In July 2020, Pershing Square raised $4bn from public investors for the biggest SPAC ever, Pershing Square Tontine Holdings (PSTH). At one point, the stock rallied to above $30/share but has since settled back down to around low-$20s. In June 2021, PSTH announced a series of transactions, with the bulk of proceeds used to acquire 10% stake in Universal Music Group (UMG).
In my previous post on SPACs, you may have known my general aversion investing in them. The founder shares and sponsor warrants typically leave public shareholders with burden of downside and significantly capped upside. However, PSTH did a great job from a structuring standpoint. And now it has announced a transaction. So let’s take a look.
PSTH Original Deal
Starting with the prospectus filed in July 2020, PSTH offered 200mm IPO units at $20 each for total proceeds of $4bn from public shareholders. One unit includes one share and a fraction of a detachable redeemable warrant. The stark difference between PSTH and typical SPACs is the lack of founder shares. Pershing Square has committed to putting up $1-$3bn, purchasing its units at the same offer price. In this case, the sponsor shares the same downside. Total capital for acquisition amounts to a min of $5bn and up to $7bn.
PSTH offers Pershing Square sponsor warrants for ~6% of the company exercisable at $24/share (i.e. 20% above initial offering price) for $65mm. One way to think about it: let’s say the acquired business doubles in 5 years, for an annualized return of 15%. You are basically giving up ~1ish% of the 15% return a year to the sponsor. Fair enough.
UMG Transactions
Now lets look at the UMG related transactions. You can find the investor presentation, transcript and call replay on its website here. In summary, total capital available at PSTH is $7bn. They are using $4bn to buy 10% stake in UMG at $40bn valuation. There remains $3bn at what they call RemainCo. As a PSTH shareholder, you are also given a warrant to buy into a future SPAC called SPARC Holdings.
In the UMG stake portion of the transaction, PSTH cancelled the sponsor warrants. So public shareholders share the same economics in the UMG shares as the sponsor. RemainCo then becomes a reduced-sized PSTH SPAC, with $3bn available. No founder shares but again with sponsor warrants for ~6% of company exercisable at 20% above NAV. Warrants to buy SPARC are basically options for loyal PSTH shareholders to buy into another future Pershing Square SPAC. In this way, it allows public shareholders to fund only after an acquisition target has been identified. Again, fair enough.
Universal Music Group
UMG discovers and develops recording artists, markets and promotes them and their music. The company earns royalties each time their songs are played. It has #1 global market share in recorded music and #2 in music publishing, representing artists such as Taylor Swift and Coldplay. 80% of the company’s revenue comes from recorded music, 16% music publishing and 4% merchandise.
Over the last 30 years, recorded music industry has gone through its own ups and downs. In the 90s through 2000, the industry experienced strong growth due to demands for physical CDs and records. For the next 15 years, with the advance of the internet, the industry was harmed by file sharing and piracy issues. In 2015, the industry revenue troughed at more than 50% below its peak in 1999/2000 timeframe. However, from 2016 and on, the industry growth has revived due to one single factor of online music streaming. In 2020, total industry revenue has grown more than 50% from 2015 level, with streaming now contributing 2/3 of total industry revenue in the US and a bit lower worldwide.
Financial Performance and Valuation
Similar to the industry trends, UMG revenue has returned to growth since 2015 at ~8% a year to ~$9bn in 2020. Operating margin expanded from 13% in 2015 to 18% in 2020. Assuming another 10% growth in operating income this year, $40bn valuation would be ~22x EBIT. The closest public comp, Warner Music Group (WMG), #3 in recorded music market behind UMG and Sony Music, is trading at around the same multiple of low-20x. Pershing Square argues that UMG has greater scale (~2x revenue of WMG), higher margins, better track record, best in class management, and better corporate governance, and should trade at a premium of say 30x.
Personally I agree with the continued growth in streaming and acknowledge the capital light nature of the UMG business should warrant a high multiple. The biggest risk I see is that growth in streaming may start to become a double-edged sword. As the largest global music streaming provider, Spotify has yet to churn out a profit. Big part of the reason is the huge payout to record label companies. In July 2020, Spotify struck a new, multi-year licensing deal with UMG. I speculate the split of economics remains roughly status quo as shown in Spotify’s latest financials. But over time, its hard to see Spotify remains a profitless operation. Something will have to give.
Summary
As of writing, PSTH is trading at ~$23/share. Assuming the full $3bn at RemainCo will get deployed, UMG stake at current valuation is worth ~$11.50/PSTH share. Maybe UMG should be valued at 30x. That would be ~$15.50/PSTH share. NAV at RemainCo is ~$9.50. Say the sponsor can buy another business at a similar discount as UMG. And accounting for the sponsor warrants, RemainCo may be worth $12/PSTH share. Plus maybe a dollar or two for the option to participate in SPARC Holdings in the future. However, the initial detachable warrants will have some dilutive effects if you just buy the shares now. So call it high-$20s of total value for a PSTH share. Interesting enough but hard to get very excited. Nonetheless, the SPAC structure is fair and reasonable. They are doing the right thing!
