Sour Notes for Warner Music

Investors bid the shares lower after the recording company reported a drop in fiscal first-quarter profit

Big-selling albums by Josh Groban, Eric Clapton, and My Chemical Romance weren't enough to keep Warner Music Group (WMG) whistling a profitable tune last quarter. During the three months ended Dec. 31, a lighter release schedule and soft sales helped cause the recording company's earnings to tumble.

The New York-based company said Feb. 8 its net income fell to $18 million in the fiscal first quarter, down 74% compared to the same period in 2005. Warner's lower profits came as the music industry continues to confront weaker album sales and online file-sharing as listeners turn to digital media players such as Apple's (AAPL) iPod (see, 2/7/07, "Steve Jobs' Music Manifesto").

Overall first-quarter sales fell 11% from the same period a year earlier, alongside only a 6% drop in operating costs. Physical sales of recorded music fell about 18%, and digital sales grew 45% from the prior-year period. However, digital sales were down 4% from the fiscal fourth quarter.

Warner's digital sales numbers came in short of Wall Street expectations. Digital revenue of $100 million "was disappointing for the first time and down sequentially for the holiday quarter, which we would not expect given the early growth phase of the product," says Goldman Sachs analyst Anthony Noto in a Feb. 8 report. (Goldman has an investment banking relationship with Warner.)

This digital shortfall may cause some analysts to reconsider their future revenue estimate. "Our valuation model assumes continued deterioration in physical sales, but a much higher future growth rate for digital sales," says Morningstar analyst Jonathan Schrader. "Given this, we'll be revisiting our growth assumptions and probably lowering our fair value estimate."

Warner faced difficult comparisons from the previous year, Chairman and CEO Edgar Bronfman, Jr., noted. "Even in the face of a challenging market backdrop, we continue to deliver value to our shareholders and aggressively seek new opportunities for growth," Bronfman said in a prepared statement.

After the news, investors bid the stock down $1.06, or 4.93%, to $20.45 in midday trading on the New York Stock Exchange.

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