STRATEGIC REPORT FOR WARNER MUSIC GROUP, INC. ELIHU BOGAN SAMUEL MEEHAN PATRICK FLEMMING April 19, 2007 TABLE OF CONTENTS EXECUTIVE SUMMARY.................................................... 3 COMPANY BACKGROUND ................................................. 4 COMPETITIVE ANALYSIS ................................................. 6 INTERNAL RIVALRY ............................................... 6 ENTRY .............................................................. 10 SUBSTITUTES AND COMPLEMENTS ............................... 11 SUPPLIER POWER ................................................. 14 BUYER P OWER..................................................... 15 SWOT ANALYSIS ........................................................ 16 FINANCIAL ISSUES ....................................................... 17 STRATEGIC ISSUES ...................................................... 20 RECOMMENDATIONS ..................................................... 24 2 EXECUTIVE SUMMARY Since its birth as a music publisher in 1929, Warner Music Group (WMG) has managed and produced a wide-range of successful musicians and performers, and now boasts a recorded music portfolio of over 38,000 artists. WMG’s artists include such big names as Led Zeppelin, The Doors, Green Day, and The Red Hot Chili Peppers, and the company owns the rights to 29 of the top 100 best selling albums of all time.i WMG’s business consists of two divisions: Recorded Music and Music Publishing. The Recorded Music business produces revenue through the marketing, sale and licensing of recorded music in various physical and digital formats. The Music Publishing business owns and acquires rights to musical compositions, and markets these compositions and receives royalties or fees for their use. WMG, along with Universal, Sony BMG, and EMI Music, competes in a music publishing industry with a small number of major players, as well as a host of smaller, independent labels. Of the major competitors, all operate internationally and compete in both traditional music markets and in new digital enterprises such as tunes. Industry competition is both price and non- price based, with advertising and marketing playing an important role in protecting firms’ market share. WMG was purchased in 2003 in a leveraged buyout led by Edgar Bronfmann, Jr., the current Chairman and CEO. In the past two years, WMG has been cutting costs and seeking out new markets in digital goods as the CD market continues a seven-year decline, and has established itself as a market leader in providing content for both MP3 players and 3G-enabled cell phones. WMG and its comparatively sized rival EMI have repeatedly initiated back-and-forth acquisition negotiations, however regulatory uncertainty in the EU continues to stifle progress. A number of factors affect the performance of WMG, as well as the music industry as a whole. The declining CD market, widespread digital piracy in the U.S. and physical piracy abroad, and the growing importance of digital goods are some of the most important. To date, WMG has been successful in positioning 3 itself aggressively in new markets, offering copyright-protected digital downloads through legal services such as iTunes, as well as marketing music videos and ringtones to 3G cell-phone subscribers. To counter the declining CD market, WMG has engaged in an aggressive cost-cutting initiative, lowering annualized costs by approximately $250 million in 2005. WMG hopes to continue improving its balance sheet, income statement and cash flows through a merger with EMI. Going forward, WMG’s greatest challenge will be to address the changing nature of the music publishing business, as technological advances have threatened to erode the traditional rival, excludable nature of music goods. COMPANY BACKGROUND The history of WMG Group can be traced all the way back to 1929 through its publishing arm, Warner Chappell Music. At that time, Jack Warner, president of Warner Bros. Pictures, Inc., sought to acquire music copyrights as a way of providing inexpensive scores and music for his films. Additional publishing firms acquired in the 1920s and 1930s by Warner Bros. were all subsequently sold within a decade, and WMG’s real roots in Time Warner began with the founding of Warner Bros. Records as a division of the Warner Bros. movie studio in 1958. In 1960, Warner Bros. Records signed the world’s first million dollar record contract with the Everly Brothers. In 1963 Warner Bros. Records acquired Reprise Records, which was founded by Frank Sinatra in 1960. In 1967, Warner Bros. became Warner Bros.-Seven Arts, when Jack Warner sold his stake in the company (and thus control of the group) to Seven Arts Productions for approximately US$95 million. The same year, the firm purchased Atlantic Records, which is now WMG’s oldest label. In 1969, Kinney National, the comics, talent agency, parking lot, cleaning and funeral parlour conglomerate, acquired the company. Kinney also acquired Elektra records (founded in 1950) for US$10 million in 1970, and rechristened itself Warner Communications. 4 WMG has operated internationally through Warner Music International (“WMI”) since 1970. The current logo of WMG was designed for use by WMI since the 1970s. In 1972, the three major labels were assembled into one group then known as WEA (Warner-Elektra-Atlantic). Later Warner Communications merged with Time Inc. to form Time Warner. The company Time Warner remained fundamentally unchanged until it was acquired by America Online in 2000. In 2003, Time Warner sold their Warner Music arm to an investment consortium led by Edgar Bronfman, Jr. (the former head of Universal) for US$2.6bn. The investor group consisted of Thomas H. Lee Partners L.P., Bain Capital, LLC, Providence Equity Partners, Inc. and Music Capital Partners L.P. In May 2005, WMG became the only stand-alone music content company in the U.S. with publicly traded common stock. The transition to independent ownership was completed on February 27, 2004. Since establishment, the group has been downsizing the firm, offloading marginal or low revenue units such as record production by closing or selling disk-pressing plants (particularly in the US and the Netherlands). In 2005 WMG sold Warner Bros. Publications (their sheet music business) to Alfred Publishing, founded in 1922. Miami-based Warner Bros. Publications printed and distributed a broad selection of sheet music, books, educational material, orchestrations and arrangements, and tutorials. The sale excluded the print music business of WMG's Word Music (church hymnals, choral music and associated instrumental music). In 2006 EMI and WMG engaged in a bizarre, reciprocal takeover battle with each rejecting an unwelcome US$4.6bn bid from the other. EMI announced that it had rejected the first acquisition offer from WMG, its smaller rival, calling the proposal "wholly unacceptable" and increasing its offer for WMG. That offer was in turn rebuffed. Also in 2006, WMG acquired Ryko Corporation for US$675m from an investment group led by J.P. Morgan Partners, and agreed to purchase a controlling stake in independent label Roadrunner (est. 1980) for US$73.5m. In 5 February 2007, WMG made another offer for EMI for $4.1bn in cash, which was also rejected, this time due to regulatory uncertainty. COMPETITIVE ANALYSIS WMG is classified as SIC Industry 7929, an all-encompassing genre defined as Bands, Orchestras, Actors, and Other Entertainers and Entertainment Groups. Other registrants under this code include World Wrestling Entertainment, Inc., Pro Elite, Inc., AVP Inc., IFSA Strongman, Inc., and Paradise Music & Entertainment, Inc. As this market classification does not include any of Warner’s major competitors, we will focus on Warner’s GICS classification, Consumer Discretionary, specifically the sub-industry classification of Movies & Entertainment (2540103), which includes rivals Universal, Sony BMG and EMI. Universal and Sony BMG are significantly larger than WMG, controlling 26% and 22% of world market share, respectively. Universal Music Group is a subsidiary of the French media conglomerate Vivendi S.A., and Sony BMG is a joint venture between Sony Corp. and the German firm Bertelsmann A.G. British firm EMI, with a market cap of $3.5 billion, accounts for another 13% of world market share. With the inclusion of WMG, with a market cap of $2.54 billion and an 11% market share, these four firms account for approximately 72% of worldwide recorded music sales (based on 2004 figures). Each of these companies competes internationally as well as in the US domestic market. In most markets, WMG and its major competitors compete to a lesser degree with smaller boutique and mid- market music publishers. Issues of scale as they relate to the music industry will be addressed in the Substitutes and Complements section below. INTERNAL RIVALRY Competition between the four major firms occurs on both price and non-price (i.e. marketing, advertising, recruitment) levels. To maintain market share, companies seek to recruit and retain popular artists for current music publishing purposes, and to effectively manage growing portfolios for reissuance and other 6 publishing purposes such as licensing. The music industry as a whole has been suffering greatly from a seven-year decline in CD sales, and this decline took an even stronger downturn in the first three months of 2007, falling 20% from a year earlier.ii CDs still account for 85% of all music sold, and sliding sales are eclipsing gains in sales of digital