XLRI GMP – Tata Steel (2019-20)

Case: EMI Group PLC

Submitted by:
CGT 19008 – Ankur Garg
CGT 19018 – Prabhat Kumar Singh
CGT 19024 – Sakshi Sharma
CGT 19027 – Sourabh Basu
CGT 19029 – Sushil Kumar Tripathy

1. Case Background
EMI group is a British music recording and publishing company that was founded in
1931. It is currently the world’s largest independent music company. Since the
mainstream introduction of digital music and specifically music stored in a MP3 file
format EMI has been struggling to keep revenues up and have seen a steady decrease in
its top line over the last few years.
Digital revenue has grown upto 10% of the revenue and EMI would enter into a joint
contract with Apple to offer digital catalog free from digital-rights management and with
improved sound quality. The new format would sell at a 30% premium and drive
increased digital sales.
Also, EMI is undergoing a major restructuring program to remove 110Mn from EMI’s
annual cost base by reducing the layers in the management structure and encouraging
cost synergy.
This year is looking particularly bleak for the company as it has seen a bigger decline in
revenue compared to previous years. Historically (since 2002) the company has been
paying a fixed dividend – 8p to shareholders and has already paid part of this dividend –
2p for the current year. The decision for EMI now is do they pay the dividend as per the
last few years or use the cash in other projects.

2. Industry Scenario:
 Music industry was oligopolistic, and the dominant players were EMI, Warner
Music, Sony BMG Music Entertainment and Universal Music Group. These
accounted for more two-thirds of the world’s recorded music and publishing sales.
 The advent of MP3 format which enabled easy download from internet was a major
digital disruption in the industry. In addition, peer to peer file sharing services like
Napster promoted illegal download of songs.
 Legitimate on-line music market had picked up with iTunes in 2003. Although this
was growing, music market was shrinking due to rapid decline in physical sales.
 “Unbundled music purchase” – 2 or 3 songs out of the album was predicted to put a
downward pressure on sales.

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3. Five critical financial problems

a. EMI had been paying a consistent dividend from 2002. Given the current
state, should they continue to maintain the same dividend?
The board had already declared an interim dividend of 2p per share in
November 2006. On an annual basis, since 2002, the dividend paid was 8p-per-
share which amounts to GBP 63 Mn. Given the current struggling financial
condition, a decision has to be made if the additional 6p of final EMI dividend
should be paid.

b. Impact of cutting down the dividend amount on the share price

Theoretically, it may be generalized that stock prices rise when the current
dividend is unexpectedly increased, and they generally fall when the dividend is
unexpectedly decreased. Companies cut dividends only with great reluctance. A
dividend cut is often a signal that the firm is on trouble. It signals that
management does not think that the current dividend policy can be maintained.
As a result, expectations of future dividends should be revised downward. The
present value of expected future dividends falls, and so does the stock price.

c. Declining annual revenue and earnings per share

Revenues from EMI Record Music declined 27% from GBP 2282 Mn in 2001 to
GBP 1660 Mn in 2006. In January 2007, the revenues from this division were
expected to decline 6% - 10%. Further, in February, the estimated decline rate
was revised to 15%. Profits were negative.

Revenue (in Mn GBP)

2300
2200 2175
2121
2080
2100 2001
2000
1900
1800 1752
1700
1600
1500
2003 2004 2005 2006 2007

Revenue (in Mn GBP)

d. How to thwart the risk of takeover?

EMI faced a considerable threat of a takeover. There was an unsolicited merger
offer at 260p-per-share from U.S. rival Warner Music. Therefore, maintaining/
boosting the stock price would be important.

e. Erosion of market capital because of poor performance of EMI’s recorded-

music division
The press and analyst’s reports are alarming. The estimate revision in less than a
month raised questions on the credibility of the firm.

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XLRI GMP – Tata Steel (2019-20)

4. Analysis and interpretation – possible directions of solutions

Miller and Modigliani theory on Dividend Policy
Definition: According to Miller and Modigliani Hypothesis or MM Approach,
dividend policy has no effect on the price of the shares of the firm and believes
that it is the investment policy that increases the firm’s share value.

The investors are satisfied with the firm’s retained earnings as long as the returns
are more than the equity capitalization rate “Ke”. If the returns are less than
“Ke” then, the shareholders would like to receive the earnings in the form of
dividends.

Assumptions of Miller and Modigliani Hypothesis

 There is a perfect capital market, i.e. investors are rational and have access to
all the information free of cost. There are no floatation or transaction costs, no
investor is large enough to influence the market price, and the securities are
infinitely divisible.
 There are no taxes. Both the dividends and the capital gains are taxed at the
similar rate.
 It is assumed that a company follows a constant investment policy. This implies
that there is no change in the business risk position and the rate of return on the
investments in new projects.
 There is no uncertainty about the future profits, all the investors are certain
about the future investments, dividends and the profits of the firm, as there is no
risk involved.
Clientele Effect

The clientele effect is the idea that the set of investors attracted to a particular kind
of security will affect the price of the security when policies or circumstances change.
For instance, some investors want a company that doesn't pay dividends but instead
invests that money in growing the business, whereas other investors prefer a stock that
pays a high dividend, and still others want one that balances payout and reinvestment. If
a company changes its dividend policy substantially, it is said to be subject to a clientele
effect as some of its investors (its established clientele) decide to sell the security due to
the change.

Therefore, it is important to analyse the clientele base for this company.

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Clientele Base
83.3

50

21.8 23.9
12.8
0.2 0.4 1.4 2
2.2 1.5 0.6
<500 <1000 <10000 <100000 <1000000 >1000000

Percentage of shares Percentage of shareholders

123 shareholders (each owning more than 1 Mn shares) own around 83.3% of the total
shares. Further, Observing the company’s ownership, there are 7 substantial shareholders
who own 48.4% of shares.

Impact of Dividend on Stock Price

600 18
16
500
14
400 12
10
300
8
200 6
4
100
2
0 0
2001 2002 2003 2004 2005 2006

Stock Price Dividend per share

When the dividend was revised from 16p to 8p in 2002, the stock price declined sharply.
Because of limited data, the isolated impact cannot be established but the sharp decline
makes it reasonable to assume that dividend change results in decline of stock price.

From the information provided, most of these investors are money managers who most
likely require a certain level of consistency in their portfolio’s returns. If EMI were to cut
dividends, this will have a negative impact on those investment companies’ Cash Flow,
whom in return might be forced to dump the stock to maintain liquidity. If that is the
case, share price could significantly drop making the company a prime target for a
takeover at low price.

A flat dividend since 2002, implies that growth is nil. With an average share price of
263.5p in 2007 and forecasted dividends of 8p, dividend to the market prices yield a 3%
return (8/263.5). If the dividend was to be cut to 2p, at current market price, the yield
would drop to 2/263 = 0.7%; much lower than the risk-free rate. The market would most

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XLRI GMP – Tata Steel (2019-20)

likely adjust; which would put extreme downwards pressure on the stock price forcing it
even lower and making the company extremely vulnerable to a takeover. More
specifically, in order to maintain the current 3% yield (assuming EMI’s risk is
unchanged), the price could drop as low as 67 (2p dividend / 3% expected return). Since
EMI recently disappointed investors by revising forecasted recorded music division
decline in revenues from 6-10% to 15%, a second disappointment with a dividend cut
could motivate investors to pull the trigger on the stock which is also indicated in the
analysts’ reports.

5. Specific recommendations and implementation

 Since the company produced a deficit in 2007, it is not possible for EMI to
distribute proceeds from profit as dividends. But cash levels increased from
191Mn in 2006 to 332Mn in 2007, which could be used to cover the dividend.
Even by making a 63Mn dividend payment to shareholders, cash on the balance
sheet would still be 269Mn; substantially higher than in 2006, thus providing the
required liquidity (125Mn) to see the recent restructure to completion and invest
in innovation that will help drive up sales. On the liability side, dividend payment
will only decrease retained earnings deficit by 2.6%.
 If EMI were private, it would make sense not to pay dividends in order to
preserve cash. But since the company is public and therefore should be focused
on increasing shareholder equity, dividends should be paid to maintain share
prices constant and avoid a massive sellout. The dividend payment will squeeze
cash reserves for the next few years, but profit is forecasted to be back to positive
levels in 2009, including dividend payments. Overall, this reduction in cash
should have a much smaller impact on share price than cutting dividends.

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