This article by John Snowden was published in The IRS Report in November 2010...

HMV Group could enjoy a Santa Claus rally

HMV has a rich heritage and its brand is probably one of the most well known, both in the UK and internationally. The inaugural HMV store at 363 Oxford Street was opened in July 1921 by the composer/conductor Sir Edward Elgar.

In those days sheet music was all the rage and an HMV-brand gramophone was obtainable for as little as five pounds, a sum which nowadays would barely cover the cost of parking your car for an hour outside the back entrance.

The "Nipper" trademark was established some 24 years earlier when a William Barry Owen departed from the shores of New York to syndicate the Berliner Gramophone. In 1901 the Gramophone Company registered the famous dog-and-gramophone His Masters Voice Nipper painting by artist Francis Barraud.

Jumping ahead in time by a century, the HMV group had diversified and had become one of the world's largest specialist retailers of entertainment and books. Through two world wars and several major recessions, the company continued to prosper and expanded internationally into Australia, North America, Japan, Singapore and Hong Kong.

The Australian operation wound down in 2005 when the stores under the HMV Australia were sold. The US operation established a strong presence in Manhattan and HMV also had a handful of stores on the Eastern United States which were managed from Canada. Poor real estate decisions led to a winding down with the last store closing in late 2004.

The Canadian operation had a shaky start in 1988 as it coincided with the bankruptcy of the Canadian A&A chain. Further retail bankruptcies followed, which strengthened HMV's market presence. Today, there are 125 stores and HMV has been awarded "Canadian Music Retailer of the Year" for the last two decades. In 2005, HMV became owner of the largest store dedicated to music and DVD as it took over the Virgin megastore in Vancouver.

On the other side of the world, HMV operates five stores in Hong Kong, following a policy of opening in new shopping malls. Prices are higher than competitors but the appeal to the shoppers is the well-organised and free-sampling environment. The company was also the first in Asia to launch in-store digital kiosks.

HMV became the second record chain to set up in Singapore, following in the footsteps of Tower Records, now closed down. Again, competition for recorded music sales is fierce but HMV is the only store which sell games, T-shirts and audio gear in addition to music and video.

Visitors to Japan will see the HMV Japan brand in around 62 shops but the Group sold out in mid 2007 to DSM Investment Catorce.

In 1998 HMV acquired the book chain Waterstones from WH Smith. It was about this time that the internet was making inroads on the established businesses. In 2006 the CEO Alan Giles, who had masterminded the Waterstones deal, retired and was replaced by Simon Fox.

The internet prompted the start of HMV's decline and competition in the high street was fierce. Having looked at ways to enhance shareholder value, HMV made a bid for rival Ottakar through the Waterstones subsidiary. The bid was finally cleared at the end of May 2007. The 130 Ottakar stores were rebranded as Waterstones in time for the Christmas season.

To add spice and give more foor for thought to the board, HMV Group was in the bid spotlight as private equity group Permira popped in a bid of £847m, worth 212p per share. The bid was rejected as the board thought it undervalued the group. The share price eased back to 185p.

By mid-March 2007, a profit warning announced that results for the year would be below market expectations. At the same time, the company announced the launch of a three-year turnaround strategy, whose cost-cutting targets have largely been achieved. At about this time my colleague Peter Shearlock selected the shares as a recovery play.

Towards the end of 2007, the board were again making bullish noises as the Japanese business was sold for approximately £70m. The shares were trading around 125p.

The first half of 2008 saw a change of financial adviser and stockbroker and a bullish statement was issued in May. The pre-Christmas statement stated the company was well prepared for this important trading period. The share price had been trading between 100p and 150p all year but ended the year as 100p. Several commentators recommended the shares for recovery which gave the price a kick-start in January 2009, and the shares traded between 120p and 150p for the first three quarters of 2009.

At the turn of 2008/2009, the group made a £46m offer for a 50% stake in MAMA Group, whose joint partners were Mean Fiddler and SMS Finance. This was part of a deal to introduce the HMV brand to live music venues, including The Hammersmith Apollo, The Forum, The Garage, Jazz Cafe and several Gay Bars outside the capital.

The deal was funded by a 20.16m share placing at 122.5p which raised about £25m gross. Part of the cash raised was used to acquire six Zavvi stores, rebranded into HMV outlets. The share price held firm, the board outlook was bullish and the three-year plan formulated in 2007 was back on track.

In September 2009 the group acquired 50% of 7digital Inc for £7.7m from its venture capital backers. The new joint venture would accelerate growth in the rapidly evolving digital entertainments market. The deal would transform existing HMV operations  in UK and Canada and provide a new platform for a new and enhanced e-books store to enable Waterstones to maintain its strong position in selling digital books. In December, HMV made an offer for all the shares in MAMA not already owned, which was accepted and completed in April 2010.

The results for the 52 weeks to 24th April 2010 certainly reflected improvement all round. The demise of Woolworth and Zavvi on the high street probably helped and pre-tax profits of £74.2m, up 17.7% from £63m and record sales in excess of £2bn, were up to market expectations. The total dividend for the year was unchanged at 7.4p, banking facilities were refinanced and in a difficult trading environment the company had successfully placed shares to fund future acquisitions.

The company was deleted from the FTSE250 Index in June and this may have contributed to the share price dropping to 55p by the end of June, though it then rose strongly to 70p in July. In September 2010 the group finance director Neil Bright announced he was leaving in December to move to Holidaybreak plc, but the board issued another positive statement adding that the plans for the peak trading period were in good shape. There were rumours that former Waterstones boss Tim Waterstone was planning a bid for the book division but these were dismissed by Simon Fox and no more has been heard.

The main recent upset was a plunge in first quarter sales (spring 2010) as shoppers stayed away from stores to watch the soccer World Cup. Sales in the UK and Irish stores were down about 15%, international sales were down 9%, while total group sales including the contribution from live music events were down 5.9% on the year.

The foray into live music initially hit a wrong note. Simon Fox told journalists that the company had been too ambitious in launching its inaugural High Voltage classic rock even on Summer 2010 and that the company would refocus its attention on taking over the running of existing festivals.

The first quarter is traditionally lower than the others and the board remains optimistic for the Christmas period as a number of new products could become festive hits. I believe this is a classic recovery situation. After all, the board turned down a bid of over 200p, since when profits are higher while long-term finance in place. The festive season is also a time where the market usually has positive thoughts.

You can see all of John Snowden's articles at www.TheIRSReport.com

John Snowden is a regular contributor to The IRS Report.

Call 0800 756 5437 or click here for more information.