How much will Universal Music Group miss that pound of flesh the European Commission took when it forced considerable concessions from the world's largest record company in exchange from its approval of a merger with EMI Music? That's the question as Universal prepares to sell business throughout Europe to reduce its competitive footprint.
The merger was a win for Universal in many ways. The company will grow its share of the recorded music market in the U.S., U.K. and other major markets. It will add artists such as the Beatles and Katy Perry to its roster. It will get some -- but not all -- of the cost savings it originally set out to achieve. This is an auspicious beginning to the Lucian Grainge era.
But the deal no longer has the instant look of success it did when Universal's bid of $1.9 billion (£1.2 billion) won Citigroup's auction in November. The EC played harder hardball than people in the industry had expected. Now Universal must divest a laundry list of assets even though its purchase price remains at $1.9 billion.
The concessions introduce a new element of risk. Selling assets at a possible loss and losing cost synergies could effectively raises EMI's acquisition price. The exact value of the assets to be divested is unknown and Universal may be able to fetch very good prices. But if we assume the value of EMI declines by just 5%, due to divestitures, the acquisition price will have increased to $2 billion from $1.9 billion. Greater losses mean a higher acquisition price. On the other hand, Universal could come out ahead if the buyers of Parlaphone, Mute and other labels pay more than Universal paid Citigroup.
Other factors erode the value of the deal, too, although in subtle ways that are all but impossible to quantify. For example, Universal cannot use a most-favored nation clause in licensing contracts with digital services. Such a clause allows Universal to receive any term granted to its competitors. A high royalty given to one competitor, for example, would mean a licensor with most-favored nation status would also receive that royalty. Without the ability to employ that clause, Universal loses some digital royalties. It could be a small amount, but the amount is significant enough for the EU to add most-favored nation to its list of concessions. This concession is worth taking to get the deal done.
If size equals power equals negotiating power, a smaller post-merger Universal will be less valuable. Universal executives were correct when they said the company -- and the record industry in general -- does not have much leverage in dealing with digital giants like iTunes and cannot simply raise prices on brick-and-mortar chains because it's the biggest music company in the world. But economic theory holds that businesses that have market power will use it to their advantage. When assessing mergers and acquisitions, regulators apply economic theory that's based on historical precedent. So you have to figure there's more than theory at work here. Understanding that Universal didn't buy EMI just for the fun, the EU had to scale down Universal's value a few notches.
Universal and the Sony-led consortium that acquired EMI's publishing business didn't buy music history, per se. They bought the future value of music history. They acquired catalogs based on the cash they will generate in the future, not the cash they have already generated in the past. They bought assets based on the cash the assets will generate on the formats of the future, not the formats of the past.
The obvious question is, did Universal overpay? That's difficult to answer without knowing the value of EMI assets it will sell. But we know Universal will sell quite a few valuable assets that make up a large portion of EMI's current business, especially in Europe. And we know Universal would rather keep those assets than take whatever money they will get for their sales. Universal will have a difficult time reinvesting that money in similar assets -- world-class catalogs and music companies don't come up for sale every day.
When compared to historical values of EMI, and when combined with the $1.4 billion purchase price of EMI's publishing business, one can see Universal paid far less than Terra Firma in 2007 (4.2 billion pounds, or roughly $8 billion at the time) and less than Terra Firma's valuation of EMI in 2009 (2.2 billion pounds). The 2.6 billion pounds ($4.1 billion) cumulatively paid by Universal and the Sony-led consortium for the sum of EMI's parts is 38.1% lower than the 4.2 billion pounds paid by private equity firm Terra Firma in 2007.
EMI fetched a good price relative to Warner Music Group's $3.3 billion price tag in May 2011. Warner has annual sales of about $2.87 billion.
With the concessions imposed by the EU and the new elements of risk, Universal's EMI deal no longer seems like the sure thing it was in November. But it's also safe to say Universal and Sony et al didn't make Terra Firma's blunder by overpaying. Valuations are -- correctly -- lower than in years past. Assuming Universal doesn't lose its shirt on the divestments, this deal, headaches and all, could work out just fine.
Besides, this was a deal that was going to get done. As businessmen often say, "If you're not growing, you're dying."
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