The Comvest Report
Initiating Coverage with a BUY,
August 6, 1998,
CDWI $17.3,
Analyst Thomas Escamilla
Growing By Creating The Pre-Owned CD Market
CD Warehouse is the Dominate Retail Chain, Selling Pre-Owned Music CDs.
CD Warehouse, Inc., is the number one retailer of pre-owned music compact discs (CDs), in the US with a total of 300 stores in its system. It is positioned to seize the lion's share of the rapidly growing $1 billion pre-owned CD market without competition by any similar retail chian. By FY98 system wide sales will account for 6% of this market, up from 3.6% in FY97. Based on date from the 1998 Billboard Record Retailing Directory, it is the fifth largest music retailer in the US, measured by number of stores.
Investment Merits
The following factors lead us to believe that CD Warehouse is poised for continued profitable growth and represents an excellent investment opportunity at current levels.
1.) In FY98 and FY99, sales and EPS are expected to grow at an annual compound rate of 74%
2.) The stock is undervalued selling at 40 times FY89 EPS estimate of $0.43 or less than half the expected EPS growth rate for that period.
3.) As the largest retailer in the high-margin and high-growth, pre-owned CD market, it deserves a valuation that reflects its 74% secular growth rate, resulting in a price target of $50 for the next 12 months.
4.) It is the leading retailer in the pre-owned CD market with 1997 store growth of 33% (added 37 stores) and same store sales growth of 23% in the first quarter 1998.
5.) The management team has a proven ability to grow business profitably through store operations, acquisitions, and franchising at Sonic Corporation and others. CEO Jerry Grizzle is a brand builder set to make "CD Warehouse" as ubiquitous as music.
6.) The proprietary Inventory Management System sets the company apart from competitors because it enables franchisees without experience in the music business to run stores profitably by telling them what titles and quantities to buy and at what prices. The main profit driver is the avoidance of titles that do not sell. Independent store operators will be compelled to sell or switch to the CD Warehouse concept.
7.) CD Warehouse is likely to sustain its secular growth rate because, i.) it has the capabilities to continue consolidating the 4,500 independent music retailers, (ii) the $1 billion US pre-owned CD market is expected to grow by at least $200 million annually and, (iii) Internet and foreign markets offer vast growth potential.
8.) The company has a record of EPS-accretive acquisitions, about $7.5 million in cash, no long-term debt, and a small float of only about 1 million shares.
9.) It is a prized takeover candidate for Sony or MCA as they recognize that the pre-owned CD market stimulates new CD sales by making new CD's more affordable.
Investment Risks:
1.) That the company may not be able to achieve the expected 33% store growth which contemplates adding 50 new stores in FY98 and 66 in FY99 plus the integration of the recently acquired 137 units.
2.) That the market of pre-owned CDs may not develop as anticipated.
New CD market is Huge and will be Fueled by Internet Sales
Based on date published by the Recording Industry Association, the size of the new CD market has grown from almost $5 billion in 1992 to $10.2 billion in 1997. During that period, more than 3.5 billion new CDs were sold. It is estimated that in the past 10 years a total of 4.5 billion new CDs have been sold.
In 1997, total music industry sales totaled $12.26 billion. According to Forrester Research, the music industry is expected to grow to $14.3 billion in 2002 with most of the growth explained by a dramatic surge in Internet sales.
Based on the above figures, it is estimated that in the enxt five years, the new CD market will grow from $10.2 billion in 1997 to $13 billion in 2002. It is estimated that during that period, 5 billion new CDs will be sold. Internet sales create distribution efficiencies that trigger downward pricing pressures while increasing CD unit volumes.
In recent years, developments in the new CD market have spawned growth in the pre-owned CD market. Non-traditional music retailers such as Best Buy, Circuit City, Wal-Mart, K-mart and Target began deep discounting of new CDs using them as loss-leaders to generate store traffic. Traditional music retailers such as Musicland, Camelot and Transworld have responded to this price erosion by taking huge losses, closing stores, changing product offerings, and changing store sizes and locations, among other strategies. The net effect is that now more CDs are sold at lower prices, thus feeding more CDs to the pre-owned or secondary CD market.
Pre-Owned CD Market Adds Value to Used CDs and Makes New CDs Affordable
The pre-owned CD market transforms the purchase of a new CD from and expense into an investment with a future recoverable value. It provides a framework to capture resale or trade-in value. For CD owners who decide to hold on to their CDs, the pre-owned CD market makes them holders of value previously not existent.
For CD owners who decide to sell or trade their CDs, the pre-owned CD market helps reduce the cost of CD ownership. Which in turn triggers new CD demand. People will purchase more new CDs (primary) if they know they can reduce their ownership cost by selling or trading them in the pre-owned CD market (secondary). This lower cost becomes like a CD rental fee for an unlimited time with the ability to return (re-sell or trade-in) it at multiple locations. Likewise, in the auto industry, care owners are more likely to buy new cars (primary) if they can trade-in (secondary) their used cars to reduce their cost of car ownership.
The emerging pre-owned or used CD market creates economic value for CD consumers. It will flourish as consumers become aware of it and the value it creates. It is organic to the music industry in the same way the used care market is an integral part of the automobile industry. In the automobile industry, te used care market is well established and is defined as 6.6% of the cumulative number of cars sold in a given year represented by the number of car registrations.
$200 Million Annual Growth Expected in the $1 Billion Pre-Owned CD Market
Pre-Owned CDs are rapidly becoming a hot commodity as consumers become aware that at certain retail outlets like CD Warehouse, they can sell CDs for cash or trade them even if they ere originally purchased in other stores like Best Buy or Musicland. Given that it is an emerging market, it is estimated that for every 31 new CDs sold, 1 of them will end up in the pre-owned market. The market for pre-owned CDs in any given year is thus defined as 3.2% of the cumulative number of new CDs sold in the US valued at an average selling price of $7.
The Emerging US Pre-owned or Secondary CD Market
(all figures in millions)
Year==================1997==1998=1999==2000==2001==2002
Cumulative New CDs (Units).4485.5376.6320.7319.8377.9488
Pre-Owned CD (Units).....144...172...202...234..268....304
Pre-Owned Retail sales ($).$1004..$1204..$1416..$1640..$1876..$2125
The size of the pre-owned CD market is estimated at $1 billion in 1997 and is expecte to more than double to $2.1 billion in 2020. During this 3-year period, annual sales grow by at least $200 million, yielding at 16% growth rate, driven by:
1.) Higher new CD sales resulting from incremental Internet sales and due to CD buyers recognizing that now CDs are more affordable if later resold in the pre-owned market.
2.) Increased availability of CDs for resale due to price discounting on new CDs and due to informed CD owners recovering value by selling CDs in the pre-owned market.
The pre-owned CD market enjoys high margins that fluctuate between 45% and 50% or more than double the average 20% margins on new CDs. The auto industry and the music industry again show striking similarities. Care dealers make more money on used cars than they do on new ones. The same applies to the music industry where used CDs command higher profit margins than new CDs.
The foreign pre-owned CD market offers a vast growth potential. According to the US Commerce Department, nearly 70% of the total market potential for most products is outside the US. This means that for most products, the size of the total foreign market equals 2.33 times the size of the US market. For example. 1997 worldwide CD sales are estimates at $35 billion and subtracting the $10.2 billion of the US market yields a foreign market of $24.8 billion. This approximates the $24 billion obtained by multiplying 2.33 by $10.2 billion. Applying the same factor to the US pre-owned CD market results in a foreign pre-owned CD market estimate of $2.3 billion in 1997 and $4.9 billion in 2002.
Independent Retail music Industry is Ripe for Consolidation:
The independent retail music industry is highly fragmented. Based on industry data, it is estimated that there are approximately 4,500 independent retail stores in the US. Further consolidation is expected due to price pressures imposed by non-traditional retailers and by Internet sales. Independents will have great difficulty competing against major players like CD Warehouse with its powerful inventory management system, increasing advertising resources, distribution efficiencies, and aggregate buying power.
Overview of CD Warehouse, Inc.
CD Warehouse, Inc., is an undiscovered retail music franchise with a proven record of profitable growth. In November 1997, the company was listed in "The Franchise Gold 100" by Success magazine. The company is engaged in the operation of retail music stores in the wholesale of pre-owned CDs, and the franchising of its retail "CD Warehouse" concept to independent entrepreneurs. It is the largest retailer of pre-owned CDs in the US with a total of 300 stores in its system. The company owns and franchises a total of 163 retail stores under the "CD Warehouse" trade name. On July 1, 1998 the company acquired from Grow Biz International, Inc., 3 retail stores and the franchise rights of 134 stores which operate under the "Disc-go-Round" name. It is likely that a majority of franchisees will switch to the CD Warehouse concept. The company employs 80 people of whom 40 work part-time. CD Warehouse is headquartered in Oklahoma City, OK and has 15 system stores located outside the US.
All stores sell both new and pre-owned CDs in addition to buying for cash and trading pre-owned CDs. A typical CD Warehouse store is located in a high traffic strip shopping center, occupies between 1,200 and 2,500 square feet, and offers between 10,000 and 16,000 CD titles.
Pre-owned CDs account for 70% of dollar sales while new CDs account for 30%. Purchase prices for pre-owned CDs range from $1 to $4 while selling prices range from $6 to $9 resulting in gross profit margins of approximately 60%. A majority of the Billboard Top 100 selections comprise the inventory of new CDs. These new CDs have gross margins of approximately 20%. As a result, the average CD Warehouse store generates gross profit margins of approximately 46%.
The cornerstone of the company's competitive advantage is its inventory management system which links corporate headquarters to all company owned and franchised stores. The program has a database of 70,000 CD titles. For every CD presented by a customer for purchase or trade, store operators can review the title's historic sales data and find out how often it moves, what purchase price to pay, how many to stock, and at what price to sell or trade. The program is dynamic and base on information sharing since it is updated quarterly with the addition of new releases and recent sales statistics. The company then adjusts prices and other parameters based on the new data. The program records all transactions at the point of sale and compiles inventory by title with the corresponding selling price and cost.
Retail Store Operation
Consistent with its expansion strategy, the company is in the business of operating stores to take advantage of acquisition opportunities and to build stores in markets with attractive demographic and competitive profiles. The growth of company owned stores is combined with subsequent franchise development in selected markets to create clusters of stores with significant operating, distribution, and advertising efficiencies.
Company owned stores foster innovation by providing a testing ground for new store designs, advertising strategies, product line additions, and training procedures. Also, these stores facilitate franchising because the company is able to provide accurate and verifiable financial data to prospective franchisees. Recently the company unveiled a prototype new store concept in Norman, OK. This store will carry 18,000 titles and will utilize updated d‚cor and lighting. Later a low cost remodel plan will be devised to implement it throughout the system.
CD Warehouse owns and operates 23 stores and reports retail sales made to consumers. In the first quarter of 1998, the company made significant improvements in its store operations as compared with a year ago, since gross profit margins jumped from 38% to 42% while store operating costs plummeted from 45% of retail sales to just 34%.
CD Warehouse has a record of completing EPS-accretive acquisitions. It adheres to a conservative acquisition valuation model which boosts EPS, notwithstanding the usual high amortization charges associated with the excess between purchase price paid and the carry value of assets acquired.
Wholesale of Pre-owned CDs to System Franchisees
Through its inventory management system, the company is able to act as a clearinghouse for all pre-owned CDs within the CD Warehouse system. Pre-owned CDs may be purchased from outside third parties or from system franchisees. Only sales made to franchisees are reported as wholesale merchandise sales. These sales generate only a 10% gross profit margin for the company but they are critical to the company's competitive advantage.
If a franchised store is overstocked in certain CD titles, the company will buy those units and sell them to another franchisee. Therefore, the company is able to balance supply and demand among stores in the system, becoming a very efficient distributor. The company also purchases excess inventory from franchisees in order to assemble pre-owned inventory packages that are sold to franchisees in order to assemble pre-owned inventory packages that are sold to franchisees when opening new stores. As much as 75% of the $50,000 opening inventory package for each new store is purchased from the current systems of CD Warehouse stores.
The company makes a market for pre-owned CDs within its system and is able to minimize total system inventory. Through the sale of excess inventory, franchisees are able to reduce their total investment in working capital while increasing profits. Likewise, franchisees that purchase CDs from the company are able to satisfy hot consumer demand.
Franchising the Pre-owned CD Market Concept
It is expected that in the future more consumers will participate in the pre-owned CD market as they become aware of its existence and recognize that it adds value to used CDs and makes new CDs more affordable. Pre-owned CDs are likely to become a hot commodity among music lovers.
The essence of the company's expansion strategy is the addition of new franchised stores to achieve system wide sales growth and economies of scale with no capital investment. The continued profitability of the company hinges on successful development of its franchise concept with a standard look and operating procedures. This professional approach is now attracting higher caliber franchisees interested in area development agreements with multi-unit growth plans in mind. Due to the recent acquisition of the 137 units, existing high caliber franchisees are likely to enter into additional area development agreements in order to secure attractive nearby markets.
Royalty income and franchise frees are the major profit drivers for the company. Franchisees pay franchise fees averaging $10,000 per store opened. Subsequently, they pay the company 5% of store sales as royalties. Franchisees also pay 2.5% of store sales to a fund that is spent on local (40%) and national (60%) advertising. Franchise revenue makes cash flow predictable and is reported by the company as royalty income. System wide sales consists of the sum of sales from company owned stores plus franchised stores. In FY98 system wide sales are expected to reach $72 million.
A now franchised store requires an average initial investment of $100,000. This includes $10,000 for franchise fees, $50,000 for the initial pre-owned inventory, $10,000 for working capital, $26,000 for leasehold improvements plus signs and fixtures, and $4,000 for proprietary software and utility deposits. In 1997 the average annual store sales was $306,000 yielding a sales to capitalization (or initial investment) of 3.06 to 1 which is very attractive by franchising industry standards.
Unit Economics: An average franchise shows the following numbers: Sales _ $306,000; Gross Profits (46%) - $141,000; Royalties and Advertising (7.5%) - $23,000; Rent $30,000, Labor $26,000; Utiltities- $12,000; Insurance - $6,000; and other $4,000. The estimated Operating Profit is $39,000 or 12.7% of sales, while Net Income is $25,000 or 8.3% of sales. Considering an initial investment of $100,000 the resulting return on investment is 25% with a four-year payback.
The initial investment gives the franchisee the right to use or receive the company's trade names and logos, design plans and color schemes, signs, and store fixtures, computerized inventory management system, buying and selling guidelines, initial management training, advertising assistance, initial pre-owned inventory, low insurance rates, and operating guidelines.
This franchise concept has significant advantages over competing franchises:
1.) The sales to capitalization ratio of 3.06 to 1 indicates low capital requirements.
2.) It enjoys high gross margins of at least 46% with no major competitor in sight.
3.) It operates in the growing pre-owned CD market with expected 15% annual growth.
4.) Franchisees do not need to have music industry experience to run profitable stores.
5.) Personnel who operate stores do not need any kind of license or certification.
6.) Product liability exposure is limited since there are not warranty issues, food contaminiation issues, or improper service issues among others.
7.) The inventory mangement system helps the franchisee increase profits while reducing working capital investments. The program keeps franchisees from buying unpopular titles, while the company purchases any excess inventory of popular titles.
Suppliers
As part of its wholesale operations, the company procures pre-owned CDs from unrelated third parties engaged n the wholesale purchase and resale of pre-owned CDs. For the purchase of new CDs the company is able to negotiate very favorable price and sales terms on behalf of all system franchisees. This volume buying power provides a significant advantage over prices and terms available to independent CD retailers. Both the company and franchisees purchase new CDs directly from record distributors such as Valley Records Distributors and others.
Competitive Environment
CD Warehouse has no major competitor focused exclusively on retailing pre-owned CDs. After the recent acquisition of the 137-unit Disc Go Round franchise, CD Warehouse has become the dominant retailer of pre-owned CDs. As a result, the company competes in this market with significant advantages.
Chain Retailers With Limited Pre-Owned CD Sales: Wherehouse Entertainment is a chain-based CD retailer that sells pre-owned CDs in 220 stores, most of them located in California. This retailer offers pre-owned CDs in less than 500 square feet of space with a limited number of titles. Given the amount of space devoted to this product category it is evident it is not the core of their business. This company emerged from bankruptcy in January 1997 and is not private after a recent restructuring.
Hastings Entertainment (HAST) is a multi-media entertainment retailer that sells books, music, software, periodicals, and videotapes in 120 superstores averaging 21,200 square feet. Music sales represent only 365 of total sales. Pre-owned CDs are merchandised in about 500 square feet in each superstore. This is another example of a retailer whose core business is not pre-owned CDs.
For the above reasons, CD Warehouse is the music industry's most profitable and efficient distributor of pre-owned CDs in the retail channel. As more independents become aware of the above advantages, consolidation will occur faster
Business Model: CD Warehouse has a profitable business model which is unique in the retail music industry. It is based on information sharing and resource optimization which create entry barriers to competitors. It performs powerful economic functions not easily replicated by others. These include balancing supply and demand by purchasing overstocked titles that can be cross-shipped, minimizing overall system inventory by purchasing excess inventory from franchisees, and information sharing by tracking popular titles and updating its database.
CD Warehouse has exciting long term growth prospects due to attributes that resemble those of a few great companies. It is virtually creating the pre-owned CD market in the same way H&R Block created the consumer tax service market. The ability to cross-ship inventory between stores gives it a logistic advantage similar to what made Wal-Mart the low cost distributor in the retail channel. Its inventory management system tracks popular titles to whip out most mom and pop video retail stores.
The company is currently evaluating its strategy to sell pre-owned and new CDs on the Internet. |
