Handleman Company [NYSE: HDL]
Though it’s been a cheap stock for years, we think Handleman now has entered the value-maximizing end game of its public existence and should be reconsidered by event-oriented investors. Our sum-of-the-parts, private market value is $24, up 125% from the current price. We expect this PMV to be realized within two years through either sales of divisions, a going-private transaction or an outright sale. Based on our detailed review of the business, we think we will do well holding HDL even if it retains the status quo.
Date 8-Apr-02 FY02E Net Sales $1,338,065
Price $10.63 FY02E EBITDA * $107,534
52-Week Range $9.34 - $17.89 Est. FY03 EBITDA $116,504
% of 52-Week Hi 58% EV/ FY03 EBITDA 2.8x
Ave Daily Volume (000s) 163 FY2002E EPS * $1.46
Shares O/S 26.9 FY2003E EPS $1.66
Market Cap. $285,756 2002 P/E 7.3x
Net Debt (4/02) $38,592 2003 P/E 6.4x
Ent. Value $324,348 FYE APR
* Excludes losses at Handleman Online and losses during FY02 from The itsy bitsy Entertainment Co. (discontinued).
Handleman is a leading distributor and category manager of recorded music [91% of revenue] with an entertainment business [9% of revenue] which licenses rights to home videos and operates an independent record label. It runs the music departments of 1/3 of all Wal-Marts, all international Wal-Marts, all Kmarts, and has begun to penetrate Best Buy and pursue Target. The company’s value-added to its customers is evidenced by the fact that domestic Wal-marts do about 2x sales/sq.ft. than other mass-merchants, including the self-managed Target.
Handleman was the subject of a compelling VIC write-up in March 2001 by Ad188 when the stock was below $10. It appreciated to $17 before running into issues related to the Kmart Chapter 11, which has knocked the stock back. However, the Kmart issues are minor and quantifiable and the overblown concern disregards several aspects of the HDL story which have turned very positive over the last year.
First, the core business has gotten stronger with good growth drivers in place for the first time in years. Primary growth opportunities for the HER (core category management) division are 1) increasing margins from sub-par to normal on 243 ASDA (Wal-Mart U.K.,) stores awarded to HDL last year; 2) eventually earning “parity” with Anderson at WMT (versus the 2/3 to 1/3 split today), which would mean an additional 400 stores, or a 20% increase in HER revenue; 2) winning TGT as a customer, which could add $400 million of annual revenue; 3) getting into more BBYs and doing category management, as opposed to just rapid replenishment and deep-catalog shipments [Handleman management believes they are under consideration for an expanded role at BBY].
Second, the company should begin to improve or eliminate certain operations to the benefit of cash flow going forward , e.g. 1) the closure of The itsy bitsy Entertainment Co. [TibECo], which will save more than $5 million annually; 2) the monetization of NCE (Handleman’s entertainment unit) by curtailment of title acquisitions or outright sale; 3) rebounds in unprofitable Wal-Marts in Mexico; and 4) getting to breakeven at Handleman Online.
Lastly, and most importantly, we see evidence that management, led by CEO Steve Strome, is finally being proactive about maximizing shareholder value. We understand the company is working with a well-regarded investment bank to explore strategic alternatives. We suspect the Kmart situation may have put certain plans on hold for now. However, the core business looks eminently MBO-able if the non-core divisions are monetized in support.
As for K-Mart [KM], the company’s 2nd-largest customer which represented 35% of FY2001 revenues the announced store closures should have a -3% revenue impact in FY2003, but little effect on the bottom line. Management notes that the closure of the 284 weakest stores identified by K-Mart were poor-performing stores for HDL as well. Even if KM ends up closing additional stores, management asserts that 1) the units will likely be poor performers, whose loss will not significantly hurt the company; 2) HDL will probably not lose all the revenue anyway, since HDL serves 1/3 of all U.S. Wal-Marts; and 3) the company has stated that Wal-Mart is a significantly more profitable customer than KM anyway.
Our private market valuation of Handleman assumes:
A financial buyer pays 6.0x core FY03 HER EBITDA of $94 million, or $20.90 per share.
The NCE unit is monetized for between $70 million (in liquidation) and up to $120 million at auction, or $3.50 per share at the mid-point.
Zero value for Handleman Online
Less than $10 million net debt at the end of FY03 (-$0.35 per share).
Total value: $24.05 per share, up 125% from the current price.
The current entry point should also have little downside due to its attractive valuation of less than 2.8x core business EBITDA with low capital investment requirements and a 6.4 P/E. The company has been a consistent buyer of its stock at these levels.
Handleman Company is a holding company that conducts business through two subsidiaries: Handleman Entertainment Resources (HER) and North Coast Entertainment (NCE). HER is a category manager and distributor of pre-recorded music to mass merchants in the United States, United Kingdom, Canada, Mexico and Brazil. HER manages a broad assortment of titles required to optimize sales in retail stores and provides direct-to-store shipments, marketing of the selections, in-store merchandising, and product exchange. NCE has two companies in its portfolio: Anchor Bay Entertainment, an independent home video label that markets a collection of titles ranging from horror to exercise to children's classics; and Madacy Entertainment, an independent record label that markets music and video products with a catalog spanning all genres.
The company is headquartered in Troy, Michigan and incorporated in Michigan. HDL has 2,700 employees. The company owns its 130,000 square foot corporate office building.
FYE 4/30 2001 2002E 2003E
Music Category Manager $1,064,003 $1,224,323 $1,285,539
Independent Records/Videos $128,887 $113,742 $125,000
Total Revenue $1,192,890 $1,338,065 $1,410,539
EBITDA * $104,983 $107,534 $116,504
EBIT $71,042 $66,337 $71,125
FCF * $54,867 $57,210 $75,504
EPS * $1.53 $1.46 $1.66
Market Cap $310,001 $276,058 $276,058
Net Debt ** $33,957 $38,592 $8,731
Enterprise Value $343,958 $334,297 $304,436
EV/EBITDA 3.3x 3.1x 2.8x
EV/EBIT 4.8x 5.0x 4.3x
EV/FCF 6.3x 5.8x 4.3x
P/E 7.4x 8.0x 6.4x
* Excludes losses at Handleman Online and FY02 losses from The itsy bitsy Entertainment Co. (discontinued).
** Net debt is sharply reduced from reported Q3 (Jan) due to a large Kmart recievable collected in Feb.
MANAGEMENT & BOARD; SHAREHOLDER BASE
Stephen Strome, Chairman & CEO – Appointed Chairman in 2001. Has been CEO since 1991. Beneficially owns 2.0% of the outstanding stock. In FY2001, Strome was paid $566,923 in salary and $550,000 in bonus. Steve is well-regarded in the industry and has a very good relationship with Wal-Mart
Peter Cline, President & COO – Named COO in 2000. Was EVP of HER since joining company in 1994. Owns 111,879 shares. Cline is also president of the National Association of Recording Merchandisers [NARM]. In FY2001, Cline was paid a salary of $384,068 and bonus of $325,000
Tom Braum, CFO – Controller since 1988. Appointed CFO in 2001. Owns 10,000 shares
Board consists of 9 members, including 3 inside members [Strome, Cline, Handleman].
Institutional shareholders are the usual mutual funds, with Fidelity [9.7%], Franklin [7.1%] and Dimensional [6.7%] being the largest.
BUSINESS SEGMENT OVERVIEW
Handleman Entertainment Resources [HER]
Handleman’s legacy business is a category manager for music at mass merchandisers and chains. HDL handles everything from ordering, shipping and stocking, to replenishing and recycling. HDL’s value-added to its customers is its ability to optimize profits in the music category for its retail customers through sophisticated inventory management and ordering systems, years of experience and a nationwide footprint. Their experience and wide geographic coverage enables HDL to knowledgeably order the right CDs in the quantities and frequencies that generate more profit for retailers than they could on their own. The category management service is not right for all retailers of recorded music - stores that choose to sell only Top 40 albums or otherwise offer a limited selection will not benefit from having a category manager, because the service is not necessary. However, for retailers willing to spend at least $50k per store on inventory, this service is worthwhile. The company believes their best prospects for the category management business are TGT, CC, Fred Meyer, and BBY [already being served for rapid replenishment]. According to the company, these customers could easily represent $400 million of potential incremental sales.
Recycling is the company’s term for returns, since most returns are actually shipped to other stores for sale there, rather than sent back to the record labels. For merchandise that still cannot be sold, the company can return the product to the labels at cost, though the company bears the freight cost. In FY2001 18.7% of COGS were returned, down from 28.2% in FY1997, with about half of that being “recycled”. Actual obsolescence is less than 0.5% COGS. HDL does not price the merchandise at the retail level, but rather recommends pricing to its customers, which is not necessarily the same as the record labels’ suggested retail prices.
Note that average music returns for the industry, including all units purchased by the distributor but not sold to the retailer, were 16.4% of purchases in 2000, versus 14.6% for HDL. Inventory turns were 3.2x for the average retailer, versus 8x for HDL. The difference is largely due to specialty stores, which carry many items that turn 1x per year.
The U.S. music industry is approximately $10 billion and was growing modestly until 2001. Unit sales were down 5.3% in 2001, as 0.8% unit growth in CD album units [89.7% of all units sold] was offset by declines of cassettes [down 36.0%] and CD singles [down 34.6%].
Mass merchants such as Wal-Mart [WMT], Target [TGT] and KM have been taking share from the specialty stores for years. The mass merchants [Big 3 plus Shopko, Fred Meyer and Meijer Hypermarkets] now account for 30.1% of total U.S. industry sales [Q3 FY2002] and this share has been growing steadily at the expense of chains [down to 53% from 57% in 1998] and independents [13.8% down from 14.3%]. The other channel growing steadily is “non-traditional”, which includes direct mail, music clubs, QVC/HSN, and online sales, and has grown to 2.9% from 0.9% in 1998. HDL’s share has risen to 11.2% in 2001 from 7.4% in 1996 as alliances with WMT and KM have driven growth.
Capital expenditures. Category management requires capex of $5k - $10k per store in fixtures, depending on the size of the store. These fixtures last at least 5 years and, even if a store is closed or remodeled, the fixtures can often be reused elsewhere. Maintenance capex on an annual basis is almost nil, but the fixtures are generally replaced every 5 years. For the base of 900 WMTs and 1800 KMs [after closings] and assuming the maximum of $10k / store, it would cost a maximum of $27 million to replace the fixtures, or $5.4 million per year over 5 years.
Facilities. The company has 4 automated distribution centers in Reno, Indianapolis, Toronto, and Warrington [UK] and 10 sales offices in the U.S. and Canada. The state-of-the-art Indiana DC receives products from the record labels as well as returns from the retailers, which are redeployed. The company is currently operating at 60% - 65% of capacity with 16-hour days [2 shifts] five days a week. During the peak processing period of December, the utilization rate reaches 99%, but can easily add capacity by running 20-hour days and/or adding 5-hour Saturdays.
The table below summarizes HER financial performance:
FYE 4/30 2001 2002E 2003E
Revenue $1,064,003 $1,224,323 $1,285,539
Operating Income 66,123 65,510 68,376
Depreciation * 16,004 19,599 20,579
EBITDA 82,127 85,109 88,955
CapEx (22,011) (29,750) (22,000)
FCF 60,116 55,359 66,955
HOL (10,000) (10,000) (5,000)
Base Business FCF 70,116 65,359 71,955
* Assumes all Depreciation is in the HER segment.
North Coast Entertainment [NCE]
NCE consists of Anchor Bay (purchased in 1989) and Madacy Entertainment (purchased in 1995). NCE represents a bid by management to diversify HDL’s customer base, improve margins, and control their own destiny through the ownership or licensing of rights to titles / artists. Additionally, management felt they could leverage their distribution network through the addition of proprietary content.
North Coast as a whole has experienced deteriorating operating income for the 3rd year in a row in FY2002. Though the company does not disclose revenue or profitability within the segment, they have stated that revenue is split roughly 50/50 but that recent performance has been strong at Anchor Bay [videos] and weak at Madacy.
The market for home video purchases was estimated to be $13.7 billion at retail in 2001 [$7.2 billion of VHS and $6.5 billion of DVDs] according to Veronis Suhler’s forecast in 2001. Growth of purchases is estimated at about 8% in 2002, with increases in DVD sales being partially offset by declines in VHS sales. Note that rentals generate another $11 billion of revenue at retail.
Anchor Bay has over 600 titles in it portfolio and is the 11th largest player in the U.S. Anchor Bay plays in several niches, such as cult horror films [i.e. Man Hunter, the precursor to Hannibal and Silence of the Lambs, Halloween and The Evil Dead series] and workout videos [i.e. Billy Blanks in an early Tae Bo classic]. Historically strong performers such as Thomas the Tank Engine are supported by more recent hits such as Crunch series and Yoga for Dummies. Because of hits such as Crunch, Tae Bo and Dummies, Anchor Bay has a 15% share of the exercise market. Thomas has given Anchor Bay a steady 4% of the children’s market. In terms of concentration, Anchor Bay derives 25% of its revenues from the Thomas series and 26% from the next 6 series’ [The Evil Dead, Man Hunter, Halloween, Crunch, Dummies, Heathers]
Madacy has licensing rights to over 100,000 recordings and 650 movie titles. The market for independent music in which Madacy competes is also known as the “catalog” segment, which historically has represented about 35% of music sales, versus 65% new releases. [Catalog is defined as those releases which are more than 15 months old]. Theoretically, this would be $3.5 billion at the retail level, though the amount that fits into “budget” is far smaller. While Madacy does have some major artists such as Merle Haggard and Don McLean, over 90% of their sales come from the “budget” category, generally defined as CDs under $10. According to Billboard Magazine, Madacy is the largest independently distributed record label in North America. Madacy’s products cover all genres.
Anchor Bay and Madacy bid on the rights to distribute titles [usually exclusively] for a period of 5 to 7 years. Often, due to the popularity of the title, acquisition of these rights requires an up-front payment by the company. This payment is capitalized and amortized over the shorter of the life of the agreement or the period in which the revenue was recouped.
The table below summarizes NCE performance:
FYE 4/30 2001 2002E 2003E
Revenue $128,887 $113,742 $125,000
Operating Income * $4,271 $57 $2,749
Amortization $4,945 $5,694 $2,800
Recoupment of Licenses $12,992 $16,036 $17,000
EBITDA $22,208 $21,787 $22,549
Acquisition of Licenses ($22,965) ($16,908) ($17,000)
CapEx ($4,492) ($3,028) ($2,000)
FCF ($5,249) $1,851 $3,549
* Excludes $12.7 million of operating losses from The itsy bitsy Entertainment Co. in FY2002.
Advanced Marketing Services [MKT; $24] is a category manager for books at retailers. The company derives 76% of its revenue from Sam’s Club and Costco. MKT has FYE 3/02 revenues and EBIT of $739 million and $41.5 million, respectively. The company has no debt and $30 million of cash, and a $462 million market cap, or an enterprise value of 10.4x 3/02 EBITDA. With estimated EPS of $1.19 for FY 3/02 and $1.32 for CY02, it trades at 20.1x FY 3/02 and 18.2x CY02 EPS.
Global Sports [GSPT; $17] provides fulfillment for online sporting goods sites. The company has trailing revenues of $103 million as is not profitable, though is expected to double revenues this year and generate CY02 EPS of $0.28. GSPT trades at 21x CY03 EPS of $0.83.
Private comps include:
Anderson is a private firm based in Alabama, has $4 billion in estimated revenue, with $800 million coming from WM, which represents 2/3 of all WMs.
Alliance is a leading distributor of some 300,000 items -- CDs, videos, DVDs, games, and related products -- to home entertainment retailers (both online retailers and traditional bricks-and-mortar stores). Customers include Barnes & Noble, Blockbuster, as well as major mass-market retail chains such as Walgreens, Eckerds, BJ's Wholesale Club and the majority of the domestic independent retailers. The Yucaipa Companies acquired a majority stake of Alliance in 1999. Alliance emerged from Chapter 11 bankruptcy in 1998. HDL points out that Alliance is not a category manager, so their value added is less and their margins are likely less.
Baker & Taylor
B&T is the #1 book supplier to libraries; B&T has three operating units. Its institutional segment distributes books, tapes, calendars, CDs, DVDs, and videos to some 8,000 schools and libraries around the world. It retail unit supplies storefront and Internet retailers, including Amazon.com, and independent booksellers. The Carlyle Group and its affiliates own nearly 85% of B&T [acquired in 1991]. HDL believes B&T operates on razor thin margins.
HDL has been supplying WMT since 1972. In 1991, WMT acquired Western Merchandisers, a competitor of Handleman, and effectively internalized over 20% of their music category management, with HDL and Anderson Companies doing the remaining stores. In 1994, WMT sold Western to Anderson, and since then the split of WMT stores between Anderson and HDL has been roughly 2/3 to 1/3. As of January 2002, there were 2,713 Wal-Marts and Supercenters in the U.S. [up 7.6% over January 2001], of which 918 or 34% are served by HDL [up 4.9%]. The number of WMT stores served increases according to new WM openings, with HDL getting all new stores east of the Mississippi and north of the Mason-Dixon Line. HDL serves 100% of the WMTs outside the U.S., as Anderson does not have international operations.
According to HDL management, music sales per square foot at WMT are $900, or more than 2x the average sales per square foot [$385 for Discount Stores and $422 for Supercenters]. With the approximate 11% gross margin WM gets on music [using low number for simplicity] versus the 22% overall gross margin, the music category for WMT would appear to net out to an “average” product category. However, taking into account the ordering/ stocking/ replenishing that HDL provides for WMT, the contribution margin to WMT is well above the average. Thus, this is an important category for WMT.
KM is in Chapter 11, and they are closing 284 stores. HDL thinks they might close an additional 20. HDL serves all KM stores, so obviously this affects them. HDL did their own analysis of the bottom 300 KM stores they service, and there was substantial overlap with the results of KM’s analysis. While the average KM generates $190k / year of revenue for HDL, these bottom 300 only average $100k. At a 22% average gross margin, these stores barely cover the SG&A required to service these stores. Thus, the net impact to HDL of closing these stores will be a 3% reduction in revenue, and no effect on the bottom line. There is a risk that KM closes a substantially larger number of stores or is even liquidated. A side effect of further KM deterioration is that many of those KM shoppers will go to WMT, which has on average, a 1/3 chance of being served by HDL. The downside is that this would make the company more dependent on WMT.
HDL believes KM will emerge from bankruptcy according to plan, and they see no big issues over the next 24 months. Beyond that, HDL management acknowledges the picture becomes cloudy. However, with $37 billion of revenues, there are clearly many other much larger suppliers who have it in their best interests to keep KM alive.
Growth. On the category manager side, growth has historically come from the addition of new Wal-Marts and K-Marts, same-store growth at existing stores, and the addition of new customers. Management believes HER can grow in the mid-single digits with existing customers. At NCE, growth is tied closely to the number of titles acquired for both Anchor Bay and Madacy. Madacy’s growth, however, is currently stagnating as music industry sales were down in 2001 doe to piracy and weakness in the economy.
Gross margins. Gross margins declined in FY02, primarily from price pressure from retailers on the CD side and the higher returns from retailers that stem from a weak economy.
SG&A. Labor [selling, warehouse, benefits] is a substantial and mostly fixed cost for the company, representing ½ of SG&A expenses. Freight to and from the company’s warehouses represents another 15% of sales, as the company is responsible for all shipping. UPS is used for most everything, and some volume discounts are received.
Working capital. Improving inventory turns are evidence of scale economies. Blended inventory turns are about 8x-9x, which consists of 9x in the U.S., 8.8x in Canada, 4x in the U.K. and 2x in Mexico. The company believes it can achieve minimum efficient scale in the U.K. and Mexico, and eventually achieve turns similar to the U.S. and Canada. However, given the small size of these businesses today, 8x levels are probably several years away.
Capex. As discussed above, maintenance capex is $5 million / year for HER [replacement fixtures] and $3 million / year for NCE, most of which is for software/hardware spending. Growth capex for HER will be another $5 million for fixtures and $12 million for IT spending, including $1 million at HOL.
Stock buybacks. The company has repurchased 6.5 million shares for $75 million during the last three years [average price of $11.52 per share]. While the company has 1.9 million shares remaining under current buyback authorizations [through March 2002.
In estimating the private market value of Handleman, we first assumed that NCE were monetized to provide asset support for the takeout of the core business. At the low end this is accomplished by simply letting NCE “run off”, i.e., curtailing reinvestment in new titles of an estimated $17 million per year. Cash flow should be immediately boosted by the same amount and the run off should last 7 years with declining contribution in the out years. The present value of this liquidation stream is over $68 million, or 4x year 1 FCF, providing low-end valuation support. At the high end, should an auction attract an industry buyer who could extract maximum value from the titles, an accretive deal could surely be done at values approaching 1x sales of $125 million. We assume the midpoint value of $95 million in a monetization of NCE
Our takeout assumptions are based on a model using 3x leverage with a 9% blended cost of debt and 30% equity diluted by an 8% management stake. On this basis, a transaction done at $565 million, or 6x FY03 EBITDA, provides a 26% free cash yield in the first year to the buyer and 5-year IRRs exceeding 40%.
We note that HDL continues to buy back stock every quarter at prices dramatically accretive to our takeout scenario.
Strong core business with good growth drivers; Management considering strategic alternatives, including sale.