Handleman Company (HDL) is a category manager and distributor of prerecorded music, video games and greeting cards. HDL has been posted multiple times on VIC, so I won’t go into too much detail on the specifics of the business, nor will I go into the challenges the prerecorded music industry is facing.  These challenges are well documented, both in HDL’s stock price performance and elsewhere.  The core of my thesis lies in the recent management change and the current pricing of the equity.  I believe that the recent appointment of CEO and President Albert Koch dramatically improves the option value of HDL’s equity.  While this is not a traditional value investment given that my downside case is a zero, I believe that the upside/downside ratio of 4-up/1-down makes it an extremely attractive investment for certain portfolios.

 

Understanding the challenges both the balance sheet and the broader business face, I will discuss three things:

-         Recent margin deterioration

-         Newly appointed President and CEO Albert Koch

-         The upside opportunity if Koch is able to fix the business

 

 

In addition to the challenges the category of recorded music faces, HDL announced in May 2007 that it lost ASDA as a customer.  This caused music-related revenue to decline over 20% in its most recent quarter.  Coupled with the ASDA development is a push by HDL into the distribution of greeting cards and video games, as well as pushing a fee-for-service model that doesn’t involve owning the inventory.  Gross margin has declined from north of 20% to roughly 16% on an LTM basis.  Despite these initiatives to better leverage SG&A, it has remained elevated above 18%.

 

 

The hiring of Koch is a materially positive event.  Koch, the Vice Chairman of AlixPartners, is a turnaround guru that has been involved in some extremely large and thorny turnarounds, and in two notable cases (Kmart and Champion Enterprises) he was able to help return the businesses to profitability despite stagnant to declining revenue.  Below is a short list of Koch’s successful turnarounds and the role he played in each:

-         Champion Enterprises, CEO

-         Kmart, CFO

-         Oxford Health Plans, CFO

 

It is somewhat surprising that Koch is now taking on such a small and seemingly impossible role given the industry dynamics.  But it is that contradiction that makes this situation so interesting.  HDL’s recent 10Q states that Koch and AlixPartners will earn a success fee based on the increase in market capitalization HDL achieves.  In another alignment of interests Koch reported purchasing stock in the open market on December 10^th.  Those two items taken together do not scream to me “bankruptcy filing imminent”, yet that is exactly how the stock is trading.

 

 

The downside in this investment is easy to quantify – it is a zero.  The business is clearly struggling and there is a meaningful debt load hanging over the equity.  But a bankruptcy filing would also mean that AlixPartners put its Vice Chairman into a sub-$50mm market cap company to manage a very small reorganization.  I believe it is safe to assume that there is at least a 50/50 chance that HDL will not be filing for bankruptcy, and therein lies the upside opportunity.

 

EBITDA margins are currently about break-even.  There is a significant challenge ahead in dealing with the loss of ASDA, and also with profitably ramping the greeting cards and video game businesses.  As recently as two years ago (well into the decline in prerecorded music sales), EBITDA margins ran well north of 4%.  Assuming a sales base of $1.1B (which backs out the ASDA business), if Koch were able to restore margins to 4% and stabilize revenue, the business would generate $44mm in EBITDA.  Valuing that at 5x would get you to $5.45/share, or more than 3x the current stock price.

 

My entire thesis is predicated on Koch being able to profitably restructure the existing business.  I cannot say that I see a path to restoring profitability in what is clearly a very difficult business, but that is why I’m not a turnaround professional.  The fact that he is there at all leads me to believe that it is possible, and the currently valuation is not reflecting that.