The Wall Street Journal-20080214-breakinviews-com - Financial Insight- Chance to Do Right by EMI- Warner Merger Could Save Fortunes of Both Companies- Music to Guy Hands-s Ears-

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breakinviews.com / Financial Insight: Chance to Do Right by EMI; Warner Merger Could Save Fortunes of Both Companies; Music to Guy Hands's Ears?

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Guy Hands, the boss of London buyout firm Terra Firma, has mishandled most aspects of his acquisition of British music company EMI. He overpaid, soured relationships with artists and dawdled with a new strategic plan. Across the pond there is an opportunity to set things right. His closest rival, Warner Music Group, has shed more than 80% of its market value since the stock reached its peak. The two have been trying, off and on, to combine for eight years. Now is the time.

The rationale for a deal is strong. EMI is stronger in the United Kingdom and Europe, Warner in North America. The two are puny competitors against larger foes Universal Music and Sony BMG. By joining forces, EMI and Warner would create a third recorded music rival of relatively equal size.

Though regulators and independent music labels have balked in the past, they could be won over. Egos have been another stumbling block to previous EMI-Warner tie-ups. But Mr. Hands could do with some help and Warner's Edgar Bronfman Jr. could provide it. He already has merged two music companies, Universal and Polygram, and restructured another, Warner.

Cost-cutting could be huge, $250 million a year, carrying a net present value to shareholders of as much as $1.8 billion -- more than double Warner's market cap. Warner's shares are trading at $5.76 each. That leaves plenty of room for a generous offer.

Citigroup, EMI's lender, already has lent $5 billion. Why would it want to pitch in another $1 billion? Because a combined EMI-Warner would be more likely to survive. Not only would it have better industrial prospects, but after including a likely sale of Warner's music-publishing arm, the combination's debt would be more manageable at six times cash flow.

Warner's private-equity backers -- Thomas H. Lee Partners, Bain Capital and Providence Equity Partners -- are surely ready for their four-year ride to end. They will regret having turned down $31 a share only 18 months ago. Now they will be lucky to get $10. Still, they already have been paid back their original investment. That they stand to pocket about another $1 billion from an EMI takeover should be music to their ears.

MySpoiler

Rupert Murdoch deserves an "A" for opportunism. The News Corp. boss is brandishing his best card in the poker game over Yahoo's future -- MySpace, the social-networking Web site. But as appealing as a trade of MySpace for a slug of Yahoo might be for Mr. Murdoch's shareholders, it wouldn't fly with Yahoo's owners.

When compared with Microsoft's offer, originally valued at $31 a share and $44.6 billion, the numbers just don't stack up. True, a Yahoo-MySpace combination carries strategic logic. Yahoo has failed in social networking but leads in display advertising. And though MySpace has blossomed since Mr. Murdoch bought it for a song three years ago, its value isn't adequately reflected in News Corp.'s stock price. (News Corp. owns Dow Jones & Co., which publishes The Wall Street Journal and owns a small stake in Breakingviews.com.)

So a deal that puts a value on MySpace would be great for Mr. Murdoch. At 20 times earnings before interest, tax, depreciation and amortization, Fox Interactive Media -- which houses MySpace -- would be valued at about $5.3 billion, according to Sanford C. Bernstein research. That is nearly $2 a share at News Corp.'s current stock price.

But News Corp. isn't likely to settle for that price. If speculation is to be believed that Mr. Murdoch is seeking a 20% stake in the merged Yahoo-MySpace, Yahoo would need to issue 400 million shares to meet his demands. That would value MySpace at $12 billion -- or a whopping 46 times Ebitda.

Yahoo shareholders wouldn't countenance paying so much for a company that derives much of its income from an advertising deal with archrival Google. Add to this investor concerns about the capacity of Yahoo's already discredited management team to integrate such a large acquisition, and it is hard to see how a MySpace deal could be anything more than a spoiling tactic. But, hey, that may be what it takes to get $35 a share from Microsoft.

-- Jeff Goldfarb and Rob Cox

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This column is by breakingviews.com, an online financial commentary site.