Merrill Bear Makes Bull Case For WMG, Switches To "Buy"

Jessica Reif Cohen, the Merrill Lynch analyst who’s been one of Warner Music Group’s biggest critics, has changed her tune. While noting that she’s still “bearish on the medium to long-term outlook for the industry,” she’s upgraded WMG from “sell” to “buy”.

The rationale: WMG has a hit act in Josh Groban (“Noel,” his Christmas CD, has sold 3.7 million copies in the U.S., making it the best-selling album of the year) and some new stuff coming from golden oldies like Madonna, R.E.M, and Alanis Morissette. More generally she argues that WMG shares, trading at $5 this morning, have been beaten up too much. Jessica figures they’re worth $6.50.

Putting faith in new albums from old stars is one of the things that has gotten the music business in the state it’s in: Just because Madonna or R.E.M used to sell a lot of albums is no reason to think they will again. But the most interesting part of Jessica’s argument has to do with the value of Warner’s music publishing business, which has been puzzling us for a while.

Her thesis: Warner’s publishing assets, which like the rest of the music publishing business have continued to grow even as CD sales plummet, should be conservatively worth $2 billion, or 12x EBITDA. That takes care of the $1.9B the company has in debt — and means the rest of the company is being valued at a mere 2x EBITDA. The short version: Buy WMG for the publishing assets, and the get the rest of company for next-to-nothing.

The problem is that music publishing — the business of making money off of songs’ underlying compositions — is really two businesses. One — selling the rights for use in films, ads, etc — is growing. The other — collecting pennies for each song sold on CDs or on the Web — is shrinking.

So far, the first business has been growing fast enough to make up for the decline in CD sales: In aggregate, Warner’s publishing business has been growing in the mid single digits.  But with CD sales expected to plummet even further this year, it’s risky to assume that Warner’s publishing assets will continue to be worth 12X EBITDA. And if they don’t, look out.

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