Warner Shares Up on Too Much Optimism April 13, 2009
By Glenn Peoples, Nashville
As Warner Music Group shares rose today on an upgrade to “sell” from “neutral” from Goldman Sachs analyst Ingrid Chung, the music industry is being viewed more favorably by some in the financial sector. WMG’s stock closed at $3.53, $0.03 above Chung’s six-month target and an increase of 14.61%. This optimism follows last week’s major announcement that Universal Music Group would partner with Google to create a music-based version of YouTube called Vevo.
Combined with a possible industry victory against The Pirate Bay and the launch of a three-tiered pricing system at iTunes, perception of the industry has improved. The Financial Times noted the many “rare signs of unity” that recently appeared.
Is such optimism called for at this juncture? Only if it is guarded optimism.
Two reasons for the upgrade were WMG’s stable EBITDA and ability to improve its market share. Both are long-established trends that reflect well on management. The company has “continued to execute better than peers,” she wrote. But if neither has been cause for optimism in the past, what has changed?
One reason for Chung’s upgrade, according to an AP report, was that music sales in the quarter were down only 7% compared to 15% in the fourth quarter of 2008. While that is correct, those figures are for the mythical track-equivalent-album (TEA) and account only for unit sales volume. In valuating a company’s future cash flows, it is better to take into account the revenue generated by those unit sales. The drop in wholesale revenue from first quarter 2009 album and track sales is greater than 7%. Because CDs are being replaced by less expensive digital downloads, the year-over-year decline in wholesale value of TEA is likely to be closer to 10-11%.
One important factor that could negate such a drop in wholesale revenue is the potential for digital sales to carry improved margins. WMG has done a good job in pushing higher-margin digital packages.
Other segments of the industry have too little momentum or too few growth prospects to change one’s outlook. Mobile downloads are not yet a major revenue factor. Subscription service revenue is flat at best. Ad-supported music sites have not yet proved their ability to pay content owners through a sustainable business model.
Even in this recession, bright spots can be seen. Vevo is an important example of the technology-content partnership that will drive growth segments in the coming years. Innovative hardware-content packages, such as Nokia’s Comes With Music, are being rolled out across the globe. The partnerships offer tangible proof that conflict will eventually lead to meaningful resolution.
Even with the above examples, record labels’ outlook is unchanged from earlier this year. The economy is a threat to consumer entertainment spending. Reduced participation at brick-and-mortar retail exposes record labels to great risk. Today the CD format still accounts for 78% of all album sales even though many retailers either close or continue to convert CD shelf space to higher-margin items. In the fourth quarter of 2008, Wal-Mart told analysts it was reducing CD inventories and cited a 23% drop in CD sales in the first four weeks of the quarter. Far greater cuts are greatly feared by record labels. Big shocks to the retail system, such as Wal-Mart pulling out of CDs except for exclusive releases, would decimate label revenues beyond the growth potential of emerging models and partnerships.
One aspect of WMG not mentioned in the analyst report was its incorporation of multi-rights contracts and its involvement in areas outside of recorded music (such as promotion, management and merchandise). These segments of the music industry provide stability and ease dependence on falling recorded music revenues.
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