Further upgrade the likely scenario at HMV

GIVEN the escalation seen in private equity buying in the retail sector in Britain over the past 12 months, it was interesting this week to see Advent, the private equity firm, sell its 7.8% holding in the HMV Group.

What was even more interesting about this share sale was the fact at £1.53 a share, Advent sold its stake for 20% less than the value of the shares when they came to the market in May 2002.

So is this an indication retail shares have moved too far and the prospects for this company are unexciting?

Institutional investors do not appear to think so. The placing of 31.7m shares on Wednesday was well- subscribed, with investors willing to buy a lot more stock should it have been available.

Sentiment towards HMV Group has turned increasingly positive since the release of the company’s final results on July 1.

Ahead of expectations, what really caught investors attention was the fact that, excluding a number of one-off exceptional costs, the underlying figure was significantly better than that reported. As a result, earnings forecasts for the current year now look conservative, with upgrades likely over the months ahead. HMV Group as it currently stands was formed in 1998, when EMI and venture capitalist Advent, came together to buy Waterstone’s from WH Smith group, and HMV and Dillons from Thorn EMI.

The group now operates more than 500 shops in 11 countries, with more than 3.2m square feet of selling space and 13,000 employees. HMV is the larger business, accounting for 75% of revenue and profits.

It is ranked number one in the British music retail market, with a 25% share and has a similar share of the DVD market. Also ranked number one, Waterstone’s is Britain’s leading specialist book retailer, with 16% of the consumer book market.

While well-positioned in terms of British market share, there have been marked differences in the performance of HMV and Waterstone’s since 1998.

HMV has performed exceptionally well, delivering strong profit growth. Waterstone’s, however, has seen profits fall nearly 60%, mainly due to the ending of price controls in Britain.

Management has responded, replacing most of its senior managers with HMV chain managers, with the aim of applying the more aggressive marketing and control methods of the music retail industry to Waterstones.

There have been early signs of success. Waterstone’s has stabilised its sales position and is now reporting positive profit growth.

But while profits recovered from £22m to £24m in the fiscal year just reported, they remain significantly lower than the £48m generated in 1998.

The HMV chain also offers potential for continued growth. In Britain, new space is being added at a rate of 7% per annum, while overseas growth will be focused on Japan and Canada.

Longer-term structural issues remain. Competition from the internet and generalist retailers looks set to remain a negative. Amazon.com took 5% share of the British book market within 18 months of entry to the market.

Since then however, market share has remained stagnant and generalist retailers have taken over as the main source of competition.

Despite this, however, the shares appear to offeran attractive upside.

Trading on 8.1 times current year earnings, the rating looks undemanding for a stock expected to deliver 14% earnings growth this year. In addition, with 10% of this 14% growth underpinned by the non-recurrence of one-off charges earnings upgrades look increasingly likely.

Recent statements from management have been upbeat, suggesting the company could once again surprise on the upside when it next reports.

For further information on HMV, please contact Goodbody Stockbrokers; telephone [phone].