Music consumption is soaring thanks to streaming platforms Spotify and Apple Music offering a virtual jukebox and letting people rediscover tracks they’ve enjoyed over the years.

This is great news for investment trust Hipgnosis Songs Fund (SONG) as it collects royalties on more than 13,000 popular songs, helping to fund an attractive stream of dividends for shareholders.

It is targeting 5p a year in dividends which equates to a 4.5% yield on the latest share price. That’s very attractive in an environment where dividends are being cut by many companies.

A third of Hipgnosis’ revenue comes from streaming royalties, meaning it earns a bit of money every time someone plays one of the songs in its catalogue which include works by Ed Sheeran, Bon Jovi, Beyonce, Stevie Wonder and Journey. Merck Mercuriadis, the founder of Hipgnosis’ investment adviser The Family (Music), says the trust will only buy the rights to successful songs.

The rest of the trust’s income is generated by royalties every time its songs are played in shops, gyms and restaurants, live on stage or on the radio; when they feature in a film, TV show, advert or video game; or when someone buys a record, CD or a digital download containing its music.

VALUE GENERATION CATALYSTS

There are numerous share price catalysts. The first is buying more song catalogues and ‘sweating the assets’, namely collecting royalties from a broader base of songs to capture growing demand for streaming, and being proactive in striking synchronisation deals (getting them in films, adverts, etc).

It has a £1bn pipeline of potential catalogue acquisitions and plans to raise an as-yet-unspecified amount of money to help buy some of these songs.

Over the last year, the average age of songs in its portfolio has gone from approximately 10 to 12 years to between 20 and 25 years old. The catalogues currently in its sights would take the average song age to between 30 and 40 years old.

The early adopters of streaming platforms such as Spotify were younger people. Now the biggest growth area in streaming is among 45 to 55-year olds which suggests they should be more familiar with the music likely to be added to Hipgnosis’ portfolio.

FAVOURABLE RULE CHANGE

In 2018 the Copyright Royalty Board ruled to increase streaming songwriter/publisher royalty rates from 10.5% to 15.1% by 2022. The first increment has already happened and the second occurs this year, meaning Hipgnosis is getting increased royalty income.

By the end of 2023, the trust says $1 worth of income bought last year would be worth $1.44. While the ruling just involves the US at present, Mercuriadis is confident it will eventually permeate around the world.

Another tailwind to expect is a reduction in the discount rate used by independent valuers on music catalogues. ‘Several music valuation experts have reduced their discount rates to reflect changing consumer behaviours towards streaming music rather than making discretionary music purchases,’ says Hipgnosis in its recent trading update.

‘As proven hit songs produce long-term cash flows (typically around 100 years), any decrease in discount rates would have a significant impact on the portfolio’s valuation. For example, a 100 basis point decrease in the discount rate would increase the valuation of the portfolio by 18%; likewise, a 100 basis point increase in the discount rate would decrease the valuation of the portfolio by 15%.’

Mercuriadis says the trust has already had an indication that its valuer will lower the discount rate on Hipgnosis’ catalogue at the next semi-annual net asset value (NAV) update.

Another boost to earnings is likely to come from various social media and leisure platforms starting to pay royalties on music consumed through their services. ‘There will be a deal for the true value of songs going forward and a settlement for usage taken place to date,’ explains Mercuriadis. ‘Spotify made a settlement last year, Facebook is this year, Peloton next year, and we expect TikTok will do the same.

‘The opportunity with TikTok is massive as social media is driving the growth of music discovery,’ he adds.

COVID-19 IMPACT

While music royalties are considered to have low correlation to financial markets, the coronavirus pandemic has had a negative impact on Hipgnosis’ income. However, it doesn’t appear to be as bad as one might have initially thought.

Live music accounts for 3% of its revenue and Mercuriadis doesn’t see normal levels of such royalty income returning for the next 12 to 18 months. He says the advertising industry only shut down for three to four weeks, yet there could be a three to six-month dip in royalty income from music played in shops, restaurants and gyms (13% of revenue).

Despite these setbacks, Mercuriadis says the revenue from a boom in streaming during lockdown will more than offset the losses from other sources.

ACQUISITION SPREE

Hipgnosis’ plan is to spend the next 20 months building up a portfolio to £2bn in value with 50,000 songs. Mercuriadis believes the assets being bought will be worth three times as much inside of seven years. More people are being hired to actively promote the trust’s song catalogue for sync deals.

There is an argument to suggest that streaming services such as Spotify are now like a utility company with customers viewing subscription fees as non-discretionary spending. The more that people continuously use such services, the greater the chance for more royalty income for Hipgnosis.

Future acquisitions are likely to be done on higher earnings multiples as there is growing competition for assets.

The trust targets 10% total return each year via a mix of capital gains and income. At 111.5p, the shares are currently trading in line with net asset value versus a 6.9% average premium over the past 12 months.

Hipgnosis looks like a great portfolio diversifier providing access to a theme with strong growth prospects, and as a potential saviour for income investors.

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