EMI debt threatens hopes of merger

EMI's stretched balance sheet came under fresh scrutiny yesterday after a leading credit agency threatened to downgrade the group's debt to junk status if it made a bid for Warner Music.

The world's third largest music company yesterday confirmed it was in talks with AOL Time Warner about a possible offer for the US media group's recorded music division.

Analysts and investors immediately raised questions about EMI's ability to fund a reported $1.6bn (£970m) bid, and ratings agency Standard & Poor's confirmed those fears by placing its debt under review with a negative outlook. EMI's £1bn debt burden is on a BBB- rating - one notch above junk status.

Standard & Poor's analyst Trevor Pritchard said there was "not much room" for an acquisition on EMI's balance sheet.

"They have very limited debt capacity and if they were to buy a valuable and profitable business it would have some earnings with it, but our concern is that there is not a lot of scope to increase the overall debt leverage," he said.

EMI's announcement followed weeks of speculation that it would attempt to come between Warner Music and Bertelsmann's BMG, who have been engaged in merger talks over the summer.

"EMI Group plc announces that it has now entered non-exclusive discussions with AOL Time Warner Inc with regard to a possible transaction involving the recorded music division of the Warner Music Group," said the music company.

In a statement that was thin on detail, the British group, whose artists include Robbie Williams and Radiohead, said the discussions were at a "very preliminary" stage.

Concerns over the structuring of the deal pushed EMI's shares down 4% to 151.75p.

"It only makes sense if you do it at the right price. If you overpay and stretch yourself the risk is greater. I suspect some people will say, hang on a moment, is this possible?" said Kingsley Wilson, an analyst at Investec Securities.

Analysts at UBS Warburg said in a note that "financing the acquisition remains the key challenge".

The $1.6bn offer for Warner Music includes $1bn in cash and $600m in EMI shares. AOL Time Warner, which announced last week that it would revert to the corporate title of Time Warner, would take a 25% stake in the new company. EMI has raised $543m in the bond markets over the past two weeks but emphasised the proceeds would be used to shore up the balance sheet rather than to fund an offer for Warner Music.

Private equity firm Blackstone has held talks with EMI over funding a bid but sources close to the firm said yesterday it would not be the sole financial backer. It was reported at the weekend that the music group might raise £650m from a syndicate of banks including Citicorp and Royal Bank of Scotland.

EMI confirmed the AOL Time Warner talks after a period of exclusive negotiations between Warner and BMG lapsed last week. Sources close to the talks said a 50:50 merger faltered over a $100m cash payment from BMG to Warner Music to ensure Bertelsmann received a 50% stake in the merged entity.

If EMI and Warner agree a deal it will attract regulatory scrutiny on both sides of the Atlantic. A merged EMI and Warner Music, excluding the US group's publishing arm, would create a new music outfit with a market share two percentage points behind Universal Music, which has a 26% share. Warner artists include Madonna, the Red Hot Chilli Peppers and Linkin Park.

The companies agreed to merge three years ago but the transaction was blocked by the European commission, which expressed serious reservations and was not swayed by EMI and Warner's proposals to structure the deal in a way that would assuage competition concerns. Brussels was unhappy with a deal that would have left 80% of Europe's recorded music market in the hands of four companies.