Description

Overview:
This is a recommendation to go long the common stock of Hollywood Entertainment (HLYW), the second largest movie and video game rental chain in the United States. Fears about consumers moving away from the movie rental market due to cheap-priced DVDs, Netflix and similar online movie rental businesses and pay-per-view/video-on-demand have caused HLYW to trade to a very cheap valuation despite the fact that the business is still flat to growing on a comp store basis and adding 150 new stores in 2004, each of which should contribute a 45% ROI within 3 years. The existing business is currently trading at 4.7x LTM EBITDA and a FCF yield on equity of over 16% and management is buying back stock as fast at their banks will let them and repaying debt with their remaining cash. This is an investment opportunity with very little downside given the tremendous cash generation and significant upside potential. I also believe that there are some near-term catalysts that are discussed below.

Business Description:
HLYW is the second largest specialty retailer of rentable home videocassettes, DVDs and video games in the United States. Their primary competition is Blockbuster, which is the largest chain, Movie Gallery holding the 3rd largest position and smaller “ma and pa” stores. At 9/30/03 the company had 1,864 stores operating in 47 states.

Movies are rented on a 5-day rental period for $3.79 for new releases and $1.99 for catalogue rentals. If the movie is not returned within 5 days, a new 5-day rental period is entered into. This 5-day rental policy has caused problems for HLYW because popular movies can rent out quickly leaving supply shortages for HLWY. This is one of the reasons that HLYW announced that it would miss Q4 consensus estimates, causing the stock to trade down over the past few months. This issue is less relevant for Blockbuster and Movie Gallery as they have 1-day or 2-day rental policies for more popular new releases. HLYW has been moving towards revenue sharing agreements with the large movie studios that would solve this problem as supply of popular videos would no longer be an issue. I believe the announcement of more revenue sharing agreements with studios will benefit HLYW and is potentially a near-term catalyst for the HLYW stock.

In addition to traditional VHS and DVD movie rentals, the company has moved into the home video game rental and sales market primarily through the roll out of Game Crazy stores, which is effectively a department store within in their existing stores that allows customers to buy, sell and trade new and used video games for use with the Sony PlayStation 2, Nintendo GameCube and Microsoft Xbox platforms. At 9/30/03 the company had 577 Game Crazy stores operating within their existing stores. HLYW had been opening Game Crazy stores at an incredibly fast rate (opening 408 stores in the last 12 months) and announced their intention to slow down these openings during the first half of 2004. I believe this move is not because the Game Crazy stores are not performing well or because management does not believe in its prospects, but rather because they have expanded so quickly that they want to take a breather and focus on operating the existing new stores efficiently before opening more. It is important to note that the Game Crazy stores are designed to be completely independent in all operating aspects (except of course for their location) from the existing HLYW store base, which I believe may imply a longer term goal to separate these two assets via a sale, spin-off or similar type of transaction.

2002 and LTM revenues were $1.49 billion and $1.62 billion, respectively, and 2002 and LTM EBITDA were $235.4 million and $250.7 million, respectively. EBITDA here is defined as EBITDA after the amortization of rental product. The company spends significant amount of recurring capital expenditures on purchasing new releases, which it then amortizes over a 4 month period to a residual value of $2.00 for VHSs and $4.00 for DVDs. When the company purchases catalogue rentals (which are older movies it plans to keep in stock because they are still in demand), it amortizes them to the same residual values over 12 months for VHSs and 60 months for DVDs.

Recently, the company announced that their 4th quarter would be below consensus estimates and the 1st quarter of 2004 would likely show mid-single digit negative rental comp store sales (although flat total comp store sales due to the Game Crazy contribution) due to an unfavorable comparison of large new releases in the 1st quarter of 2004 relative to the 1st quarter of 2003. The company gave guidance for all the remainder of 2004 of flat same store rental sales, resulting in full-year same store sales in the range of negative 1-2%. Total same store sales including Game Crazy contribution should be positive, although the company did not give specific guidance on how Game Crazy stores would contribute to the top line in 2004. Management indicated that they will do between $180 - $200 million in discretionary FCF in 2004. This is defined as EBITDA less amortization of rental product, less interest expense, less maintenance cap ex, but before new store expenditures. Note that the amortization of rental product income statement expense should be very similar to the actual cash expenditures on rental product in 2004 (~$225 million) as the company has recently completed the buildout of their catalogue (which explains why the cash flow item exceeded the amortization expense in 2003). The company plans on opening 150 new stores in 2004. A new store costs approximately $400,000 to open and generates $183,000 of EBITDA within 3 years. So the company will spend an additional $60 million on new stores and will thus generate $120 - $140 of true FCF. The company will not be a significant tax payer in 2004 as they have a $180 million NOL.

The company has been buying back stock in the open market. Their banks gave them a $30 million basket to repurchase stock towards the end of 2003, all of which I believe is spent, and they will be allowed to spend half of their free cash flow going forward to repurchase stock. HLYW should produce in access of $50 million of FCF in the 4th quarter, which will give them $25 million to repurchase stock as soon as they can represent to their banks that they produced the cash (early January).

The CEO had been selling shares on a planned 10b-5 program to diversify what was 90% of his wealth in HLYW stock. These sales were ceased when the stock fell below approximately $15.75.

Valuation:
As of 9/30/03, HLYW had the following capitalization:

Debt $372.4
Cash $39.9
Net Debt $332.5
Equity (T-Method) $893.0 using $13.25 stock price
Total Capitalization $1225.5

At 9/30/03, the company has only spent $20 million of the $30 million permitted to buy back stock, so I adjusted the above table by decreasing cash by $10 million and repurchasing stock at an average price of $15.00. I then further adjust the capitalization by adding the $50 million in FCF they will generate in the 4th quarter to cash and using $25 million of it to purchase stock at an average price of $14.00. This gives me an adjusted pro forma capitalization table of:

Debt $372.4
Cash $54.9
Net Debt $317.5
Equity (T-Method) $860.6
Total Capitalization $1178.1

EV/LTM EBITDA 4.7x
2004 FCF/Equity Yield 16.3%

Conclusion:

The recent performance and announcements out of the company have caused the HLYW stock to trade down from over $18 a share to the current price of approximately $13 due I think to an overreaction to two slightly poor performing (but explainable) quarters. There is no evidence yet that the fundamental business model of HLYW is at all in jeopardy from DVD sales or the NetFlix’s of the world, despite the bears’ rhetoric. The story I believe is one of a cash cow that is buying back stock as fast as their banks will let them and reducing debt with the remaining cash balances trading at 4.7x LTM EBITDA and with a FCF yield on equity of over 16%. Plus, I believe that management has intentionally guided expectation very low so that they can exceed them during 2004. What results is a low risk and relatively liquid equity with the potential for 50% or greater returns in the next year.

Catalyst

Low valuation
Sale of Blockbuster attracting attention to HLYW
Announcement of more revenue sharing agreements with movie studios
Significant stock buybacks and debt repayments
Exceeding low expectations set by management in 2004