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Wednesday, March 3, 1999

An Investment Opinion
by Louis Corrigan

Trans World In a Web of Trouble?

It's hard to know what to make of Trans World Entertainment (Nasdaq: TWMC), a 501-store retailer of CDs and videos through its mall-based Record Town, Saturday Matinee, and F.Y.E. stores and strip mall-based Coconuts, Strawberries, and Planet Music chains. On the one hand, Trans World has been simply all world, the obvious winner in the recent multi-year consolidation of the music retailing space. After its pending acquisition of Camelot Music Holdings (OTC: CMHDA), Trans World should generate FY99 sales of $1.5 billion, or about 10% of U.S. music sales. Also, the FY98 results reported last week show the company just rocking, even if that's mostly thanks to mellow performers like Celine Dion and Jewel.

On the other hand, this company has got to be sitting in the middle of the old e-commerce superhighway, just waiting to become roadkill, right? As much as people like to browse through a store, who really will continue to pay $16.98 per CD when they can pay nearly the wholesale price via the Web? And what about all the industry talk about setting standards so consumers can download music from the Web and burn their own disks on their own writable CD recorder/players? That won't happen in the next year on any mass basis, but between improved compression technology and bandwidth enhancements via DSL and cable modems, it could happen soon enough to prove a meaningful threat. At $12 11/16, the stock currently reflects these serious cross currents.

Fourth quarter results announced last Wednesday showed revenue up 11% to $268 million on a 6% increase in same-store sales (SSS). Net income showed a titanic 44% gain to $30.7 million versus $21.3 million a year ago. Accounting for the dilution from the 6 million shares issued in a secondary offering last April (priced at $17.50, adjusted for splits), EPS increased 34% to $0.90 versus $0.67 a year ago. That crushed the consensus estimate of $0.81 per share.

Each major line of the income statement showed improvement. Gross margins jumped to 38.4% from 36.1%. Selling, general and administrative (SG&A) expenses remained nearly flat in real dollars and declined to 17.9% of sales from 19.6% last year. With money from the secondary offering, the small interest expense reported in FY97 turned into a small gain.

Since Trans World reported profits in the usually money-losing first two quarters of the year, overall FY98 results were even more impressive. Even after closing another 94 stores during FY98 (a net of 38 closings after acquisitions), sales still danced ahead 22% to $698 million on 8% stronger same-store sales. Excluding the one-time benefit, net income nearly doubled to $40.3 million from $20.6 million, spinning operating earnings up 96% to $1.19 per share versus $0.66 a year ago. Gross margins improved to 37.8% from 36.7%, while SG&A expenses dipped to 25.5% of sales from 27.2%. Interest expenses declined 69% to $1.5 million.

The balance sheet is also terrific. The company has $116 million in cash, up from $95 million a year ago. Inventory is up 12% overall to $211 million, or just 8% on a square foot basis, thanks partly to a new point of sale inventory management system rolled out last year. The company has paid down all of its $35 million in long-term debt, ending the year with long-term lease obligations of just $16 million. So Trans World has $100 million cash net of long-term obligations, or $2.92 a share. Back that out of the current share price and you have a stock trading at 8.2 times trailing earnings. That's also just 7 times the $1.40 per share that Chair/CEO Robert Higgins says he's comfortable with for FY99. And that number assumes just 4% same-store sales growth for the first half of FY99 and 5% for the second half while excluding Camelot, which should prove accretive to earnings.

Trans World seems like a no-brainer bargain, a hot new release that somehow got thrown in the cut-out bin by mistake. But then there's the Internet. My main impression from listening to Higgins on last week's conference call is that he just doesn't get it.

In November, the company rolled out its online store to test the waters. Higgins said in last week's press release that the site's initial success "has proven to us that e-commerce will be an important complement to our highly successful retail store concepts. We believe that there are synergies between both formats and that the strong brand recognition that exists among customers of our traditional retail outlets will be key to the on-going success of our e-commerce site."

While Higgins said last week that Trans World is determined to be a dominant Web player and plans to spend the money to do so, don't expect big ad spending. He suggested on the call that CD e-tailers such as N2K (Nasdaq: NTKI), which runs MusicBoulevard, have probably been paying too much for prime real estate on America Online (NYSE: AOL) and the major portals. He said that the key is not when you get into a business (Trans World was a relative latecomer to music retailing) but how good you are getting into it.

Moreover, although online CD sales are projected to grow from about $200 million in 1998 to more than $1.6 billion by 2002, that will still represent just 10% of the industry. In the near term, he said the companies that will really be hurt by the Web are the mail order companies and music clubs, which together account for about 12% of industry sales. "We don't think it's really going to hurt the brick and mortar stores," he said on the call. Indeed, Higgins hopes to leverage the 500 million customer visits that the company's stores receive each year to cross-promote the online store. He talked about using the Web to "breathe new life into the vast catalog" of music that isn't sitting in the stores but that could be readily marketed and purchased via the Web. One analyst said Barnes & Noble (NYSE: BKS) has talked about reducing its store-level inventories as a competitive response to increased online book sales. Higgins said he thought that would be a mistake, noting that Trans World has actually been building bigger stores with broader selection, such as its F.Y.E. format, which will grow from 7 to 13 units this year.

Traditional retailers can use their stores to promote their websites. If you take a radical view of where the business is headed, you could even argue that the stores function as extremely cost-effective advertising for a website, even if the stores will eventually be shuttered or left to operate at a loss. But I think it's simply misguided to imagine that the Web will complement the stores and not cannibalize store sales. The typical customer who buys CDs at high prices from a mall-based retailer may be so extremely convenience-oriented and price-insensitive as to operate differently than the typical superstore book buyer, who's clearly already begun to change her buying habits. Still, I doubt it. The market does, too.

Trans World's game plan looks inadequate for a number of reasons. First, if you market the online store mainly to your existing customers, you're likely to cannibalize sales without expanding them by reaching new customers. Second, to reach those new customers, Trans World has to develop an online brand. Plugging in or takes you to the TWEC site. However, TWEC itself isn't a brand at all. And what seems true so far is that being early online, and in force, is far more important than being good. That's what Border's (NYSE: BGP) has taught us. Higgins is trying to extrapolate lessons from offline retailing (where, over time, operating efficiency can win out in a commodity business) to the online world where operations only matter if you already have the brand to draw in customers. Prime online real estate simply may never become available to Trans World because brand creates location on the Web. That's what Amazon (Nasdaq: AMZN) is teaching us.

Finally, Higgins seems oblivious to the coming online price wars. Now that I've embraced the view that the Web really will transform retailing, I look at Trans World's incredible 37.8% gross margin as a major liability. While the company's Camelot acquisition and perhaps future acquisitions will do much to keep this number high thanks to increased purchasing power and operating efficiencies, the figure has still got to come down in a world where someone will be willing to sell CDs at cost, or less. When that happens, Trans World's profits will disappear. If the company's gross margins had been 27.7% in FY98, its operating income before taxes or interest income would have plunged from $70.6 million to zero. For comparison, Amazon's FY98 gross margin was 21.9%.

Trans World may have a more compelling plan in the works. Higgins did say that in the next 90 days the company would make a major Web-related announcement that "would impress everybody." That may be behind his comments on CNBC last week that the stock should soon "be back to the $25 to $30 range," where it was just last fall. In my view, though, the only thing worse than a retailer without a solid strategy for dealing with the Web's competitive threat is one with a CEO who talks stock price targets. If nothing else, it's a signal that Higgins may be overconfident.

Related articles:
-- Trans World Still All World, Lunchtime News, 11/12/98

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