CD price war sparks EMI merger heat

UK music group keeps a close eye on AOL Time Warner's merger talks with Bertelsmann

Shares in music firm EMI Group tumbled 10 per cent yesterday after Universal Music, the world's largest recording company, decided to cut CD prices in the US. Universal's move is seen as part of a strategy to combat illegal downloading and copying of music, a phenomenon which has depressed global CD sales and caused headaches for the world's major recording groups.

"Given that the United States accounts for a third of global music sales, and UMG is the market leader with a market share close to 30 per cent, this is a dramatic move which the other music majors are likely to have to follow," said Panmure analyst Jonathan Helliwell yesterday.

The prospect of a price war in the CD market brings the spotlight sharply back on to the issue of consolidation in the market in order to cut costs and improve revenues.

In the past few weeks EMI has been keeping a close eye on merger talks between its rivals Warner Music and BMG, with some industry watchers still thinking it could gatecrash the party and it comes as no surprise that consolidation is on EMI's mind. Despite taking the knife to its own cost base in recent months EMI, home to artists such as The Beatles and Kylie Minogue, still runs the risk of being left behind if it cannot group together with one of its major rivals.

The AOL/Bertelsmann talks themselves are officially denied by both companies, yet many industry watchers believe that EMI chairman Eric Nicoli and his colleagues are poring over what could be potentially a make-or-break deal for the UK company, namely to "have another go" at doing a deal with Warner Music, should those talks collapse.

EMI's first effort at getting in to bed with Warner was in January 2000, but that approach was scuppered when it became clear the European Commission would block it. EMI later also pulled out of subsequent talks with BMG, fearing further censure from the Commission.

Opposition to the EMI/Warner deal in 2000 centred on the dominance the new entity might have had in terms of digital distribution - since AOL fancied itself as the pre-eminent distributor of online music three years ago - and the fact that the combined companies' market share in music publishing would have been more than 50 per cent. This figure has not been forgotten and Helen Smith, the deputy secretary general of IMPALA, the European association of independent music companies, said: "We are opposed, as we were in 2000, to any further concentration of the major music companies."

While it would certainly attract criticism this time around, any EMI/Warner deal would possibly be structured in a way to create less of a market dominance problem, with EMI perhaps only going after Warner's recorded music division, allowing the music publishing operation to be sold to a third party.

As for the other possible merger, AOL/Time Warner is keen to reduce debt, which runs into tens of billions of dollars, while Bertelsmann would also be happy to further reduce its costs, operating as it does in an industry under siege, and not least following on from a recent series of costly outlays, such as last year's call option which required it to pay some $2bn to Clive Calder for his Zomba Records, home to Britney Spears and Justin Timberlake.

Although there is no evidence that talks between AOL/Time Warner and Bertelsmann will founder, EMI will be on the lookout to merge with a peer should the opportunity arise.

And while EMI is refusing to comment on any suggestion of a tie-up with Warner, it is nevertheless being lined up by many as the obvious replacement in AOL/Time Warner's affections.

Whether EMI could find the money to mount a bid for Warner Music is another question. "Financing for EMI is the big challenge," said one City analyst. "They are very stretched already in terms of their balance sheet, with £950m of net debt and they really don't have much scope to leverage up much further to offer any kind of cash transaction. The only reason AOL is a net seller of its assets is because it wants to reduce its debt."

EMI's rationale for a merger with Warner Music is straightforward enough. As one commentator put it recently: "There is considerable room for de-duplication."

It would certainly enable EMI to cut further into its cost base, a process begun last year by former PolyGram Records boss Alain Levy, who replaced the ousted head of EMI's recorded music operations, Ken Berry, two years ago.

"Mr Levy has de-layered the recorded music operation," said Paul Richards of Numis Securities, "and shrunk it down to a more profitable size. Warner and EMI would have such huge overlap on their international operations that where you've got two offices you just shut one."

Cynics might suggest that Levy's success in turning round EMI's fortunes has been spurred on by his own executive incentive package which, on his arrival, included £10m-worth of share options based on hitting certain price targets up to £7 a share. He has introduced new management across the company, chopped out £100m in costs - in part by slashing the company's workforce by around 2,000 and cutting the less successful parts of EMI's artist roster, firing 1 in 4 acts. He even infamously stirred up his own Finnish colleagues by suggesting he couldn't recall a single successful artist hailing from that part of the world.

Although his efforts have not had the effect on the company's share price that he and EMI's investors would like, there is no doubt that creatively at least EMI is currently going through a purple patch. There have been continued success stories in the UK with the likes of Robbie Williams, Radiohead, Coldplay and Kylie Minogue, while in the US the company's jazz chanteuse Norah Jones is currently riding high in the sales charts with her multi-million selling debut album Come Away With Me.

EMI's cost cutting has fed through to the bottom line too, with pre-tax profits for 2002/03 of £319m, against a loss of £152m in 2001/02. And while the share price continues to disappoint, it has at least managed to clamber back up from the sub-£1 mark and now nestles around the £1.60 mark (closing yesterday at 153.75p).

However, despite protestations to the contrary from senior EMI board members, the music industry is not "merely going through a cyclical downturn". It is more like a seismic shift in how the industry operates.

Music itself is more popular than ever but making a business out of selling the recorded product is proving tough and while record companies are now selling their music in a consumer-friendly manner the attraction of music for free has yet to wane, despite heavy-handed threats from the industry.

Mr Nicoli has publicly defended EMI's solitary position but privately he has acknowledged the benefits which would accrue with consolidation. The next few months will reveal which becomes company policy for the long term.

Hamish Champ was formerly editor of 'Music Business International' magazine