Finance lifeline gives HMV another chance

Entertainment retailer HMV Group has negotiated a £220m refinancing lifeline with its lenders, but analysts believe the onerous repayment terms could wipe out profitability for the next two to three years.

HMV’s shares, which have slumped 80 per cent in a year marred by profit warnings, covenant risks and increasing online competition, initially rallied by 10 per cent on Tuesday morning as the markets responded positively to the news. However, its shares closed down 14 per cent as the true costs of survival became apparent.

A £90m slice of HMV’s debt known as “Facility B” will be subject to hefty exit fees, costing up to 14 per cent of the outstanding loan amount unless it is repaid by January 2013.

HMV confirmed that current trading is about 15 per cent behind the level of a year ago. This led analysts to believe early repayment is impossible, predicting that potential interest charges of £10m to £15m a year will wipe out profits.

“There is no longer an immediate liquidity issue, but there is clearly a profitability issue on a three-year view,” said Adam Cochrane, retail analyst at UBS.

Describing the debt transaction as “one of the more complex I’ve seen in the retail sector”, he added: “Sales continue to be weak, so it’s likely HMV will incur some of these punitive interest charges, and that will probably eat away a large chunk of its profits. The return on capital expenditure will struggle to be greater than the cost of finance, suggesting the banks want to see further disposals.”

Dividend payments will be suspended while the £90m facility remains outstanding – a further blow for HMV’s shareholder base, which remains dominated by income funds.

The final stage of the refinancing deal rests on shareholders voting through the £53m sale of high street book chain Waterstone’s to Russian tycoon Alexander Mamut. On Tuesday evening, a circular was distributed to shareholders in advance of an extraordinary meeting on June 23.

HMV’s long-suffering chief executive Simon Fox said he was “confident” that shareholders would vote through the deal, but insisted that a rights issue or forced disposal of the group’s live music division were both unlikely.

“The banks are not running the company,” he said. “HMV and the live division work extremely well together. I’d be foolish to rule out [a rights issue] in the future, but to raise equity, one has to have an equity story.”

The disposal of HMV Canada is expected to conclude in the coming weeks, though this will only raise an additional £5m. Mr Fox intends to spend £6m converting a further 150 HMV stores by September, devoting one-quarter of the shop floor to music technology to stem falling sales of CDs and DVDs.

A pilot in six stores showed a 150 per cent uplift in technology sales, he said, but analysts remained deeply sceptical of the strategy, questioning its impact on working capital.

Andy Wade, retail analyst at Numis, forecast that working capital constraints coupled with declining profits would produce a negative free cash flow movement of £95m for the financial year just ended.

“It remains to be seen how much support HMV’s suppliers will give it after the refinancing is agreed,” he said. “Music suppliers have been very flexible in the past, as they have an interest in supporting HMV’s survival. However, there will be a greater bias towards electrical products and games in the future, which could drag on working capital as the stock turns more slowly and credit terms are likely to be tighter.”

HMV’s consortium of lenders, led by Lloyds Banking Group, will take warrants worth 5 per cent of the company’s share capital under the terms of the refinancing.

“If like-for-like sales continue to run 15 per cent down, HMV will fall into loss this year and the bank warrants will be worthless,” said Nick Bubb, retail analyst at Arden Partners.

He predicted that this Christmas would be “make or break” for the embattled retailer. “HMV may very well have changed the shape of their business, by pushing into new product areas, but they’ve simply been swamped by the alarming fall in their core markets,” he said. “They can only watch helplessly as the supermarkets sell The King’s Speech DVDs for zero profit. HMV will have to sell an awful lot of iPods, games, T-shirts and headphones to make up for it.”