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.

Warner Music Group: No Wonder Edgar Doesn't Want To Sell

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.

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.