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Sony terminates merger with Zee

Fallout of merger

After more than two years of deliberation, Sony has terminated its merger cooperation agreement (MCA) with Zee and sought a termination fee of USD90m from the company for an alleged breach of the MCA. Zee has said that it would evaluate all its options, including a legal action. Surprisingly, it has mentioned that Mr. Punit Goenka, Zee’s MD and CEO, had agreed to step down, a key bone of contention between the two parties. As a result, we downgrade our rating on the stock to Neutral.

Why are we downgrading?

When the merger was announced in Dec’21, we had upgraded the stock to BUY after retaining the Neutral rating for a long period, as we believed it would create a strong entity and benefit Zee in three ways:

1. Improve product bouquet with 75 channels across a wide array of genres and languages, garnering a dominant revenue market share of >35%.

2. Expansion in OTT space (INR100b market). The combined Zee-Sony entity would be able to create a niche in a market which is dominated by big players like JioCinema, Netflix, Amazon Prime, and Hotstar.

3. Improve the perception of the company’s governance with Sony’s majority shareholding as well as board composition.

Zee individually may find it challenging to improve on each of these factors. The company’s performance has been abysmal for the last four years as ad revenue declined 14% over FY20-23 due to weak market conditions and continued market share loss over the last 4-5 years, from over 20% to sub-17-18%. At a time when the industry is seeing a shift toward OTT, Zee5 individually would be on a weak footing, playing the second fiddle in a market dominated by strong players like Disney, Netflix, Amazon Prime, and Reliance Industries-led Network18. This is unlike the linear TV market, in which it has maintained its position among the top two players for a prolonged period.

What are the options for Zee?

We do not expect a recovery in earnings in the near term. Zee has not stated whether it will pursue the merger while the litigation with Sony could hinder improvements in operations or explore a merger with other players. Media reports indicate that Disney is exploring a potential India exit (Article link: Click Here), while a deal with RIL was also explored earlier. It is unclear what path Zee may take going ahead and there is limited clarity on the long-term outlook of the business.

Valuation and view

The linear TV business garners ~30% EBITDA margin vs. consolidated EBITDA margin of low-teens, highlighting the profitability of the business even in the current downcycle (revenue down 10% over FY20-23). But there is no clarity on its OTT business’s growth and profitability, especially after the termination of the merger, with an annualized EBITDA loss of INR12b (14% of overall revenue). The merger could have created a linear TV business with EBITDA of INR40-45b, which could have boosted OTT investments and the company’s competitive position.

But the big question is: where is the bottom of the stock price, which would make it look compelling? If we assume zero value for the OTT business and assign 10x to current Linear TV EBITDA (1HFY24 annualized), the stock would be valued at INR230 per share. However, if we assume no material recovery in OTT’s profitability and ascribe 15x on FY26E PAT of INR10.7b (factors some recovery in linear TV business and adjustments for recent one-offs), the stock would be valued at INR167 per share. As a result, we downgrade the stock to Neutral with a TP of 200 (18x on oneyear forwards P/E).

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