In the cyclical music business, Warner Music Group Corp. has shown a knack for bouncing back after a downturn.

For investors, the question is whether the company can come out on top after this particular downturn: an industry-wide slump amid the radical transformation to a digital model.

The challenge was brought into clear focus when the company's first quarter results were released on Feb. 8. They showed a 74 percent drop in profit that sent the stock skidding by nearly 6 percent. Revenue declined by 11 percent and operating income decreased by 44 percent compared to the previous year. Net income amounted to $18 million.

Quarterly earnings over the past two years have fluctuated between $69 million and a loss of $179 million. In a conference call, Chief Executive Edgar Bronfman Jr. said the company emphasizes annual results rather than quarterly numbers because the release dates of songs depend on marketing factors and artistic career development, not calendar dates.

The company's stock soared last summer, when rumors of two deals with rival EMI Group PLC drove its stock higher. In July 2006 the company's stock traded for $30; last week it was selling under $20. So far this month, Goldman Sachs has reduced its target price from $28 to $23, and analyst Richard Greenfield at Pali Capital downgraded the stock to sell status.

"Warner Music Group will find it quite difficult to grow market share in 2007 the way it did in 2006," Greenfield warned in his report. He set a new target price of $18.50.

Beyond the ups and downs of the fickle music market, two factors will determine the fate of Warner Music: the direction of the music industry as a whole and the elusive merger with competitor EMI.

Digital downloads, especially for Apple Inc.'s iPod devices, have significantly changed the economics of music. Apple's iTunes site allows users to buy any song for 99 cents apiece, encouraging fans to buy the hottest songs instead of an entire album. The site also sells most albums for $9.99, less than the $12.97 average for CDs, based on 2005 data from the Recording Industry Association of America.

Warner had three of the five best-selling downloaded tracks for 2006, and for the last two quarters its digital income has topped $100 million. Meanwhile, CD volume has declined for four straight years, and Greenfield expects it to decrease another 10-plus percent in 2007.

On the upside, Laura Martin, an analyst at Soliel Securities, estimates the profit margin on digital music at 65 percent, compared to 50 percent for the sale of CDs.

To grow, Warner has entered mobile, online and other platforms. For example, the company partnered with YouTube on its New Year's Eve Countdown, sponsored by the Chevrolet brand of General Motors Corp.

The online concert/countdown generated 3 million page-views and "underscores how quickly and easily we can reach an audience of critical mass," Bronfman explained. On the business side, "this showcases how we are thinking about the business differently using advertising and other means to monetize our content," he said.

The second factor affecting Warner Music's stock price a possible merger with EMI appears as Wall Street fiction. Last year London-based EMI offered $4.2 billion to acquire Warner, but the company rejected the offer. Later, Warner mulled a buy of EMI, but backed off due to concerns about European anti-trust regulators. Nevertheless, Greenfield's latest report delved into the details of an EMI-Warner combination. He concluded that Warner Music "is now overvalued even with an EMI merger."

A future EMI-Warner marriage would represent a lost opportunity made good. In 2004, Time Warner Inc. sold its music operation to Bronfman and supporting investors, thus creating Warner Music Group, even though EMI has made a higher bid. Bronfman took the company public the following year.

Despite the current downturn or even because of it Laura Martin at Soliel maintains a wait-and-see approach on both Warner and its industry sector.

"We retain our hold on Warner Music Group but we might upgrade our rating at a more favorable entry point," she said.

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