The sweet sound of private equity

If speculation regarding an imminent takeover of EMI Group (LSE, EMI) is beginning to sound like a broken record, then this week's developments should be welcome. After many false starts, private equity group Terra Firma have offered management at EMI an acceptable proposal.

We believe the deal, pitched at 265p per share in cash, is likely to either carry the day or be very near the top of any other forthcoming bid. Having been in discussions with various other interested parties of late, EMI noted in their announcement recommending the offer that this was the most attractive so far received.

In light of this week's full year results (period ending 31 March), we believe the timing of the deal is fortuitous. Challenging market conditions saw underlying revenue decline 12.1 percent whilst earnings before interest, tax and amortisation (EBITA) fell a whooping £100 million to £150.5 million. Disappointing to say the least but expected given the group's earlier trading updates.

The silver lining in this otherwise cloudy situation remains the phenomenal growth of digital music revenue and the steady performance of the Music Publishing division.

We have always been big believers in the potential of digital music and it appears that Terra Firma are as well. These revenue streams along with the steady income provided by Publishing formed the basis for the approach for EMI which on the surface looks to be struggling.

As value investors we can appreciate Terra Firma's opportune approach. Given the vast quantities of private equity capital shopping for purchases, cheap assets are becoming increasingly rare. The fact EMI has been "in play" however, has meant the offer is not too far below our expected acceptable range.

EMI management could we believe claim some credit for this outcome. After failing to reach agreement with Warner Music earlier in the year, the company issued a trading statement on April 18. Besides the usual business and market discussion was the revelation management were pursuing the potential securitisation of the Publishing division.

It is no secret that private equity firms were interested in the same steady cash flows the division generates. By securitising them first, EMI would effectively remove the industry as potential bidders. We believe this decision forced the hand of the private equity industry. By the beginning of this month, EMI announced talks with several interested buyers and of course this week, Terra Firma has emerged with a recommended offer.

What were some of the factors contributing to the superiority of Terra Firma's offer?

First is simply the price. The competition for EMI's publishing division means the price of the deal comes in at 18 times 2007 EBITDA (EBITA plus depreciation). Given a declining global market for music sales due to digital turnover not replacing physical sales (i.e. CDs) fast enough, we agree with the Board when they say this is a "fair and reasonable" price.

On top of the industry conditions, there is also the specific performance of EMI within this environment. As the full year numbers indicate, the second half of 2006/07 was a difficult period for the group. The offer allows investors to crystallise value today without the execution risk inherent in such a rapidly changing industry.

There is also the elimination of regulatory risk, which was a stumbling block in prior attempts to combine with Warner Music. The offer on the table today is unencumbered by this uncertainty and if successful, shareholders can expect to receive payouts much sooner.

Currently the shares of EMI are trading above the 265p offer price. We believe this is due to market sentiment that another offer will be forthcoming.

Warner Music could in our view make another attempt in combination with another private equity group. The rationale would be a break up of EMI where Warner would acquire the Recording business and the private equity partner would receive the Publishing segment. In fact, assuming the current offer is successful, Warner could approach Terra Firma regarding this split.

However, having been down this road to a potential takeover with EMI on many occasions, we believe the prudent course of action is to take advantage of the market's optimistic outlook and sell above the offer price. The shares trading near our current internal target of around 275p reinforce this position.

Accordingly, we recommend Members sell their holdings in EMI around 272p.