Hollywood Entertainment (HLYW) is very undervalued.
Price target is $22-$25
Following are my investment hypothesis:
1) Significant baked in-cash flow in maturing store base
2) Market large and fragmented, significant opportunity to grow store base from 1000 to 3000 stores
- Mature store ROI = ~50%
3) Revenue sharing will hasten consolidation opportunity
4) Stock market overreacted significantly to fears about re-emergence of Blockbuster video
- I believe this quarter will be fine
Detail on investment hypothesis:
1) Significant baked in-cash flow in maturing store base:
New Hollywood Entertainment stores perform better over time. When a new store opens, it takes a while to ween people from their traditional mom & pop video retail outlet to the more compelling shopping/availability Hollywood format. People slowly become familiar with the store and brand name over time, and gradually do more shopping there (Just like Home Depot takes more people from the local hardware store over time). Goldman Sachs data indicates that on average a typical Hollywood Store does $625k revenue in year 1 and $70k of cash flow, and then $800k of revenue and $180k of cash flow in year 4 (large incremental contribution - tape gross margin drops to bottom line). At the end of FY 97, they had 907 stores. Of those 907, 356 were opened during 1997, and another 246 were opened in 1996. Well over half their store base therefore is very new. If you looked at how much cash flow the existing 907 stores will generate in 2 more years after they are fully matured, at Hollywood's current valuation, you are buying the existing stores for about less than 6x fully burdened (corporate overhead, etc.) free cash flow, which is incredibly cheap for the 907 stores alone.
2) Market large and fragmented, significant opportunity to grow store base from 1000 to 3000 stores - Mature store ROI =~50%
Blockbuster has about 30% of the market, Hollywood about 8%, Other public companies about 6%, and the rest are Mom & Pops. There is a huge remaining opportunity for both Hollywood and Blockbuster to gain share. In the previous paragraph, my hypothesis is that at the current valuation, you are getting the 907 stores that Hollywood already has on the cheap. The extension of that hypothesis is that you are getting the next 2,000 stores that Hollywood opens for "Free". Goldman Sachs data indicates It costs about $400k to open a store and the average store does $180k cash flow on a mature basis. This is a 45% mature store ROI, so the economics of these stores are incredibly good. I don't think the stock market understands how good video stores are from a cash flow/ROI perspective.
3) Revenue sharing will hasten consolidation opportunity
My first two hypotheses become magnified under revenue sharing. Revenue sharing greatly increases customer satisfaction through guaranteed availability of tapes. This makes it all the more compelling for someone to go to a Hollywood as opposed to their normal retailer because they know they can get the hit movie at a Hollywood Entertainment store. Therefore, the dynamics of 1) the store maturation pattern should improve because 2) the consolidation pattern accelerates because Hollywood will now be offering a more compelling value proposition than they previously had
4) Stock market overreacted significantly to fears about re-emergence of Blockbuster video
- I believe this quarter will be fine
Hollwyod was a $14 stock about 2 months ago. It collapsed to $11 recently. The collapse started after Viacom reported and indicated Blockbuster comped up 10%, as compared to Hollywood's latest 5% rental comp. Then, another public competitor, Video Update, reported a bad quarter, and blamed their troubles on a rejuvinated Blockbuster. My reaction is several fold. A) Blockbuster comped up 10% against a (1%) comp last year as opposed to Hollywood doing 5% against a 5% comp last year. Over the year period, therefore, Hollywood actually did better (1.05x1.05=1.1025 vs. 1.10x.99=1.089). Blockbuster just had an easy quarter to comp. against B) Blockbuster and Hollywood don't really compete against each other, the focus of both is to consolidate a very large and fragmented market. Concepts with inferior product offerings/retail environments bear the brunt of Hollywood and Blockbuster growth. Video Update is having trouble because their stores are no-frills boring shopping environments that don't attract customers. Mom & Pops have got it even worse when you compare their offerings to a Hollywood or a Blockbuster. C) However, I don't completely dismiss Blockbuster either, as they are a sleeping giant. To me, this quarter is a very interesting quarter for Hollywood. This is the last quarter Blockbuster will be ahead of Hollywood both in terms of revenue sharing agreements with major studious and a national advertising campaign. Next quarter, Hollywood will be "caught up" as their revenue sharing deals are finalized and the advertising campaign rolls out. Also, during this quarter, they comp. against Jerry McGuire, which is the single best rental title of all time. Anyway, this quarter is their single biggest risk point in my mind, both due to lag against Blockbuster and Jerry McGuire comparisons. Apparently, in the face of these two issues, they are doing fine (with only one week left in current Q). If they can do fine in this period, things should only get better. Comping up this quarter would be a stunning achievement, and if it happens it really demonstrates the robustness of the Hollywood concept.
Summary:
Valuation compellingly cheap on a cash flow basis, huge opportunity in large market to grow store base and free cash flow -> story very misunderstood by Wall Street as stock out of favor.
The above information is all my opinion. I have posted this hypothesis because I own the stock and I want to give people a chance to react to my thoughts so I am better informed. I appreciate all constructive comments, whether positive or negative. Feedback is appreciated. Good luck investing.
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