**UNITEDSTATESSECURITIES AND EXCHANGE COMMISSION**

**Washington, D.C.  20549**

 

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**FORM 10-Q**

 
| **(Mark One)**                                          | ** ** | ** **                                                                                                              |
|---------------------------------------------------------|------------|-------------------------------------------------------------------------------------------------------------------------|
| **ý**                                              | ** ** | **QUARTERLY REPORT PURSUANT TO SECTION 13  OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934**   |
| ** **                                              | ** ** | ** **                                                                                                              |
| **For the quarterly period ended March 31,  2005** |
| ** **                                              | ** ** | ** **                                                                                                              |
| **OR**                                                  |
| ** **                                              | ** ** | ** **                                                                                                              |
| **o**                                                   | ** ** | **TRANSITION  REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE  SECURITIES EXCHANGE ACT OF 1934** |

 

**Commission File Number 001-319161**

 

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**WMGACQUISITION CORP.**

(Exact name of Registrant as specified in itscharter)

 
| **Delaware**                                                    | ** ** | **13-35665869**                       |
|-----------------------------------------------------------------|------------|---------------------------------------|
| (State or other jurisdiction of  incorporation or organization) | ** ** | (I.R.S. Employer  Identification No.) |
| ** **                                                      | ** ** | ** **                            |
| **75 Rockefeller Plaza  New York, NY 10019**                    |
| (Address of principal executive  offices)                       |
|                                                            |
| **(212) 275-2000**                                         |
| (Registrant’s telephone number, including  area code)      |

 

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Indicate by check mark whether the Registrant (1) has filed allreports required to be filed by Section 13 or 15(d) of the SecuritiesExchange Act of 1934 during the preceding 12 months (or for such shorterperiod that the Registrant was required to file such reports), and (2) hasbeen subject to such filing requirements for the past90 days. Yes o  No ý

 

Indicate by check mark whether the registrant is an accelerated filer(as defined in Rule 12b-2 of the Exchange Act.) Yes o  No ý

 

As of May 13, 2005, the number of shares of the Registrant’s commonstock, par value $0.001 per share, outstanding was 1,000.

 

 

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**WMG ACQUISITION CORP.**

**INDEX**

 
| **Part I.**  | **Financial Information**                                                                                                                                                                                     |   |
|--------------|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|--------|
| Item 1.      | Financial Statements (unaudited)                                                                                                                                                                              |   |
|         | Consolidated Balance Sheets as of March 31, 2005 and September 30,  2004                                                                                                                            |   |
|         | Consolidated and Combined Statements of  Operations for the Three Months Ended March 31, 2005, One Month Ended  March 31, 2004 and Two Months Ended February 29, 2004                          |   |
|         | Consolidated and Combined Statements of  Operations for the Six Months Ended March 31, 2005, One Month Ended  March 31, 2004 and Five Months Ended February 29, 2004                           |   |
|         | Consolidated and Combined Statements of  Cash Flows for the Six Months Ended March 31, 2005, One Month Ended March 31,  2004 and Five Months Ended February 29, 2004                           |   |
|         | Consolidated and Combined Statements of  Shareholder’s and Group Equity for the Six Months Ended March 31, 2005,  One Month Ended March 31, 2004 and Five Months Ended February 29,  2004 |   |
|         | Notes to Consolidated and Combined Interim  Financial Statements                                                                                                                                              |   |
|         | Supplementary Information—Condensed Consolidating Financial  Statements                                                                                                                                  |   |
| Item 2.      | Management’s Discussion and Analysis of  Financial Condition and Results of Operations                                                                                                                   |   |
| Item 3.      | Quantitative and Qualitative Disclosures  About Market Risk                                                                                                                                                   |   |
| Item 4.      | Controls and Procedures                                                                                                                                                                                       |   |
| **Part II.** | **Other Information**                                                                                                                                                                                         |   |
| Item 1.      | Legal Proceedings                                                                                                                                                                                             |   |
| Item 2.      | Unregistered Sales of Equity Securities and  Use of Proceeds                                                                                                                                                  |   |
| Item 3.      | Defaults Upon Senior Securities                                                                                                                                                                               |   |
| Item 4.      | Submission of Matters to a Vote of Security  Holders                                                                                                                                                          |   |
| Item 5.      | Other Information                                                                                                                                                                                             |   |
| Item 6.      | Exhibits                                                                                                                                                                                                      |   |
| Signatures   |                                                                                                                                                                                                          |   |

 

1

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**PART I—FINANCIALINFORMATION**

 

**ITEM 1. FINANCIAL STATEMENTS (unaudited)**

 

**WMG Acquisition Corp.**

**Consolidated Balance Sheets**

 
| ** **                                                          | ** ** | **March 31,  2005** | ** ** | **September 30,  2004** | ** ** |
|---------------------------------------------------------------------|------------|--------------------------|------------|------------------------------|------------|
| ** **                                                          | ** ** | **(unaudited)**          | ** ** | **(audited)**                | ** ** |
| ** **                                                          | ** ** | **(in millions)**        | ** ** |
| **Assets**                                                          |       |                     |       |                         |       |
| Current assets:                                                     |       |                     |       |                         |       |
| Cash and equivalents(a)                                             |       | $                        | 440        |                         | $          | 555 |   |
| Accounts receivable, less allowances of  $223 and $222 million |       | 487                      |       | 571                          |       |
| Inventories                                                         |       | 66                       |       | 65                           |       |
| Royalty advances expected to be recouped  within one year           |       | 195                      |       | 223                          |       |
| Deferred tax assets                                                 |       | 42                       |       | 38                           |       |
| Due from parent companies, net                                      |       | 1                        |       | —                       |       |
| Other current assets                                                |       | 58                       |       | 86                           |       |
| Total current assets                                                |       | 1,289                    |       | 1,538                        |       |
| Royalty advances expected to be recouped  after one year            |       | 195                      |       | 223                          |       |
| Investments                                                         |       | 22                       |       | 8                            |       |
| Property, plant and equipment, net                                  |       | 172                      |       | 189                          |       |
| Goodwill                                                            |       | 935                      |       | 978                          |       |
| Intangible assets subject to amortization,  net                     |       | 1,894                    |       | 1,937                        |       |
| Intangible assets not subject to  amortization                      |       | 100                      |       | 100                          |       |
| Other assets                                                        |       | 113                      |       | 117                          |       |
| Total assets                                                        |       | $                        | 4,720      |                         | $          | 5,090 |   |
|                                                                |       |                     |       |                         |       |
| **Liabilities  and Shareholder’s Equity**                      |       |                     |       |                         |       |
| Current liabilities:                                                |       |                     |       |                         |       |
| Accounts payable                                                    |       | $                        | 206        |                         | $          | 226 |   |
| Accrued royalties                                                   |       | 1,076                    |       | 1,003                        |       |
| Taxes and other withholdings                                        |       | 26                       |       | 10                           |       |
| Current portion of long-term debt                                   |       | 12                       |       | 12                           |       |
| Other current liabilities                                           |       | 342                      |       | 432                          |       |
| Total current liabilities                                           |       | 1,662                    |       | 1,683                        |       |
| Long-term debt                                                      |       | 1,830                    |       | 1,828                        |       |
| Deferred tax liabilities, net                                       |       | 263                      |       | 265                          |       |
| Other noncurrent liabilities                                        |       | 277                      |       | 333                          |       |
| Due to parent companies                                             |       | —                   |       | 3                            |       |
| Total liabilities                                                   |       | 4,032                    |       | 4,112                        |       |
| Shareholder’s equity:                                          |       |                     |       |                         |       |
| Common stock                                                        |       | —                   |       | —                       |       |
| Additional paid-in capital(a)                                       |       | 741                      |       | 1,076                        |       |
| Retained deficit                                                    |       | (57                      | )          | (104                         | )          |
| Accumulated other comprehensive income  (loss), net                 |       | 4                        |       | 6                            |       |
| Total shareholder’s equity(a)                                  |       | 688                      |       | 978                          |       |
| Total liabilities and shareholder’s equity                     |       | $                        | 4,720      |                         | $          | 5,090 |   |

 

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(a) As described further in Note 13, concurrent with the initial publicoffering of Parent the Company has declared a dividend of approximately $316million to its immediate parent, WMG Holdings Corp. When such dividends arepaid, it will have the effect of reducing cash and equivalents, additionalpaid-in capital and the shareholder’s equity by $316 million.

 

See accompanying notes.

 

2

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**WMG Acquisition Corp.**

**Consolidated and Combined Statements of****Operations (Unaudited)**

**Three Months Ended March 31, 2005, OneMonth Ended March 31 2004and Two Months Ended February 29, 2004**

 
| ** **                                            | ** ** | **Successor**                                | ** ** | **Predecessor**                           | ** ** |
|-------------------------------------------------------|------------|----------------------------------------------|------------|-------------------------------------------|------------|
| ** **                                            | ** ** | **Three Months  Ended  March 31, 2005** | ** ** | **One Month  Ended  March 31, 2004** | ** ** | **Two Months  Ended  February 29, 2004** | ** ** |
| ** **                                            | ** ** | **(in millions)**                            | ** ** |
| Revenues(b)                                           |       | $                                            | 767        |                                      | $          | 245 |   | $ | 490 |   |
| Costs and expenses:                                   |       |                                         |       |                                      |       |   |   |
| Cost of revenues(a)(b)                                |       | (400                                         | )          | (130                                      | )          | (258 | ) |
| Selling, general and administrative  expenses(a)(b)   |       | (293                                         | )          | (97                                       | )          | (219 | ) |
| Amortization of intangible assets                     |       | (47                                          | )          | (15                                       | )          | (37 | ) |
| Total costs and expenses                              |       | (740                                         | )          | (242                                      | )          | (514 | ) |
| Operating income (loss)                               |       | 27                                           |       | 3                                         |       | (24 | ) |
|                                                  |       |                                         |       |                                      |       |   |   |
| Interest (expense) income, net(b)                     |       | (35                                          | )          | (10                                       | )          | 1 |   |
| Equity in the losses of equity-method investees,  net |       | —                                       |       | (1                                        | )          | (2 | ) |
| Loss before income taxes                              |       | (8                                           | )          | (8                                        | )          | (25 | ) |
| Income tax (expense) benefit                          |       | (10                                          | )          | 1                                         |       | (13 | ) |
| Net loss                                              |       | $                                            | (18        | )                                         | $          | (7 | ) | $ | (38 | ) |

 

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| (a)                                  Includes  depreciation expense of:                                                       |   | $      | (14    | )      | $      | (6     | )      | $ | (11 | )      |
|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|--------|--------|--------|--------|--------|--------|--------|---|-----|--------|
| (b)                                 Includes  the following income (expenses) resulting from transactions with related  companies: |   |   |   |   |   |   |   |
| Revenues                                                                                                                                                                                                                                                                                           |   | $      | — |   | $      | — |   | $ | 3   |   |
| Cost of revenues                                                                                                                                                                                                                                                                                   |   | — |   | — |   | (1     | )      |
| Selling, general and administrative  expenses                                                                                                                                                                                                                                                      |   | (3     | )      | (1     | )      | (8     | )      |
| Interest expense, net                                                                                                                                                                                                                                                                              |   | — |   | — |   | 1      |   |

 

See accompanying notes.

 

3

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**WMG Acquisition Corp.**

**Consolidated and Combined Statements ofOperations (Unaudited)**

**Six Months Ended March 31, 2005, OneMonth Ended March 31, 2004 and****Five Months Ended February 29, 2004**

 
| ** **                                            | ** ** | **Successor**                              | ** ** | **Predecessor**                           | ** ** |
|-------------------------------------------------------|------------|--------------------------------------------|------------|-------------------------------------------|------------|
| ** **                                            | ** ** | **Six Months  Ended  March 31, 2005** | ** ** | **One Month  Ended  March 31, 2004** | ** ** | **Five Months  Ended  February 29, 2004** | ** ** |
| ** **                                            | ** ** | **(in millions)**                          | ** ** |
| Revenues(b)                                           |       | $                                          | 1,855      |                                      | $          | 245 |   | $ | 1,668 |   |
| Costs and expenses:                                   |       |                                       |       |                                      |       |   |   |
| Cost of revenues(a)(b)                                |       | (981                                       | )          | (130                                      | )          | (906 | ) |
| Selling, general and administrative  expenses(a)(b)   |       | (624                                       | )          | (97                                       | )          | (610 | ) |
| Impairment of goodwill and other intangible  assets   |       | —                                     |       | —                                    |       | (1,019 | ) |
| Amortization of intangible assets                     |       | (93                                        | )          | (15                                       | )          | (97 | ) |
| Restructuring costs                                   |       | —                                     |       | —                                    |       | (8 | ) |
| Total costs and expenses                              |       | (1,698                                     | )          | (242                                      | )          | (2,640 | ) |
| Operating income (loss)                               |       | 157                                        |       | 3                                         |       | (972 | ) |
|                                                  |       |                                       |       |                                      |       |   |   |
| Interest expense, net(b)                              |       | (71                                        | )          | (10                                       | )          | (2 | ) |
| Net investment-related losses                         |       | —                                     |       | —                                    |       | (9 | ) |
| Equity in the losses of equity-method  investees, net |       | (1                                         | )          | (1                                        | )          | (11 | ) |
| Deal-related transaction costs and other  costs       |       | —                                     |       | —                                    |       | (63 | ) |
| Other income (expense), net (b)                       |       | 4                                          |       | —                                    |       | (7 | ) |
| Loss before income taxes                              |       | 89                                         |       | (8                                        | )          | (1,064 | ) |
| Income tax (expense) benefit                          |       | (42                                        | )          | 1                                         |       | (120 | ) |
| Net income (loss)                                     |       | $                                          | 47         |                                      | $          | (7 | ) | $ | (1,184 | ) |

 

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| (a)                                  Includes  depreciation expense of:                                                       |   | $      | (28    | )      | $      | (6     | )      | $ | (31 | )      |
|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|--------|--------|--------|--------|--------|--------|--------|---|-----|--------|
| (b)                                 Includes  the following income (expenses) resulting from transactions with related  companies: |   |   |   |   |   |   |   |
| Revenues                                                                                                                                                                                                                                                                                           |   | $      | — |   | $      | — |   | $ | 25  |   |
| Cost of revenues                                                                                                                                                                                                                                                                                   |   | — |   | — |   | (46    | )      |
| Selling, general and administrative expenses                                                                                                                                                                                                                                                       |   | (5     | )      | (1     | )      | (42    | )      |
| Interest expense, net                                                                                                                                                                                                                                                                              |   | — |   | — |   | 3      |   |
| Other income (expense), net                                                                                                                                                                                                                                                                        |   | — |   | — |   | (7     | )      |

 

See accompanying notes.

 

4

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**WMG Acquisition Corp.**

**Consolidated and Combined Statements of CashFlows (Unaudited)**

**Six Months Ended March 31, 2005, OneMonth Ended March 31, 2004 and Five Months Ended February 29, 2004**

 
| ** **                                                                                | ** ** | **Successor**                              | ** ** | **Predecessor**                           | ** ** |
|-------------------------------------------------------------------------------------------|------------|--------------------------------------------|------------|-------------------------------------------|------------|
| ** **                                                                                | ** ** | **Six Months  Ended  March 31, 2005** | ** ** | **One Month  Ended  March 31, 2004** | ** ** | **Five Months  Ended  February 29, 2004** | ** ** |
| ** **                                                                                | ** ** | **(in millions)**                          | ** ** |
| **Cash  flows from operating activities**                                                 | ** ** | ** **                                 | ** ** | ** **                                | ** ** | ** ** | ** ** |
| Net income (loss)                                                                         |       | $                                          | 47         |                                      | $          | (7 | ) | $ | (1,184 | ) |
| Adjustments to reconcile net income (loss)  to net cash provided by operating activities: |       |                                       |       |                                      |       |   |   |
| Impairment of goodwill and other intangible  assets                                       |       | —                                     |       | —                                    |       | 1,019 |   |
| Depreciation and amortization                                                             |       | 121                                        |       | 21                                        |       | 128 |   |
| Deferred taxes                                                                            |       | 2                                          |       | (2                                        | )          | 94 |   |
| Non-cash interest expense                                                                 |       | 17                                         |       | 3                                         |       | 3 |   |
| Net investment-related losses                                                             |       | —                                     |       | —                                    |       | 9 |   |
| Equity in the losses of equity-method  investees, including distributions                 |       | 1                                          |       | 1                                         |       | 11 |   |
| Non-cash, stock-based compensation expense                                                |       | 9                                          |       | —                                    |       | — |   |
| Changes in operating assets and  liabilities:                                             |       |                                       |       |                                      |       |   |   |
| Accounts receivable                                                                       |       | 103                                        |       | —                                    |       | 93 |   |
| Inventories                                                                               |       | 1                                          |       | (2                                        | )          | (1 | ) |
| Royalty advances                                                                          |       | 9                                          |       | 12                                        |       | 109 |   |
| Accounts payable and accrued liabilities                                                  |       | (44                                        | )          | 6                                         |       | 32 |   |
| Other balance sheet changes                                                               |       | 31                                         |       | (34                                       | )          | 39 |   |
| Net cash provided by (used in) operating  activities                                      |       | 297                                        |       | (2                                        | )          | 352 |   |
| **Cash  flows from investing activities**                                                 | ** ** | ** **                                 | ** ** | ** **                                | ** ** | ** ** | ** ** |
| Acquisition of Old WMG                                                                    |       | —                                     |       | (2,638                                    | )          | — |   |
| Investments and acquisitions                                                              |       | (48                                        | )          | (2                                        | )          | (16 | ) |
| Investment proceeds                                                                       |       | 1                                          |       | —                                    |       | 57 |   |
| Capital expenditures                                                                      |       | (14                                        | )          | —                                    |       | (24 | ) |
| Net cash provided (used in) by investing  activities                                      |       | (61                                        | )          | (2,640                                    | )          | 17 |   |
| **Cash  flows from financing activities**                                                 |       |                                       |       |                                      |       |   |   |
| Borrowings                                                                                |       | —                                     |       | 1,650                                     |       | — |   |
| Financing costs of borrowings                                                             |       | —                                     |       | (78                                       | )          | — |   |
| Debt repayments                                                                           |       | (6                                         | )          | (125                                      | )          | (124 | ) |
| Capital contributions (a)                                                                 |       | —                                     |       | 1,250                                     |       | 262 |   |
| (Decrease) increase in amounts due to  parent companies                                   |       | (4                                         | )          | 3                                         |       | — |   |
| Decrease in amounts due from                                                              |       |                                       |       |                                      |       |   |   |
| Time Warner-affliliated companies                                                         |       | —                                     |       | —                                    |       | 290 |   |
| Dividends and return of capital paid                                                      |       | (344                                       | )          | —                                    |       | (410 | ) |
| Net cash provided (used in) by financing  activities                                      |       | (354                                       | )          | 2,700                                     |       | 18 |   |
| Effect of foreign currency exchange rate  changes on cash                                 |       | 3                                          |       | —                                    |       | 3 |   |
| Net (decrease) increase in cash and  equivalents                                          |       | (115                                       | )          | 58                                        |       | 390 |   |
| Cash and equivalents at beginning of period                                               |       | 555                                        |       | 471                                       |       | 81 |   |
| Cash and equivalents at end of period                                                     |       | $                                          | 440        |                                      | $          | 529 |   | $ | 471 |   |

 

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(a)                                  Capital contributionfor the one month ended March 31, 2004 excludes $35 million of non-cashconsideration issued as part of the purchase price paid to Time Warner in theform of warrants.

 

See accompanying notes.

 

5

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**WMG Acquisition Corp.**

**Consolidated and Combined Statements ofShareholder’s and Group Equity**

**(Unaudited)**

 
| ** **                                                                      | ** ** | **Successor**                              | ** ** | **Predecessor**                           | ** ** |
|---------------------------------------------------------------------------------|------------|--------------------------------------------|------------|-------------------------------------------|------------|
| ** **                                                                      | ** ** | **Six Months  Ended  March 31, 2005** | ** ** | **One Month  Ended  March 31, 2004** | ** ** | **Five Months  Ended  February 29, 2004** | ** ** |
| Balance at beginning of period (a)                                              |       | $                                          | 978        |                                      | $          | 1,691 |   | $ | 2,673 |   |
|                                                                            |       |                                       |       |                                      |       |   |   |
| Adjustments to record the Acquisition:                                          |       |                                       |       |                                      |       |   |   |
| Elimination of historical equity balances                                       |       | —                                     |       | (1,691                                    | )          | — |   |
| Capital contributions                                                           |       | —                                     |       | 1,250                                     |       | — |   |
| Pushdown of a portion of the purchase price  funded by the issuance of warrants |       | —                                     |       | 35                                        |       | — |   |
| Balance at March 1, 2004, adjusted to  give effect to the Acquisition      |       | —                                     |       | 1,285                                     |       | — |   |
|                                                                            |       |                                       |       |                                      |       |   |   |
| Comprehensive income (loss):                                                    |       |                                       |       |                                      |       |   |   |
| Net income (loss) (b)                                                           |       | 47                                         |       | (7                                        | )          | (1,184 | ) |
| Foreign currency translation adjustment                                         |       | (12                                        | )          | (5                                        | )          | 24 |   |
| Deferred gains on foreign exchange  contracts                                   |       | —                                     |       | —                                    |       | 4 |   |
| Deferred gains on derivative financial  instruments                             |       | 10                                         |       | —                                    |       | — |   |
| Total comprehensive income (loss)                                               |       | 45                                         |       | (12                                       | )          | (1,156 | ) |
| Return of capital and dividends paid                                            |       | (344                                       | )          | —                                    |       | (1,037 | ) |
| Capital contributions                                                           |       | —                                     |       | 262                                       |       |   |   |
| Decrease in amounts due from Time  Warner-affiliated companies, net             |       | —                                     |       | —                                    |       | 949 |   |
| Issuance of stock options and restricted  stock                                 |       | 9                                          |       | —                                    |       | — |   |
| Balance at end of period                                                        |       | $                                          | 688        |                                      | $          | 1,273 |   | $ | 1,691 |   |

 

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(a)                                  Beginningbalance for the one month ended March 31, 2004 relates to the predecessorbalance as of February 29, 2004.

(b)                                 Netloss for the five months ended February 29, 2004 includes an approximate$1.019 billion impairment charge to reduce the carrying value of goodwill,trademarks and other intangible assets.

 

See accompanying notes.

 

6

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**WMG Acquisition Corp.**

**Notes toConsolidated and Combined Inter****im Financial Statements(Unaudited)**

 

**1.****                                     ****Description of Business**

 

WMG Acquisition Corp. (the “Company”or “New WMG”), is one of the world’s major music companies and the successor tothe interests of the recorded music and music publishing businesses of TimeWarner Inc. (“Time Warner”).  Suchpredecessor interests formerly owned by Time Warner are hereinafter referred toas “Old WMG” or the “Predecessor”. Effective March 1, 2004, the Company acquired Old WMG from TimeWarner for approximately $2.6 billion (the “Acquisition”). The Company is adirect, wholly owned subsidiary of WMG Holdings Corp. (“Holdings”). Holdings,in turn, is a direct, wholly owned subsidiary of Warner Music Group Corp. (“Parent”,formerly known as WMG Parent Corp.). Parent, Holdings and the Company wereformed in November 2003 by a private equity consortium of investors (the “InvestorGroup”) to facilitate the Acquisition.

 

TheCompany classifies its business interests into two fundamental areas: recordedmusic and music publishing.  A briefdescription of those operations is presented below.

 

*RecordedMusic Operations*

 

TheCompany’s recorded music operations consist of the discovery and development ofartists and the related marketing and distribution of recorded music producedby such artists.  In the United States,the Company’s operations are conducted principally through its major recordlabels - Warner Bros. Records and The Atlantic Records Group.  Internationally, the Company’s recorded musicoperations are conducted through its Warner Music International division (“WMI”)in over 50 countries outside the United States through various subsidiaries,affiliates and non-affiliated licensees. The Company’s current roster of recording artists includes, amongothers, Cher, Enya, Eric Clapton, Faith Hill, Green Day, Josh Groban, Kid Rock,Linkin Park, Luis Miguel, Madonna, matchbox twenty, Metallica, Phil Collins andRed Hot Chili Peppers.

 

TheCompany’s recorded music operations also include a catalog division calledWarner Strategic Marketing (“WSM”).  WSMspecializes in marketing the Company’s music catalog through compilations andreissuances of previously released music and video titles, as well as in thelicensing of tracks to/from third parties for various uses, including film andtelevision soundtracks.

 

TheCompany’s principal recorded-music distribution operations includeWarner-Elektra-Atlantic Corporation (“WEA Corp.”), which primarily markets anddistributes music products to retailers and wholesale distributors in theUnited States; a 90% interest in Alternative Distribution Alliance, anindependent distribution company; various distribution centers and ventures operatedinternationally; and an 80% interest in Word Entertainment, whose distributionoperations specialize in the distribution of music products in the Christianretail marketplace.

 

7

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**1.****                                     ****Description of Business(Continued)**

 

Theprincipal recorded-music revenue sources to the Company are sales of CDs,digital downloads and other recorded music products, and license fees receivedfor the ancillary uses of its recorded music catalog.

 

*MusicPublishing Operations*

 

TheCompany’s music publishing operations include Warner/Chappell Music, Inc. andits wholly owned subsidiaries, and certain other music-publishing affiliates ofthe Company.  The Company owns orcontrols the rights to more than one million musical compositions, includingnumerous pop music hits, American standards, folk songs and motion picture andtheatrical compositions.  Its catalogincludes works from a diverse range of artists and composers, including Georgeand Ira Gershwin, Barry Gibb, Cole Porter, Dido, Madonna, Moby, Nickelback,R.E.M. and Staind.  The Company alsoadministers the music of several television and motion picture companies,including Lucasfilm, Ltd. and Hallmark Entertainment.

 

TheCompany’s music publishing operations include Warner Bros. Publications U.S.Inc. (“Warner Bros. Publications”), one of the world’s largest publishers ofprinted music.  Warner Bros. Publicationsmarkets publications throughout the world containing works of such artists asShania Twain, The Grateful Dead and Led Zeppelin.  However, in December 2004, the Companyentered into an agreement to sell its printed music business to AlfredPublishing Co., Inc. (“Alfred Publishing”). The sale is expected to close in the third quarter of fiscal 2005 and issubject to customary closing conditions. See Note 3 for additional information.

 

Theprincipal music-publishing revenue sources to the Company are royalties for theuse of its compositions on CDs and DVDs, in television commercials, ring tones,music videos and the Internet; license fees received for the use of its musicalcompositions on radio, television, in motion pictures and in other publicperformances; and sales of published sheet music and songbooks.

 

**2.****                                     ****Basis of Presentation**

 

**New Basis of Presentation**

 

The accompanying consolidated and combined financialstatements present separately the financial position, results of operations,cash flows and changes in equity for both the Company and its predecessor, OldWMG. Old WMG was acquired by the Company effective as of March 1,2004.  In connection with theAcquisition, a new accounting basis was established for the Company as of theacquisition date based upon an allocation of the purchase price to theunderlying net assets acquired. Financial information for the pre- and post-acquisition periods havebeen separated by a vertical line on the face of the consolidated and combinedfinancial statements to highlight the fact that the financial information forsuch periods have been prepared under two different historical-cost bases ofaccounting.

 

**Old Basis of Presentation**

 

As previously described, the operations of theCompany were under the control of Time Warner through the end of February 2004.  In January 2001, historic Time Warnerwas acquired by America Online Inc. (“AOL”) in a transaction hereinafterreferred to as the “AOL Time Warner Merger”. The AOL TimeWarner Merger was accounted for under the purchase method of accounting.  Under the purchase method of accounting, thebasis of the historical net assets included in the accompanying combinedfinancial statements of the predecessor was adjusted, effective as of January 1,2001, to reflect an allocable portion of the purchase price relating to the AOLTime Warner Merger.

 

For all periodsprior to the closing of the Acquisition, the accompanying combined financialstatements of the Predecessor

 

8

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reflect all assets, liabilities, revenues, expenses and cash flowsdirectly attributable to Old WMG.  Inaddition, the accompanying combined financial statements include allocations ofcertain costs of Time Warner and Old WMG deemed reasonable by the Company’smanagement, in order to present the results of operations, financial position,changes in group equity and cash flows of Old WMG on a stand-alone basis.  The principal allocation methodologies aredescribed below.  The financialinformation included herein does not necessarily reflect the results ofoperations, financial position, changes in group equity and cash flows of OldWMG in the future or what would have been reflected had Old WMG been aseparate, stand-alone entity during the periods presented.  The income tax benefits and provisions,related tax payments and deferred tax balances have been prepared as if Old WMGoperated as a stand-alone taxpayer for the periods presented.

 

Forall periods prior to the closing of the Acquisition, certain general andadministrative costs incurred by Time Warner have been allocated to thecombined financial statements of Old WMG, including pension and otherbenefit-related costs, insurance-related costs and other general andadministrative costs.  These costallocations were determined based on a combination of factors, as appropriate,including Old WMG’s pro rata share of the revenues under the management of OldWMG and other more directly attributable methods, such as claim experience forinsurance costs and employee-related attributes for pension costs.  The costs allocated to the Company are notnecessarily indicative of the costs that would have been incurred if Old WMGhad obtained such services independently, nor are they indicative of costs thatwill be charged or incurred in the future. However, management believes that such allocations are reasonable.

 

**Fiscal Year**

 

Infiscal year 2004, in connection with the Acquisition, the Company changed itsfiscal year-end to September 30th from November 30th.As such, the Company restated its prior quarters starting October 1, 2003,under the new fiscal year format, to enhance comparability between periods.

 

**Interim Financial Statements**

 

Theaccompanying consolidated financial statements are unaudited but, in theopinion of management, contain all the adjustments (consisting of those of anormal recurring nature) considered necessary to present fairly the financialposition and the results of operations and cash flows for the periods presentedin conformity with accounting principles generally accepted in the UnitedStates (“U.S. GAAP”) applicable to interim periods. The accompanying consolidatedand combined interim financial statements should be read in conjunction withthe audited consolidated and combined financial statements of the Companyincluded in its Amendment No. 3 to Registration Statement No. 333-1213122 onForm S-4.

 

**Basisof Consolidation and Combination**

 

Priorto the closing of the Acquisition, the recorded music and music publishingoperations of the Company were legally held by multiple subsidiaries andaffiliates of Old WMG and Time Warner. As such, the accompanying financial statements present the *combined* accounts of such businesses for all periods priorto the Acquisition.  After the closing ofthe Acquisition, New WMG acquired the stock or net assets of those predecessorbusinesses.  Accordingly, theaccompanying financial statements present the *consolidated*accounts of such businesses for all periods after the closing of theAcquisition.  The consolidated accountsinclude 100% of the assets, liabilities, revenues, expenses, income, losses andcash flows of New WMG and all entities in which New WMG  has a controlling voting interest and/orvariable interest entities required to be consolidated in accordance with U.S.GAAP.  All significant intercompanybalances and transactions have been eliminated in consolidation andcombination.

 

**Reclassifications**

 

Certainreclassifications have been made to the prior period’s financial information inorder to conform to the current period’s presentation.

 

9

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**Amounts Due To/From Time Warner-Affiliated Companies**

 

Priorto the closing of the Acquisition that was effective in March 2004, OldWMG had various commercial and financing arrangements with Time Warner and itsaffiliates.  To illustrate, Old WMGdistributed home video product for Time Warner’s filmed entertainment divisionand the Old WMG’s financing requirements were funded by Time Warner.  Given the intercompany nature of these andother arrangements, the related payables and receivables generally were notsettled through periodic cash payments and receipts.  Accordingly, except as noted below for incometaxes, the net amounts due from all transactions with Time Warner-affiliatedcompanies were classified as a reduction of group equity in the combinedbalance sheet for all periods prior to March 2004.

 

Withrespect to income taxes for all periods prior to the closing of the Acquisitionthat was effective in March 2004, the income tax benefits and provisions,related tax payments and deferred tax balances have been prepared as if Old WMGoperated as a stand-alone taxpayer.  Assuch, while generally attributable to Time Warner or its subsidiaries becauseOld WMG’s taxable results were included in the consolidated income tax returnsof Time Warner or its subsidiaries, all current and deferred tax liabilitiesfor those periods were classified as liabilities in the combined balance sheetfor all periods prior to March 2004.

 

Inconnection with the Acquisition, substantially all of the intercompanyreceivables and payables between Old WMG and Time Warner and its affiliateswere settled, and any receivables and payables that existed between the partiesas of September 30, 2004 and March 31, 2005 have been presented asthird-party balances in the accompanying consolidated balance sheet.  In addition, with respect to taxes, TimerWarner assumed all of the underlying tax obligations of Old WMG for all periodsprior to the closing of the Acquisition. As such, all historical current and deferred tax assets and liabilitiesthat existed as of the closing date of the Acquisition were transferred to TimeWarner.  Current and deferred tax assetsand liabilities that existed as of September 30, 2004 and March 31,2005 are third-party in nature and have been presented as such in theaccompanying consolidated balance sheet.

 

**Cash and Equivalents**

 

Prior to theclosing of the Acquisition, Old WMG had agreements with Time Warner, wherebyall cash received or paid by Old WMG was included in, or funded by, clearingaccounts or international cash pools within Time Warner’s centralized cashmanagement system.  The average monthlybalance of amounts due from Time Warner and its affiliates was $375 million and$603 million for the two-month and five-month periods ended February 29,2004, respectively.

 

**Stock-Based Compensation**

 

*Post-Acquisition*

 

EffectiveMarch 1, 2004, in connection with the Acquisition, the Company adopted thefair value recognition provisions of FASB Statement No. 123, “Accounting forStock-Based Compensation” (“FAS 123”) to account for all stock-basedcompensation plans adopted subsequent to the Acquisition.  Under the fair value recognition provisionsof FAS 123, stock-based compensation cost is measured at the grant date basedon the fair value of the award and is recognized as expense over the vestingperiod.

 

**Change in Stock Option Estimate**

 

In January 2004, the Company determined thatthe binomial method was a more accurate and appropriate methodology tocalculate the fair value of the Company’s stock options.  All stock option grants subsequent to thisdate will be valued using the binomial method, while all stock option grantsprior to this date will be valued using the Black-Scholes method on theoriginal grant date.  This change inestimate does not have a material impact on the Company’s consolidatedstatement of operations.  During thethree-month and six-month periods ended March 31, 2005, the Company recordedexpenses related to its stock-based awards of $7 million and $9 million,respectively.

 

*Pre-Acquisition*

 

Prior to the Acquisition, certainemployees of Old WMG participated in various Time Warner stock optionplans.  In accordance with AccountingPrinciples Board Opinion No. 25, “Accounting for Stock Issued to Employees” (“APB25”) and related interpretations, compensation cost for stock options or otherequity-based awards granted to employees was recognized in income based on theexcess, if any, of the quoted market price of the stock at the grant date ofthe award over the amount an employee must pay to acquire the stock.  Generally, the exercise price for stockoptions granted to employees equaled or exceeded

 

10

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the fair market value of TimeWarner common stock at the date of grant, thereby resulting in no recognitionof compensation expense by Old WMG.  Forany awards that generated compensation expense as defined under APB 25, Old WMGcalculated the amount of compensation expense and recognized the expense overthe vesting period of the award.

 

Hadcompensation cost for Time Warner’s stock option plans been determined based onthe fair value method set forth in FAS 123, Old WMG’s net loss for all periodspresented prior to the closing of the Acquisition would have been as follows:

 
| ** **  | ** ** | **Two Months Ended February 29,  2004** | ** ** | **Five Months Ended February 29,  2004** | ** ** |
|-------------|------------|----------------------------------------------|------------|-----------------------------------------------|------------|
| ** **  | ** ** | **(in millions)**                            | ** ** |
| Net loss:   |       |                                         |       |                                          |       |
| As reported |       | $                                            | (38        | )                                             | $          | (1,184 | ) |
| Pro forma   |       | $                                            | (44        | )                                             | $          | (1,202 | ) |

 

**3.****                                     ****Acquisitions andDispositions**

 

**Bad Boy Records LLC Joint Venture**

 

OnApril 8, 2005, the Company entered into an agreement with an affiliate ofSean ‘‘P. Diddy’’ Combs to form Bad Boy Records LLC (“Bad Boy”), a jointventure, owned 50% by the Company and 50% by the affiliate. The Companypurchased its 50% membership interest in Bad Boy Records LLC for approximately$30 million in cash. The joint venture includes catalog and roster artists suchas Notorious B.I.G., Mario Winans, Mase, Carl Thomas, B5 and P. Diddy. Mr.Combs will be the CEO of the joint venture and will supervise its staff andday-to-day operations. The Company will provide funding, marketing, promotionand certain back-office services for the joint venture. The transaction will beaccounted for under the purchase method of accounting during the third quarterof fiscal 2005. Under the purchase method of accounting, the acquisition costof approximately $30 million would be allocated to the Company’s share of BadBoy’s underlying net assets based on their respective fair values. The excessof the purchase price over the Company’s share of the estimated fair values ofthe net assets acquired will be recorded primarily as goodwill.

 

**Sale of Warner Bros. Publications**

 

In December 2004,the Company entered into an agreement to sell Warner Bros. Publications, whichconducts the Company’s printed music operations, to Alfred Publishing. As partof the transaction, the Company agreed to license the right to use its musicpublishing copyrights in the exploitation of printed sheet music and songbooksfor a twenty-year period of time. No gain or loss is expected to be recognizedon the transaction as the historical book basis of the net assets being soldwas adjusted to fair value in connection with the accounting for theAcquisition. The sale is expected to close in the third quarter of fiscal year2005 and is subject to customary closing conditions.

 

Thesale is not expected to have a material effect on the future operating resultsand financial condition of the Company. For the three months and six monthsended March 31, 2005, the operations being sold generated revenues ofapproximately $11 million and $26 million, respectively; operating (loss)income of approximately $(1) million and $1 million, respectively; operating(loss) income before depreciation and amortization expense of $(1) million, and$1 million, respectively; and net loss of approximately $(1) million and $(1)million, respectively. For the three months ended March 31, 2004 and sixmonths ended March 31, 2004, the operations being sold generated revenuesof approximately $14 million and $30 million, respectively; operating income ofapproximately $1 million and $2 million, respectively; operating income beforedepreciation and amortization expense of $1 million, and $2 million,respectively; and net (loss) income of approximately $(1) million and $2million, respectively.

 

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**Maverick**

 

InNovember 2004, the Company acquired an additional 30% interest in MaverickRecording Company (‘‘Maverick’’) from its existing partner for approximately$17 million and certain amounts previously owed by such partner to the Company.The transaction was accounted for under the purchase method of accounting andthe purchase price has been allocated to the underlying net assets of Maverickin proportion to the estimated fair value, principally artist contracts andrecorded music catalog. As part of the transaction, the Company and theremaining partner in Maverick entered into an agreement pursuant to whicheither party can elect to have the Company purchase the remaining 20% interestin Maverick that it does not own by December 2007.

 

**4.****                                     ****Inventories**

 

Inventoriesconsist of the following:

 
| ** **                                                 | ** ** | **March 31,  2005** | ** ** | **September 30,  2004** | ** ** |
|------------------------------------------------------------|------------|--------------------------|------------|------------------------------|------------|
| ** **                                                 | ** ** | **(unaudited)**          | ** ** | **(audited)**                | ** ** |
| ** **                                                 | ** ** | **(in millions)**        | ** ** |
|                                                       |       |                     |       |                         |       |
| Compact  discs, cassettes and other music-related products |       | $                        | 83         |                         | $          | 79 |   |
| Published  sheet music and song books                      |       | 23                       |       | 23                           |       |
|                                                       |       | 106                      |       | 102                          |       |
| Less reserve  for obsolescence                             |       | (40                      | )          | (37                          | )          |
|                                                       |       | $                        | 66         |                         | $          | 65 |   |

 

**5.****                                     ****Goodwill and IntangibleAssets**

 

**Goodwill**

 

The following analysis details the changes in goodwillfor each reportable segment during the six months ended March 31, 2005:

 
| ** **                          | ** ** | **Recorded  Music** | ** ** | **Music  Publishing** | ** ** | **Total** | ** ** |
|-------------------------------------|------------|---------------------|------------|-----------------------|------------|-----------|------------|
| ** **                          | ** ** | **(in millions)**   | ** ** |
|                                |       |                |       |                  |       |      |       |
| Balance at September 30,  2004 |       | $                   | 395        |                  | $          | 583       |       | $ | 978 |   |
| Purchase  accounting adjustments    |       | (45                 | )          | 2                     |       | (43       | )          |
|                                |       |                |       |                  |       |      |       |
| Balance at March 31,  2005     |       | $                   | 350        |                  | $          | 585       |       | $ | 935 |   |

 

Purchaseaccounting adjustments represent changes to the initial estimates ofrestructuring costs arising from the Acquisition and fair value adjustmentsdetermined in connection with the Company’s finalization of purchase price allocationrelated to the Acquisition.

 

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**OtherIntangible Assets**

 

Other intangible assets consist of the following:

 
| ** **                                           | ** ** | **March 31,  2005** | ** ** | **September 30,  2004** | ** ** |
|------------------------------------------------------|------------|--------------------------|------------|------------------------------|------------|
| ** **                                           | ** ** | **(unaudited)**          | ** ** | **(audited)**                | ** ** |
| ** **                                           | ** ** | **(in millions)**        | ** ** |
| Intangible  assets subject to amortization:          |       |                     |       |                         |       |
| Recorded  music catalog                              |       | $                        | 1,233      |                         | $          | 1,216 |   |
| Music  publishing and copyrights                     |       | 828                      |       | 811                          |       |
| Trademarks                                           |       | 10                       |       | 10                           |       |
| Other  intangible assets                             |       | 20                       |       | 4                            |       |
|                                                 |       | 2,091                    |       | 2,041                        |       |
| Accumulated  amortization                            |       | (197                     | )          | (104                         | )          |
| Total net  intangible assets subject to amortization |       | 1,894                    |       | 1,937                        |       |
| Intangible  assets not subject to amortization:      |       |                     |       |                         |       |
| Trademarks                                           |       | 100                      |       | 100                          |       |
| Total net  other intangible assets                   |       | $                        | 1,994      |                         | $          | 2,037 |   |

 

Theincrease in the Company’s gross intangible assets represents the allocation ofthe purchase price of the Company’s acquisition of an additional interest inMaverick to the net assets acquired, principally music copyrights ofapproximately $17 million and artist contracts of approximately $16 million,and the acquisition of approximately $17 million of publishing rights duringthe six months ended March 31, 2005.

 

**6.****                                     ****Restructuring Costs**

 

**Acquisition-Related Restructuring Costs**

 

Inconnection with the Acquisition that was effective as of March 1, 2004,the Company reviewed its operations and implemented several plans torestructure its operations.  As part ofthese restructuring plans, the Company recorded a restructuring liability ofapproximately $307 million during 2004. This restructuring liability included costs to exit and consolidatecertain activities of the Company, as well as costs to terminate employees andcertain artist,  songwriters andco-publisher contracts.  Such liabilitieswere recognized as part of the cost of the Acquisition.

 

Duringthe six months ended March 31, 2005, the Company revised its originalestimates of restructuring costs based on the restructuring plans alreadyimplemented. This resulted in an overall reduction in the restructuring costsof approximately $33 million. The Company’s restructuring liabilities andgoodwill as of March 31, 2005 has been reduced by such amounts.  As of March 31, 2005, the Company hadapproximately $86 million of liabilities for Acquisition-related restructuringcosts recorded in its balance sheet. These liabilities represent estimates of future cash obligations for allrestructuring activities that had been implemented, as well as for allrestructuring activities that had been committed to by management but have yetto occur.  The outstanding balance ofthese liabilities primarily relate to extended payment terms for severanceobligations and long-term lease obligations for vacated facilities.  These remaining obligations are expected tobe settled by 2019.  We expect to pay amajority of the remaining costs in 2005 and 2006.

 

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| ** **                                                         | ** ** | **Employee  Terminations** | ** ** | **Other  Exit Costs** | ** ** | **Total** | ** ** |
|--------------------------------------------------------------------|------------|----------------------------|------------|-----------------------|------------|-----------|------------|
| ** **                                                         | ** ** | **(in millions)**          | ** ** |
|                                                               |       |                       |       |                  |       |      |       |
| Initial  accrual in 2004                                           |       | $                          | 164        |                  | $          | 143       |       | $ | 307 |   |
| Cash paid in  2004                                                 |       | (92                        | )          | (13                   | )          | (105      | )          |
| Non-cash  reduction in 2004 (a)                                    |       | (1                         | )          | (22                   | )          | (23       | )          |
| Liability as  of September 30, 2004                           |       | 71                         |       | 108                   |       | 179       |       |
| Cash paid in  the six months ended March 31, 2005             |       | (38                        | )          | (22                   | )          | (60       | )          |
| Non-cash  reduction in the six months ended March 31, 2005(a) |       | 2                          |       | (35                   | )          | (33       | )          |
| Liability as  of March 31, 2005                               |       | $                          | 35         |                  | $          | 51        |       | $ | 86 |   |

 

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# (a)          Principally relates to changes in foreign currency exchange rates, thenon-cash write-off of the carrying value of advances relating to terminatingcertain artist, songwriter and co-publishers contracts and the reversal ofrestructuring costs no longer estimated to be required.

 

Inaddition, in connection with the Acquisition, the Company approved acost-savings incentive compensation plan during 2004 in order to incentivizemanagement to implement the aforementioned restructuring plans and reduceoperating costs.  Under the plan, keyemployees of the Company will be entitled to earn up to $20 million in theaggregate based on the attainment and maintenance of certain cost-savingstargets.  Based on the level of costsavings actually generated at the end of September 30, 2004, whichexceeded the cost-savings targets under the plan, the Company determined thatit was probable that eligible employees would vest in the full benefits underthe plan.  Accordingly, the Companyrecorded the full $20 million liability under the plan, along with otherrestructuring-related costs of $6 million, during the seven months ended September 30,2004.  Out of the aggregate $26 millionliability, $16 million has been paid during the six months ended March 31,2005.

 

**7. Debt**

 

The Company’s long-term debtconsists of:

 
| ** **                                     | ** ** | **March 31, 2005** | ** ** | **September 30, 2004** | ** ** |
|------------------------------------------------|------------|-------------------------|------------|-----------------------------|------------|
| ** **                                     | ** ** | **(unaudited)**         | ** ** | **(audited)**               | ** ** |
| ** **                                     | ** ** | **(in millions)**       | ** ** |
| Senior  secured credit facility:               |       |                    |       |                        |       |
| Revolving  credit facility                     |       | $                       | —     |                        | $          | — |   |
| Term loan                                      |       | 1,188                   |       | 1,194                       |       |
|                                           |       | 1,188                   |       | 1,194                       |       |
| Subordinated  notes:                           |       |                    |       |                        |       |
| 7.375% U.S.  dollar-denominated Notes due 2014 |       | 465                     |       | 465                         |       |
| 8.125%  Sterling-denominated Notes due 2014    |       | 189                     |       | 181                         |       |
|                                           |       | 654                     |       | 646                         |       |
| Total debt                                     |       | 1,842                   |       | 1,840                       |       |
| Less current  portion                          |       | (12                     | )          | (12                         | )          |
| Total  long-term debt                          |       | $                       | 1,830      |                        | $          | 1,828 |   |

 

Asdescribed further in Note 13, the Company has obtained an amendment to itssenior secured credit facility to provide for, among other things, anadditional term loan of $250 million which the Company has obtained concurrentwith the initial common stock offering of Parent, a reduction in the marginapplicable to the term loan and more flexibility under certain restrictivecovenants.

 

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**Holdings Debt**

 

InDecember 2004, Holdings, the Company’s direct parent, issued $847 millionprincipal amount of debt. The Company is not a party to, or an obligor of, anyof Holdings’ debt. However, Holdings is a holding company with no independentoperations or assets other than its interest in the Company. Accordingly,Holdings’ ability to service its debt obligations is dependent on the cashflows and operations of the Company.

 

Holdings’$847 million principal amount of debt consist of (i) $250 million principalamount of Floating Rate Senior Notes due 2011 (the ‘‘Holdings Floating RateNotes’’), (ii) $397 million principal amount at maturity of 9.5% SeniorDiscount Notes due 2014, which had an initial issuance discount of $147 million(the ‘‘Holdings Discount Notes’’), and (iii) $200 million principal amount ofFloating Rate Senior PIK Notes due 2014 (the ‘‘Holdings PIK Notes’’, andcollectively, the ‘‘Holdings Notes’’). The gross proceeds of $696 millionreceived from the issuance of the Holdings Notes were used to (i) redeem theremaining shares of cumulative preferred stock of Holdings at a redemptionprice of $209 million, including $9 million of accrued and unpaid dividends,(ii) pay a return of capital to Parent and its shareholders in the aggregateamount of $472 million, of which all but $7 million was distributed to Parent’sshareholders as of March 31, 2005, and (iii) pay debt related issuancecosts of approximately $15 million.  Theremaining $7 million was distributed to Parent’s shareholders in May 2005.

 

TheHoldings Floating Rate Notes bear interest at a quarterly, floating rate basedon three-month LIBOR rates plus a margin equal to 4.375%. Interest is payablequarterly in cash beginning on March 15, 2005. The Holdings Floating RateNotes mature on December 15, 2011.

 

TheHoldings Discount Notes were issued at a discount and have an initial accretedvalue of $630.02 per $1,000 principal amount at maturity. Prior to December 15,2009, no cash interest payments are required. However, interest accrues on theHoldings Discount Notes in the form of an increase in the accreted value ofsuch notes such that the accreted value of the Holdings Discount Notes willequal the principal amount at maturity on December 15, 2009. Thereafter,cash interest on the Holdings Discount Notes is payable semi-annually at afixed rate of 9.5% per annum. The Holdings Discount Notes mature on December 15,2014.

 

TheHoldings PIK Notes bear interest at a semi-annual floating rate based onsix-month LIBOR rates plus a margin equal to 7%. Interest is payablesemi-annually beginning on June 15, 2005 either in the form of cash oradditional PIK notes at the election of the Company. The Holdings PIK Notesmature on December 15, 2014.

 

TheHoldings Notes are redeemable in whole or in part, at the option of Holdings,at any time at a redemption price defined under the Indentures governing theHoldings Notes that generally includes a premium. In addition, upon a change ofcontrol and upon certain asset sales as specified under the indentures,Holdings may be required to make an offer to redeem the Holdings Notes from theholders at a redemption price defined under the indentures that includes apremium.

 

TheHoldings Notes are unsecured and subordinated to all of Holdings’ existing andfuture secured debt, including Holdings’ guarantee of borrowings by the Companyunder the Company’s senior secured credit facility. In addition, the HoldingsNotes are structurally subordinated to the subordinated notes of the Company.

 

Theindentures limit Holdings’ ability and the ability of its restrictedsubsidiaries to incur additional indebtedness or issue certain preferredshares; to pay dividends on or make other distributions in respect of itscapital stock or make other restricted payments; to make certain investments;to sell certain assets; to create liens on certain debt without securing thenotes; to consolidate, merge, sell or otherwise dispose off all orsubstantially all of its assets; to enter into certain transactions with affiliates;and to designate its subsidiaries as unrestricted subsidiaries.

 

Asdescribed further in Note 13, a portion of the proceeds from the initial commonstock offering of Parent were used to redeem all outstanding Holdings FloatingRate Notes, all outstanding Holdings PIK Notes and 35% of the aggregateprincipal

 

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amountof the outstanding Holdings Discount Notes, including redemption premiums andinterest obligations through the date of redemption.

 

**8.****                                     ****Shareholder’s Equity**

 

**Return of Capital**

 

Inthe fall of 2004, the Company used its available excess cash to pay a return ofcapital to Holdings, its direct parent, in the amount of approximately $352million. Of such aggregate amount, approximately $8 million was declared andpaid in September 2004 and the balance of approximately $344 million wasdeclared and paid in October 2004. Accordingly, whereas the September 2004dividend was reflected in the Company’s fiscal 2004 audited financialstatements, the October 2004 dividend has been reflected in theaccompanying interim financial statements.

 

**9.****                                     ****Stock-Based Compensation**

 

**Long-Term Incentive Plan andOther Equity Issuances**

 

InDecember 2004, the Board of Directors of the Company approved a long-termincentive plan (the ‘‘LTIP Plan’’) for employees or directors of the Companyand any of its affiliates. 1,355,066 shares of common stock of Parent wereauthorized under the plan. During the six months ended March 31, 2005,pursuant to certain contractual arrangements or in connection with the LTIPPlan, the Company granted 1,271,124 service-based stock options and 2,542,248performance-based options to purchase shares of Parent’s common stock tocertain employees of the Company. During the six months ended March 31,2005, the Company allowed certain employees to purchase 1,496,646 restrictedshares of Parent’s common stock and awarded certain employees 239,190restricted shares of Parent’s common stock.

 

**Payments Relating to ExecutiveCompensation**

 

The Company determinedthat certain shares of Parent’s restricted stock issued in 2004 and early 2005may have been sold at prices below fair market value on the applicable date ofsale and certain options to purchase shares of Parent’s stock granted may havehad exercise prices below fair market value on the applicable date ofgrant.  As a result, certain U.S.employee holders of the restricted stock who made elections under Section 83(b)of the Internal Revenue Code will be subject to additional ordinary income taxto the extent of the fair market value of the restricted stock received overthe purchase price they paid for such stock. In other cases, certain employeeswho did not make such an election will be subject to higher taxes on theirrestricted shares at the time of vesting than would have been the case had theypurchased the shares for fair market value. In addition, under the provisionsof the American Jobs Creation Act of 2004, signed into law in October 22,2004, U.S. employee option holders whose options vest with exercise pricesbelow fair market value on the date of grant are subject to significantpenalties under new Section 409A of the Internal Revenue Code. IRS Notice2005-1 provides transitional guidance on the application of Section 409Awhich, among other things, permits options with exercise prices below the fairmarket value of the underlying stock on the date of grant to be amended orreplaced with new options having an exercise price at least equal to the fairmarket value on the grant date. Non-U.S. employee holders of restricted stockor options may be subject to similar or other related issues. In order for theCompany to address these issues, on April 11, 2005, the compensationcommittee, based on a re-assessment of fair market values on the applicabledates, approved the actions discussed below.

 

**Restricted Stock**

 

The Company isauthorized to pay each employee who purchased restricted stock at prices thatwere below fair market value on the date of purchase a cash bonus. The cashbonus payable to those employees who made a Section 83(b) election will bean amount equal to the tax liability incurred by the employee as of the date ofpurchase based on any difference between the re-determined purchase date fairmarket value and the amount originally paid by the employee, plus an amountnecessary to pay the

 

16

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taxes on the bonus. Thebonus that would be payable to each of those employees who did not make a Section 83(b)election or the applicable foreign equivalent would be an amount reflecting anestimate of the additional tax which would be payable by the employee at thetime the restricted stock is scheduled to vest due to that taxable amount beingsubject to ordinary income rather than capital gains tax rates, and assumingthat the re-determined value of the stock remains constant over the vestingperiod, adjusted down to reflect a present value discount based on the earliestpossible vesting dates. The Company would also pay these employees an amount necessaryto pay the taxes on the bonus.   Thiswould result in total cash payments of approximately $10 million, which theCompany expects to pay in the third quarter of this fiscal year.

 

**Options**

* *

The Companyexpects to revise the exercise prices of certain options to purchase Parent’sstock to prices equal to the applicable re-determined fair market values of thecommon stock on the dates of the respective grants. To compensate the granteesfor the loss of value represented by this adjustment to the option exerciseprices, the Company expects to pay each affected employee a cash bonus in anamount equal to the excess of the adjusted aggregate exercise price of theemployee’s options over the original aggregate exercise price of the employee’soptions, adjusted down to reflect a present value discount based on theearliest possible exercise dates. In connection with the revision of theexercise prices of certain option grants, the Company will remeasure theaggregate compensation expense relating to such grants.  This would result in total cash payments ofapproximately $9 million, which the Company expects to pay in the third quarterof this fiscal year.

 

Further,in connection with the cash dividends Parent intends to declare to the holdersof its Class L Common Stock and Class A Common Stock, as described in Note 13,the Company intends to make an adjustment to all options outstanding at thetime of declaration of the dividend. The adjustment would consist of a cashmake-whole payment consisting of an amount equal to the pro rata amount thatwould have been received per share had all outstanding options been exercisedat the time of the declaration of the dividend adjusted down to reflect apresent value discount based on the earliest possible exercise dates. Thiswould result in a cash payment of approximately $5 million, which the Companyintends to pay when Parent declares and pays the dividend to its stockholders.

 

**10.****                              ****Commitments andContingencies**

 

**Litigation**

 

TheCompany is subject to a number of state and federal class action lawsuits, aswell as an action brought by a number of state Attorneys General allegingunlawful horizontal and vertical agreements to fix the prices of compact discsby the major record companies. The parties to the federal action commenced bythe Attorneys General have entered into a settlement agreement. On July 9,2003, the Court entered a final judgment approving the settlement. In one ofthe two remaining lawsuits, *Ottinger**v. EMI Music, Inc., et al.,*theCourt entered an order granting final approval of the settlement on January 21,2004. In the other action, *In re CompactDisc. Antitrust Litig.,*which was brought by individual retailers ofcompact discs alleging unlawful horizontal agreements to fix the prices ofcompact discs by the major record companies, on July 29, 2004, the Courtdenied the parties’ motion to grant final approval to the settlement. On August 30,2004, plaintiffs filed a Second Amended Consolidated Complaint addingadditional individual retailers as named plaintiffs in the litigation, whichthe Company answered, denying all claims, on September 15, 2004. On October 22,2004, the parties reached an agreement in principle on the terms of asettlement. The Company does not expect the final terms of that settlement todiffer materially from the settlement agreement previously entered into by theparties. On February 2, 2005, the court entered a Stipulation of Dismissalwith Prejudice of the entire action.

 

On September 7,2004, November 22, 2004 and March 31, 2005, Eliot Spitzer, theAttorney General of the State of New York, served Warner Music Group withrequests for information in the form of subpoenas duces tecum in connectionwith an industry-wide investigation of the relationship between music companiesand radio stations, including the use of independent promoters and accountingfor any such payments. In response to the Attorney General’s subpoenas, we havebeen producing documents and expect to complete our production in May or June.We also understand that the investigation has been expanded to

 

17

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include companies that own radiostations. The investigation is pursuant to New York Executive Law §63(12) andNew York General Business Law §349, both of which are consumer fraud statutes.It is too soon to predict the outcome of this investigation but it has thepotential to result in changes in the manner in which the recorded musicindustry promotes its records or financial penalties, which could adverselyaffect the Company’s business, including its brand value.

 

Inaddition to the State of New York investigation discussed above, the Company isinvolved with employment claims and other legal proceedings that are incidentalto its normal business activities. It is possible that an adverse outcome onany of these matters could result in a material effect on the Company’sconsolidated financial statements. Due to the preliminary status of many ofthese matters, the Company is unable to predict the outcome or determine arange of loss at this time.

 

**Management/ MonitoringAgreement**

 

Asdescribed in Note 19 to the Company’s audited consolidated financial statementsfor the seven months ended September 30, 2004, the Company and its directand indirect parents entered into a management monitoring agreement (the“Management Agreement”) with the Investor Group in connection with theAcquisition.

 

Underthe Management Agreement, the Company or its direct and indirect parents arerequired to pay the Investor Group an aggregate annual fee of $10 million peryear (the “Periodic Fees”) in consideration for ongoing consulting andmanagement advisory services. In addition, in the case of future servicesprovided in connection with any future acquisition, disposition, or financing transactionsinvolving the Company or its direct and indirect parents, the ManagementAgreement requires the Company or its parents to pay the Investor Group anaggregate fee of one percent of the gross transaction value of each suchtransaction (“Subsequent Fees”). The Management Agreement also requires theCompany or its direct and indirect parents to pay the reasonable expenses ofthe Investor Group in connection with, and indemnify them for liabilitiesarising from, the Management Agreement, the Acquisition and any relatedtransactions, their equity investment in the Company or its direct and indirectparents, their operations, and the services they provide to the Company or itsparents.

 

TheManagement Agreement continues in full force and effect until December 30,2014, provided, however, that the Investor Group may cause the agreement toterminate at any time upon agreement of the Investor Group. In the event of thetermination of the Management Agreement, the Company or any of its direct andindirect parents shall pay each of the Investor Group (x) any unpaid portion ofthe Periodic Fees, any Subsequent Fees and any expenses due with respect toperiods prior to the date of termination plus (y) the net present value (usinga discount rate equal to the then yield on U.S. Treasury Securities of likematurity) of the Periodic Fees that would have been payable with respect to theperiod from the date of termination until December 30, 2014.

 

Asdescribed further in Note 13, the Company, along with its direct and indirectparents, has terminated the Management Agreement for an approximate $73 milliontermination fee.

 

**11.          Derivative Financial Instruments**

 

During the sixmonths ended March 31, 2005, the Company entered into additional interest rateswap agreements to hedge the variability of its expected future cash interestpayments. As of March 31, 2005, the Company had total national amounts hedgedunder these agreements of $897 million and recorded deferred gains incomprehensive income of $6 million.

 

 

**12.****                              ****SegmentInformation**

 

Asdiscussed more fully in Note 1, based on the nature of its products andservices, the Company classifies its business interests into two fundamentalareas:  recorded music and musicpublishing.  Information as to each ofthese operations is set forth below.

 

TheCompany evaluates performance based on several factors, of which the primaryfinancial measure is operating income (loss) before non-cash depreciation oftangible assets, non-cash amortization of intangible assets and non-cash impairmentcharges to reduce the carrying value of goodwill and intangible assets(“OIBDA”).  The Company has supplementedits analysis of

 

18

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OIBDAresults by segment with an analysis of operating income (loss) by segment.

 

Theaccounting policies of the Company’s business segments are the same as thosedescribed in the summary of significant accounting policies included elsewhereherein.  The Company accounts forintersegment sales at fair value as if the sales were to third parties.  While intercompany transactions are treatedlike third-party transactions to determine segment performance, the revenues(and corresponding expenses recognized by the segment that is counterparty tothe transaction) are eliminated in consolidation or combination and, therefore,do not themselves impact consolidated or combined results.

 

During2004, in connection with the Acquisition, the Company changed its methodologyfor allocating certain corporate costs to its business segments.  Accordingly, the Company has restated itsoperating performance measures for the prior period to reflect its newcost-allocation methodology on a consistent basis.

 
| ** **               | ** ** | **Successor**                                  | ** ** | **Predecessor**                       | ** ** |
|--------------------------|------------|------------------------------------------------|------------|---------------------------------------|------------|
| ** **               | ** ** | **Three  Months  Ended  March 31,  2005** | ** ** | **Six Months  Ended March 31,  2005** | ** ** | **One Month  Ended March 31,   2004** | ** ** | **Two Months  Ended February 29,  2004** | ** ** | **Five Months  Ended February 29,  2004** | ** ** |
| ** **               | ** ** | **(in millions)**                              | ** ** |
| **Revenues:**            |       |                                           |       |                                  |       |   |   |   |   |   |   |
| Recorded music           |       | $                                              | 621        |                                  | $          | 1,561 |   | $ | 190 |   | $ | 402 |   | $ | 1,430 |   |
| Music publishing         |       | 154                                            |       | 309                                   |       | 55 |   | 94 |   | 253 |   |
| Intersegment elimination |       | (8                                             | )          | (15                                   | )          | — |   | (6 | ) | (15 | ) |
|                     |       |                                           |       |                                  |       |   |   |   |   |   |   |
| Total revenues           |       | $                                              | 767        |                                  | $          | 1,855 |   | $ | 245 |   | $ | 490 |   | $ | 1,668 |   |

 
| ** **         | ** ** | **Successor**                                  | ** ** | **Predecessor**                       | ** ** |
|--------------------|------------|------------------------------------------------|------------|---------------------------------------|------------|
| ** **         | ** ** | **Three  Months  Ended  March 31,  2005** | ** ** | **Six Months  Ended March 31,  2005** | ** ** | **One Month  Ended March 31,  2004** | ** ** | **Two Months  Ended  February 29,  2004** | ** ** | **Five Months  Ended February 29,  2004** | ** ** |
| ** **         | ** ** | **(in millions)**                              | ** ** |
| **OIBDA:**         |       |                                           |       |                                  |       |   |   |   |   |   |   |
| Recorded music     |       | $                                              | 72         |                                  | $          | 266 |   | $ | 12 |   | $ | 9 |   | $ | 146 |   |
| Music publishing   |       | 47                                             |       | 71                                    |       | 15 |   | 30 |   | 57 |   |
| Corporate expenses |       | (31                                            | )          | (59                                   | )          | (3 | ) | (15 | ) | (28 | ) |
|               |       |                                           |       |                                  |       |   |   |   |   |   |   |
| Total OIBDA        |       | $                                              | 88         |                                  | $          | 278 |   | $ | 24 |   | $ | 24 |   | $ | 175 |   |

 

19

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| ** **                                         | ** ** | **Successor**                           | ** ** | **Predecessor**                       | ** ** |
|----------------------------------------------------|------------|-----------------------------------------|------------|---------------------------------------|------------|
| ** **                                         | ** ** | **Three Months  Ended March 31,  2005** | ** ** | **Six Months  Ended March 31,  2005** | ** ** | **One Month  Ended March 31,  2004** | ** ** | **Two Months  Ended February 29,  2004** | ** ** | **Five Months  Ended February 29,  2004** | ** ** |
| ** **                                         | ** ** | **(in millions)**                       | ** ** |
| **Depreciation of Property, Plant and Equipment:** |       |                                    |       |                                  |       |   |   |   |   |   |   |
| Recorded music                                     |       | $                                       | 9          |                                  | $          | 18 |   | $ | 4 |   | $ | 7 |   | $ | 22 |   |
| Music publishing                                   |       | 1                                       |       | 2                                     |       | 1 |   | 1 |   | 2 |   |
| Corporate expenses                                 |       | 4                                       |       | 8                                     |       | 1 |   | 3 |   | 7 |   |
|                                               |       |                                    |       |                                  |       |   |   |   |   |   |   |
| Total depreciation                                 |       | $                                       | 14         |                                  | $          | 28 |   | $ | 6 |   | $ | 11 |   | $ | 31 |   |
|                                                    |            |                                         |            |                                       |            |  |  |  |  |  |  |  |  |  |  |  |  |  |

 
| ** **                             | ** ** | **Successor**                                  | ** ** | **Predecessor**                       | ** ** |
|----------------------------------------|------------|------------------------------------------------|------------|---------------------------------------|------------|
| ** **                             | ** ** | **Three  Months  Ended  March 31,  2005** | ** ** | **Six Months  Ended March 31,  2005** | ** ** | **One Month  Ended March 31,  2004** | ** ** | **Two Months  Ended  February 29,  2004** | ** ** | **Five Months  Ended February 29,  2004** | ** ** |
| ** **                             | ** ** | **(in millions)**                              | ** ** |
| **Amortization of Intangible Assets:** |       |                                           |       |                                  |       |   |   |   |   |   |   |
| Recorded music                         |       | $                                              | 33         |                                  | $          | 66 |   | $ | 10 |   | $ | 23 |   | $ | 63 |   |
| Music publishing                       |       | 14                                             |       | 27                                    |       | 5 |   | 14 |   | 34 |   |
| Corporate expenses                     |       | —                                         |       | —                                |       | — |   | — |   | — |   |
|                                   |       |                                           |       |                                  |       |   |   |   |   |   |   |
| Total amortization                     |       | $                                              | 47         |                                  | $          | 93 |   | $ | 15 |   | $ | 37 |   | $ | 97 |   |

 
| ** **                                        | ** ** | **Successor**                                  | ** ** | **Predecessor**                       | ** ** |
|---------------------------------------------------|------------|------------------------------------------------|------------|---------------------------------------|------------|
| ** **                                        | ** ** | **Three  Months  Ended  March 31,  2005** | ** ** | **Six Months  Ended March 31,  2005** | ** ** | **One Month  Ended March 31,  2004** | ** ** | **Two Months  Ended  February 29,  2004** | ** ** | **Five Months  Ended February 29,  2004** | ** ** |
| ** **                                        | ** ** | **(in millions)**                              | ** ** |
| **Impairment of Goodwill and Other Intangibles:** |       |                                           |       |                                  |       |   |   |   |   |   |   |
| Recorded music                                    |       | $                                              | —     |                                  | $          | — |   | $ | — |   | $ | — |   | $ | 1,019 |   |
| Music publishing                                  |       | —                                         |       | —                                |       | — |   | — |   | — |   |
| Corporate expenses                                |       | —                                         |       | —                                |       | — |   | — |   | — |   |
|                                              |       |                                           |       |                                  |       |   |   |   |   |   |   |
| Total impairment                                  |       | $                                              | —     |                                  | $          | — |   | $ | — |   | $ | — |   | $ | 1,019 |   |

 

20

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| ** **                    | ** ** | **Successor**                                  | ** ** | **Predecessor**                       | ** ** |
|-------------------------------|------------|------------------------------------------------|------------|---------------------------------------|------------|
| ** **                    | ** ** | **Three  Months  Ended  March 31,  2005** | ** ** | **Six Months  Ended March 31,  2005** | ** ** | **One Month  Ended March 31,  2004** | ** ** | **Two Months  Ended  February 29,  2004** | ** ** | **Five Months  Ended February 29,  2004** | ** ** |
| ** **                    | ** ** | **(in millions)**                              | ** ** |
| **Operating Income (Loss):**  |       |                                           |       |                                  |       |   |   |   |   |   |   |
| Recorded music                |       | $                                              | 30         |                                  | $          | 182 |   | $ | (2 | ) | $ | (21 | ) | $ | (958 | ) |
| Music publishing              |       | 32                                             |       | 42                                    |       | 9 |   | 15 |   | 21 |   |
| Corporate expenses            |       | (35                                            | )          | (67                                   | )          | (4 | ) | (18 | ) | (35 | ) |
|                          |       |                                           |       |                                  |       |   |   |   |   |   |   |
| Total operating income (loss) |       | $                                              | 27         |                                  | $          | 157 |   | $ | 3 |   | $ | (24 | ) | $ | (972 | ) |

 
| ** **                                              | ** ** | **Successor**                                  | ** ** | **Predecessor**                       | ** ** |
|---------------------------------------------------------|------------|------------------------------------------------|------------|---------------------------------------|------------|
| ** **                                              | ** ** | **Three  Months  Ended  March 31,  2005** | ** ** | **Six Months  Ended March 31,  2005** | ** ** | **One Month  Ended March 31,  2004** | ** ** | **Two Months  Ended  February 29,  2004** | ** ** | **Five Months  Ended February 29,  2004** | ** ** |
| ** **                                              | ** ** | **(in millions)**                              | ** ** |
| **Reconciliation of OIBDA to Operating Income (Loss):** |       |                                           |       |                                  |       |   |   |   |   |   |   |
| OIBDA                                                   |       | $                                              | 88         |                                  | $          | 278 |   | $ | 24 |   | $ | 24 |   | $ | 175 |   |
| Depreciation expense                                    |       | (14                                            | )          | (28                                   | )          | (6 | ) | (11 | ) | (31 | ) |
| Amortization expense                                    |       | (47                                            | )          | (93                                   | )          | (15 | ) | (37 | ) | (97 | ) |
| Impairment of goodwill and other intangible assets      |       | —                                         |       | —                                |       | — |   | — |   | (1,019 | ) |
| Operating income (loss)                                 |       | $                                              | 27         |                                  | $          | 157 |   | $ | 3 |   | $ | (24 | ) | $ | (972 | ) |

 

**13.****                              ****Additional FinancialInformation**

 

**Cash Interest and Taxes**

 

TheCompany made interest payments of approximately $61 million during the sixmonths ended March 31, 2005, $2 million during the one month ended March 31,2004 and $7 million in the five months ended February 29, 2004.

 

TheCompany paid income and withholding taxes of approximately $23 million in thesix months ended March 31, 2005, $7 million in the one month ended March 31,2004 and $15 million in the five months ended February 29, 2004. TheCompany received foreign income tax refunds of approximately $9 million in thesix months ended March 31, 2005, $8 million in the one month ended March 31,2004 and $2 million in the five months ended February 29, 2004. Withrespect to income and withholding taxes paid currently but relating in a periodprior to the closing of the Acquisition that was effective in March 2004,such payments are a receivable from Time Warner. Conversely, any refundsreceived currently that are for a period prior to the closing of theAcquisition are a payable to Time Warner.

 

21

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**Noncash Transactions**

 

Significantnon-cash investing and financing activities during the five months ended February 29,2004 included the non-cash recapitalization of certain intercompany receivablesand payables between Old WMG and Time Warner.

 

There were no significant non-cashinvesting and financing activities during the six months ended March 31,2005 and one month ended March 31, 2004.

 

**14.****                              ****The Initial Common Stock Offeringof Parent**

 

In March 2005,Parent’s Board of Directors approved a registration statement on Form S-1 to befiled with the Securities and Exchange Commission in connection with a plannedinitial public offering of Parent’s common stock (the ‘‘Initial Common StockOffering’’). Prior to the consummation of the Initial Common Stock Offering,Parent, among other things, renamed all of its outstanding shares of Class ACommon Stock as common stock and authorized a 1,139 for 1 split of the Parent’scommon stock (the “Recapitalization”). Accordingly, the disclosures related tostock-based compensation in these historical financial statements have beenrestated to reflect the Recapitalization for all periods occurring after theAcquisition that was effective as of March 1, 2004.

 

Parentreceived approximately $    million innet proceeds from the closing of this offering in May 2005, which wascontributed to Holdings as an equity capital contribution.  Holdings used $574 million of such funds toredeem all outstanding Holdings Floating Rate Notes, all outstanding HoldingsPIK Notes and 35% of the aggregate principal amount of the outstanding HoldingsDiscount Notes, including redemption premiums and interest obligations throughthe date of redemption.

 

Further,concurrent with the Initial Common Stock Offering, Parent (i) terminated theManagement Agreement with the Investors and pay an approximate $73 milliontermination fee (ii) paid certain special one-time bonuses to employees of theCompany totaling $35 million (iii) paid dividends of approximately $150 millionto its Class L and Class A stockholders and (iv) repurchased Historic TimeWarner’s three-year warrants at a cost at approximately $166 million(collectively, the “Concurrent Transactions”). The dividend to Parent’s stockholdersand the cost to repurchase the warrants were funded through a one-time dividenddeclared by the Company to its parent companies using a portion of the cash onhand plus the proceeds from $250 million of new term loan borrowings under theCompany’s new amendment to the senior secured credit facility. As part of theConcurrent Transactions, the Company obtained an amendment to its seniorsecured credit facility to provide for, among other things, an additional $250million of term loan, a reduction in the margin applicable on the term loan,more flexibility under certain restrictive covenants, the ability to use theproceeds from the Initial Common Stock Offering to repay part of Holdingsindebtedness and to consummate certain of the Concurrent Transactions.

 

22

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**Supplementary Information**

**Condensed Consolidating Financial Statements (Unaudited)**

 

WMGAcquisition Corp. (the “Company” or “New WMG”), is one of the world’s majormusic companies and the successor to the interests of the recorded music andmusic publishing businesses of Time Warner Inc. (“Time Warner”).  Such predecessor interests formerly owned byTime Warner are hereinafter referred to as “Old WMG”.  Effective March 1, 2004, the Companyacquired Old WMG from Time Warner for approximately $2.6 billion.

 

NewWMG has issued (i) $465 million principal amount of 7.375% Senior SubordinatedNotes due 2014 and (ii) 100 million Sterling principal amount of 8.125% SeniorSubordinated notes due 2014 (the “Notes”). The Notes are guaranteed by all of New WMG’s domestic wholly ownedsubsidiaries on a senior subordinated basis. These guarantees are full, unconditional, joint and several.  The following condensed consolidatingfinancial statements are presented for the information of the holders of theNotes and present the results of operations, financial position and cash flowsof (i) New WMG, which is the issuer of the Notes, or its predecessor Old WMG,(ii) the guarantor subsidiaries of New WMG, (iii) the non-guarantorsubsidiaries of New WMG and (iv) the eliminations necessary to arrive at theinformation for New WMG on a consolidated or Old WMG on a combined basis.  Investments in consolidated or combinedsubsidiaries are presented under the equity method of accounting.  There are no restrictions on New WMG’sability to obtain funds from any of its wholly owned subsidiaries throughdividends, loans or advances.

 

23

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**Consolidating Balance Sheet (Unaudited)**

**March 31, 2005**

 
| ** **                                                      | ** ** | **New WMG**       | ** ** | **Guarantor  Subsidiaries** | ** ** | **Non-  Guarantor  Subsidiaries** | ** ** | **Eliminations** | ** ** | **New WMG  Consolidated** | ** ** |
|-----------------------------------------------------------------|------------|-------------------|------------|-----------------------------|------------|-----------------------------------|------------|------------------|------------|---------------------------|------------|
| ** **                                                      | ** ** | **(in millions)** | ** ** |
| **Assets:**                                                     |       |              |       |                        |       |                              |       |             |       |                      |       |
| Current assets:                                                 |       |              |       |                        |       |                              |       |             |       |                      |       |
| Cash and equivalents                                            |       | $                 | 2          |                        | $          | 215                               |       | $                | 223        |                      | $          | — |   | $ | 440 |   |
| Accounts receivable, net                                        |       | 26                |       | 228                         |       | 233                               |       | —           |       | 487                       |       |
| Inventories                                                     |       | —            |       | 36                          |       | 30                                |       | —           |       | 66                        |       |
| Royalty advances expected to be recouped within one year        |       | —            |       | 102                         |       | 93                                |       | —           |       | 195                       |       |
| Deferred tax assets                                             |       | —            |       | 25                          |       | 17                                |       |             |       | 42                        |       |
| Due from parent companies, net                                  |       | 1                 |       | —                      |       | —                            |       |             |       | 1                         |       |
| Other current assets                                            |       | —            |       | 14                          |       | 44                                |       |             |       | 58                        |       |
| Total current assets                                            |       | 29                |       | 620                         |       | 640                               |       |             |       | 1,289                     |       |
|                                                            |       |              |       |                        |       |                              |       |             |       |                      |       |
| Royalty advances expected to be recouped after one year         |       | —            |       | 102                         |       | 93                                |       | —           |       | 195                       |       |
| Investments in and advances to (from) consolidated subsidiaries |       | 2,257             |       | 471                         |       | (278                              | )          | (2,450           | )          | —                    |       |
| Intercompany notes receivable                                   |       | 189               |       | —                      |       | —                            |       | (189             | )          | —                    |       |
| Investments                                                     |       | —            |       | 16                          |       | 6                                 |       | —           |       | 22                        |       |
| Property, plant and equipment                                   |       | —            |       | 114                         |       | 58                                |       | —           |       | 172                       |       |
| Goodwill                                                        |       | —            |       | 248                         |       | 687                               |       | —           |       | 935                       |       |
| Intangible assets subject to amortization                       |       | —            |       | 1,203                       |       | 691                               |       |             |       | 1,894                     |       |
| Intangible assets not subject to amortization                   |       | —            |       | 100                         |       | —                            |       | —           |       | 100                       |       |
| Other assets                                                    |       | 85                |       | 3                           |       | 25                                |       |             |       | 113                       |       |
|                                                            |       |              |       |                        |       |                              |       |             |       |                      |       |
| **Total assets**                                                |       | $                 | 2,560      |                        | $          | 2,877                             |       | $                | 1,922      |                      | $          | (2,639 | ) | $ | 4,720 |   |
|                                                            |       |              |       |                        |       |                              |       |             |       |                      |       |
| **Liabilities and Shareholder’s Equity**                   |       |              |       |                        |       |                              |       |             |       |                      |       |
| Current liabilities:                                            |       |              |       |                        |       |                              |       |             |       |                      |       |
| Accounts payable                                                |       | $                 | —     |                        | $          | 113                               |       | $                | 93         |                      | $          | — |   | $ | 206 |   |
| Accrued royalties                                               |       | —            |       | 565                         |       | 511                               |       | —           |       | 1,076                     |       |
| Taxes and other withholdings                                    |       | —            |       | —                      |       | 26                                |       |             |       | 26                        |       |
| Current portion of long-term debt                               |       | 12                |       | —                      |       | —                            |       | —           |       | 12                        |       |
| Other current liabilities                                       |       | 30                |       | 115                         |       | 197                               |       | —           |       | 342                       |       |
| Total current liabilities                                       |       | 42                |       | 793                         |       | 827                               |       | —           |       | 1,662                     |       |
|                                                            |       |              |       |                        |       |                              |       |             |       |                      |       |
| Long-term debt                                                  |       | 1,830             |       | —                      |       | —                            |       | —           |       | 1,830                     |       |
| Intercompany notes payable                                      |       | —            |       | —                      |       | 189                               |       | (189             | )          | —                    |       |
| Deferred tax liabilities, net                                   |       | —            |       | 25                          |       | 238                               |       | —           |       | 263                       |       |
| Other noncurrent liabilities                                    |       | —            |       | 181                         |       | 96                                |       |             |       | 277                       |       |
| Total liabilities                                               |       | 1,872             |       | 999                         |       | 1,350                             |       | (189             | )          | 4,032                     |       |
|                                                            |       |              |       |                        |       |                              |       |             |       |                      |       |
| Shareholder’s equity                                       |       | 688               |       | 1,878                       |       | 572                               |       | (2,450           | )          | 688                       |       |
|                                                            |       |              |       |                        |       |                              |       |             |       |                      |       |
| **Total liabilities and shareholder’s equity**             |       | $                 | 2,560      |                        | $          | 2,877                             |       | $                | 1,922      |                      | $          | (2,639 | ) | $ | 4,720 |   |

 

24

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**Consolidating Balance Sheet (audited)**

**September 30, 2004**

 
| ** **                                                      | ** ** | **New WMG**       | ** ** | **Guarantor  Subsidiaries** | ** ** | **Non-  Guarantor  Subsidiaries** | ** ** | **Eliminations** | ** ** | **New WMG  Consolidated** | ** ** |
|-----------------------------------------------------------------|------------|-------------------|------------|-----------------------------|------------|-----------------------------------|------------|------------------|------------|---------------------------|------------|
| ** **                                                      | ** ** | **(in millions)** | ** ** |
| **Assets:**                                                     |       |              |       |                        |       |                              |       |             |       |                      |       |
| Current assets:                                                 |       |              |       |                        |       |                              |       |             |       |                      |       |
| Cash and cash equivalents                                       |       | $                 | 2          |                        | $          | 433                               |       | $                | 120        |                      | $          | — |   | $ | 555 |   |
| Accounts receivable, net                                        |       | 24                |       | 278                         |       | 269                               |       | —           |       | 571                       |       |
| Inventories                                                     |       | —            |       | 37                          |       | 28                                |       | —           |       | 65                        |       |
| Royalty advances expected to be recouped within one year        |       | —            |       | 122                         |       | 101                               |       | —           |       | 223                       |       |
| Deferred tax assets                                             |       | —            |       | 24                          |       | 14                                |       | —           |       | 38                        |       |
| Other current assets                                            |       | 4                 |       | 13                          |       | 69                                |       | —           |       | 86                        |       |
| Total current assets                                            |       | 30                |       | 907                         |       | 601                               |       | —           |       | 1,538                     |       |
|                                                            |       |              |       |                        |       |                              |       |             |       |                      |       |
| Royalty advances expected to be recouped after one year         |       | —            |       | 124                         |       | 99                                |       | —           |       | 223                       |       |
| Investments in and advances to (from) consolidated subsidiaries |       | 2,556             |       | 6                           |       | (269                              | )          | (2,293           | )          | —                    |       |
| Intercompany notes receivable                                   |       | 188               |       | —                      |       | —                            |       | (188             | )          | —                    |       |
| Investments                                                     |       | —            |       | 11                          |       | (3                                | )          | —           |       | 8                         |       |
| Property, plant and equipment                                   |       | —            |       | 127                         |       | 62                                |       | —           |       | 189                       |       |
| Goodwill                                                        |       | —            |       | 274                         |       | 704                               |       | —           |       | 978                       |       |
| Intangible assets subject to amortization                       |       | —            |       | 1,253                       |       | 684                               |       | —           |       | 1,937                     |       |
| Intangible assets not subject to amortization                   |       | —            |       | 100                         |       | —                            |       | —           |       | 100                       |       |
| Other assets                                                    |       | 93                |       | 12                          |       | 12                                |       | —           |       | 117                       |       |
| **Total assets**                                                |       | $                 | 2,867      |                        | $          | 2,814                             |       | $                | 1,890      |                      | $          | (2,481 | ) | $ | 5,090 |   |
|                                                            |       |              |       |                        |       |                              |       |             |       |                      |       |
| **Liabilities and Shareholder’s Equity**                   |       |              |       |                        |       |                              |       |             |       |                      |       |
| Current liabilities:                                            |       |              |       |                        |       |                              |       |             |       |                      |       |
| Accounts payable                                                |       | $                 | —     |                        | $          | 116                               |       | $                | 110        |                      | $          | — |   | $ | 226 |   |
| Accrued royalties                                               |       | —            |       | 511                         |       | 492                               |       | —           |       | 1,003                     |       |
|                                                            |       |              |       |                        |       |                              |       |             |       |                      |       |
| Taxes and other withholdings                                    |       | —            |       | 4                           |       | 6                                 |       | —           |       | 10                        |       |
| Current portion of long-term debt                               |       | 12                |       | —                      |       | —                            |       | —           |       | 12                        |       |
| Other current liabilities                                       |       | 42                |       | 139                         |       | 251                               |       | —           |       | 432                       |       |
| Total current liabilities                                       |       | 54                |       | 770                         |       | 859                               |       | —           |       | 1,683                     |       |
|                                                            |       |              |       |                        |       |                              |       |             |       |                      |       |
| Long-term debt                                                  |       | 1,828             |       | —                      |       | —                            |       | —           |       | 1,828                     |       |
| Intercompany notes payable                                      |       | —            |       | —                      |       | 188                               |       | (188             | )          | —                    |       |
| Deferred tax liabilities, net                                   |       | —            |       | 24                          |       | 241                               |       | —           |       | 265                       |       |
| Other noncurrent liabilities                                    |       | 4                 |       | 209                         |       | 124                               |       | (4               | )          | 333                       |       |
| Due to WMG Parent Corp.                                         |       | 3                 |       | —                      |       | —                            |       | —           |       | 3                         |       |
| Total liabilities                                               |       | 1,889             |       | 1,003                       |       | 1,412                             |       | (192             | )          | 4,112                     |       |
|                                                            |       |              |       |                        |       |                              |       |             |       |                      |       |
| Shareholder’s equity                                       |       | 978               |       | 1,811                       |       | 478                               |       | (2,289           | )          | 978                       |       |
|                                                            |       |              |       |                        |       |                              |       |             |       |                      |       |
| **Total liabilities and shareholder’s equity**             |       | $                 | 2,867      |                        | 2,814      |                              | $          | 1,890            |       | $                         | (2,481     | ) | $ | 5,090 |   |

 

25

----

 

**Consolidating Income Statement (Unaudited)**

**Three Months Ended March 31, 2005**

 
| ** **                                   | ** ** | **New WMG**       | ** ** | **Guarantor  Subsidiaries** | ** ** | **Non-  Guarantor  Subsidiaries** | ** ** | **Eliminations** | ** ** | **New WMG  Consolidated** | ** ** |
|----------------------------------------------|------------|-------------------|------------|-----------------------------|------------|-----------------------------------|------------|------------------|------------|---------------------------|------------|
| ** **                                   | ** ** | **(in millions)** | ** ** |
|                                         |       |              |       |                        |       |                              |       |             |       |                      |       |
| Revenues                                     |       | $                 | —     |                        | $          |                              |       | $                |       |                      | $          | (140 | ) | $ |   |   |
| Costs and expenses:                          |       |              |       |                        |       |                              |       |             |       |                      |       |
| Costs of revenues                            |       | —            |       | (243                        | )          | (296                              | )          | 139              |       | (400                      | )          |
| Selling, general and administrative expenses |       | (2                | )          | (150                        | )          | (142                              | )          | 1                |       | (293                      | )          |
| Amortization of intangible assets            |       | —            |       | (32                         | )          | (15                               | )          | —           |       | (47                       | )          |
|                                         |       |              |       |                        |       |                              |       |             |       |                      |       |
| Total costs and expenses                     |       | (2                | )          | (425                        | )          | (453                              | )          | 140              |       | (740                      | )          |
|                                         |       |              |       |                        |       |                              |       |             |       |                      |       |
| Operating income (loss)                      |       | (2                | )          | 20                          |       | 9                                 |       | —           |       | 27                        |       |
|                                         |       |              |       |                        |       |                              |       |             |       |                      |       |
| Interest expense, net                        |       | (27               | )          | (5                          | )          | (3                                | )          | —           |       | (35                       | )          |
| Equity gains from consolidated subsidiaries  |       | 21                |       | 2                           |       | —                            |       | (23              | )          | —                    |       |
|                                         |       |              |       |                        |       |                              |       |             |       |                      |       |
| Income (loss) before income taxes            |       | (8                | )          | 17                          |       | 6                                 |       | (23              | )          | (8                        | )          |
| Income tax (expense) benefit                 |       | (10               | )          | (8                          | )          | (6                                | )          | 14               |       | (10                       | )          |
|                                         |       |              |       |                        |       |                              |       |             |       |                      |       |
| Net income (loss)                            |       | $                 |       |                        | $          |                              |       | $                |       |                      | $          |   |   | $ |   |   |

 

26

----

 

**Combining Income Statement (Unaudited)**

**Six Months Ended March 31, 2005**

 
| ** **                                           | ** ** | **New WMG**       | ** ** | **Guarantor  Subsidiaries** | ** ** | **Non-  Guarantor  Subsidiaries** | ** ** | **Eliminations** | ** ** | **New WMG  Consolidated** | ** ** |
|------------------------------------------------------|------------|-------------------|------------|-----------------------------|------------|-----------------------------------|------------|------------------|------------|---------------------------|------------|
| ** **                                           | ** ** | **(in millions)** | ** ** |
|                                                 |       |              |       |                        |       |                              |       |             |       |                      |       |
| Revenues                                             |       | $                 | —     |                        | $          | 972                               |       | $                | 1,131      |                      | $          | (248 | ) | $ | 1,855 |   |
| Costs and expenses:                                  |       |              |       |                        |       |                              |       |             |       |                      |       |
| Costs of revenues                                    |       | —            |       | (522                        | )          | (703                              | )          | 244              |       | (981                      | )          |
| Selling, general and administrative expenses         |       | (5                | )          | (322                        | )          | (301                              | )          | 4                |       | (624                      | )          |
| Amortization of intangible assets                    |       | —            |       | (64                         | )          | (29                               | )          | —           |       | (93                       | )          |
|                                                 |       |              |       |                        |       |                              |       |             |       |                      |       |
| Total costs and expenses                             |       | (5                | )          | (908                        | )          | (1,033                            | )          | 248              |       | (1,698                    | )          |
|                                                 |       |              |       |                        |       |                              |       |             |       |                      |       |
| Operating income (loss)                              |       | (5                | )          | 64                          |       | 98                                |       | —           |       | 157                       |       |
|                                                 |       |              |       |                        |       |                              |       |             |       |                      |       |
| Interest expense, net                                |       | (54               | )          | (10                         | )          | (7                                | )          | —           |       | (71                       | )          |
| Equity in the losses of equity-method investees, net |       | —            |       | —                      |       | (1                                | )          | —           |       | (1                        | )          |
| Equity gains from consolidated subsidiaries          |       | 144               |       | 64                          |       | —                            |       | (208             | )          | —                    |       |
| Other income, net                                    |       | 4                 |       | —                      |       | —                            |       | —           |       | 4                         |       |
|                                                 |       |              |       |                        |       |                              |       |             |       |                      |       |
| Income (loss) before income taxes                    |       | 89                |       | 118                         |       | 90                                |       | (208             | )          | 89                        |       |
| Income tax (expense) benefit                         |       | (42               | )          | (32                         | )          | (34                               | )          | 66               |       | (42                       | )          |
|                                                 |       |              |       |                        |       |                              |       |             |       |                      |       |
| Net income (loss)                                    |       | $                 | 47         |                        | $          | 86                                |       | $                | 56         |                      | $          | (142 | ) | $ | 47 |   |

 

27

----

 

**Combining Income Statement (Unaudited)**

**One Month Ended March 31, 2004**

 
| ** **                                           | ** ** | **New WMG**       | ** ** | **Guarantor  Subsidiaries** | ** ** | **Non-  Guarantor  Subsidiaries** | ** ** | **Eliminations** | ** ** | **New WMG  Consolidated** | ** ** |
|------------------------------------------------------|------------|-------------------|------------|-----------------------------|------------|-----------------------------------|------------|------------------|------------|---------------------------|------------|
| ** **                                           | ** ** | **(in millions)** | ** ** |
|                                                 |       |              |       |                        |       |                              |       |             |       |                      |       |
| Revenues                                             |       | $                 | —     |                        | $          | 200                               |       | $                | 132        |                      | $          | (87 | ) | $ | 245 |   |
| Costs and expenses:                                  |       |              |       |                        |       |                              |       |             |       |                      |       |
| Costs of revenues                                    |       | —            |       | (131                        | )          | (80                               | )          | 81               |       | (130                      | )          |
| Selling, general and administrative expenses         |       | (1                | )          | (54                         | )          | (48                               | )          | 6                |       | (97                       | )          |
| Amortization of intangible assets                    |       | —            |       | (11                         | )          | (4                                | )          | —           |       | (15                       | )          |
| Total costs and expenses                             |       | (1                | )          | (196                        | )          | (132                              | )          | 87               |       | (242                      | )          |
| Operating income (loss)                              |       | (1                | )          | 4                           |       | —                            |       | —           |       | 3                         |       |
| Interest expense, net                                |       | (8                | )          | (2                          | )          | —                            |       | —           |       | (10                       | )          |
| Equity in the losses of equity-method investees, net |       | —            |       | —                      |       | (1                                | )          | —           |       | (1                        | )          |
| Equity gains from consolidated subsidiaries          |       | 1                 |       | 5                           |       | —                            |       | (6               | )          | —                    |       |
| Income (loss) before income taxes                    |       | (8                | )          | 7                           |       | (1                                | )          | (6               | )          | (8                        | )          |
| Income tax (expense) benefit                         |       | 1                 |       | —                      |       | 1                                 |       | (1               | )          | 1                         |       |
| Net income (loss)                                    |       | $                 | (7         | )                           | $          | 7                                 |       | $                | —     |                      | $          | (7 | ) | $ | (7 | ) |

 

28

----

 

**Combining Income Statement (Unaudited)**

**Two Months Ended February 29, 2004**

 
| ** **                                           | ** ** | **Old  WMG(a)**   | ** ** | **Guarantor  Subsidiaries** | ** ** | **Non-  Guarantor  Subsidiaries** | ** ** | **Eliminations** | ** ** | **Old WMG  Combined** | ** ** |
|------------------------------------------------------|------------|-------------------|------------|-----------------------------|------------|-----------------------------------|------------|------------------|------------|-----------------------|------------|
| ** **                                           | ** ** | **(in millions)** | ** ** |
|                                                 |       |              |       |                        |       |                              |       |             |       |                  |       |
| Revenues                                             |       |              |       | $                           | 279        |                              | $          | 303              |       | $                     | (92        | ) | $ | 490 |   |
| Costs and expenses:                                  |       |              |       |                        |       |                              |       |             |       |                  |       |
| Costs of revenues                                    |       |              |       | (178                        | )          | (176                              | )          | 96               |       | (258                  | )          |
| Selling, general and administrative expenses         |       |              |       | (89                         | )          | (126                              | )          | (4               | )          | (219                  | )          |
| Amortization of intangible assets                    |       |              |       | (30                         | )          | (7                                | )          | —           |       | (37                   | )          |
|                                                 |       |              |       |                        |       |                              |       |             |       |                  |       |
| Total costs and expenses                             |       |              |       | (297                        | )          | (309                              | )          | 92               |       | (514                  | )          |
|                                                 |       |              |       |                        |       |                              |       |             |       |                  |       |
| Operating income (loss)                              |       |              |       | (18                         | )          | (6                                | )          | —           |       | (24                   | )          |
|                                                 |       |              |       |                        |       |                              |       |             |       |                  |       |
| Interest expense, net                                |       |              |       | 2                           |       | (1                                | )          | —           |       | 1                     |       |
| Net investment-related (losses) gains                |       |              |       | (1                          | )          | 1                                 |       | —           |       | —                |       |
| Equity in the losses of equity-method investees, net |       |              |       | (1                          | )          | (1                                | )          | —           |       | (2                    | )          |
| Equity losses from consolidated subsidiaries         |       |              |       | (19                         | )          | —                            |       | 19               |       | —                |       |
| Other expense, net                                   |       |              |       | 1                           |       | (1                                | )          | —           |       | —                |       |
|                                                 |       |              |       |                        |       |                              |       |             |       |                  |       |
| (Loss) profit before income taxes                    |       |              |       | (36                         | )          | (8                                | )          | 19               |       | (25                   | )          |
| Income tax (expense) benefit                         |       |              |       | (20                         | )          | (9                                | )          | 16               |       | (13                   | )          |
|                                                 |       |              |       |                        |       |                              |       |             |       |                  |       |
| Net (loss) income                                    |       |              |       | $                           | (56        | )                                 | $          | (17              | )          | $                     | 35         |   | $ | (38 | ) |

 

----

(a) For periods prior to theAcquisition, New WMG did not exist.

 

29

----

 

**Combining Income Statement (Unaudited)**

**Five Months Ended February 29, 2004**

 
| ** **                                           | ** ** | **Old  WMG(a)**    | ** ** | **Guarantor  Subsidiaries** | ** ** | **Non-  Guarantor  Subsidiaries** | ** ** | **Eliminations** | ** ** | **Old WMG  Combined** | ** ** |
|------------------------------------------------------|------------|--------------------|------------|-----------------------------|------------|-----------------------------------|------------|------------------|------------|-----------------------|------------|
| ** **                                           | ** ** | **(in  millions)** | ** ** |
|                                                 |       |               |       |                        |       |                              |       |             |       |                  |       |
| Revenues                                             |       |               |       | $                           | 860        |                              | $          | 1,026            |       | $                     | (218       | ) | $ | 1,668 |   |
| Costs and expenses:                                  |       |               |       |                        |       |                              |       |             |       |                  |       |
| Costs of revenues                                    |       |               |       | (502                        | )          | (622                              | )          | 218              |       | (906                  | )          |
| Selling, general and administrative expenses         |       |               |       | (290                        | )          | (320                              | )          | —           |       | (610                  | )          |
| Impairment of goodwill and other intangible assets   |       |               |       | (1,014                      | )          | (5                                | )          | —           |       | (1,019                | )          |
| Amortization of intangible assets                    |       |               |       | (80                         | )          | (17                               | )          | —           |       | (97                   | )          |
| Restructuring costs                                  |       |               |       | (7                          | )          | (1                                | )          | —           |       | (8                    | )          |
| Total costs and expenses                             |       |               |       | (1,893                      | )          | (965                              | )          | 218              |       | (2,640                | )          |
| Operating (loss) income                              |       |               |       | (1,033                      | )          | 61                                |       | —           |       | (972                  | )          |
| Interest expense, net                                |       |               |       | 2                           |       | (4                                | )          | —           |       | (2                    | )          |
| Net investment-related (losses) gains                |       |               |       | —                      |       | (9                                | )          | —           |       | (9                    | )          |
| Equity in the losses of equity-method investees, net |       |               |       | (3                          | )          | (8                                | )          | —           |       | (11                   | )          |
| Equity losses from consolidated subsidiaries         |       |               |       | (17                         | )          | —                            |       | 17               |       | —                |       |
| Deal-related transaction and other costs             |       |               |       | (63                         | )          | —                            |       | —           |       | (63                   | )          |
| Other expense, net                                   |       |               |       | (5                          | )          | (2                                | )          | —           |       | (7                    | )          |
| (Loss) profit before income taxes                    |       |               |       | (1,119                      | )          | 38                                |       | 17               |       | (1,064                | )          |
| Income tax (expense) benefit                         |       |               |       | (113                        | )          | (143                              | )          | 136              |       | (120                  | )          |
| Net loss                                             |       |               |       | $                           | (1,232     | )                                 | $          | (105             | )          | $                     | 153        |   | $ | (1,184 | ) |

 

----

(a) For periods prior to theAcquisition, New WMG did not exist.

 

30

----

 

**Consolidating Statement of Cash Flows (Unaudited)**

**Six Months Ended March 31, 2005**

 
| ** **                                                                                          | ** ** | **New WMG**       | ** ** | **Guarantor  Subsidiaries** | ** ** | **Non-  Guarantor  Subsidiaries** | ** ** | **Eliminations** | ** ** | **New WMG  Consolidated** | ** ** |
|-----------------------------------------------------------------------------------------------------|------------|-------------------|------------|-----------------------------|------------|-----------------------------------|------------|------------------|------------|---------------------------|------------|
| ** **                                                                                          | ** ** | **(in millions)** | ** ** |
| **Cash flows from operating activities:**                                                           |       |              |       |                        |       |                              |       |             |       |                      |       |
| Net income (loss)                                                                                   |       | $                 | 47         |                        | $          | 86                                |       | $                | 56         |                      | $          | (142 | ) | $ | 47 |   |
| Adjustments to reconcile net income (loss) to net cash provided by  (used in) operating activities: |       |              |       |                        |       |                              |       |             |       |                      |       |
| Depreciation and amortization                                                                       |       | —            |       | 85                          |       | 36                                |       | —           |       | 121                       |       |
| Deferred taxes                                                                                      |       | —            |       | —                      |       | 2                                 |       | —           |       | 2                         |       |
| Non-cash interest expense                                                                           |       | 6                 |       | 11                          |       | —                            |       | —           |       | 17                        |       |
| Equity in the losses of equity-method investees, including  distributions                           |       | —            |       | —                      |       | 1                                 |       | —           |       | 1                         |       |
| Non-cash, stock-based compensation expense                                                          |       | —            |       | 7                           |       | 2                                 |       | —           |       | 9                         |       |
| Equity losses from consolidated subsidiaries                                                        |       | (102              | )          | (40                         | )          | —                            |       | 142              |       | —                    |       |
| Changes in operating assets and liabilities:                                                        |       |              |       |                        |       |                              |       |             |       |                      |       |
| Accounts receivable                                                                                 |       | (2                | )          | 50                          |       | 55                                |       |             |       | 103                       |       |
| Inventories                                                                                         |       | —            |       | 1                           |       | —                            |       | —           |       | 1                         |       |
| Royalty advances                                                                                    |       | —            |       | 1                           |       | 8                                 |       | —           |       | 9                         |       |
| Accounts payable and accrued liabilities                                                            |       | (6                | )          | 39                          |       | (77                               | )          | —           |       | (44                       | )          |
| Other balance sheet changes                                                                         |       | 23                |       | (28                         | )          | 36                                |       | —           |       | 31                        |       |
| Net cash provided by (used in) operating activities                                                 |       | (34               | )          | 212                         |       | 119                               |       | —           |       | 297                       |       |
|                                                                                                |       |              |       |                        |       |                              |       |             |       |                      |       |
| **Cash flows from investing activities:**                                                           |       |              |       |                        |       |                              |       |             |       |                      |       |
| Investments and acquisitions                                                                        |       | —            |       | (24                         | )          | (24                               | )          | —           |       | (48                       | )          |
| Investment proceeds                                                                                 |       | —            |       | 1                           |       | —                            |       | —           |       | 1                         |       |
| Capital expenditures                                                                                |       | —            |       | (9                          | )          | (5                                | )          | —           |       | (14                       | )          |
| Net cash used in investing activities                                                               |       | —            |       | (32                         | )          | (29                               | )          | —           |       | (61                       | )          |
|                                                                                                |       |              |       |                        |       |                              |       |             |       |                      |       |
| **Cash flows from financing activities:**                                                           |       |              |       |                        |       |                              |       |             |       |                      |       |
| Debt repayments                                                                                     |       | (6                | )          | —                      |       | —                            |       | —           |       | (6                        | )          |
| Change in intercompany                                                                              |       | 388               |       | (398                        | )          | 10                                |       | —           |       | —                    |       |
| Decrease in amounts due to parent companies                                                         |       | (4                | )          | —                      |       | —                            |       | —           |       | (4                        | )          |
| Dividends paid                                                                                      |       | (344              | )          | —                      |       | —                            |       | —           |       | (344                      | )          |
| Net cash provided by (used in) financing activities                                                 |       | 34                |       | (398                        | )          | 10                                |       | —           |       | (354                      | )          |
| Effect of foreign currency exchange rate changes on cash                                            |       | —            |       | —                      |       | 3                                 |       |             |       | 3                         |       |
| Net increase in cash and equivalents                                                                |       | —            |       | (218                        | )          | 103                               |       | —           |       | (115                      | )          |
| Cash and equivalents at beginning of period                                                         |       | 2                 |       | 433                         |       | 120                               |       | —           |       | 555                       |       |
| Cash and equivalents at end of period                                                               |       | $                 | 2          |                        | $          | 215                               |       | $                | 223        |                      | $          | — |   | $ | 440 |   |

 

31

----

 

**Consolidating Statement of Cash Flows (Unaudited)**

**One Month Ended March 31, 2004**

 
| ** **                                                                                          | ** ** | **New WMG**        | ** ** | **Guarantor  Subsidiaries** | ** ** | **Non-Guarantor  Subsidiaries** | ** ** | **Eliminations** | ** ** | **New WMG  Consolidated** | ** ** |
|-----------------------------------------------------------------------------------------------------|------------|--------------------|------------|-----------------------------|------------|---------------------------------|------------|------------------|------------|---------------------------|------------|
| ** **                                                                                          | ** ** | **(in  millions)** | ** ** |
| **Cash flows from operating activities:**                                                           |       |               |       |                        |       |                            |       |             |       |                      |       |
| Net income (loss)                                                                                   |       | $                  | (7         | )                           | $          | 7                               |       | $                | —     |                      | $          | (7 | ) | $ | (7 | ) |
| Adjustments to reconcile net income (loss) to net cash provided by  (used in) operating activities: |       |               |       |                        |       |                            |       |             |       |                      |       |
| Depreciation and amortization                                                                       |       | —             |       | 15                          |       | 6                               |       | —           |       | 21                        |       |
| Deferred taxes                                                                                      |       | —             |       | —                      |       | (2                              | )          | —           |       | (2                        | )          |
| Non-cash interest expense                                                                           |       | 1                  |       | 2                           |       | —                          |       | —           |       | 3                         |       |
| Equity in the losses of equity-method investees, including  distributions                           |       | —             |       | —                      |       | 1                               |       | —           |       | 1                         |       |
| Equity gains from consolidated subsidiaries                                                         |       | (2                 | )          | (5                          | )          | —                          |       | 7                |       | —                    |       |
| Changes in operating assets and liabilities:                                                        |       |               |       |                        |       |                            |       |             |       |                      |       |
| Accounts receivable                                                                                 |       | —             |       | (36                         | )          | 36                              |       | —           |       | —                    |       |
| Inventories                                                                                         |       | —             |       | (3                          | )          | 1                               |       | —           |       | (2                        | )          |
| Royalty advances                                                                                    |       | —             |       | —                      |       | 12                              |       | —           |       | 12                        |       |
| Accounts payable and accrued liabilities                                                            |       | 2                  |       | 3                           |       | 1                               |       | —           |       | 6                         |       |
| Other balance sheet changes                                                                         |       | 2                  |       | (12                         | )          | (24                             | )          | —           |       | (34                       | )          |
| Net cash provided by (used in) operating activities                                                 |       | (4                 | )          | (29                         | )          | 31                              |       | —           |       | (2                        | )          |
|                                                                                                |       |               |       |                        |       |                            |       |             |       |                      |       |
| **Cash flows from investing activities:**                                                           |       |               |       |                        |       |                            |       |             |       |                      |       |
| Acquisition of Old WMG                                                                              |       | (2,638             | )          | —                      |       | —                          |       | —           |       | (2,638                    | )          |
| Investments and acquisitions                                                                        |       | —             |       | (1                          | )          | (1                              | )          | —           |       | (2                        | )          |
| Net cash used in investing activities                                                               |       | (2,638             | )          | (1                          | )          | (1                              | )          | —           |       | (2,640                    | )          |
|                                                                                                |       |               |       |                        |       |                            |       |             |       |                      |       |
| **Cash flows from financing activities****:**                                                       |       |               |       |                        |       |                            |       |             |       |                      |       |
| Borrowings                                                                                          |       | 1,650              |       | —                      |       | —                          |       | —           |       | 1,650                     |       |
| Financing costs of borrowings                                                                       |       | (78                | )          | —                      |       | —                          |       | —           |       | (78                       | )          |
| Debt repayments                                                                                     |       | —             |       | —                      |       | (125                            | )          |             |       | (125                      | )          |
| Capital contributions                                                                               |       | 1,250              |       | —                      |       | —                          |       | —           |       | 1,250                     |       |
| Increase in amounts due to parent companies                                                         |       | 3                  |       | —                      |       | —                          |       | —           |       | 3                         |       |
| Change in intercompany                                                                              |       | (183               | )          | 361                         |       | (178                            | )          | —           |       | —                    |       |
| Net cash provided by (used in) financing activities                                                 |       | 2,642              |       | 361                         |       | (303                            | )          | —           |       | 2,700                     |       |
| Effect of foreign currency exchange rate changes on cash                                            |       | —             |       | —                      |       | —                          |       | —           |       | —                    |       |
| Net increase in cash and equivalents                                                                |       | —             |       | 331                         |       | (273                            | )          | —           |       | 58                        |       |
| Cash and equivalents at beginning of period                                                         |       | —             |       | 29                          |       | 442                             |       | —           |       | 471                       |       |
| Cash and equivalents at end of period                                                               |       | $                  | —     |                        | $          | 360                             |       | $                | 169        |                      | $          | — |   | $ | 529 |   |

 

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**Combining Statement of Cash Flows (Unaudited)**

**Five Months Ended February 29, 2004**

 
| ** **                                                                                 | ** ** | **Old WMG(a)**     | ** ** | **Guarantor  Subsidiaries** | ** ** | **Non-Guarantor  Subsidiaries** | ** ** | **Eliminations** | ** ** | **Old WMG  Combined** | ** ** |
|--------------------------------------------------------------------------------------------|------------|--------------------|------------|-----------------------------|------------|---------------------------------|------------|------------------|------------|-----------------------|------------|
| ** **                                                                                 | ** ** | **(in  millions)** | ** ** |
| **Cash flows from operating activities:**                                                  |       |               |       |                        |       |                            |       |             |       |                  |       |
| Net loss                                                                                   |       |               |       | $                           | (1,232     | )                               | $          | (105             | )          | $                     | 153        |   | $ | (1,184 | ) |
| Adjustments to reconcile net loss to net cash provided by (used in)  operating activities: |       |               |       |                        |       |                            |       |             |       |                  |       |
| Impairment of goodwill and other intangible assets                                         |       |               |       | 1,014                       |       | 5                               |       | —           |       | 1,019                 |       |
| Depreciation and amortization                                                              |       |               |       | 104                         |       | 24                              |       | —           |       | 128                   |       |
| Deferred taxes                                                                             |       |               |       | (25                         | )          | 119                             |       | —           |       | 94                    |       |
| Non-cash interest expense                                                                  |       |               |       | 3                           |       | —                          |       | —           |       | 3                     |       |
| Net investment-related losses (gains)                                                      |       |               |       | —                      |       | 9                               |       | —           |       | 9                     |       |
| Equity in the losses of equity-method investees, including  distributions                  |       |               |       | 3                           |       | 8                               |       | —           |       | 11                    |       |
| Equity losses from consolidated subsidiaries                                               |       |               |       | 153                         |       | —                          |       | (153             | )          | —                |       |
| Changes in operating assets and liabilities:                                               |       |               |       |                        |       |                            |       |             |       |                  |       |
| Accounts receivable                                                                        |       |               |       | 66                          |       | 27                              |       | —           |       | 93                    |       |
| Inventories                                                                                |       |               |       | (1                          | )          | —                          |       | —           |       | (1                    | )          |
| Royalty advances                                                                           |       |               |       | 79                          |       | 30                              |       | —           |       | 109                   |       |
| Accounts payable and accrued liabilities                                                   |       |               |       | 22                          |       | 10                              |       | —           |       | 32                    |       |
| Other balance sheet changes                                                                |       |               |       | (31                         | )          | 70                              |       | —           |       | 39                    |       |
| Net cash provided by (used in) operating activities                                        |       |               |       | 155                         |       | 197                             |       | —           |       | 352                   |       |
|                                                                                       |       |               |       |                        |       |                            |       |             |       |                  |       |
| **Cash flows from investing activities:**                                                  |       |               |       |                        |       |                            |       |             |       |                  |       |
| Investments and acquisitions                                                               |       |               |       | (1                          | )          | (15                             | )          | —           |       | (16                   | )          |
| Investment proceeds                                                                        |       |               |       | 38                          |       | 19                              |       | —           |       | 57                    |       |
| Capital expenditures                                                                       |       |               |       | (18                         | )          | (6                              | )          | —           |       | (24                   | )          |
| Net cash provided by (used in) investing activities                                        |       |               |       | 19                          |       | (2                              | )          | —           |       | 17                    |       |
|                                                                                       |       |               |       |                        |       |                            |       |             |       |                  |       |
| **Cash flows from financing activities****:**                                              |       |               |       |                        |       |                            |       |             |       |                  |       |
| Debt repayments                                                                            |       |               |       | —                      |       | (124                            | )          | —           |       | (124                  | )          |
| Capital contributions                                                                      |       |               |       | 224                         |       | 457                             |       | (419             | )          | 262                   |       |
| Decrease (increase) in amounts due from Time Warner-affiliated  companies                  |       |               |       | (171                        | )          | 491                             |       | (30              | )          | 290                   |       |
| Dividends paid                                                                             |       |               |       | (202                        | )          | (657                            | )          | 449              |       | (410                  | )          |
| Net cash provided by (used in) financing activities                                        |       |               |       | (149                        | )          | 167                             |       | —           |       | 18                    |       |
| Effect of foreign currency exchange rate changes on cash                                   |       |               |       | —                      |       | 3                               |       | —           |       | 3                     |       |
| Net increase in cash and equivalents                                                       |       |               |       | 25                          |       | 365                             |       | —           |       | 390                   |       |
| Cash and equivalents at beginning of period                                                |       |               |       | 4                           |       | 77                              |       | —           |       | 81                    |       |
| Cash and equivalents at end of period                                                      |       |               |       | $                           | 29         |                            | $          | 442              |       | $                     | —     |   | $ | 471 |   |

 

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(a) For periods prior to theAcquisition, New WMG did not exist.

 

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**ITEM 2**.  MANAGEMENT’SDISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

 

The following discussion and analysis of our resultsof operations and financial condition includes periods prior to theconsummation of the Acquisition and related financing (the “Transactions”).Accordingly, the discussion and analysis of operating results for the threemonths and six months ended March 31, 2004 does not reflect the fullimpact that the Transactions have had on us, including significantly increasedfinancing costs. You should read the following discussion of our results ofoperations and financial condition with the unaudited interim financialstatements included elsewhere in this Quarterly Report on Form 10-Q for thefiscal quarter ended March 31, 2005 (the “Quarterly Report”). Thisdiscussion contains forward-looking statements and involves numerous risks anduncertainties. Actual results may differ materially from those contained in anyforward-looking statements.

** **

**“SAFEHARBOR” STATEMENT UNDER PRIVATE SECURITIES LITIGATION REFORM ACT OF 1995**

 

This Quarterly Report includes “forward-lookingstatements” within the meaning of Section 27A of the Securities Act of1933 and Section 21E of the Securities Exchange Act of 1934. Allstatements other than statements of historical facts included in this QuarterlyReport, including, without limitation, statements regarding our future financialposition, business strategy, budgets, projected costs, savings and plans andobjectives of management for future operations, are forward-looking statements.In addition, forward-looking statements generally can be identified by the useof forward-looking terminology such as “may,” “will,” “expect,” “intend,” “estimate,”“anticipate,” “believe” or “continue” or the negative thereof or variationsthereon or similar terminology. Although we believe that the expectationsreflected in such forward-looking statements are reasonable, we can give noassurance that such expectations will prove to have been correct.

 

There are a number of risks and uncertainties thatcould cause our actual results to differ materially from the forward-lookingstatements contained in this Quarterly Report. Additionally important factorscould cause our actual results to differ materially from the forward-lookingstatements we make in this Quarterly Report. As stated elsewhere in thisQuarterly Report, such risks, uncertainties and other important factorsinclude, among others:

 

•                  the impact ofour substantial leverage on our ability to raise additional capital to fund ouroperations, on our ability to react to changes in the economy or our industryand on our ability to meet our obligations under our indebtedness;

 

•                  the continueddecline in the global recorded music industry and the rate of overall declinein the music industry;

 

•                  our ability tocontinue to identify, sign and retain desirable talent at manageable costs;

 

•                  the threat posedto our business by piracy of music by means of home CD-R activity and Internetpeer-to-peer file-sharing;

 

•                  the significantthreat posed to our business and the music industry by organized industrialpiracy;

 

•                  the impact ofour restructuring plan on our business (including our ability to generaterevenues and attract desirable talent);

 

•                  the populardemand for particular recording artists and/or songwriters and albums and thetimely completion of albums by major recording artists and/or songwriters;

 

•                  the diversityand quality of our portfolio of songwriters;

 

•                  the diversityand quality of our album releases;

 

•                  significantfluctuations in our results of operations and cash flows due to the nature ofour business;

 

•                  our involvementin intellectual property litigation;

 

•                  the possibledownward pressure on our pricing and profit margins;

 

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•                  the seasonal andcyclical nature of recorded music sales;

 

•                  our ability tocontinue to enforce our intellectual property rights in digital environments;

 

•                  the ability todevelop a successful business model applicable to a digital environment;

 

•                  the ability tomaintain product pricing in a competitive environment;

 

•                  the impact ofheightened and intensive competition in the recorded music and music publishingbusinesses and our inability to execute our business strategy;

 

•                  risks associatedwith our non-U.S. operations, including limited legal protections of ourintellectual property rights and restrictions on the repatriation of capital;

 

•                  the possibleunexpected loss of artists and key employees and our market share as a resultof our restructuring plan;

 

•                  the impact oflegitimate music distribution on the Internet or the introduction of other newmusic distribution formats;

 

•                  the impact ofrate regulations on our Music Publishing business;

 

•                  risks associatedwith the fluctuations in foreign currency exchange rates;

 

•                  our ability andthe ability of our joint venture partners to operate our existing joint venturessatisfactorily;

 

•                  the enactment oflegislation limiting the terms by which an individual can be bound under a “personalservices” contract could impair our ability to retain the services of keyartists;

 

•                  potential lossof catalog if it is determined that recording artists have a right to recapturerecordings under the U.S. Copyright Act;

 

•                  changes in lawand government regulations;

 

•                  legal or otherdevelopments related to pending litigation or the industry-wide investigationof the relationship between music companies and radio stations by the AttorneyGeneral of the State of New York;

 

•                  trends thataffect the end uses of our musical compositions (which include uses inbroadcast radio and television, film and advertising businesses);

 

•                  the growth ofother products that compete for the disposable income of consumers;

 

•                  risks inherentin relying on one supplier for manufacturing, packaging and distributionservices in North America and Europe;

 

•                  risks inherentin our acquiring or investing in other businesses;

 

•                  the possibilitythat our owners’ interests will conflict with ours or yours;

 

•                  our ability toact as a stand-alone company;

 

•                  increased costsand diversion of resources associated with complying with the internal controlreporting or other requirements of Sarbanes-Oxley;

 

•                  weaknesses inour internal controls that could affect our ability to ensure timely andreliable financial reports;

 

35

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•                  the effectsassociated with the formation of Sony BMG Music Entertainment; and

 

•                  failure toattract and retain key personnel.

 

There may be other factors not presently known to usor which we currently consider to be immaterial that may cause our actualresults to differ materially from the forward-looking statements.

 

All forward-looking statements attributable to us orpersons acting on our behalf apply only as of the date of this Quarterly Reportand are expressly qualified in their entirety by the cautionary statementsincluded in this Quarterly Report. We undertake no obligation to publiclyupdate or revise forward-looking statements to reflect events or circumstancesafter the date made or to reflect the occurrence of unanticipated events.

 

**INTRODUCTION**

** **

Management’s discussion and analysis of results ofoperations and financial condition (“MD&A”) is provided as a supplement tothe unaudited interim financial statements and footnotes included elsewhereherein to help provide an understanding of our financial condition, changes infinancial condition and results of our operations. MD&A is organized asfollows:

 

•                  *Overview.*This section provides ageneral description of our businesses, as well as recent developments that webelieve are important in understanding our results of operations and financialcondition and in anticipating future trends.

 

•                  *Results of operations.*This section providesan analysis of our results of operations for the three months and six monthsended March 31, 2005 and 2004. This analysis is presented on both aconsolidated and segmental basis.

 

•                  *Financial condition and liquidity.*This section providesan analysis of our cash flows for the three months ended March 31, 2005and 2004, as well as a discussion of our financial condition and liquidity asof March 31, 2005. The discussion of our financial condition and liquidityincludes (i) our available financial capacity under the revolving creditportion of our senior secured credit facility and (ii) a summary of our keydebt compliance measures, consisting of leverage and interest coverage ratiosunder our senior secured credit facility.

 

•                  *Market risk management.*This section discusseshow we manage exposure to potential losses arising from adverse changes ininterest rates and foreign currency exchange rates.

 

**Useof OIBDA**

 

We evaluate our operating performance based on severalfactors, including our primary financial measure of operating income (loss)before non-cash depreciation of tangible assets, non-cash amortization ofintangible assets and non-cash impairment charges to reduce the carrying valueof goodwill and other intangible assets (which we refer to as “OIBDA”). Weconsider OIBDA to be an important indicator of the operational strengths andperformance of our businesses, including the ability to provide cash flows to servicedebt. However, a limitation of the use of OIBDA as a performance measure isthat it does not reflect the periodic costs of certain capitalized tangible andintangible assets used in generating revenues in our businesses. Accordingly,OIBDA should be considered in addition to, not as a substitute for, operatingincome (loss), net income (loss) and other measures of financial performancereported in accordance with U.S. GAAP.

 

**Changein Fiscal Year and Basis of Presentation**

** **

In 2004, in connection with the Acquisition, theCompany changed its fiscal year-end to September 30 from November 30.As such, we restated our prior quarters starting October 1, 2003, underthe new fiscal year format, to enhance comparability between periods.

 

In connection with the Acquisition, a new accountingbasis was established for the Company as of the acquisition date based upon anallocation of the purchase price to the underlying net assets acquired. Assuch, financial information for the three months and six months ended March 31,2004 is separated into pre-acquisition and post-acquisition periods as a

 

36

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result of the change inaccounting basis that occurred relating to the Acquisition. That is, we havepresented our operating results and cash flows separately for each of thepre-acquisition two-month and five-month periods ended February 29, 2004and the post-acquisition, one-month period ended March 31, 2004.

 

The split presentation mentioned above is requiredunder GAAP in situations when a change in accounting basis occurs. This isbecause the new accounting basis requires that the historical carrying value ofassets acquired and liabilities assumed be adjusted to fair value, which mayyield results that are not strictly comparable on a period-to-period basis dueto the different, and sometimes higher, cost basis associated with theallocation of the purchase price.

 

We believe that this split presentation may impede theability of users of our financial information to understand our operating andcash flow performance. Consequently, in order to enhance an analysis of ouroperating results and cash flows, we have presented our operating results andcash flows on a combined basis for the full three month and six-month periodsended March 31, 2004. This combined presentation for the three-month andsix-month periods ended March 31, 2004 simply represents the mathematicaladdition of the pre-acquisition, two-month and five-month periods ended February 29,2004 and the post-acquisition, one-month period ended March 31, 2004. Itis not intended to represent what our operating results would have been had theAcquisition occurred at the beginning of the period. A reconciliation showingthe mathematical combination of our operating results for such periods isincluded herein.

 

Though we believe that the combined presentation ismost meaningful for the three and six months ended March 31, 2004, it isnot in conformity with GAAP. As such, we have supplemented our historicaloperating results for that period, as appropriate, with pro forma financialinformation and have further highlighted in our discussions that follow anysignificant effects from the Acquisition to facilitate an understanding of acomparison of our operating results from period-to-period.

 

**OVERVIEW**

 

**Descriptionof Business**

 

We are one of the world’s major music companies.Effective as of March 1, 2004, substantially all of Time Warner Inc.’smusic division was acquired from Time Warner by us for approximately $2.6 billion.

 

We classify our business interests into twofundamental areas: Recorded Music and Music Publishing. A brief description ofthose operations is presented below.

 

*Recorded Music Operations*

* *

Our Recorded Music business consists of the discoveryand development of artists and the related marketing, distribution andlicensing of recorded music produced by such artists. In the U.S., ouroperations are conducted principally through our major record labels—WarnerBros. Records Inc. and The Atlantic Records Group. Internationally, ourRecorded Music operations are conducted through our Warner Music Internationaldivision (“WMI”) which includes various subsidiaries, affiliates andnon-affiliated licensees in more than 50 countries.

 

Our Recorded Music operations also include a catalogdivision named Warner Strategic Marketing (“WSM”). WSM specializes in marketingour music catalog through compilations and reissuances of previously releasedmusic and video titles, as well as in the licensing of recordings to/from thirdparties for various uses, including film and television soundtracks.

 

Our principal Recorded Music distribution operationsinclude Warner-Elektra-Atlantic Corporation (“WEA Corp.”), which primarilymarkets and sells music products to retailers and wholesale distributors in theU.S.; a 90% interest in Alternative Distribution Alliance, an independentdistribution company; various distribution centers and ventures operatedinternationally; and an 80% interest in Word Entertainment, whose distributionoperations specialize in the distribution of music products in the Christianretail marketplace.

 

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Our principal recorded music revenue sources are salesof CDs, digital downloads and other recorded music products and license feesreceived for the ancillary uses of our recorded music catalog. The principalcosts associated with our Recorded Music operations are as follows:

 

•                  artist andrepertoire costs—the costs associated with (i) signing and developing artists,(ii) creating master recordings in the studio, (iii) creating artwork for albumcovers and liner notes and (iv) paying royalties to artists, producers,songwriters, other copyright holders and trade unions;

 

•                  manufacturing,packaging and distribution costs—the costs to manufacture and distributeproduct to wholesale and retail distribution outlets;

 

•                  marketing andpromotion costs—the costs associated with the promotion of artists and recordedmusic products, including costs to produce music videos for promotionalpurposes and artist tour support; and

 

•                  administrationcosts—the costs associated with general overhead and other administrativecosts, as well as costs associated with anti-piracy initiatives.

 

*Music Publishing Operations*

* *

Our Music Publishing operations includeWarner/Chappell Music, Inc. and its wholly owned subsidiaries, and certainother music publishing affiliates of the Company. We own or control the rightsto more than one million musical compositions, including numerous pop music hits,American standards, folk songs and motion picture and theatrical compositions.Our Music Publishing operations also include Warner Bros. Publications (“WBP”),which markets printed versions of our music throughout the world. On December 15,2004, we entered into a definitive agreement to sell WBP to Alfred Publishing.The sale is expected to close in the third quarter of 2005 and is subject tocustomary closing conditions. The sale is not expected to have a materialeffect on our future operating results and financial condition.

 

Publishing revenues are derived from four main royaltysources:

 

•                  *Mechanical:*the licensor receivesroyalties with respect to compositions embodied in recordings sold in anyformat or configuration, including singles, albums, CDs, digital downloads andmobile phone ring tones.

 

•                  *Performance:*the licensor receivesroyalties if the composition is performed publicly (e.g., broadcast radio andtelevision, movie theater, concert, nightclub or Internet and wirelessstreaming).

 

•                  *Synchronization:*the licensor receivesroyalties or fees for the right to use the composition in combination withvisual images (e.g., in films, television commercials and programs andvideogames).

 

•                  *Other:*the licensor receives royaltiesfrom other uses such as stage productions and printed sheet music.

 

The principal costs associated with our MusicPublishing operations are as follows:

 

•                  repertoirecosts—the costs associated with (i) signing and developing songwriters and (ii)paying royalties to songwriters, co-publishers and other copyright holders inconnection with income generated from the exploitation of their copyrightedworks;

 

•                  manufacturing,packaging and distribution costs—the costs to manufacture and distribute sheetmusic and songbooks to retail distribution outlets and schools; and

 

•                  administrationcosts—the costs associated with general overhead and other administrativecosts.

 

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**FactorsAffecting Results of Operations and Financial Condition**

** **

*Market Factors*

* *

Over the past four years, the recorded music industryhas been unstable, which has adversely affected our operating results. Theindustry-wide decline can be attributed primarily to digital piracy. Otherdrivers of this decline are the overall recessionary economic environment,bankruptcies of record retailers and wholesalers, growing competition forconsumer discretionary spending and retail shelf space, and the maturation ofthe CD format which has slowed the historical growth pattern of recorded musicsales. While potential new formats for selling recorded music product have beencreated, including the legal downloading of digital music using the Internetand DVD-Audio formats, significant revenue streams from these new markets haveyet to emerge. Accordingly, although we believe that the recorded musicindustry should continue to improve as evidenced by the year-over-year growthin U.S. music physical unit sales in 2004 and flat performance in overall(physical and digital) music unit sales globally in 2004, the best year-on-yeartrend in global music sales for five years according to the IFPI, the industrymay relapse into a period of decline, as witnessed from 1999 to 2003, whichwould continue to negatively affect operating results. For example, as of May1, 2005, year-to-date U.S. recorded music sales (excluding sales of digitaltracks) are down approximately 8.2% year-over-year. In addition, a decliningrecorded music industry could continue to have an adverse impact on the musicpublishing business. This is because our music publishing business generates asignificant portion of its revenues from mechanical royalties received from thesale of music in recorded music formats such as the CD.

 

Due in part to the development of the new channelsmentioned above and ongoing anti-piracy initiatives, we believe that therecorded music industry is positioned to improve over the coming years.However, the industry may relapse into a period of decline. In addition, therecan be no assurances as to the timing or the extent of any improvement in theindustry. Accordingly, we have executed a number of cost-saving initiativesover the past few years in an attempt to realign our cost structure with thechanging economics of the industry. These initiatives have included significantheadcount reductions, exiting certain leased facilities in an effort toconsolidate locations and the sale of our manufacturing, packaging and physicaldistribution operations. We have conducted a detailed assessment of our existingcost structure. As a result of this assessment, we have identified substantialcost-reduction opportunities in our business, the majority of which areassociated with headcount reductions from the consolidation of operations andthe streamlining of corporate and label overhead. By the end of March 2004,we had implemented approximately $250 million of annualized cost savings, ofwhich approximately $202 million has been reflected in our statement ofoperations through March 31, 2005. We have completed substantially all ofour restructuring efforts. We project the one-time costs associated with ourrestructuring to be $225 million to $250 million, of which approximately $165million has been paid through March 31, 2005. There are still significantrisks associated with the restructuring plan. See “Risk Factors.”

 

*Transactions with Time Warner and its Affiliates*

* *

As previously described, prior to March 1, 2004,Old WMG was owned and operated by Time Warner. As such, in the normal course ofconducting our business, Old WMG had various commercial and financingarrangements with Time Warner and its affiliates. In particular, Old WMGpurchased manufacturing packaging and physical distribution services fromaffiliates of Time Warner, and Time Warner funded its operating and capitalrequirements. See Note 19 to our audited financial statements for a summary ofthe principal transactions between Old WMG and Time Warner and its affiliates.

 

Time Warner sold its CD and DVD manufacturing,packaging and physical distribution operations to Cinram at the end of October 2003.Prior to the sale, these operations were under the control of Time Warner andOld WMG’s management. As such, pricing for such services was not negotiated onan arm’s-length basis and did not reflect market rates. As part of the sale,Time Warner and Old WMG entered into long-term arrangements with Cinram. Underthese arrangements, Cinram will provide manufacturing, packaging and physicaldistribution services for our products in the U.S. and Europe at favorable,market-based rates that were negotiated on an arm’s-length basis.

 

With respect to the financing arrangements with TimeWarner, all cash received or paid by Old WMG was included in, or funded by,clearing accounts or shared international cash pools within Time Warner’scentralized cash management system. Some of those arrangements wereinterest-bearing and others were not. Accordingly, historical net interestexpense is not representative of the amounts incurred by us under our newleveraged capital structure created in connection with the Acquisition.

 

39

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*Future Charges and PaymentsRelating to Executive Compensation*

* *

Primarily in 2004, but also to a limited extent in2005, Parent sold shares of restricted stock and granted options to variousemployees to assist us in recruiting, retaining and motivating key employees. Parentsubsequently determined that certain shares of restricted stock may have beensold at prices below fair market value on the applicable date of sale andcertain options may have had exercise prices below fair market value on theapplicable date of grant.

 

As a result, certain U.S. employee holders ofrestricted stock who made elections under Section 83(b) of the InternalRevenue Code will be subject to additional ordinary income tax to the extent ofthe fair market value of the restricted stock received over the purchase pricethey paid for such stock. In other cases, certain employees who did not makesuch an election will be subject to higher taxes on their restricted shares atthe time of vesting than would have been the case had they purchased the sharesfor fair market value. In addition, under the provisions of the American JobsCreation Act of 2004, signed into law October 22, 2004, U.S. employeeoption holders whose options vest with exercise prices below fair market valueon the date of grant are subject to significant penalties under new Section 409Aof the Internal Revenue Code. IRS Notice 2005-1 provides transitional guidanceon the application of Section 409A which, among other things, permitsoptions with exercise prices below the fair market value of the underlyingstock on the date of grant to be amended or replaced with new options having anexercise price at least equal to the fair market value on the grant date.Non-U.S. employee holders of restricted stock or options may be subject tosimilar or other related issues. In order for us to address these issues,including implementing the changes permitted by Notice 2005-1, on April 11,2005, our compensation committee, based on a re-assessment of fair marketvalues on the applicable dates, approved the actions described below.

 

*Restricted Stock.* The Company is authorized to pay each employee who purchased restrictedstock on or after May 1, 2004 at prices that may have been below fairmarket value on the date of purchase a cash bonus. The cash bonus payable tothose employees who made a Section 83(b) election will be an amount equalto the tax liability incurred by the employee as of the date of purchase basedon any difference between the re-determined purchase date fair market value andthe amount originally paid by the employee, plus an amount necessary to pay thetaxes on the bonus. The bonus that would be payable to each of those employeeswho did not make a Section 83(b) election or the applicable foreignequivalent would be an amount reflecting an estimate of the additional taxwhich would be payable by the employee at the time the restricted stock isscheduled to vest due to that taxable amount being subject to ordinary incomerather than capital gains tax rates, and assuming that the re-determined valueof the stock remains constant over the vesting period, adjusted down to reflecta present value discount based on the earliest possible vesting dates. We wouldalso pay these employees an amount necessary to pay the taxes on thebonus.  This would result in total cashpayments of approximately $10 million, which we would expect to pay and expensein the third fiscal quarter of this year.

 

*Options.* We granted stock options to employees to purchase an aggregate of5,304,116 with a weighted average exercise price of $1.62. The exercise pricesof these options are expected to be adjusted to prices equal to the applicablere-determined fair market values of the common stock on the applicable dates ofthe respective grants. To compensate the grantees for the loss of valuerepresented by this adjustment to the option exercise prices, we expect to payeach affected employee a cash bonus in an amount equal to the excess of theadjusted aggregate exercise price of the employee’s options over the originalaggregate exercise price of the employee’s options, adjusted down to reflect apresent value discount based on the earliest possible exercise dates.  This would result in total cash payments ofapproximately $9 million, which we expect to pay and expense in the thirdfiscal quarter of this year.

 

*Non-cash, Stock-based CompensationExpense.*    Asa result of the aforementioned changes approved by our compensation committee,we have determined that a modification of the terms of our previously grantedstock options has occurred for accounting purposes. Accordingly, we will berequired to remeasure the aggregate compensation expense relating to suchgrants. Based on our preliminary analysis, we expect our aggregate non-cashcompensation expense to increase to approximately $34 million for allawards granted as of April 14, 2005, which will be recognized over thevesting period of such awards. Such amount of non-cash compensation expense isexpected to be recognized in the following manner: $15 million in fiscal2005, $10 million in fiscal 2006, $6 million in fiscal 2007 and$3 million in fiscal 2008. This compares to previously recorded non-cash,stock-based compensation expense of $1 million for the seven months ended September 30,2004 and $2 million for the three months ended December 31, 2004.

 

*Option Adjustments as a Result ofDividend to Investors*  In connection with the $141.5 million cash dividendour parent company intend to declare to the holders of its Class L CommonStock and Class A Common Stock, we intend to make an adjustment to alloptions outstanding at the time of declaration of the dividend. The adjustmentwould generally consist of a cash make-whole payment consisting of an amountequal to the pro rata amount that would have been received per share had alloutstanding options been exercised at the time of the declaration of thedividend adjusted down to reflect a

 

40

----

 

present value discountbased on the earliest possible exercise dates. We expect that this payment toholders of unvested options will result in additional compensation expense ofapproximately $5 million in the third fiscal quarter of 2005.

 

*Employee Bonus Plan*  Our compensation committeehas approved a special one-time bonus that will be payable only uponconsummation of our parent’s initial common stock offering to all orsubstantially all of our employees, excluding senior management and anyemployees that have, or to whom we plan to grant, an equity participation inour company. We expect the amount of the award granted to an employee to beequal to approximately 4% of the employee’s annual salary. The aggregate amountof the bonuses shall not exceed $10 million.

 

***Termination of Management/ Monitoring Agreement***

 

Inconnection with the Acquisition, the Company entered into a managementmonitoring agreement (the “Management Agreement”) with the Investor Group forongoing consulting and management advisory services. Under the ManagementAgreement, the Company or its direct and indirect parents are required to paythe Investor Group an aggregate annual fee of $10 million per year (the “PeriodicFees”) in consideration for ongoing consulting and management advisoryservices. In addition, in the case of future services provided in connectionwith any future acquisition, disposition, or financing transactions involvingthe Company or its direct and indirect parents, the Management Agreementrequires the Company or its parents to pay the Investor Group an aggregate feeof one percent of the gross transaction value of each such transaction (“SubsequentFees”). The Management Agreement also requires the Company or its direct andindirect parents to pay the reasonable expenses of the Investor Group inconnection with, and indemnify them for liabilities arising from, theManagement Agreement, the Acquisition and any related transactions, theirequity investment in the Company or its direct and indirect parents, theiroperations, and the services they provide to the Company or its parents.

 

TheManagement Agreement continues in full force and effect until December 30,2014, provided, however, that the Investor Group may cause the agreement toterminate at any time upon agreement of the Investor Group. In the event of thetermination of the Management Agreement, the Company or any of its direct andindirect parents shall pay each of the Investor Group (x) any unpaid portion ofthe Periodic Fees, any Subsequent Fees and any expenses due with respect toperiods prior to the date of termination plus (y) the net present value (usinga discount rate equal to the then yield on U.S. Treasury Securities of likematurity) of the Periodic Fees that would have been payable with respect to theperiod from the date of termination until December 30, 2014.

 

Inconnection with Parent’s initial common stock offering, we terminated theManagement Agreement, other than with respect to reimbursement andindemnification provisions, for a fee of approximately $73 million payable tothe Investors. The termination fee was paid using a portion of the cash on handand proceeds from the $250 million new term loan borrowings under the Company’snew amendment to the senior secured credit facility.

 

**RESULTSOF OPERATIONS**

 

**ThreeMonths Ended March 31, 2005 Compared to Three Months Ended March 31,2004**

 

The following table summarizes our historical resultsof operations:

 
| ** **                                           | ** ** | **Successor**                                  | ** ** | **Combined**                                   | ** ** | **Successor**                               | ** ** | **Predecessor**                                 | ** ** |
|------------------------------------------------------|------------|------------------------------------------------|------------|------------------------------------------------|------------|---------------------------------------------|------------|-------------------------------------------------|------------|
| ** **                                           | ** ** | **Three  Months  Ended  March 31,  2005** | ** ** | **Three  Months  Ended  March 31,  2004** | ** ** | **One  Month  Ended  March 31,  2004** | ** ** | **Two  Months  Ended  February 29,  2004** | ** ** |
| ** **                                           | ** ** | **(unaudited)**                                | ** ** | **(unaudited)**                                | ** ** | **(unaudited)**                             | ** ** | **(unaudited)**                                 | ** ** |
| ** **                                           | ** ** | **(in millions)**                              | ** ** |
| Revenues                                             |       | $                                              | 767        |                                           | $          | 735                                         |       | $                                               | 245        |   | $ | 490 |   |
| Costs and expenses:                                  |       |                                           |       |                                           |       |                                        |       |                                            |       |
| Cost of revenues(1)                                  |       | (400                                           | )          | (388                                           | )          | (130                                        | )          | (258                                            | )          |
| Selling, general and administrative expenses(1)      |       | (293                                           | )          | (316                                           | )          | (97                                         | )          | (219                                            | )          |
| Amortization of intangible assets                    |       | (47                                            | )          | (52                                            | )          | (15                                         | )          | (37                                             | )          |
| Total costs and expenses                             |       | (740                                           | )          | (756                                           | )          | (242                                        | )          | (514                                            | )          |
| Operating income (loss)                              |       | 27                                             |       | (21                                            | )          | 3                                           |       | (24                                             | )          |
| Interest expense, net                                |       | (35                                            | )          | (9                                             | )          | (10                                         | )          | 1                                               |       |
| Equity in the losses of equity-method investees, net |       | —                                         |       | (3                                             | )          | (1                                          | )          | (2                                              | )          |
| Income (loss) before income taxes                    |       | (8                                             | )          | (33                                            | )          | (8                                          | )          | (25                                             | )          |
| Income tax (expense) benefit                         |       | (10                                            | )          | (12                                            | )          | 1                                           |       | (13                                             | )          |
| Net income (loss)                                    |       | $                                              | (18        | )                                              | $          | (45                                         | )          | $                                               | (7         | ) | $ | (38 | ) |

 

41

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----

(1) Includes depreciation expense of $14 million and$17 million for the three months ended March 31, 2005 and March 31,2004, respectively.

 

***Consolidated Pro Forma Results***

* *

As previously discussed, the Acquisition occurredeffective as of March 1, 2004. Accordingly, our operating results for thetwo-month period ended February 29, 2004 do not reflect the significanteffects of the Transactions. Had the Transactions occurred on January 1,2004, our pro forma results for the three months ended March 31, 2004would have been as follows:

 
| ** **                    | ** ** | **Pro Forma**                               | ** ** |
|-------------------------------|------------|---------------------------------------------|------------|
| ** **                    | ** ** | **Three Months Ended  March 31, 2004** | ** ** |
| ** **                    | ** ** | **(in millions, unaudited)**                | ** ** |
| Revenue                       |       | $                                           | 735        |   |
| OIBDA                         |       | 46                                          |       |
| Depreciation and amortization |       | (62                                         | )          |
| Operating income (loss)       |       | (16                                         | )          |
| Interest expense, net         |       | (29                                         | )          |
| Net income (loss)             |       | (59                                         | )          |
|                               |            |                                             |            |  |

 

A discussion of our consolidated historical resultsfor the three-month periods ended March 31, 2005 and 2004 follows:

 

***Consolidated Historical Results***

* *

*Revenues*

* *

Our revenues increased to $767 million for the threemonths ended March 31, 2005, compared to $735 million for the three monthsended March 31, 2004. The increase was largely driven by a $29 millionincrease in Recorded Music revenues, and a $5 million increase in MusicPublishing revenues.

 

Recorded Music revenues benefited from an $18 millionfavorable impact of foreign currency exchange rates, an approximate $31 millionincrease in revenues from digital sales of Recorded Music product relating tothe development and increased consumer usage of legal, online distributionchannels for the music industry and an approximate $10 million increase inphysical revenues by our independent distribution company.  For the three months ended March 31,2005, digital sales of Recorded Music product of $31 million representedapproximately 5% of total Recorded Music revenue. These benefits were offset bya decline in physical worldwide music sales of $30 million due to thecontinuing industry-wide impact of piracy, lower sales volume associated with afewer number of key commercial releases that sold in excess of one millionunits and the effects from our cost-savings initiative to consolidate two ofour U.S. record labels. Substantially all of the decline in physical worldwidemusic sales resulted from lower unit sales volume.

 

Music Publishing revenues benefited from a $5 millionfavorable impact of foreign currency exchange. While overall Music Publishing revenues remained flat, there wereincreases in performance and synchronization revenue of $6 million and $5million, respectively.  The increase inperformance royalties related to a number of top-performing songs that were notevident in the same quarter of the prior year. Synchronization royalties continue to increase due to favorable marketopportunities

 

42

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and continued increasesin sales in newer formats, such as music DVDs.  Mechanical revenues saw an overall decrease of $11 million principallyrelated to the industry-wide decline in sales of physical recorded musicproduct, offset in part by increased royalties of $4 million from sales innewer formats.  For the three monthsended March 31, 2005, digital revenue from Music Publishing of $4 millionrepresented 3% of total Music Publishings revenue.  Print revenues declined by $4 million fromthe prior quarter as our focus shifted to selling the business, which willoccur in the third quarter of 2005.

 

See “Business Segment Results” presented hereinafterfor a discussion of revenues by business segment.

 

*Cost of revenues*

* *

Our cost of revenues increased to $400 million for thethree months ended March 31, 2005, compared to $388 million for the threemonths ended March 31, 2004. Expressed as a percentage of revenues, costof revenues was approximately 52% and 53% for the three months ended March 31,2005 and 2004, respectively. The increase in cost of revenues is impacted by anapproximate $13 million unfavorable impact of foreign currency exchangerates.  This was offset by a decrease incosts as a result of a decrease in manufacturing costs and artist andrepertoire-related costs of $15 million associated with our lower physicalsales volume and cost savings associated with the restructuring plan that wasimplemented in 2004 in connection with the Acquisition.

 

*Selling, general and administrative expenses*

* *

Our selling, general and administrative expenses were$293 million for the three months ended March 31, 2005, compared to $316million for the three months ended March 31, 2004. Expressed as apercentage of revenues, selling, general and administrative expenses wereapproximately 38% for the three months ended March 31, 2005, compared with43% for the three months ended March 31, 2004. Selling, general andadministrative expenses decreased primarily due to a decrease of $25 million insales and marketing costs as a result of our cost-saving initiatives andheadcount reductions as well as an additional decrease of $3 million indepreciation expense related to lower capital spending requirements and lowerdepreciation of software development costs. The three months ended March 31, 2004 also included certain leasevacancy costs of approximately $5 million that were not incurred in the threemonths ended March 31, 2005.  Thesedecreases were offset by an approximate $7 million unfavorable impact offoreign currency exchange rates and approximately $3 million of management andadvisory fees paid to the Investor Group.

 

***Reconciliation of Consolidated Historical OIBDA toOperating Income (Loss) and Net Income (Loss)***

 

As previously described, we use OIBDA as our primarymeasure of financial performance. The following table reconciles OIBDA tooperating income (loss) and further provides the components from operatingincome (loss) to net income (loss) for purposes of the discussion that follows:

 
| ** **                                            | ** ** | **Successor**                                  | ** ** | **Combined**                                   | ** ** | **Successor**                              | ** ** | **Predecessor**                           | ** ** |
|-------------------------------------------------------|------------|------------------------------------------------|------------|------------------------------------------------|------------|--------------------------------------------|------------|-------------------------------------------|------------|
| ** **                                            | ** ** | **Three  Months  Ended  March 31,  2005** | ** ** | **Three  Months  Ended  March 31,  2004** | ** ** | **One Month  Ended  March 31,  2004** | ** ** | **Two Months  Ended  February  29, 2004** | ** ** |
| ** **                                            | ** ** | **(unaudited)**                                | ** ** | **(unaudited)**                                | ** ** | **(unaudited)**                            | ** ** | **(unaudited)**                           | ** ** |
| ** **                                            | ** ** | **(in millions)**                              | ** ** |
| OIBDA                                                 |       | $                                              | 88         |                                           | $          | 48                                         |       | $                                         | 24         |   | $ | 24 |   |
| Depreciation expense:                                 |       | (14                                            | )          | (17                                            | )          | (6                                         | )          | (11                                       | )          |
| Amortization expense                                  |       | (47                                            | )          | (52                                            | )          | (15                                        | )          | (37                                       | )          |
| Operating income (loss)                               |       | 27                                             |       | (21                                            | )          | 3                                          |       | (24                                       | )          |
| Interest expense, net                                 |       | (35                                            | )          | (9                                             | )          | (10                                        | )          | 1                                         |       |
| Equity in the losses of equity-method  investees, net |       | —                                         |       | (3                                             | )          | (1                                         | )          | (2                                        | )          |
| Income (loss) before income taxes                     |       | (8                                             | )          | (33                                            | )          | (8                                         | )          | (25                                       | )          |
| Income tax expense                                    |       | (10                                            | )          | (12                                            | )          | 1                                          |       | (13                                       | )          |
| Net income (loss)                                     |       | $                                              | (18        | )                                              | $          | (45                                        | )          | $                                         | (7         | ) | $ | (38 | ) |

 

43

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*OIBDA*

* *

Our OIBDA increased to $88 million for the threemonths ended March 31, 2005, compared to $48 million for the three monthsended March 31, 2004. Expressed as a percentage of revenues, total OIBDAmargin was 11% and 7% for the three months ended March 31, 2005 and 2004,respectively. The increase related to a $51 million increase in Recorded MusicOIBDA and a $2 million increase in Music Publishing OIBDA, offset by a $13million increase in corporate expenses.

 

Recorded Music OIBDA benefited principally fromapproximately $31 million of lower marketing and overhead costs associated withour cost-savings initiatives and a $10 million favorable impact from foreigncurrency exchange rates, offset by a loss of margin contributions due to thecontinued decline in physical sales.

 

Music Publishing OIBDA benefited principally fromlower overhead costs associated with our cost-savings initiatives and a $2million favorable impact from foreign currency exchange rates, offset by a lossof margin contributions related to the aggregate decline in mechanical andprint revenues.

 

Corporate expenses increased by $13 million due tohigher costs associated with operating as an independent company including $3million of management and advisory fees paid to the Investor Group.  Significant other costs were incurred inrelation to functioning as a public company, including audit fees, consultantfees for Sarbanes-Oxley and the hiring of several new corporate employees.

 

See “Business Segment Results” presented hereinafterfor a discussion of OIBDA by business segment.

 

*Depreciation expense*

* *

Our depreciation expense decreased to $14 million forthe three months ended March 31, 2005, compared to $17 million for thethree months ended March 31, 2004. The decrease principally related tolower capital spending requirements and lower depreciation of softwaredevelopment costs.

 

*Amortization expense*

* *

Our amortization expense decreased to $47 million forthe three months ended March 31, 2005, compared to $52 million for thethree months ended March 31, 2004. The decrease related to the new basisof accounting recorded in connection with the Acquisition, which resulted in alower revaluation of the historical cost bases of our identifiable intangibleassets.

 

*Operating income (loss)*

* *

Our operating income increased to $27 million for thethree months ended March 31, 2005, compared to an operating loss of $21million for the three months ended March 31, 2004. The improvement inoperating income related to a $40 million increase in OIBDA, a $3 milliondecrease in depreciation expense and a $5 million decrease in amortizationexpense.  See “Business Segment Results”presented hereinafter for a discussion of operating income (loss) by businesssegment.

 

*Interest expense, net*

* *

Our net interest expense increased to $35 million inthe three months ended March 31, 2005, compared to $9 million for thethree months ended March 31, 2004. The increase primarily related to theapproximately $1.8 billion of debt issued in March 2004 in connection withthe capitalization of the Company.

 

*Equity in the losses ofequity-method investees, net*

* *

We did not recognize any gains or losses related toequity-method investees in the three months ended March 31, 2005.  However, for the three months ended March 31,2004, we recognized $3 million of equity in losses of equity-method investeesprincipally related to certain of our former loss-generating investees, such asour former interest in MusicNet.

 

44

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*Income tax expense*

* *

We incurred income tax expense of $10 million for thethree months ended March 31, 2005, compared to an income tax expense of$12 million for the three months ended March 31, 2004. The income taxprovisions are not entirely comparable due to the changes in our tax profilerelating to the closing of the Acquisition. In particular, prior to the closingof the Acquisition, we were a member of the Time Warner consolidated tax returnand were able to recognize U.S.-based deferred tax benefits on domestic-sourcenet operating losses incurred. However, upon the closing of the Acquisition,our membership in the Time Warner consolidated tax group terminated along withour ability to recognize similar, U.S.-based, deferred tax benefits.Accordingly, the income tax expense in 2004 primarily relates to the taxprovisions on foreign-source income. There were no offsetting income taxbenefits on domestic-source losses recognized in 2005 due to the uncertainty ofrealization of those deferred tax assets.

 

*Net income (loss)*

* *

We recognized net losses of $18 million for the threemonths ended March 31, 2005, compared to a net loss of $45 million for thethree months ended March 31, 2004. As described more fully above, theimprovement in 2005 related principally to the $48 million increase inoperating income (including $8 million of lower depreciation and amortizationexpense) primarily related to the decrease in operating costs as a result ofour cost savings initiatives.  This waspartially offset by the $26 million higher net interest cost we recognized in2005.

 

**BusinessSegment Results**

 

Revenue, OIBDA and operating income (loss) by businesssegment are as follows:

 
| ** **                             | ** ** | **Successor**                                  | ** ** | **Combined**                                   | ** ** | **Successor**                               | ** ** | **Predecessor**                                 | ** ** |
|----------------------------------------|------------|------------------------------------------------|------------|------------------------------------------------|------------|---------------------------------------------|------------|-------------------------------------------------|------------|
| ** **                             | ** ** | **Three  Months  Ended  March 31,  2005** | ** ** | **Three  Months  Ended  March 31,  2004** | ** ** | **One  Month  Ended  March 31,  2004** | ** ** | **Two  Months  Ended  February 29,  2004** | ** ** |
| ** **                             | ** ** | **(unaudited)**                                | ** ** | **(unaudited)**                                | ** ** | **(unaudited)**                             | ** ** | **(unaudited)**                                 | ** ** |
| ** **                             | ** ** | **(in millions)**                              | ** ** |
| **Recorded Music**                     |       |                                           |       |                                           |       |                                        |       |                                            |       |
| Revenue                                |       | $                                              | 621        |                                           | $          | 592                                         |       | $                                               | 190        |   | $ | 402 |   |
| OIBDA                                  |       | 72                                             |       | 21                                             |       | 12                                          |       | 9                                               |       |
| Operating income (loss)                |       | 30                                             |       | (23                                            | )          | (2                                          | )          | (21                                             | )          |
|                                   |       |                                           |       |                                           |       |                                        |       |                                            |       |
| **Music Publishing**                   |       |                                           |       |                                           |       |                                        |       |                                            |       |
| Revenue                                |       | 154                                            |       | 149                                            |       | 55                                          |       | 94                                              |       |
| OIBDA                                  |       | 47                                             |       | 45                                             |       | 15                                          |       | 30                                              |       |
| Operating income (loss)                |       | 32                                             |       | 24                                             |       | 9                                           |       | 15                                              |       |
|                                   |       |                                           |       |                                           |       |                                        |       |                                            |       |
| **Corporate and Revenue Eliminations** |       |                                           |       |                                           |       |                                        |       |                                            |       |
| Revenue eliminations                   |       | (8                                             | )          | (6                                             | )          | —                                      |       | (6                                              | )          |
| OIBDA                                  |       | (31                                            | )          | (18                                            | )          | (3                                          | )          | (15                                             | )          |
| Operating income (loss)                |       | (35                                            | )          | (22                                            | )          | (4                                          | )          | (18                                             | )          |
|                                   |       |                                           |       |                                           |       |                                        |       |                                            |       |
| **Total**                              |       |                                           |       |                                           |       |                                        |       |                                            |       |
| Revenue                                |       | 767                                            |       | 735                                            |       | 245                                         |       | 490                                             |       |
| OIBDA                                  |       | 88                                             |       | 48                                             |       | 24                                          |       | 24                                              |       |
| Operating income (loss)                |       | $                                              | 27         |                                           | $          | (21                                         | )          | $                                               | 3          |   | $ | (24 | ) |

 

*Recorded Music*

* *

Recorded Music revenues increased by 5% to $621million for the three months ended March 31, 2005, compared to $592million for the three months ended March 31, 2004. Expressed as apercentage of revenue, Recorded Music OIBDA margin was 12% and 4% for the threemonths ended March 31, 2005 and 2004, respectively. Revenues benefitedfrom an $18 million favorable impact of foreign currency exchange rates, anapproximate $31 million increase in revenues from digital sales of RecordedMusic product relating to the development and increased consumer usage oflegal, online distribution channels for the music industry and an approximate$10 million increase in physical revenues by our independent distribution

 

45

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company.  For the three months ended March 31,2005 digital sales of Recorded Music product was $31 million. These benefitswere offset by a decline in physical worldwide music sales of $30 million dueto the continuing industry-wide impact of piracy, lower sales volume associatedwith a fewer number of key commercial releases that sold in excess of onemillion units and the effects from our cost-savings initiative to consolidatetwo of our U.S. record labels. Substantially all of the decline in physicalworldwide music sales resulted from lower unit sales volume.

 

Recorded Music OIBDA increased to $72 million for thethree months ended March 31, 2005, compared to $21 million for the threemonths ended March 31, 2004. Recorded Music OIBDA benefited principallyfrom approximately $31 million of lower marketing and overhead costs associatedwith our cost-savings initiatives and a $1 million favorable impact fromforeign currency exchange rates, offset by a decrease in contribution marginsdue to the continued decline in physical sales.

 

Recorded Music operating income improved to $30million for the three months ended March 31, 2005, compared to a loss of$23 million for the three months ended March 31, 2004. Recorded Musicoperating income (loss) included the following components: 

 
| ** **                    | ** ** | **Successor**                                 | ** ** | **Combined**                                  | ** ** | **Successor**                              | ** ** | **Predecessor**                                | ** ** |
|-------------------------------|------------|-----------------------------------------------|------------|-----------------------------------------------|------------|--------------------------------------------|------------|------------------------------------------------|------------|
| ** **                    | ** ** | **Three Months  Ended  March 31,  2005** | ** ** | **Three Months  Ended  March 31,  2004** | ** ** | **One Month  Ended  March 31,  2004** | ** ** | **Two Months  Ended  February 29,  2004** | ** ** |
| ** **                    | ** ** | **(unaudited)**                               | ** ** | **(unaudited)**                               | ** ** | **(unaudited)**                            | ** ** | **(unaudited)**                                | ** ** |
| ** **                    | ** ** | **(in millions)**                             | ** ** |
| OIBDA                         |       | $                                             | 72         |                                          | $          | 21                                         |       | $                                              | 12         |   | $ | 9 |   |
| Depreciation and amortization |       | (42                                           | )          | (44                                           | )          | (14                                        | )          | (30                                            | )          |
| Operating income (loss)       |       | $                                             | 30         |                                          | $          | (23                                        | )          | $                                              | (2         | ) | $ | (21 | ) |

 

The $53 million improvement in operating incomerelates primarily to the increase in OIBDA described above and to a decrease of$2 million of depreciation and amortization expense.

 

*Music Publishing*

* *

Music Publishing revenues increased by 3% to $154million for the three months ended March 31, 2005, compared to $149million for the three months ended March 31, 2004.  Revenues benefited from a $5 millionfavorable impact of foreign currency exchange. While overall Music Publishing revenues remained flat excluding theimpact of foreign currency exchange, there were increases in performance andsynchronization revenue of $6 million and $5 million, respectively.  The increase in performance royalties relatedto a number of top-performing songs that were not evident in the same quarterof the prior year.  Synchronizationroyalties increased due to favorable market opportunities and continuedincreases in sales in newer formats, such as music DVDs.   Mechanical revenues saw an overall decreaseof $11 million principally related to the industry-wide decline in sales ofphysical recorded music product, offset in part by increased royalties of $4million from sales in newer formats.  Forthe three months ended March 31, 2005 digital sales of Music Publishingwas $4 million.  Print revenues declinedby $4 million from the prior quarter as our focus shifted to selling thebusiness, which will occur in the third quarter of 2005.

 

Music Publishing OIBDA increased to $47 million forthe three months ended March 31, 2005, compared to $45 million in thethree months ended March 31, 2004. OIBDA benefited principally from loweroverhead costs associated with our cost savings initiatives and a $1 millionfavorable impact from foreign currency exchange rates, offset by a loss ofmargin contributions related to the aggregate decline in mechanical and printrevenues.

 

Music Publishing operating income increased to $32million in the three months ended March 31, 2005, compared to $24 millionin the three months ended March 31, 2004. Music Publishing operatingincome includes the following components:

 

46

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| ** **                    | ** ** | **Successor**                                 | ** ** | **Combined**                                  | ** ** | **Successor**                              | ** ** | **Predecessor**                                | ** ** |
|-------------------------------|------------|-----------------------------------------------|------------|-----------------------------------------------|------------|--------------------------------------------|------------|------------------------------------------------|------------|
| ** **                    | ** ** | **Three Months  Ended  March 31,  2005** | ** ** | **Three Months  Ended  March 31,  2004** | ** ** | **One Month  Ended  March 31,  2004** | ** ** | **Two Months  Ended  February 29,  2004** | ** ** |
| ** **                    | ** ** | **(unaudited)**                               | ** ** | **(unaudited)**                               | ** ** | **(unaudited)**                            | ** ** | **(unaudited)**                                | ** ** |
| ** **                    | ** ** | **(in millions)**                             | ** ** |
| OIBDA                         |       | $                                             | 47         |                                          | $          | 45                                         |       | $                                              | 15         |   | $ | 30 |   |
| Depreciation and amortization |       | (15                                           | )          | (21                                           | )          | (6                                         | )          | (15                                            | )          |
| Operating income (loss)       |       | $                                             | 32         |                                          | $          | 24                                         |       | $                                              | 9          |   | $ | 15 |   |

 

The $8 million increase in operating income primarilyrelated to a $6 million decrease in depreciation and amortization expense andthe $2 million increase in OIBDA discussed above.  The decrease in depreciation and amortizationexpense principally relates to $5 million of lower amortization expenseresulting from a lower revaluation of the historical cost bases of ouridentifiable intangible assets in connection with the allocation of purchaseprice as part of the Acquisition.

 

*Corporate Expenses*

* *

Corporate expenses before depreciation andamortization expense increased to $31 million for the three months ended March 31,2005, compared to $18 million for the three months ended March 31, 2004.Corporate expenses increased by $13 million due to higher costs associated withoperating as an independent company, including $3 million of management andadvisory fees paid to the Investor Group and costs incurred in relation tofunctioning as a public company, including audit fees, consultant fees forSarbanes-Oxley and the hiring of several new corporate employees.   The incrementally higher level of costs waspartially offset by lower overhead costs associated with our cost-savingsinitiatives. Corporate depreciation and amortization expense was $4 million forboth the three-month periods ended March 31, 2005 and 2004.

 

**SixMonths Ended March 31, 2005 Compared to Six Months Ended March 31,2004**

 

The following table summarizes our historical resultsof operations:

 
| ** **                                           | ** ** | **Successor**                               | ** ** | **Combined**                                | ** ** | **Successor**                              | ** ** | **Predecessor**                             | ** ** |
|------------------------------------------------------|------------|---------------------------------------------|------------|---------------------------------------------|------------|--------------------------------------------|------------|---------------------------------------------|------------|
| ** **                                           | ** ** | **Six Months  Ended  March 31,  2005** | ** ** | **Six Months  Ended  March 31,  2004** | ** ** | **One Month  Ended  March 31,  2004** | ** ** | **Five  Months  Ended  February  29, 2004** | ** ** |
| ** **                                           | ** ** | **(unaudited)**                             | ** ** | **(unaudited)**                             | ** ** | **(unaudited)**                            | ** ** | **(unaudited)**                             | ** ** |
| ** **                                           | ** ** | **(in millions)**                           | ** ** |
| Revenues                                             |       | $                                           | 1,855      |                                        | $          | 1,913                                      |       | $                                           | 245        |   | $ | 1,668 |   |
| Costs and expenses:                                  |       |                                        |       |                                        |       |                                       |       |                                        |       |
| Cost of revenues(1)                                  |       | (981                                        | )          | (1,036                                      | )          | (130                                       | )          | (906                                        | )          |
| Selling, general and administrative expenses(1)      |       | (624                                        | )          | (707                                        | )          | (97                                        | )          | (610                                        | )          |
| Impairment of intangible assets                      |       | —                                      |       | (1,019                                      | )          | —                                     |       | (1,019                                      | )          |
| Amortization of intangible assets                    |       | (93                                         | )          | (112                                        | )          | (15                                        | )          | (97                                         | )          |
| Restructuring costs                                  |       | —                                      |       | (8                                          | )          | —                                     |       | (8                                          | )          |
| Total costs and expenses                             |       | (1,698                                      | )          | (2,882                                      | )          | (242                                       | )          | (2,640                                      | )          |
| Operating income (loss)                              |       | 157                                         |       | (969                                        | )          | 3                                          |       | (972                                        | )          |
| Interest expense, net                                |       | (71                                         | )          | (12                                         | )          | (10                                        | )          | (2                                          | )          |
| Net investment-related losses                        |       | —                                      |       | (9                                          | )          | —                                     |       | (9                                          | )          |
| Equity in the losses of equity-method investees, net |       | (1                                          | )          | (12                                         | )          | (1                                         | )          | (11                                         | )          |
| Deal-related and transaction costs                   |       | —                                      |       | (63                                         | )          | —                                     |       | (63                                         | )          |
| Other income (expense), net                          |       | 4                                           |       | (7                                          | )          | —                                     |       | (7                                          | )          |
| Income (loss) before income taxes                    |       | 89                                          |       | (1,072                                      | )          | (8                                         | )          | (1,064                                      | )          |
| Income tax expense                                   |       | (42                                         | )          | (119                                        | )          | 1                                          |       | (120                                        | )          |
| Net income (loss)                                    |       | $                                           | 47         |                                        | $          | (1,191                                     | )          | $                                           | (7         | ) | $ | (1,184 | ) |

 

47

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----

(1) Includes depreciation expense of $28 million and$37 million for the six months ended March 31, 2005 and March 31,2004, respectively.

 

***Consolidated Pro Forma Results***

 

As previously discussed, the Acquisition occurredeffective as of March 1, 2004. Accordingly, our operating results for thefive-month period ended February 29, 2004 do not reflect the significanteffects of the Transactions. Had the Transactions occurred on October 1,2003, our pro forma results for the six months ended March 31, 2004 wouldhave been as follows:

 
| ** **                                         | ** ** | **Pro Forma**                             | ** ** |
|----------------------------------------------------|------------|-------------------------------------------|------------|
| ** **                                         | ** ** | **Six Months Ended  March 31, 2004** | ** ** |
| ** **                                         | ** ** | **(in millions, unaudited)**              | ** ** |
| Revenue                                            |       | $                                         | 1,912      |   |
| OIBDA                                              |       | 201                                       |       |
| Impairment of goodwill and other intangible assets |       | (1,019                                    | )          |
| Depreciation and amortization                      |       | (126                                      | )          |
| Operating income (loss)                            |       | (944                                      | )          |
| Interest expense, net                              |       | (64                                       | )          |
| Net income (loss)                                  |       | (793                                      | )          |
|                                                    |            |                                           |            |  |

 

A discussion of our consolidated historical resultsfor the six-month periods ended March 31, 2005 and 2004 follows:

 

***Consolidated Historical Results***

* *

***Revenues***

 

Our revenues decreased to $1.855 billion for the sixmonths ended March 31, 2005, compared to $1.913 billion for the six monthsended March 31, 2004. The decrease was largely driven by a $59 milliondecrease in Recorded Music revenues, offset by a $1 million increase in MusicPublishing revenues. Recorded Music revenues benefited from a $63 millionfavorable impact of foreign currency exchange rates, and an approximate $51million increase in revenues from digital sales of Recorded Music productrelating to the development and increased consumer usage of legal, onlinedistribution channels for the music industry and an approximate $10 millionincrease in physical revenues by our independent distribution company.  For the six months ended March 31, 2005,digital sales of Recorded Music product of $51 million representedapproximately 3% of total Recorded Music revenue.  These benefits were more than offset by adecline in physical worldwide music sales of $176 million due to the continuingindustry-wide impact of piracy, lower sales volume associated with a fewernumber of key commercial releases that sold in excess of one million units andthe effects from our cost-savings initiative to consolidate two of our U.S.record labels. Substantially all of the decline in physical worldwide musicsales resulted from lower unit sales volume.

 

Music Publishing revenues benefited from a $12 millionfavorable impact of foreign currency exchange rates, which was offset by a $14million decrease in mechanical and performance revenues principally related tothe industry-wide decline in sales of physical recorded music product and alower number of top-performing songs in comparison to the comparable period inthe prior year, offset in part by increased royalties of $9 million from salesin newer formats, such as music DVDs and mobile phone ring tones.   Synchronization royalties increased by $4million due to favorable market opportunities and continued increases in salesin newer formats, such as music DVDs. Print revenues declined by approximately $4 million, which was due, inpart, to the shifting of focus to selling the business, which will occur in thethird quarter of 2005.

 

See “Business Segment Results” presented hereinafterfor a discussion of revenues by business segment.

 

*Cost of revenues*

 

Our cost of revenues decreased to $981 million for thesix months ended March 31, 2005, compared to $1.036 billion for the sixmonths ended March 31, 2004. Expressed as a percentage of revenues, costof revenues was approximately 53% and 54% for the six months ended March 31,2005 and 2004, respectively. The decrease in cost of revenues principallyrelates to approximately $17 million of lower manufacturing costs due, in part,to lower sales volume and lower pricing under

 

48

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the new Cinram agreementsthat went into effect in late October 2003, approximately $70 million oflower artist and repertoire-related costs associated with our lower salesvolume and lower artist advance write-offs, and cost savings associated withthe restructuring plan that was implemented in 2004 in connection with theAcquisition. These cost reductions were partially offset by an approximate $42million unfavorable impact of foreign currency exchange rates.

 

*Selling, general and administrative expenses*

 

Our selling, general and administrative expenses were$624 million for the six months ended March 31, 2005, compared to $707million for the six months ended March 31, 2004. Expressed as a percentageof revenues, selling, general and administrative expenses were approximately34% for the six months ended March 31, 2005, compared with 37% for the sixmonths ended March 31, 2004. Selling, general and administrative expensesdecreased due to a decrease of $91 million in sales and marketing costs as aresult of our cost-saving initiatives and headcount reductions, as well as adecrease in depreciation expense of $9 million related to lower capitalspending requirements and lower depreciation of software development costs.  These decreases were offset by an approximate$21 million unfavorable impact of foreign currency exchange rates,approximately $5 million of management and advisory fees paid to the InvestorGroup, and $28 million of higher corporate expenses as discussed further below,including higher costs associated with operating as an independent company.

 

***Reconciliation of ConsolidatedHistorical OIBDA to Operating Income (Loss) and Net Income (Loss)***

 

As previously described, we use OIBDA as our primarymeasure of financial performance. The following table reconciles OIBDA tooperating income (loss) and further provides the components from operatingincome (loss) to net income (loss) for purposes of the discussion that follows:

 
| ** **                                           | ** ** | **Successor**                               | ** ** | **Combined**                                | ** ** | **Successor**                               | ** ** | **Predecessor**                                 | ** ** |
|------------------------------------------------------|------------|---------------------------------------------|------------|---------------------------------------------|------------|---------------------------------------------|------------|-------------------------------------------------|------------|
| ** **                                           | ** ** | **Six Months  Ended  March 31,  2005** | ** ** | **Six Months  Ended  March 31,  2004** | ** ** | **One Months  Ended  March 31,  2004** | ** ** | **Five Months  Ended  February 29,  2004** | ** ** |
| ** **                                           | ** ** | **(unaudited)**                             | ** ** | **(unaudited)**                             | ** ** | **(unaudited)**                             | ** ** | **(unaudited)**                                 | ** ** |
| ** **                                           | ** ** | **(in millions)**                           | ** ** |
| OIBDA                                                |       | $                                           | 278        |                                        | $          | 199                                         |       | $                                               | 24         |   | $ | 175 |   |
| Depreciation expense:                                |       | (28                                         | )          | (37                                         | )          | (6                                          | )          | (31                                             | )          |
| Amortization expense                                 |       | (93                                         | )          | (112                                        | )          | (15                                         | )          | (97                                             | )          |
| Impairment of goodwill and other intangible assets   |       | —                                      |       | (1,019                                      | )          | —                                      |       | (1,019                                          | )          |
| Operating income (loss)                              |       | 157                                         |       | (969                                        | )          | 3                                           |       | (972                                            | )          |
| Interest expense, net                                |       | (71                                         | )          | (12                                         | )          | (10                                         | )          | (2                                              | )          |
| Net investment-related losses                        |       | —                                      |       | (9                                          | )          | —                                      |       | (9                                              | )          |
| Equity in the losses of equity-method investees, net |       | (1                                          | )          | (12                                         | )          | (1                                          | )          | (11                                             | )          |
| Deal—related transaction and other costs        |       | —                                      |       | (63                                         | )          | —                                      |       | (63                                             | )          |
| Other income (expense), net                          |       | 4                                           |       | (7                                          | )          | —                                      |       | (7                                              | )          |
| Income (loss) before income taxes                    |       | 89                                          |       | (1,072                                      | )          | (8                                          | )          | (1,064                                          | )          |
| Income tax expense                                   |       | (42                                         | )          | (119                                        | )          | 1                                           |       | (120                                            | )          |
| Net income (loss)                                    |       | $                                           | 47         |                                        | $          | (1,191                                      | )          | $                                               | (7         | ) | $ | (1,184 | ) |

 

*OIBDA*

* *

Our OIBDA increased to $278 million for the six monthsended March 31, 2005, compared to $199 million for the six months ended March 31,2004. Expressed as a percentage of revenue, total OIBDA margin was 15% and 10%for the six months ended March 31, 2005 and 2004, respectively. Theincrease related to a $108 million increase in Recorded Music OIBDA, offset bya $1 million decrease in Music Publishing OIBDA and a $28 million increase incorporate expenses.

 

Recorded Music OIBDA benefited principally from lowermarketing and overhead costs associated with our cost-savings initiatives,approximately $17 million of lower manufacturing costs due, in part, to lowersales volume and lower pricing under the new Cinram agreement that went intoeffect in late October 2003, a $10 million favorable impact from foreigncurrency exchange rates and approximately $70 million of lower artist andrepertoire-related costs associated with our lower sales volume and lowerartist advance write-offs. These benefits more than offset the loss of margincontributions related to lower worldwide recorded music sales.

 

49

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Music Publishing OIBDA benefited principally fromlower overhead costs associated with our cost-savings initiatives and a $2million favorable impact from foreign currency exchange rates, but was morethan offset by a loss of margin contributions related to the aggregate declinein mechanical, performance and print revenues.

 

Corporate expenses increased by $28 million due tohigher costs associated with operating as an independent company and a changein the allocation of corporate-related costs. Certain corporate related costswere allocated in 2003 to Time Warner’s former CD and DVD manufacturing andprinting operations because such operations were managed by Old WMG. Suchoperations were sold by Time Warner in October 2003, and accordingly, suchcosts were no longer allocable. The incrementally higher level of costs waspartially offset by lower overhead costs associated with our cost-savingsinitiatives. See “Business Segment Results” presented hereinafter for adiscussion of OIBDA by business segment.

* *

*Depreciation expense*

 

Our depreciation expense decreased to $28 million forthe six months ended March 31, 2005, compared to $37 million for the sixmonths ended March 31, 2004. The decrease principally related to lowercapital spending requirements and lower depreciation of software developmentcosts.

* *

*Amortization expense*

 

Our amortization expense decreased to $93 million forthe six months ended March 31, 2005, compared to $112 million for the sixmonths ended March 31, 2004. The decrease related to the new basis ofaccounting recorded in connection with the Acquisition, which resulted in alower revaluation of the historical cost bases of our identifiable intangibleassets.

* *

*Operating income (loss)*

 

Our operating income increased to $157 million for thesix months ended March 31, 2005, compared to an operating loss of $969million for the six months ended March 31, 2004. The improvement inoperating income related to a $79 million increase in OIBDA, a $9 milliondecrease in depreciation expense, a $19 million decrease in amortizationexpense and the absence of the 2003 impairment charge of $1.019 billion.  See “Business Segment Results” presentedhereinafter for a discussion of operating income (loss) by business segment.

* *

*Interest expense, net*

 

Our net interest expense increased to $71 million inthe six months ended March 31, 2005, compared to $12 million for the sixmonths ended March 31, 2004. The increase primarily related to theapproximately $1.8 billion of debt issued in March 2004 in connection withthe capitalization of the Company.

* *

*Net investment-relatedlosses*

 

We did not recognize any investment-related losses forthe six-months ended March 31, 2005. However, for the six months ended March 31, 2004, we recognized $9million of net investment-related losses principally related to reductions incarrying values of certain equity-method investments.

* *

*Equity in the losses ofequity-method investees, net*

 

Our equity in the losses of equity-method investeeswas $1 million for the six months ended March 31, 2005, compared to $12million for the six months ended March 31, 2004.  The lower losses principally related to thefact that certain of our former loss-generating investees, such as our formerinterest in MusicNet, were retained by Time Warner and were not part of theassets acquired.

 

**Deal-related transaction and other costs**

 

We did not recognize any deal-related transactioncosts for the six months ended March 31, 2005.  However for the six months ended March 31,2004, we recognized $63 million of deal-related transaction and othercosts.  These costs primarily related totransaction costs associated with the prior pursuit of other strategic venturesor dispositions of Old WMG’s business in 2003 by Time Warner that did notoccur, looses incurred in connection with the probable pension curtailment thatultimately occurred, and losses related to certain executive contractualobligations triggered upon closing of the Acquisition.

 

50

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*Incometax expense*

* *

We incurred incometax expense of $42 million and $119 million for the six months ended March 31,2005 and 2004, respectively. The income tax provisions are not entirelycomparable due to the changes in our tax profile relating to the closing of theAcquisition. In particular, prior to the closing of the Acquisition, we were amember of the Time Warner consolidated tax return and were able to recognizeU.S.-based deferred tax benefits on domestic-source net operating lossesincurred. However, upon the closing of the Acquisition, our membership in theTime Warner consolidated tax group terminated along with our ability torecognize similar, U.S.-based, deferred tax benefits. Accordingly, the incometax expense in 2004 primarily relates to the tax provisions on foreign-sourceincome. There was no offsetting income tax benefit on domestic-source lossesrecognized in 2004 due to the uncertainty of realization of those deferred taxassets.

 

*Netincome (loss)*

* *

We recognized netincome of $47 million for the six months ended March 31, 2005, compared to anet loss of $1.191 billion for the six months ended March 31, 2004. Asdescribed more fully above, the improvement in 2005 related principally to the$1.126 billion increase in operating income (including $28 million of lowerdepreciation and amortization expense) primarily relating to the absence of the$1.019 billion impairment charge and $63 million of deal-related transactionand other costs recognized in 2004. These benefits were offset, in part, by $59 million of higher netinterest costs recognized in 2005

 

**Business Segment Results**

 

Revenue, OIBDA andoperating income (loss) by business segment are as follows:

 
| ** **                         | ** ** | **Successor**                           | ** ** | **Combined**                            | ** ** | **Successor**                          | ** ** | **Predecessor**                             | ** ** |
|------------------------------------|------------|-----------------------------------------|------------|-----------------------------------------|------------|----------------------------------------|------------|---------------------------------------------|------------|
| ** **                         | ** ** | **Six  Months  Ended  March 31,  2005** | ** ** | **Six  Months  Ended  March 31,  2004** | ** ** | **One  Month  Ended  March 31,  2004** | ** ** | **Five  Months  Ended  February  29, 2004** | ** ** |
| ** **                         | ** ** | **(unaudited)**                         | ** ** | **(unaudited)**                         | ** ** | **(unaudited)**                        | ** ** | **(unaudited)**                             | ** ** |
| ** **                         | ** ** | **(in millions)**                       | ** ** |
| Recorded Music                     |       |                                    |       |                                    |       |                                   |       |                                        |       |
| Revenue                            |       | $                                       | 1,561      |                                    | $          | 1,620                                  |       | $                                           | 190        |   | $ | 1,430 |   |
| OIBDA(1)                           |       | 266                                     |       | 158                                     |       | 12                                     |       | 146                                         |       |
| Operating income (loss)(1)         |       | 182                                     |       | (960                                    | )          | (2                                     | )          | (958                                        | )          |
| Music Publishing                   |       |                                    |       |                                    |       |                                   |       |                                        |       |
| Revenue                            |       | 309                                     |       | 308                                     |       | 55                                     |       | 253                                         |       |
| OIBDA(1)                           |       | 71                                      |       | 72                                      |       | 15                                     |       | 57                                          |       |
| Operating income (loss)(1)         |       | 42                                      |       | 30                                      |       | 9                                      |       | 21                                          |       |
| Corporate and Revenue Eliminations |       |                                    |       |                                    |       |                                   |       |                                        |       |
| Revenue eliminations               |       | (15                                     | )          | (15                                     | )          | —                                 |       | (15                                         | )          |
| OIBDA(1)                           |       | (59                                     | )          | (31                                     | )          | (3                                     | )          | (28                                         | )          |
| Operating income (loss)(1)         |       | (67                                     | )          | (39                                     | )          | (4                                     | )          | (35                                         | )          |
| Total                              |       |                                    |       |                                    |       |                                   |       |                                        |       |
| Revenue                            |       | 1,855                                   |       | 1,913                                   |       | 245                                    |       | 1,668                                       |       |
| OIBDA(1)                           |       | 278                                     |       | 199                                     |       | 24                                     |       | 175                                         |       |
| Operating income (loss)(1)         |       | $                                       | 157        |                                    | $          | (969                                   | )          | $                                           | 3          |   | $ | (972 | ) |

 

----

(1)                                  OIBDAand operating income for the six months ended March 31, 2005 have each beenreduced by $8 million of restructuring costs. Of such amount, $7 millionrelates to Recorded Music and $1 million relates to Corporate.

 

51

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*RecordedMusic*

* *

Recorded Musicrevenues decreased to $1.561 billion for the six months ended March 31, 2005,compared to $1.620 billion for the six months ended March 31, 2004.  Recorded Music revenues benefited from a $63million favorable impact of foreign currency exchange rates, and an approximate$51 million increase in revenues from digital sales of Recorded Music productrelating to the development and increased consumer usage of legal, onlinedistribution channels for the music industry and an approximate $10 millionincrease in physical revenues by our independent distribution company.  For the six months ended March 31, 2005 digitalsales of Recorded Music product was $51 million. These benefits were more thanoffset by a decline in physical worldwide music sales of $176 million due tothe continuing industry-wide impact of piracy, lower sales volume associatedwith a fewer number of key commercial releases that sold in excess of onemillion units and the effects from our cost-savings initiative to consolidatetwo of our U.S. record labels. Substantially all of the decline in physicalworldwide music sales resulted from lower unit sales volume.

 

Recorded MusicOIBDA increased to $266 million for the three months ended March 31, 2005,compared to $158 million for the three months ended March 31, 2004. Expressedas a percentage of revenue, Recorded Music OIBDA margin was 17% and 10% for thesix months ended March 31, 2005 and 2004, respectively. The $108 millionincrease in OIBDA benefited principally from lower marketing and overhead costsassociated with our cost-savings initiatives, approximately $17 million oflower manufacturing costs due, in part, to lower sales volume and lower pricingunder the new Cinram agreement that went into effect in late October 2003, a$10 million favorable impact from foreign currency exchange rates andapproximately $70 million of lower artist and repertoire-related costsassociated with our lower sales volume and lower artist advance write-offs.These benefits more than offset the loss of margin contributions related tolower worldwide recorded music sales.

 

Recorded Musicoperating income improved to $182 million for the six months ended March 31,2005, compared to a loss of $960 million for the six months ended March 31,2004. Recorded Music operating income (loss) included the following components:

 
| ** **                      | ** ** | **Successor**                          | ** ** | **Combined**                           | ** ** | **Successor**                         | ** ** | **Predecessor**                            | ** ** |
|---------------------------------|------------|----------------------------------------|------------|----------------------------------------|------------|---------------------------------------|------------|--------------------------------------------|------------|
| ** **                      | ** ** | **Six Months  Ended  March 31,  2005** | ** ** | **Six Months  Ended  March 31,  2004** | ** ** | **One Month  Ended  March 31,  2004** | ** ** | **Five Months  Ended  February 29,  2004** | ** ** |
| ** **                      | ** ** | **(unaudited)**                        | ** ** | **(unaudited)**                        | ** ** | **(unaudited)**                       | ** ** | **(unaudited)**                            | ** ** |
| ** **                      | ** ** | **(in millions)**                      | ** ** |
| OIBDA                           |       | $                                      | 266        |                                   | $          | 158                                   |       | $                                          | 12         |   | $ | 146 |   |
| Depreciation and amortization   |       | (84                                    | )          | (99                                    | )          | (14                                   | )          | (85                                        | )          |
| Impairment of intangible assets |       | —                                 |       | (1,019                                 | )          | —                                |       | (1,019                                     | )          |
| Operating income (loss)         |       | $                                      | 182        |                                   | $          | (960                                  | )          | $                                          | (2         | ) | $ | (958 | ) |

 

The $1.142 billionimprovement in operating income primarily related to the absence of the 2004impairment charge, which reduced the carrying value of our goodwill and otherintangible assets by $1.019 billion, a decrease in depreciation andamortization of $15 million, and the $108 million improvement in OIBDAdiscussed above.  The decrease indepreciation and amortization expense principally relates to $7 million oflower amortization expense resulting from a lower revaluation of the historicalcost bases of our identifiable intangible assets in connection with theallocation of purchase price as part of the Acquisition.

 

*MusicPublishing*

* *

Music Publishingrevenues increased to $309 million for the six months ended March 31, 2005,compared to $308 million for the six months ended March 31, 2004.  Revenues benefited from a $12 millionfavorable impact of foreign currency exchange rates, which was offset by a $14million decrease in mechanical and performance revenues principally related tothe industry-wide decline in sales of physical recorded music product and alower number of top-performing songs in comparison to the comparable period inthe prior year, offset in part by increased royalties of $9 million from salesin newer formats, such as music DVDs and mobile phone ring tones.   Synchronization royalties increased by $4million due to favorable market opportunities and continued increases in salesin newer formats, such as music DVDs. For the six months ended March 31, 2005 digital sales of MusicPublishing was $10 million.  Printrevenues declined by approximately

 

52

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$4 million, which was due, in part, to the shifting of focus to sellingthe business, which will occur in the third quarter of 2005.

 

Music PublishingOIBDA decreased to $71 million for the six months ended March 31, 2005,compared to $72 million in the six months ended March 31, 2004. OIBDA benefitedprincipally from lower overhead costs associated with our cost-savingsinitiatives and a $2 million favorable impact from foreign currency exchangerates, but was more than offset by a loss of margin contributions related tothe aggregate decline in mechanical, performance and print revenues.

 

Music Publishingoperating income increased to $42 million in the six months ended March 31,2005, compared to $30 million in the six months ended March 31, 2004. MusicPublishing operating income includes the following components:

 
| ** **                    | ** ** | **Successor**                          | ** ** | **Combined**                           | ** ** | **Successor**                         | ** ** | **Predecessor**                            | ** ** |
|-------------------------------|------------|----------------------------------------|------------|----------------------------------------|------------|---------------------------------------|------------|--------------------------------------------|------------|
| ** **                    | ** ** | **Six Months  Ended  March 31,  2005** | ** ** | **Six Months  Ended  March 31,  2004** | ** ** | **One Month  Ended  March 31,  2004** | ** ** | **Five Months  Ended  February 29,  2004** | ** ** |
| ** **                    | ** ** | **(unaudited)**                        | ** ** | **(unaudited)**                        | ** ** | **(unaudited)**                       | ** ** | **(unaudited)**                            | ** ** |
| ** **                    | ** ** | **(in millions)**                      | ** ** |
| OIBDA                         |       | $                                      | 71         |                                   | $          | 72                                    |       | $                                          | 15         |   | $ | 57 |   |
| Depreciation and amortization |       | (29                                    | )          | (42                                    | )          | (6                                    | )          | (36                                        | )          |
| Operating income (loss)       |       | $                                      | 42         |                                   | $          | 30                                    |       | $                                          | 9          |   | $ | 21 |   |

 

The $12 millionincrease in operating income primarily related to a $13 million decrease indepreciation and amortization expense, offset by the $1 million decrease inOIBDA discussed above.  The decrease indepreciation and amortization expense principally relates to $12 million oflower amortization expense resulting from a lower revaluation of the historicalcost bases of our identifiable intangible assets in connection with theallocation of purchase price as part of the Acquisition.

 

*CorporateExpenses*

* *

Corporate expensesbefore depreciation and amortization expense increased to $59 million for thesix months ended March 31, 2005, compared to $31 million for the six monthsended March 31, 2004. Corporate expenses increased due to higher costsassociated with operating as an independent company and a change in theallocation of corporate-related costs. Certain corporate-related costs wereallocated in 2004 to Time Warner’s former CD and DVD manufacturing and printingoperations because such operations were managed by Old WMG. Such operationswere sold by Time Warner in October 2003, and accordingly, such costs were nolonger allocable. The incrementally higher level of costs was partially offsetby lower overhead costs associated with our cost-savings initiatives. Corporatedepreciation and amortization expense was $8 million for each of the six-monthperiods ended March 31, 2005 and 2004.

 

**FINANCIAL CONDITION ANDLIQUIDITY**

 

**Financial Condition**

 

At March 31, 2005,we had $1.842 billion of debt, $440 million of cash and equivalents (net debtof $1.402 billion, defined as total debt less cash and equivalents) and $688million of shareholder’s equity. This compares to $1.840 million of debt, $555million of cash and equivalents (net debt of $1.285 billion) and $978 millionof shareholder’s equity at September 30, 2004. The increase in net debtresulted from the foreign currency exchange impact on our Sterling-denominatednotes, offset by our quarterly repayment of our term loans under the seniorsecured credit facility. The principal factor for the reduction in shareholder’sequity that occurred during the six months ended March 31, 2005 was the returnof capital of $344 million paid in October 2004.

 

**Cash Flows**

 

The followingtable summarizes our historical cash flows. The financial data for the sixmonths ended March 31, 2005 and 2004 are unaudited and are derived from ourinterim financial statements included elsewhere herein.

 

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| ** **                  | ** ** | **Successor**                          | ** ** | **Combined**                           | ** ** | **Successor**                         | ** ** | **Predecessor**                            | ** ** |
|-----------------------------|------------|----------------------------------------|------------|----------------------------------------|------------|---------------------------------------|------------|--------------------------------------------|------------|
| ** **                  | ** ** | **Six Months  Ended  March 31,  2005** | ** ** | **Six Months  Ended  March 31,  2004** | ** ** | **One Month  Ended  March 31,  2004** | ** ** | **Five Months  Ended  February 29,  2004** | ** ** |
| ** **                  | ** ** | **(unaudited)**                        | ** ** | **(unaudited)**                        | ** ** | **(unaudited)**                       | ** ** | **(unaudited)**                            | ** ** |
| ** **                  | ** ** | **(in millions)**                      | ** ** |
| Cash provided by (used in): |       |                                   |       |                                   |       |                                  |       |                                       |       |
| Operating activities        |       | $                                      | 297        |                                   | $          | 350                                   |       | $                                          | (2         | ) | $ | 352 |   |
| Investing activities        |       | (61                                    | )          | (2,623                                 | )          | (2,640                                | )          | 17                                         |       |
| Financing activities        |       | (354                                   | )          | 2,718                                  |       | 2,700                                 |       | 18                                         |       |
|                             |            |                                        |            |                                        |            |                                       |            |                                            |            |  |  |  |  |

 

*OperatingActivities*

* *

Cash provided byoperations was $297 million for the six months ended March 31, 2005, comparedto cash provided by operations of $350 million for the six months ended March31, 2004. The $53 million decrease in cash provided by operations resultedprimarily from $52 million of higher interest payments associated with ourleveraged capital structure, $60 million of cash payments related to ourrestructuring activities and approximately$        million of bonus payments madein January for the fiscal year 2004 bonus plan. These amounts were offset by higher business segment OIBDA of $79million.

 

*InvestingActivities*

* *

Cash used ininvesting activities was $61 million for the six months ended March 31, 2005,compared to $2.623 billion for the six months ended March 31, 2004. Thedecrease in cash used in investing activities primarily related to the cashpurchase price of $2.638 billion, including transaction costs, paid inconnection with the Acquisition. In addition, capital expenditures for the sixmonths ended March 31, 2005 were $14 million compared to $24 million for thethree months ended March 31, 2004.

 

*FinancingActivities*

* *

Cash used infinancing activities was $354 million for the six months ended March 31, 2005,compared to $2.718 billion of cash provided for the six months ended March 31,2004. Cash flows from financing activities are not comparable from period toperiod. In 2004, we began operating as an independent company. However, in2003, we were owned by Time Warner. As such, all of our cash requirements werefunded by Time Warner and Time Warner received most of the cash generated by usthrough a centralized cash management system or use of shared internationalcash pooling arrangements. Consequently, except for principal payments oncapital leases and certain net borrowings of third-party debt, which were notsignificant, all financing activities for the historical 2004 period related tomovement of cash between Time Warner and us.

 

Cash provided byfinancing activities for 2004 principally reflected activities to fund thepurchase price paid in connection with the Acquisition, settle intercompanyreceivables and payables for the period preceding the Acquisition, and modifyour initial capital structure by returning a portion of the initial capitalcontributed by the Investors. In particular, we borrowed $1.650 billion whichwas used primarily to fund a portion of the purchase price paid in connectionwith the Acquisition (including transaction costs) and to pay $78 million offinancing-related debt issuance costs. We also received capital contributionsof $1.250 billion from the Investors to fund a portion of the purchase pricepaid in connection with the Acquisition. Finally, with respect to thepre-acquisition, two-month period ended February 29, 2004, $114 million of netfunding was received by Time Warner and used, in part, to repay $124 million ofthird-party indebtedness. Cash used in financing activities for the six monthsended March 31, 2005 primarily relates to the quarterly term loan debtrepayments of $6 million and the payment of a $344 million return of capital toour parent companies.

 

**Liquidity**

 

Our primarysources of liquidity are the cash flow generated from our subsidiaries’operations, availability under the $250 million (less $4****million of outstanding letters of creditas of March 31, 2005) revolving credit portion of our senior secured creditfacility and available cash and equivalents. These sources of liquidity areneeded to fund our and Holdings’ new debt service requirements, working capitalrequirements, capital expenditure requirements and the remaining one-time costsassociated with the execution of our restructuring plan to generate costsavings.

 

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As of March 31,2005, our long-term debt consisted of $1.176 billion of borrowings (excluding$12 million of debt that is classified as a current obligation) under the termloan portion of our senior secured credit facility and $654 million ofAcquisition Corp. Subordinated Notes. There have been no borrowings under therevolving portion of our senior secured credit facility as of March 31, 2005.

 

*Seniorsecured credit facility*

* *

The senior securedcredit facility consists of a $1.188 billion outstanding term loan portion anda $250 million revolving credit portion. The term loan portion of the facilitymatures in February 2011. We are required to prepay outstanding term loans,subject to certain exceptions and conditions, with excess cash flow or in theevent of certain asset sales and casualty and condemnation events andincurrence of debt. We are required to make minimum repayments requirementsunder the term loan portion of our facility in quarterly principal amounts of$3 million for the first six years and nine months, with a remaining balloonpayment in February 2011. The revolving credit portion of the senior securedcredit facility matures in six years in February 2010. There are no mandatoryreductions in borrowing availability for the revolving credit portion of thefacility through its term.

 

Borrowings underboth the term loan and revolving credit portion of the senior secured credit facilitycurrently bear interest at a rate equal to an applicable margin plus, at ouroption, either (a) a base rate determined by reference to the higher of (1) theprime rate of Bank of America, N.A. and (2) the federal funds rate plus 1/2 of1% or (b) a LIBOR rate determined by reference to the costs of funds fordeposits in the currency of such borrowing for the interest period relevant tosuch borrowing adjusted for certain additional costs. The initial applicablemargin for borrowings under the revolving credit facility and the term loanfacility was 1.75% with respect to base rate borrowings and 2.75% with respectto LIBOR borrowings. As of March 31, 2005, the applicable margins with respectto base rate borrowings and LIBOR borrowings were 1.00% and 2.00%,respectively, for borrowings under the revolving credit facility, and 1.50% and2.50%, respectively, for borrowings under the term loan facility. Theapplicable margin for borrowings under both the revolving credit facility andthe term loan facility are variable subject to changes in certain of ourleverage ratios. Subsequent to March 31, 2005, we amended our senior securedcredit agreement to lower the base rate and LIBOR margins for borrowings underthe term loan facility to 0.75% and 1.75%, respectively, if the senior secureddebt of Acquisition Corp. is rated at least BB by S&P and Ba2 by Moody’s(or if the ratings are lower, 1.00% and 2.00%, respectively).

 

In addition topaying interest on outstanding principal under the senior secured credit facility,we are required to pay a commitment fee to the lenders under the revolvingcredit facility in respect of the unutilized commitments. The initialcommitment fee rate was 0.50%. As of March 31, 2005, the commitment fee ratewas 0.375%. The commitment fee rate is variable subject to changes in certainof our leverage ratios. We also are required to pay customary letter of creditfees, as necessary.

 

The senior securedcredit facility contains a number of covenants that, among other things,restrict, subject to certain exceptions, our ability and the ability of oursubsidiaries to sell assets, incur additional indebtedness or issue preferredstock, repay other indebtedness, pay dividends and distributions or repurchasecapital stock, create liens on assets, make investments, loans or advances,make certain acquisitions, engage in mergers or consolidations, engage incertain transactions with affiliates, amend certain material agreements, changethe business conducted by us and enter into agreements that restrict dividendsfrom subsidiaries. In addition, the senior secured credit facility requires usto maintain the following financial covenants: a maximum total leverage ratio,a minimum interest coverage ratio and a maximum capital expenditures limitation.

 

Concurrent withthe initial public offering of Parent, the Company obtained an additional termloan of $250 million.  The borrowingsunder the new term loan are subject to base rate and LIBOR margins of 0.75% and1.75%, respectively.

 

*SeniorSubordinated Notes*

* *

We haveoutstanding two tranches of senior subordinated notes due 2014: $465 millionprincipal amount of U.S. dollar-denominated notes and £100 million principalamount of Sterling-denominated notes (collectively, the ‘‘Subordinated Notes’’).The Subordinated Notes mature on April 15, 2014. The Subordinated Notes bearinterest at a fixed rate of 73/8% per annum on the $465 million dollar notesand 81/8% per annum on the £100 million sterling notes. The indenture governingthe notes limits our ability and the ability of our restricted subsidiaries toincur additional indebtedness or issue certain preferred shares; to paydividends on or make other distributions in respect of its capital stock ormake other restricted payments; to make certain investments; to sell certainassets; to create liens on certain debt without securing the notes; toconsolidate, merge, sell or otherwise dispose of all or substantially all ofits assets; to enter into certain transactions with affiliates; and todesignate its subsidiaries as unrestricted subsidiaries. Subject to certainexceptions, the indenture governing

 

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the notes permits us and our restricted subsidiaries to incuradditional indebtedness, including secured indebtedness, and to make certainrestricted payments and investments.

 

*HoldingsNotes*

* *

In December 2004,Holdings, the Company’s direct parent, issued $847 million principal amount ofdebt. The Company is not a party to, or an obligor on, any of the Holdings’debt. However, Holdings is a holding company with no independent operationsother than its interest in the Company. Accordingly, Holdings’ ability toservice its debt obligations is dependent on the cash flows and operations ofthe Company and, consequently, such obligations need to be considered inevaluating the Company’s financial condition and liquidity.

 

The $847 millionprincipal amount of Holdings’ debt consists of (i) $250 million principalamount of Floating Rate Senior Notes due 2011 (the ‘‘Holdings Floating RateNotes’’), (ii) $397 million principal amount at maturity of 9.5% SeniorDiscount Notes due 2014, which had an initial issuance discount of $147 million(the ‘‘Holdings Discount Notes’’) and (iii) $200 million principal amount ofFloating Rate Senior PIK Notes due 2014 (the ‘‘Holdings PIK Notes’’, andcollectively, the ‘‘Holdings Notes’’). As of March 31, 2005, Holdings had $708million of debt on its balance sheet relating to such securities, net ofissuance discounts.

 

The Holdings FloatingRate Notes bear interest at a quarterly, floating rate based on three-monthLIBOR rates plus a margin equal to 4.375%. Interest is payable quarterly incash beginning on December 15, 2005. The Holdings Floating Rate Notes mature onDecember 15, 2011.

 

The HoldingDiscount Notes were issued at a discount and had an initial accreted value of$630.02 per $1,000 principal amount at maturity. Prior to December 15, 2009, nocash interest payments are required. However, interest accrues on the HoldingsDiscount Notes in the from of an increase in the accreted value of such notessuch that the accreted value of the Holdings Discount Notes will equal theprincipal amount at maturity on December 15, 2009. Thereafter, cash interest onthe Holdings Discount Notes is payable semi-annually at a fixed rate of 9.5%per annum. The Holdings Discount Notes mature on December 15, 2014.

 

The Holdings PIKNotes bear interest at a semi-annual floating rate based on six-month LIBORrates plus a margin equal to 7%. Interest is payable semi-annually beginning onJune 15, 2005 either in the form of cash or additional PIK Notes at theelection of the Company. The Holdings PIK Notes mature on December 15, 2014.

 

Holdings’ primarysource of liquidity for its interest payments will be cash flow generated fromthe operation of the Company. However, the terms of certain of the debtinstruments governing our existing notes significantly restrict us and Holdings’other subsidiaries from paying dividends, making distributions and otherwise transferringassets to Holdings. For example, our ability to make such payments is generallygoverned by a formula based on 50% of its consolidated net income (which, asdefined in the indenture governing our existing notes, excludes goodwillimpairment charges and any after-tax extraordinary, unusual or nonrecurringgains and losses) accruing from June 1, 2004. In addition, as a condition tomaking such payments to Holdings based on such formula, we must have a ratio ofAdjusted EBITDA to fixed charges (‘‘Fixed Charge Coverage Ratio’’) of at least2.0 to 1.0 after giving effect to any such payments. The Company may also makepayments to Holdings or other restricted payments if, on a pro forma basisafter giving effect to any such payment, it has a Net Indebtedness to AdjustedEBITDA ratio of no greater than 3.75 to 1.0 and a Net Senior Indebtedness toAdjusted EBITDA Ratio of no greater than 2.5 to 1.0. The Company may also payup to $45 million to Holdings or make other restricted payments without regard toany such provisions. Finally, the Company’s senior secured credit agreementpermits it to make payments to Holdings so that Holdings can pay interest incash on its indebtedness (including on its notes) up to a maximum amount of $35million in any fiscal year for the next five years. Thereafter, the creditagreement will permit Holdings to pay cash interest when due if it is thenrequired to be paid in cash, assuming there has been no event of default underthe credit agreement.

 

*Initial Common Stock Offering of Parent*

* *

*InMarch 2005, Parent’s Board of Directors approved a registration statement onForm S-1 to be filed with the Securities and Exchange Commission in connectionwith a planned initial public offering of Parent’s common stock (the “InitialCommon Stock Offering”).  Prior to theconsummation of the Initial Common Stock Offering, Parent, among other things,renamed all of its outstanding shares of Class A Common Stock as common stockand authorized a 1,139 for 1 split of the Parent’s common stock. Parent tocontributed the net proceeds from the Initial Common Stock Offering of$        million to Holdings as anequity capital contribution. Holdings used $574 million of such funds to redeemall outstanding Holdings Floating Rate Notes, all outstanding Holdings PIKNotes and 35% of the aggregate principal amount of*

 

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*theoutstanding Holdings Discount Notes, including redemption premiums and interestobligations through the date of redemption.*

* *

In connection withthe Initial Common Stock, the Company declared dividends of $316 million to itsimmediate parent company, WMG Holdings Corp. The dividends will be used to pay a dividend to the Investors of Parentand, to repurchase from Historic Time Warner the warrants issued as part of theinitial purchase price of the Acquisition. When such dividends are paid, it will have the effect of reducing theCompany’s cash and equivalents, additional paid-in capital and shareholder’sequity by $316 million.

 

Additionally, wehave terminated the Management Agreement with the Investor Group for ongoingconsulting and advisory services.  Weexpect to pay for a termination fee of approximately $73 million, which willreduce our cash and equivalents and stockholder’s equity by $73 million.  See “*Termination ofManagement/Monitoring Agreement*” presented herein.

 

Also in connectionwith the Initial Common Stock Offering of Parent, we intend to pay one-timespecial bonuses of approximately $35 million to management and employees of theCompany consisting of (a) approximately $20 million to be paid to certainholders of restricted stock and stock options to make employees whole forunfavorable certain tax consequences, (b) approximately $5 million to be paidto holders of stock options representing an adjustment as a result of thespecial dividend to be paid to the holders of Parent’s Class L and Class Acommon stock and (c) approximately $10 million to substantially all of ouremployees who have no equity participation in Parent subsequent to the initialpublic offering.  This will have theimpact of decreasing cash and equivalents and stockholder’s equity by $35million when paid.  See “Future Changesand Payments Relating to Executives Compensation” presented herein.

 

*Dividends*

* *

Parent hasdisclosed that they intend to pay regular quarterly dividends on their commonstock outstanding in an amount not to exceed $80 million per year.  We may be required to fund these dividendsthrough dividends to our parent companies. The ability of Parent to pay this dividend is dependent on the cashflows and operations of the Company.

 

**Covenant Compliance**

 

Our borrowingarrangements, including the senior secured credit facility and notes containcertain financial covenants which are tied to ratios based on Adjusted EBITDA,which is defined under the indentures governing the notes as ‘‘EBITDA.’’Adjusted EBITDA (as defined in the indentures) differs from the term ‘‘EBITDA’’as it is commonly used. In addition to adjusting net income to exclude interestexpense, income taxes, and depreciation and amortization, Adjusted EBITDA (asdefined in indentures) also adjusts net income by excluding items or expensesnot typically excluded in the calculation of ‘‘EBITDA’’ such as, among otheritems, (1) any reasonable expenses or charges related to any issuance ofsecurities, investments permitted, permitted acquisitions, recapitalizations,asset sales permitted or indebtedness permitted to be incurred; (2) the amountof any restructuring charges or reserves, subject to certain limitations; (3)any non-cash charges (including any impairment charges); (4) any gain or lossresulting from hedging currency exchange risks; (5) the amount of management,monitoring, consulting and advisory fees paid to the Investor Group; and (6)any net after-tax income or loss from discontinued operations.

 

Adjusted EBITDA ispresented herein because it is a material component of the covenants containedwithin the aforementioned agreements. Non-compliance with those covenants couldresult in the requirement to immediately repay all amounts outstanding underthose agreements which could have a material adverse effect on our results ofoperations, financial position and cash flow. Adjusted EBITDA does notrepresent net income or cash flow from operations as those terms are defined byGAAP and does not necessarily indicate whether cash flows will be sufficient tofund cash needs. While Adjusted EBITDA and similar measures are frequently usedas measures of operations and the ability to meet debt service requirements,these terms are not necessarily comparable to other similarly titled captionsof other companies due to the potential inconsistencies in the method ofcalculation. Adjusted EBITDA does not reflect the impact of earnings or chargesresulting from matters that we may consider not to be indicative of our ongoingoperations. In particular, the definition of Adjusted EBITDA in the indenturesallows us to add back certain non-cash, extraordinary, unusual or non-recurringcharges that are deducted in calculating net income. However, these areexpenses that may recur, vary greatly and are difficult to predict.

 

Adjusted pro formaEBITDA as presented below is not a measure of the performance of our businessand should not be used by investors as an indicator of performance for anyfuture period. Further, our debt instruments require that it be calculated forthe most recent four fiscal quarters. As a result, the measure can bedisproportionately affected by a particularly

 

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strong or weak quarter. Further, it may not be comparable to themeasure for any subsequent four-quarter period or any complete fiscal year.

 

The following is areconciliation of net income (loss), which is a GAAP measure of our operatingresults, to Adjusted EBITDA as defined, and the calculation of fixed chargecoverage and Net Indebtedness to Adjusted EBITDA ratios under our indenture forthe most recently ended four fiscal quarters ended March 31, 2005. The terms andrelated calculations are defined in the indenture (in millions, except ratios).

 
| ** **                                                          | ** ** | **Pro Forma**                              | ** ** |
|---------------------------------------------------------------------|------------|--------------------------------------------|------------|
| ** **                                                          | ** ** | **Twelve  Months  Ended  March 31,  2005** | ** ** |
| Net loss                                                            |       | $                                          | (50        | ) |
| Interest expense, net                                               |       | 141                                        |       |
| Income tax expense                                                  |       | 73                                         |       |
| Depreciation and amortization                                       |       | 240                                        |       |
| Management fees(a)                                                  |       | 10                                         |       |
| Restructuring costs(b)                                              |       | 26                                         |       |
| Equity in losses of equity method investees(c)                      |       | 2                                          |       |
| Loss on repayment of bridge loan(d)                                 |       | 6                                          |       |
| Non-cash compensation expense(e)                                    |       | 10                                         |       |
| Adjusted EBITDA                                                     |       | 458                                        |       |
| Cost savings from Acquisition-related restructuring(f)              |       | 48                                         |       |
| Adjusted pro forma EBITDA                                           |       | $                                          | 506        |   |
| Fixed Charges(g)                                                    |       | 109                                        |       |
| Net Indebtedness                                                    |       | 1,402                                      |       |
|                                                                |       |                                       |       |
| Fixed Charges Coverage ratio(h)                                     |       | 4.64x                                      |       |
| Net Indebtedness to Adjusted pro forma EBITDA ratio—(i)        |       | 2.77x                                      |       |
| Net Senior Indebtedness to Adjusted pro forma EBITDA ratio—(i) |       | 1.48x                                      |       |

 

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(a) Reflectsmanagement fees paid to the Investor Group for management advisory services.

 

(b) Reflects costsassociated with the restructuring plan and pre-Acquisition restructurings.

 

(c) Represents ourshare of the net income of investments in companies accounted for using theequity method.

 

(d) Reflects lossincurred on the repayment of the bridge loan used to fund the Acquisition.

 

(e) Reflects costsof stock-based compensation accounted for under FAS 123 and representativecosts of services provided by employees of the Investor Group who have filledin management roles on an interim basis.

 

(f) Reflectsreduction in operating expenses from restructurings already implemented forwhich the cost savings have not been fully reflected in our Statement ofOperations.

 

(g) Fixed chargesis defined in the indenture as consolidated interest expense excluding certainnoncash interest expense. Pro forma effect has been given to the fixed chargefor the Transactions as if they had occurred as of January 1, 2004.

 

(h) In order to bein compliance with our debt covenants, the Fixed Charge coverage ratio needs toexceed a 2.0x ratio.

 

(i) In order forus to make certain restricted payments, including payments to Holdings on a proforma basis after giving effect to such payments, our Net Indebtedness toAdjusted EBITDA ratio needs to be lower than 3.75x, and our Net SeniorIndebtedness to Adjusted EBITDA ratio needs to be lower than 2.5x. We may makeadditional restricted payments using certain other exceptions provided for inthe indenture governing the notes.

 

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The indenturesgoverning the notes, subject to certain exceptions, also require us to have aFixed Charge Coverage Ratio of at least 2.0 to 1.0 in order to incur additionaldebt.

 

**Summary**

 

Managementbelieves that future funds generated from our operations and availableborrowing capacity will be sufficient to fund Holdings’ and our debt servicerequirements, working capital requirements, capital expenditure requirementsand the remaining one-time costs associated with the execution of ourrestructuring plan to generate cost savings for the foreseeable future.However, our ability to continue to fund these items and to reduce debt may beaffected by general economic, financial, competitive, legislative andregulatory factors, as well as other industry-specific factors such as theability to control music piracy.

 

**ITEM 3**. QUANTITATIVE AND QUALITATIVEDISCLOSURES ABOUT MARKET RISK

 

As discussed inNote 21 to our audited consolidated financial statements for the seven monthsended September 30, 2004, the Company is exposed to market risk arising fromchanges in market rates and prices, including movements in foreign currencyexchange rates and interest rates. As of March 31, 2005, other than asdescribed below, there have been no material changes to the Company’s exposureto market risk since September 30, 2004.

 

As of March 31,2005, we have hedged our material foreign currency exposures related to royaltypayments remitted between our foreign affiliates and our U.S. affiliates forthe balance of the fiscal year.

 

During the sixmonths ended March 31, 2005, the Company entered into additional interest rateswap agreements with a notional face amount of $597 million.  Under these interest rate swap agreements, weagreed to receive floating-rate payments (based on three-month LIBOR rates) inexchange for fixed-rate payments.  Basedon the addition of the new interest-rate swap agreements, each 25 basis pointincrease or decrease in interest rates would increase or decrease our annualinterest expense and cash outlay by approximately $1 million.  This potential increase or decrease is basedon the simplified assumption that the level of floating-rate debt remainsconstant with an immediate across the board increase or decrease as of March31, 2005 with no subsequent changes in rates for the remainder of the period.

 

As previouslydescribed, Holdings issued approximately $450 million of variable-rate debt inDecember 2004. Although the Company is not a party to, or an obligor on, theHoldings Notes, the cash flow of the Company will be needed to service Holdings’interest obligations thereunder. Accordingly, each 25 basis point increase ordecrease in interest rates would increase or decrease the Company’s annual cashfunding requirements by approximately $1 million. This potential increase ordecrease is based on the simplified assumption that the level of floating-ratedebt remains constant with an immediate across-the-board increase or decreaseas of March 31, 2005 and no subsequent change in rates for the remainder of theperiod.  Additionally, if the InitialPublic Offering were to occur, this variable debt would be repaid and nopotential funding requirement would remain in relation to changes in interestrates.

 

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**ITEM 4****. CONTROLS AND PROCEDURES**

 

*Certification.*

 

The certifications of theprincipal executive officer and the principal financial officer (or personsperforming similar functions) required by Rules 13a-15(e) and 15d-15(e) ofthe Securities Exchange Act of 1934, as amended (the “Certifications”) arefiled as exhibits to this report. This section of the report contains theinformation concerning the evaluation of the Company’s disclosure controls andprocedures (as defined in Exchange Act Rules 13a-15(e) and 15d-15(e)) (“DisclosureControls”) and changes to internal control over financial reporting (as definedin Exchange Act Rules 13a-15(f) and 15d-15(f)) (“Internal Controls”)referred to in the Certifications and this information should be read inconjunction with the Certifications for a more complete understanding of thetopics presented.

 

*Introduction.*

 

The Company became subject tothe periodic and other reporting requirements of the Securities Exchange Act of1934, as amended, on February 10, 2005, the effective date of the Company’sregistration statement relating to its exchange offer to exchange outstandingunregistered notes for freely tradeable exchange notes that were registeredunder the Securities Act of 1933, as amended.

 

SEC rules define “disclosurecontrols and procedures” as controls and procedures that are designed to ensurethat information required to be disclosed by public companies in the reportsfiled or submitted under the Exchange Act is recorded, processed, summarizedand reported, within the time periods specified in the SEC’s rules and forms.

 

SEC rules define “internalcontrol over financial reporting” as a process designed by, or under thesupervision of, a public company’s principal executive and principal financialofficers, or persons performing similar functions, and effected by our board ofdirectors, management and other personnel, to provide reasonable assuranceregarding the reliability of financial reporting and the preparation offinancial statements for external purposes in accordance with generallyaccepted accounting principles, or U.S. GAAP, including those policies andprocedures that: (i) pertain to the maintenance of records that inreasonable detail accurately and fairly reflect the transactions anddispositions of the assets of the company, (ii) provide reasonableassurance that transactions are recorded as necessary to permit preparation offinancial statements in accordance with U.S. GAAP, and that receipts andexpenditures of the company are being made only in accordance withauthorizations of management and directors of the company and(iii) provide reasonable assurance regarding prevention or timelydetection of unauthorized acquisition, use or disposition of our assets thatcould have a material effect on the financial statements.

 

Our management, including theprincipal executive officer and principal financial officer, does not expect thatour Disclosure Controls or Internal Controls will prevent all error and allfraud. A control system, no matter how well conceived and operated, can provideonly reasonable, not absolute, assurance that the objectives of the controlsystem are met. Because of the limitations in any and all control systems, noevaluation of controls can provide absolute assurance that all control issuesand instances of fraud, if any, within the Company have been detected. Further,the design of any control system is based in part upon certain assumptionsabout the likelihood of future events, and there can be no assurance that anydesign will succeed in achieving its stated goals under all potential futureconditions. Because of these inherent limitations in a cost-effective controlsystem, misstatements due to error or fraud may occur and not be detected evenwhen effective Disclosure Controls and Internal Controls are in place.

 

*InternalControls.*

 

In connection with the mostrecent audit of WMG Acquisition Corp., our outside auditors identified a numberof significant deficiencies that together constitute material weaknesses in ourinternal controls. A material weakness, as defined by the Public CompanyAccounting Oversight Board, is a significant deficiency that by itself, or incombination with other significant deficiencies, results in more than a remotelikelihood that a material misstatement of the annual or interim financialstatements will not be prevented or detected.

 

During the transition from adivision of a multinational company to a stand alone business, our outsideauditors advised the audit committee of our board of directors and ourmanagement that numerous entity level controls were limited or not in place,including the need for a permanent chief financial officer (who we have sincehired) and additional skilled accounting and SEC experienced personnel toenhance the accounting department both domestically and internationally, theneed to considerably enhance our documentation of our systems and controls andthe need to develop and implement a formal code of conduct. In addition, ouroutside auditors noted that our domestic operations currently use differentroyalty systems, which has

 

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created certain complexities in reconcilingroyalty expense and payables. While we recognize that additional staff isneeded to cope with current requirements in royalty processing until a newsystem can be developed, we may not be able to hire and train additional staff.Finally, our auditors noted that our overall controls at our print business aresignificantly deficient. On December 15, 2004, we entered into adefinitive agreement to sell our print business to Alfred PublishingCo., Inc., subject to customary closing conditions. See also “RiskFactors—Our outside auditors have identified weaknesses in our internalcontrols that could affect our ability to ensure timely and reliable financialreports.”

 

*Evaluation ofDisclosure Controls and Procedures*.

 

Based on our management’sevaluation (with the participation of our principal executive officer andprincipal financial officer), as of the end of the period covered by thisreport and as a result of the weaknesses in our internal controls describedabove and below, our principal executive officer and principal financialofficer have concluded that our Disclosure Controls need to be improved so thatthey will provide reasonable assurance that information required to bedisclosed by us in reports that we file or submit under the Exchange Act willbe recorded, processed, summarized and reported within the time periodsspecified in SEC rules and forms. In addition, the Company is also in theprocess of reviewing its disclosure controls and procedures during thetransition to a stand alone business with the objective of implementingcomprehensive periodic reporting standards as well as addressing the weaknessesin Internal Controls identified by our outside auditors. Since completion ofthe most recent audit, the Company has undertaken a number of actions, as setforth below, to remedy the weaknesses discovered in our Internal Controls sothat the Company’s Disclosure Controls are effective in the future. We willcontinue to devote resources to improve our controls and remedy these weaknesses.

 

*Changes inInternal Control over Financial Reporting*

 

We have already taken a numberof actions to begin to address the items identified by our outside auditors andto provide reasonable assurances that the objectives of our Disclosure Controlsand Internal Controls will be met including:

 

•                  hiring apermanent chief financial officer;

 

•                  establishing anaudit committee and appointing an independent director who is a financialexpert as the chair of the committee;

 

•                  outsourcing ourinternal audit functions;

 

•                  hiring externalresources to lead our Section 404 evaluation efforts;

 

•                  adopting a newcode of conduct and hiring outside consultants to assist in the implementationof a new code of conduct;

 

•                  hiring otheraccounting and SEC experienced personnel to enhance the accounting department;

 

•                  hiringadditional outside resources to assist our internal personnel with royaltiesaccounting and SEC reporting;

 

•                  hiring adirector of taxation and other tax department members; and

 

•                  entering into ajoint venture with Universal Music Group, Exigen Group and Lightspeed VenturePartners to build a new uniform royalty system for all U.S. operations.

 

We are committed to maintaininghigh standards of internal control over financial reporting, corporate governanceand public disclosure and continue to improve and refine our Internal Controlsas an ongoing process and will continue to take corrective actions andimplement improvements as appropriate.

 

Other than as summarized above,there have been no changes in our Internal Controls over financial reporting orother factors that have materially affected, or are reasonably likely tomaterially affect, our Internal Controls.

 

*Institutionof Internal Controls in compliance with Section 404 of Sarbanes-Oxley*

 

As a result of our registrationwith the Securities and Exchange Commission, we will be required to comply withSection 404 of the Sarbanes-Oxley Act of 2002 and regulations promulgatedthereunder as of September 30, 2006. We are

 

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currently performing the system and processevaluation and testing required (and any necessary remediation) in an effort tocomply with management certification and auditor attestation requirements ofSection 404. In the course of our ongoing evaluation, we have identifiedareas of our internal controls requiring improvement, and plan to designenhanced processes and controls to address these and any other issues thatmight be identified through this review. As a result, we expect to incuradditional expenses and diversion of management’s time. We cannot be certain asto the timing of completion of our evaluation, testing and remediation actionsor the impact of the same on our operations and may not be able to ensure thatthe process is effective or that the internal controls are or will be effectivein a timely manner. If we are not able to implement the requirements ofSection 404 in a timely manner or with adequate compliance, ourindependent auditors may not be able to certify as to the effectiveness of ourinternal control over financial reporting and we may be subject to sanctions orinvestigation by regulatory authorities, such as the Securities and ExchangeCommission. As a result, there could be an adverse reaction in the financialmarkets due to loss of confidence in the reliability of our financialstatements. In additional, we may be required to incur costs in improving ourinternal control system and the hiring of additional personnel. Any such actioncould adversely affect our results. See also “Risk Factors—Our internalcontrols over financial reporting may not be adequate and our independentauditors may not be able to clarify as to their adequacy, which could have asignificant affect on our business and reputation.”

 

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**RISK FACTORS**

 

*Any of thefollowing risks could materially and adversely affect our business, financialcondition or results of operations. In such a case, you may lose all or part ofyour original investment.*

 

**Risks Related to the Business**

 

**Increased costsassociated with corporate governance compliance may significantly affect ourresults of operations.**

 

The Sarbanes-Oxley Act of 2002and our being subject to the Securities Exchange Act of 1934, as amended, willrequire changes in some of our corporate governance and securities disclosureand compliance practices, and will require a review of our internal controlprocedures. For example, we are now required to have disclosure controls, whichcurrently need to be improved. We expect these developments to increase ourlegal compliance and financial reporting costs. In addition, they could make itmore difficult for us to attract and retain qualified members of our board ofdirectors, or qualified executive officers. Finally, director and officerliability insurance for public companies like us has become more difficult andmore expensive to obtain, and we may be required to accept reduced coverage orincur higher costs to obtain coverage that is satisfactory to us and ourofficers or directors. We are presently evaluating and monitoring regulatorydevelopments and cannot estimate the timing or magnitude or additional costs wemay incur as a result.

 

**Our internalcontrols over financial reporting may not be adequate and our independentauditors may not be able to certify as to their adequacy, which could have asignificant and adverse effect on our business and reputation.**

 

We are evaluating our internalcontrols over financial reporting in order to allow management to report on,and our independent auditors to attest to, our internal controls over financialreporting, as required by Section 404 of the Sarbanes-Oxley Act of 2002and rules and regulations of the SEC thereunder, which we refer to asSection 404. Section 404 requires a reporting company such as ours to,among other things, annually review and disclose its internal controls overfinancial reporting, and evaluate and disclose changes in its internal controlsover financial reporting quarterly. We will be required to comply with Section404 as of September 30, 2006. We are currently performing the system andprocess evaluation and testing required (and any necessary remediation) in aneffort to comply with management certification and auditor attestation requirementsof Section 404. In the course of our ongoing evaluation, we haveidentified areas of our internal controls requiring improvement, and plan todesign enhanced processes and controls to address these and any other issuesthat might be identified through this review. As a result, we expect to incuradditional expenses and diversion of management’s time. We cannot be certain asto the timing of completion of our evaluation, testing and remediation actionsor the impact of the same on our operations and may not be able to ensure thatthe process is effective or that the internal controls are or will be effectivein a timely manner. If we are not able to implement the requirements ofSection 404 in a timely manner or with adequate compliance, our independentauditors may not be able to certify as to the effectiveness of our internalcontrol over financial reporting and we may be subject to sanctions orinvestigation by regulatory authorities, such as the Securities and ExchangeCommission. As a result, there could be an adverse reaction in the financialmarkets due to a loss of confidence in the reliability of our financialstatements. In addition, we may be required to incur costs in improving ourinternal control system and the hiring of additional personnel. Any such actioncould adversely affect our results.

 

**Our outsideauditors have identified weaknesses in our internal controls that could affectour ability to ensure timely and reliable financial reports.**

 

In addition to our evaluation ofinternal controls under Section 404 of the Sarbanes-Oxley Act and anyareas requiring improvement that we identify as part of that process, inconnection with our most recent audit, our outside auditors identified a numberof significant deficiencies that together constitute material weaknesses in ourinternal controls. A material weakness, as defined by the Public CompanyAccounting Oversight Board, is a significant deficiency that by itself, or incombination with other significant deficiencies, results in more than a remotelikelihood that a material misstatement of the annual or interim financialstatements will not be prevented or detected.

 

During the transition from asubsidiary of a multinational company to a stand alone entity, our outsideauditors advised the audit committee of our board of directors and ourmanagement that numerous entity level controls were limited or not in place,including the need for a permanent chief financial officer (who we have sincehired) and additional skilled accounting and SEC experienced personnel toenhance the accounting department both domestically and internationally, theneed to develop a tax group, the need to establish our own internal auditdepartment, the need to considerably enhance our documentation of our systems andcontrols, and the need to develop and implement a formal code of conduct. Inaddition, our outside auditors noted that our domestic operations currently usedifferent royalty systems, which has created certain complexities inreconciling

 

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royalty expense and payables. While werecognize that additional staff is needed to cope with current requirements inroyalty processing until a new system can be developed, we may not be able tohire and train additional staff. Finally, our auditors noted that our overallcontrols at our print business are significantly deficient. OnDecember 15, 2004, we entered into a definitive agreement to sell ourprint business to Alfred Publishing, subject to customary closing conditions.

 

We have already taken a numberof actions to begin to address the items identified including:

 

•                  hiring apermanent chief financial officer;

 

•                  establishing anaudit committee and appointing an independent director who is a financialexpert as the chair of the committee;

 

•                  outsourcing ourinternal audit functions;

 

•                  hiring externalresources to lead our Section 404 evaluation efforts;

 

•                  adopting a newcode of conduct and hiring outside consultants to assist in the implementationof the new code of conduct;

 

•                  hiringadditional outside resources to assist our internal personnel with royaltiesaccounting and SEC reporting;

 

•                  hiring otheraccounting and SEC experienced personnel to enhance the accounting department;

 

•                  hiring adirector of taxation and other tax department members; and

 

•                  entering into ajoint venture with Universal Music Group, Exigen Group and Lightspeed VenturePartners to build a new uniform royalty system for all U.S. operations.

 

While we have begun to takeactions to address the items identified, additional measures will be necessaryand these measures along with other measures we expect to take to improve ourinternal controls may not be sufficient to address the issues identified by ouroutside auditors or ensure that our internal controls are effective. If we areunable to provide reliable and timely financial reports our business andprospects could suffer material adverse effects and our share price could beadversely affected.

 

**The recordedmusic industry has been declining and may continue to decline, which mayadversely affect our prospects and our results of operations.**

 

Illegal downloading of musicfrom the Internet, CD-R piracy, industrial piracy, economic recession,bankruptcies of record wholesalers and retailers and growing competition forconsumer discretionary spending and retail shelf space may all be contributingto a declining recorded music industry. Additionally, the period of growth inrecorded music sales driven by the introduction and penetration of the CDformat has ended. While DVD-Audio, DualDisc and downloadable digital files arethought to represent potential new avenues for growth, no significant newlegitimate audio format has yet emerged to take the place of the CD. The valueof worldwide sales fell as the music industry witnessed a decline of 4.9% from1999 to 2000, 5.7% from 2000 to 2001, 6.7% from 2001 to 2002 and 7.6% from 2002to 2003. Although we believe that the recorded music industry should improve asevidenced by the year-over-year growth in U.S. music physical unit sales in2004 and flat performance in overall (physical and digital) music unit salesglobally in 2004, the best year-on-year trend in global music sales for fiveyears according to the IFPI, the industry may relapse into a period of declineas witnessed from 1999 to 2003. We cannot assure you as to the timing or theextent of any improvement in the industry or that the evidence of improvementin 2004 based upon U.S. sales through the one-year period endingJanuary 2, 2005 and global sales in the first half of 2004 will continue.For example, as of May 1, 2005, year-to-date U.S. recorded music sales(excluding sales of digital tracks) are down approximately 8.2% year-over-year.A declining recorded music industry is likely to lead to reduced levels ofrevenue and operating income generated by our Recorded Music business.Additionally, a declining recorded music industry is also likely to have anegative impact on our Music Publishing business, which generates a significantportion of its revenues from mechanical royalties, primarily from the sale ofmusic in CD and other recorded music formats.

 

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**There may be downward pressure on our pricingand our profit margins.**

 

There are a variety of factorswhich could cause us to reduce our prices and erode our profit margins. Theyare, among others, increased price competition among record companies resultingfrom the Universal and Sony BMG recorded music duopoly, price competition fromthe sale of motion pictures in DVD-Video format and videogames, the evergreater price negotiating leverage of mass merchandisers and big box retailers,the increased costs of doing business with mass merchandisers and big boxretailers as a result of complying with operating procedures that are unique totheir needs and the adoption by record companies of initially lower-marginformats such as DualDisc and DVD-Audio. See “Risk Factors—We may be materiallyand adversely affected by the formation of Sony BMG Music Entertainment.”

 

**Our prospectsand financial results may be adversely affected if we fail to identify, signand retain artists and songwriters and by the existence or absence of superstarreleases and by local economic conditions in the countries in which we operate.**

 

We are dependent on identifying,signing and retaining artists with long-term potential, whose debut albums arewell received on release, whose subsequent albums are anticipated by consumersand whose music will continue to generate sales as part of our catalog foryears to come. The competition among record companies for such talent isintense. Competition among record companies to sell records is also intense andthe marketing expenditures necessary to compete have increased as well. We arealso dependent on signing and retaining songwriters who will write the hitsongs of today and the classics of tomorrow under terms that are economicallyattractive to us. Our competitive position is dependent on our continuingability to attract and develop talent whose work can achieve a high degree ofpublic acceptance. Our financial results may be adversely affected if we areunable to identify, sign and retain such artists and songwriters under termsthat are economically attractive to us. Our financial results may also beaffected by the existence or absence of superstar artist releases during aparticular period. Some music industry observers believe that the number ofsuperstar acts with long-term appeal, both in terms of catalog sales and futurereleases, has declined in recent years. Additionally, our financial results aregenerally affected by the general economic and retail environment of thecountries in which we operate, as well as the appeal of our recorded musiccatalog and our music publishing library.

 

**We may havedifficulty addressing the threats to our business associated with home copyingand Internet downloading.**

 

The combined effect of thedecreasing cost of electronic and computer equipment and related technologysuch as CD burners and the conversion of music into digital formats have madeit easier for consumers to create unauthorized copies of our recordings in theform of, for example, CDs and MP3 files. A substantial portion of our revenuecomes from the sale of audio products that are potentially subject tounauthorized consumer copying and widespread dissemination on the Internetwithout an economic return to us. We are working to control this problemthrough litigation, by lobbying governments for new, stronger copyright protectionlaws and more stringent enforcement of current laws and by establishinglegitimate new media business models. We cannot give any assurances that suchmeasures will be effective. For instance, the Inducing Infringement ofCopyrights Act of 2004 introduced in the Senate on June 22, 2004 was notenacted in 2004. If we fail to obtain appropriate relief through the judicialprocess or the complete enforcement of judicial decisions issued in our favor(or if judicial decisions are not in our favor, such as in the recentfile-sharing cases in the U.S. and Canada, Metro-Goldwyn-MayerStudios, Inc. *et al* vs.Grokster Ltd. *et al*, and BMGCanada Inc. *et al* vs. JohnDoe *et al*, respectively), if weare unsuccessful in our efforts to lobby governments to enact and enforcestronger legal penalties for copyright infringement or if we fail to developeffective means of protecting our intellectual property (whether copyrights orother rights such as patents, trademarks and trade secrets) or entertainment-relatedproducts or services, our results of operations, financial position andprospects may suffer. On March 29, 2005, the U.S. Supreme Court heard theappeal of the decision of the U.S. Court of Appeals for the 9th Circuit in the Grokster case. The issue to be decided by the Supreme Court is theliability of file sharing software developers and vendors for the copyrightinfringement that takes place on their services. Both the district court andthe Ninth Circuit had found that Grokster and Streamcast could not be found contributorilyand vicariously liable for the copyright infringement committed by the users oftheir services.

 

**Organizedindustrial piracy may lead to decreased sales.**

 

The global organized commercialpirate trade is a significant threat to the music industry. Worldwide,industrial pirated music (which encompasses unauthorized physical copiesmanufactured for sale but does not include Internet downloads or home CDburning) is estimated to have generated over $4.5 billion in revenues in2003, according to IFPI. IFPI estimates that 1.7 billion pirated unitswere manufactured in 2003. According to IFPI estimates, approximately 35% ofall music CDs sold worldwide in 2003 were pirated. Unauthorized copies andpiracy contributed to the decrease in the volume of legitimate sales and putpressure on the price of legitimate sales. They have had, and may continue tohave, an adverse effect on our business.

 

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**Ourrestructuring plan may not be successful and may adversely affect our business.**

 

The scope of our restructuringplan is broad and significant and may cause losses to our business that wecannot predict. At the time of the Acquisition, we had identified up to$277 million of annualized cost savings to be achieved within18 months and had identified approximately $310 million of associatedrestructuring charges. Although we have now implemented annualized cost savingsof approximately $250 million and expect the actual charges to be between$225 million and $250 million, we cannot assure you that:

 

•                  we will actuallyachieve all such identified savings;

 

•                  we willimplement all measures needed to achieve such savings; and

 

•                  the costs toimplement our restructuring plan will not exceed our identified costs due to,among other things, higher than expected costs related to staff reductions orconsolidation of our operations.

 

The primary challenge we face inrealizing the cost savings in our restructuring plan is avoiding increasedcosts required to support our ongoing operations. Specifically, a variety offactors could cause us not to achieve the benefits of the restructuring, orcould result in harm to our business, including, among others, the following:

 

•                  higher thanexpected retention costs for employees that will be retained;

 

•                  increasedoperating costs or other unexpected costs associated with supporting thebusiness and meeting financial objectives such as revenue growth;

 

•                  loss of revenuesand market share due to, among other things, a diminished ability to attractand hire desirable talent;

 

•                  unexpected lossof artists or key employees; and

 

•                  loss of revenuesand market share due to, among other things, a lack of sufficient resources topromote records and albums, and a lack of sufficient resources to attract newartists.

 

If we fail to successfullyimplement the remainder of the restructuring plan, including our cost-savingmeasures, our results of operations and financial position may suffer. Inaddition, we cannot predict the extent to which our restructuring plan mayadversely affect our business.

 

**Our involvementin intellectual property litigation could adversely affect our business.**

 

Our business is highly dependentupon intellectual property, a field that has encountered increasing litigationin recent years. If we are alleged to infringe the intellectual property rightsof a third party, any litigation to defend the claim could be costly and woulddivert the time and resources of management, regardless of the merits of theclaim. There can be no assurance that we would prevail in any such litigation.If we were to lose a litigation relating to intellectual property, we could beforced to pay monetary damages and to cease the sale of certain products or theuse of certain technology. Any of the foregoing may adversely affect ourbusiness.

 

**The recordedmusic industry is under investigation by Eliot Spitzer, the Attorney Generalfor the State of New York, regarding its practices in promoting its records toradio stations.**

 

On September 7, 2004,November 22, 2004 and March 31, 2005, Eliot Spitzer, the Attorney Generalof the State of New York, served us with requests for information in the formof subpoenas duces tecum in connection with an industry-wide investigation ofthe relationship between music companies and radio stations, including the useof independent promoters and accounting for any such payments. In response tothe Attorney General’s subpoenas, we have been producing documents and expectto complete our production in May or June. We understand that the investigationhas been expanded to include companies that own radio stations. Theinvestigation is pursuant to New York Executive Law §63(12) and New YorkGeneral Business Law §349, both of which are consumer fraud statutes. It is toosoon to predict the outcome of this investigation, but it has the potential toresult in changes in the manner in which the recorded music industry promotesits records or financial penalties, which could adversely affect our business,including our brand value.

 

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**Due to thenature of our business, our results of operations and cash flows may fluctuatesignificantly from period to period.**

 

Our net sales, operating incomeand profitability, like those of other companies in the music business, arelargely affected by the number and quality of albums that we release, ourrelease schedule, and, more importantly, the consumer demand for thesereleases. We also make advance payments to recording artists and songwriters,which impact our operating cash flows. The timing of album releases and advancepayments is largely based on business and other considerations and is madewithout regard to the timing of the release of our financial results. We reportresults of operations quarterly and our results of operations and cash flows inany reporting period may be materially affected by the timing of releases andadvance payments, which may result in significant fluctuations from period toperiod.

 

**Our operatingresults fluctuate on a seasonal and quarterly basis, and, in the event we donot generate sufficient net sales in our first fiscal quarter, we may not beable to meet our debt service and other obligations, including those under theSubordinated Notes.**

 

Our business is seasonal. Forthe twelve months ended March  31, 2005, we derived approximately 83% ofour revenues from our Recorded Music business. In the recorded music business,purchases are heavily weighted towards the last three months of the calendaryear which represent our first quarter under our new September 30 fiscalyear. Historically, we have realized greater than 35% of recorded music netsales worldwide during the last three months of the calendar year, making thosethree months (i.e., our new first fiscal quarter) material to our full-yearperformance. We realized 35% of recorded music calendar year net sales duringthe last three months of 2004. This sales seasonality affects our operatingcash flow from quarter to quarter. We cannot assure you that our recorded musicnet sales for the last three months of any calendar year will continue to besufficient to meet our obligations or that they will be higher than such netsales for our other quarters. In the event that we do not derive sufficientrecorded music net sales in such last three months, we may not be able to meetour debt service under the notes and Subordinated Notes other obligations.

 

**We may beunable to compete successfully in the highly competitive markets in which weoperate and we may suffer reduced profits as a result.**

 

The industry in which we operateis highly competitive, is based on consumer preferences and is rapidlychanging. Additionally, the music industry requires substantial human andcapital resources. We compete with other recorded music companies and musicpublishers to identify and sign new recording artists and songwriters whosubsequently achieve long-term success and to renew agreements with establishedartists and songwriters. In addition, our competitors may from time to timereduce their prices in an effort to expand market share and introduce newservices, or improve the quality of their products or services. We may losebusiness if we are unable to sign successful artists or songwriters or to matchthe prices or the quality of products and services, offered by our competitors.Our Music Publishing business competes not only with other music publishingcompanies, but also with songwriters who publish their own works. Our RecordedMusic business is to a large extent dependent on technological developments,including access to and selection and viability of new technologies, and issubject to potential pressure from competitors as a result of theirtechnological developments. For example, our Recorded Music business may beadversely affected by technological developments that facilitate the piracy ofmusic, such as Internet peer-to-peer file-sharing and CD-R activity; by itsinability to enforce our intellectual property rights in digital environments;and by its failure to develop a successful business model applicable to adigital online environment. It also faces competition from other forms ofentertainment and leisure activities, such as cable and satellite television,pre-recorded films on videocassettes and DVD, the Internet and computer andvideogames.

 

**Our businessoperations in some countries subject us to trends, developments or other eventsin foreign countries which may affect us adversely.**

 

We are a global company withstrong local presences, which have become increasingly important as thepopularity of music originating from a country’s own language and culture hasincreased in recent years. Our mix of national and international recordingartists and songwriters provides a significant degree of diversification forour music portfolio. However, our creative content does not necessarily enjoyuniversal appeal. As a result, our results can be affected not only by generalindustry trends, but also by trends, developments or other events in individualcountries, including:

 

•                  limited legalprotection and enforcement of intellectual property rights;

 

•                  restrictions onthe repatriation of capital;

 

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•                  differences andunexpected changes in regulatory environment, including environmental, healthand safety, local planning, zoning and labor laws, rules and regulations;

 

•                  varying taxregimes which could adversely affect our results of operations or cash flows,including regulations relating to transfer pricing and withholding taxes on remittancesand other payments by subsidiaries and joint ventures;

 

•                  exposure todifferent legal standards and enforcement mechanisms and the associated cost ofcompliance;

 

•                  difficulties inattracting and retaining qualified management and employees or rationalizingour workforce;

 

•                  tariffs, duties,export controls and other trade barriers;

 

•                  longer accountsreceivable settlement cycles and difficulties in collecting accountsreceivable;

 

•                  recessionarytrends, inflation and instability of the financial markets;

 

•                  higher interestrates; and

 

•                  politicalinstability.

 

We may not be able to insure orhedge against these risks, and we may not be able to ensure compliance with allof the applicable regulations without incurring additional costs. Furthermore, financingmay not be available in countries with less than investment-grade sovereigncredit ratings. As a result, it may be difficult to create or maintain profit-makingoperations in developing countries.

 

In addition, our results can beaffected by trends, developments and other events in individual countries.There can be no assurance that in the future other country-specific trends,developments or other events will not have such a significant adverse effect onour business, results of operations or financial condition.

 

**Our businessmay be adversely affected by competitive market conditions and we may not beable to execute our business strategy.**

 

We intend to increase revenuesand cash flow through a business strategy which requires us to, among otherthings, continue to maximize the value of our music assets, significantlyreduce costs to maximize flexibility and adjust to new realities of the market,continue to act to contain digital piracy and capitalize on digitaldistribution and emerging technologies.

 

Each of these initiativesrequires sustained management focus, organization and coordination oversignificant periods of time. Each of these initiatives also requires success inbuilding relationships with third parties and in anticipating and keeping upwith technological developments and consumer preferences. The results of thestrategy and the success of our implementation of this strategy will not beknown for some time in the future. If we are unable to implement the strategysuccessfully or properly react to changes in market conditions, our financialcondition, results of operations and cash flows could be adversely affected.

 

**Our ability tooperate effectively could be impaired if we fail to attract and retain ourexecutive officers.**

 

Our success depends, in part,upon the continuing contributions of our executive officers. Although we haveemployment agreements with our executive officers, there is no guarantee thatthey will not leave. The loss of the services of any of our executive officersor the failure to attract other executive officers could have a materialadverse effect on our business or our business prospects.

 

**Legitimatechannels for digital distribution of our creative content are a recentdevelopment, and their impact on our business is unclear and may be adverse.**

 

We have positioned ourselves totake advantage of the Internet and wireless as a sales distribution channel andbelieve that the development of legitimate channels for digital musicdistribution holds promise for us in the future. However, legitimate channelsfor digital distribution are a recent development and we cannot predict theirimpact on our business. Any legitimate digital distribution channel that doesdevelop may result in lower or less profitable sales for us than comparablephysical sales.

 

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In addition, if piracy continues unabated andlegitimate digital distribution channels fail to gain consumer acceptance, ourresults of operations could be harmed.

 

**A significantportion of our music publishing revenues is subject to rate regulation eitherby government entities or by local third-party collection societies throughoutthe world, which may limit our profitability.**

 

Mechanical royalties andperformance royalties are the two largest sources of income to our MusicPublishing business and mechanical royalties are a significant expense to ourRecorded Music business. In the U.S., mechanical rates are set pursuant toindustry negotiations contemplated by the U.S. Copyright Act and performancerates are set by performing rights societies and subject to challenge byperforming rights licensees. Outside the U.S., mechanical and performance ratesare typically negotiated on an industry-wide basis. The mechanical and performancerates set pursuant to such processes may adversely affect us by limiting ourability to increase the profitability of our Music Publishing business. If themechanical rates are set too high it may also adversely affect us by limitingour ability to increase the profitability of our Recorded Music business. TheGerman IFPI group has filed a petition with the Arbitration Board of the GermanPatent and Trademark Office for the reduction of the current royalty rate forlicensing compact discs from 9.01% of the Published Price for Dealers (PPD) to5.57%. If the German IFPI group succeeds or other record companies or recordedmusic industry groups take similar positions in other countries and succeed,this could result in a significant loss of revenues for our Music Publishingbusiness.

 

**Unfavorablecurrency exchange rate fluctuations could adversely affect our results ofoperations.**

 

The reporting currency for ourfinancial statements is the U.S. dollar. We have substantial assets,liabilities, revenues and costs denominated in currencies other than U.S.dollars. To prepare our consolidated financial statements, we must translatethose assets, liabilities, revenues and expenses into U.S. dollars atthen-applicable exchange rates. Consequently, increases and decreases in thevalue of the U.S. dollar versus other currencies will affect the amount ofthese items in our consolidated financial statements, even if their value hasnot changed in their original currency. These translations could result insignificant changes to our results of operations from period to period. For thethree months ended March 31, 2005, approximately 54% of our revenues and 38% ofour assets related to operations in foreign territories. From time to time, weenter into foreign exchange contracts to hedge the risk of unfavorable foreigncurrency exchange rate movements.  As ofMarch 31, 2005, we have hedged our material foreign currency exposures relatedto royalty payments remitted between our foreign affiliates and our U.S.affiliates for the balance of the fiscal year.

 

**We may not havefull control and ability to direct the operations we conduct through jointventures.**

 

We currently have interests in anumber of joint ventures and may in the future enter into further jointventures as a means of conducting our business. In addition, we structurecertain of our relationships with recording artists and songwriters as jointventures. We may not be able to fully control the operations and the assets ofour joint ventures, and we may not be able to make major decisions or may notbe able to take timely actions with respect to our joint ventures unless ourjoint venture partners agree.

 

**The enactmentof legislation limiting the terms by which an individual can be bound under a “personalservices” contract could impair our ability to retain the services of keyartists.**

 

California Labor CodeSection 2855 (“Section 2855”) limits the duration of time anyindividual can be bound under a contract for “personal services” to a maximumof seven years. In 1987, Subsection (b) was added, which provides alimited exception to Section 2855 for recording contracts, creating adamages remedy for record companies. Legislation was introduced in Californiato repeal Subsection (b) and then withdrawn. Legislation was introduced inNew York to create a statute similar to Section 2855, which did notadvance. There is no assurance that New York, California or any other statewill not reintroduce or introduce similar legislation in the future. In fact,legislation similar to Section 2855 has recently been introduced in the NewYork Assembly. The repeal of Subsection (b) of Section 2855 and/orthe passage of legislation similar to Section 2855 by other states couldmaterially affect our results of operations and financial position.

 

**We face apotential loss of catalog if it is determined that recording artists have aright to recapture rights in their recordings under the U.S. Copyright Act.**

 

The U.S. Copyright Act providesauthors (or their heirs) a right to terminate licenses or assignments of rightsin their copyrighted works. This right does not apply to works that are “worksmade for hire”. Since the effective date of U.S. copyrightability for soundrecordings (February 15, 1972), virtually all of our agreements withrecording artists provide that such recording artists render services under anemployment-for-hire relationship. A termination right exists under the U.S.Copyright Act for musical compositions that are not “works made for hire”. Ifany of our commercially available recordings were

 

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determined not to be “works made for hire”,then the recording artists (or their heirs) could have the right to terminatethe rights they granted to us, generally during a five-year period starting atthe end of 35 years from the date of a post-1977 license or assignment(or, in the case of a pre-1978 grant in a pre-1978 recording, generally duringa five-year period starting either at the end of 56 years from the date ofcopyright or on January 1, 1978, whichever is later). A termination ofrights could have an adverse effect on our Recorded Music business. From timeto time, authors (or their heirs) can terminate our rights in musicalcompositions. However, we believe the effect of those terminations is alreadyreflected in the financial results of our Music Publishing business.

 

**If we acquireor invest in other businesses, we will face certain risks inherent in suchtransactions.**

 

We may acquire, make investmentsin, or enter into strategic alliances or joint ventures with, companies engagedin businesses that are similar or complementary to ours. If we make suchacquisitions or investments or enter into strategic alliances, we will facecertain risks inherent in such transactions. For example, gaining regulatoryapproval for significant acquisitions or investments could be a lengthy processand there can be no assurance of a successful outcome. We could facedifficulties in managing and integrating newly acquired operations. Additionally,such transactions would divert management resources and may result in the lossof artists or songwriters from our rosters. We cannot assure you that if wemake any future acquisitions, investments, strategic alliances or jointventures that they will be completed in a timely manner, that they will bestructured or financed in a way that will enhance our creditworthiness or thatthey will meet our strategic objectives or otherwise be successful.

 

Failure to effectively manageany of these transactions could result in material increases in costs orreductions in expected revenues, or both.

 

**We arecontrolled by entities that may have conflicts of interest with us or you inthe future.**

 

The Investor Group controls amajority of our capital stock on a fully diluted basis. In addition,representatives of the Investor Group occupy substantially all of the seats onour board of directors and pursuant to a stockholders agreement, will have theright to appoint all of the independent directors to our board. As a result,the Investor Group has the ability to control our policies and operations,including the appointment of management, the entering into of mergers,acquisitions, sales of assets, divestitures and other extraordinarytransactions, future issuances of our common stock or other securities, thepayments of dividends, if any, on our common stock, the incurrence of debt byus and the amendment of our certificate of incorporation and bylaws. TheInvestor Group will have the ability to prevent any transaction that requiresthe approval of our board of directors or the stockholders regardless ofwhether or not other members of our board of directors or stockholders believethat any such transaction is in their own best interests. For example, the InvestorGroup could cause us to make acquisitions that increase our indebtedness or tosell revenue-generating assets. Additionally, the Investor Group are in thebusiness of making investments in companies and may from time to time acquireand hold interests in businesses that compete directly or indirectly with us.The Investor Group may also pursue acquisition opportunities that may becomplementary to our business, and, as a result, those acquisitionopportunities may not be available to us. So long as the Investor Groupcontinues to hold a majority of our outstanding common stock the Investor Groupwill be entitled to nominate a majority of our board of directors, and willhave the ability to effectively control the vote in any election of directors.In addition, so long as the Investor Group continues to own a significantamount of our equity, even if such amount is less than 50%, they will continueto be able to strongly influence or effectively control our decisions.

 

**Our reliance onone company for the manufacturing, packaging and physical distribution of ourproducts in North America and Europe could have an adverse impact on ourability to meet our manufacturing, packaging and physical distributionrequirements.**

 

Cinram is currently ourexclusive supplier of manufacturing, packaging and physical distributionservices in North America and most of Europe. Accordingly, our continuedability to meet our manufacturing, packaging and physical distributionrequirements in those territories depends largely on Cinram’s continuedsuccessful operation in accordance with the service level requirements mandatedby us in our service agreements. If, for any reason, Cinram were to fail tomeet contractually required service levels, we would have difficulty satisfyingour commitments to our wholesale and retail customers, which could have anadverse impact on our revenues. Even though our agreements with Cinram give usa right to terminate based upon failure to meet mandated service levels, andthere are several capable substitute suppliers, it might be difficult for us toswitch to substitute suppliers for any such services, particularly in theshort-term, and the delay and transition time associated with findingsubstitute suppliers could itself have an adverse impact on our revenues. Inaddition, our agreements with Cinram begin to expire in the next two years,beginning in 2006. If we are unable to negotiate renewals of these agreementswe would have to switch to substitute suppliers. Further, pricing negotiatedwith Cinram in future agreements may be more or less favorable than theexisting agreements.

 

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**We may bematerially and adversely affected by the separation of our business from TimeWarner.**

 

As a result of the Acquisition,we are an independent entity. We cannot assure you that our separation fromTime Warner will progress smoothly, which could materially and adversely impactour results. In the past, we have relied on contractual arrangements whichrequired Time Warner and its affiliates to provide some services such ascritical transitional services and shared arrangements to us such as tax,treasury, benefits and information technology, most of which expired as ofDecember 31, 2004. Time Warner still provides some DX Online Services, aweb-based solution designed to manage small package shipping. However, we havereplaced the majority of these services and arrangements and are in the processof replacing any remaining services and arrangements that we will still need asan independent entity. The new services and arrangements we have put in placemay not operate as effectively or cost effectively as those we previouslyreceived from Time Warner and we may not be able to replace any remainingservices and arrangements on terms and conditions, including service levels andcost, as favorable as those we have received from Time Warner.

 

**We may bematerially and adversely affected by the formation of Sony BMG MusicEntertainment.**

 

In August 2004 Sony MusicEntertainment (“Sony”) and Bertelsmann Music Group (“BMG”) merged theirrecorded music businesses to form Sony BMG Music Entertainment (“Sony BMG”). Asa result, the recorded music market now consists of four major players(Universal, Sony BMG, EMI Recorded Music (“EMI”) and us) rather than five(Universal, Sony, BMG, EMI and us). Prior to the formation of Sony BMG, therewas one disproportionately large major, Universal, with approximately 25%market share and four other majors relatively equal in size with market sharesranging between 11% and 14%. Now there are two majors with 25% to 30% marketshares, Universal and Sony BMG, and two significantly smaller majors, EMI andus. There is a threat that the change in the competitive landscape caused bythe new Universal and Sony BMG duopoly could drive up the costs of artistsignings and the costs of marketing and promoting records to our detriment.

 

**Risks Related to our Leverage**

 

**Our substantialleverage on a consolidated basis could adversely affect our ability to raise additionalcapital to fund our operations, limit our ability to react to changes in theeconomy or our industry and prevent us from meeting our obligations under ourindebtedness.**

 

We are highly leveraged. As ofMarch 31, 2005, our total consolidated indebtedness was $1.842 billion. Inaddition, on May 13, 2005, we borrowed an additional $250 million under ouramended senior secured credit facility as described under “Management’sDiscussion and Analysis of Financial Condition and Results of Operations – Liquidity.”  We have an additional $250 millionavailable for borrowing under the revolving portion of WMG Acquisition Corp.’ssenior secured credit facility (less $4 million of current letters ofcredit).

 

Our high degree of leveragecould have important consequences for you, including:

 

•                  making it moredifficult for us and our subsidiaries to make payments on indebtedness;

 

•                  increasing ourvulnerability to general economic and industry conditions;

 

•                  requiring asubstantial portion of cash flow from operations to be dedicated to the paymentof principal and interest on indebtedness, therefore reducing our ability touse our cash flow to fund our operations, capital expenditures and futurebusiness opportunities;

 

•                  exposing us tothe risk of increased interest rates as certain of the borrowings of oursubsidiaries, including borrowings under WMG Acquisition Corp.’s senior securedcredit facility, will be at variable rates of interest;

 

•                  limiting ourability and the ability of our subsidiaries to obtain additional financing forworking capital, capital expenditures, product development, debt servicerequirements, acquisitions and general corporate or other purposes; and

 

•                  limiting ourability to adjust to changing market conditions and placing us at a competitivedisadvantage compared to our competitors who are less highly leveraged.

 

We and our subsidiaries may beable to incur substantial additional indebtedness in the future, subject to therestrictions contained in WMG Acquisition Corp.’s senior secured creditfacility and the indenture relating to the Subordinated. Notes. If newindebtedness is added to our current debt levels, the related risks that we andour subsidiaries now face could intensify.

 

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**We may not beable to generate sufficient cash to service all of our indebtedness, includingthe notes, and may be forced to take other actions to satisfy our obligationsunder our indebtedness, which may not be successful.**

 

Our ability to make scheduledpayments on or to refinance our debt obligations depends on our financialcondition and operating performance, which is subject to prevailing economicand competitive conditions and to certain financial, business and other factorsbeyond our control. We cannot assure you that we will maintain a level of cashflows from operating activities sufficient to permit us to pay the principal,premium, if any, and interest on our indebtedness, including the notes.

 

If our cash flows and capitalresources are insufficient to fund our debt service obligations, we may beforced to reduce or delay investments in recording artists, and songwriterscapital expenditures, or to sell assets, seek additional capital or restructureor refinance our indebtedness, including the notes. These alternative measuresmay not be successful and may not permit us to meet our scheduled debt serviceobligations. In the absence of such operating results and resources, we couldface substantial liquidity problems and might be required to dispose ofmaterial assets or operations to meet our debt service and other obligations.Our senior secured credit facility and the indenture governing the notesrestrict our ability to dispose of assets and use the proceeds from thedisposition. We may not be able to consummate those dispositions or to obtainthe proceeds which we could realize from them and these proceeds may not beadequate to meet any debt service obligations then due.

 

Holdings also will be relying onus and our subsidiaries to make payments on the Holdings Notes. For example,interest on Holdings’ Floating Rate Senior Notes is payable quarterly, in cash,commencing in March 2005. If we do not dividend funds to Holdings in an amountsufficient to make such payments, Holdings may default under the indenturegoverning the Holding Notes, which would result in all such notes becoming dueand payable. Because our debt agreements have covenants that limit our abilityto make payments to Holdings, Holdings may not have access to funds in anamount sufficient to service its indebtedness.

 

**Our debtagreements contain restrictions that limit our flexibility in operating ourbusiness.**

 

WMG Acquisition Corp.’s seniorsecured credit agreement and the indenture governing the Subordinated Notescontain various covenants that limit our ability to engage in specified typesof transactions. These covenants limit the ability of restricted subsidiariesof WMG Acquisition Corp. to, among other things:

 

•                  incur additionalindebtedness or issue certain preferred shares;

 

•                  pay dividends onor make distributions in respect of our capital stock or make other restrictedpayments;

 

•                  make certaininvestments;

 

•                  sell certainassets;

 

•                  create liens oncertain indebtedness without securing the notes;

 

•                  consolidate,merge, sell or otherwise dispose of all or substantially all of our assets;

 

•                  enter intocertain transactions with our affiliates; and

 

•                  designate oursubsidiaries as unrestricted subsidiaries.

 

In addition, under WMGAcquisition Corp.’s senior secured credit agreement, WMG Acquisition Corp., andits subsidiaries are required to satisfy and maintain specified financialratios and other financial condition tests. Their ability to meet thosefinancial ratios and tests can be affected by events beyond our control, and theymay not be able to meet those ratios and tests. A breach of any of thesecovenants could result in a default under WMG Acquisition Corp.’s seniorsecured credit agreement. Upon the occurrence of an event of default under WMGAcquisition Corp.’s senior secured credit agreement, the lenders could elect todeclare all amounts outstanding under WMG Acquisition Corp.’s senior securedcredit agreement to be immediately due and payable and terminate allcommitments to extend further credit. If we were unable to repay those amounts,the lenders under WMG Acquisition Corp.’s senior secured credit agreement couldproceed against the collateral granted to them to secure that indebtedness. Wehave pledged a significant portion of our assets as collateral under WMG AcquisitionCorp.’s senior secured credit agreement. If the lenders under WMG AcquisitionCorp.’s senior secured credit agreement accelerate the repayment of borrowings,we may not have sufficient assets to repay Acquisition Corp.’s senior securedcredit

 

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agreement, as well as any unsecuredindebtedness. On December 6, 2004, we amended the senior secured creditagreement to make certain changes. We intend to further amend the seniorsecured credit agreement.

 

###### **PARTII—OTHER INFORMATION**

 

**ITEM 1.  LEGAL PROCEEDINGS**

 

On September 7, 2004,November 22, 2004 and March 31, 2005, Eliot Spitzer, the Attorney Generalof the State of New York served Warner Music Group with requests forinformation in the form of subpoenas duces tecum in connection with anindustry-wide investigation of the relationship between music companies andradio stations, including the use of independent promoters and accounting forany such payments. In response to the Attorney General’s inquiry, we have beenproducing documents and expect to complete our production in May or June. Wealso understand that the investigation has been expanded to include companiesthat own radio stations.

 

We are involved in litigationarising in the normal course of our business. Management does not believe thatany legal proceedings pending against us will have, individually, or in theaggregate, a material adverse effect on our business. However, we cannotpredict with certainty the outcome of any litigation or the potential forfuture litigation. Regardless of the outcome, litigation can have an adverseimpact on us because of defense costs, diversion of management resources andother factors.

 

**ITEM 2.  UNREGISTERED SALES OF EQUITY SECURITIES ANDUSE OF PROCEEDS**

 

Item 2 is not applicable and hasbeen omitted.

 

**ITEM 3.  DEFAULTS UPON SENIOR SECURITIES**

 

Item 3 is not applicable and hasbeen omitted.

 

**ITEM 4.  SUBMISSION OF MATTERS TO A VOTE OF SECURITYHOLDERS**

 

Item 4 is not applicable and hasbeen omitted.

 

**ITEM 5.  OTHER INFORMATION**

 

Item 5 is not applicable and hasbeen omitted.

 

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**ITEM 6.  EXHIBITS**

 
| 3.1  | [Amended  and Restated] Certificate of Incorporation of WMG Acquisition Corp. [Note –  the certificate of incorporation as in effect at the time of filing of this  10-Q should be filed or incorporated by reference] |
|------|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 3.2  | [Amended  and Restated] Bylaws of WMG Acquisition Corp. [Note – the bylaws as in effect  at the time of filing of this 10-Q should be filed or incorporated by  reference]                                             |
| 10.1 | Restricted  Stock Award, dated as of January 28, 2005, between Warner Music Group Corp.  and David H. Johnson (1)                                                                                                           |
| 10.2 | Separation  Agreement and Release dated as of March 31, 2005 between Warner Music Inc.  and Les Bider (2)                                                                                                                   |
| 10.3 | Employment  Agreement dated as of March 7, 2005 between Warner/Chappell Music, Inc. and  Richard Blackstone (3)                                                                                                             |
| 10.4 | Restricted  Stock Award Agreement dated as of March 7, 2005 between Warner Music Group  Corp. and Richard Blackstone (3)                                                                                                    |
| 31.1 | Certification  of the Chief Executive Officer pursuant Rule 13a-14(a) and Rule 15d-14(a) of  the Securities Exchange Act, as amended**                                                                                      |
| 31.2 | Certification  of the Chief Financial Officer pursuant to Rule 13a-14(a) and Rule 15d-15(a)  of the Securities Exchange Act, as amended**                                                                                   |
| 32.1 | Certification  of the Chief Executive Officer pursuant to 18 U.S.C. Section 1350, as adopted  pursuant to Section 906 of the Sarbanes-Oxley Act of 2002*                                                                    |
| 32.2 | Certification  of the Chief Financial Officer pursuant to 18 U.S.C. Section 1350, as adopted  pursuant to Section 906 of the Sarbanes-Oxley Act of 2002*                                                                    |

 

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*                                         Pursuant to SEC Release No. 33-8212, thiscertification will be treated as “accompanying” this Quarterly Report onForm 10-Q and not “filed” as part of such report for purposes of Section 18of the Securities Exchange Act, as amended, or otherwise subject the liabilityof Section 18 of the Securities Exchange Act, as amended, and thiscertification will not be deemed to be incorporated by reference into anyfiling under the Securities Act of 1933, as amended, or the Securities ExchangeAct, as amended, except to the extent that the registrant specificallyincorporates it by reference.

 

**                                  Filed herewith

 

(1)                                  Incorporated by reference to Warner Music GroupCorp.’s Registration Statement on Form S-1 (File No. 333-123249).

 

(2)                                  Incorporated by reference to WMG Acquisition Corp.’sCurrent Report on Form 8-K filed on April 11, 2005 (File No. 333-121322)

 

(3)                                  Incorporated by reference to WMG Acquisition Corp.’sCurrent Report on Form 8-K filed on April 11, 2005 (File No. 333-121322)

 

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**SIGNATURE**

 

Pursuant to the requirements ofthe Securities Exchange Act of 1934, the Registrant has duly caused this reportto be signed on its behalf by the undersigned, thereunto duly authorized.

 

May 16, 2005

 
|   | WMG  ACQUISITION CORP. |
|--------|------------------------|
|   |                   |
|   |                   |
|   | By:                    | /s/ Edgar Bronfman,  Jr. |
|   |                   | Name: | Edgar  Bronfman, Jr. |
|   |                   | Title: | Chief  Executive Officer and Chairman of the  Board of Directors  (Principal Executive Officer) |
|   |                   |   |   |
|   |                   |   |   |
|   | By:                    | /s/  Michael  D. Fleisher |
|   |                   | Name: | Michael  D. Fleisher |
|   |                   | Title: | Chief  Financial Officer  (Principal Financial Officer and  Principal Accounting Officer) |

 

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