Corporate Finance EMI Group PLC Case

EMI GROUP PLC
CASE

REPORT CASE 2
CORPORATE FINANCE
Tuesday Afternoon, Semester 1, 2017-2018
Lecturer: Nguyen Kim Thu, Ph.D
Group 5:
Nguyễn Thị Bích Ngọc
Phan Diệu Hiền
Thái Thiên Kim

BAFNIU15101
BAFNIU15097
BAFNIU15143

Nguyễn Phương Thục Hiền

BAFNIU15097

Trương Thị Hoài Linh

BAFNIU15166

Nguyễn Thị Ngọc Trâm

BAFNIU15106

1

CONTENT

A. OVERVIEW
3
Summary..........................................................................3
EMI situation...................................................................4
B. CASE ANALYSIS
6
Dividend policy effect on EMI.......................................6
Positive effect.......................................................................6
1. Information content effect............................................6
2. Clientele effect...............................................................6
3. Bird-in-hand theory......................................................7
4. Agency cost theory........................................................8
5. Imputation tax system..................................................8
 Negative effect....................................................................8
1. Irrelevance of dividend policy......................................8
2. Dividend signaling.........................................................9
3. Transaction cost & Pecking order theory...................9
4. Imputation tax system................................................10
5. Debt obligation............................................................10
6. Investment policy........................................................10



C. RECOMMENDATIONS

11

List of Reference...................................................................13

A.

OVERVIEW

Summary
-

EMI’s Group Background
EMI music group was established in 1931 when Gramophone Company merged with
Columbia Graph phone to form Electric and Musical Industries. With a storied history
closely related to famous names such as the Beatles, the Beach Boys, Pink Floyd, and
Duran Duran, EMI has considered its current and historical catalog of songs and recordings
2


among the best in the world. EMI, along with Warner Music Group, Sony BMG Music
Entertainment, and Universal Music Group, has known as the one of the majors dominating
the music industry in the early 21st century and accounting for more than two thirds of the
world's recorded music and publishing sales. EMI Group has two main revenue drivers
which are recorded music and music publishing and EMI divided its organization into two
divisions devoted to each of these operations. With the EMI‟s view, the recorded music
sought out artists it believed would be long-term commercial-recording successes. Its
extensive music catalog consisted of more than three million songs. Besides, recordedmusic division sales were comprised of not only new but also old recordings, which
brought up to 30% to 35% of this division’s sale revenue. Meanwhile, publishing division
operates when songwriters with commercial potential and sign long term contracts with
them. This catalog division has produced more than one billion musical compositions up to
now. In that “major” group, EMI‟s publishing business was estimated about one-fourth of
the total group revenue and this division revenue was stable by years and also operating
profit also positive annually.

-

The effects digital audio’s revolution on EMI Group PLC
Changes in technology and customers demand have brought EMI Group into a difficult
case. The growth of digital audio as well as online music industry and the global decline in
music industry revenues. Online music industry gave the customer ability to purchase two
or three favorite songs from an album online versus purchasing the entire album of a
physical retail store – put negative pressure on music sales for the future. When iTune was
launched, EMI‟s revenue was actually decreased by 15% over year instead of 6% to 10%
in previous announcement and then its stock price dropped another 12%. To be more
detailed, annual underlying revenue for the company was down 16% to GBP1.8 billion and
earnings per share had also dropped from 10.9 pence in 2006 to minus 36.3 pence in
FY2007. Digital media is believed to be a leading segment in music industry in the future.
Moreover, EMI’s digital sales were growing and represented an increasingly larger
percentage of total revenue. In 2004, EMI generated group digital revenues of GBP15
million and the expected 2007digital sales for EMI were close to 10% of group revenue.
However, EMI’s recorded- music division where revenues had declined 27% from
GBP2,282 million in 2001 to GBP11,660 million in 2006. On February 14, the company
3


announced that the recorded- music division’s FY2007 revenues decreased by round 15%
year- over- year.
-

Dividend policy
Besides, on an annual basis, EMI had consistently paid an 8p-per-share dividend to
ordinary shareholders since 2002. However, under the recent financial performance of EMI
Group and the downside in global music industry, CFO‟s EMI Group Martin Stewart is
questioning whether EMI should maintain the past payout level of 2p per share by

recommending an additional 6p final EMI dividend be paid. Otherwise, leaving out the
dividend could possibly be a bad signal of lost in confidence by management and may
further disappoint investors, leading to greater softening of EMI share value in the market
in the future.

EMI situation
The EMI’s main stream of revenue is recorded music which is declining and cause loss
last year. The overall revenue was down 16% to GBP1.8 billion (British pound) and
earning per share (EPS) had not only decreased, but also be negative which from 10.9
pence (p) in 2006 to -36.3p in FY2007.
Although given the positive expectations for 2007 fiscal year, EMI surprised investor
community with negative earning guidance on January 12, underperformance compared
with expectations. Moreover, the expected decline from 6% to 10% in revenue of EMI’s
recorded-music division brought big influence on trading volume of EMI and their market
capitalization ended up down more than 7%. In addition, the announcement of EMI that the
recorded-music division’s FY2007 revenues would actually decrease by around 15% year
over year had shaken investors’ confident in the current management’s competence, and the
EMI’s stock price dropped 12%. Because of these news, EMI had lost all their credibility
with their shareholders. The big challenge for EMI is that how can they get credibility from
shareholders also investor community again.
In order to improve profit, EMI had plan to restructure that will help them to have more
cost savings, reduce layers in management structure with the purpose to recover loss due to
4


decline in recorded-music division’s revenue and publishing-division’s revenue. Besides,
with development of digital audio, EMI’s digital revenue had grown by 59% and would
represent 10% of revenue. However, the growth in digital revenue cannot offset the decline
in recorded-music division’s revenue and publishing-division’s revenue. This reflect the
global decline in music industry.

According to investors, EMI's current business model was very vulnerable to current
market threats, with its main revenues coming from recorded music, and 90% are still from
physical records. Besides, EMI also put attempts in taking advantage of development in
digital sales with the joint deal with Apple, but it is not clear how effective those measures
will be.
The biggest problem that EMI had to face is about dividend. Base on annual basis, EMI
has consistently paid an 8p per-share dividend for ordinary shareholders since 2002.
However, with current situation, Martin Stewart as chief Financial officer (CFO) of EMI
questioned whether EMI should continue to maintain that amount dividend or not. Without
paying dividend, EMI can preserve their cash but they would have many negative effects
on the share price. Moreover, EMI also faced to threat of takeover by US rivalry – Warner
Music. Realizing these threats, EMI had to carefully consider about their dividend because
it will cause specific impacts on the EMI stock price.

B.

CASE ANALYSIS

Dividend policy effect on EMI
 Positive effect:
1. Information content effect

An increase in dividend payouts may send a signal to the market that the firm is
confident in its future prospect. This may lead to the increase in the share price because the
investors raise their expectation of the future earnings of the company and vice versa.
In this case of EMI, they considered whether to proceed the interim decreasing
dividend payout of 2p per share or maintain the historical payout level. If the EMI decided
to pay the dividend of 2p per share, it would send a negative signal to the investors that
their business was not going so well and the future prospects of EMI was not promising.
5

Once the investors absorb such information, they will sell their shares and price share will
drop dramatically due to the mass selling out. So this hypothesis tells us that the decision to
decrease the dividend payout may affect the firm severely.
In conclusion, if EMI decided to maintain their historical payout level, they would
prevent the bad situation in which the stock price declined from happening.
2. Clientele effect

This idea states about the different payout level corresponding to clienteles - different
groups of investors of a company. The first group to be mentioned is individuals with high
tax brackets. These people tend to prefer either zero-to-low dividends. Whereas investors
with low tax brackets usually prefer firms those who have dividend policy to pay low-tomedium dividend. The third group is tax free institutions who would enjoy the medium
level of payout. And the last one is corporations whom the high dividend payout level
would satisfy them. As a result, any decisions about paying dividends of a firm should
consider these categories of investors.
Applying in the case of EMI, 0.6% of shareholders of the firm holds 83.3% of the total
share (Exhibit 6). So any decision about the dividend of EMI should be taken into
consideration the behavior of these investors. With the amount of 1,000,001 shares and
over, these shareholders may be corporations. This kind of investor, they can exclude at
least 70 percent of their dividend income but cannot exclude any of their capital gains.
Moreover, with a significant number of shares, the dividend payout would provide the
corporation a considerable amount of income and this source of income enjoys a
preferential tax rate. As a result, corporations tend to prefer high-dividend stocks rather
than the increase in the share price. If EMI decided to pay the dividend payout of 2p per
share, these large investors would begin to dump these stocks and affected greatly on the
EMI’s stock price.
To conclude, if EMI decided to maintain the historical 8p dividend, they could maintain
the satisfaction of these shareholders - who take important roles in the capital source of
EMI.

6


3. Bird-in-hand theory

This theory suggests that the investors would prefer the current income which is the
dividend payout to the promise but risky capital gains in the future – the increase in share
price.
In this case of EMI, things might go exactly the same. The disappointing numbers
about the annual underlying revenue and earnings per share in FY2007 had been
announced to the public and the investors might more or less doubt about the future
prospects of EMI. Reacting to this situation, they probably might be satisfied more with the
scheduled dividend payout than the promise increase in the EMI’s stock price.
So the decision to maintain the scheduled dividend payout level would hold the
potential investors of EMI and prevent them from any action of selling the stock mass
which may affect the stock price.
4. Agency cost theory

The concept of this theory is that the managers have the tendency to pursue their selfish
goals if the firm has plenty of free cash flow. To prevent the managers to do so, the firm can
decide to pay the dividends so that there are no more substantial cash flow for the managers
to misspend.
Applying in the case of EMI, the continuing bad news about the business of EMI
together with the lack of cash flow remaining in EMI would push the managers in their
actions. To be more specific, they would consider carefully about which effective project to
invest and not waste the money in bad investment opportunities.
In a nut shell, the decision to maintain the historical payout level of 8p per share would
affect positively in the EMI managers’ actions which could increase EMI’s revenue.
5. Imputation tax system:

The characteristic of this tax system is that dividend income is effectively taxed at
personal tax rate. Under this tax system, corporate tax paid by a company may be imputed
to the shareholders by means of tax credit to reduce the income tax payable on a
7


distribution. To be more understandable, if an investor has marginal tax rate lower than the
corporate tax rate, he/she will be refunded the tax amount that is equal to dividends
multiplied by the difference between the corporate tax rate and the investor’s marginal tax
rate. Vice versa for the case when an investor has a marginal tax rate higher than the
corporate tax system, the investor will have to pay the extra tax amount equal to the
dividends multiplied by the difference between corporate tax rate and investor’s marginal
tax rate.
Britain is one of those countries which use imputation tax system. So any investors who
have lower tax rate than EMI’s corporate tax rate would prefer the high dividend payouts
because they would enjoy the tax refunds.
 Negative effect:
1. Irrelevance of dividend policy

According to Miller-Modigliani theorem, the dividend policy of a company does not
affect the value of a stock or return of the investors as the higher the dividend payout is, the
less capital gain the investors can earn. Miller-Modigliani theorem conclude that even if a
firm does not pay dividends, it still has value. Because in fact, there are various ways for
the stockholders to receive the cash flows without receiving the dividend. The easiest one is
that the firm can repurchase its shares. Consequently, it has the same value it would have if
it paid dividends (Exhibit 8, Excerpts from Fischer Black’s “The Dividend Puzzle”).
So if this theorem is correct, it will be better for EMI to pay the dividend of 2p per
share to save the cash for investment projects and the decision to maintain the historical
payout level may be not a good idea.
2. Dividend signaling

As being mentioned above, an increase in dividend payouts may send a signal to the
market that the firm is confident in its future prospect. This may lead to the increase in the
share price because the investors raise their expectation of the future earnings of the
company. But sometimes, things can be different by the way each investor acknowledges
8


the situation. Some investors may think that the action of paying dividend in case of
financial distress wastes the free cash flow for potential investment opportunities
The whole market knew the disappointing news about the revenue of EMI. So they
probably knew that the availability amount of cash flows of EMI is low. If EMI maintains
the historical payout level by recommending an additional 6p final EMI dividend be paid,
investors will absorb the information that the cash flow has not increased, but instead
profitable capital expenditures have been cut.
As a result, the decision of maintaining the scheduled payout level might result in the
situation in which stocks’ price will fall below what it would have been increased the
dividends.
3. Transaction cost theory and Pecking order theory

Firm with more investment opportunities prefers internal financing than issuing
securities to finance their investment needs, especially with those firm who have high
transaction cost. As a result, firm will take priority to use cash to invest in their positive
NPV projects
If EMI is one of those firm who have high transaction cost, EMI should not maintain
their historical dividend payout when they were suffering from loss in operation. According
to Exhibit 11, EMI had the highest long-term debt/equity among the firms in the music
industry (0.72) in FY2006. So it might not be a good idea for EMI to maintain the historical
payout level because EMI had to borrow more to pay the dividends.
4. Imputation tax system

As stated above about the imputation tax system, those investors who have higher
marginal tax rate than EMI’s corporate may prefer the decision of decreasing the dividend
payout level and anticipating more in the future capital gains.
5. Debt obligation

A company should not pay dividend when it is likely to deplete their retained earnings.
If the company cannot generate a positive profit in the future, they may not have ability to
9


maintain its scheduled dividend payout level. In such case, EMI can decide to manage their
dividend payout through additional borrowing. This decision may cause risk to the
company because it is a must of a company to fulfill their debt obligations to the
debtholders whereas they are not obliged to do the same with the stockholders.
6. Investment policy

Firms should never give up a positive NPV project to increase a dividend (Ross, S. A.,
Westerfield, R. W. and Jaffe, J., 2005). As we knew that EMI was suffering from deduction
of revenue and the decision to maintain the historical may result in the negative profits for
EMI. That means there is not available cash for EMI to invest in any good projects at the
time. But the urgent thing that EMI should do at the time was focusing on their investment
policy, which is that they should invest in any project that providing them positive NPV.
Because the most effective way to increase the stock price is to increase the cash flows
which we can derive from a positive NPV projects.

C.

RECOMMENDATIONS
Our suggestion for Steward is that he should maintain the historical dividend payouts.

However, based on the Exhibit 7, keeping dividend payouts the same will make the net
income in 2007 of EMI negative so that the company has to borrow money to pay dividend.
As a result, EMI has to pay back this loan in the future. With the following evidence, there
are chances for EMI to pay back this loan.
Firstly, based on the data of estimated net income in 2008 and 2009 in Exhibit 7, it can
be seen that the net income will increase in comparison with 2007. In 2008, the net income
is -80.4. Although EMI still has loss but the loss is lower than 2007. And up to 2009, EMI
is estimated to gain profit. Thus, there is potential that EMI’s future will be better than at
the present.
Secondly, EMI management has planned to cooperate with Apple. With this plan, EMI
expected to increase digital sales of the company, which could bring profit for company in
10


the future. So, EMI has investment policy to invest in new projects that can bring
advantages for the company. EMI should focus on this investment since Apple can help
company by their iTunes store which customer would pay money for digital music and also
the broadcast of Ipod in people life. As a result, the EMI’s revenue and operating cash flow
will increase.
Thirdly, from the cooperative with Apple, EMI would become the first major music
company to offer digital catalog free from digital rights management and with improved
sound quality. So, becoming the first means that EMI had higher comparative advantage in
comparison with other companies in the same business line. There are many opportunities
for EMI to gain extra boost revenue in the future. Since it was the first company, the profit
of the cooperation would be higher. At the time EMI worked with Apple, EMI became the
unique company in this field so that the revenue would be high. In the future, other
companies would collaborate with Apple but it couldn’t gain much profit like EMI because
there were a lot of companies that also do the same thing. The market has divided into
many parts so the profit would reduce.

Fourthly, since EMI did not well in recent years, it has lost the credibility of the
shareholders. Therefore, the maintaining the dividend payouts will gain back the trust of
the shareholders. Paying historical dividend can signal the market that EMI expects that the
business will improve in the future. Therefore, shareholders would still believe in the
company and didn’t leave EMI.
This is just some evidences to show that the EMI will have high chances to pay back
the loans so that it could maintain the same dividend payouts.
The most important thing EMI should focus on is the investment policy. Dividend
policy is just the supporting policy. There is possibility that EMI will still be taken over
since the fact that the increase in the digital sales could not be offset fully the loss of CD
sales. So, it cannot maintain the historical dividend payouts only. EMI has to choose the
right investment policy to follow. It should find many new projects that has high NPV so
that the profit of the company will increase. Choosing the right investment policy can
11


reduce the cons of the EMI has to face, which has been listed in the question 2. Dividend
signaling and imputation tax system are not too significant to be main problems of the
company. The other disadvantages such as debt obligation, transaction cost theory is just in
the short-term if EMI invest the right project to cover these drawbacks.

List of References
Ross, S. A., Westerfield, R. W. and Jaffe, J. (2005), Corporate Finance, 10th edition, McGrawHill.
Investopedia Staff. Dividend Imputation. Investopedia Website. Retrieved from:
/>Investopedia Staff. Dividend Signaling. Investopedia Website. Retrieved from:
/>
12