Market share has always driven the music business. It did when the major labels, known back then as the Big Six, were unloading vinyl at Tower Records and other retail music chains. It did when the Big Five were stocking as many CDs as they could into Wal-Marts and other big-box outlets. And it continues to drive the business, as the Big Four cut deals with Spotify Ltd., Pandora Media Inc. and other digital-music services. Market share and the clout it confers drive the business so relentlessly that Vivendi SA's Universal Music Group recently started claiming its market share is overstated. Why? To get more market share, of course.
Welcome to the high-stakes game being played by industry leader UMG and runner-up Sony Corp. of America as they set about disemboweling EMI Group Ltd., the smallest of today's Big Four labels. EMI's owner, Citigroup Inc., ended an auction in November that designated a separate winner for each of the London-based music company's two major divisions. UMG broke through first, winning EMI's recorded-music operations with a bid of $1.9 billion; a consortium headed by a Sony joint venture with the estate of Michael Jackson -- Sony/ATV Music Publishing LLC -- signed up EMI's music-publishing division for $2.2 billion. Never mind that third-ranked Warner Music Group Corp. would have been the logical new owner of both EMI operations. Its victory, after all, would have transformed the industry into an evenly matched triopoly. But in compressing from a Big Four to a Big Three, the industry fulfilled other destinies.
Lucian Grainge, UMG's chairman and CEO for the past year, certainly doesn't want to be upstaged by his former boss and industry elder statesman, Doug Morris. Yet that's possible, some think probable, after Morris left UMG last year to head über competitor Sony Music Entertainment. And the market share difference between the two companies' recorded-music operations, using the same numbers UMG does in its presentations, is a mere 3.5 percentage points. While the balance favors UMG, Morris is just getting started on his plan, as he recently told The New York Times, "to help create the pre-eminent record company in the world." Is it any wonder, then, that Grainge covets the 10 percentage points that a takeover of EMI Music would add to UMG's recorded-music share?
The backstory for the sale of EMI's music-publishing division is equally rich. In 2005, after 16 years as chairman and CEO of EMI Music Publishing, Marty Bandier tried getting his parent company to sell him the division. EMI rebuffed the overtures, thus leading to Bandier's resignation and a return to the business in 2007 as chairman and CEO of rival Sony/ATV. As the public face of the winning consortium, Bandier is now in line to reunite with EMI Music Publishing and, with his own JV, preside over the industry's leading music-publishing operation. If and when this happens, current leader Universal Music Publishing Group would see its market share eclipsed by 10 percentage points.
The problem for both UMG and Sony/ATV is that winning their respective auctions will prove the easy part. Likely to be much harder is the challenge under way of winning regulatory approval from the European Commission and the Federal Trade Commission. Although neither music company is expected to clear both hurdles unscathed, Sony/ATV's chances are considered better than UMG's. This is because pro forma calculations attribute less than a third of the global market for music publishing to a Sony-EMI combo but nearly 40% of the global market for recorded music to a UMG-EMI combo. In some markets, moreover, the pro forma market share of UMG and EMI exceeds 50%.
UMG remains a point of fascination for another reason. Its winning bid to Citi included a so-called hell-or-high-water clause that obligates UMG to pay £1.1 billion ($1.75 billion) of the total £1.2 billion purchase price at the earliest of 10 months, which will be in September, or upon regulatory approval in the U.S. (UMG's final payment of £100 million is due on closing.) The same clause further stipulates that, should UMG not be able to complete its merger with EMI, Citi has the right not only to resell the asset but to hold UMG accountable for any shortfall in the $1.9 billion price that it agreed to pay.
On March 23, while announcing that its investigation had entered Phase II, the EC articulated its concern about the anticompetitive threat of a UMG-EMI combo: "At this stage of the investigation, the new entity, which would be almost twice the size of the next largest player in the [European Economic Area], would not appear to be sufficiently constrained by the remaining competitors on the market, by its customers' buyer power, and/or by the threat of illegal music consumption (so-called 'piracy')."
The pronouncement struck some observers as unexpectedly harsh in that it marginalizes two arguments believed to be instrumental to UMG's defense. What the EC is saying, these tea leaf readers explain, is UMG should not base its case on the notion that it needs the additional leverage a merger with EMI would provide to stand up to iTunes (the industry's "buyer power" nonpareil). Nor should it expect the EC to regard digital piracy through peer-to-peer file-sharing networks and locker services such as The Pirate Bay as an effective check against the market and pricing power of a UMG-EMI combo.
UMG, nonetheless, took the EC announcement in stride. "Phase II was always expected," it said in a statement. "We will continue to co-operate fully with them and look forward to a successful resolution of the process." UMG may also be comforted by the fact that, since the beginning of 2008, the EC has approved 25 of the last 27 mergers after they moved to Phase II. It may even approve this one should UMG agree to enough divestitures to make it, to quote the EC again, "sufficiently constrained by the remaining competitors on the market."
It wouldn't be the first time the EC forced sales on UMG. In 2007, preparatory to closing its $2.1 billion acquisition of BMG Music Publishing, the music company went through three rounds of market tests before coming up with a divestiture package the EC deemed satisfactory. Each round was increasingly draconian, with the third finally addressing all the shortcomings identified in previous tests. "It added considerable revenues (almost 50% more than the second divestiture package) and included an important U.S. catalogue with many chart hits and successful authors," the EC reported in its 166-page decision on why it let UMG proceed.
What's interesting about those divestitures was their necessity for a merger of two music-publishing operations, with a combined share of only 22%, to pass regulatory muster. This precedent already has would-be buyers of music assets salivating over the divestiture package they expect UMG to bring to market before clearing a merger with a pro forma share of 40%. Whatever they ultimately gain, though, won't come close to what UMG would lose.
Assume, for instance, that the EC requires UMG to jettison assets amounting to 10% of the $260 million in Ebitda generated by EMI Music in 2010. The properties so identified, based on the winning bid's multiple of 7.1 times Ebitda, would have cost UMG about $185 million. But in a forced sale, they would likely command a multiple closer to 5 times Ebitda, a reflection of the economic environment and a reduced number of strategic buyers in position to submit inflated bids with a view toward capturing synergies. This suggests a sales price of $130 million and a loss of $55 million. Sadly for UMG, the losses wouldn't end there but would go on to include transaction fees. And, at 3% to 5% of the sales price, these would come in between $4 million and $6.5 million. So, even before assessing the synergy implications of a forced sale, UMG would be sitting on a loss that could be greater than $60 million.
It's axiomatic that properties the EC would want UMG to divest would be synergy-rich. Or, looked at another way, divestitures forced by the EC would be in areas, genres and territories where a UMG-EMI combo would otherwise command an anticompetitive share. These are the same places, invariably, that hold the most promise in terms of back-office and infrastructure redundancies. Returning to the example -- a forced sale in the amount of 10% of EMI Music's Ebitda -- the synergies contained therein could easily represent 30% of the total. If so, they'd account for $48 million of the $160 million in total synergies UMG anticipates from an unfettered takeover of EMI. And their removal from the deal, based on its 7.1 Ebitda multiple, would lop off $340 million in enterprise value.
This back-of-the-envelope exercise, which explores the impact of divestitures amounting to only 10% of EMI Music's Ebitda, indicates how quickly UMG's winning bid could turn into a losing hand. The exercise's three components, taken together, would reduce the merger's value to UMG by no less than $400 million, or more than 20% of the purchase price. Might it be easier, even better, for UMG to demonstrate its market share isn't as big as generally perceived? The question is timely given a movement afoot that, in the U.S. at least, could save UMG's proposed acquisition of EMI from regulatory ruin.
UMG didn't initiate the movement to revise the measurement of recorded music. That distinction belongs to Rich Bengloff, the president of the American Association of Independent Music, or A2IM, who early last year began arguing for a change in the methodology employed by standard industry measurers Billboard and Nielsen SoundScan. "Ownership of master recordings, not distribution, should be used to calculate market share," the trade group head wrote in a Billboard editorial.
Bengloff's argument held that major labels should no longer receive market share credit when retained by an independent label to distribute the content of its indie artists. That credit rightfully belongs to the indie, the editorial asserted, which not only owns the master recordings but controls the timing, pricing and other marketing aspects of their release. "Why should distribution be considered differently than any other third-party services?"
The call for change was no ordinary vanity play but an attempt to right what Bengloff identified as two marketplace wrongs: "When independents go to new digital-music services to negotiate deals, the services point to Billboard and SoundScan's market share calculations and say our independent community isn't a big enough market segment to deserve equitable treatment. Artist signings and promotion have become equally problematic, as our potential business partners believe that the four majors control 90% of the U.S. music market and deserve preferential treatment."
To the surprise of many, especially those accustomed to the glacial pace of music industry change, Bengloff's argument gained traction. In July, after specifically citing A2IM's call for market share revisions, Billboard published half-year figures for the domestic market the old way, which gave indies a 12.5% share, and the new A2IM-advocated way, which gave them a 31.2% share. SoundScan followed suit for all of 2011, with the U.S. share of indies rising from 12.1% the old way to 30.4% the new way. Full-year figures for music's major labels were also presented both ways, with, notably, the U.S. share accorded industry leader UMG falling from 29.8% the old way to 24.7% the new way.
In its quest to secure EMI, UMG isn't just embracing a new way of market share measurement. It's also abandoning an old way of measurement, one it forced on the music business after launching its own indie, Fontana Distribution, in 2004. However, instead of breaking out the startup's results for the entire industry to see, UMG lumped them with its own. The withholding of this information ran counter to the reporting practices of the other majors, which always segmented the results of their indies. After a while, though, it didn't matter.
"Without having the ability to know what Fontana's market share was, Billboard made an editorial decision to keep an apple-to-apple comparison when tracking market share," the music publication explained on revamping its measurement system last July. "The only way to do that was to use summary report market share totals, which meant that all the major-owned indie distributors would be counted under the majors."
For UMG, the return of major-label indies to market share compilations is nothing if not expedient. Consider, for starters, the FTC's reliance on the Herfindahl-Hirschman Index as an indicator of competitive effects caused by a merger. The HHI for any one market is calculated by summing the squares of its participants' market shares -- an exercise that would give a pure monopoly an HHI of 10,000 and a market of 10 participants, each with a 10% share, an HHI of 1,000.
According to Horizontal Merger Guidelines, which lays out the techniques and practices of both the FTC and the Department of Justice, markets with post-merger HHIs below 1,500 are unconcentrated, between 1,500 and 2,500 are moderately concentrated and above 2,500 are highly concentrated. "Significant competitive concerns" are also raised when a merger increases an HHI more than 100 points in a moderately concentrated market or between 100 and 200 points in a highly concentrated market.
Enders Analysis, the London-based media consultancy, recently estimated a UMG-EMI merger would raise the HHI for recorded music in the U.S. from a moderately concentrated 2,237 to a highly concentrated 2,865. The 628-point increase would give rise to significant competitive concerns as well. Yet that's hardly the case when A2IM-advocated statistics replace those used by Enders Analysis. Indeed, as recalculated by a source privy to all the necessary data, the HHI in the latter instance would actually fall to 1,817, a sum too moderate to roust the FTC.
Among those publicly opposed to a UMG-EMI tie-up -- a group that includes WMG's former chairman and CEO and current director Edgar Bronfman Jr. (who no longer has an economic interest in the business), the Future of Music Coalition, Impala (a European trade association that represents 4,000 of the Continent's nonmajor music labels), the International Federation of Musicians, Media Access Project and Public Knowledge -- is the same A2IM that's inadvertently the architect of what will likely be UMG's defense. And while the irony is inescapable, UMG's about-face on market share calculations could still backfire. That is, rather than accept UMG market share figures scaled downward under a revised formula, the EC and FTC could focus their analyses on how UMG presents its clout in the marketplace when negotiating licenses with digital-music services and terms with outlets for physical product.
Although UMG declined to participate in this article, in deference to the two reviews, those familiar with its thinking really do believe it's pinning regulatory success on the market share revisions advocated by indie champion and UMG-EMI opponent A2IM. They believe UMG is stealing a page from the indie handbook, in other words, to advance a corporate agenda inconsistent with indie objectives. By doing so, by downplaying its market share so that it can clear regulatory hurdles to acquire more market share, UMG stands to achieve what many thought impossible: render arguments about its merger with EMI even more polarizing during the review process than they were before that process began.