Tuesday, 30 November 2010

HMV: Pedigree or Prize Mongrel?

HMV Group owns the HMV (surprise, surprise!) and Watersone's retail chains on the high street, as well as a smattering of live events (Mama) and digital (7 digital) businesses, to offer an holistic retailing service (see above graphic).

The plan appears to be developing into growing areas (live events and digital) to withstand the structural pressures in the High St, whilst unlocking synergies and turning Waterstone's around.

On the face it, at a share price of 46p (as at 30 Nov 10) based on FY10 (12m/e 24 April) EPS (basic) of 11.6p, giving an implied PER of 4x, it looks as cheap as chips.

In terms of my rules:

1 - Assets - to be valued at no more than a 10% premium - The Group balance sheet shows net assets worth £100m as at 24 April 10, which compares to a market value of £195m as at 30 Nov 10. A 95% mark-up on assets doesn't seem to be a great starting point for a value-based approach! Worse still, of those assets £122m relates to intangibles, which is comprised, broadly, of £68m for the purchase of Ottaker's (2006) and £44m for MAMA (2010).

Given the nature of the business, high street and digital, I wouldn't have expected it to be asset rich. There is a lot to be said for having leases, notwithstanding the future (off balance sheet) lease commitment of £1.2 billion. On this basis, having low asset cover is not unreasonable.

Not too keen on the £39m pension deficit, but this will ebb and flow with actuarial valuations, and I've seen worse. Ask BT.

2 - Market cap - at £195m is greater than the £50m target. Hurrah.

3- Cash flow - (a) balance sheet - working cap: current assets less current liabilities = -£191m, which has worsened by £40m from the prior year, largely due to the extra debt taken on and increased stock levels. Ouch. This shows that the business is running to standstill -ie future sales (cash) are required to pay the current bills, which is not a nice position to be in.

(b) operating cash - looks healthier, with cash generated from operations of £82m. Out of this we need to deduct a tax bill of £16m and capex of £30m (actually £40m, but have assumed that 75% is replacement capex), which leaves free cash of £36m. Dividends were £31m in the year. With extra debt to service (total of £96.3m) and a negative balance sheet working capital, something is going to have to give...which will probably the dividend (as the market seems to be pricing in)

4 - Debt - (a) net debt of £66m versus equity of £100m = 66% and isn't far over my target ratio of 50%

(b) EV/Adjusted EBITDA - EV of £261m (£195m market cap + £66m net debt); Adjusted EBITDA of £82m (EBITDA of £112m less replacement capex of £30m), results in a multiple of 3.2x, which is below my ceiling of 5x. Hurrah.

5 - PER - I make the 9 year EPS (basic) to be 10.4p (source: Sharelockholmes). Based on the current market price of 46p, this represents a staggeringly low multiple of 4.4x. The market appears to be pricing in World War 3 on the High St.

6 - Yield - a DPS of 7.4p for each of the last six years, which represents a yield of 16%. The market appears to think that this is unsustainable. Interestingly, dividend cover has been less than 1.3x in only one out of the previous eight years (2007), which is a good record.

7 - ROE - Per Sharelockholmes, the average ROE for the last three years is a staggering 56%. This is to do with having a high level of profitability relative to a low value equity base on the balance sheet (due to not being an asset intensive business and having a relatively high level of dividends being paid out).

8 - Directors - the directors hold around 886,000 shares directly, in addition to various share options (most of which are under water), which only equates to £407k in value. Given total director remuneration of £2.3m in 2010, this doesn't seem like a high enough holding to me. Disappointing. There has been a trickle of director buying in October, but this was in the region of 30,000 shares, which is peanuts.

9/10 - Buy or Bye? 9 yr EPS of 10.4p and a 7 year ave PER (per Sharelockholmes again) of 10.5x, gives an implied fair market price of 109p based on L/T averages. I like the look of a 58% discount!

Other stuff ...evidence of a moat? Hmm, subjective, but in my opinion, HMV is the destination for music and Waterstone's for books on the High St. I'm less in tune (ha, ha) with live music and digital, but these appear to be sound businesses. It would be difficult to replicate the High St presence quickly or cheaply. The bigger issue is the long-term structural decline of the High St vis-a-vis online, and whether the strength of the brands can flourish on the web.

The recent acquisitions appear sensible from a diversification/finessing the business model point of view, but they have a come at a price. The hefty price, extra debt and lack of earnings, are likely to hold back the share price in the short-term, but should, hopefully, support medium term growth objectives.

On the negative sides....retail is a dirty word, discretionary expenditure is going down, World War 3 is predicted on the high street, Woolworths/Zavvi/Borders don't provide happy case studies, debt has gone up, the pension deficit has gone up, free cash will get squeezed, the dividend is under pressure...BUT

the business is diversifying, there is potential for turn-around at Waterstone's, the market is valuing the business at 4 times long-term earnings, operating cash flows are healthy, debt levels are reasonable and manageable, and even if the dividend was halved, the yield would still be over 8%, plus there is scope for a re-rating with a FTSE250 promotion.

On my scorecard approach, the biggest short-comings are on the balance sheet valuation, balance sheet working cap and lack of director ownership. All in all, whilst not the finished product, I think the investment opportunity is a pedigree one though.

For me the shares are a BUY at 46p. I will add them to my virtual portfolio (watch this space) today. Watch out for the interims on 9 December too as there could be a buying opportunity if the L-F-L's are a bit too red.


  1. Hi, noticed your blog off the motley fool website- very refreshing to see someone else who sees some positives in HMV! I have a fair holding in them, based on the ridiculously low p/e valuation (Though I completely take into account its cashflow and balance sheet weaknesses)

    You might want to consider having a look at Game group? essentially HMV with a less catastrophic balance sheet! Though not as cheap (pe of circa 7.5) it is still quite attractive from a value perspective. Keep up the good work, I know how hard creating a website/blog is. I hate to join the crowd of people that leave a self serving link to their own sites, but I think you might genuinely find them vaguely interesting- all value investing based! If you dont want the links there, please feel free to delete the comment. Best of luck, Ed


  2. TheDrugsDon'tWork4 December 2010 at 13:15

    Very impressed.

    Sadly I don't think HMV is a buy.

    Of your 10 very sensible points I think the 2 most important for me are 3)Cash flow and 8)Directors.

    If I was Russian off with HMV?
    Step A) buy 10% of shares
    Step B) kindly offer to refinance debt
    Step C) promise board not to sack them
    Step D) wait for administration
    Step E) debt for equity
    Step F) shareholders got stuffed

    MD knows that they are not going to get more than 2.3 million a year elsewhere. Silently go along with it.

  3. Edward

    Thanks for the comments. I have a healthy amount of companies to review, and Game is certainly on the list.

    Thanks for the links to the websites - I've only had a chance to have a quick perusal, but they look just the ticket. I'll have a more through review in due course


  4. Drugs

    One of my concerns with HMV was whether it was just another Woolies. I got myself satisfied (maybe deluded) that HMV was just more than another high street presence, but was a bit more a destination, which gives it a flavour of a moat. I know that retailing is cut-throat and the future is online, but at the end of the day, I can see a sustainable future for the right hybrid business.

    I can understand why the the market value appears to be relatively low, but I'm seeing (hoping) that the market has over-reacted. It is fair to say that stronger cash/less debt and more director buying would give me a healthier glow.