Bad Days For Warner Music Group

Jan.30.08 | About: Warner Music (WMG)

The bankruptcies of record retailers (bye-bye Tower Records and Musicland) and wholesalers, the growth of new formats for recorded music distribution (legal downloading of digital music using the Internet), the maturation of the CD format, and digital piracy are factors which continue to negatively impact the operating results at Warner Music Group (NYSE:WMG). The company generates more than 80 percent of its annual revenue from recorded music, split 90/10—physical (such as CDs, cassettes, LPs and DVDs) and digital (such as downloads and ringtones) formats, respectively. The remainder sales are generated from music publishing.

Aiming to effectively address the continued development of digital distribution channels along with the decline of industry-wide CD sales, Warner Music, home to acts such as Faith Hill, Green Day, Led Zeppelin, Red Hot Chili Peppers, and R.E.M, announced a re-alignment plan in its second-quarter of fiscal year 2007. New business initiatives included cost-structure savings (i.e. layoffs) and the evolution from a traditional record and songs-based business to a music-based content provider (across online and mobile platforms).

Shares in the world's third-largest record company are up almost 60 percent in three-weeks, primarily attributable to investor anticipation that the music label is close to signing a deal with Yahoo! for ad-supported online music offerings. A digital distribution partnership of this kind would be the best action—to date—to jumpstart its sputtering digital marketplace and offer leverage in future content-pricing negotiations with Apple, whose iTunes product remains the dominant online distribution outlet (controlling more than 70 percent of digital download music sales).

Financial Trends

We do not favor buying Warner Music, for we do not believe that Chairman & CEO Edgar Bronfman [not a big fan!] and his management can embrace the digital world fast enough to offset plummeting CD sales and lost revenue due to counterfeiting (approximately $63.0 million, according to our estimates), and digital piracy.

In addition, we believe the 52 cents a share annual dividend—yielding 6.8%--will be cut in coming months.

It will take time for Warner Music to adapt to the changing economics of the music industry. As for now, the Company remains highly leveraged. As of fiscal year ended September 30, 2007, total net consolidated indebtedness was $1.94 billion, with shareholder equity of $(36.0) million.

Warner Music recorded a loss of $21 million, or 14 cents a share, on revenue of $3.385 billion during the fiscal year ended September 30, 2007. That compared to a profit of $60 million, or 40 cents per share, in the 2006 fiscal year.

We caution investors that the Company has limited financial flexibility (debt covenants) to absorb operating losses in the coming year. In 2007, the interest coverage ratio fell to 1.08 times EBIT, down from 1.57 times EBIT in the prior year.

Our risk assessment also includes the massaging of accounts receivable (decrease) and accounts payable/accrued liabilities (increases) of $73.0 million and $78.0 million, respectively, to positively impact cash flow from operations (which totaled $305.0 million)—barely enough to fund debt service, capex requirements, and quarterly dividends of $199.0 million, $30.0 million, $76.0 million, respectively.

In addition, Warner Music has firm commitments (in the aggregate) owed to signed talent (such as artists, songwriters, and co-publishers) that approximated $424 million, as of September 30, 2007 (usually payable over a ten-year period).

In fiscal year 2008, analysts are expecting a loss of 12 cents per share on sales of $3.16 billion, on average, according to a poll by Thomson Financial.

The Company will release fiscal first-quarter financial results (for the period ended December 31, 2007) prior to the opening of trading on Wednesday, February 6, 2008.

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smoke and mirror lock down. Broadcast me a joyful noise unto the times, lord,
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Count your blessings.
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~ R.E.M. [ Bad Day Lyrics]

Author David J. Phillips does not hold a financial interest in any stocks mentioned in this article. The 10Q Detective has a Full Disclosure Policy.