With so many competitive threats out there, I haven’t always been so kind to the video store business model. In fact, I’ve probably been downright hostile when it comes to my outlook on the industry in part because I can read the writing on the wall about consumer shifts, but mostly because I believe that the industry’s massive debt and high fixed cost structure will make it impossible for them to maintain profitability in an industry facing revenue decline.
The industry took on so much debt are for a variety of reasons. Blockbuster’s (BBI) debt was a dirty deal for investors and even today shareholders are still suing Viacom (VIA) to try and get their money back. When Viacom first put Blockbuster on the market, they couldn’t find a private buyer. Instead of trying to run the business themselves as a distribution arm, they instead chose to spin it off to an unwitting public. As part of the deal, they forced Blockbuster to make a massive dividend payment after the spin off, which made them assume debt in order to do so. This gave Viacom time to exit their investment, let them rob Blockbuster of their credit and leave a beached bloated whale in the hands of public investors who were too dumb to tell a fish from a carcass.
Movie Gallery’s (MOVI) debt, on the other hand, largely stemmed from their own poor decision making when they acquired Hollywood Video right before the bottom dropped out on the video store market. Desperate to catch up to Blockbuster in market share, Movie Gallery made a huge bet and paid an astonishing $1.2 billion for control of Hollywood Video. Ironically, this very acquisition is what now threatens their very survival, but had the FTC not blocked Blockbuster’s attempt at acquiring Hollywood Video due to anti-trust concerns, Movie Gallery would be in a much stronger competitive position today.
To say the least, the debt has been a disaster and as Movie Gallery has continually been forced to return to lenders and renegotiate covenants on their debt, it’s become a serious liability for the company and represents a ticking time bomb that many believe is ready to explode at any moment.
According to their last SEC filing, in July, Movie Gallery had about $22 million in cash. The good news is that this left enough for them to make an $18 million interest payment at the beginning of November, but the bad news is that when you have to issue a press release to announce that you successfully paid interest on your debt, you can bet that the financial picture doesn’t inspire a lot of confidence. At the time of their announcement, investors were pretty much convinced that it would be curtains for Movie Gallery and the company’s stock was trading at about a $70 million market cap.
Since then Movie Gallery’s stock has been hotter then dancing penguins at the box office. By the end of November, their stock had gone from $2.17 a share to approximately $2.84.
This rally was driven in part due to partial financial results that showed better then expected revenue for the company, even though management didn’t include net income figures. All of the activity with their stock seemed normal enough up until a week and a half ago Friday. It was at that point that their stock surged on heavy trading from $2.84 to a closing price this past Thursday of $4.49.
MOVI 1-yr chart
Over the last five trading sessions, Movie Gallery has seen nearly 20 million shares trade hands when normally on any given week they’d be lucky to see 3 million shares trade.
With Movie Gallery’s stock price up 50% over just one week, a lot of people have been wondering what the heck has been going on, including myself. While there are several theories that have been circulating, I contacted a few Movie Gallery bond traders, and their theory behind the surge stems from a rumor that Movie Gallery debt holders are planning on converting their bonds into an equity position.
Now normally, if you are a stock owner, this would be terrible news. A debt for equity swap would lead to massive dillution of your shares, but in Movie Gallery’s case the market had become so convinced that were going to file bankruptcy that the stock had been oversold to a point where everyone was convinced that bankruptcy was the only option. If bondholders do agree to swap their debt for equity however, there could still be significant upside for shareholders, as long as Movie Gallery manages to stay out of bankruptcy court. By investing in the equity over the last week, shareholders have essentially been betting on a single number on the roulette table. If their number doesn’t come up, they’ll lose their lunch, but if their number does, then they could see significant returns, even after this most recent rally.
As one bond trader pointed out to me, “regardless of what management comes up with, MOVI is going to get rid of this debt one way or another, it’s just a matter of whether the bond owners want to do this the easy way or the hard way.” Bond holders aren’t stupid; they want to get paid just like everyone else and if they force Movie Gallery into bankruptcy then the odds of their bonds paying off go down significantly, plus they then have to go through the hassle of fighting with other creditors, liquidating the business and spending time in court. Currently, Moody’s estimates that bondholders would get anywhere between .44 cents to .88 cents on the dollar depending on the note, if a liquidation sale were to take place.
At the same time, bond holders can’t continue to give Movie Gallery more rope by easing covenants again because the fact of the matter is that Movie Gallery simply cannot continue to pay the interest rates on their debt. At this point, bond holders can either force a fire sell or they can seize control of the company peacefully and hope to squeeze a profit from the free cash flow, as the video store business model slowly unwinds. The activity over the last week, clearly indicates that Wall Street believes that the bond holders are ready to become stock holders.
While all of this is just rumor and speculation it’s still been enough to drive up Movie Gallery’s stock price, and if you think through the implication that this kind of a deal might have, it does have the potential to turn the video store industry completely upside down.
Even after Movie Gallery’s recent sharp run up in price, the company’s equity is still only valued at $143 million dollars. In addition to their equity they are also sitting on $1.38 billion in debt. With Movie Gallery’s bonds currently trading at about 78 cents on the dollar, if we were to assume that the bond holders allow their debt to convert to equity at 80% of the debt’s worth, it would take Movie Gallery’s market cap to about $1.25 billion following the conversion.
When you consider that Movie Gallery would have earned approximately $100 million in net income over the last year, if you exclude their interest payments and one time items, you can see that even if you valued the business at a p/e ratio of 10, it would still put the business at a market value of about $1 billion. If you valued the business closer to Blockbuster’s P/E of 19, then it means that Movie Gallery’s stock price could still go up another 50%, to around $6.80, before stock holders would lose out from dilution from the debt.
Even without the higher multiples on Movie Gallery’s stock though, without their debt they’d still make a pretty attractive company from a balance sheet perspective. It would leave them still sitting on $1.2 billion in assets and, while it's always possible that the company’s stock price could drop below that, with their newly found free cash flow and a healthier balance sheet it’s hard to make an argument that they’d deserve to trade very far under book value, unless you felt the DVD market was going to collapse overnight, instead of a more orderly dismantling.
Now all of this is a pretty speculative on my part and of course if you play with the numbers or the conversion rate even a little bit, it can dramatically change these valuations, but the point is that if bond holders behave rationally and take over the company in a peaceful transition, there could be tremendous upside potential for both debt and equity holders. If on the other hand, bond holders force a bankruptcy, then the bond holders will still be left with something, but stock holders would likely be left holding a bunch of VHS tapes.
If Movie Gallery is even able to successfully convert part of their debt into equity [a more likely scenario then all of it really], it could represent a serious blow to Blockbuster. Netflix’s (NFLX) variable cost structure and their online only business model would help isolate them from a stronger Movie Gallery, but Blockbuster competes head to head in many of the same markets as Movie Gallery and they have been very vocal about their plans to try and cash in on Movie Gallery’s demise.
With Blockbuster left dealing with problems related to their own debt, a more nimble Movie Gallery could use their new found flexibility to attack markets that Blockbuster has been leaving or to be more competitive in markets where they face the rental giant directly.
Even free of their debt obligations though, Movie Gallery would still need to adjust to this new digital world. If by eliminating their debt they can remove the ticking time bomb that investors have feared for so long, Movie Gallery could quickly emerge with a hit sequel that even I never thought possible, after their first one bombed so bad.
Disclosure: Author holds positions in above-mentioned stocks.