Warner Music Beat Goes On

The company still may end up with EMI someday. If not, it has growth prospects of its own.
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In the music industry, the drumbeat of consolidation goes on, and

Warner Music Group

(WMG) - Get Report

can still carry the tune.

Wall Street turned down the volume on shares of the world's second-largest major music label last summer when the company's efforts to merge with its U.K.-based counterpart,

EMI Group

, fizzled. But recent news that private equity buyers are now closing in on EMI could ultimately bring the two companies together.

Aram Sinnreich, managing partner with media consulting firm Radar Research, says a leveraged buyout of EMI only makes sense for a company that will spin off EMI's publishing business and eventually sell the recorded-music business to a buyer like Warner Music.

"There's a serious possibility that Warner and EMI will still be a combination sometime over the next five years," says Sinnreich.

Talks broke down between the parties in July after a European court issued an unfavorable antitrust ruling on the merger between

Sony

(SNE) - Get Report

and

Bertelsmann's

jointly owned Sony BMG Music Entertainment company.

At the time, shares of Warner Music dropped about 13% because investors had been pricing in a deal. In a music industry in which longstanding business models are being riddled by technological change, consolidation is king.

"During these times of change and insecurity, music companies are essentially circling the wagons to mitigate risk and escape competitive pressures," says Sinnreich.

Warner Music was itself sold by

Time Warner

(TWX)

in 2004 to a private equity consortium led by Thomas H. Lee Partners, which took it public. For the company's new CEO, the investment firm backed Edgar Bronfman, the heir to Seagram who was best known for blowing $3 billion of his family's fortune when he sold the liquor business to

Vivendi

in 2000 for $34 billion in stock, which later sank.

Despite the EMI disappointment, Bronfman's run in the music business has so far been a success. Warner Music's stock has jumped 60% since its May 2005 IPO as the company has grabbed market share. And analysts view it as leading the charge among the four major music labels in adapting to the digital age.

"They slashed their artist roster and executive team, and they've intelligently focused on adding to their repertoire in growing genres like rap and hip-hop," says Sinnreich.

According to SoundScan data, total industrywide album units sold in the U.S. -- using both digital and physical distribution -- fell by 5% in the June quarter compared with last year. Meanwhile, thanks to the strength of its Warner Brothers and Atlantic labels, Warner Music's total album units sold increased by 18%.

As a result, Warner Music grew its total U.S. album share by four percentage points to 20% for the quarter, its highest level in nearly a decade.

"The industry's underperformance, we believe, is a result of the dearth of major superstar releases by competitors in the first half of the calendar year, which will likely reverse in the second half of 2006, helping to ameliorate the industry's current trend," said Bronfman on the company's third-quarter conference call.

On Friday, Warner will post results for its fiscal fourth quarter, which ended Sept. 30. P.J. McNealy, analyst with American Technology Research, said in a note to clients Thursday that he expects to see continued strong catalog sales in the fourth quarter from artists like the Red Hot Chili Peppers, Gnarls Barkley, James Blunt and Seal Paul.

"We also expect to hear more about the releases in the December quarter, including those from Josh Groban, My Chemical Romance, Diddy, and the new album from Yusuf Islam

the former Cat Stevens," said McNealy.

The company is expected to report break-even results on revenue of $893 million, but analysts will be listening to see if the CD-selling business is still dropping off a cliff.

"It would be nice to see them continue to build on their market-share gains," says Pacific Crest analyst Steve Lidberg. "But the real question is whether we are going to continue to see this movement to digital and the faster-than-expected falloff of the physical CD."

Even while Warner bills itself as a force for change in the industry, recording third-quarter digital revenue growth of 109%, that portion of its business is still just a drop in the bucket in comparison with its traditional physical distribution business. Phil Leigh, senior analyst with Inside Digital Media, says the company remains vulnerable to the changes in the industry.

"I think they're somewhat more aggressive than the other major labels, but not nearly as aggressive as they should be to foster the transition from physical media to digital media," says Leigh.

That could take a bite out of Warner's shares in the holiday season.

"In the short term, things are going to look ugly because in this Christmas season, CDs are going to take a huge hit, and sales of music DVDs, which are one of the undersung growth engines for music, are going to flatten out.," says Sinnreich. "But the market is so short-term minded on this."

Whereas annual CD sales for the industry have dropped in recent years to $30 billion from $40 billion, Sinnreich says alternative revenue streams are making up the difference, including sales of downloads on online music services like

Apple's

(AAPL) - Get Report

iTunes and licensing revenue from digital broadcasting like satellite and online radio.

Also, Warner is making gains in European and Asian markets, where downloadable ring-tones for cell phones are a popular item. Last quarter, it signed a direct catalogwide content deal with

China Unicom

(CHU) - Get Report

, the world's third-largest mobile operator. China's digital music business is forecast to grow at a 30% compound annual rate to $1.6 billion by 2010.

In October, Warner Music struck a deal with YouTube, which was acquired by

Google

(GOOG) - Get Report

, to share advertising revenue with the popular video Web site. In return, YouTube will be able to post copyrighted Warner music video content.

Sinnreich says music companies like Warner Music Group will continue to find new ways to monetize their popular content.

"It's tough to predict exactly how things will shake out because it could happen any number of ways, but the owners of popular content stand to benefit when new business models reach the market," he says.