Greenfield Downgrades Warner Music; Believes Digital Music Should Be Free

Warner Music Group (WMG) shares are coming under pressure after Pali Research analyst Richard Greenfield cut his rating on the stock to Sell from Neutral. Greenfield, in short, thinks the recorded music industry is going to have to find a new business model.

“No matter how many people the RIAA sues, no matter how many times music executives point to the growth of digital music, we believe an increasing majority of worldwide consumers simply view recorded music as free,” he asserted in a research report Thursday morning. “A new model for music consumption must emerge and that model most likely involves DRM-free downloadable music at no cost to consumers, fully supported by advertising.” But as Greenfield notes, “the music industry is not ready to endorse such a move at this point, and even if it was, the economic model transition will be incredibly painful.”

Greenfield notes that he had actually upgraded the stock to Neutral in June as industry trends recovered a bit from a weak first quarter. But he now thinks the fourth quarter will be even worse than the first. And he thinks 2008 will be worse still. Greenfield expects WMG to generate $460 million in EBITDA this year, a tad lower than his old estimate of $469 million. More ominously, he sees EBITDA in 2008 dropping 14% to $398 million; his previous estimate had called for a flat year. He sees revenue this year at $3.44 billion, down from $3.52 billion in 2006; next year he sees another drop, to $3.32 billion.

Greenfield says CD sales will be down 22% in the fourth quarter, and could drop at least 25%, and maybe more than 30%, in 2008. He notes that mass merchants like Wal-Mart (WMT) Target (TGT), Crircuit City (CC) and Best Buy (BBY) have been accelerating their shrinking of floor space devoted to recorded music, with “even more radical reductions” likely in 2008.

In 2007, he says, digital sales are expected to increased 50%, with CDs down 19%; Greenfield says that translates into “album equivalent units” down 8.6%. For next year, he sees 35% growth in digital tracks, combined with a 25% drop in CD sales, to produce a 12% decline in revenues for the industry, “if not substantially greater.” He notes that music industry revenues are likely to be only $10.3 billion in 2007, down from $14.3 billion in 2000.

“Artists make the vast majority of their money on touring and merchandise, not CDs,” he notes. “In turn, it is increasingly logical to believe that artists want to have their music reach the widest possible audience at the lowest possible price…meaning free.” The problem, of course, is that the recorded music business makes most of their revenue from the sale of…duh…recorded music. Greenfield says they need to shift their businesses to artist representation, touring and merchandising. But that will not be easy to do, to say the least.

Meanwhile, Greenfield notes that WMG’s fat dividend - the stock has a 5.1% yield - could be in jeopardy. Without a dividend cut or an improvement in its outlook, he says, the company could run into debt covenant issues by mid-to-late 2008.

And one other thing: Greenfield notes that 75% of the company’s shares are held by private equity firms and other pre-IPO insiders with a very low cost basis - in fact, given previous dividends and distribution, these investors now have a basis of -$3.20 a share, he calculates. Greenfield thinks the private equity investors will likely be itching to get out of the stock, but he sees few options for them other than simply selling blocks in the public market; if that happens, Greenfield warns, it could add pressure to the stock.

Greenfield set at price target on Warner Music of $7.50. Thursday, the stock is down 25 cents, or 2.5%, at $9.93.