Why the music industry no longer calls the tune

Top of the Pops is no more, downloads are the norm and budding stars launch their careers on MySpace. As traditional music firms struggle to adapt, is the industry still worth investing in?

Top of the Pops has been axed, track downloading and cheap CDs are the norm and record company merger and acquisition is rife. Just what is happening in the music business?

The demise of the BBC's flagship pop show sums up most of the problems the industry is facing. The first-ever episode of Top of the Pops aired on 1 January 1964 featured bands such as the Beatles and the Rolling Stones and over the succeeding years the audience reached a peak of 15 million. Now, however, with music videos available just about anywhere from laptops to mobiles, there's no need to wait for next week's show. Videos and downloads can be accessed right now. And it's not only the BBC that is suffering: times are tough for traditional music firms too, leading to a rash of consolidation in the sector.

The two major players in this merger mania are the UK's EMI and its US competitor Warner, the world's third- and fourth-biggest music firms, who are each attempting to acquire the other. EMI, which has artists such as Robbie Williams and the Arctic Monkeys on its roster, has seen its album sales fall 8% year-on-year, according to Nielsen SoundScan, while Warner in turn suffered a 5% decline in album sales in the second quarter of the year. Geographically, the two are a good fit. Warner would get into the European and Asian markets, and EMI would break into America, where the firm currently has just a 10% market share. The associated £200m or so of annual cost savings that analysts estimate the deal would generate would be some sweetener. And it's the only way that either firm can really threaten industry giants Sony, BMG and Universal. EMI started the battle in May with an offer Warner rejected and then earlier this month the US group launched its own bid, which EMI dismissed in turn. But with the stakes so high, the tussle seems set to intensify further.

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Meanwhile, troubled music group Sanctuary, which manages artists such as James Blunt and Elton John, has been approached by Aim-listed MAMA Group, a holding company for a number of music businesses, including representation for Franz Ferdinand and The Kaiser Chiefs. Sanctuary, whose chairman is former British Airways chief executive, Bob Ayling, has had a tough twelve months, during which it has had to refinance and replace senior executives. However, whether minnow Mama can land this particular big fish is open to question.

But that's by no means the end of it. EMI, Universal and Warner Music

are all involved in a $1.5bn battle for Bertelsmann's music publishing business. The recording side of the music business, which makes its money mainly from CD sales and digital downloads, may be higher profile, but in

fact it has lower margins than publishing, which makes its money by collecting royalties from the songs it owns on behalf of its artists, as well using the rights in areas like films and advertisements.

Where does the industry go from here? Consolidation is just the first step. But the future for the major players lies in a business model that features music downloads and advertising tie-ups like the ones between T-Mobile and Robbie Williams, Starbucks and Bob Dylan. MTV's move into community music television in response to the popularity of the likes of MySpace is also a development to watch. Below, we suggest how to benefit from trends like these.

Two music groups worth tuning into

The share price of radio-to-music firm Chrysalis (CHS, 111.3p) has collapsed by 39% since the start of the year, due to worries over the media sector. These mainly surround the bad news coming from other radio station owners, but investors appear to be overlooking the substantial publishing assets the firm owns. In light of the premium price that Bertelsmann seems likely to get for its publishing catalogue, it appears that Chrysalis's shares could be significantly undervalued. Broker Dresdner Kleinwort estimates that the non-publishing part of the firm trades on a p/e ratio of less than ten times, while the stock as a whole trades on a reasonable 21 times.

Conversely, EMI Group (EMI, 262p) is the UK's best-performing major media company this year, with its shares up 25% (and over 200% from their 2003 lows). The reason? Investors have realised that music firms are beginning to step up to the challenges of the download environment. Regardless of the outcome of its bidding war with Warner, the firm's results are going in the right direction. Last year's were impressive for example, digital sales grew 139% to £112m and now represent 5% of group sales (up from 2% the year before). EMI believes that revenues in this area will rise to 25% of industry sales by 2010. The shares yield 3% and trade on a p/e ratio of around 20 times last year's earnings.