Description

Handleman Company is trading below liquidation value, at 0.79x tangible book, and is cash flow positive.

HDL sold its Anchor Bay Entertainment subsidiary in fiscal 2004, and its Madacy Entertainment subsidiary in fiscal 2003 to focus on its core category management business. In order to diversify its revenue streams and broaden its customer base, the company acquired privately held Crave Entertainment (a distributor of video game hardware, software and accessories).

Handleman Company now operates in two business segments: category management and distribution operations (93.5% of sales)  and video game operations (6.5% of sales). As a category manager, the Company manages a broad assortment of prerecorded music titles to optimize sales and inventory productivity in leading retail stores in the US, Canada and UK. HDL represents approximately 11% of all music sold in the U.S., 10% in the UK and 26% in Canada. In addition, with the acquisition of Crave Entertainment, Handleman now is also a distributor of video game hardware, software and accessories to major retailers throughout the U.S. The company was the subject of compelling writeups in the past on this board. This writeup will serve to update on the current situation.

Music industry

a)      In the music industry, mass merchant retailers continue to outperform the music industry and take market share from chains and independent retailers. For example, in the US, between the years 2000-2005, Mass merchants increased sales by 4.3% (from 240 to 250 million units), compared to Chains whose sales decreased by 39.2% (456 to 277 million units) and Independents whose sales decreased by 62% (123 to 47 million units). In Canada, Mass merchants increased sales by 47% during the same period compared to a loss of 35% for all other retailers. In the UK, between 2003-2005, mass merchants increased share from 21% to 25%. In other words, HDL serves a customer base that is growing its market share,

b)      Managing the music selection at stores is complex. Over 44,000 new titles are released every year and over 338,000 unique titles are sold. It takes over 40,000 unique titles to maximize sales in the 3000 retail stores serviced by Handleman in the US. Managing the Top 10 titles in each store (over a three month period) requires over 300 unique titles but represents only 12% of total music sales. During the same three month period, managing the top 350 titles requires 10,000 unique titles and represents only 60% of total music sales.

c)      It thus makes sense for a typical retailer to hand over the category management to HDL.

Video game hardware, software and accessories

a)      The Console video game market generated $9.8 billion in 2004 ($6.2 billion from Software, $2.4 billion from Hardware and $1.2 billion from accessories). It is projected to grow at 9.2% annually between 2005 and 2009

b)      The console video game industry is comprised of platforms from three manufacturers: Sony, Microsoft, and Nintendo. Hardware introductions typically run in a 7-10 year cycle.

c)      All three major hardware manufacturers are introducing enhanced platforms (Xbox 360, PlayStation3 and Nintendo Revolution) During a platform lifecycle, consoles are typically introduced at a high price point ($299-$399), and then gradually lowered as the adoption rate grows. Software sales typically lag the growth in hardware sales by a year. During the previous platform cycle, software sales grew at approximately 11% annually

d)      Like music, console video game publishers are responsible for the development and publication of content for specific hardware and distribution oversight.

e)      However differences between the two segments lie in the way console video game publishers sell software. Typically, software is sold one-way, with markdown dollars allotted instead of store returns. In addition, they often distribute lower-priced software through third parties.

In FY2006, HDL did $1.31 billion in Sales, $225.5 million in Gross profit (margin of 17.2%) and Operating profit of $15.45 million (margin of 1.2%). This compares to $1.26 billion in Sales, $244 million in Gross profit (margin of 19.38%), and $50.8 million in Operating income (margin of 4%) in FY2005. The stock price also has declined in recent years to a price of $8.21. The challenges facing the company have been

a)            Softness in the US music industry. During FY 2006, U.S. music industry sales were down nearly 6%, and the industry results within the UK and Canada were similar. Basically, there have been very few new releases that have generated excitement to drive sales. For example, during calendar 2005 the number of albums that sold over one million copies during the year declined to 48 from 70 in 2004. In comparison, there were a 100 albums in the year 2001 that sold over a million copies. Legal digital music sales continue to grow. This category represented 7% of total industry dollar sales in 2005. Digital downloads and online purchases of physical CDs represent 11% of industry sales.

b)            Videogame sales are expected to be spurred by the next generation of video game consoles by Sony and Nintendo during 2006. Each of these new devices will offer enhanced graphics and playing features, thus stimulating consumer demand for software. However, Sony Corporation announced that due to production problems they will only have a limited number of PlayStation 3 units available when the new game console launches in November. This has basically put a lot of software purchasing decisions on hold and PS3 sales will not contribute meaningful sales to software until 2007.

c)            Gross Margin Compression – The Company’s gross margin as a percentage of revenues has decreased because a large proportion of the Company’s revenues come from the UK, which carry a lower gross margin than the Company’s consolidated rate. Also, increased revenues attributable to less than full category management services, which carry a lower gross margin than full category management services, have negatively impacted the Company’s gross margin.

d)            The Company’s revenues were reduced by approximately $47 million due to the loss of 400 Kmart stores. Going forward (ie effective Q1 2006), HDL would provide category management and distribution to approximately 1,070 Kmart stores. In addition to this, Kmart assumed responsibility for the performance of in-store merchandising in all of its stores.

What the Company is doing to tackle these issues :

a)      The company is shareholder friendly. They are focused on reducing costs and generating free cash flow. In addition, HDL is implementing a strategy of growth consisting of initiatives to cross-sell music and video game products to current customers (aka Crave acquisition) as well as expand category management, logistics and in-store services.

b)      In June 2005, the company acquired REPS LLC. REPS provides nationwide in-store merchandising for home entertainment and consumer product brand owners at mass merchant, warehouse club and specialty retailers. The in-store merchandising structure of REPS is similar to the Company’s in-store merchandising structure, thus providing the opportunity to consolidate certain functions and generate cost savings and synergies.

c)      TESCO is the largest retailer in the UK. HDL announced that it will provide distribution, in-store merchandising and category management support for music, video and video games to Tesco PLC beginning in April 2007. This agreement allows Handleman Company to extend its core services to over 700 Tesco stores in the United Kingdom and is expected to generate approximately $50 million in annual revenue for the Company. What is good for HDL, is that there is no ownership of inventory (TESCO will own the inventory). This is expected to cost $20 million in capex for warehouse equipment, IT infrastructure and leashold improvements.

d)      HDL will also provide category management, logistics and in-store service to ASDA for greeting card distribution. Again, there is no ownership of inventory. The Company is also providing these services to a US retailer for Latin DVDs. This entry basically provides an opportunity for them to enter into other DVD genres and customers.

e)      HDL has initiated a program to get $20 million in annual savings. Initiatives include the relocation of Crave's distribution facilities into its existing facility at Indianapolis, combining REPS and Handleman’s in store service organization, freezing the Company's defined benefit pension plan, and adjusting employee healthcare benefits to market requirements. The Company is also initiating programs to reduce discretionary spending and improve service level efficiencies. These, already launched initiatives have yielded savings of $7 million to date. The Company is also considering ways to reduce customer returns and SKU reduction.

f)        Playstation 3 delay: Most of their Crave business is lower priced, or budget priced video games. Due to the delay in PlayStation 3, if Sony takes the PlayStation 2 from $129 to $99, it will basically open up a whole new segment of buyers. In addition there would be demand for budget video games that go along with it, because these buyers are not likely to buy a lot of high priced video games, if they are paying $99 for the hardware. This also holds true for the PSP. If that comes down in price then they could generate demand for the budget video game software. Thus, even with the delay in Sony’s PS3, these factors will determine what will happen in Crave.

g)      HDL authorized a 15% share repurchase program in February 2005. During fiscal 2006, the Company repurchased a total of 1,65 million shares at a total cost of $21.9 million and an average purchase price of $13.31 per share. Shares outstanding were 19,99 million as of April 29, 2006 compared to 21.45 million at April 30, 2005. As of April 29, 2006 the Company had repurchased 2 million shares, or 63% of the authorized shares under the 15% share repurchase program. This was the 6th repurchase authorization approved by the Board since 1997. Over $220 million has been spent since 1997 to repurchase nearly 16 million shares.

Downside and potential for profit -

a)      Enterprise value is $233 million. Book Value per share is $14.4. Tangible book value per share is $10.49. If you subtract the value of capitalized leases and pension under funding, adjusted liquidation value is around $8.72. Stock options, Performance shares, Performance units and Restricted stock are well out of the money (with weighted average strike prices of $15.91, $18.66, $16.61 and $13.02 respectively) so I have not considered them in the calculation.

b)      Receivables are clean, collectable from some of the strongest retailers in the world, so the only risk that you could ever have with receivables is if someone wanted to settle those with excess product returns. You would still get the product back. But from a pure collection standpoint, they are clean and collectable.

c)      The inventory is carried at the lower of cost or market. The Company’s music suppliers offer return privileges for excess inventory quantities, minus  some return charges of around a quarter a unit. So there would not be a substantial haircut if they had to be liquidated. Video game hardware and software are generally purchased as a one-way sale. The company stated in their Q4 2006 conference call that inventory would be down if not for the Crave acquisition. In other words, if we consider the excess ie $13 million as non-music inventory, it works out to $0.65 book. This certainly will have some value in a liquidation scenario. Nevertheless, giving it a 50% haircut and subtracting from adjusted liquidation value gives us $8.395 which is above the current stock price.

d)      In FY 2005, EBITDA was $32 million. Once the $20 million cost reduction initiatives bear fruition, EV/EBITDA (est.) would be 4.5. Since the Company is cash flow positive, it could trade (at a minimum) at tangible book value or 20% above the current stock price. If Crave starts ramping up, all that goodwill on the balance sheet will be actually worth something. If it trades at book value, the upside then is 75%.

e)      There is also significant upside from potential new music releases from well known artists like Justin Timberlake, Beyonce and  Janet Jackson which may spur music sales. In any case, given current trends, some hits are well overdue :o).

Risks :-

a)      Customer concentration - . The Company’s two largest customers represented approximately 83% of the sales during 2006 (74% Walmart and 9% K-mart). This is a risk and needs to be watched carefully.

b)      Music artists continue releasing duds.

c)      Further delays in PS3 may impact sales in Crave. Also, the results of Crave in the holiday quarter will depend upon how Sony prices PS2.

Catalyst