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Valuation Anomaly at HMV?

|Includes: Hmv Group Plc (HMVMF)

The CEO of HMV, Simon Fox is two years through a three year turnaround program and appears to be doing an excellent job.

A glance at the above chart of the FTSE 100 highlights the continued strength experienced in equities this week.

Global markets have rallied substantially over the past six month, with the FTSE and S&P gaining around 50% and 60% respectively since the March lows.

US Federal Reserve (FED) chairman, Ben Bernanke said this week that the recession in the US “is very likely over”, which helped equities to extend their run of gains. The FED also released industrial production data showing a better than forecast 0.8% rise in August as factories boosted production of cars, machinery and other goods, which sparked renewed optimism over the economy.

Technical analysis shows the continuation of the sharp bullish channel formation that has been in place since early July, with the upper boundary seen at 5400. The relative strength index (RSI) has also traded a fresh high for the first time in a while, which suggests that the buying momentum is building in this new wave of enthusiasm.

However, it is worth noting that the rally has been among the sharpest experienced for decades and a period of aggressive profit taking could occur very quickly. A move below the lower band of the channel at 5000 may suggest a break of trend and could be the trigger behind a move downwards.

In summary, the inherent momentum and growing confidence of further economic improvement cannot be ignored. Having experienced a horrific last two years on the market many investors are almost pre-disposed to thinking the rally won’t last and after sitting on the sidelines for a few week they are being forced to reconsider their views.

Trading with the trend is a much talked about phrase and is likely to be the safest and most effective way of trading this market, although investors should be vigilant and be prepared to close positions should a break of 5000 occur in the short term.

Many of the major UK retailers have updated the market with better than expected results recently, with the likes of Next, Kingfisher, Primark and Dunelm reacting positively to their reports.

However, despite a strong start to the year many retailers are predicting tough trading conditions ahead. John Lewis is seen as a barometer of British retail and posted a 20% fall in first half profit this week. Chairman, Charlie Mayfield said that 2010 may be difficult, forecasting a “slow drawn out economic recovery ahead”.

The Office for National Statistics (NASDAQ:ONS) published a flat month for retail sales in August, against expectations of a small rise, with clothing sales exerting the biggest downward impact.

Analysts had predicted a 0.1% rise on the month and August’s unchanged reading took the annual rate of growth in retail sales to 2.1% from 2.9% in July. In addition, July’s previously reported monthly gain of 0.4% was revised down to a rise of 0.2%.

However, despite last months weak data, sales in the three months to August rose 1.2%, the biggest rise since May 2008, which is an impressive performance given the weakness of the economy. The official measure of retail sales has been unusually resilient for much of this year, which has surprised analysts who had predicted much weaker conditions given Britain is in the midst of its worst recession in decades.

There is no denying the backdrop for the sector is tough, with challenging economic conditions and cautious outlooks from many companies. Although the shares of Marks and Spencer, Next, Kingfisher, etc have doubled this year it is hard to ignore the inherent momentum behind the sector.

I have spent much time analysing the retailers and in general I am cautious at current prices and valuations. However, HMV (Epic: HMV), which is one of the worlds leading retailers of music, video and console games and also the leading retailer of books in the UK through its Waterstone’s brand, appears to be a valuation anomaly.

The CEO of HMV, Simon Fox is two years through a three year turnaround program and appears to be doing an excellent job. Historically net debt has been of concern, but this has been reduced to around £6.5 million, which for a profitable company turning over circa £2 billion a year is no longer seen as a major problem.

The demise of competitors such as Woolworths and Zavvi has played into their hands and management is capitalising on this by opening temporary stores in a few of the locations of its fallen rivals in order to take advantage of the run up to Christmas.

The group has also diversified recently into cinemas and live music by entering many joint ventures, which will add further depth and value to the business. Also, the recent acquisition of a 50% stake in 7digital, a digital media company, should grant them access to a large digital catalogue and improve Waterstone’s e-book capability.

The shares are currently trading on a forward PE of 8.3x, which puts them at a 60% discount to the sector average of 13.5x. This is accompanied by an attractive dividend yield of around 7%, which is well covered with almost twice earnings and should support the shares from much further weakness. Directors have been buying and many analysts have recently published targets of 150p+.

As can be seen from the above chart of HMV the shares are well off their 2009 high of 159p and are re-testing support marginally above 100p.

The oscillators are in oversold territory with both the stochastic and RSI trading within close proximity of multi-year lows. The stochastic has also started to cross over, which often gives an early indication of a change in direction.

In light of our earlier analysis of the FTSE and the strong fundamental and technical analysis discussed for HMV, I am bullish on the stock in the near term and believe the dividend and valuation will support the share price going forwards.

At the time of writing the share price is 106.3p and my short term opinion is higher. Near term targets are seen at 112.5p, 116p and 122p, with a stop loss marginally below the psychological 100p level at 99p, it offers an attractive risk/reward basis.

In order to reduce risk, traders may consider pairing it with a smaller size short in another retailer. Marks and Spencer is on a forward PE of 15.2x, which puts them at an 83% premium to the sector and the shares are technically extremely overbought.

This report was written by Mark Allen – Head of derivatives at Simple Investments Stockbrokers. The writer does not hold a position in HMV. The material in this report has come from Simply Charts and HMV’s corporate website.