Description

About 11 months ago, when HDL was $10.63, we said HDL “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….” We are posting HDL again, to reiterate that $24 target value and to point out that, due to recent actions of management, the odds of HDL attaining such value have improved greatly!

Since our write-up of April 2002, Handleman has: (1) increased earnings by 19% [LTM 1/31/03 EPS ex-items vs. LTM 1/31/02], (2) significantly improved its balance sheet [from $132 million net debt 1/31/02 to $18 million net cash 1/31/03, before the sale of Madacy, which is discussed below], (3) weathered the Kmart store closings with minimal EPS effect, (4) bought back 4.5% of its shares and (5) largely implemented our proposed restructuring plan (see below). All this happened in the “worst year in a generation” for music sales (US CD sales down -12.7%), which we believe confirms the strength of the mass merchants (Handleman’s core customers) as the long-term “gorillas” in music distribution.

Most importantly, Handleman management is finally reacting to pressure from its shareholder base to pursue value- unlocking dispositions of non-core business units and to repurchase a significant percentage of its outstanding shares. Specifically, the company has written down and refocused Handleman Online (eliminating a $5 million annual loss) and has agreed to sell Madacy (its independent record label), a non-core inherently volatile and capital-intensive business, in a transaction that will generate $41 million in cash proceeds. These proceeds (plus an additional $2 per share from permanent working capital reductions, already achieved) will fund an announced 20% share buyback program. We believe Handleman has begun some kind of going-private process which will result in a transaction one day, or perhaps just the continued shrinking of its outstanding shares through continual buybacks.

In light of these improvements, we reiterate our belief in a $24 fair value of HDL, which is 10x FY 4/30/04 EPS and also 10x FY 4/30/04 FCF [NI+DA-CAPEX] of $2.36. Below we provide an update since the April 2002 write-up. Readers looking for more detail should see the old write-ups by us and by Ad188 in 2001.

Briefly, Handleman is a leading distributor and category manager of recorded music [95% of revenue] with an entertainment business [5% of revenue] which licenses rights to DVDs [from movies to exercise videos]. HDL runs the music departments of 1/3 of all Wal-Marts, all international Wal-Marts, all Kmarts, and has begun to penetrate Best Buy. 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. Revenue, EBITDA, EBIT, net income, and EPS for the LTM 1/30/03, pro-forma [estimated] for the sale of Madacy and the exclusion of impairment charges associated with the sale of Madacy ($28 million pre-tax) and the refocusing of the Handleman Online unit ($5 million pre-tax), were $1.3 billion, $108 million, $71 million, $52 million, and $1.85, respectively. For the FYE 4/04, revenue, EBITDA, EBIT, net income and EPS are projected to be $1.3 billion, $112 million, $81 million, $51 million and $2.32, respectively.

There are currently 25.7 million fully-diluted shares outstanding and the company had net cash of $18 million 1/31/03. Assuming the buybacks get done at an average of $16 or better, Handleman will have fewer than 21 million fully-diluted shares (and no debt) down the road.

UPDATE - PROGRESS REPORT

Last year, we encouraged HDL to take a number of strategic steps to improve its business and its use of free cash. Below is a summary of those items and the progress made on those items:

Task 1 - Increase ASDA [WMT] business in U.K. to reach breakeven

Progress - Done; ASDA has gained market share, with the resulting volume gains for HDL improving gross margin; U.K. is now breakeven.

Task 2 - Increase Best Buy business

Progress - Done; BBY is now 7%-8% of sales vs. 0% 1 year ago

Task 3 - Win more Wal-Mart business in the U.S. and Canada

Progress - Done; HDL added 50 WMTs in the U.S, 23 in Canada, and 10 in the U.K. in the last 12 months

Task 4 - Get Handleman Online to breakeven

Progress - Done; refocused business to just fulfillment, not website design; HOL is breakeven now, versus losing $5 million annually on a pretax basis

Task 5 - Monetize Madacy [independent record label]

Progress - Done; sale announced 2/26/03 should close in March; $41 million proceeds and tax benefits while giving up only $5 million in free cash flow
Close down The itsy bitsy Entertainment Company Done; completely shut down by Spring 2002; division lost $10 million in the FYE 4/02

Task 6 - Increase customer diversification by adding at least one major discount retailer

Progress - In progress; the company has been talking with Circuit City, which could be significant; limited progress with TGT thus far; expecting to win non-Wal-Mart customers this year in UK

Task 7 - Manage the Kmart revenue decline

Progress - Ongoing; SG&A and capex for fixtures have been reduced, which have largely mitigated the lost revenues

Task 8 - Buy back lots of stock

Progress - Done; 4.5% so far, 20% more of outstanding shares to be repurchased via the announcement of a 5.1 million share buyback

Handleman has also pleasantly surprised us with a massive $86 million permanent reduction in working capital via the reduction of DSOs and inventory days [due largely to better systems].

FY04 ESTIMATES

Top line: For the FYE 4/30/04, the company has not given formal guidance, but we are comfortable projecting revenues to decline 3% because of the sale of Madacy [$60 million, or 4.5% of sales] and the runoff at Kmart [a decline of $45 million, or 3.3% of sales]. That is consistent with the company's view that US Wal-Marts are experiencing modestly POSITIVE same store music sales, despite the overall music industry decline. Plus, they expect to win new international business from Wal-Mart this year and to steal some non-Wal-Mart customers from competitors in the U.K. The main point here is that Handleman does have significant long-term revenue GROWTH opportunities after the self-imposed decline we expect in FY04.

Margins: Assuming flat gross margins and slightly improving EBIT margins [Madacy was low margin and Kmarts are lower-margin than Wal-Marts], the company should post revenue, EBITDA, EBIT, and net income of $1.28 billion, $112 million, $81 million, and $51 million in FY04. If no shares were bought back, and the company just built cash, FY04 EPS would be about $1.98. Assuming the company purchases 1 mm shares / quarter for the next 5 quarters at a $16 average, HDL will finish FY04 with 20.7 mm shares [average 22.0 for FY04] and earn $2.32 per share.

FCF vs. EPS: Depreciation and Recoupment of License Advances [part of the Anchor Bay video business] runs about $31.5 million and capex and License Acquisition should be around $32 million. Note the capex figure includes $5 - $10 million of expenditures for the company’s Oracle implementation, so ‘maintenance’ capex is a lot lower. Working capital should continue to be a small source of cash, as the company is still improving DSOs and the Kmart collections should exceed revenues for a few quarters.

WAL-MART CONCENTRATION AND MUSIC PIRACY

Obviously, concentration with any one customer is a risk, and significant concentration with Wal-Mart usually scares investors away. However, HDL’s relationship with Wal-Mart goes back 20 years; its viability is supported by the facts that WMT 1) formerly did its own music merchandising but got out of it; and 2) has awarded HDL the merchandising business for each new WMT in Canada, Mexico, the U.K. Latin America, and east of the Mississippi in the U.S. Wal-Mart is also a more profitable customer for HDL than Kmart, as WMT stores generate much higher sales per square foot.

The music industry is beaten up right now. CD sales were down 12.7% in 2002 due to piracy, a weak economy, and weak music releases. Specific to HDL, Kmart is declining and Wal-Mart is growing. However, the mass merchant channel keeps taking share from traditional record stores and independents (US share is approximately 31% and growing steadily – share is over 50% in Canada)!

Piracy and legitimate online music distribution are, of course, persistent industry issues. However, they should not overshadow the fantastic performance of the mass-merchant channel. Plus, as HDL management points out, the drag on CD sales has a lot more to do with post-Britney malaise than KaZaA. The next hot band or music trend will still drive a potentially significant industry rebound. Our own view is that, the WMT music buyer is a housewife who will not be into downloading music in our lifetimes.

VALUATION

Free cash flow for FY04, or NI+DA-CAPEX, should be about $50 million, which at the current price represents a 12.5% free cash flow yield. By the time the buybacks are complete, we think run-rate FCF will be around $60 million, generating a free cash flow yield of 19.5% at current prices. There will be 20.7 mm shares and no debt, so using the same 12.5% free cash flow yield gets you $23.20. In better times for the industry, a 10% free cash flow yield may be appropriate which justifies a $28 stock.

For EBITDA fans: at the current $14.82 price and 25.7 million shares, $18 million of net cash, and $112 million of EBITDA for the FYE 4/04, HDL trades at an EV / EBITDA multiple of $363 / $112 = 3.3x. Adjusting for the $41 million expected from the Madacy sale this month yields an EV / EBITDA of $322 / $112 = 2.9x.

CATALYSTS

Sharply increasing earnings and cash flow;

Close of the sale of Madacy and receipt of cash proceeds;

Massive stock buyback. HDL announced a 5.1 million stock buyback, or 20% of the 25.7 million outstanding shares on 2/26/03. Given the strong balance sheet [$20 million of net cash 1/31/03] and expected $40 million of proceeds from the sale of Madacy [3/31/03], we expect the company to be in the market soon. Since the April 2002 write-up, the company has continued to buy back stock, buying 1.2 million shares or 4.5% of the float.

Catalyst

Sharply increasing earnings and cash flow;

Close of the sale of Madacy and receipt of cash proceeds;

Massive stock buyback. HDL announced a 5.1 million stock buyback, or 20% of the 25.7 million outstanding shares on 2/26/03. Given the strong balance sheet [$20 million of net cash 1/31/03] and expected $40 million of proceeds from the sale of Madacy [3/31/03], we expect the company to be in the market soon. Since the April 2002 write-up, the company has continued to buy back stock, buying 1.2 million shares or 4.5% of the float.