Music to the ears

EMI Group (EMI) is the world's third largest recorded music company, with a global market share of over 13 percent, and is the largest music publisher with the copyrights to over one million songs and compositions. In recorded music, the group has a broad portfolio of current recording musicians and an extensive catalogue of popular, classical and world artists. Included are famous recordings by the Rolling Stones, Queen, Spice Girls, Janet Jackson, and Robbie Williams. Record labels include EMI, Virgin, Capital, Parlophone, and Priority Records, with a broad portfolio of publishing rights.

EMI has endured a turbulent trading environment over the last decade which has impacted directly on the company's share price. EMI was a market favourite until the mid 1990's with the share price more than tripling in value over an eight year period. However this out-performance could not last indefinitely. Increasing competition and pressure on industry sales sparked a deep correction in the share price. From an all time high of 1,045p in 1996, EMI plummeted by more than 90 percent to a low of just 78p in March last year. Although prices have since rebounded off their lows, EMI remains a long way below the heady levels of only a few years ago.

EMI has endured continuing pressure on traditional revenue streams in recent years. In response management has sought to drive earnings growth via alternative means. We are encouraged by EMI's trading performance in the six months to 30 September 2004, with total operating profit (EBITA) rising 8.1 percent on last year to £80.1 million. While group turnover declined 11.4 percent to £851 million this was largely attributable to a light first half release schedule and a weak US dollar.

Turnover in the recorded music business declined by 7.2 percent in constant currency terms to £660 million, however we are comforted that this year's release schedule is heavily biased towards the second half of the year. Operating profit in EMI Music increased 18.4 percent in constant currency on the back of tight cost management, restructuring savings, and the decision to outsource manufacturing in Europe and the US. Encouragingly, EMI Music remains on track to deliver £50 million in annualised cost savings, £25 million of which will be realised this financial year.

We are confident that earnings at EMI Music will gather momentum in the second half, and we are heartened by management comments that sales in October and November are well ahead of last year. Popular releases have included a live album from The Rolling Stones and greatest hits albums from Robbie Williams, Tina Turner, Placebo and Blue. In addition we continue to be impressed by the quality of EMI's stable of talent following the significant success of new artists such as Joss Stone, Keith Urban and Yellowcard, as well as more established artists including Norah Jones, Lenny Kravitz, and Anita Baker.

For the six months ended 30 September 2004, EMI Music Publishing further strengthened its position as the world's largest and most successful music publishing business. Turnover increased by 1.1 percent to £191.0 million while operating profit rose 1.7 percent to £48.9 million.

Encouragingly there have been ongoing improvements in the landscape of the global recorded music industry. The decline in industry sales in the first six months slowed to 1.3 percent compared with a 9.6 percent fall last year. EMI now expects growth of 0 percent to -4 percent for the industry as a whole in the full year. It appears that a four-year decline in global music sales could end in 2005 amid a slowdown in piracy, the expansion of legitimate digital music, and signs of a rebound in the world's three leading music markets (US, Japan and Britain).

The threat of piracy has cast a dark cloud over the music industry in recent years so we are heartened that progress has been made to eradicate this. Industry bodies both in Europe and the US have taken action against illegal music file sharing. Total lawsuits in the US for instance now stand at more than 5,700.

We are particularly excited by the growth of the legitimate digital music marketplace and the likely impact on EMI's long term earnings. EMI's first half digital revenues more than quadrupled to £18.3 million and now represent more than 2 percent of sales. We expect full year earnings to be boosted by the recent launch of Apple's iTunes service (which allows songs to be downloaded via computer) in the UK, France and Germany. This service is already available in the US and there are plans to launch in Japan in March 2005.

Digital music also represents an exciting and fast-growing opportunity for EMI in the mobile music marketplace. Last month Microsoft launched MSN Music, which is compatible with mobile telephones as well as computers. This impressive new technology greatly increases the accessibility of legitimate digital music. Robbie Williams recently became the first artist in history to record an entire collection, plus video content, onto a memory card that inserts directly into a mobile phone.

As a result of restructuring costs and the phasing of the release schedule, EMI's net debt levels increased 30 percent during the last six months to £976.2m. There is still some way to go before we will be comfortable with EMI's balance sheet position, however we are confident that a strong second half release schedule combined with an ongoing industry recovery will see indebtedness fall from current levels. In the meantime we comforted that interest cover is solid at 2.1 times. Nevertheless the level of debt means that investment in EMI does carry a significant level of risk. We however believe this is offset by a substantially improved outlook for long term earnings.

Three years ago, EMI unsuccessfully attempted to merge with Warner Music, and late last year returned to the negotiating table to discuss a takeover proposal. Rumours continue to circulate about renewed merger talks following last year's failed tie up. We believe ongoing merger speculation will further underpin support for the shares. However we are confident EMI holds strong value on a standalone basis.

From a technical perspective we believe that a solid base has been established, and that an enduring recovery is now underway. This view is supported by the recent breakout from a bullish wedge formation that had originated in March. Bullish wedges are common chart patterns that often appear prior to the resumption of upward momentum.

Supporting further share price recovery are signs that negative industry growth is abating, now that the piracy issue is being tackled aggressively. We believe that the explosive growth of digital music through internet and mobile distribution channels will be a key earnings driver for EMI. At a 2005 price earnings multiple of 16 times and a yield of 3 percent, we believe the shares offer compelling value. We believe that the market has already priced in the negatives relating to the balance sheet. Fat Prophets recommend EMI as a Buy to all Members up to 245p. An initial target is resistance around 280p, however in time we believe higher levels are achievable.