Hit that looks too hot to handle

Thorn EMI's demerger plan has dazzled the City, but investors should beware the takeover siren song
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The Independent Online
ONE ARTICLE of faith for many investors is never to buy stock on takeover hopes alone. According to this conventional, risk-averse argument, it is better to evaluate known information rather than punt on rumours of imminent takeover activity that may come to nought and only result in badly burnt fingers.

Not so in the case of leisure group Thorn EMI, currently the City's favourite bid target, whose shares are hitting new highs almost every day and breaking some of the most basic rules of stock market investment in the process.

From a low of pounds 9.63 last November, the shares have raced ahead to pounds 15.00, outperforming the index of 100 leading shares by more than a quarter. It is a performance only bettered among Thorn's blue-chip peers by Standard Chartered, Asda and British Aerospace.

The excitement stems largely from news earlier this year that the company, led by Sir Colin Southgate, was seeking a de-merger of its electrical rental business (Radio Rentals, Rent-a-Center) from EMI, the world's third largest music company, with labels embracing Virgin and Chrysalis.

Initially, hopes centred on the de-merger process "unlocking hidden value'' - in other words, the sum of the parts is found to be worth more than the whole.

Speculation then focused on the prospect of a predator building up a stake in or seeking a strategic alliance with EMI.

Apparently in the grip of bid fever, there were signs last week that some in the City had taken leave of their senses. "The share price cannot fall," one analyst opined last week.

The textbooks would have a field day with such sentiments. There is no such thing as a one- way bet, they say. The time to sell is when everyone else says buy. Share prices, to coin the famous warning, can go down as well as up. And sure enough, the siren voices appeared to be vindicated the very next day when Thorn's share price fell by 32p.

But there is another investment nostrum which investors ignore at their peril. It says a company's assets are ultimately worth whatever a bidder is prepared to pay for them - if the stock market refuses to appreciate their value, somebody will come along who does.

Since the de-merger announcement, Thorn EMI is, in City-speak, "in play" or vulnerable to takeover. Although no bidder has yet thrown its hat in the ring, the list of potential the company's suitors is as long as it is illustrious.

One front-runner is Viacom, the US entertainment group which owns the MTV music channel, Paramount film studios and Blockbuster video stores. Unlike other possible bidders for EMI, such as Walt Disney and Seagram, Viacom has kept its powder dry this year during the recent bout of consolidation in the US media and entertainment sectors.

Instead, Viacom has been quietly reducing debt incurred from the Paramount purchase to the point where it may be about to embark on the acquisition trail once again.

Others in the frame for EMI include Bill Gates's Microsoft and Rupert Murdoch's News Corporation. Indeed, just about any global entertainment conglomerate with multimedia ambitions and in need of a strong library of music titles - the much sought-after software content - will be on the case right now.

What EMI enjoys is scarcity value - it is the only "big five" record company available for sale, whereas most independent labels have already been swallowed up. Music industry executives drool over EMI's star-studded roster, which includes the Rolling Stones, Janet Jackson, Blur, and the Beatles.

Estimates vary as to how much EMI - including the HMV retail outlets - might fetch. Figures as high as pounds 5bn are being bandied about, compared to the pounds 6.4bn price tag the stock market currently places on the whole of the unbundled parent.

Nor is it clear exactly how the de-merger will be carried out. The knottiest problem remains having to satisfy 22 different tax regimes; another is what will happen to the group's debt. One suggestion is for the Thorn "rump" to be floated debt-free, leaving EMI to take most of the borrowings on to its highly cash-generative balance sheet.

What is not in dispute is that shares in Thorn are overvalued on fundamentals after such a strong run.

Certainly, the prospective price-earnings ratio of 21 looks demanding, but forecasts are largely irrelevant when sentiment is being driven by the other factors outlined above.

All of this makes calling the shares tricky in the extreme. At these rarefied levels, even the most speculative investor should steer clear. And for those sitting on handsome returns, the best option, surely, is to take some profits.

Thorn EMI Share price 1500p Prospective yield 3.3% Prospective price-earnings ratio 21 Dividend cover 1.8

1994 1995 1996*

Sales pounds 4.29bn pounds 4.51bn n/a Pre-tax profits pounds 344m pounds 426m pounds 510m Earnings per share 52.5p 61.9p 71p Dividend per share 34p 36.5p 39.5p * Charles Stanley estimates