Corporate Finance EMI Group PLC Case

EMI GROUP PLC CASE REPORT CASE 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 CONTENT A OVERVIEW Summary EMI situation B CASE ANALYSIS Dividend policy effect on EMI .6 Positive effect .6 Information content effect Clientele effect .6 Bird-in-hand theory Agency cost theory Imputation tax system  Negative effect Irrelevance of dividend policy Dividend signaling .9 Transaction cost & Pecking order theory Imputation tax system 10 Debt obligation 10 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 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 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 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: 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 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 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 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 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 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 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 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: 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 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 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 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 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 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 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 the same with the stockholders 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 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 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 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: https://www.investopedia.com/terms/d/dividendimputations.asp Investopedia Staff Dividend Signaling Investopedia Website Retrieved from: https://www.investopedia.com/terms/d/dividendsignaling.asp 12 ... 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... 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