Management will take over vidtailer

No. 2 U.S. vidtailer Hollywood Entertainment on Monday proved there’s still investment appetite for the old-fashioned movie rental store biz, as it announced Monday an agreement to be acquired in a management buyout that values the video and game chain at around $840 million.

Shares of the foundering firm soared nearly 28% in Monday trading to close $13.66, as shareholders were offered $14 per share in cash, representing a 30% premium over their Friday closing price of $10.70.

The Portland, Ore.-based firm, which has struggled along with market leader Blockbuster amid a slumping rental market, will effectively be free of the probing eyes of the growth-hungry equity market. Company will be taken private in the cash- and debt-financed deal led by Los Angeles investment banker Leonard Green & Partners.

Debt financing was provided by UBS AG, a current Hollywood creditor.

Hollywood Entertainment chairman-CEO Mark Wattles will own half the equity in the reconstituted company and continue on at the helm. Deal is expected to be completed by the third quarter.

Hollywood, which operates 1,920 Hollywood Video stores and 600 Game Crazy outlets, has been stung worse than Blockbuster by the sliding rental market: The company produced a string of quarterly profit declines that sent its share price down by nearly 50%. But the depressed share price may have helped the company secure the backing of private equity firms that have steered clear of Viacom-owned Blockbuster.

Blockbuster, which had worked hard to keep its margins and cash flow up despite the tough climate, failed to find a buyer among private equity firms. In February, Blockbuster parent Viacom said it would instead split off the retailer through a tax-free stock swap.

Shopping around

Blockbuster’s search for a buyer may actually have helped Hollywood Entertainment. Some of the private equity firms that talked to Blockbuster also kicked the tires at Hollywood and may have been drawn to the No. 2 chain’s more attractive valuation, analysts said.

The focus on maintaining profits through cost-cutting in recent years helped keep Blockbuster’s valuation relatively high, despite sluggish revenue growth, making it look pricey to potential buyers. Hollywood, in contrast, has suffered a steeper drop in its stock market valuation in recent months, making it look relatively cheap, even with a 30% premium.

“I would call it a good price, considering the state of the market and the current business trends,” said Bear Sterns specialty retail analyst Jim Hurley.

Split still better

Fulcrum Partners analyst Stacey Widlitz said a similar deal to take Blockbuster private would make sense if it were already a standalone company, but the tax implications of such a sale make it cleaner for Viacom to go ahead with the split-off.

She also said it would not be a surprise if the new owners of Hollywood stopped opening new stores and possibly pulled the plug on Game Crazy.

“Right now their (capital expenditure) is $80 million, and they really only need about $20 million or $30 million for maintenance. The rest you could keep as cash.”

Fulcrum colleague Rich Greenfield said the deal should also send a strong message to Viacom that there is still real value to video chains. He maintains that rather than spinning off Blockbuster, Viacom should buy it and claim full control of its still-plentiful cash flow.

“It would only cost them around $600 million to buy it in, and if they milked it, rather than trying to invest for growth, it would be a very accreditive deal,” he said.

For the fourth quarter of 2003, Hollywood reported adjusted net income of 36¢ per share, compared to $2.21 in the fourth quarter of 2002. Same-store sales in the fourth quarter, excluding Game Crazy, fell 1%.

In January, Hollywood officials projected rental comps for all of 2004 to be down 2%-3%.

“Full-year earnings per share could be lower than in 2003, but we do not expect it to be lower than $1.33,” Wattles said in January. EPS for 2003 was $1.40.

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