Hastings Entertainment: Small Market Cap, Big Potential

| About: Hastings Entertainment, (HAST)

Hastings Entertainment (NASDAQ:HAST) is an under-followed, under-loved, and under-valued stock in my humble opinion. I first purchased shares in this company back in 2005 when the stock hit $4.75 per share in October of that year. At the time, Hastings had around 11,500,000 shares outstanding and a book value of around $8.3 per share. I knew of the company from shopping there as a a kid in my home town, where Hastings has a small location that is said to be their last mall based store (most stores are 10,000 square feet located near colleges).

I always liked the value proposition -- movie rentals and CDs on the cheap. Hastings was in fact started as an offshoot of Western Merchandising and grew out of Wal-Mart (NYSE:WMT), so the value priced philosophy is at the heart of the business model. I also always had fun shopping at Hastings, whose stores are usually filled with younger people and have morphed into a small town gathering place for teenagers on Saturday night.

Hastings unique model is based on diversification. When I first started shopping at Hastings, their biggest category was CD sales and VHS rentals. Over the years, Hastings has managed to transition into new and used video game sales, new and used books, food and beverage, musical instruments, consumer electronics including Apple (NASDAQ:AAPL) products, toys, greeting cards, clothing and accessories, and last but certainly not least... movies. The coffee shops have Wi Fi but the stores are so much fun that the customers respect the place, unlike a Borders (BGP), for example, where last week my friend said he saw an arts and crafts class being taught in their coffee shop. Many times, people at Borders read through all of the magazines only to slip out the side door without actually buying anything. Hastings is the low cost leader in their markets so there is always something cool to pick up for a few bucks; for example, the last time I shopped Hastings I bought a used Beastie Boyz album for $3 bucks and a baseball cap for $6 with a Rolling Stones Lips logo on the front -- and I'm still a fan even though Keith Richards recently called Mick Jagger "Her Magisty" and tried to snort his creamated father -- alas, the trials and tribulations of a rock star.

The movie rental and DVD sales business are not very "sexy" businesses right now as far as investors are concerned, and obviously these lines are under some pressure due to Netflix (NASDAQ:NFLX) and the much publicized push towards digital and vending in the home entertainment market. That said, Hastings is not a dinosaur like Movie Gallery (MVGR.PK) or Blockbuster (BBI) and has become the lowest price movie rental business option in the country, offering movie rentals for just $.49 cents per day and a max late fee of around $15 bucks on most titles. For me, there is no reason to purchase cable television or Netflix if you live near a Hastings.

As a value investor and value conscious shopper, these moves are impressive to me, and the dollar store concept is a main reason I hold a large concentration in the stock. Trading at $6.50 per share, Hastings is valued at just 56% of Net Tangible Book Value and just 4.46X 2009 free cash flow.

Over the past six years, Hastings has repurchased millions upon millions of shares of its common stock, reducing share count to roughly 8,920,000 shares from 11,450,000 shares in Q4 2005. The book value per share today is $11.77 up from $8.4 in Q4 of 2005, or a gain of 40% -- roughly 6.7% per year. Needless to say, all of my relatives receive Christmas gifts from Hastings.

Although sales and earnings per share have stayed roughly flat over this time frame, the value created for shareholders is truly undeniable and results partly from the low float in the name and the wild swings in the company's share price. Hastings, for example, traded from $4.75 where I first bought it to a high of $10 per share in 2007, to a low of $1.38 in 2008, and to a high of $9.3 in April of 2010... Talk about a roller coaster ride -- thankfully, management repurchased shares at low prices which more than makes up for any discomfort the Level 2 screen might induce. For me, the lower the stock drops the less I think about the position as I know management can repurchase shares at pennies on the dollar.

One of the many reasons that beta does not do justice to market risk is a stock like Hastings. Although it sports a tiny market cap, Hastings does over half a billion in revenue yearly and has spit off over 23MM in operating cash flow per year over the past several years.

When investors were buying shares recently over $9 they were buying with a fairly sizable discount to tangible book value and at a price of $9 were paying just 3.6X operating cash flow for one of the strongest businesses in my home town. The best part about investing in companies you really understand and love is that you can hang out at the stores and watch the shoppers and customer reaction to the product or service. In other words, the more you know about a company, the better the investment becomes over time.

At $6.50 per share, Hastings is trading for around 2.3X cash flow from operating activities and just 57% of book value. Over the past three years, the company's average liability levels have decreased from 160MM to 130MM, which led the stock to become a member of the "Piotroski" screen on AAII. Investors then bid the stock up to $9.3 per share in April of 2010. Unfortunately, many of those Piotroski screen buyers with shorter term investment horizons likely sold the stock for a loss instead of adding "on the puke."

Hastings creates value by knowing their customer base and by returning cash to shareholders through share repurchases at a steep discount to book value. The company has much larger operating and free cash flow margins than net profit margins, which is one reason the company continues to remain undiscovered, under-loved, and undervalued. Mainly this stems from large depreciation expense from building out things like "Hardback Cafe" used books, etc..

My strategy for the stock is to buy on the dips like the recent crash from $9.3 to $6.5 -- if one had shopped the stores on a Saturday night and waited in the sometimes 20 people long lines they would see that at the low in 2008, a 1000% return was possible. So, while I am bullish on the shares in the short, medium, and long term, I am also aware that the stock price has a wild and manic trading pattern and that its always best to add on the big drops and possibly to sell some of the shares close to book value. This company is well managed and the CEO owns 30% of the shares. I find it promising that the company recently announced an additional $10,000,000 share buyback plan and that the CEO is not selling his shares in any major way at the highs in April. In fact, in the last quarter Hastings repurchased around $3.5MM of its own stock, which is the equivalent of CEO John Marmaduke buying $1.1MM of HAST common stock.

In the end, this is a long term investment growing book value per share at 7% compounded per year at a 43% discount to tangible book value with a price to free cash flow ratio of under 5X.. Eventually the market will discover Hastings common stock in the same way Hastings customers' have discovered the stores.

Disclosure: Long HAST