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February 15, 2006

Warner Music: Not Ready To Buy. Yet.

One stock I've had my eye on as a possible long is Warner Music Group (WMG). The company reported yesterday and the shares fell slightly in response against a strong market.

My working thesis has been that the transition from physical to digital music sales would turn out more favorably than the Street expected. I am fairly comfortable with this idea, but to make money the stock requires that the negative sentiment toward the music industry put WMG shares at a valuation discount. At 10 times 2006 estimated EBITDA, I haven’t found the valuation cheap enough to attract me.

Nevertheless, I've tried to keep an eye on WMG as the company's results could set up an opportunity in the shares. In the December quarter, the company's 1Q06, the trend toward digital sales was quite strong. Digital sales were $69 million, 7% of total sales, up 176% against the year ago quarter of $25 million, and up 30% sequentially. With massive iPods sales in the December quarter, a strong quarter for digital sales was expected but I have to believe that growth in the current quarter will be exceptional as well given that many of those iPods were delivered at the end of the month on Christmas morning....

The strength of digital sales was not enough to produce revenue growth in total Recorded Music sales, however. Overall, sales in this segment fell 2%, as physical sales fell by more than 6%, producing a decline of about $61 million, more than the $44 million gain for digital sales. This situation should reverse shortly as digital sales growth will remain robust and the base will be large enough to offset the steady downtrend in physical sales.

Despite the negative revenue growth in total Recorded Music Sales, EBITDA in the segment rose almost 7% as expenses fell by $33 million, more than 4%. Key to whether WMG can ultimately become a winning stock is if the strict cost controls are sustainable and won’t impact revenues. The music industry requires a lot of advertising and promotion and support and development of artists. There is probably only so much room on costs before revenues could be impacted. I also wonder how advertising and promotional spending will change when the goal is to promote digital rather than physical sales.

I think the jury remains out on WMG shares. If the stock were a lot cheaper, say at 8 times EBITDA, the risk-reward profile would be a lot better. I got my eyes wide open but I remain on the sidelines for now.

Posted by Steve Birenberg at February 15, 2006 09:51 AM in WMG