Warner Music Group (NYSE:WMG) started off its new fiscal year like a scratchy record (I assume everyone remembers what a "record" is). There just seems to be a lot of background noise.

Revenues for the first quarter decreased 11% (or 14% on a constant-currency basis) to $928 million, with the cost of getting those revenues increasing 4%. Operating income dived 44%, coming in at $80 million. Earnings per diluted share fell 73% to $0.12.

This concert of statistics is certainly off-key, to say the very least. One of the problems this past quarter can be found in the tough comparisons -- there were fewer releases this year, and on top of that, there wasn't the star power of Green Day or Madonna to help things along. The entire recorded-music segment was down, but as can be expected, there was one conspicuous bright spot in the mix -- recorded digital music. Yep, thanks to Apple's (NASDAQ:AAPL) iPod generation and services provided by companies like RealNetworks (NASDAQ:RNWK), digital music players continue to be the rage. The consumption of music on a long-term basis is definitely tilted in the direction of non-physical distribution via services such as iTunes, which is very beneficial for WMG, since the margins are much more attractive. WMG grew its revenues in this area by 45% over the last three months.

Music publishing sales increased by 2%. Spoiling the party, however, is the fact that sales in this segment actually declined 3% on a constant-currency basis. Drops in mechanical and synchronization revenues drove the weakness here (the former is based on physical CD sales, while the latter is monies generated by the use of copyrighted songs in movies, television shows, and video games). Digital publishing, however, increased 40%. Again, we see the promise of the digital revolution.

Is all lost? No. For one thing, the company did generate a 33% increase in free cash flow for the quarter, equaling $32 million (which excludes the effects of cash paid out for investments). For another thing, a look at WMG's recent 10-K shows that the music mogul has been growing operating cash flow the last couple of years. $205 million of net cash from operating activities was recorded in 2005, while $307 million was made in 2006. And on the net-income front, the company changed from a loss of $169 million in 2005 to a profit of $60 million in 2006.

In terms of valuation, WMG's stock is actually yielding a decent 2.6%. Of note: The company isn't necessarily keen on increasing dividends. It states in its latest 10-Q that, for now at least, it does not intend to pay more than $80 million in dividends in a given year on the common stock.

Analysts estimate that the company might earn $0.56 a share in fiscal 2008; furthermore, they see perhaps 40% annual growth on a five-year basis. At the current price, that puts the PEG ratio at about 0.9. (Estimates are subject to revision, of course.)

That's not a bad valuation, especially considering the yield. I might like to see an even better valuation on the stock, however, to compensate me for the risk of further downtrends in the physical CD market and the complexities of the digital marketplace -- as both Alyce Lomax and Rick Munarriz have mentioned, it's easy for artists to cut out the middleman. Piracy is also an issue that continues to plague music companies like Sony (NYSE:SNE), EMI, and others.

WMG could be a good long-term play, but I remain cautious on it at this time. Music will be with us forever, and digital distribution strategies will certainly be optimized over time. I'll let Fools decide for themselves if they want to join WMG's roster of shareholders or not.

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Fool contributor Steven Mallas owns none of the companies mentioned. As of this writing, he was ranked 16,396 out of 22,022 investors in the CAPS system. Don't know what CAPS is? Check it out. The Fool has a disclosure policy.