The Thorny question of valuation

The proposed break-up of Thorn EMI has been talked about for so long that if, and when, it is finally announced next week the sense of anti-climax will be palpable. But with Sir Colin Southgate reliably expected to set the ball rolling with Tuesday's third-quarter figures, attention will really start to focus on what the demerged parts might be worth.

Under the plan, investors are expected to receive two shares in exchange for their Thorn EMI units, one in the larger EMI music business and another in Thorn's rental operation. With about 12 per cent of the shares held in the US, there will probably be a London and New York listing for the new equity.

The company first mooted the idea of a demerger last summer, but the process has been complicated by its tax implications. The group's different operations are governed by more than 20 tax jurisdictions, but it finally appears that the group has ironed out all the wrinkles and is ready to press ahead.

As one of the least well kept secrets, much of the hidden value of the two parts has already seeped out into the marketplace and over the past year the shares have soared. From little more than pounds 10 a share 12 months ago the stock broke through pounds 17 last month, before settling since then to yesterday's pounds 16.69. During that period Thorn has outperformed the rest of the market by a thumping 30 per cent.

The two businesses are both attractive in different ways. EMI, which for the purposes of the demerger will include the HMV record shop chain, has an enormously valuable back catalogue of hit songs and an enviable array of stars on its books. The record-breaking $85m four-album deal with the American singer Janet Jackson bolstered the division's Virgin label, albeit at a price that had the company's rivals spitting tacks.

Its publishing arm, the ultimate cash-cow with fantastic margins, has the rights to songs from performers such as Rod Stewart and Take That. For the cost of administering that list, Thorn coins in the lucrative rights to its songs from radio stations, advertising agencies and film companies.

EMI is the side of the business that has received most attention, and it's the bit most likely to attract a bidder after the two-way split, but Thorn has its own appeal with good revenue growth in prospect and useful cash flow. Concentration on new finance packages appears to have arrested the underlying decline of rental in developed markets.

So what are the parts worth? That depends on the methodology used and the extent to which bid premiums are factored into the final valuations, but however the cake is sliced the deal leaves the break-ups of Hanson and British Gas in the shade from the point of view of creating shareholder value.

One method of putting a price tag on EMI involves attaching a multiple to the company's sales, which reached pounds 2.2bn in the year to March 1995 and could be pounds 370m higher in the current year. A consensus figure of 2.25 times sales, which is about what PolyGram paid for Motown in 1993, generates a value of between pounds 5.8bn and pounds 6bn for EMI.

That could be too high, because there is less scope with this deal for wringing extra efficiencies from EMI's already tight operation. It is also complicated by EMI's 55 per cent stake in its Japanese off-shoot, which the crude sales measure appears to overvalue.

A more sophisticated model attaches a sales measure to EMI's recorded music side, while valuing the publishing side on a multiple of its share of royalties. Using that methodology, one broker comes up with a range of between pounds 5bn and pounds 5.7bn.

Valuing Thorn and HMV is simpler. The rentals business is expected to trade on something approaching a market rating after demerger, suggesting a value of about pounds 1.6bn. HMV, the smallest division, is probably worth another pounds 250m to pounds 350m.

In total then, pounds 8bn seems a reasonable price tag for the whole group, which compares with Thorn EMI's market capitalisation at yesterday's close of pounds 7.2bn. Given the remaining uncertainty there is little incentive for anyone who has missed the fun so far to jump aboard. But long-standing shareholders should hold on to squeeze what value remains locked up in the combined group.

The risk for shareholders is that any hitch will send the shares tumbling. Profit forecasts for the full year of just over pounds 500m put them on a prospective price/earnings multiple of about 23, which only falls to 20 in the year to March 1997. That is high but, even if a yield of 3 per cent provides little support, not astronomically so for this type of business. Hold for next week's developments.