Virtuous Vertu and the canine status of HMV

A flurry of activity this morning when I switched on my Blackberry to see trading updates from HMV and Vertu. Let's start with the bad...

HMV (LON:HMV)

The two pieces of news this morning were short and pithy, but no less significant.  The first announcement was a trading update since the last one a mere seven weeks ago. In that period, profits will now be "moderately" below market expectations (which were £45m of PBT based on the median expectations -  there must be some crazy stuff out for them to use median) due to "challenging" trading conditions.  To compound matters, debt will not be less than £130m due to changing product mix and adverse working capital, and it now expects to breach certain banking covenants based on the full-year tests. The Company has commenced discussions with its lenders, who "continue to be supportive".

In the second announcement, the Chairman has stepped aside (to focus more on M&S presumably) and Philip Rowley has picked up the mantle with immediate effect.  The shares dropped over 20% to 16.5p in early morning trade, giving the Company a market value of £88m.  Before I starting writing this, my mind-set was to ditch HMV along the lines of 'run the winners and cut the losers'. 

It's easy to paint a very bleak picture: tough trading, profits below expectations, covenant breach on the cards, debt higher than forecast, reduced cash generation, big sector/cyclical issues playing themselves out and the Chairman stepping aside.

Is there any Value here?

I have no idea what "moderate" means in terms of black and white (or red) numbers, but let's assume PBT comes in at £30m (two-thirds of median expectations - sounds moderate to me). Tax this at 28% and EPS equates to about 4p per share. The current share price of 16.5p equates to a PER of 4.1x. The dividend policy is to aim for say 3-4x times cover, so a theoretical dividend of 1p per share would be possible. The interim dividend was 0.9p, so rule out any further dividends in the short-term from an earnings perspective and in any event, the banks will not permit it if the Company has breached covenants or will breach covenants on a look-forward basis. EBITDA looks interesting given that that DA was about £45m in FY10 (I would expect it to be higher in FY11) and Interest will be, say, £10m (v £7m in FY10). This gets us to an underlying EBITDA of £85-90m for FY11. Based on an EV of £220m (£130m debt and £90m equity), this represents an EV/EBITDA ratio of 2.5 times.

We would want to look at the rent-adjusted position given that it is a retailer, but I am not sure how much sensible analysis can be undertaken given that they are on a store closing programme.  HMV is priced for failure based on a PER of 4x and an EV/EBITDA of 2.5x. The two aspects that worry me most are (i) cash generation - is the adverse working capital temporary or permanent (if the former, then the level of debt is higher than normalised and cash should come back in) and (ii) the size of the 'exceptionals' and the extent to which these are cash items (eg redundancies and unexpired lease costs).

The other interesting aspects are: the Russian Mamut waiting in the wings and/or the potential disposal of Waterstone's. If Waterstone's was valued at £50m (figure plucked from the air via "media sources"), this would equate to a fully-taxed gain of about 7p per share - from what I can see, this is not reflected in the share price.  I would not be surprised to see a Rights Issue appear sooner rather than later too. HMV is one sick mutt, but is it terminal? Not yet; I can still see some value here, but the next few months are going to be very interesting indeed. Stick or twist?

Vertu Motors (LON:VTU)

Vertu is the Ying to HMV's Yang (if that's the right way around).  Trading has remained strong and results are likely to be ahead of FY11 expectations (EPS of 2.7p as per Digital Look) . Market share has grown, cash generation has been good and a final dividend of 0.3p has been disclosed (full year DPS 0.5p; yield of 1.8%). On the down-side, there will be exceptional costs in relation to asset write downs and financing costs. I am topping up my holdings in HMV (LON:HMV) and Vertu Motors (LON:VTU).