The deep undervaluation of Trans World Entertainment Corporation ("Trans World") presents a great opportunity for smaller value-focused investors/funds. The company is a specialty retailer of entertainment products and was founded in 1972 by its current CEO/Chairman Bob Higgins. Mr. Higgins is also the largest shareholder in the company with over a 50% ownership interest.
The company has been buffeted by the digital entertainment revolution and has been forced to institute dramatic changes to its product mix, lease portfolio, and corporate strategy. These fundamental changes are now bearing fruit.
Since my first article, the stock has rallied by about 25%. In this article, I continue the analysis by incorporating the recent strategic shift of Best Buy Co., Inc. (BBY) and its potential impact on Trans World's performance and valuation.
Best Buy: Renew Blue Strategy
Since taking the helm late last year, CEO Hubert Joly has focused on reviving the Best Buy shopping experience and remedying its flagging financial performance. In November 2012, he formalized his turnaround principles in the so-called Renew Blue strategy. Essentially, Renew Blue calls for a drastic revamp of Best Buy's merchandising and sales functions with the ultimate goal of increasing ROIC by about 20%.
Integral to the Renew Blue strategy is a substantial and rapid movement away from sales of CDs, DVDs and to a lesser extent, video gaming. This program calls for an expected 50% reduction in entertainment-content square footage from almost 8 million to less than 4 million and a major change in merchandising mix in these categories away from catalog/deep catalog media. I have estimated that these changes will leave nearly $1 billion in physical media sales up for grabs and this surrendered market share will be available in the very near-term. Thus, I believe Trans World will be a big beneficiary of Renew Blue.
What does Renew Blue mean for Entertainment Sales?
Best Buy (in millions)
annualized 11-month transition year
10% of Domestic Revenues
Entertainment square footage
about 7.7 million
19% of Best Buy large-format store(2)
(1) The Entertainment category includes video gaming hardware and software, DVDs, Blu-rays, CDs, digital downloads and computer software
(2) Based on CEO Joly sketch in Renew Blue Investor Day presentation (11/13/12)
According to the Renew Blue presentation and discussions with Best Buy's investor relations (IR) department, I have calculated that roughly 50% of entertainment square footage will be reallocated to the new Samsung in-store kiosks and other categories such as small appliances. The largest space reduction will be in CDs/DVDs and a lower drop in the smaller gaming footprint. Moreover, the company's entertainment strategy will now focus primarily on new releases and away from catalog/deep catalog sales. "Catalog" sales are generally defined as music/video released over 18 months ago and "deep catalog" is music/video released several years ago.
Conservatively (and confirmed by IR), I have estimated that the 50% reduction in square footage will result in a smaller decrease of say 30% or about $1 billion in Best Buy's entertainment sales. Best Buy is confident any lost entertainment sales will be replaced by higher sales of Samsung electronics and other merchandise.
Also, Best Buy has established a "three phase" timeline to this transition with the ultimate goal of having the newer product lines in place ahead of this year's holiday shopping season. The first phase was completed earlier this year with the addition of Samsung kiosks into the 500 top performing stores. In this phase there was only a minor decrease in entertainment footage as the company followed a wait and see approach before a wholesale entertainment footage reduction. Currently, it is implementing stage two, and rolling out the kiosks in the remaining 500 stores. In the final stage, entertainment footage will undergo the substantial majority of the planned reduction. This final phase should be completed ahead of the 2013 holiday season so as to maximize the benefit of the new product mix at Best Buy.
Best Buy's loss should be Trans World's gain
With very few remaining bricks and mortar entertainment retailers it seems reasonable that a portion of the sales that Best Buy relinquishes will be picked up by Trans World. So how much should we conservatively expect?
Firstly, let's look at the size of the physical entertainment market:
Physical Media Sales (in billions)
Best Buy estimates(2)
Physical gaming & accessories
(1) Based on data from Trans World's 2012 10-K - statistics from Warner Brothers Home Entertainment, Nielsen Sound Scan and NPD
(2) Based on data from Best Buy IR calls in June, 2013
Secondly, let's estimate the market share breakdown of the major players in physical entertainment sales:
Estimated Market Share(1)
$4.5 billion in 2012 "Entertainment" sales
Wal-Mart Stores, Inc.
1/3 of 2012 "Entertainment" sales
1/4 of "Hardlines" sales
Trans World Entertainment
All physical media sales
Total Bricks & Mortar
50% of 2012 "Media" sales is physical
Total Physical Market
(1) Author estimates based on company filings and IR calls - see Revenue Assumptions (company segment in quotes) for assumption of companies' total physical entertainment revenues
Finally, with sales of physical media in structural decline a portion of the $1 billion in relinquished sales will most likely be forever lost to digital competition. So far in 2013, physical music sales have declined at roughly 16%, as noted by Trans World in its recent earnings release. Physical video sales are benefiting from Blu-ray sales and grew slightly. And GameStop Corp. noted that physical video games sales dropped 14% but is optimistic that sales will grow following the upcoming release of the next-generation gaming consoles. Therefore, I conservatively assume about a 10% first year obsolescence loss in physical media sales. Accordingly, in the period from winter 2013 to winter 2014, I assume $900 million in physical media sales will be up for grabs from Renew Blue. Additionally, I estimate that these sales will continue declining over the following years as physical sales migrate to a digital platform.
Short-term impact on Trans World
With sales of $458 million in FY2013, Trans World is poised to significantly benefit from even a small pick-up of the entertainment sales surrendered by the Renew Blue strategy. I expect considerable short-term gains for the company due to the scarcity of physical competition; especially in its mall-based and catalog-focused niche. Additionally, there is significant locational overlap of Best Buy and Trans World that I estimate at well over 30%.
With the majority of Best Buy's surrendered sales coming from catalog/deep catalog, I believe Trans World will see a jump in its market share. In fact, with both Wal-Mart and Target preceding Best Buy in moving away from catalog sales, Trans World will be the only remaining national chain with an extensive selection of new and old releases. Notably, as reported by Nielsen Company & Billboard, while "current" physical album unit sales dropped 20% in 2012 catalog physical sales fell only 3.5%. This considerably stronger performance of physical catalog reflects steady consumer interest; an interest that should drive traffic into Trans World' stores.
Therefore, I believe that Trans World could secure about 5% of the sales surrendered by Best Buy in the short-term. Assuming most of these sales will be higher-margin catalog and with some incremental increase in variable costs, every $1 increase in sales should lead to roughly a $0.25 increase in operating income. This calculation assumes a gross margin of 30% and incremental variable costs of 5%. Since Trans World possesses significant deferred tax assets, no debt and has minimum capital expenditures, nearly all of this operating income will go directly to its cash balances.
Sales from Renew Blue to TWMC
EBIT (in millions)
Cash per share(1)
2% of sales = $18 million
5% of sales = $45 million
10% of sales = $90 million
(1) As of May 20, 2013, 33,063,582 shares were outstanding
This outcome would boost Trans World's sales by 10% over the next year and would reverse the sales declines it has faced in the past several years. To analyze Renew Blue's impact on Trans World's profitability in the current fiscal year (FY2014), I first estimated the company's pre-Renew Blue financial performance:
FY13 Sales (in millions)
Est. Change in Sales
FY14E Sales (in millions)
Assuming continued gross margins of 37.5% and SG&A of $148 million (reflects limits on further cost cutting), operating income increases in FY2014 to $16 million. This equates to roughly $0.50/share of earnings per share and a comparable increase to Trans World's current cash balance of $4.13/share (FYE2013 plus employee stock option activity) to $4.63/share.
Secondly, I add the estimated impact of Renew Blue on Trans World's upcoming holiday sales. I assume Trans World captures over a third of the aforementioned sales from Renew Blue in the fourth quarter or roughly $16 million of the $45 million. This leads to an additional increase in cash per share of $0.12 by year-end. Therefore, I estimate that by FYE2014, Trans World will be holding $4.75 in cash per share. Moreover, the company would have generated an operating margin of nearly 4.5% and a ROE of over 9% (cash-adjusted ROE of 20%).
Long-term impact on Trans World's valuation
As demand for physical media has declined sharply, CDs/DVDs have become a more niche and impulse purchase versus their historic role as a loss leader driving traffic into superstores. Renew Blue is a reflection of this shift and it seems likely Best Buy is just beginning a structural move away from entertainment sales. As described above, Renew Blue's unexpectedly large drop in entertainment sales will have short-term benefits for Trans World. But I believe the real impact will be felt longer term.
Trans World will be able to profit from Best Buy's exit as it has done consistently over the past several years as its smaller competition disappeared. The company's convenient mall-based stores are perfectly situated for impulse purchases of physical entertainment products, and Best Buy's exit will further heighten this advantage. I estimate that over the next five or so years, market share gained from Renew Blue and other retailers' exits should help Trans World counterbalance the steady structural decline in overall physical media sales. Therefore, Trans World should be able to sustain its sales and operating profits at its current levels. Ceteris paribus by FYE2019, I estimate cash per share would increase to about $7.00 or nearly a 70% increase.
However, Renew Blue's real impact may be on Trans World's transformation strategy (see article). The sales gains arising from Renew Blue will provide more time for Trans World to implement this transformation away from being a pure-play media retailer to a mall-based novelty/pop culture merchandiser (such as Hot Topic, Inc.). If Trans World achieves this transformation, it would no longer be facing the headwinds of a structurally declining market but may in fact achieve long-term sales and profit growth. And consequently with its long-term future no longer in doubt, the company would not be valued at its liquidation value. Rather it would be rightly valued on its earnings power. For instance, if it achieved a multiple of 10 on its current operating earnings, its cash-adjusted intrinsic value would be $9/share.
Overall, I believe Best Buy's strategic shift away from physical media will boost Trans World in the both the short-term and long-term. Some of the roughly $900 million of sales that will be up for grabs from Renew Blue will flow to Trans World, lengthening its time to transform its business away from declining physical media sales. This upside potential is presented to current and prospective shareholders at a market value that is only marginally above its net cash balance ($4.13/share) and below both its "net-net" (current assets less total liabilities) value ($5.03/share) and its book value ($5.57/share) (all figures from FYE2013 and adjusted for employee stock option activity). Therefore, I continue to believe that Trans World is an attractive investment that is substantially undervalued by the market.
Additional disclosure: I may change my views on Trans World and the value of Trans World’s shares at any time and for any reason. And I reserve the right to buy or sell shares in Trans World at any time. I disclaim any obligation to publicly notify of any such changes.