In this Internet age, the consumer is using music content more than ever before— whether that’s playlisting, podcasting, personalizing, sharing, downloading or just simply enjoying it. The digital revolution has caused a complete change to the culture, operations, and attitude of music companies everywhere. It hasn’t been easy, and we must certainly continue to fight piracy in all its forms. But there can be no doubt that with even greater commitment to innovation and a true focus on the consumer, digital distribution is becoming the best thing that ever happened to the music business and the music fan.
—Eric Nicoli, CEO, EMI Group1
In early spring of 2007, Martin Stewart drove through the darkened streets of Kensington in West London. As chief financial officer (CFO) for global music giant EMI, Stewart already knew most of the news that would break at the company’s April 18 earnings announcement. Annual underlying revenue for the company was down 16% to GBP 1.8 billion (British pounds). Earnings per share (EPS) had also dropped from 10.9 pence (p) in 2006 to −36.3p in FY2007 (fiscal year). Those disappointing numbers were roughly in line with the guidance Stewart had given investors in February. The performance reflected the global decline in music industry revenues, as well as the extraordinary cost of the restructuring program EMI was pursuing to realign its investment priorities and focus its resources to achieve the best returns in the future. The earnings announcement would include an announcement of the dividend amount, which had not yet been determined. The board would meet soon to review EMI’s annual results,
International Federation of Phonographic Industry (IFPI), “IFPI: 07 Digital Music Report,” January 2007.
This case was written by Elizabeth W. Shumadine (MBA ’01), under the supervision of Professor Michael J. Schill, based on public information. Funding was provided by the L. White Matthews Fund for Finance case writing. Copyright © 2008 by the University of Virginia Darden School Foundation, Charlottesville, VA. All rights reserved. To order copies, send an e-mail to [email protected] No part of this publication may be reproduced, stored in a retrieval system, used in a spreadsheet, or transmitted in any form or by any means— electronic, mechanical, photocopying, recording, or otherwise—without the permission of the Darden School Foundation. Rev. 2/09.
.2 On an annual basis, EMI had consistently paid an 8p-per-share dividend to ordinary shareholders since 2002 (Exhibit 1). Now in light of EMI’s recent performance, Stewart questioned whether EMI should continue to maintain what would represent a combined GBP 63-million annual dividend payment. Although omitting the dividend would preserve cash, Stewart appreciated the negative effect the decision might have on EMI’s share price, which was currently at 227p. Stewart recognized that EMI faced considerable threat of a takeover. Although its board had recently been able to successfully reject an unsolicited 260p-per-share merger offer from U.S. rival Warner Music, there remained considerable outside interest in taking over EMI. It seemed that boosting EMI’s share price was imperative if EMI was to maintain its independence.
With a storied history that included such names as the Beatles, the Beach Boys, Pink Floyd, and Duran Duran, it was not difficult to understand why EMI considered its current and historical catalog of songs and recordings among the best in the world. EMI, Warner Music Group, Sony BMG Music Entertainment, and Universal Music Group, collectively known as “the majors,” dominated the music industry in the early 21st century and accounted for more than two-thirds of the world’s recorded music and publishing sales.3 Exhibit 2 contains a list of the global top-10 albums with their respective record labels for the last four years. Recorded music and music publishing were the two main revenue drivers for the music industry. EMI divided its organization into two corresponding divisions. EMI Music, the recorded-music side, sought out artists it believed would be long-term commercial recording successes.
Each EMI record label marketed its artist’s recordings to the public and sold the releases through a variety of retail outlets. EMI’s extensive music catalog consisted of more than 3 million songs. Recorded-music division sales came from both new and old recordings with existing catalog albums constituting 30% to 35% of the division’s unit sales. Exhibit 3 contains a list of EMI’s most successful recording artists in FY2007. EMI Music Publishing focused not on recordings but on the songs themselves. Generally, there were three categories of publishing-rights ownership in the music industry: the lyric’s author, the music’s composer, and the publisher who acquired the right to exploit the song. These publishing-rights owners were entitled to royalties whenever and however their music was used. Music publishers categorized their revenue streams as mechanical royalties (sales of recorded 2
In the United Kingdom, companies typically declared dividends twice a year, first with the midyear results and second with the full-year results. Typically, EMI paid an interim dividend of 2p per share and a final dividend of 6p per share. In addition, both EMI’s interim and final dividends were paid out to shareholders in the following fiscal year. In November 2006, EMI’s board committed to paying the interim dividend of 2p per share following its 2007 fiscal midyear results with actual payment to shareholders expected in April 2007. Both the 2p interim dividend and the recommended final dividend would be reflected in the 2008 financial statements. 3
EMI included a fourth category of royalties labeled “other,” which included sales of sheet music and, increasingly, mobile ring tones and ring backs. Similar to the recorded-music division, the music-publishing division identified songwriters with commercial potential and signed them to long-term contracts. The division then assisted the songwriters in marketing their works to record companies and other media firms. EMI’s current publishing catalog encompassed more than 1 million musical compositions. Exhibit 3 includes a list of EMI’s most-successful songwriters in FY2007. EMI’s publishing business generated onefourth of the total group revenue. Revenue in the publishing business was stable, and operating profits were positive.
In addition to seeking out and signing flourishing recording artists and songwriters to long-term agreements, both EMI divisions also expanded and enhanced their individual catalogs and artist rosters by strategic transactions. Two key acquisitions for EMI’s recorded-music division were the 1955 acquisition of a leading American record label, Capitol Records, and the 1992 acquisition of Virgin Music Group, then the largest independent record label. Together the transactions added such key recording stars as Frank Sinatra, Nat King Cole, Janet Jackson, and the Rolling Stones. The music-publishing division similarly targeted existing publishing assets with large, proven commercial potential such as the purchase in various stages of Motown founder Berry Gordy’s music catalog in 1997, 2003, and 2004.
Since the company’s founding in 1897, EMI’s model had been that of “constantly seeking to expand their catalog, with the hits of today forming the classics of tomorrow.”4 Both divisions pursued the goal of having the top-selling artists and songwriters and the deepest, mostrecognized catalog assets. EMI welcomed technological innovations, which often drove increased music sales as consumers updated their music collections with the latest music medium (e.g., replacing an LP or cassette with the same recording on compact disc). But the latest technology, digital audio on the Internet, was different and revolutionary. Digital audio on the Internet demanded rethinking the business model of all the majors, including EMI.
Digital Audio and the Music Industry
Digital audio had been around since the advent of the compact disc (CD) in the early 1980s, but the 1990s combination of digital audio, Internet, and MP3 file format brought the music industry to a new crossroads. The MP3 format had nearly the same sound quality as CDs, but its small file size allowed it to be easily downloaded from the Internet, stored on a computer hard drive, and transferred to a digital audio player, generally referred to as an MP3 player. Peer-to-peer file-sharing Internet services, most notably Napster, emerged in the late 1990s. First available in mid-1999, Napster facilitated the exchange of music files. The use of Napster’s file-sharing program exploded, and Napster claimed 20 million users by July 2000.
EMI Group PLC annual report, 2007.
Napster’s swift growth did not go unnoticed by the music industry. While the Recording Industry Association of America (RIAA) was eventually successful in using the court system to force Napster to remove copyrighted material, it did not stop peer-to-peer file sharing. New services were quickly developed to replace Napster. The International Federation of the Phonographic Industry (IFPI), an organization representing the recording industry worldwide, estimated that almost 20 billion songs were downloaded illegally in 2005.
EMI was an early presence on the Internet in 1993. In 1999, EMI artist David Bowie’s album, hours…, was the first album by a major recording artist to be released for download from the Internet. None of the record labels were prepared, however, for how quickly peer-to-peer file sharing would change the dynamics of the music industry and become a seemingly permanent thorn in the music industry’s side. In the wake of Napster’s demise, the music labels, including EMI, attempted various subscription services, but most failed for such reasons as cost, CDburning restrictions, and incompatibility with available MP3 players. Only in the spring of 2003, when Apple launched its user-friendly Web site, iTunes Music Store, did legitimate digital-audio sales really take off in the United States, the world’s largest music market. Apple began to expand iTunes globally in 2004 and sold its one-billionth download in February 2006.
According to the IFPI, there were 500 legitimate on-line music services in more than 40 countries by the beginning of 2007, with $2 billion in digital music sales in 2006. Despite the rise of legally downloaded music, the global music market continued to shrink due to the rapid decline in physical sales. Nielsen SoundScan noted that total album units sold (excluding digital-track equivalents) declined almost 25% from 2000 to 2006.5 IFPI optimistically predicted that digital sales would compensate for the decrease in physical sales in 2006, yet in early 2007, IFPI admitted that this “holy grail” had not yet occurred, with 2006 overall music sales estimated to have declined by 3%.6 IFPI now hoped digital sales would overtake the decline in physical sales in 2007.
Credit Suisse’s Global Music Industry Forecasts incorporated this view with a relatively flat music market in 2007 and minor growth of 1.1% to 1.5% in 2008 and 2009.7 The Credit Suisse analyst also noted that the music industry’s operating margins were expected to rise as digital sales became more significant and related production and distribution costs declined.8 Lehman Brothers was more conservative, assuming a flat market for the next few years and commenting that the continued weakness in early 2007 implied that the “market could remain tough for the next couple of years.”9 Many in the industry feared that consumers’ ability to unbundle their music purchases— to purchase two or three favorite songs from an album on-line versus the entire album at a physical retail store—would put negative pressure on music sales for the foreseeable future. A Bear Stearns research report noted:
While music consumption, in terms of listening time, is increasing as the iPod and other portable devices have become mass-market products, the industry has still not found a way of monetizing this consumption. Instead, growing piracy and the unbundling of the album, combined with the growing power of big retailers in the physical and iTunes in the digital worlds, have left the industry in a funk. There is no immediate solution that we are aware of on the horizon and in our view, visibility on sales remains poor.10
Recent Developments at EMI
The last few years had been incredibly difficult, particularly within EMI’s recordedmusic division, where revenues had declined 27% from GBP 2,282 million in 2001 to GBP 1,660 million in 2006. (Exhibits 4 and 5 show EMI’s financial statements through FY2007.) Fortunately, downloadable digital audio did not have a similar ruinous effect on the publishing division. EMI’s publishing sales were a small buffer for the company’s performance and hovered in a tight range of GBP 420 million to GBP 391 million during that period. CEO Eric Nicoli’s address at the July 2006 annual general meeting indicated good things were in store for EMI in both the short term and the long term. Nicoli stressed EMI’s exciting upcoming release schedules, growth in digital sales, and success with restructuring plans. EMI’s digital sales were growing and represented an increasingly large percentage of total revenues. In 2004, EMI generated group digital revenues of GBP 15 million, which represented just less than 1% of total group revenues. By 2006, EMI had grown the digital revenue to GBP 112 million, which represented 5.4% of total group revenues.
The expected 2007 digital sales for EMI were close to 10% of group revenues. Given the positive expectations for its 2007 fiscal year, financial analysts had expected EMI’s recorded-music division to see positive sales growth during the year. EMI’s surprising negative earnings guidance on January 12 quickly changed its outlook. EMI disclosed that the music industry and EMI’s second half of the year releases had underperformed its expectations. While the publishing division was on track to achieve its goals, EMI’s recorded-music division revenues were now expected to decline 6% to 10% from one year ago. The market and investor community reacted swiftly to the news.
With trading volume nearly 10 times the previous day’s volume, EMI’s market capitalization ended up down more than 7%. EMI further shocked the investment community with another profit warning just one month later. On February 14, the company announced that the recorded-music division’s FY2007 revenues would actually decrease by about 15% year-over-year. EMI based its new dismal forecast on worsening market conditions in North America, where SoundScan had calculated that the physical music market had declined 20% in 2007. The investment community punished EMI more severely after this second surprise profit warning, and EMI’s stock price dropped another 12%. British newspaper The Daily Telegraph reported shareholders were increasingly disgruntled with performance surprises.
One shareholder allegedly said, “I think [Nicoli]’s a dead duck. [EMI] is now very vulnerable to a [takeover] bid, and Nicoli is not in any position to defend anything. I think the finance director [Martin Stewart] has also been tainted because it suggests they did not get to the bottom of the numbers.” EMI analyst Redwan Ahmed of Oriel Securities also decried EMI management’s recent news: “It’s disastrous … they give themselves a big 6% to 10% range and a month later say it’s 15%. They have lost all credibility. I also think the dividend is going to get slashed to about 5p.”11 Exhibit 6 contains information on EMI’s shareholder profile.
As its fiscal year came to a close, EMI’s internal reports indicated that its February 14 forecast was close to the mark. The recorded-music division’s revenue was down, and profits were negative. The publishing-division revenue was essentially flat, and its division’s margin improved as a result of a smaller cost base. The company expected underlying group earnings before interest, taxes, depreciation, and amortization (EBITDA), before exceptional items, to be GBP 174 million, which exceeded analysts’ estimates. Digital revenue had grown by 59% and would represent 10% of revenue. EMI management planned to make a joint announcement with Apple in the next few days that it was going to be the first major music company to offer its digital catalog free from digital-rights management and with improved sound quality. The new format would sell at a 30% premium. EMI management expected this move would drive increased digital sales.
Management was pleased with the progress of the restructuring program announced with the January profit warning. The plan was being implemented quicker than expected and, accordingly, more cost savings would be realized in FY2008. The program was going to cost closer to GBP 125 million, as opposed to the GBP 150 million previously announced. Upon completion, the program was expected to remove GBP 110 million from EMI’s annual cost base, with the majority of savings coming from the recorded-music division. The plan reduced layers in the management structure and encouraged the recorded-music and publishing divisions to work more closely together for revenue and cost synergies.12 One headline-worthy change in the reorganization was the surprise removal of the recorded-music division head, Alain Levy, and Nicoli taking direct responsibility for the division.
The Dividend Decision
Since the board had already declared an interim dividend of 2p per share in November 2006, the question was whether to maintain the past payout level by recommending that an additional 6p final EMI dividend be paid. Considering EMI’s struggling financial situation, there was good reason to question the wisdom of paying a dividend. Exhibit 7 provides a forecast of the cash flow effects of maintaining the dividend, based on market-based forecasts of 11
Alistair Osborne, “Nicoli ‘a dead duck’ as EMI issues new warning,” Daily Telegraph, February 16, 2007. Restructuring efforts over the previous three years had collectively saved the company GBP 180 million annually; however, the result was a one-time implementation cost of GBP 300 million.
Omitting the dividend, however, was likely to send a message that management had lost confidence, potentially accelerating the ongoing stock price decline—the last thing EMI needed to do.13 (Exhibit 9 depicts trends in the EMI share price from May 2000 to May 2006.) Many believed that music industry economics were on the verge of turning the corner. A decision to maintain the historical 8p dividend would emphasize management’s expectation of business improvement despite the disappointing recent financial news. Forecasts for global economic growth continued to be strong (Exhibit 10), and reimbursements to shareholders through dividends and repurchases were on the upswing among media peers (Exhibit 11). As Stewart navigated his way home, the radio played another hit from a well-known EMI artist. Despite the current difficulties, Stewart was convinced there was still a lot going for EMI.
Historically, there was strong evidence of significant negative stock-price reactions to dividend cancellations (see Balasingham Balachandran, John Cadle, and Michael Theobald, “Interim Dividend Cuts and Omissions in the U.K.,” European Financial Management 2:1 (March 1996), 23–38, for a study using only British firms, and Roni Michaely, Richard Thaler, and Kent Womack, “Price Reactions to Dividend Initiations and Omissions: Overreaction of Drift?” Journal of Finance, 50, 2 (June 1995), 573–608, for a larger study using U.S. firms. Both academics and practitioners vigorously debated the impact of dividend policy. In fact, Nobel laureate economists had argued that dividend policy should maintain little relevance to investors. Exhibit 8 contains a summary of Modigliani and Miller arguments.