the "Old Secured Notes") as well as associated fees and expenses and to redeem all of the remaining Old Secured Notes not tendered in the tender offers. We also retired our existing $60 million revolving Credit Facility in connection with the 2012 Refinancing, replacing it with the New Revolving Credit Facility. As a result of the 2012 Refinancing, our annual cash payments for interest will decrease. In addition, as part of the 2012 Refinancing, we commenced consent solicitations relating to our outstanding unsecured notes. On October 29, 2012, valid consents from unaffiliated holders of a majority in aggregate principal amount of the outstanding notes were received and we executed supplemental indentures to effect amendments to the related indentures to increase our capacity to incur senior secured indebtedness. Following the consummation of the 2012 Refinancing, we would have had pro forma total consolidated long-term indebtedness as of September 30, 2012 as follows (in millions): Revolving Credit Facility-Acquisition Corp. (a) $ 31 Term Loan Facility due 2018-Acquisition Corp. (b) 594 6.0% Senior Secured Notes due 2021-Acquisition Corp. 500 6.25% Senior Secured Notes due 2021-Acquisition Corp. (c) 225 11.5% Senior Unsecured Notes due 2018-Acquisition Corp. (d) 749 13.75% Senior Notes due 2019-Holdings 150 Total long term debt $ 2,249 (a) Reflects $150 million of commitments under the New Revolving Credit Facility of which $31 million was drawn at closing of the 2012 Refinancing, less letters of credit outstanding of approximately $1 million at closing of the 2012 Refinancing. We repaid in full the $31 million of borrowings incurred under the New Revolving Credit Facility in connection with the 2012 Refinancing on December 3, 2012. 79 -------------------------------------------------------------------------------- Table of Contents (b) Face amount of $600 million less unamortized discount of $6 million. (c) Face amount of €175 million. Amount above represents the dollar equivalent of such notes as of September 30, 2012. (d) Face amount of $765 million less unamortized discount of $16 million. New Debt The following is a description of our New Revolving Credit Facility, Term Loan Facility and New Secured Notes which are now outstanding following completion of the 2012 Refinancing. New Revolving Credit Facility On November 1, 2012 (the "2012 Refinancing Closing Date"), Acquisition Corp. entered into a credit agreement (the "Revolving Credit Agreement") for a senior secured revolving credit facility with Credit Suisse AG, as administrative agent, and the other financial institutions and lenders from time to time party thereto (the "New Revolving Credit Facility"). General Acquisition Corp. is the borrower (the "Revolving Borrower") under the New Revolving Credit Facility. The New Revolving Credit Facility provides for a revolving credit facility in the amount of up to $150,000,000 (the "Commitments") and includes a $50,000,000 letter of credit sub-facility. Amounts are available under the New Revolving Credit Facility in U.S. dollars, euros or pounds Sterling. The New Revolving Credit Facility permits loans for general corporate purposes. The New Revolving Credit Facility may also be utilized to issue letters of credit on or after the 2012 Refinancing Closing Date. The final maturity of the New Revolving Credit Facility will be five years from the 2012 Refinancing Closing Date. Interest Rates and Fees The loans under the Revolving Credit Agreement bear interest at Revolving Borrower's election at a rate equal to (i) the rate for deposits in the currency in which the applicable borrowing is denominated in the London interbank market (adjusted for maximum reserves) for the applicable interest period ("Revolving LIBOR Rate"), plus 3.50% per annum, or (ii) the base rate, which is the highest of (x) the corporate base rate established by the administrative agent from time to time, (y) the overnight federal funds rate plus 0.50% and (z) the one-month Revolving LIBOR Rate plus 1.0% per annum, plus, in each case, 2.50% per annum. If there is a payment default at any time, then the interest rate applicable to overdue principal will be the rate otherwise applicable to such loan plus 2.0% per annum. Default interest will also be payable on other overdue amounts at a rate of 2.0% per annum above the amount that would apply to an alternative base rate loan. The New Revolving Credit Facility bears a facility fee equal to 0.50%, payable quarterly in arrears, based on the daily commitments during the preceding quarter. The New Revolving Credit Facility bears customary letter of credit fees. Acquisition Corp. is also required to pay certain upfront fees to lenders and agency fees to the agent under the New Revolving Credit Facility, in the amounts and at the times agreed between the relevant parties. Prepayments If, at any time, the aggregate amount of outstanding loans (including letters of credit outstanding thereunder) exceeds the Commitments, prepayments of the loans (and after giving effect to such prepayment the cash collateralization of letters of credit) will be required in an amount equal to such excess. The application of 80 -------------------------------------------------------------------------------- Table of Contents proceeds from mandatory prepayments shall not reduce the aggregate amount of then effective commitments under the New Revolving Credit Facility and amounts prepaid may be reborrowed, subject to then effective commitments under the New Revolving Credit Facility. Voluntary reductions of the unutilized portion of the Commitments and prepayments of borrowings under the New Revolving Credit Facility are permitted at any time, in minimum principal amounts as set forth in the New Revolving Credit Facility, without premium or penalty, subject to reimbursement of the lenders' redeployment costs actually incurred in the case of a prepayment of LIBOR-based borrowings other than on the last day of the relevant interest period. Ranking The indebtedness incurred under the New Revolving Credit Facility constitutes senior secured obligations of the Revolving Borrower, which are secured on an equal and ratable basis with all existing and future indebtedness secured with the same security arrangements as the New Revolving Credit Facility. Indebtedness incurred under the New Revolving Credit Facility ranks senior in right of payment to the Revolving Borrower's subordinated indebtedness; ranks equally in right of payment with all of the Revolving Borrower's existing and future senior indebtedness, including indebtedness under the Term Loan Credit Agreement (as defined below), the New Secured Notes and any future senior secured credit facility; is effectively senior to the Revolving Borrower's unsecured senior indebtedness, including its existing unsecured notes, to the extent of the value of the collateral securing the New Revolving Credit Facility; and is structurally subordinated in right of payment to all existing and future indebtedness and other liabilities of any of the Revolving Borrower's non-guarantor subsidiaries (other than indebtedness and liabilities owed to the Revolving Borrower or one of its Subsidiary Guarantors (as defined below)). Guarantee Certain of the domestic subsidiaries of Acquisition Corp. entered into a Subsidiary Guaranty, dated as of the 2012 Refinancing Closing Date (the "Revolving Subsidiary Guaranty"), pursuant to which all obligations under the New Revolving Credit Facility are guaranteed by Acquisition Corp.'s existing subsidiaries that guarantee the New Secured Notes and each other direct and indirect wholly-owned U.S. subsidiary, other than certain excluded subsidiaries (collectively, the "Subsidiary Guarantors"). Covenants, Representations and Warranties The New Revolving Credit Facility contains customary representations and warranties and customary affirmative and negative covenants. The negative covenants are limited to the following: limitations on dividends on, and redemptions and purchases of, equity interests and other restricted payments, limitations on prepayments, redemptions and repurchases of certain debt, limitations on liens, limitations on loans and investments, limitations on debt, guarantees and hedging arrangements, limitations on mergers, acquisitions and asset sales, limitations on transactions with affiliates, limitations on changes in business conducted by the Revolving Borrower and its subsidiaries, limitations on restrictions on ability of subsidiaries to pay dividends or make distributions and limitations on amendments of subordinated debt and unsecured bonds. The negative covenants are subject to customary and other specified exceptions. There are no financial covenants included in the Revolving Credit Agreement, other than a springing leverage ratio, which will be tested only when there are loans outstanding under the Revolving Credit Facility in excess of $30,000,000 (excluding (i) letters of credit that have been cash collateralized and (ii) undrawn outstanding letters of credit that have not been cash collateralized not exceeding $20,000,000). 81-------------------------------------------------------------------------------- Table of Contents Events of Default Events of default under the Revolving Credit Agreement are limited to nonpayment of principal, interest or other amounts, violation of covenants, incorrectness of representations and warranties in any material respect, cross default and cross acceleration of certain material debt, bankruptcy, material judgments, ERISA events, actual or asserted invalidities of the Revolving Credit Agreement, guarantees or security documents and a change of control, in each case subject to customary notice and grace period provisions. Term Loan Facility On the 2012 Refinancing Closing Date, Acquisition Corp. entered into a credit agreement (the "Term Loan Credit Agreement") for a senior secured term loan credit facility with Credit Suisse AG, as administrative agent, and the other financial institutions and lenders from time to time party thereto (the "Term Loan Facility" and, together with the New Revolving Credit Facility, the "New Senior Credit Facilities"). General Acquisition Corp.is the borrower (the "Term Loan Borrower") under the Term Loan Facility. The Term Loan Facility provides for term loans thereunder (the "Term Loans") in an amount of up to $600,000,000. The Term Loan Facility also permits the Term Loan Borrower to add one or more incremental term loan facilities of up to $300,000,000 plus a certain amount depending on a senior secured indebtedness to EBITDA ratio included in the Term Loan Facility (subject to the conditions set forth therein). The Term Loan Facility will mature on November 1, 2018. Interest Rates and Fees The loans under the Term Loan Credit Agreement bear interest at Term Loan Borrower's election at a rate equal to (i) the rate for deposits in U.S. dollars in the London interbank market (adjusted for maximum reserves) for the applicable interest period ("Term Loan LIBOR Rate"), plus 4.00% per annum, or (ii) the base rate, which is the highest of (x) the corporate base rate established by the administrative agent from time to time, (y) the overnight federal funds rate plus 0.50% and (z) the one-month Term Loan LIBOR Rate plus 1.0% per annum, plus, in each case, 3.00% per annum. The Term Loan LIBOR Rate shall be deemed to be not less than 1.25%. If there is a payment default at any time, then the interest rate applicable to overdue principal and interest will be the rate otherwise applicable to such loan plus 2.0% per annum. Default interest will also be payable on other overdue amounts at a rate of 2.0% per annum above the amount that would apply to an alternative base rate loan. Customary fees will be payable in respect of the Term Loan Facility. Scheduled Amortization The Term Loans under the Term Loan Facility will amortize in equal quarterly installments in aggregate annual amounts equal to 5.00% of the original principal amount of the Term Loan Facility with the balance payable on maturity date of the Term Loans; provided further that the individual applicable lenders may agree to extend the maturity of their Term Loans upon the Term Loan Borrower's request and without the consent of any other applicable lender. Prepayments The Term Loans may be prepaid without premium or penalty, except that, if such Term Loans are prepaid on or prior to the first anniversary of the 2012 Refinancing Closing Date pursuant to a Repricing Transaction (as defined in the Term Loan Credit Agreement), a 1.00% prepayment premium will apply. 82-------------------------------------------------------------------------------- Table of Contents Subject to certain exceptions, the Term Loan Facility will be subject to mandatory prepayment in an amount equal to: (i) 100% of the net proceeds (other than those that are used to purchase certain assets or to repay certain other indebtedness) of certain asset sales and certain insurance recovery events; (ii) 100% of the net proceeds (other than those that are used to repay certain other indebtedness) of indebtedness for borrowed money (other than indebtedness incurred in compliance with the debt covenant of the Term Loan Facility); and (iii) 50% of the annual excess cash flow for any fiscal year (as reduced by the repayment of certain indebtedness), such percentage to decrease to 25% and 0% depending on the attainment of certain senior secured debt to EBITDA ratio targets. In addition, in the event of certain events that constitute a Change of Control (as defined in the Term Loan Credit Agreement), Acquisition Corp. may offer to prepay the Term Loans at a price equal to 100% of their principal amount, plus accrued and unpaid interest, if any, to the repayment date. Ranking The indebtedness incurred under the Term Loan Facility constitutes senior secured obligations of the Term Loan Borrower, which are secured on an equal and ratable basis with all existing and future indebtedness secured with the same security arrangements as the Term Loan Facility. Indebtedness incurred under the Term Loan Facility ranks senior in right of payment to the Term Loan Borrower's subordinated indebtedness; ranks equally in right of payment with all of the Term Loan Borrower's existing and future senior indebtedness, including indebtedness under the New Revolving Credit Agreement, the New Secured Notes and any future senior secured credit facility; is effectively senior to the Term Loan Borrower's unsecured senior indebtedness, including its existing unsecured notes, to the extent of the value of the collateral securing the Term Loan Facility; and is structurally subordinated in right of payment to all existing and future indebtedness and other liabilities of any of the Term Loan Borrower's non-guarantor subsidiaries (other than indebtedness and liabilities owed to the Term Loan Borrower or one of its Subsidiary Guarantors). Guarantee The Subsidiary Guarantors entered into a Guarantee Agreement, dated as of the 2012 Refinancing Closing Date (the "Term Loan Guarantee Agreement"), pursuant to which all obligations under the Term Loan Facility are guaranteed by the Subsidiary Guarantors. Covenants, Representations and Warranties The Term Loan Facility contains customary representations and warranties and customary affirmative and negative covenants. The Term Loan Facility contains negative covenants limiting, among other things, Acquisition Corp.'s ability and the ability of most of its subsidiaries to: incur additional indebtedness or issue certain preferred shares; pay dividends on or make distributions in respect of its capital stock or make investments or other restricted payments; create restrictions on the ability of its restricted subsidiaries to pay dividends to it or make certain other intercompany transfers; sell certain assets; create liens; consolidate, merge, sell or otherwise dispose of all or substantially all of its assets; repurchase or repay certain indebtedness following a change of control; and enter into certain transactions with its affiliates. Events of Default Events of default under the Term Loan Credit Agreement are limited to nonpayment of principal, interest or other amounts, violation of covenants, incorrectness of representations and warranties in any material respect, 83-------------------------------------------------------------------------------- Table of Contents cross default and cross acceleration of certain material debt, bankruptcy, material judgments, ERISA events, actual or asserted invalidities of the security documents and a change of control (subject to the Term Loan Borrower's ability to make an offer to prepay the Term Loans), in each case subject to customary notice and grace period provisions. New Secured Notes On the 2012 Refinancing Closing Date, Acquisition Corp. issued (i) $500 million in aggregate principal amount of its 6.000% Senior Secured Notes due 2021 (the "Dollar Notes") and (ii) €175 million in aggregate principal amount of its 6.250% Senior Secured Notes due 2021 (the "Euro Notes" and, together with the Dollar Notes, the "New Secured Notes" or the "Notes") under the Indenture, dated as of November 1, 2012 (the "Base Indenture"), among the Issuer, the guarantors party thereto, Credit Suisse AG, as Notes Authorized Agent and Collateral Agent and Wells Fargo Bank, National Association, as Trustee (the "Trustee"), as supplemented by the First Supplemental Indenture, dated as of November 1, 2012 (the "Euro Supplemental Indenture"), among Acquisition Corp., the guarantors party thereto and the Trustee, in the case of the Euro Notes, and the Second Supplemental Indenture, dated as of November 1, 2012, among the Issuer, the guarantors party thereto and the Trustee, in the case of the Dollar Notes (the "Dollar Supplemental Indenture" and, the Base Indenture, together with the Euro Supplemental Indenture or the Dollar Supplemental Indenture, as applicable, the "Indenture"). Interest on the Dollar Notes will accrue at the rate of 6.000% per annum and will be payable semi-annually in arrears on January 15 and July 15, commencing on July 15, 2013. Interest on the Euro Notes will accrue at the rate of 6.250% per annum and will be payable semi-annually in arrears on January 15 and July 15, commencing on July 15, 2013. Ranking The Notes are Acquisition Corp.'s senior secured obligations and are secured on an equal and ratable basis with all existing and future indebtedness secured with the same security arrangements as the Notes. The Notes rank senior in right of payment to the Issuer's subordinated indebtedness; rank equally in right of payment with all of the Issuer's existing and future senior indebtedness, including indebtedness under the New Senior Credit Facilities and any future senior secured credit facility; are effectively senior to the Issuer's unsecured senior indebtedness, including its existing unsecured notes, to the extent of the value of the collateral securing the Notes; and are structurally subordinated in right of payment to all existing and future indebtedness and other liabilities of any of the Issuer's non-guarantor subsidiaries (other than indebtedness and liabilities owed to Acquisition Corp. or one of its subsidiary guarantors (as such term is defined below)). Guarantees The Notes are fully and unconditionally guaranteed on a senior secured basis by each of the Issuer's existing direct or indirect wholly-owned domestic restricted subsidiaries and by any such subsidiaries that guarantee obligations of the Issuer under the New Senior Credit Facilities, subject to customary exceptions. Such subsidiary guarantors are collectively referred to herein as the "subsidiary guarantors," and such subsidiary guarantees are collectively referred to herein as the "subsidiary guarantees." Each subsidiary guarantee is a senior secured obligation of such subsidiary guarantor and is secured on an equal and ratable basis with all existing and future obligations of such subsidiary guarantor that are secured with the same security arrangements as the guarantee of the Notes (including the subsidiary guarantor's guarantee of obligations under the New Senior Credit Facilities). Each subsidiary guarantee ranks senior in right of payment to all subordinated obligations of the subsidiary guarantor; is effectively senior to the subsidiary guarantor's existing unsecured obligations, including the subsidiary guarantor's guarantee of Acquisition Corp.'s existing senior unsecured notes, to the extent of the collateral securing such guarantee; ranks equally in right of payment with all of the subsidiary guarantor's existing and future senior obligations, including the subsidiary guarantor's guarantee of obligations under the New Senior Credit Facilities; 84 -------------------------------------------------------------------------------- Table of Contents and is structurally subordinated in right of payment to all existing and future indebtedness and other liabilities of any non-guarantor subsidiary of the subsidiary guarantor (other than indebtedness and liabilities owed to the Issuer or one of its subsidiary guarantors). Any subsidiary guarantee of the Notes may be released in certain circumstances. Optional Redemption Dollar Notes At any time prior to January 15, 2016, Acquisition Corp. may on any one or more occasions redeem up to 40% of the aggregate principal amount of Dollar Notes (including the aggregate principal amount of any additional securities constituting Dollar Notes) issued under the Indenture, at its option, at a redemption price equal to 106.000% of the principal amount of the Dollar Notes redeemed, plus accrued and unpaid interest thereon, if any, to the date of redemption (subject to the rights of holders of Dollar Notes on the relevant record date to receive interest on the relevant interest payment date), with funds in an aggregate amount not exceeding the net cash proceeds of one or more equity offerings by Acquisition Corp. or any contribution to Acquisition Corp.'s common equity capital made with the net cash proceeds of one or more equity offerings by Acquisition Corp.'s direct or indirect parent; provided that: (1) at least 50% of the aggregate principal amount of Dollar Notes originally issued under the Indenture (including the aggregate principal amount of any additional securities constituting Dollar Notes issued under the Indenture) remains outstanding immediately after the occurrence of such redemption; and (2) the redemption occurs within 90 days of the date of, and may be conditioned upon, the closing of such equity offering. The Dollar Notes may be redeemed, in whole or in part, at any time prior to January 15, 2016, at the option of Acquisition Corp., at a redemption price equal to 100% of the principal amount of the Dollar Notes redeemed plus the applicable make-whole premium as of, and accrued and unpaid interest thereon, if any, to, the applicable redemption date (subject to the right of holders of record on the relevant record date to receive interest due on the relevant interest payment date). On or after January 15, 2016, Acquisition Corp. may redeem all or a part of the Dollar Notes, at its option, at the redemption prices (expressed as percentages of principal amount) set forth below plus accrued and unpaid interest thereon, if any, on the Dollar Notes to be redeemed to the applicable redemption date, if redeemed during the twelve-month period beginning on January 15 of the years indicated below: Year Percentage 2016 104.500 % 2017 103.000 % 2018 101.500 % 2019 and thereafter 100.000 % In addition, during any 12-month period prior to January 15, 2016, Acquisition Corp. will be entitled to redeem up to 10% of the original aggregate principal amount of the Dollar Notes (including the principal amount of any additional securities of the same series) at a redemption price equal to 103.000% of the aggregate principal amount thereof, plus accrued and unpaid interest thereon, if any, to the redemption date (subject to the right of holders of record on the relevant record date to receive interest due on the relevant interest payment date). 85 -------------------------------------------------------------------------------- Table of Contents Euro Notes At any time prior to January 15, 2016, Acquisition Corp. may on any one or more occasions redeem up to 40% of the aggregate principal amount of Euro Notes (including the aggregate principal amount of any additional securities constituting Euro Notes) issued under the Indenture, at its option, at a redemption price equal to 106.250% of the principal amount of the Euro Notes redeemed, plus accrued and unpaid interest thereon, if any, to the date of redemption (subject to the rights of holders of Euro Notes on the relevant record date to receive interest on the relevant interest payment date), with funds in an aggregate amount not exceeding the net cash proceeds of one or more equity offerings by Acquisition Corp. or any contribution to Acquisition Corp.'s common equity capital made with the net cash proceeds of one or more equity offerings by Acquisition Corp.'s direct or indirect parent; provided that: (1) at least 50% of the aggregate principal amount of Euro Notes originally issued under the Indenture (including the aggregate principal amount of any additional securities constituting Euro Notes) remains outstanding immediately after the occurrence of such redemption; and (2) the redemption occurs within 90 days of the date of, and may be conditioned upon, the closing of such equity offering. The Euro Notes may be redeemed, in whole or in part, at any time prior to January 15, 2016, at the option of the Issuer, at a redemption price equal to 100% of the principal amount of the Euro Notes redeemed plus the applicable make-whole premium as of, and accrued and unpaid interest thereon, if any, to, the applicable redemption date (subject to the right of holders of record on the relevant record date to receive interest due on the relevant interest payment date). On or after January 15, 2016, Acquisition Corp. may redeem all or a part of the Euro Notes, at its option, at the redemption prices (expressed as percentages of principal amount) set forth below plus accrued and unpaid interest thereon, if any, on the Euro Notes to be redeemed to the applicable redemption date, if redeemed during the twelve-month period beginning on January 15 of the years indicated below: Year Percentage 2016 104.688 % 2017 103.125 % 2018 101.563 % 2019 and thereafter 100.000 % In addition, during any 12-month period prior to January 15, 2016, Acquisition Corp. will be entitled to redeem up to 10% of the original aggregate principal amount of the Euro Notes (including the principal amount of any additional securities of the same series) at a redemption price equal to 103.000% of the aggregate principal amount thereof, plus accrued and unpaid interest thereon, if any, to the redemption date (subject to the right of holders of record on the relevant record date to receive interest due on the relevant interest payment date). Change of Control Upon the occurrence of a change of control, which is defined in the Base Indenture, each holder of the Notes has the right to require Acquisition Corp. to repurchase some or all of such holder's Notes at a purchase price in cash equal to 101% of the principal amount thereof, plus accrued and unpaid interest, if any, to the repurchase date. Covenants The Indenture contains covenants limiting, among other things, Acquisition Corp.'s ability and the ability of most of its subsidiaries to: incur additional indebtedness or issue certain preferred shares; pay dividends on or 86-------------------------------------------------------------------------------- Table of Contents make distributions in respect of its capital stock or make investments or other restricted payments; create restrictions on the ability of its restricted subsidiaries to pay dividends to it or make certain other intercompany transfers; sell certain assets; create liens; consolidate, merge, sell or otherwise dispose of all or substantially all of its assets; and enter into certain transactions with its affiliates. Events of Default The Indenture also provides for events of default which, if any of them occurs, would permit or require the principal of and accrued interest on Notes to become or to be declared due and payable. Covenant Compliance See "Liquidity" above for a description of the covenants governing our indebtedness. Our Old Revolving Credit Facility contained a springing leverage ratio that was tied to a ratio based on Consolidated EBITDA, which was defined under the Old Revolving Credit Agreement governing the Revolving Credit Facility. Our New Revolving Credit Facility also has a similar springing leverage ratio based on Consolidated EBITDA. Consolidated EBITDA differs from the term "EBITDA" as it is commonly used. For example, the definition of Consolidated EBITDA, in addition to adjusting net income to exclude interest expense, income taxes, and depreciation and amortization, also adjusts net income by excluding items or expenses not typically excluded in the calculation of "EBITDA" such as, among other items, (1) the amount of any restructuring charges or reserves; (2) any non-cash charges (including any impairment charges); (3) any net loss resulting from hedging currency exchange risks; (4) the amount of management, monitoring, consulting and advisory fees paid to Access under the management agreement (as defined in the Credit Agreement); (5) business optimization expenses (including consolidation initiatives, severance costs and other costs relating to initiatives aimed at profitability improvement) and (6) stock-based compensation expense and also includes an add-back for certain projected cost savings and synergies. The indentures governing our notes use a similar financial measure called "EBITDA." However, the financial measure used in the indentures governing the notes may differ from Consolidated EBITDA as presented herein. Consolidated EBITDA may include additional adjustments not included in EBITDA as defined in the indentures, that may cause calculations under such definitions of EBITDA and Consolidated EBITDA, as presented herein, to differ. Consolidated EBITDA is presented herein because it is a material component of the leverage ratio contained in the credit agreements governing the Old Revolving Credit Facility and our New Revolving Credit Facility. Non-compliance with the leverage ratio could result in the inability to use our New Revolving Credit Facility which could have a material adverse effect on our results of operations, financial position and cash flow. Consolidated EBITDA does not represent net income or cash flow from operations as those terms are defined by GAAP and does not necessarily indicate whether cash flows will be sufficient to fund cash needs. While Consolidated EBITDA and similar measures are frequently used as measures of operations and the ability to meet debt service requirements, these terms are not necessarily comparable to other similarly titled captions of other companies due to the potential inconsistencies in the method of calculation. Consolidated EBITDA does not reflect the impact of earnings or charges resulting from matters that we may consider not to be indicative of our ongoing operations. In particular, the definition of Consolidated EBITDA in our credit agreements allow us to add back certain non-cash, extraordinary, unusual or non-recurring charges that are deducted in calculating net income. However, these are expenses that may recur, vary greatly and are difficult to predict. Consolidated EBITDA as presented below is not a measure of the performance of our business and should not be used by investors as an indicator of performance for any future period. Further, our debt instruments require that it be calculated for the most recent four fiscal quarters. As a result, the measure can be disproportionately affected by a particularly strong or weak quarter. Further, it may not be comparable to the measure for any subsequent four-quarter period or any complete fiscal year. 87-------------------------------------------------------------------------------- Table of Contents The following is a reconciliation of net income (loss), which is a GAAP measure of our operating results, to Consolidated EBITDA as defined, and the calculation of the Adjusted Consolidated Funded Indebtedness to Consolidated EBITDA ratio, which we refer to as the leverage ratio, under our credit agreements for the most recently ended four fiscal quarters ended September 30, 2012. The terms and related calculations are defined in the credit agreements. All amounts in the reconciliation below reflect Acquisition Corp.: Twelve Months Ended September 30, 2012 (in millions, except ratios) Net Loss $ (90 ) Income tax expense 1 Interest expense, net 203 Depreciation and amortization 244 Restructuring costs (a) 45 Net hedging losses (b) 1 Management fees (c) 8 Transaction costs (d) 16 Business optimization expenses (e) 6 Proforma savings (f) 30 Consolidated EBITDA $ 464 Consolidated Funded Indebtedness (g) $ 2,032 Leverage Ratio (h) 4.37x Pro Forma Consolidated Funded Indebtedness (i) $ 1,960 Pro Forma Leverage Ratio (j) 4.22x (a) Reflects severance costs and other restructuring related expenses. (b) Reflects net losses from hedging activities. (c) Reflects management fees paid to Access, including an annual fee and related expenses (excludes $2 of expenses reimbursed related to certain consultants with full-time roles at the Company). (d) Reflects costs mainly related to the Company's participation in the EMI sales process, including the subsequent regulatory review. (e) Reflects primarily costs associated with IT systems updates. (f) Reflects net cost savings and synergies projected to result from actions taken or expected to be taken no later than twelve (12) months after the end of such period (calculated on a pro forma basis as though such cost savings and synergies had been realized on the first day of the period for which Consolidated EBITDA is being determined), net of the amount of actual benefits realized during such period from such actions during the twelve months ended September 30, 2012. Pro forma savings reflected in the table above reflect a portion of the previously announced additional targeted savings of $50-$65 million following the Merger as well as other cost savings and synergies. (g) Reflects the principal balance of external debt at Acquisition Corp of $2.015 billion, as well as contractual obligations of deferred purchase price of approximately $6 million and contingent consideration related to acquisitions of approximately $11 million as of September 30, 2012. (h) Reflects the ratio of Consolidated Funded Indebtedness to Consolidated EBITDA, as calculated under the Old Revolving Credit Facility, as of the twelve months ended September 30, 2012 after also giving pro forma effect to certain transactions and the change in consolidated EBITDA resulting therefrom as if they had occurred on the first day of the measurement period. The Old Revolving Credit Facility was replaced by the New Revolving Credit Facility in connection with the 2012 Refinancing. See footnotes (i) and (j) for a calculation of the leverage ratio under the New Revolving Credit Facility. (i) Reflects the principal balance of external debt at Acquisition Corp of $2.090 billion after giving pro forma effect for the 2012 Refinancing, as well as the assumed annualized daily average revolver borrowings of $3 million with respect to the $31 million of revolver borrowings outstanding at the close of the 2012 Refinancing, contractual obligations of deferred purchase price of approximately $6 million and contingent 88 -------------------------------------------------------------------------------- Table of Contents consideration related to acquisitions of approximately $11 million as of September 30, 2012, less cash and cash equivalents of $150 million. We repaid in full the $31 million of borrowings incurred under the New Revolving Credit Facility in connection with the 2012 Refinancing on December 3, 2012. (j) Reflects the ratio of Consolidated Funded Indebtedness (after giving pro forma effect for the 2012 Refinancing) to Consolidated EBITDA, as calculated under the New Revolving Credit Facility, as of the twelve months ended September 30, 2012 after also giving pro forma effect to certain transactions and the change in consolidated EBITDA resulting therefrom as if they had occurred on the first day of the measurement period. If the outstanding aggregate principal amount of borrowings under our New Revolving Credit Facility is greater than $30 million at the end of a fiscal quarter, the maximum leverage ratio permitted under our New Revolving Facility is 6.00x as of the end of any fiscal quarter in fiscal 2013. Summary Management believes that funds generated from our operations and borrowings under our New Revolving Credit Agreement will be sufficient to fund our debt service requirements, working capital requirements and capital expenditure requirements for the foreseeable future. We also have additional borrowing capacity under our indentures and the Term Loan Facility. However, our ability to continue to fund these items and to reduce debt may be affected by general economic, financial, competitive, legislative and regulatory factors, as well as other industry-specific factors such as the ability to control music piracy and the continued industry-wide decline of CD sales. We or any of our affiliates may also, from time to time depending on market conditions and prices, contractual restrictions, our financial liquidity and other factors, seek to repurchase our Holdings Notes, our Acquisition Corp. Unsecured WMG Notes or our Acquisition Corp. New Secured Notes in open market purchases, privately negotiated purchases or otherwise. The amounts involved in any such transactions, individually or in the aggregate, may be material and may be funded from available cash or from additional borrowings. In addition, we may from time to time, depending on market conditions and prices, contractual restrictions, our financial liquidity and other factors, seek to refinance our Holdings Notes, Acquisition Corp. Unsecured WMG Notes and/or our Acquisition Corp. New Secured Notes with existing cash and/or with funds provided from additional borrowings. Contractual and Other Obligations Firm Commitments The following table summarizes the Company's aggregate contractual obligations at September 30, 2012, and the estimated timing and effect that such obligations are expected to have on the Company's liquidity and cash flow in future periods. Fiscal years Less than 1-3 3-5 After 5 Firm Commitments and Outstanding Debt (1) 1 year years years years Total (in millions) First Tranche of Old Secured Notes $ - $ - $ 1,100 $ - $ 1,100 Interest on First Tranche of Old Secured Notes 104 209 74 - 387 Second Tranche of Old Secured Notes - - 150 - 150 Interest on Second Tranche of Old WMG Notes 14 29 10 - 53 Unsecured WMG Notes - - - 765 765 Interest on Unsecured WMG Notes 88 176 176 88 528 Holdings Notes - - - 150 150 Interest on Holdings Notes 21 41 41 41 144 Operating leases 49 80 50 25 204 Artist, songwriter and co-publisher commitments 232 - - - 232 Minimum funding commitments to investees and other obligations 1 3 - - 4 Total firm commitments and outstanding debt $ 509 $ 538 $ 1,601 $ 1,069 $ 3,717 89 -------------------------------------------------------------------------------- Table of Contents (1) Does not reflect the 2012 Refinancing. The following is a description of our firmly committed contractual obligations at September 30, 2012: • Outstanding debt obligations consist of the First Tranche of Old Secured Notes, Second Tranche of Old Secured Notes, Unsecured WMG Notes and the Holdings Notes. These obligations have been presented based on the principal amounts due, current and long term as of September 30, 2012. Amounts do not include any fair value adjustments, bond premiums or discounts. See Note 8 to the audited financial statements for a description of our financing arrangements. • Operating lease obligations primarily relate to the minimum lease rental obligations for our real estate and operating equipment in various locations around the world. These obligations have been presented without the benefit of $20 million of total sublease income expected to be received under non-cancelable agreements. The future minimum payments reflect the amounts owed under our lease arrangements and do not include any fair market value adjustments that may have been recorded as a result of the Acquisition. • The Company routinely enters into long-term commitments with artists, songwriters and co-publishers for the future delivery of music product. Such commitments are payable principally over a ten-year period, and generally become due only upon delivery and Company acceptance of albums from the artists or future musical compositions by songwriters and co-publishers. Additionally, such commitments are typically cancelable at the Company's discretion, generally without penalty. Based on contractual obligations and the Company's expected release schedule, aggregate firm commitments to such talent for the next 12 month period approximates $232 million at September 30, 2012. Because the timing of payment, and even whether payment occurs, is dependent upon the timing of delivery of albums and musical compositions from talent, the timing and amount of payment of these commitments as presented in the above summary can vary significantly. • We have minimum funding commitments and other related obligations to support the operations of various investments, which are reflected in the table above. MARKET RISK MANAGEMENT We are exposed to market risk arising from changes in market rates and prices, including movements in foreign currency exchange rates and interest rates. Foreign Currency Risk We have significant transactional exposure to changes in foreign currency exchange rates relative to the U.S. dollar due to the global scope of our operations. For the fiscal year ended September 30, 2012, prior to intersegment elimination, approximately $1.686 billion, or 60%, of our revenues were generated outside of the U.S. The top five revenue-producing international countries are the U.K., Germany, Japan, France and Italy, which use the British pound sterling, Japanese yen and euro as currencies, respectively. See Note 15 to our audited financial statements included elsewhere herein for information on our operations in different geographical areas. Historically, we have used (and continue to use) foreign exchange forward contracts, primarily to hedge the risk that unremitted or future royalties and license fees owed to our domestic companies for the sale, or anticipated sale, of U.S.-copyrighted products abroad may be adversely affected by changes in foreign currency exchange rates. In addition, we hedge foreign currency risk associated with financing transactions such as third-party and inter-company debt. We focus on managing the level of exposure to the risk of foreign currency exchange rate fluctuations on our major currencies, which include the euro, British pound sterling, Japanese yen, Canadian dollar, Swedish 90-------------------------------------------------------------------------------- Table of Contents krona and Australian dollar. See Note 14 to our audited financial statements included elsewhere herein for additional information. Interest Rate Risk We have $2.206 billion debt outstanding at September 30, 2012. Based on the level of interest rates prevailing at September 30, 2012, the fair value of this fixed-rate debt was approximately $2.390 billion. Further, based on the amount of our fixed-rate debt, a 25 basis point increase or decrease in the level of interest rates would decrease or increase the fair value of the fixed-rate debt by approximately $11 million and $9 million, respectively. This potential increase or decrease is based on the simplified assumption that the level of fixed-rate debt remains constant with an immediate across the board increase or decrease in the level of interest rates with no subsequent changes in rates for the remainder of the period. We monitor our positions with, and the credit quality of, the financial institutions that are party to any of our financial transactions. CRITICAL ACCOUNTING POLICIES The SEC's Financial Reporting Release No. 60, "Cautionary Advice Regarding Disclosure About Critical Accounting Policies" ("FRR 60"), suggests companies provide additional disclosure and commentary on those accounting policies considered most critical. FRR 60 considers an accounting policy to be critical if it is important to our financial condition and results, and requires significant judgment and estimates on the part of management in our application. We believe the following list represents critical accounting policies as contemplated by FRR 60. For a summary of all of our significant accounting policies, see Note 3 to our audited consolidated financial statements included elsewhere herein. Business Combinations We account for our business acquisitions under the Financial Accounting Standards Board ("FASB") Accounting Standards Codification ("ASC") Topic 805, Business Combination ("ASC 805") guidance for business combinations. The total cost of acquisitions is allocated to the underlying identifiable net assets based on their respective estimated fair values. The excess of the purchase price over the estimated fair values of the net assets acquired is recorded as goodwill. Determining the fair value of assets acquired and liabilities assumed requires management's judgment and often involves the use of significant estimates and assumptions, including assumptions with respect to future cash inflows and outflows, discount rates, asset lives and market multiples, among other items. Accounting for Goodwill and Other Intangible Assets We account for our goodwill and other indefinite-lived intangible assets as required by FASB Accounting Standards Codification ("ASC") Topic 350, Intangibles-Goodwill and other ("ASC 350"). Under ASC 350, we no longer amortize goodwill, including the goodwill included in the carrying value of investments accounted for using the equity method of accounting, and certain other intangible assets deemed to have an indefinite useful life. ASC 350 requires that goodwill and certain intangible assets be assessed for impairment using fair value measurement techniques on an annual basis and when events occur that may suggest that the fair value of such assets cannot support the carrying value. Goodwill impairment is tested using a two-step process. The first step of the goodwill impairment test is used to identify potential impairment by comparing the fair value of a reporting unit with its net book value (or carrying amount), including goodwill. In performing the first step, management determines the fair value of its reporting units using a combination of a discounted cash flow ("DCF") analysis and a market-based approach. Determining fair value requires 91-------------------------------------------------------------------------------- Table of Contents significant judgment concerning the assumptions used in the valuation model, including discount rates, the amount and timing of expected future cash flows and, growth rates, as well as relevant comparable company earnings multiples for the market-based approach including the determination of whether a premium or discount should be applied to those comparables. The cash flows employed in the DCF analyses are based on management's most recent budgets and business plans and when applicable, various growth rates have been assumed for years beyond the current business plan periods. Any forecast contains a degree of uncertainty and modifications to these cash flows could significantly increase or decrease the fair value of a reporting unit. For example, if revenue from sales of physical products continues to decline and the revenue from sales of digital products does not continue to grow as expected and we are unable to adjust costs accordingly, it could have a negative impact on future impairment tests. In determining which discount rate to utilize, management determines the appropriate weighted average cost of capital ("WACC") for each reporting unit. Management considers many factors in selecting a WACC, including the market view of risk for each individual reporting unit, the appropriate capital structure and the appropriate borrowing rates for each reporting unit. The selection of a WACC is subjective and modification to this rate could significantly increase or decrease the fair value of a reporting unit. If the fair value of a reporting unit exceeds its carrying amount, goodwill of the reporting unit is considered not impaired and the second step of the impairment test is unnecessary. If the carrying amount of a reporting unit exceeds its fair value, the second step of the goodwill impairment test is performed to measure the amount of impairment loss, if any. The second step of the goodwill impairment test compares the implied fair value of the reporting unit's goodwill with the carrying amount of that goodwill. If the carrying amount of the reporting unit's goodwill exceeds the implied fair value of that goodwill, an impairment loss is recognized in an amount equal to that excess. The implied fair value of goodwill is determined in the same manner as the amount of goodwill recognized in a business combination. That is, the fair value of the reporting unit is allocated to all of the assets and liabilities of that unit (including any unrecognized intangible assets) as if the reporting unit had been acquired in a business combination and the fair value of the reporting unit was the purchase price paid to acquire the reporting unit. As of September 30, 2012, we had recorded goodwill in the amount of $1.380 billion, including $916 million and $464 million for Recorded Music and Music Publishing, respectively, primarily related to the Merger. We test our goodwill and other indefinite-lived intangible assets for impairment on an annual basis in the fourth quarter of each fiscal year as of July 1. The performance of our fiscal 2012 impairment analysis did not result in an impairment of the Company's goodwill and other indefinite-lived intangible assets. The discount rates utilized in the fiscal 2012 analysis ranged from 7% to 15% while the terminal growth rates used in the DCF analysis ranged from 1% to 2%. The percentage by which the fair value of each reporting unit exceeded the respective carrying value was as follows: Percentage by which Fair Value Exceeded Reporting Unit Carrying Value U.S. Recorded Music Greater than 10 % International Recorded Music Greater than 15 % Publishing Greater than 25 % If our assumptions or estimates in the fair value calculation change, we could incur impairment charges in future periods. For example, if the discount rates utilized in our fiscal 2012 annual impairment testing increased by approximately 100-200 basis points, the estimated fair values of our reporting units would have fallen below their carrying values. The impairment test for other intangible assets not subject to amortization involves a comparison of the estimated fair value of the intangible asset with its carrying value. If the carrying value of the intangible asset exceeds its fair value, an impairment loss is recognized in an amount equal to that excess. The estimates of fair 92 -------------------------------------------------------------------------------- Table of Contents value of intangible assets not subject to amortization are determined using a DCF valuation analysis. Common among such approaches is the "relief from royalty" methodology, which is used in estimating the fair value of the Company's trademarks. Discount rate assumptions are based on an assessment of the risk inherent in the projected future cash flows generated by the respective intangible assets. Also subject to judgment are assumptions about royalty rates, which are based on the estimated rates at which similar trademarks are being licensed in the marketplace. See Note 6 to our audited consolidated financial statements contained in our annual report on Form 10-K for the fiscal year ended September 30, 2012 for a further discussion of our goodwill and other intangible assets. Revenue and Cost Recognition Sales Returns and Uncollectible Accounts In accordance with practice in the recorded music industry and as customary in many territories, certain products (such as CDs and DVDs) are sold to customers with the right to return unsold items. Under FASB ASC Topic 605, Revenue Recognition, revenues from such sales are recognized when the products are shipped based on gross sales less a provision for future estimated returns. In determining the estimate of product sales that will be returned, management analyzes historical returns, current economic trends, changes in customer demand and commercial acceptance of our products. Based on this information, management reserves a percentage of each dollar of product sales to provide for the estimated customer returns. Similarly, management evaluates accounts receivables to determine if they will ultimately be collected. In performing this evaluation, significant judgments and estimates are involved, including an analysis of specific risks on a customer-by-customer basis for larger accounts and customers, and a receivables aging analysis that determines the percent that has historically been uncollected by aged category. Based on this information, management provides a reserve for the estimated amounts believed to be uncollectible. Based on management's analysis of sales returns and uncollectible accounts, reserves totaling $63 million and $40 million were established at September 30, 2012 and September 30, 2011, respectively. The ratio of our receivable allowances to gross accounts receivables was 14% at September 30, 2012 and 9% at September 30, 2011. Gross Versus Net Revenue Classification In the normal course of business, we act as an intermediary or agent with respect to certain payments received from third parties. For example, we distribute music product on behalf of third-party record labels. The accounting issue encountered in these arrangements is whether we should report revenue based on the "gross" amount billed to the ultimate customer or on the "net" amount received from the customer after participation and other royalties paid to third parties. To the extent revenues are recorded gross (in the full amount billed), any participations and royalties paid to third parties are recorded as expenses so that the net amount (gross revenues, less expenses) flows through operating income. Accordingly, the impact on operating income is the same, whether we record the revenue on a gross basis or net basis (less related participations and royalties). Determining whether revenue should be reported gross or net is based on an assessment of whether we are acting as the "principal" in a transaction or acting as an "agent" in the transaction. To the extent we are acting as a principal in a transaction, we report as revenue the payments received on a gross basis. To the extent we are acting as an agent in a transaction, we report as revenue the payments received less participations and royalties paid to third parties, i.e., on a net basis. The determination of whether we are serving as principal or agent in a transaction is judgmental in nature and based on an evaluation of the terms of an arrangement. 93-------------------------------------------------------------------------------- Table of Contents In determining whether we serve as principal or agent in these arrangements, we follow the guidance in FASB ASC Subtopic 605-45, Principal Agent Considerations ("ASC 605-45"). Pursuant to such guidance, we serve as the principal in transactions where we have the substantial risks and rewards of ownership. The indicators that we have substantial risks and rewards of ownership are as follows: • we are the supplier of the products or services to the customer; • we have latitude in establishing prices; • we have the contractual relationship with the ultimate customer; • we modify and service the product purchased to meet the ultimate customer specifications; • we have discretion in supplier selection; and • we have credit risk. Conversely, pursuant to ASC 605-45, we serve as agent in arrangements where we do not have substantial risks and rewards of ownership. The indicators that we do not have substantial risks and rewards of ownership are as follows: • the supplier (not the Company) is responsible for providing the product or service to the customer; • the supplier (not the Company) has latitude in establishing prices; • the amount we earn is fixed; • the supplier (not the Company) has credit risk; and • the supplier (not the Company) has general inventory risk for a product before it is sold. Based on the above criteria and for the more significant transactions that we have evaluated, we record the distribution of product on behalf of third-party record labels on a gross basis, subject to the terms of the contract. However, recorded music compilations distributed by other record companies where we have a right to participate in the profits are recorded on a net basis. Accounting for Royalty Advances We regularly commit to and pay royalty advances to our recording artists and songwriters in respect of future sales. We account for these advances under the related guidance in FASB ASC Topic 928, Entertainment-Music ("ASC 928"). Under ASC 928, we capitalize as assets certain advances that we believe are recoverable from future royalties to be earned by the recording artist or songwriter. Advances vary in both amount and expected life based on the underlying recording artist or songwriter. Advances to recording artists or songwriters with a history of successful commercial acceptability will typically be larger than advances to a newer or unproven recording artist or songwriter. In addition, in most cases these advances represent a multi-album release or multi-song obligation and the number of albums releases and songs will vary by recording artist or songwriter. Management's decision to capitalize an advance to a recording artist or songwriter as an asset requires significant judgment as to the recoverability of the advance. The recoverability is assessed upon initial commitment of the advance based upon management's forecast of anticipated revenue from the sale of future and existing albums or songs. In determining whether the advance is recoverable, management evaluates the current and past popularity of the recording artist or songwriter, the sales history of the recording artist or songwriter, the initial or expected commercial acceptability of the product, the current and past popularity of the genre of music that the product is designed to appeal to, and other relevant factors. Based upon this information, management expenses the portion of any advance that it believes is not recoverable. In most cases, advances to recording artists or songwriters without a history of success and evidence of current or past popularity will be expensed immediately. Advances are individually assessed for recoverability continuously and at minimum on a quarterly 94 -------------------------------------------------------------------------------- Table of Contents basis. As part of the ongoing assessment of recoverability, we monitor the projection of future sales based on the current environment, the recording artist's or songwriter's ability to meet their contractual obligations as well as our intent to support future album releases or songs from the recording artist or songwriter. To the extent that a portion of an outstanding advance is no longer deemed recoverable, that amount will be expensed in the period the determination is made. We had $258 million and $308 million of advances in our balance sheet at September 30, 2012 and September 30, 2011, respectively. We believe such advances are recoverable through future royalties to be earned by the applicable recording artists and songwriters. Accounting for Income Taxes As part of the process of preparing the consolidated financial statements, we are required to estimate income taxes payable in each of the jurisdictions in which we operate. This process involves estimating the actual current tax expense together with assessing temporary differences resulting from differing treatment of items for tax and accounting purposes. These differences result in deferred tax assets and liabilities, which are included within our consolidated balance sheets. FASB ASC Topic 740, Income Taxes ("ASC 740"), requires a valuation allowance be established when it is more likely than not that all or a portion of deferred tax assets will not be realized. In circumstances where there is sufficient negative evidence, establishment of a valuation allowance must be considered. We believe that cumulative losses in the most recent three-year period generally represent sufficient negative evidence to consider a valuation allowance under the provisions of ASC 740. As a result, we determined that certain of our deferred tax assets required the establishment of a valuation allowance. The realization of the remaining deferred tax assets is primarily dependent on forecasted future taxable income. Any reduction in estimated forecasted future taxable income may require that we record additional valuation allowances against our deferred tax assets on which a valuation allowance has not previously been established. The valuation allowance that has been established will be maintained until there is sufficient positive evidence to conclude that it is more likely than not that such assets will be realized. An ongoing pattern of profitability will generally be considered as sufficient positive evidence. Our income tax expense recorded in the future may be reduced to the extent of offsetting decreases in our valuation allowance. The establishment and reversal of valuation allowances could have a significant negative or positive impact on our future earnings. From time to time, the Company engages in transactions in which the tax consequences may be subject to uncertainty. Significant judgment is required in assessing and estimating the tax consequences of these transactions. The Company prepares and files tax returns based on its interpretation of tax laws and regulations. In the normal course of business, the Company's tax returns are subject to examination by various taxing authorities. Such examinations may result in future tax and interest assessments by these taxing authorities. In determining the Company's tax provision for financial reporting purposes, the Company establishes a reserve for uncertain tax positions unless such positions are determined to be more likely than not of being sustained upon examination based on their technical merits. There is considerable judgment involved in determining whether positions taken on the Company's tax returns are more likely than not of being sustained. New Accounting Principles In addition to the critical accounting policies discussed above, we adopted several new accounting policies during the past two years. None of these new accounting principles had a material effect on our audited financial statements. See Note 3 to our audited financial statements included elsewhere herein for a complete summary. ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK As discussed in Note 14 to our audited financial statements the Company is exposed to market risk arising from changes in market rates and prices, including movements in foreign currency exchange rates and interest 95-------------------------------------------------------------------------------- Table of Contents rates. As of September 30, 2012, other than as described below, there have been no material changes to the Company's exposure to market risk since September 30, 2011. We have transactional exposure to changes in foreign currency exchange rates relative to the U.S. dollar due to the global scope of our operations. We use foreign exchange contracts, primarily to hedge the risk that unremitted or future royalties and license fees owed to our domestic companies for the sale, or anticipated sale, of U.S.-copyrighted products abroad may be adversely affected by changes in foreign currency exchange rates. We focus on managing the level of exposure to the risk of foreign currency exchange rate fluctuations on our major currencies, which include the British pound sterling, euro, Japanese yen, Canadian dollar, Swedish krona and Australian dollar. As of September 30, 2012, the Company had outstanding hedge contracts for the sale of $349 million and the purchase of $21 million of foreign currencies at fixed rates. Subsequent to September 30, 2012, certain of our foreign exchange contracts expired and were renewed with new foreign exchange contracts with similar features. The fair value of foreign exchange contracts is subject to changes in foreign currency exchange rates. For the purpose of assessing the specific risks, we use a sensitivity analysis to determine the effects that market risk exposures may have on the fair value of our financial instruments. For foreign exchange forward contracts outstanding at September 30, 2012, assuming a hypothetical 10% depreciation of the U.S dollar against foreign currencies from prevailing foreign currency exchange rates and assuming no change in interest rates, the fair value of the foreign exchange forward contracts would have decreased by $33 million. Because our foreign exchange contracts are entered into for hedging purposes, these losses would be largely offset by gains on the underlying transactions. 96 -------------------------------------------------------------------------------- Table of Contents |