A big year for digital

In recent years the music industry has faced challenging trading conditions brought on by rapid changes in technology. Despite all of its promise, digital music has until recently been a thorn in the side of music distribution businesses because of the problems associated with piracy. We believe however that legitimate digital music is now establishing itself in a significant manner in the marketplace. Full year results from the EMI Group (EMI) seem to confirm this position. Going forward, we believe that digital music will underpin earnings growth at EMI, aided by improving physical sales and cost savings initiatives.

From a technical perspective, the past four months have witnessed EMI consolidate in a relatively tight range between 258p and 224p following a sharp correction in February. Once the present consolidation is complete, we anticipate EMI regaining upward momentum. As the weekly chart depicts, the shares remain at historically low levels and we believe this provides significant upside potential.

Last year's challenging conditions contributed to group sales declining by 8.4 percent to £1,942.8 million. Excluding adverse exchange rate movements however, turnover only declined 5.1 percent. As a result, profit before tax, amortisation and exceptional items were also lower at £141.9 million, a 13 percent decline on last year. As previously stated above, due to the foothold that the fast growing digital music market has established, we believe EMI's performance this year will be markedly better.

The music division was impacted significantly by lower than anticipated reorders in the fourth quarter and a delay in the release of two major albums. As a result the division's sales declined by 7.4 percent on a constant currency (CC) basis as market share fell from 13.5 to 12.9 percent.

Since the end of EMI's financial year, we have been encouraged by the commercial success of two delayed releases from Coldplay and Gorillaz. EMI Music also completed restructuring initiatives during the year which delivered costs savings of £35 million with an additional £15 million expected this year. We are impressed by the group's focus on both revenue enhancement through artist development and cost containment via continued efficiency drives.

Music Publishing at EMI had a much better performance as turnover rose 4.9 percent on a CC basis. We are heartened by the company's ability to maximise the potential of its music catalogue. As the world's largest music publisher, we believe the publishing division is well positioned to continue performing strongly as new applications emerge, particularly in digital format.

Both divisions are however making solid progress in the promising digital music market. Total digital music revenue more than tripled last year to £49.7 million, representing 2.5 percent of total group sales. Starting from a low base, Music and Publishing increased digital sales 300 and 90 percent respectively. The creativity and technology behind services such as iTunes and 3G mobile phones has spurred growth in the digital market and this has in turn meant that downloads and mobile music products have gained widespread acceptance. We are heartened to see EMI embrace these changes and maximise the value of its extensive music portfolio.

Deriving profit from digital sales will not come only from providing consumer friendly access solutions, but also an aggressive response to piracy. EMI along with other industry participants are taking this fight seriously and have now initiated 12,000 lawsuits internationally. Statistics from IFPI, which represent the recording industry worldwide, show a significant drop in the number of illegal music files on the internet. We believe this indicates the anti-piracy initiatives are working. EMI is also collaborating to enhance copyright protection with various governments around the world with weak intellectual property protection laws.

We believe with a popular stable of music artists, EMI will deliver improved performance as the industry stabilises. In addition to new product development, maintaining healthy growth rates in the digital music sector will also require continuous enforcement of copyright protection. We strongly believe these initiatives will continue at both the company and industry level. In our opinion robust growth in legitimate digital music will underpin earnings as they contribute a larger percentage of group sales.

We believe the latest price action in EMI is constructive. The shares have established a base between 230p and 224p which is encouraging and this should mitigate downside risk. With resistance at 280p being our initial target, EMI has considerable upside potential over the medium to longer term in our opinion. As such, EMI will remain firmly held in the Fat Prophets Portfolio.