I'm not a big fan of trying to predict which companies can successfully transition from one business model to another. Nevertheless, I am intrigued by one company trying to cross the digital chasm: Warner Music Group (NYSE:WMG). I recently tuned in to Warner CEO Edgar Bronfman's speech at a Deutsche Bank analyst conference. According to Bronfman, two of the biggest challenges and opportunities facing Warner are mobile distribution and value-added content.
Whereas the physical sale of music has declined at approximately 4% annually since 1999, according to the Recording Industry Association of America, the International Federation of the Phonographic Industry (IFPI) reports the sale of music via Internet and mobile devices jumped roughly 82% in 2006 to $2 billion. Warner's digital revenue grew at an astounding 126% and accounted for 10% of total sales in fiscal 2006, up from 4% the previous year. Having planted itself in the middle of the digital market, Warner Music is looking around for more dollars.
Dialing for dollars
Perhaps the most intriguing thing about Warner is the possibility of making big money selling music through cell phones. There was a lot of hoopla about this when Motorola's (NYSE:MOT) ROKR phone -- the first mobile phone with Apple's (NASDAQ:AAPL) iTunes -- was released, but the phone failed to garnish enough popularity to meet expectations.
However, now Apple is releasing its own iPhone, so it's safe to say that it'll be trying a little harder this time around. Bronfman noted that the iPhone's release could spur the Verizons (NYSE:VZ) and Sprints (NYSE:S) of the world to become more competitive with their own mobile music offerings.
Given the ubiquity of mobile phones, the ability to order music with a couple of keystrokes would be music to Warner's ears. I'm still baffled that there are people out there making a lot of money selling ringtones and bowling games on cell phones, but Warner Music and competitors aren't raking in the dough.
How big is the mobile music opportunity? Bronfman noted that at a conference of representatives of the largest cell phone companies, when attendees were polled on the biggest economic opportunities, microprocessing payments was ranked No. 1 and music was No. 2. Bronfman believes wireless is going to be the largest content distribution platform ever.
Stemming the tide
Although industry sales continue to slide -- Bronfman estimates that all-in sales were down by the mid-single digits so far in 2007 -- Warner Music is looking for ways to put out a better, and more profitable, product.
I thought it was interesting that Bronfman didn't waste time pointing a finger at the bootleggers of the world but rather noted that the CD is a 30-year-old format and the music industry has largely resisted innovation in the past.
Now that the golden goose (CD sales) is gone, Warner is exploring things like selling MVIs, or musical video interactives, which along with musical content offer videos, lyrics, behind-the-scenes looks and photo galleries. The MVI for the recently released Linkin Park album has been successful with fans, and this format helps the company sell more value-added content at a higher price point than CDs and similar margins. (Warner also offers digital bundles that provide more features for a couple more dollars.)
Paying the piper
Bronfman noted that Warner should be able to tap other revenue streams. As a recording label, Warner makes very large and risky investments in unknown artists and hopes for a payback if an artist makes it big.
Thus, Warner has an unexploited opportunity to partner with the artists in those early stages on more lucrative areas, by working with companies like Live Nation (NYSE:LYV), the largest live concert company in America, as well as in other areas like sponsorship and merchandising.
Musical moat?
I think Warner's shares are worth investigating, and the company might have a defensible moat. I compare Warner Music to a venture capital firm that has a huge distributional advantage, but is faced with the inability to fully monetize its assets.
However, Warner's distributional strength -- its clout can get artists radio airplay and help get their music into national retailers like Wal-Mart (NYSE:WMT) and Target (NYSE:TGT) -- and large up-front investments in artists should give it a leg up on generating a reasonable rate of return. The company just needs to execute on taking advantage of new distribution platforms and revenue sources and pushing the bar on offering the customer a better and more profitable experience.
At the end of the day, the music industry continues to face the very real problem of declining physical sales, and trying to predict the future is a dicey proposition. Thus, the digital transformation is both the problem and the opportunity. Warner Music has a very strong lineup of artists, and there are plenty of people who want the product, but they need to keep the momentum going as the company continues to explore potential revenue paths.
Related Foolishness:
Wal-Mart is a Motley Fool Inside Value recommendation. Try any one of our investing services free for 30 days.
Fool contributor Emil Lee is an analyst and a disciple of value investing. He doesn't own shares in any of the companies mentioned above. Emil appreciates your comments, concerns, and complaints. The Motley Fool has a disclosure policy.
