Plenty of clouds are hanging over Warner Music Group’s future. But one of them might rain money.
The conglomerate of record labels has seen its stock rise 11 percent in the last two months, including a 4.6 percent spike since Google announced plans for a new “cloud” music download service.
“Cloud” refers to data that’s stored off-site but accessible as part of a company’s network. The Google service would let people buy music, store it on Google’s servers and access it anywhere on an Internet-connected device. Consumers would pay a $25 annual fee for access, plus the purchase price of songs.
How does this help Warner Music?
Laura Martin, a senior media analyst for New York brokerage Needham & Co., said the company, which is headquartered in New York but keeps most of its operations in Burbank, is the most technologically adept of the major record labels, and as such is well-positioned to take advantage of the Google cloud.
“Technology benefits music because it increases the ways a consumer can access the product,” Martin said. “Demand for music is intact, and despite a migration away from physical recordings to digital sales, those digital sales are robust.”
Martin gives Warner Music a “buy” rating with a 12-month price target of $8.50, a 70 percent premium over its current value.
Fulfillment of that prediction would represent a happy segue in an industry that’s been singing the blues.
Music sales in the United States peaked in 1999 at $14.6 billion, according to the Recording Industry Association of America. Forrester Research estimates the total will decline to $9.2 billion by 2013.
The RIAA cites digital piracy as the main catalyst behind the slumping sales. Since 1999, when the free music-sharing site Napster went online, record companies and government regulators have struggled in vain to stop consumers from getting their songs for free, said Keith Holzman, a record company management consultant in West Los Angeles. As a result, small independent record companies that carefully control their distribution and overhead have become more profitable than big corporate labels such as Warner Music.
“All the majors are losing money to some extent,” he said.
However, Holzman, who has worked as a consultant at two Warner labels in the past, said the company is well-positioned to compete in the digital music market. He also believes Warner Music will benefit from technological advances such as Google’s cloud concept.
“They are doing better than their competitors with downloaded music,” he said. “The majors and particularly Warners are still launching new artists, but they’re just not getting the kind of volume sales they did before.”
Since 2004, when Chairman Edgar Bronfman Jr. and a group of equity investors took over Warner Music, the company has increased its market share from 16.3 of all U.S. record sales to 21 percent, based on data from SoundScan Nielsen.
Nevertheless, the company has reported cumulative losses of more than $280 million since the takeover. The company stopped paying a shareholder dividend in the second quarter of fiscal 2008.
In addition to digital piracy, the 2009 annual report cites the bankruptcies of record retailers such as Sam Goody and Tower Music, and the global recession as factors in contracting the overall record market.
Meanwhile, lower advertising revenue at mainstream radio stations has driven down royalty payments. Royalties have decreased to the point where Pandora, an Internet radio site, now pays the record companies more than all the terrestrial radio stations in the country, said Martin, the Needham analyst.
Warner Music’s annual report states that the increase in digital hasn’t fully offset the decrease in CD sales, radio royalties and other traditional revenue streams. That’s what may change with the advent of Google’s cloud concept.
“New digital models, such as access models that typically bundle the purchase of a mobile device with access to music and streaming subscription services, continue to develop,” the company stated in its latest annual report. “We believe that growth in revenue from new digital models has the potential to offset physical declines and drive overall future revenue growth.”
In particular, Bronfman has stated publicly he wants to move away from reliance on iTunes, the popular site run by Apple. For years all songs on iTunes were sold for download at 99 cents each, regardless if the tune was a golden oldie or a new smash hit.
Apple has recently introduced tiered prices at 69 cents, 99 cents or $1.29 per song, but the amount paid to the record companies remains nearly the same – about 60 cents per download – because Apple takes a bigger share of the higher-price songs, Holzman said.
Digital distribution “has the opportunity to return to more robust growth rates as we see the introduction more broadly of access models and new business models beyond the iTunes model,” Bronfman told analysts in an Aug. 5 conference call.
Doug Mitchelson, an analyst at Deutsche Bank in New York, gives Bronfman high marks for managing the company’s challenges, but he doesn’t think investors should put their money into Warner Music until the industry’s future becomes clear.
“The music sector remains in an uncertain transition to digital, with deterioration in physical sales still outpacing digital revenue growth,” Mitchelson wrote in an Aug. 17 research note. He gives the company a hold rating with a target price of $6 per share.
Executives at Warner Music declined to be interviewed for this article.
Happier tunes
Warner Music was founded in 1929 by Jack Warner, who also launched Warner Bros. movie studio. During the ensuing decades, the company accumulated a vast library of more than 1 million songs by such artists as Frank Sinatra, Eagles and Metallica. Its current hit-makers include Linkin Park, Zac Brown Band and Faith Hill.
In 2004, Bronfman and a group of investors led by Bain Capital, Providence Equity Partners and Thomas H. Lee Partners acquired the company from Time Warner Inc. The company went public in 2005.
The company has 3,400 employees and a debt load of $1.94 billion. It would be consistently profitable if not for debt payments. In the nine months ended June 30, the company had an operating income of $70 million but wasn’t profitable due to $143 million in debt payments. While the debt reduces money available for investments or dividends, Martin said it doesn’t affect the company’s financial stability.
“The debt level is irrelevant because their venture capital backers are some of the largest in the business,” she said. “If the debt load became a problem, they have deep-pocketed investors who could step in.”
Holzman said Warners could benefit from the industry’s grim state because it could force one of the big four labels into bankruptcy – and it would most likely be London-based EMI rather than Warners. The other two competitors, Sony and Universal Music, have large corporate parents to sustain them.
