Handleman Shares Look Greatly Undervalued (HDL)

| About: Handleman Co. (HDL)

Handleman (HDL) is a small cap stock traded on the NYSE with a market cap of $193.5 million. The stock traded around the $26 range at the beginning of 2004 and has been on a downward spiral ever since, and now currently trading around $9.50.

Handleman operates as a category manager and distributor of prerecorded music to mass merchants in the United States, Canada, and the United Kingdom. It also provides category management services in Brazil and Argentina. With their recent acquisition of Crave Entertainment Group, a private corporation, Handleman has entered in to the video game operations business, distributing video game hardware, software and accessories to major retailers throughout the U.S.

Handleman is in an industry which has declining music sales and much uncertainty about the success of upcoming new music releases, along with a recent softness in console video game market. This can be attributed to the Internet and various devices like the iPod.

The music industry, in which the Company predominately operates, is seasonal in nature. Approximately 32% of U.S. music industry sales occur during the last three months of the calendar year, with the month of December accounting for approximately 17% of annual sales.


The Company had borrowings of $102,385,000 against its line of credit at January 31, 2006 of which $5,385,000 was classified as current and $97,000,000 was classified as non-current. This debt was primarily incurred to finance the Crave acquisition.

Interest expense in the third Q totaled $2.5 million, compared to $0.4 million in the third Q of last year, which had a material effect on the net income for the Q, as Handleman had no borrowings as of April 30, 2005.


This fiscal, Handleman has acquired two businesses, REPS LLC and Crave Entertainment Group, Inc.


REPS was acquired for $20,459,000 on June 24, 2005. REPS provides in-store merchandising for home entertainment and consumer product brand owners at mass merchant, warehouse club and specialty retailers in the United States. The in-store merchandising structure of REPS is similar to the Company’s in-store merchandising structure, thus providing the opportunity to consolidate certain functions and generate cost savings and synergies.


Crave was acquired for $72,000,000 plus the assumption of working capital debt on November 22, 2005. Crave is a distributor of video game software, including Crave-branded exclusively distributed video game software, as well as video game hardware and accessories to major retailers throughout the United States. Customers of Crave include: Sam’s Club, Costco, Toys“R”Us, GameStop, Best Buy, Target, K•BToys, Army & Air Force Exchange Service (AAFES), and other national and regional retailers. CEG’s sales for the 12 months ended August 2005 were approximately $240 million.

Insider Buying

Both Eugene Miller & James Nicholson have recently purchased Handleman stock.

Eugene Miller, Director purchased 10,000 shares at a price between $8.79-$8.82
James Nicholson, Director purchased 1,000 shares at a price of $8.825

The 3rd Q Results

Net income for the third Q of fiscal 2006 was $14.0 million or $0.68 per diluted share, compared to $20.8 million or $0.94 per diluted share for the third Q of fiscal 2005.

Net income for the first nine months of fiscal 2006 was $20.1 million or $0.95 per diluted share, compared to $29.8 million or $1.31 per diluted share for the first nine months of fiscal 2005.

Net income for the first nine months of fiscal 2006 included income from continuing operations of $20.5 million or $0.97 per diluted share and a loss from discontinued operations of $0.4 million or $0.02 per diluted share; whereas net income for the first nine months of fiscal 2005 included income from continuing operations of $30.3 million or $1.33 per diluted share and a loss from discontinued operations of $0.5 million or $0.02 per diluted share.

Revenues for the first nine months of fiscal 2006 were $1,027.7 million, compared to $986.7 million for the first nine months of fiscal 2005. This improvement in year-over-year revenues was due to the addition of $53.8 million and $13.7 million of revenues attributable to Crave and REPS, respectively, as well as increased revenues in the UK and Canadian operations of $26.2 million and $7.8 million, respectively. The increase in UK revenue was the result of higher consumer purchases of music in mass merchant retailers, while 81% of the increase in Canadian revenues was attributable to a strengthening of the local currency. These increases were offset, in part, by a $60.3 million decline in revenues in the U.S., which was primarily related to the reassignment of customer stores earlier in the fiscal year.

Operating income for the third Q of fiscal 2006 was $22.3 million, compared to operating income of $32.5 million for the third Q of fiscal 2005. This decrease in operating income was principally due to increased direct product costs as a percentage of sales as previously discussed. Operating income for the first nine months of this fiscal year was $22.1 million, compared to operating income of $44.8 million for the first nine months of last fiscal year.

Q3 Conference Call Notes:

Results were disappointing – especially in US music operations, which were negatively effected by reassignment of 425 of customer stores this year (1st and 2nd Q) and weakness of industry music sales leading up to the holidays.

However, mass merchant retailers, music sales increased over 5% the week ending Dec. 25 and increased 13% the week between Christmas and new years. It is the belief that many consumers use gift cards to purchase CD’s.

Crave – which the company acquired in Nov 2005, had sales $54 million for 10 weeks end Jan 31, and operation income of $1million.

UK operations, sales increased $14 million or 13% same period yr ago

Gross profit margin Q3 16.8 and below expectations,

Trying to reduce costs by doing the following:

* Reduction in operating costs of distribution network
* Benefit cost reductions
* Reorganization of field services

Q3 repurchased 500,000 shares @ $12.97, to a total of approx 1.9 million or 57% of authorization, and committed to fulfilling the repurchase program and expect to be in market to be repurchasing shares in the market when the window opens

Sales of new releases were disappointing,
Video games sales will be accelerated by new video game units by Sony and Nintendo and will be out by holiday season of 2006

Recent publication forecast video game market at 9.2% annually thru calendar year 2009

Balance Sheet update

During 3rd Q, amended revolving credit facility in order to finance its acquisition of Crave and meet ongoing working capital needs, increased size of facilities to $250 million and extended term to Nov. 2010. Debt at the end of the Q was mostly due to acquisition of Crave, and sat at $102 million.

With A/R – in addition to Craves a portion of increase year over year is due to UK operations, which ships significant orders in the second half of the Q in connection with a January promotion.

Included in other assets, $36 million in goodwill, and $55 million in amortizable intangibles in regards to the Crave and REPS acquisitions.

Additions to property and Equip were $1.4 million for Q and $9 million for first 9 months in fiscal year, these expenditures levels were less than deprecation expense, which was $4.2 million in Q and $12.7 for 9 months.


Declining music industry sales coupled with recent softness in industry video game sales expected to have a negative performance in near term.

Number of new releases for music that might have potential to drive sales ie) Kid Rock, Alan Jackson, Tim McGraw
Based on recent trends however there is greater uncertainly in regards to these sales potentials.

Video game market – Sony is expected to lower price of Playstation 2 consol, which could spur sales for both consol and software.

Near term operating performance will be substantially below last year.

Question was brought up in the Conference Call:

Given the negative outlook, why continue to repurchase shares instead of pay down debt?

Answer: Plan to do both, want to continue our commitment to repurchase shares for shareholders under authorized plan, under recent price feels it’s an appropriate use of cash flow.

In response to the answer: But commitment was made when B/S was a lot stronger than it is now, and would prefer Handleman to pay down debt, until business stabilizes.

Another analyst brought up the subject again, you should know the business better than any of us, and you thought purchasing the stock was a good buy, and it’s been wrong, wrong, wrong, and a lot of money has been spent, and we are just seeing new lows. Maybe makes more sense to be a private company, don’t see value of repurchasing shares, B/S is worrisome to us.

However, Handleman recognizes the hire level of debt, and believe debt not overly troublesome.

Would they consider going private? Handleman would consider, looking at all options in regards to capital structure and ownership of the company and take into consideration again, that analyst feel uncomfortable with the debt level while still repurchasing shares.

On a side note, Handleman did not repurchase any shares in the open market for the first month of the 4th Q, as it shows in the 3rd Q release. Maybe Handleman will back off on the repurchase of shares, due to analyst concerns. However, there has been above average volume in the stock lately, maybe it’s possibly due to Handleman back repurchasing stock?

Company feels they outperformed the market and based on information they have seen, performed well against competitors.

Guidance on Crave profit margins: Crave profit margins generally runs in 14-16% range and one would expect that over a term, that is where Handleman’s expectation where it might run.

Gross profit margins - will go down, but not as fast as the past year, due to 3 factors

* growth of video game business- through Craves
* growth of UK business – don’t provide as much services, that’s why margins lower
* US where having greater proportion of non-service business, where operating on lower margins but providing lower level of service.

REPS was profitable for the Q.


Handleman is trading at a discount to book of 34%, a p/s of .15, has been repurchasing a large amount of shares and looks committed to completing their 15% buy back initiative. I believe Handleman’s shares to be greatly undervalued and believe there is a lot more upside than down side risk. I am not currently worried about the current debt load of the company, I feel that Handleman can handle this size of debt, and is profitable enough to be able to consistently pay down the debt, while maintain some buybacks. It is my hope that they will continue with the buybacks even with the concerns of the analyst as I believe the stock is at a price which has the company greatly undervalued and will help significantly improve shareholders wealth in the company for the long term.

As of March 10, 2006, 7.8% of the stock was being shorted, which is a fair size and could help the stock price spike if results are better than expected for the next Q.

Further, I like the acquisition of Crave, which helps diversify the companies operations and will help to improve sales through cross-selling services and products with their customers.

Full Disclosure: I do not own this stock as of this writing.