Warner Music (WMG) reported very strong March quarter results this morning. EMI, which is trying to buy the company, now has extra incentive to raise its price slightly. The combination of good earnings and takeover interest should keep WMG shares at current levels or slightly higher. Upside is limited, however, as a buyout is unlikely to occur at too much higher of a price and management admitted that the exceptionally strong results seen in the December and March quarters was partially fueled by the seasonality of iPod sales. In other words, expect results in the upcoming June and September to be subdued relative to the ability to beat estimates and the year over year growth rates.
In the March quarter, WMG exceeded estimates across the board. EPS of a loss of 5 cents were 10 cents better than expected. Revenue grew 4% to $779 million ahead of consensus of $772 million. Adjusted for currency and the divestiture of the sheet music business, revenues were up 10%. EBITDA rose 18% to $104 million, well ahead of estimates benefiting from the better than expected revenues and greater than anticipated margin expansion. The only area that fell sort was free cash flow, which fell year over year. In response to a question, management said this was a timing issue as receivables were up due to several releases in the final month of the quarter….

Digital revenues grew 135% year over year and 30% sequentially to $90 million, representing 11% of total revenues. Digital revenues are still dominated by the US, although it is worth noting in Europe digital growth is driven by both music downloads and ring tones.
Beyond seasonality issues, the key questions for WMG are: (1) is the outperformance vs. the industry on digital revenue sustainable, and (2) can growing digital downloads actually stabilize physical CD sales? On the first question, management feels that it is doing a better job of launching acts and creating sku’s in the digital world than its peers. This includes a greater focus on independent artists/labels. On the second point, there are some surveys that support the idea that growing digital downloads help physical sales. I think what could happen is that the convenience of the iPod is making consumers more interested in music again. Time spent listening to music is up and that might get people to order more CDs to rip onto their PCs and Macs and ultimately to their iPods.
For WMG shares to continue to rise will require the music business to enjoy a renaissance, at least one that Wall Street believes. The shares aren’t cheap and trade at a premium to almost all other traditional media stocks. To sustain the premium absent a buyout requires sustainable growth above the media sector (or at least a belief in the concept by the Street). In our household, music listening and purchases of digital downloads and CDs are a growing portion of out budget ever since the first iPod came into our house. I think it is possible that for a year or two, or as long as iPod sales maintain healthy year-over-year growth rates, the music industry could surprise on the upside. WMG shares probably reflect most of this potential so I would not be a buyer at current prices. But I am really kicking myself for not acting on my favorable review of WMG’s presentation at the UBS Media Conference in December.