CFIN-522 EMI Group PLC Case Study Report 1

EMI Group PLC Case Study Report

CFIN-522: Applied Topics: Corporate Finance

           

Table of Contents

Company Overview and Problem Statement..................................3

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SWOT Analysis..................................................................................3
Strengths........................................................................................................................3
Weaknesses....................................................................................................................3
Opportunities.................................................................................................................4
Threats...........................................................................................................................4

Factors Affecting Dividend Decision...............................................4

A. Current Financial Situation...................................................................................4
B. The Company's Future...........................................................................................5
C. Clientele Effect........................................................................................................5
D. Dividend Signaling..................................................................................................6
E. Efficient Market Hypothesis..................................................................................6

Recommendation..............................................................................7

References.........................................................................................9

Figures...............................................................................................9

Company Overview and Problem Statement

EMI Group was a British music recording and publishing company founded in 1931. EMI
Music, the recorded-music side, had control of over a 100 of recording labels including
Capital Record, Chrysalis, EMI Classics, and much more. These labels were the
distribution channels of many big stars and musical legends. EMI Music Publishing had
the rights to an extensive collection of over one million musical compositions, including
some of the biggest hits of the past decades such as the Beatles, ABBA, and Queen.
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As with many of its competitors in the industry, EMI had been hit hard by the advent of
digital music publishing and the changing trends in music distribution, and had seen a
steep decline in its revenue which had reflected in stock price that was continuously
falling over the years.
EMI had been paying a fixed dividend of 8p per share per year since 2002 (see Figure
1) and had already declared an interim 2p per share for the current year 2007. However
since its financial situation was worsening, the company was contemplating whether
to maintain the past payout level that an additional 6p final dividend be paid or to
invest that money in other projects.

SWOT Analysis

Strengths
1. EMI Group had a strong global market spanning more than 50 countries across all
the continents.
2. EMI Group had an extensive catalogue, which was considered to be one of the
largest and most valuable in the world, including many musical legends such as the
Beatles, Queen, David Bowie, ABBA, and Pink Floyd.
3. EMI Group had a strong brand image and presence, derived from the great number
of successful artists associated with EMI and its divisions.
4. The large size of the company took advantages such as cost reduction through
economies of scale and a good global distribution network.
5. EMI Group was offering digital music on many platforms and managed to increase
digital sales from less than 1% of total revenue 2 years ago to 10% in 2007.

Weaknesses
1. Unlike its main competitors Universal Music Group, Sony Music Entertainment, and
Warner Music Group, EMI was a fully independent company which meant that it had
to generate its own revenues without conglomerate support.
2. Negatively affected by the changes in the music industry, the main source of
revenue for EMI, recorded music, had been rapidly declining over the years.
3. Growing piracy and file sharing on the internet had been having a severe impact on
the global music industry as well as EMI’s revenues and profits, and had led EMI’s
attempt to set a subscription based service to be a disappointing experiment.

Opportunities
1. Within the current context of the music industry, it was necessary for EMI to focus
more on the digital market as it would inevitably dominate the physical market as the
internet became more and more accessible. Apple’s iTunes platform had become an
example of how it was possible to successfully sell songs online. For EMI Group, it
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was very important to create more partnerships in order to prevent the erosion of its
market share and revenues. A joint deal with Apple to offer its digital catalogue,
which would be announced soon, could be an important starting point for EMI to
increase its digital sales.
2. There was also a big potential in the emerging markets such as Asian and African
markets.

Threats
1. As the music market was dominated by a few players which were Universal Music
Group, Sony Music Entertainment, Warner Music Group, BMG Entertainment and
EMI, the competition were fierce. Any action from the competitors should be
carefully considered. As a matter of fact, EMI currently faced considerably threat of a
takeover. Although its board had recently been able to successfully reject an
unsolicited merger offer of 260p per share from its U.S. rival Warner Music, there
remained considerable outside interest in taking over EMI.
2. Despite of the rise of legally downloaded music, the global music market continued
to shrink due to rapid decline in physical sales.

Factors Affecting Dividend Decision

A. Current Financial Situation

The underlying Group revenue had been decreasing steadily since 2003. In 2007,
revenue decreased from £2,080 million in 2006 by 15.8% or £328 million to £1,752
million. The underlying gross margin, after distribution costs, declined from 37.2% in
2006 to 34.9% in 2007. Group profit from operations EBITA decreased by £100 million
or 39.8% from £251 million in 2006 to £151 million in 2007. Total loss after tax was
£(287) million in 2007 compared to a profit of £90 million in 2006. However, this
decrease was largely due to exceptional items of £307 million occurred in 2007.
Earnings per share were negative £(36.3)p in 2007 compared to a profit of 10.9p in
2006 (see Figure 2). The only silver lining on the income statement was that group
digital revenue increased to £164 million in 2007 from £112 million in 2006, an increase
of 46.4%, and represented close to 10% of total underlying group revenue for the
current year 2007. The stock price was dropping from 2000 high of 691p to current
227p.
On the balance sheet side, it seems that EMI had been dangerously liquidating its
assets. Noncurrent assets went from £741 million in 2005 to £511 million in 2007. This
included assets like music copyrights and intangibles which decreased from £405
million in 2005 to £306 million in 2007. However, property, plant and equipment along
with financial assets also dropped significantly. On the other hand, noncurrent financial
liabilities increased from £1,162 million in 2005 to £1,317 million in 2007 (see Figure 3).
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These were clear indications that EMI had been struggling with cash in these two years
and relying on money from selling assets and issuing long-term debts due to declining
revenue and profit.
Overall, EMI’s current financial condition was depressing. The downward trending of
revenue since 2003 was especially problematic and raised our concerns.

B. The Company’s Future

In January 2007, EMI initiated a restructuring program, which was going to cost closer
to £125 million, was expected to deliver £110 million of annualized savings. The
majority of these savings would be coming from the recorded-music division by reducing
layers in the management and encouraging the recorded-music and publishing divisions
work more closely for cost synergies. The plan was being carried out quicker than
expected and most cost savings would be realized in 2008. Although the restructuring
program would help EMI to reduce the cost, there was no evidence to show the positive
signal of future revenue growth.
From the above “Current Financial Situation”, we could see that the only substantial
increase in revenue came from group digital music sales with an increase of 46.4% from
the prior year. But still digital revenue represented only close to 10% of the total
underlying group revenue for 2007. The market was moving from physical sales to
digital sales. The development of digital technology and digital sales should be the key
strategic priority for the company in this dynamically changing digital era and money
should be preferentially used to invest in the projects related to the digital technology
and digital sales to turn the decline in revenues around and increase its profitability. In
the long run, a total digital distribution plan would be the most crucial objective for the
company. The joint venture with Apple would be a significant move for EMI but more
aggressive measures were necessary in order to turn the company around.

C. Clientele Effect
When analyzing EMI’s dividend decision, a factor that one should consider is clientele
effect. Clienteles are likely to form in the following way for various dividend payout
policy:
Group Payout Policy

Individuals in high-tax brackets Zero-to-low dividend payout

Individuals in low-tax brackets Low-to-medium dividend payout

Tax-free institutions Medium-dividend payout

Corporations High-dividend payout

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There were 7 substantial shareholders, who were either big banks or large investing
corporations, together owning 48.42% of EMI’s shares. Also large shareholders who
owned more than 1 million shares made up 0.6% of all investors but held 83.3% of total
shares (See Figure 4). These few large corporations who owned majority of EMI’s
shares were influential when considering the dividend payout decision. All of these
large corporations preferred high dividend payout, which would provide them with
significant income stream meanwhile benefiting tax exemptions. Hence, if EMI decided
to suspend the rest of 6p dividend, it would have negative effects on these large
corporations as they were expecting the dividends as additional cash flow. In return,
these large corporations would begin to unload the EMI stocks and buy other high-yield
dividend stocks, which would drive EMI’s stock price to decline further, making the
company a prime target for a hostile takeover.

D. Dividend Signaling
Because EMI has paid a stable 8p dividend every year since 2002, continuing paying
the 8p dividend in 2007 would send a positive signal to the shareholders and emphasize
the management’s expectation of business improvement despite the recent
disappointing financial news and bolster the investors’ trust and confidence in the
management of the company. If EMI decided not to pay the rest of 6p dividend, it would
send a negative signal to the shareholders that would make the investors think that the
management had no confidence about the company’s future prospects. As a result, the
investors would begin to sell the EMI stocks and the stock price would drop further – the
last thing EMI wanted to see.

E. Efficient Market Hypothesis

According to the efficient market hypothesis, in an efficient capital market, the stock
prices fully reflect available information. In our case, EMI group already shocked the
investors with two profit warnings on January 12, 2007 and February 14, 2007
respectively. On January 12, EMI disclosed that EMI’s second half of the year releases
had underperformed its expectations and its recorded-music division revenues were
now expected to decline 6% to 10% from a year ago meanwhile its publishing division
was on track to achieve its goals. The market reacted swiftly to the news and EMI’s
market capitalization were down more than 7% with trading volume nearly 10 times the
previous day’s volume. On February 14, the company announced that the recorded-
music division’s revenues of Fiscal Year 2007 would actually decrease by about 15%
year-over-year because of worsening market conditions in North America, where the
physical music market had declined 20% in 2007. The investors punished EMI more
severely this time, and EMI’s stock price dropped another 12%. After these two profit
warnings, the shareholders of EMI group were not only questioning the management’s
ability and credibility, but also beginning to consider the possibility of dividend reduction
or even dividend suspension. EMI analyst Redwan Ahmed of Oriel Securities already
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expected that the dividend was going to be slashed to 5p instead of 8p. Therefore, we
believe that after two profit warnings, the investors were already prepared for the worst
including the dividend reduction or even dividend suspension at the company’s earnings
announcement on April 18. In other words, the investors already adjusted their estimate
of the stock price to reflect the worst situation they expected. The current share price of
227p was already priced in the possibility of cutting the dividend. The stock price might
only decline slightly or even remain the same if EMI decided to cut the rest of 6p
dividend.

Recommendation
After all the analysis has been done, it was obvious that EMI was facing a very difficult
situation. Our recommendation is that EMI should not pay the additional 6p dividend to
the shareholders.
It was no secret that EMI was experiencing a very rough time. Music industry was
changing fast and EMI was struggling to maintain its competitive edge. In the recent
years, the global music market continued to shrink and most of analysts expected a
relatively flat music market for the coming years. The future of the industry was in the
digital music sales. The digital music sales were $2 billion in 2006 and keeping growing
rapidly. The next few years were essentially important for the companies in the music
industry. Anyone who did not adapt fast enough to the digital era would significantly lose
its share or even be wiped out completely.
To adapt to these rapid changes, EMI needed cash to improve its digital infrastructures,
equipment, and operations for a new digital era of music distribution and retailing. The
collaboration with Apple was a step in the right direction but it was certainly not enough.
Amazon and Youtube could be the next plausible partners. EMI could provide some of
its music catalogues for free on Youtube. Instead of selling the songs, EMI could make
money from advertisement, which was a completely different business model for the
music industry. In this dynamically changing environment, there would be numerous
opportunities worth investing, and you would be running out of cash before running out
of these worthy projects. The company’s cash increased from £191 million in 2006 to
£332 million in 2007 despite the dramatic decrease in profit. This increase of cash was
mainly due to the sales of music copyrights, property, plant and equipment, and the
issuing of new debts. There were also rumors about the EMI’s plan to securitize its
music publishing assets. When this showed the management realized the importance of
having proper cash reserve in this fast changing market, it would not be a wise decision
to pay around £47 million for the current year and subsequent full annual £63 million for
the following years as dividend instead of investing the projects that could boost its
digital music sales and increase its digital music market share in the coming crucial
years. Therefore, we recommend that further dividend payments should be suspended
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until the benefits of the restructuring program were fully realized, and the digital music
sales were on the right track to turn the revenues and profits around.
Furthermore, borrowing money to pay dividend would worsen the financial situation of
the company and could create higher financial stress cost for the company. Liquidating
the assets and paying dividend would be milking the property and, as a consequence,
bondholders would oppose it. Agency conflicts and costs would rise and had a negative
effect on the company.
Although suspending dividend payment might send a negative signal to the investors
about the confidence of management in the future of the company, the investors’
decision did not solely depend on this signal. The restructuring plan was being
implemented quicker than expected and the deal with apple could be a breakthrough.
Investors took into account all these signals when they valued the firm. Especially since
the majority of shares of EMI were in the hands of a few big institutional investors, the
company could easily communicate its strategic plans to them. Moreover, after two
profit warnings, the investors most probably expected the cut in the dividend and they
valued the share accordingly. Therefore, the dividend cut would not be a new signal to
reduce the share price. In the last 4 years, the dividend yield of EMI share was well
above the FTSE all-share dividend yield and one of the highest in the industry. The
majority shareholders of EMI were institutional investors who preferred high dividend
yield. The dividend cut was certainly a bad news for them. However they were not
myopic investors. As long as they were well communicated and convinced that the
management knew what they were doing and were able to turn the company around,
they would not dump the stock.
As a final remark, although we thought keeping the cash for investment and suspending
further dividend payments was a right move and it would not hurt the stock price that
much, the management should be aware that it would also have a potential risk to make
them susceptible to a hostile takeover. Therefore, although their main focus must be on
the big picture to transition the operation of the company from the physical music sales
to the digital music sales, they should also prepare defensive strategies against
possible takeover attempts.

References
[1] H. Kent Baker. Dividends and Dividend Policy. Wiley, 1st Edition, 2009
[2] S. Ross, R Westerfield, J. Jaffe, G. Roberts. Corporate Finance. McGraw-Hill
Ryerson, 7th Edition, 2015
[3] EMI Group PLC financial review for the fiscal year ended 31 March 2007.
http://www.investegate.co.uk/article.aspx?id=20070521161206P73F6
[4] M. J. Schill, E. Shumadine. EMI Group PLC. Harvard Business Review, 2008
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Figures

Figure 1: Financial and Stock Data per Share (in pence) of EMI Group PLC

Figure 2: Consolidated Income Statement of EMI Group PLC

(in millions GBP, except per-share data)
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Figure 3: Consolidated Balance Sheets of EMI Group PLC

(in millions GBP)
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Figure 4: Analysis of Ordinary Shareholdings of EMI Group PLC