Handleman (HDL) reported very disappointing earnings over the last quarter. EPS came in at a unpleasant -.32/share. It looks as if the turnaround is going to take a while longer than expected.
However, I still believe that the fundamentals still hold and the stock is very attractive at this time. HDL is currently selling for $8.15 at the close of June 30. Handleman has plans to cut costs that will help the company save money (about $20 million/year) and still feel they will be profitable for the year.
After listening in on the conference call, it seems as though Handleman would be more than willing to sell the company at a fair price or they may be contemplating taking the company private. Currently, book value stands around $14.75 and I believe the stock is at least worth that and maybe even more. If Handleman can find some money to spend on buybacks, I believe it would be very beneficial for the shareholders in the long run, but probably not the short run.
The following are notes I took from the conference call:
The results for Q and year were disappointing
Higher consolidated sales were driven mostly by acquisitions CRAVE and REQ but not enough to offset decline gross profit margins and higher selling & general admin expenses.
Poor results driven by US music operations, and operations were below expectations at Craves.
Music Industry sales continue to be soft, US music sales were down nearly 6% that past yr and industry results in UK and Canada were similar.
Very few new releases to help create excitement to drive sales.
Expect overall music sales to continue to underperform until new release quality improves.
Within console video game industry, sales began to flatten around acquisition of Craves, believe this industry is in period of transition, and expect it to rebound when Sony and Nintendo release their next generation game consoles later this year.
Based on financial results taking steps to reduce costs. It is their goal to reduce costs by 10%
Goal is to achieve costs savings of 10% of SG&A expenses, which should account for $20,000,000. Some have been completed and others are being implemented.
Closing of Crave’s distribution centre in California and combine them with companies facility in Indianapolis, with saving in rent and freight costs, as a result it is expected savings of $1,500,000 - $2,000,000 on a full year basis. Combining the rest of Craves in store services org. will result in consolidation of locations and eliminate duplicate activities and better leverage employees time and customers stores to border category of product, est. savings $1.5-$2 million.
Restructuring of employee benefit programs. – include changes to pension and health care, which would allow them to save approx $2.5 million annually.
Some new strategies include:
Aimed at lowering customer product return: reduce initial shipping quantities on new releases and focus on quantity of titles on customer generating promotions.
In process of completing architecture review that will help reduce total IT costs of hardware, storage and operating leases. ie) re-negotiate an outsourcing contract with a technology provider that will take $11 million in costs out during life of contract.
It is our plan to complete these initiatives in F07, while we expect benefits to happen immediately, the full impact will not be reflected until F08.
In future cc will share results of initiatives to reduce costs and customer development.
Sales were up $11m, however this is due to inclusion of Craves and Reps, not counting these, 4Q rev would have decreased about 10%,
Net loss was $6.5 million or .32/share, due to lower revenues and gross margins in US business, lower profitability in UK business, and softness in video game category were primary drives for change in profitability compared to Q4 last yr. Q4 was particularly impacted by US music operations, where sales of Q were down 13% or $23 million. Due to loss of 425 customer stores to competitors in Q1 and Q2 and compounded by overall weakness in music industry sales. Further, gross profit margins in US business was down 3 points, due to increase in proportion of sales to customers who received less than full category management services, as well as increased customer promotions. In addition higher customer returns, during Q resulted in higher incremental vendor returns penalties and increase freight and handling costs.
Sales for Craves since acquisition were $85 million, operating results were only marginally profitable, and clearly results were below expectations. This can be directly linked to weak sales in video game console industry. Results are expected to rebound when new video games consoles come out later in the year.
Included in results was $700,000 in a one-time cost to relocate the distribution facility to Indianapolis. This will result in a cost savings of $1.5-$2 million in operating expenses on an annual basis starting in F07. The timing of the close of the acquisition, closed in late Nov. after a substantial portion of the holiday shipments had mostly taken place and thus since acquisition had to absorb the burden of all fixed cost without benefit of holiday sales.
Expectations of Future Growth for Crave: growth of mid to high single digits for 3-4 years.
New music releases have been weak and have not generated the same level of sales as they have in the past. For example for the top 10 sellers in May and June this year, when compared to last year was down 20%. Only three new releases during this period sold more than 250,000 copies during their first week of release compared to nine, last years.
Based on operating performance for first two months, company expects operating loss greater than loss incurred same period Q1 F06. Expects Q1 to be the weakest overall this fiscal year and return to profitability during Q2
Questions Q & A
Q: Does it look over the past year, is part of the problem; there has been a prolonged period of weak music releases. Have you ever experience such a weak period? When is music going to turn up again?
A: There was a period early in career where huge disco craze and then there was no interest and sales were impacted for a couple of years. There is an issue this summer, we are not seeing artists with strong products. Everyone is saying that there key artists will be coming out with strong products in the fall, that there will be lot of new releases, but that is yet to be seen.
Q: Rumors that Wal-mart might start selling stickered products, what could that mean for Handleman?
A: There is no indication that, that is going to happen or not. But clearly that would have a large impact on some of stores in community where largely urban, and there might be some nice increases there. But they would turn around some of there urban stores and have some nice sale improvements there.
Q: CAPEX was low about 10.4 million for the full year, what are you looking at in F07?
A: We see a substantial increase in CAPEX for 2 reasons, the level of 2006 was lower than historic levels, and so from a normal operations standpoint we would expect it to move back to historic levels with the primary driver being to continue to keep store fixtures current and invest in technology. In preparation in beginning to service new customer in UK, the need to invest in capital equipment, primarily warehouse equipment in late 2007 time period.
Q: UK was less profitable especially in Q4, what was driving that?
I think three things, margins in UK like elsewhere were under pressure, and so you had margin pressure. Q4 last year was strong quarter in UK operations, and part of the decline was because we are measuring against a strong prior Q period. We also incurred costs in relation to testing a distribution of a new product in the UK.
Q: What was that new product?
A: What happened was there was question weather we could distribute greeting cards for a customer. And it was a non-automated test, which took place. So the cost of that was somewhat higher than what the sales generated. It’s still ongoing, so we don’t have a definitive answer yet.
Q: (Speaker mentions it was a very disappointing quarter) Since you have started to buyback stock, you have bought about $150million worth since the beginning is that correct?
A: If you go back to very beginning to 1998 we actually bought back $225 million.
Q: Spent $15 in the first 6 months of this year (avg price $13.31, which has been cut in half), As much as I applaud buying back stock, you guys better than we know better where the business is going, and when you know the business is going the wrong way, it doesn’t take a genius to buy cheap stocks. We have a low market cap, that’s a lot of money. Why didn’t you do a Dutch auction or more importantly why didn’t you just take it private rather than just keep spending this money and if I was accountable (and I am long on the stock) for stock performance, I would be out of a job, but I don’t know how much you are going to buy, and I have talked to somebody about someone doing a LBO ?
A: We are prepared to have a conversation and open with individuals who are interested in providing or discussions about LBO, we are always willing to hear what people have to say regarding that. I’m surprised you didn’t get a warm reception or there was no interest.
Q: Well maybe it was perhaps the way it was related. No one would say absolutely we would speak with anybody, so I understand what you are saying. Can you tell me as of today what your stated book value is?
A: Book value/share is $14.75, tangible book value is $10.66 at end of fiscal.
Q: Well that makes sense, that Q after Q, that there isn’t any to make sense to buyback stock. But where does it end? You have probably an average of $14 or $15, and I know you probably see where I’m going with this, but at some point in time this cash is valuable cash. With Crave, has something gone way wrong than what you have done your due diligence on?
A: Unhappy with results, closed at a bad time, after most of holiday shipments were made and we acquired right when video game industry turned soft but still believe product line diversification is important driver of our future business and we still remain optimistic about long term growth potential of the video game category. May was the first month where sales of video game category exceed the prior year, since the acquisition, which is indicating somewhat of a turn around.
Q: Spending money for Tesco infrastructure, what would total CAPEX is for F07, as well what you would be spending for ramp up for Tesco?
A: F07 CAPEX could be around $40 million of which a little over half, related to new UK customer. Biggest driver is warehouse equipment in respect to that new business in all three categories.
Q: What kind of operating margin would you expect Tesco to operate at?
A: Would expect that it will drive an IR greater than low teens.
Q: Could you talk a little about your new UK client, why do they want you to have this new type of model and your ability to roll out this new type of model elsewhere and why is it attractive to you.
A: I believe the customer made a determination to try and do something different than been done historically. They believe in fact, they wanted relationships with suppliers that were more direct in terms of purchase of product. They believe that some of our systems were up tailored to categories and our performance with other customers demonstrated our capabilities and came to us to see if we were interested in a new model.
We do have the capability to roll it out and or modify it in certain ways. There may be selected a large volume title that someone might want to purchase on a direct basis, and manage yet on a standard category, the majority of the skews handle it in a more normal manner. We have that capability.
Analyst then goes to make a statement after more talk about the model:
Despite the current price of the stock, we think that over the years, buying back stock has been a reasonable good use of cash, and would encourage management and the board, the continuation of the current program, especially since that current levels, we believe that the stock is selling for little more than it’s liquidation value of it’s balance sheet.
Q: Inventory and Accounts Receivable are up 11%, can you explain why this is?
A: For inventory, the increase is driven by the inclusion of Craves (which didn’t own last year), inventory levels would actually be down without the inclusion of Craves. The increase in receivables is mostly due to the extent the inclusion of Craves revenues.
Q: Can you sort out what expenses in SG&A were from one-time items as opposed to expense creep that is an ongoing challenge?
A: In terms of one offs, I would suggest there are probably in the range of $4 million included this year. A couple of factors are more important to consider, one is, the increase in customer returns, and the impact higher customer returns has on SG&A, and it’s something we can control by working with our customers to reduce. The other aspect is the fixed component of our cost structure, and the lower volume, our business leverage as well as we increase volume, but clearly because of fixed components it doesn’t de-leverage as quickly as we’d like.
Excluding Craves and Reqs, SG&A was down $4.7 million vs. last year. That was probably $4 million of a one-time charge.
Q: How much weaker do you think profitability will be relative to last year
A: The company is not ready to make speculation of that at this point, but sales are soft in June.
Q: Do you comment on profitability for the whole year, will you be profitable for the entire year?
Full Disclosure: I do own shares in this company as of this writing.