Description

This write up is a recommendation to short Transworld Entertainment (TWMC).  The Company is the result of a rollup of failed music retailers and is now the last pure play in music and video retailing.  It is a Company beset by declining comps, a shrinking store base, increased competition, declining margins and poor merchandising.  TWMC is free cash flow negative and its once pristine balance sheet is now devoid of cash and the seasonal demands of building inventory for the Christmas selling season leave it vulnerable to its lack of profitable sales.  For Fiscal 2008 (January 31), TWMC is projecting mid-single digit negatives comp’s and an overall sales decline in the low double digits including store closings.  Today it is very easy to borrow this stock, unlike many other short recommendations on this board.

 

Transworld was founded in 1972 in Albany, New York by Robert Higgins, the current CEO.  TWMC grew through the acquisition (Rollup) of failed competitors and de novo store start ups.  Over the years it acquired Camelot, Strawberries, Coconuts, Wherehouse Music and Movies, Suncoast and Sam Goody’s.  Approximately two years ago, TWMC began to re-brand the myriad of store names into FYE (For Your Entertainment) to help with the company’s transition away from music (CD’s) into movies (VHS and DVD’s), video games and other consumer entertainment products.  Today, TWMC operates approximately 1,000 stores under the FYE name in malls and freestanding stores.  In February 2006, TWMC acquired about 200 Musicland stores out of chapter 11 bankruptcy, which left it as the last music dominated retailer in the United States.  Store count has remained largely constant as acquired stores have offset closed stores over the last six years.

 

Number of Stores	2001	2002	2003	2004	2005	2006	2007
Mall	755	686	650	595	560	532	737
Freestanding	229	216	205	286	250	250	255
Total	984	902	855	881	810	782	992

 

 

 

MUSIC

 

While store count has for TWMC has remained largely constant, the competitive landscape has changed markedly.  Over the last ten years the number and type of competitors has shifted from small and regional chains to national companies across different channels.  In traditional music retailing, WalMart and Target began to use music and movies as loss leaders to attract younger demographics to their stores, becoming the largest music retailers in the US.  Amazon.com has taken the next spot by selling directly over the internet.  But by far the largest new competitor is Itunes, which legitimized the online downloading of music MP3’s.  The proliferation of legal and illegal downloading of music is a trend that is not going to abate and today it is the only growing section in music sales.  Other remaining big box competitors include Best Buy and Borders.  These two retailers are the 3^rd and 4^th largest traditional retailers of music and both have downsized their offerings of this product due to declining demand.

 

According to industry leader RIAA, annual CD sales have been slumping for years.  Last year CD unit sales were down about 13% (TWMC was down 14%) and year to date industry statistics have sales down over 20%.  Due to decreases in average selling price, TWMC’s sales are expected to trail industry statistics according to one sell side analyst.  TWMC’s annual music comp’s are as follows:

 

Comp Store Sales	2002	2003	2004	2005	2006	2007
Music	-12.7%	-16.8%	-5.5%	-2.0%	-9.2%	-14.0%

 

As music sales make up 44% of all of TWMC’s revenues, this is a major negative.

 

MOVIES

 

Sales of VHS and DVD’s (movies) currently make up 38% of sales for TWMC.  This category has grown over time as follows:

 

As a % of Sales	2001	2002	2003	2004	2005	2006	2007
Video (VHS/DVD)	14.5%	19.3%	24.5%	28.2%	29.2%	30.0%	38.0%

 

While movies have grown, this too is a category that is beset by current and emerging competition.  The retail competitors in this segment are almost too numerous to mention, but they include WalMart, Target, Best Buy, Amazon, Borders, Barnes and Noble, Circuit City, Blockbuster and Movie Gallery.  Many of these chains use hot new movie releases as loss leaders, thus cheating TWMC out of much needed profit margin.  All of these chains have better foot traffic, larger formats and greater resources.  Other non-traditional retailers have entered this space too.  Many grocery stores now carry popular titles as impulse purchases upon checkout.  Two new DVD machine purchase/rental kiosks have been rolled out at an increasing pace by Coinstar at many retailers and McDonald’s locations.

 

Another indirect but meaningful competitor to movies purchases are the legal rental of titles via the internet, stores, kiosk and pay per view cable.  Today Blockbuster and Netflix offer fixed price services from $5 to $24 per month that let you view as many titles as you want on a monthly basis.  Red Box and DVDXpress, Coinstar (CSTR) startups, are quickly rolling out kiosks and currently has over 3,000 units in operation.

 

Additionally, Itunes has begun to offer podcasts of TV shows that were traditionally sold through retail channels as offerings of a full season’s episodes.  If this digital downloading of Video product catches on with consumers, we could see a similar degradation of hard copy video sales like we did in music.  Sites like Google’s Youtube are also a threat to the acquisition of hard copy video sales.  Annual comps for TWMC in this category have not been stellar for a couple of years as shown below:

 

 

Comp Store Sales	2002	2003	2004	2005	2006	2007
Video (VHS/DVD)	35.3%	19.9%	15.7%	6.5%	-3.7%	1.2%

 

These two sectors represent 82% of total revenues that are under attack by larger, stronger and more efficient competitors.  The remaining two reporting segments are video games and other.

 

VIDEO GAMES

 

TWMC began selling video games in the early part of this decade.  It has taken small parts of existing stores and stocked a wide variety of video games.  It competitors in this sector are also a who’s who of specialty and big box retailers.  The major retailers in this sector include GameStop (owns Funco and Electronics Boutique), Best Buy, WalMart, Target, Blockbuster and Amazon.  The most effective competitor is GameStop, which operates all of the major brands in video game retailing.  TWMC is an also ran in this sector and does not get material allocations of major titles and equipment until after the larger competitors have filled their channels.  This is borne out by GameStop’s comps for the 4^th quarter which was up 22% versus TWMC’s gain of 4%.  

 

Finally, the video game sale tends to be somewhat consultative (what games are “hot” or “fun”).  TWMC is not set up to have well informed associates selling titles since it staffs its stores with inventory clerks and cashiers, not gamers.  As TWMC has increased square footage associated with this segment sales responded accordingly until the last two years.

 

Comp Store Sales	2002	2003	2004	2005	2006	2007
Video Games	75.9%	37.3%	1.6%	9.6%	2.3%	4.0%

 

 

As a percentage of sales, video games in not material enough to bail TWMC out of its troubles.

 

As a % of Sales	2001	2002	2003	2004	2005	2006	2007
Video Games	2.3%	4.1%	6.1%	6.1%	6.5%	7.3%	8.0%

 

Another looming issue for TWMC is the digital downloading of video game titles.  One of the major titles in PC gaming allows for monthly subscriptions over the internet and some titles can now be downloaded without purchasing hard disks.

 

OTHER

 

The category represents TWMC’s entry into consumer electronics and other entertainment accessories.  The Company uses spare wall and floor space to merchandise these offerings.  Needless to say, since Movies and Music dominate sales, this category gets the worst retail space.  Comps have been fine in the last two years, but its contribution to revenues is still not meaningful.  As you might expect, competition in this area is fierce.

 

Comp Store Sales	2002	2003	2004	2005	2006	2007
Other	11.8%	10.5%	-5.8%	-5.8%	4.4%	7.9%

 

 

As a % of Sales	2001	2002	2003	2004	2005	2006	2007
Other	8.1%	8.9%	10.5%	10.1%	9.3%	9.1%	10.0%

 

 

Intangible Factors

 

Having shopped numerous FYE stores over the last few years I believe that I can safely say that TWMC is a weak merchandiser with a customer base that is not a desirable demographic.  In most stores, music is the primary offering to a consumer walking in the door.  The traditional customer, a 13 – 30 year old middle class consumer, is no longer coming to the store in strong numbers.  The customer base is now dominated by those who can’t afford high speed internet access or don’t have the technical savvy to use computers.  TWMC attempted to correct this deficiency by investing $4 million (out of $5.2MM committed) in a company that designed in store kiosks for creating personalized CD’s.  Unfortunately, this product offering is more expensive that doing a CD mix on your home computer and those that don’t know this do not have the technical comprehension of how to create a disc.  In all of my visits, I have yet to see someone use the stations.

 

TWMC’s online site is a “me too” entry into music retailing and the Company lacks the financial clout and vision to make it a meaningful source of revenues.  I encourage you to go online to review the site, it is nothing special.

 

During conference calls the Company discusses how important it is to its suppliers and how they provide cooperative advertising and in-store displays to generate consumer interest.  Unfortunately for TWMC, supplier support for its sales is decreasing as a percentage in advertising from 49% of costs in fiscal 2005 to 44% in fiscal 2006 to 36% in fiscal 2007.   I believe the suppliers see this as a dying channel and are accordingly providing a decreasing amount of support.

 

FINANCIALS STATEMENTS AND RATIOS

 

Over the last five years, TWMC’s operating income has been trending in the wrong direction.  In 2003, TWMC acquired Wherehouse Entertainment.  This allowed them to benefit in fiscal 2004 and 2005 from restructuring those operations.  In fiscal 2006, TWMC began to show the signs from the malaise that affects this whole market segment, digital music downloads.  Even the purchase of Musicland in 2006 did not allow them to escape the effects of this trend.  Based on management’s prediction of a low double digit decline in revenues for fiscal 2008, I would estimate that revenues come in at about $1.3 billion.  Assuming gross margins stay constant, this translates into a decrease of over $50MM in gross profit.  While I believe that TWMC will cut some operating costs to offset some of this, the Company will begin to run into the difficulty of negative economies of scale.  By the middle of fiscal 2009 (June 2008) TWMC could be at the limit of its formula based borrowing capacity.  After this Christmas selling season I believe that their bank group will recognize this fact.  This leaves TMWC in a precarious position unless hard copy music and movies sales miraculously move back into their stores. 

 

To illustrate this point, in 2007 excluding one time gains from its acquisition of Musicland ($10.7MM) and pension assumption changes ($4.3MM), TWMC lost money on the operating and net income lines. In addition, Capital expenditures were over $10MM greater than EBITDA.  To offset this loss of cash flow TWMC increased its line of credit twice in 2006 from $100MM to $130MM in March and to $160MM in October. 

 

Jan 31 FY	2002	2003	2004	2005	2006	2007
Revenue
Music	$ 939,698	$ 755,021	$ 740,964	$ 750,612	$ 663,712	$ 650,352
Video (VHS/DVD)	267,890	314,058	374,868	398,043	371,965	552,722
Video Games	56,909	78,194	80,888	89,297	90,408	114,514
Other	123,535	134,596	133,906	127,181	112,401	153,569
Total Sales	1,388,032	1,281,869	1,330,626	1,365,133	1,238,486	1,471,157
Cost of Sales	935,256	815,071	842,726	869,999	806,873	951,935
Gross Profit	452,776	466,798	487,900	495,134	431,613	519,222
SG&A	422,737	465,893	459,441	450,161	426,854	519,246
Goodwill Impair Charge		40,914
Total Costs and Expenses	422,737	506,807	459,441	450,161	426,854	519,246
Operating Income	30,039	(40,009)	28,459	44,973	4,759	(24)
Depreciation	42,355	42,476	40,539	39,796	35,563	37,212
EBITDA	72,394	2,467	68,998	84,769	40,322	37,188
Interest Expense	2,477	2,349	2,147	2,444	2,954	5,504
Other Expense/(income)	(2,120)	(1,231)	(718)	(1,039)	(2,171)	(4,435)
Pre-tax Income	29,682	(41,127)	27,030	43,568	3,976	(1,093)
Taxes	12,891	(9,341)	8,302	4,892	1,090	(2,041)
Net Inc	$   16,791	$  (31,786)	$   18,728	$   38,676	$     2,886	$       948
Extraordinary Gain/(Loss)		(13,684)	4,339	3,166	(2,277)	10,721
Basic Income	$   16,791	$  (45,470)	$   23,067	$   41,842	$       609	$   11,669
Diluted EPS	$      0.39	$     (1.13)	$      0.60	$      1.15	$0.02	$0.36
Diluted Shares	42,553	40,224	38,209	36,297	31,962	31,986

 

As competition has heated up in TWMC’s two main segments, margins have come under pressure.  Gross profit margins are down over 100 basis points over the 2003 to 2005 period.  In addition, selling, general and administrative expenses over 80 basis points when compared to the average costs from the last three years.  I believe that the increased level of competition on new releases and the decreased pricing caused by digital downloads and online purchasing will continue to negatively affect margins for the foreseeable future.  The margins from the last five years are shown below.

 

 

 

	2002	2003	2004	2005	2006	2007
Cost of Sales	67.4%	63.6%	63.3%	63.7%	65.1%	64.7%
Gross Profit	32.6%	36.4%	36.7%	36.3%	34.9%	35.3%
SG&A	30.5%	36.3%	34.5%	33.0%	34.5%	35.3%
Operating Income	2.2%	-3.1%	2.1%	3.3%	0.4%	0.0%
Depreciation	3.1%	3.3%	3.0%	2.9%	2.9%	2.5%
EBITDA	5.2%	0.2%	5.2%	6.2%	3.3%	2.5%
tax rate	43.4%	22.7%	30.7%	11.2%	27.4%	186.7%

 

 

When looking at TWMC’s balance sheet it is important to evaluate the Company after it has paid off its Christmas selling season payables.  This gives the reader the opportunity to see the Company without the distortions to cash caused by the inventory builds and payable accruals caused by the business’ seasonality. 

 

Fiscal 2007 was the first time that TWMC had net debt at the end of the first fiscal quarter.  This was despite stretching accounts payable days to an all time high (120 days) for that time period.  The first fiscal quarter balance sheets and days payable are shown below.

 

 

Balance Sheets	2003	2004	2005	2006	2007
Jan 31 FY	Q1	Q1	Q1	Q1	Q1
Cash	58,841	62,016	89,094	68,005	17,887
Inventory	391,406	401,678	442,630	409,369	568,735
Def Tax & Inc Tax Rec	1,693	4,721	8,070	14,059	15,792
Other Current Assets	15,452	17,102	10,844	12,695	15,224
Total Current Assets	467,392	485,517	550,638	504,128	617,638
Net Fixed Assets	154,942	147,503	126,025	126,266	128,878
Deferred Taxes	30,176	36,388	39,112	27,755	29,593
Other Assets	62,591	11,294	14,906	14,369	15,925
Total Assets	$  715,101	$  680,702	$  730,681	$  672,518	$ 792,034
Liabilities
Accounts Payable	209,763	222,219	242,975	184,942	252,311
Income Taxes Payable	7,874	3,701	15,306	2,170	-
Accrued Expenses	31,237	33,021	42,289	36,473	72,683
Curr LTD &  Lines of Credit	-	-	-	456	36,034
Current Capital Lease Ob's	3,978	955	407	1,312	3,144
Total Current Liabilities	252,852	259,896	300,977	225,353	364,172
Long-Term Debt	-	-	-	4,943	4,464
Capital Lease Obligations	8,720	7,765	7,359	11,752	14,093
Deferred Rent and Other Liab's	26,965	25,851	23,866	30,795	37,220
Total Liabilities	288,537	293,512	332,202	272,843	419,949
Shareholders' Equity
Common Stock	540	541	544	554	559
Add Paid in Capital	287,119	287,532	288,964	296,931	299,324
Unearned Compensation	(239)	(76)	(6)	(41)	(27)
Acc Other Comp Loss	-	-	-	(652)	(2,048)
Treasury Stock	(120,833)	(129,103)	(149,930)	(194,452)	(217,564)
Retained Earnings	259,977	228,296	258,907	297,335	291,841
Total Shareholders Equity	426,564	387,190	398,479	399,675	372,085
Total Liab & Share Eq	$  715,101	$  680,702	$  730,681	$  672,518	$ 792,034
Net Debt	(46,143)	(53,296)	(81,328)	(49,542)	39,848
Days Payable	101.58	113.74	114.38	92.04	120.73

  

 

 

POSSIBLE NEGATIVE CATALYSTS FOR SHORTS

 

TWMC trades at about a 50% discount to book value.  One could make a case that if you liquidated the stores today, it is possible to recover somewhere near this level.  Since TWMC’s fixed assets are mostly furniture and fixtures and it owns virtually no real estate, the only recovery would be the after cost proceeds of its inventory.  However, as TWMC builds inventory and has operating losses towards the Christmas season, this scenario becomes less viable. 

 

The most troubling trend is that net debt will be positive at the end of the 1^st quarter when TWMC will have paid off its accounts payable from its 4^th quarter selling season.  This is a departure from the way Higgins has operated the business prior to buying Musicland.

 

The other risk to shorting TWMC is the possibility of a buyout of the Company.  Other than TWMC’s purchase of it competitors, there has been only three other M&A transactions in the industry.  Musicland was purchased by Best Buy in 2000.  Best Buy unloaded Musicland for a large loss in 2003 to a private equity shop, who put the company into bankruptcy approximately two years later.  The other transaction was the liquidation of Tower records in 2006, where a liquidator out bid TWMC for the stores.

 

This leads me to the conclusion that the only buyer for TWMC could be Higgins, who controls 40% of the stock.  He would need to raise about $100MM of additional capital with the stock at these levels to buy out the public shareholders.  However, the fundamentals of the business, declining sales and negative free cash flow, lead me to conclude that this scenario is very unlikely.

Catalyst

1. Continuing negative store comp’s due to increased competition in all of its operating segments and the resulting increase in negative free cash flow.
2. Possible bankruptcy in calendar 2008 (Fiscal 2009).