Commentators have been quick to lay the blame for HMV’s demise squarely on the structural challenges it faced – competition from internet retailers and music downloads to name two - but the explanation of why the entertainment retailer finally had to admit defeat and call in the administrators when it did are more complicated than that and offer some lessons for investors.
HMV went into administration on 15 January because its directors decided it was unlikely to comply with its banking covenants at the end of the month and we might reasonably assume the banks were unwilling to waive those covenants or to extend the company extra money as they have done in the past.
As HMV has been limping along for some time now its fate, whilst sad, doesn’t come as much of a surprise. Nevertheless, if you had been examining HMV’s finances a few years ago you might have though the chance of it getting into such financial trouble were much lower. The company’s accounts for the 12 months to April 2008, for example, show that it had negligible net debt, making its balance sheet look prudent compared to some other retailers at the time.
Two years later, in April 2010, HMV’s net borrowings had risen to £70m. by the time of its last reported full year accounts in April 2012 this had deteriorated to £176m despite the company having sold some of its more attractive assets, including book chain Waterstone’s. Without these disposals HMV’s net debt might have been over £200m and these are year-end figures which, for seasonal businesses like retailers, often understate the average or peak debt levels a business has, especially in the build-up to peak trading periods like Christmas.
Look for what caused this sharp rise in borrowings and one thing stands out to us in HMV’s cash flow statement – the large amounts of cash that left the business because of changes in its working capital. Put simply, changes in the terms by which HMV had to pay its suppliers caused more than £180m to flow out of the company over the four years to April 2012.
This was partly a natural consequence of the business’s falling sales, and partly due to changes in the mix of products it was selling. However it was also caused by suppliers growing increasingly concerned about whether HMV was capable of paying them for their goods. As we saw in Game theory, it was ultimately the reluctance of some suppliers to extend game group credit that pushed it over the edge last march and this is ultimately what it does for a lot of retailers.
It is also interesting to note that in the four years to April 2012 HMV paid a total of £90m in dividends to shareholders. With the benefit of hindsight, that money would have come in very handy over the last few years and, whilst it’s all too easy to be critical after the event, these dividend payments were not covered by free cash flow. Consistently paying uncovered dividends can often be an indication that a management team are failing to face up to changes in a business’s circumstances.
There were naturally a number of other factors at play, not least the business’s struggle to trade profitably as it grappled with declining prices and volumes of the goods it sold and the expensive and inflexible leases that prevented management from right-sizing its store footprint. One could also point to other strategic mistakes, such as the acquisition of struggling bookshop chain Ottakar’s in 2006.
The dramatic structural changes in HMV’s end-markets in recent years meant that the business was always going to face a very tough time. However it was the company’s unsustainable debt burden - caused by poor capital allocation and latterly a loss of supplier confidence - that ultimately strangled the business.