Musical Chairs

Warner Music Group, EMI, and Hugh Hendry

Stuart Fieldhouse
Originally published in the July/August 2006 issue

There is a wide range of views regarding just how proactive fund managers should be as shareholders. Talk to the directors of some major European companies, and they will privately express an ardent desire that fund managers simply get back in their boxes. This was certainly the view of one senior German executive I spoke to in the wake of Deutsche Börse’s failure to acquire the London Stock Exchange.

Yet fund managers will continue to surface in the national newspapers, urging corporate management and shareholders towards courses of action they feel will benefit the share price. For some, this is a tactic they resort to regularly, for others, it is a final resort when it becomes obvious that management is simply not reacting to shareholder concerns.

One recent case was that of EMI, the UK music publisher, and Warner Music Group. EMI had made two offers for Warner this summer, but the stakes were raised when Warner went into battle, with a counter-offer for EMI. Into the midst of this walked hedge fund manager Eclectica Asset Management, and its contrarian CIO Hugh Hendry. It was Hendry who raised the flag for shareholders when he wrote to the Financial Times on 5 July, demanding that a future merged Warner/EMI entity be led by Warner Music boss Edgar Bronfman. “He and his private equity associates have a strong record of creating shareholder value,” Hendry said in his letter. “We believe that as a chief executive officer with a substantial financial interest in the company he would be able to generate superior value compared with the EMI management, which has minimal equity holding in EMI.”

Hendry said that, as a Warner Music shareholder, he would insist Warner finance its transaction with the maximum amount of debt, and without equity issuance. “We believe the increase in leverage would make sense for Warner shareholders because of the substantial savings expected by combining both companies,” he said in his letter.

According to Hendry, the letter to the FT was a last resort, and came following little progress with the management of EMI. It was an attempt to sound out like-minded investors in the company, but he admitted that he had had little feedback from other investors, although Eclectica had been to visit a number of other investors in EMI to present its case.

With the pre-deal rhetoric heating up in the financial pages in early July, Eclectica had 17% of its fund invested in EMI, as well as a stake with Warner Music Group. “Our role as asset allocators has become very difficult because of auto-correlation,” Hendry told The Hedge Fund Journal in the second week of July. “EMI correlated with our global macro view: we have held it since last year.”

Hendry follows a very precise formula when it comes to picking companies to invest with: he uses long-term price data and charts to point out when bear markets have finished and when there is evidence that they are entering a primary bull phase. Positions are cut and sold entirely when they breach the appropriate moving average of the price. The very longest moving averages are used to determine the primary position. The signal to take an interim profit will come when the traded price drops through a shorter term moving average. Hendry is seeing potential for there to be a bull market in the music publishing industry, which up until recently has been broadcasting strong bearish characteristics. He is seeing consolidation in the sector, and the IPO of Warner Music Group itself in 2005 has, in his view, helped to create a more positive vibe.

Hendry’s style of investment management is very much founded on his own convictions and criteria: “We’ve had lots of endorsements,” he says of Eclectica’s approach. “We feel as if we’ve been vindicated. I do not need management, I do not read research, I do not talk to stock brokers.” As a manager, he very much likes to chart his own course, and avoid correlating his fund with those of his peers. “We are looking for situations where macro change will bring benevolent factors. One of the truths in the world of capitalism is that any good idea gets copied, but if you’re a contrarian, it’s hard for anyone to come and copy you. Information is evil – I don’t even have a Bloomberg terminal!”

In the case of EMI/Warner, he met with both companies to offer his services as a shareholder and seasoned investor, as well as someone who is very interested in the prospects offered by music publishers. “It’s been very unpleasant if you’ve held EMI for the last five years,” Hendry says, of a stock that has seen 80% of its value disappear over that period. “By the end of the first quarter this year it was the seventh most heavily shorted stock in the UK. I was keen for them to know that we’d come in, that they could use our enthusiasm, and embrace the future with some bombasity.”

Bullish on music

“Its strength is its lack of cyclicality,” Hendry says of the music publishing industry. “You can see this when an artist securitises their revenue.” He cites the example of David Bowie, who in 1997 became the first music star to issue bonds using future royalties as security, making financial history when he raised $55m through the issue of 10-year asset-backed bonds, the collateral consisting of future royalties from 25 albums he recorded before 1990. “The Beatles are not making any more Beatles songs,” Hendry says, “and the private equity guys have worked that out. This is not an ever-lasting supply curve.”

Although enthusiastic about the prospects of the music publishing industry, Hendry was dispirited with the lack of reaction from EMI to his concerns as a shareholder, particularly about any proposed financing of an acquisition of Warner Music Group. “The structure is timid,” he said in July. “It really deflates the potential return.”

With EMI planning to finance its acquisition of Warner Music Group by issuing more equity, Hendry was wondering whether the company’s management was caving in to regulatory concerns. “It’s not the fact that we own more than Standard Life but can’t get a hearing,” Hendry said, “it’s the fact that the EMI management team can’t see what we’re concerned about. The failure to embrace the logic of the argument is more of a concern than the failure to recognise the size of our position. [They] are accepting ex ante that the regulator will not allow them to combine the publishing businesses…they should take on the regulator.”

The process of offer and counter-offer was finally derailed by the announcement of the European court of first instance, which torpedoed the merger of Sony and Bertelsmann’s BMG. The ruling cast serious doubt on regulatory approval of a Warner/EMI merger either, and both sides admitted the deal was off in the last week of July.

By writing to the FT, Hendry was hoping to mobilise support from some of the long-only managers for his position. Fidelity, for example, was sitting on a 15% stake in EMI. But Hendry remained perplexed with a lack of action or support from other EMI investors. He remains baffled at the idiosyncratic nature of the European court, which ruled on a procedural rather than economic issue in the Sony/BMG case. EMI still constitutes 13-14% of his NAV, and if he is trimming his exposure, it is largely because of activity elsewhere in his portfolio, and the consequent risk management dictats. Ultimately, he still feels positive about EMI’s future prospects, and confidently expects that eventually, despite 20 years in the doldrums, EMI will provide its worth.