Warner Music Off Key

Earnings miss estimates, and the company sees a tough quarter ahead.
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Updated from 7:18 a.m. EST

At a recent conference in New York City,

Warner Music Group

(WMG) - Get Report

CEO Edgar Bronfman said he wanted to lead the music industry with "innovation, not litigation."

It was litigation, though, that led to the fourth-quarter profit his company reported Friday.

Thanks to a $13 million gain from a lawsuit against online file-sharing service Kazaa, Warner Music was able to record a profit of $12 million, or 8 cents a share, for the period ending Sept. 30. That marks a reversal from last year's loss of $30 million, or 21 cents a share.

Excluding the settlement, the music company recorded a loss of a penny a share, missing Wall Street's expectations for a break-even performance on this basis, according to reported by Thomson First Call.

"Recent releases from Gnarls Barkley, Red Hot Chili Peppers, Mana, Danity Kane and Muse could not overcome

strong comparisons to last year and a weak U.S. marketplace," wrote Doug Mitchelson, research analyst with Deutsche Bank, in a note to clients.

On the top line, Warner's fourth-quarter revenue dropped 5.6% from a year ago to $854 million. Analysts were looking for revenue of $893 million.

Once again, the company showed strong growth in digital music sales, which comes mostly from online downloading services like

Apple's

(AAPL) - Get Report

iTunes. Warner's digital revenue rose 13% from the third quarter and 96% from last year to $102 million, but that segment makes up only 12% of total revenue.

The lion's share of Warner's recorded-music income comes from physical CD sales, which continued to slump as consumers embrace the Internet for music entertainment. Revenue from recorded music, which includes CDs and digital products, fell 5.7% in the quarter to $731 million, reflecting weakness in CD sales.

In the U.S., revenue decreased 8.5% while international revenue was down 3.1%, or 6% on a constant-currency basis.

"Obviously, this quarter we faced the expected tough comparisons against last year's significant carryover sales and revitalized release schedule at Atlantic," said Bronfman in a press release. "Based on the company's performance this year, we're confident that Warner Music is on the right path."

In the near-term, analysts say Warner Music and the rest of the music industry will have a disappointing holiday as CD sales are expected to be slow. On Warner's conference call with analysts, Chief Financial Officer Michael Fleischer said the company will suffer "substantial pressure" on its operating income line in the first quarter of its fiscal 2007.

In last year's first quarter, Warner benefited from new releases from the likes of Madonna and Enya. New releases this year are from Diddy and My Chemical Romance, among others.

"The quarterly numbers

for Warner Music Group are always subject to swings based on the timing of various releases," says American Technology Research analyst P.J. McNealy. "It's also a tough time for the industry -- there's no way around it -- but the growth in digital sales is promising."

Digital sales growth reflects Warner's ongoing efforts to shift its business model to fit the changes in music consumption around the world that is being wrought by the Internet.

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 catalog-wide content deal with

China Unicom

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, 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

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

Online music piracy remains a big problem, although lawsuits brought by the music industry against file-swappers like Kazaa are helping to mitigate it. Also, music companies like Warner are wrestling with the threat to their longtime marketing practice of bundling music content into albums.

By selling entire albums, record labels could extract more money from consumers who wanted to own a single song from an album.

"Typically, consumers are really only interested in owning one or two tracks from any particular CD," says Phil Leigh, senior analyst with Inside Digital Media. "So, in actuality, they were spending $10 to $15 for just a couple of songs."

On music downloading sites, like iTunes, consumers can now buy single tracks at a time for $1.

"The major recording companies are terrified of what this will do to their revenue," says Leigh.

Some observers have speculated that online music consumption will eventually transition to a subscription-based model, where users will pay a regular fee for access to a library of music content.

Morningstar analyst Jonathan Schrader said in a recent research note that while Warner owns some of the best content in music, he's not sure how the company's sales will fare as it transitions to new business models.

"Previous transitions -- for example, from vinyl to CD-- ultimately resulted in tons of cash for artists and executives, as listeners spent hundreds or thousands of dollars updating their music collections," said Schrader. "This time, though, it's different. In moving from vinyl to cassette to CD, Warner was always in control of its content. In the movement from physical to digital, the consumer -- not Warner -- has been in control."

Shares of Warner Music were recently down 56 cents, or 2.2%, to $24.86.