Warner Music Group's decision on whether to counter bid for British rival EMI Group has become a tortuously long one, as the No. 4 player grapples with exposing itself further to recorded music amid a faster-than-expected decline in the industry.
EMI agreed to a 2.4 billion pounds ($4.73 billion) takeover from private equity group Terra Firma in May, thwarting a seven-year flirtation between Warner and EMI.
For Warner, which has a market value of about $2.2 billion, it's make-your-mind-up time, with a July 19 deadline to bid fast approaching.
But with recorded music sales dropping more rapidly than industry expectations this year and a weak near-term outlook, Warner management is struggling to come to a decision on whether to take the plunge.
Valuations in the music space are not going in the right direction, said an industry insider familiar with Warner's talks. Warner's shares have fallen more than 17 percent since Terra Firma's May 21 bid.
The executive, who asked not to be named, said that alongside market valuations, Warner's decision will be impacted by its own opinion of EMI's worth after going through the rival's books while watching debt markets trending up. The cost of debt has increased in recent weeks as investors have been shaken by rising subprime mortgage defaults and the recent near-collapse of several hedge funds.
All these things combined show that Terra Firma paid a lot of money, said the executive.
Warner management has been considering all options for EMI, including a counter-bid, walking away altogether, or just waiting to see if it could buy the recorded music division from Terra Firma at a later date, the executive said.
The company, the fourth-largest after Universal Music Group, owned by French media giant Vivendi, Sony BMG Music Entertainment, and EMI, said in June that it was still considering an offer for EMI but would only make a bid if it first received anti-trust clearance.
The chances of getting regulatory approval were boosted in February when independent record labels agreed to support a tie-up between the two, leaving the biggest question the economic one.
The market clearly expects Warner to make a move, with a small minority of EMI shareholders having accepted the offer so far while the company's share price is trading above Terra Firma's offer, and on Thursday closing at 269 pounds sterling.
EMI shareholders certainly seem to have voted by just standing there and waiting, said Bishop Cheen, analyst at Wachovia Capital Markets LLC.
Warner's delay on a decision comes amid a change in the recorded music industry which has been hit by people moving from traditional CDs to digital songs that are downloadable from the Internet and therefore more subject to piracy.
Sales of CDs were down nearly 20 percent year-on-year for the first half of 2007 and the industry's hopes that digital music sales would make up for the shortfall have yet to be fulfilled.
Richard Greenfield of Pali Research thinks a deal between Warner and EMI would simply be adding two weak businesses together with limited upside.
Music industry revenues are set to decline for the next several years, said Greenfield. So having an greater amount of revenues that are declining and being more highly leveraged makes for a difficult situation.
To win EMI, Warner may need to significantly out-bid Terra Firma's 265p offer -- some analysts say it would need to be at least 300p per share to succeed. Warner's last formal bid for EMI was in February at 260 pence a share.
But Cheen argues that EMI is an expensive deal and that the private equity firms that bought Warner in 2003 from Time Warner, and took the music label public a year later are likely reluctant to pay too much.
They acquired Warner Music from a very motivated seller in '03 at essentially half price, said Cheen in a recent interview. They made all their money back. What exactly is the motivation to ... do it again?
Cheen says Bronfman is very keen on owning EMI, but the decision would come down to the private equity owners.
Warner Music was bought for $2.6 billion by an investor group led by Thomas H. Lee Partners, chief executive Edgar Bronfman Jr., Bain Capital and Providence Equity Partners. They took the company public the following year although the three private equity groups still own about 62 percent, according to Reuters data.
If Warner decides against bidding, it could push its energies into growing its publishing unit and diversifying the business in areas including artist management, touring and merchandising, the executive said.
Analysts also question whether Warner would become a takeover target itself. The three private equity groups that control 60 percent ... could be looking for an exit at top dollar, having already recouped all of their original $2.6 billion investment via prior recaps and the IPO, Cheen wrote in a recent research report.