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MERRILL LYNCH’S REIF COHEN
ON WMG: SELL!
Veteran Music Industry Analyst Still Thinks Shares are Overpriced
On a day that saw at least four major research notes on Warner Music Group from Wall Street firms, Merrill Lynch’s Jessica Reif Cohen initiated coverage of the newly public music company with a “sell” rating.

Reif Cohen, a veteran analyst who has counted the music business among her areas of expertise for years, issued a 30-page note on WMG highlighting four major reasons not to hold shares in the company:

First, she writes, if WMG were trading at the same multiple as a diversified media company such as News Corp or Time Warner, which is to say 7.2 times estimated 2006 EBITDA, WMG shares would have a “theoretical value below $10.” Even supposing an 8.5 to 9.0 multiple in line with Disney or Viacom (both of which, like News Corp and Time Warner, have shown double-digit EBITDA growth), WMG would still fall short of its current price, as “the upper range of values appears to be $14 to $15.”

Second, Reif Cohen finds that WMG’s share price should be relatively less than those of diversified media companies: “We believe that Warner Music should trade at a discount to the diversified media group given our significant concerns about the sustainability of current investment levels and the economic impact of the transition to a digital business model.”

Third, she cites concern that WMG isn’t investing enough in the business it’s in—music. “Warner has cut its artist roster by approximately 30% with investment in Artists and Repertoire...now estimated to be nearly 50% less than EMI as a percentage of revenue. A focus on the hits has allowed for short-term EBITDA gains, but these may be unsustainable and eventually lost to either higher spending or lower revenue.”

 

Finally, Reif Cohen doesn’t buy Edgar Bronfman Jr.’s assertions that the developing digital frontier will mean a near-term windfall for the majors: “We are confident that the digital music market will grow significantly, but the benefits to record company revenues and profits seem less certain. In our view, margins should be significantly higher, but the unknown consequences of unbundling (purchasing one digital track vs. an entire album) suggests substantial risk. Lower unit pricing offsets higher margins, requiring higher unit sales to retain similar revenue levels and drive increased profits.”

 

It was Reif Cohen’s opinion that WMG was pricing its IPO shares too high that led Merrill Lynch to drop out of the IPO at the last minute, at a cost of millions of dollars to the investment bank. The all but unheard-of move is a byproduct of New York Attorney General Eliot Spitzer’s $1.4 billion settlement in 2003 with Wall Street firms engaged in the shady practice of hyping questionable stocks in order to increase their profits.

 

In a New York Times article on the subject Sunday, Cohen’s bold move prompted Columbia University securities law professor John C. Coffee to quip that “Integrity has reared its head” in the analyst business.

 

“This whole story couldn’t have happened three years ago. That analyst would have been threatened in so many ways,” Coffee explained to the Times. “Now the bankers can’t say anything.”

 

Even WMG’s lead underwriter, Goldman Sachs, fell short of recommending the stock on Monday, issuing an “in line/neutral” rating, despite a GS analyst’s opinion that WMG shares should trade at up to $22 over the next 12 months.

WMG also got an “equal weight” rating on Monday from Morgan Stanley, while Banc of America Securities issued a lone “buy” rating based on potential market events such as a merger with EMI and improvement in CD sales.

As of this post, shares in WMG were trading at $16.30, down from yesterday's close of $16.40.

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