Despite the questionable economics of the music industry, investors are bidding up shares of Warner Music Group in the hopes that its new strategy of pushing digital music buying over the Internet will offset sagging CD sales.
Shares of Warner Music, the fourth-largest music company in the world, have jumped 27 percent since November to $20.53. Analysts attribute the increase to better-than-expected digital sales in its fiscal fourth quarter, a solid slate of upcoming releases, and strong sales during Christmas of its top artists Green Day, James Blunt and Faith Hill.
Warner Music also captured slightly more market share last year and now accounts for 15 percent of total music sales, up from 14.7 percent in 2004.
Yet analysts are torn between two very disparate outlooks for the overall music industry.
Standard & Poor’s equity research analyst Tuna Amobi initiated coverage of Warner Music last month with a “strong sell” rating and a $15 price target.
While there are plenty of new outlets for music sales through broadband, wireless and portable devices like MP3 players, Amobi said “physical sales of recorded music could continue to struggle, and for 2006 we may see further discounts in wholesale CD prices by big box retailers.”
But Douglas Mitchelson, an analyst at Deutsche Bank, thinks Warner Music will be able to offset declining CD sales by growing its digital sales by as much as 50 percent in the next four years. He has a $22 price target on Warner Music’s stock. “We believe the benefits of digital are being overlooked,” he said.
Investors continue to stoke speculation that Warner Music and its British rival EMI Group will ultimately merge, since they have tried twice in the past five years but were thwarted by regulators. The European Commission has objected on the belief that such a marriage would crush small music labels. Executives at both companies have denied merger talks are ongoing, though analysts will not dismiss the possibility that the two companies may ultimately wed.
Major payouts
Also troubling for investors is the fact that Warner Music’s main backers have paid themselves more than $100 million in fees and stock option awards while implementing a restructuring that cut 1,000 jobs and one-quarter of its artists, mostly on the Atlantic Records label.
Warner Music was purchased for $2.6 billion in 2004 from Time Warner Inc. by three venture capital firms Thomas H. Lee Partners, Bain Capital, and Providence Equity Partners along with Edgar Bronfman Jr., a one-time songwriter and heir to the Seagrams fortune.
The venture capital firms put up $1.25 billion of equity toward the purchase price of the company. But they received $1.23 billion back in the form of three dividend payments made through May 2005.
Warner Music also paid the three venture capital firms a $73 million termination fee, a $10 million one-time bonus in connection with the May 2005 initial public offering, and $19 million associated with stock option awards.
A spokesman for the company did not return a call seeking comment.
In leading the company’s turnaround, Bronfman has pursued a strategy focused on digital music as the best way to combat the industry’s twin problems of illegal downloading and rampant piracy. Of course, distribution costs for music downloads are far lower than for traditional CDs. Moreover, Bronfman has pointed to a 20 percent sequential jump in digital revenue from its fiscal third quarter to its fiscal fourth quarter as evidence of better times ahead.
Digital sales however, including ring tones for cell phones and online downloads, accounted for just 6 percent of Warner’s total sales in the fiscal fourth quarter. Though that pace is likely to accelerate this year, it is at this point too small a percentage of total sales to mark a radical change.
The rise in Warner stock has come against the backdrop of an ongoing antitrust investigation into the pricing of digital music downloads by New York Attorney General Eliot Spitzer.
The company was subpoenaed in December as part of an investigation into whether the four largest music studios Warner, Sony Corp.’s Sony BMG Music Entertainment, EMI and Vivendi’s Universal Music colluded to set wholesale pricing for downloads.
In November, the company’s stock hit a low of $15 a share when it agreed to settle a separate “payola” probe into music company payments to radio stations in exchange for airplay of their favorite artists.
