Description

TWMC operates a chain of mall-based and stand-alone stores. Compact discs, pre-recorded audio cassettes, singles, pre-recorded video/DVD, and other/video games represented 67%, 7%, 2%, 15%, and 10% of FY2000 (ended January 2001) sales respectively. TWMC operates 984 stores. All are leased and many have exclusive arrangements with malls. Approximately 627 stores are full-line stores located in large, regional shopping malls and average 5,000 square feet. TWMC also operates 14 FYE (For Your Entertainment) stores. The remaining are predominantly stand-alone units or those located in strip malls.

TWMC purchases the majority of its inventory from 5 suppliers: Warner, Sony, Universal, BMG, and EMI. All allow returns in exchange for merchandise, but all but one charge a return fee, which differs, dependant on the percentage of merchandise returned. Merchandise is shipped to company-operated warehouses and then delivered to the stores via trucks, 20% of which are owned by the company.

Industry
Industry sales in 2000 were $14.3bn. TWMC’s market share is 10% and other competitors include traditional music/video stores as well as mass merchants, and book stores. Through the decade of the 90s, mass merchants such as Walmart gained tremendous market share, which I estimate currently at 30%-40%, at the expense of traditional outlets such as TWMC. The market share shift has slowed, though, to roughly 1% per year. Equilibrium may not be far off.

The industry is highly competitive. It most recently emerged from a period of intense price wars in 1996. If you look at a stock chart, note TWMC’s stock price in 1996: 60 cents. During this period, TWMC was regularly posting like-for-like (LFL) declines. However, from the work I have done, this was more a reflection of the industry's heightened state of competition at the time than a reflection of TWMC's position in the industry. Indeed, as price wars have abated, since FY1996, the company's LFL sales have grown from 0% to 10% per year.

Recent History
TWMC operates in a market where operating results can swing materially based on the calendar for new releases. The previous year included a release by ‘N Synch which was a huge hit. Unfortunately, the back half of the just-completed fiscal year had few hit titles, causing a shortfall in sales and margins. Like-for-like sales posted their first declines since 1996 (-4% in Q4), resulting in a decline of operating margins from 9.5% to 6% for the fiscal year ending Jan '01.

Also effecting profitability is a decline in the sales of the high-profit singles category and a shift to lower-margin DVD sales. If Napster has had an effect on music sales, its through the sales of singles. Singles sales in the first quarter were down 37%, contributing a lot to the first quarter’s 5% decline in LFLs. I caution against assigning all blame on the internet, though, because this past quarter was a particularly bad one for new releases. Also, this quarter is not nearly as significant as the fourth, which accounts for 75% of net income.

Re-branding Strategy
Since the company was built through acquisitions, its stores have historically operated under a variety of trade names such as Camelot, Disc Jockey, and Record Town. The company has recently embarked on re-branding strategy, wherein all stores will be converted to the FYE name. The re-branding effort will cost about $40mn, about half of which will be included in operating expenses (including depreciation) this year. The remainder will be capital costs for fixtures, which the company makes.

Financials
Given the decline in margins and earnings, not to mention the stock price, I was surprised to discover quite a healthy company. Operating cash flow in ’00 was $133mn, while capex was about $33. This compares to a four-year average of $137mn and$39. The roughly $100mn in free cash flow equates to about 7% of sales and…27%of market cap. So what have they done with the free cash? They bought back $85mn worth of stock last year, or about 15% of then-outstanding shares. They continue to buy shares at these prices and have about 3.5mn shares remaining of 5mn authorized. According to filings, the Chairman, Robert Higgins, is also adding to his stake. (See ownership section.). The company’s year-end net debt was $265mn. While significant when compared with its $350mn market cap, it is important to take an average-cash balance because of the seasonal cash receipts. I estimate average net cash of about $85mn, or 25% of market cap.

My estimate for the fiscal year ending Jan ’02 is for sales of $1.45bn, EBIT of $55mn (after $20mn in re-bradning expenses). One can make the assumption, as I do, that run rate EBIT is at least $75 to $80mn, because the incremental advertising expenses from the re-branding effort are short-term in nature. Run-rate profitability should also be higher because of “return-to-operating-normalcy” due to an improved music release schedule, DVD schedule, and the company’s video game business. This is more fully addressed in the catalyst section.

Valuation
Market Cap (fully-diluted): $380mn
Net Cash (including from options and less capital lease obligation): $116mn
EV: $263
Sales (‘01e): $1.45bn
EBITDA (‘01e): $90
EBITDA, normalized: $110
EBITA (‘01e): $55mn
EBITA, normalized: $75mn
Earnings: $34
Earnings, normal: $46
EPS: $76 cents (includes 4 cents of goodwill)
EPS. Normal: $1.02 (“” “”)

EV to :
Sales: 18%
EBITDA: 2.9x
EBITDA (n): 2.4x
EBIT: 4.8x
EBIT (n): 3.5x
P/E: 10x
P/E (n):7.7x
FCF yield: 27% (trailing)

Ownership
Robert Higgins, CEO, owns 30% of shares outstanding. He has increased his stake by a couple of percentage points at the last filing date. Cerberus Partners owns 16%. I don’t know who that is. The stock trades an average of 138,000 shares per day.

Risk
The internet seems to be an obvious risk. But that is one reason that the stock is down from $30 to $7. At 4-5x EBIT, suffice it to say that I think the risk is priced in. Another risk is a return to price wars. There is some concern about this due to Best Buy’s entry into mall-based music retailing. Again, margins have already fallen from 10% to 4%, so at the least one might assume that the majority of any margin deterioration has already occurred. But this bares watching.

Catalyst

This is again a mis-priced stock, but there are three potential catalysts that could get people interested again. First, the music release schedule looks very strong in the next six months, especially when compared with last year’s comparable period, with albums from ‘n Synch, Mariah Carrey, and several others slated for release. Secondly, theatre attendance has actually been increasing lately making me believe that after 5 years there are finally some good movies to be viewed. Also, the next 6 months will have some highly popular releases including The Lord of the Rings, Harry Potter, and others. If so, this will have an impact on DVD sales 6 months from now, right in time for Xmas, and through next year. Finally, the company sells video games. Though a small part of the business, TWMC could benefit from the release of Xbox and expanded base of PS2 consoles. (See catalyst info for Barnes & Noble). Interestingly, all three catalysts have a reasonable chance of occurring at the same time making the odds better than 50/50 that my estimates will be too low. We shall see!