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May 08, 2007

Warner Music: Might Be Stabilizing But No Upside

Warner Music Group (WMG) reported slightly better than expected 2Q07 results with revenues of $784 million and EBITDA of $96 million both soundly beating analyst estimates. Despite the big beat on these metrics, the source of the upside was not material relative to the challenges faced by the music industry. Upside in publishing and foreign exchange looks like it accounted for most of the variation as trends in recorded music were as poor as expected.

I think investors might be able to takeaway that for the time being things are not getting worse at WMG. When added to the cyclical benefit of a backend loaded release schedule, the worst may be over for the stock for the next several quarters. However, barring a dramatic deceleration in the rate of CD sales decline or an acceleration in digital sales, I don’t think much upside exists....

In 2Q, overall recorded music sales fell 4% on a reported basis and 7% in local currency. Digital sales were up 14% sequentially and 23% year over year and accounted for 14% of total revenue. In the US, digital sales represented 22% of revenue. This is the second consecutive quarter where WMG dramatically underperformed the industry in digital sales growth. It is hard to see how this anything other than a release schedule issue but I find it troubling nonetheless. The pressure is on for digital sales to accelerate sharply as the release schedule improves.

WMG also announced a "realignment" that will involve about 400 layoffs. The company intends to reinvest the savings in digital distribution and video initiatives so there won’t be any flow through to operating income. WMG is continuing to try to diversify its revenue stream with focus on mobile phones, video games, and video.

The company does provide guidance but management did not that it expects sequentially improving results over the balance of 2007 driven by the release schedule.

Management said it had not changed its opinion of going DRM-free despite EMI's decision to do so.

I see little reason to be involved with WMG shares form either side at the moment. Downside momentum has peaked for the short-term which eliminates the short side but industry challenges are too severe to overcome the negative sentiment even as the release schedule boosts results the rest of the year.

Posted by Steve Birenberg at May 8, 2007 10:28 AM in WMG