Last week, I received an I-Dog. The petite plaything by Motley Fool Stock Advisor pick Hasbro (NYSE:HAS) makes puppy sounds, wiggles about, and uses colors to reflect its mood. Unlike the Tamagotchi virtual pets from yesteryear or even the hot new Nintendogs simulation, an I-Dog doesn't just crave attention. It really digs music. It reacts to tunes and depends on the genre to set its personality traits.
The I-Dog can pick up the music playing in a room, or, better yet, you can plug in your Apple (NASDAQ:AAPL) iPod -- or any portable MP3 player -- and it will serve as a low-end standalone speaker.
Digital music? Toys? The convergence has arrived. Sure, music has always been a big part of children's toys. However, instead of some monophonic ear-candy placebo, today's kids want the real deal. They crave hit music at a younger age. They're getting it, too.
Don't take it from me. Ask yourself why Disney (NYSE:DIS) last week introduced its Mix Sticks product line. The company is targeting kids ages 6-12 with colorful electronic gizmos that also store digital downloads or tracks ripped from CDs.
So much music is being funneled to willfully receptive kids these days. They are consuming more, and that will only heighten their appetites as they get older. You've heard of the baby boomers? These are the boom boomers. An investor would be silly not to connect the dots and find investing opportunities. There's just one problem: the music suppliers. The record companies are struggling. What the market doesn't know yet is that the major labels are sick, but the malady isn't malignant.
These go to eleven
When Warner Music Group (NYSE:WMG) went public earlier this year, the investing community hit the "mute" button. CD sales had been falling off for years. Whether you blamed the quality of the content, the proliferation of peer-to-peer file-swapping, or just connoisseur apathy, it was still poor timing on Warner's part.
In its quest to become the only standalone publicly traded major label, Warner also had the gall to expect its IPO be priced as high as $24 a stub. That would value the company at more than the owners had paid to acquire the company a year earlier, despite their decision to gut it for substantial distributions before the Wall Street debut.
Humbled, Warner went public in May at $17. Despite a strong song-publishing business, and historically significant prerecorded-music labels like Atlantic, Elektra, Maverick, Warner Bros., and the Rhino retro haven, demand just wasn't there. There was no opening-day pop on the stock. Two months later, it bottomed out at $14.70. A better-than-expected quarter later, Warner Music is finally trading comfortably above its IPO price, with shares trading hands for roughly $19 apiece.
Warner? Really?
Really. When the CD market peaked five years ago, the industry moved 942 million discs domestically, generating $13.2 billion in sales. These days, the industry has tallied that same $13.2 billion worldwide through the first six months of the year, according to International Federation of the Phonographic Industry. CD sale prices have fallen. Unit sales have also taken a hit. The silver lining? Digital-music sales tripled to $790 million through the first half of 2005.
Of that amount, 10% went to Warner, which rang up $79 million in digital music revenue in its March and June periods. Because of the strength in digital music, revenue actually clocked in marginally higher this past quarter for Warner, despite the softness elsewhere. From Green Day to Michael Buble, Warner always seems to have a hot artist to offer. Thanks to its lineage and rich publishing business, it's able to garner royalties on older tracks as well.
Yes, Warner has more than $2 billion in debt on its balance sheet. That butters up the company's enterprise value to $5 billion. A company losing money isn't going to seem like much of a bargain, even at 1.5 times trailing sales.
However, keep thinking about that digital future. Keep thinking about the young kids who now have an appetite for music. Satellite radio networks like XM (NASDAQ:XMSR) have broadened consumers' exposure to new music -- tunes that we may then consider purchasing. Music-subscription services are plentiful these days thanks to pioneers like RealNetworks (NASDAQ:RNWK) and Napster (NASDAQ:NAPS). Now, many of the leading portals offer their own marked-down knockoffs.
One can look back at the early rebels among peer-to-peer platforms, like Grokster, KaZaA, and the original Napster, but they're not around in their piracy-geared states anymore. Many have either gone legit or dark. The labels once blasted the file-sharing networks as the reason for their malaise, but mark my words -- history will remember them as industrial saviors. They opened up the demand for digital music. The labels had bonded together to offer premium services early on, but they faltered badly. The market needed to be established. It was up to swap facilitators like Napster and Morpheus to hand out the free cigarettes to the kiddies. Now everyone is hooked on ear candy.
Add it all up, and it's hard not to look back at Warner. It is one of the few spigots out there, destined to gush through so many digital revenue streams.
Does that mean that I think that Warner Music Group is a Rule Breaker? No. It just happens to be at the right place at the right time while the rest of the investing public can't see it through the quarantine tape they spooled. So Warner may not make the cut for Motley Fool Rule Breakers, our ultimate growth-stock investing newsletter, but after bashing the company earlier this year, I'm starting to come around. I've ducked under the quarantine tape. Warner isn't contagious. It's making the most of the inventory-free fulfillment wonders of tomorrow's music industry. Thanks to digital music, Warner Music's got a really catchy beat.
Longtime Fool contributor Rick Munarriz has more than a few Hasbro games around the house. He does own shares in Disney. The Fool has a disclosure policy. He is also part of the Rule Breakers newsletter research team, seeking out tomorrow's ultimate growth stocks a day early.
