Universal Music-EMI Merger: UMG Struck Gold With PolyGram in the 1990s, Can They Do It Again?

Now that the Universal Music Group has approval to complete its acquisition of EMI's recorded music operation, it will hit the ground running to integrate the two companies, insiders say.

The Universal Music Group already presided over a highly successful merger of two major record labels when it combined PolyGram into Universal back in 1998. Given that a number of Universal Music Group players -- Lucian Grainge, Zach Horowitz, Bruce Resnikoff, Jim Urie, Boston Consulting Group -- still are around from that time, this one promises to go just as smoothly. In fact, sources suggest that the two companies have already been having informal integration talks around back room functions like information technology. In addition sources say that Universal Music Group has hired Boston Consulting to help with the integration, as it did last time in the PolyGram deal.

As for the sale of the assets that UMG has agreed to divest in order to win approval, it has already hired Goldman Sachs, Bank of America, and Merrill Lynch to sell the assets UMG has conceded in order to win EU regulatory approval, which include the Parlophone, Chrysalis, Sanctuary, Mute, and Virgin Classics catalog. That auction process is expected to begin next month, while the EMI-UMG deal is slated to formerly close Sept. 28.

Universal-EMI Merger: A Timeline Of Events

In UMG's moment of triumph, some naysayers contend the deal is not worth it, given the difficulties that UMG had in getting its deal approved--it had to keep adding to the pile of divested assets. They claim that that with the assets that UMG has to sell, it will have paid too much for the deal and won't be able to achieve the synergy savings they hoped for.

But others say the jury is still out on that front.

For example, if EMI announced that it was keeping Parlophone, Chysalis, Ensign and Mute and said it was selling Capitol, Blue Note, and Virgin -- the assets that UMG essentially bought -- everyone who tried to buy the entire company would have been lining up to buy the partial-asset sale. And whoever bought them would have felt like they hit the jackpot.

According to sources, the assets being placed up for sale carry a value of around 350 million euros ($454.4 million) and generate annual sales equivalent to 27% of EMI's recorded music annual sales of $1.6 billion, or $432 million. Meanwhile, the industry will have to wait to see what the auction brings in for the concessions package, before a more critical assessment can be made on how UMG fared.

And who knows if a bidding war over those assets won't result in a higher-than-expected price, that could more than offset what UMG is giving up? If the divested assets bring in 280 million pounds ($454 million), its a wash and UMG is doing fine. If the asset sales brings in more than 280 million pounds, then UMG gets an even bigger win and if it brings in less, and the argument can be made that that the divested assets hurt the deal's valuation.

But observations that UMG may not realize all the savings it wants because of the EMI assets it has to divest in Europe are hard to understand. UMG says it only expects 100 million euros ($130 million) in savings, and it should be able to do that easily. In the past when majors have merged, the goal has been generally to push for about $300 million in savings. So if UMG is losing anticipated savings in Europe, it should be able to find them elsewhere.

BMG Rights Management CEO Hartwig Masuch disagrees with those that think that UMG lost out. "If you look at valuations five or six years ago, even with the drop in sales that the industry has experienced, I think they have a terrific deal," he says. Even though UMG had to give up Parlophone, "they have Capitol Records; it is one of the iconic labels. They kept Virgin too.

He also pointed out that even though UMG has to divest EMI in 10 European markets like France, Spain, Belgium and Poland, they get to keep both EMI and UMG assets in Italy and Germany, two significant markets.

Masuch says that BMG Rights Management -- which is backed by Kohlberg Kravis Roberts -- is interested in being at the table when the UMG concessions package come up for sale; the same for the publishing assets that need to be divested by the Sony's consortium as part of their winning EU's regulatory approval.

FAQ on Approval of Universal Music - EMI Deal

Combined, those assets have annual sales of about $457 million to $472 million. So if BMG, which has an estimated $325 million in annual sales, wins both auctions, it could have a company with annual sales of $800 million, large enough to qualify it possibly as the fourth major.

Meanwhile, the Warner Music Group has annual sales of about $2.87 billion, while Sony's music assets, which are comprised of Sony Music Entertainment, Sony/ATV Music Publishing and Sony Music Japan, will have revenues of about $6 billion; and the Universal Music Group, which would have revenues of about $6.6 billion (with Sony and Universal's tallies including the EMI assets they get to keep minus the assets they say they will sell.)

While in the past, Masuch has said that he likes master rights for catalog titles, he now says he is also happy to be in the frontline record business.

"If you have a writer who you believe in and you sign him, its a perfectly logical development from doing that to publishing to also doing it at a label." Besides, since BMG invests so much money in developing songwriter/artist, "We don't want to be at the mercy of the three active companies out there to bring our product to market," he added.

BMG should count itself lucky if it is the only bidder, but the Warner Music Group is also expected to be among the bidders, as are a number of independent label executives and possibly Richard Branson.

In fact, the EU appears to have imposed a condition on UMG: that it must sell the assets to purchasers that are either already active as a record company, or have a proven track record in the music industry. Ultimately, this could impact its ability to get top dollar in auction. In one fell swoop, the EU has knocked private equity out of the auction for the divested assets, at least on their own. But by adding the caveat that Universal can sell to those in the record business or with a proven track, the EU may have left open a back door for private equity to align with industry players.

For example, it suggests that music publishers seeking to enter or re-enter the recorded music business would be eligible to participate in an auction. With a few music publishers looking to refinance, the fact that they may be eligible to buy divested catalogs may make them more attractive to private equity.

Branson, meanwhile, was reportedly in talks with French indie Naïve CEO Patrick Zelnick
, and an equity player could fit nicely in there too. But its still too early to know for sure who is involved because the process probably won't start for another month, said a source familiar with the timing.

Finally, some point out that the EU inclusion of behavioral remedies -- like disallowing it from using most-favored-nation clauses in deals with digital-service providers -- is another drawback to the deal for UMG. But at least so far it appears that the EU didn't constrain UMG's main negotiating tactic that had all the independent labels up in arms. UMG is fond of agreeing to license a digital music service provider, only if it gets more than its market share in prime real estate in the store. So far, no mention about that negotiating tactic has emerged in all the details about the concessions package revealed so far.

After the UMG/PolyGram merger, the two companies proved to be more than the sum of their parts as their market share grew year after year, which has not been the case with the Sony-BMG merger. As for how this one works out, time will tell.