Growth Matters: Watch Out iTunes, HMV Is Coming Back

Just two years ago, entertainment retailer HMV (HMV) was giving iTunes -- the world's largest music seller -- a run for its money in the U.K.

The storied U.K.-based retailer of music, videos, electronic games and books seemed to be building itself up as a successful example of bricks-and-mortar businesses shifting to the Web. In 2008, HMV.com attracted more than 1 million visitors a week, which is twice as many as iTunes was getting in the U.K., CEO Simon Fox told the Telegraph.

Then its fortune took a turn for the worse. Losses, as a result of weak consumer spending -- especially on books and games -- helped to plunge HMV shares from a high of $159.50 per share in April of 2009 to a low of $67.60 per share in February of this year. Total CD sales have been falling 10% a year, reports the London Evening Standard.

Gaining Market Share in Spare Times

But the company has been anything but idle, and it has used the recession to pave the way for a turnaround. In the last Christmas season, the company increased its market share in games, music and DVD sales, outperforming a sluggish market, even though its bookstore, Waterstone's, posted a fall that led to the ouster of its chief executive. Its e-commerce sales were particularly strong, featuring double-digit sales growth in the five weeks ending Jan. 2, according to paidContentUK.

One big factor helping HMV grow has been a customer-reward program called Pure HMV, which the company launched in 33 stores in 2008 and then expanded throughout the U.K. last May. Customers earn points when they buy from the store or website and can trade those points for rewards like concert tickets, movie premiers, backstage passes, exclusive limited editions and signed and rare memorabilia.

Pure HMV has dramatically boosted customers' spending. Pure card holders spend twice as much as other HMV customers, on average, according to HMV.

HMV also has been buying up new assets in the recession, expanding its selection of products by acquiring half of digital-music company 7digital for £7.7 million in September and entering the concert business with the purchase of Mama Group in December. HMV expects the Mama acquisition to add about £15 million to its earnings, before interest and taxes, in the 2012-2013 fiscal year, and expects the live-music market to exceed the recorded-music industry by around a third by 2012.

Shares Turn UpAfter Prolonged Fall

All these factors -- along with the announcement March 26 that it had completed its official three-year turnaround plan -- helped boost HMV's stock 22.5% last month.

The company has plenty more in the works: most notably, a liberal dose of cost cutting. Specifically, HMV said in March that it plans to cut £25 million more in costs by the 2012-2013 fiscal year, including £10 million in 2010-2011.

But cutting costs is no way to achieve long-term success. While the news of HMV's new strategic plan increased its earnings expectations for the fiscal year ending in April 2010, it also reflects the challenges that HMV continues to face.

Is HMV's Growth Worth the Price?

Taking a long view, HMV's stock has fallen 70% from its February 2005 peak of £282 per share to its current price of £84.5 per share. With all of its recent growth, does that lower price make HMV a good buy?

Well, take a look at its price/earnings-to-growth (PEG) ratio, which measures how fast a stock is rising relative to its growth prospects. (The calculation divides a stock's price-earnings ratio -- which divides the current stock price by its earnings per share -- with its projected annual earnings-per-share growth.) To me, a PEG of less than 1 suggests a stock is starting to look cheap. But HMV's PEG is a whopping 3, based on a price-earnings ratio of 7.8 on earnings projected to grow 2.6% to $13.04 per share by April 2011. In other words, the current price still looks expensive.

So, while digital growth is helping HMV's turnaround, even after a 70% fall from its peak, HMV's stock won't be a bargain unless it can increase its earnings even faster than expected.