Can't stop the music
Stockport-based discount music retailer Music Zone called in the administrators in January. Does it mean the death of niche retail, or is it an example of bad borrowing on buyouts? Michael Taylor presses play
It was the worst piece of pre-Christmas news Steve Oliver could have received. A hand-delivered letter from the Bank of Ireland informed the managing director of Music Zone that banking facilities - a £34m overdraft - were being withdrawn and a £31.7m debt had been collected from Music Zone's current account.
Oliver was gutted. He knew almost immediately that without the support of his bank, the very people that had funded his management buyout in 2005 and supported him through the opportunistic acquisition of MVC stores in 2005, the game was up. He'd have to lay off friends, over Christmas; he'd have tricky discussions with suppliers. And there was no chance of paying the rent on all 104 stores that his business operated.
One of his directors, Carl Wormald, was also pretty upset. He was on the board as the representative of LDC, the private equity backer of Music Zone and he and Oliver had become close.
LDC has enjoyed a good track record of investing in growing businesses. In particular the team has consistently won awards and provided a good return for their fund. Part of LDC's style has also been to make up the difference on their investment by constructing deals where the company borrows heavily. Cash-generative businesses then re-engineer their payments to suppliers and other creditors and focus on paying off the bank at the earliest opportunity. The more quickly the bank gets the money, the higher the value of the stake of the management team and the private equity investor.
Getting the balance right is important and the case of LDC was that the borrowing from Bank of Ireland, the first such deal from the relative newcomer into this field, was actually a small proportion of Music Zone's projected and past earnings.
It also wasn't a complete shock. The business, which would have turned over £3115m for the financial year, was behind its own forecasts and had therefore breached its banking covenants. As a result, Bank of Ireland was within its legal rights to reclaim the debt.
November and December are crucial months in the cycle of an entertainment retailer. More cash was due in the business and the overdraft -stretched to its limits in September and October -was in a healthy position. It also helped that LDC supplied £32m of short-term funding to give the business a bit more comfort and took back the cash when the business could stand it.
Sadly, for Oliver, it wasn't enough, and he was angry not only at the timing of the plug pulling, but the manner of the hand-delivered letter. But his statement, issued on 5 January 2007, spoke bravely about the conditions on the high street. "The decision by our bankers to recover debts and withdraw credit facilities without notice and with immediate effect left us and our private equity backers with no real alternative other than to appoint administrators,"he said.
"There is a growing number of high street retailers like Music Zone experiencing challenging trading conditions. Pre-Christmas spending was also poorer than expected."
Bill Dawson, the partner at accountancy Deloitte tasked with saving the business, has faced some tough choices. Another blunt and clear-headed northerner, like Oliver, he knew there was something to save, and he worked night and day to try and save the remnants of a business that someone would buy.
"Music Zone has an excellent store portfolio, with a UK-wide footprint covering predominantly prime high street locations,"he says.
LDC briefly looked at a rescue deal. For it to work the size of management's stake in the business would have had to dilute to almost nothing, but it was asking for a big commitment from individuals already stretched and who could see the writing on the wall.
Oliver, a large and imposing man, but as genial as they come, has suffered minor defeats before. Fibreply, a company making panels for lorries went bust in 1999. He dusted himself off and ended up taking a job with Music Zone. At the time the retailer was a seat-of-your-pants operation that had expanded from a stall at Longsight market, one of Manchester's toughest areas. The owner and founder of this feisty and ambitious business was Russ Grainger, who took to Oliver, liked his style and made him his finance director, impressed as he was by the management systems and stock information he was able to create.
None of this is ancient history or unnecessary detail. It's important. Oliver ran a disciplined operation at Music Zone. Everyone involved has said so. But when the quality of your financial information is good it tells you the truth and the truth is this: the market share of supermarkets in the CD and DVD market has soared from 20 per cent to 35 per cent of the total. Some of the giants were aggressively pricing their product at rates less than Music Zone could buy them. The base price of a single CD in the UK has long since dropped below £310 and they are now the cheapest in Europe.
Part of this has been driven by VAT-free sales through Channel Islands-based retailers diluting prices on the UK mainland. The Knutsford-based Forum of Private Business has thrown its support behind a group of business owners -including Music Zone -pushing for a judicial review of the Treasury's application of the VAT relief, which is evidence of the detrimental impact of Low Value Consignment Relief. This works when goods of £318 or less are imported from outside the European Union free of the sales tax.
Despite warnings from the industry, the Treasury is adamant that VAT-free mail order sales are not the problem, blaming other factors such as supermarkets and downloads.
But Oliver has brushed aside the issue of downloads before. At an Insider event in May 2006 he pointed to sales increasing and painted a different picture. "It's absolute rubbish," he said. "The physical sales of CDs are increasing year on year, and those close to the industry are clear that digital music is complementary to physical products rather than a substitution.
Ask yourself how many downloads were gift wrapped this Christmas and indeed how many downloads are proudly displayed on the nation's lounge shelves before questioning the future of CDs?"
Downloads have largely failed to create any significant demand and, despite the initial jump in sales coinciding with the demise of the singles market, they have remained at just 3 per cent of the total market in 2006, an increase of only 1 per cent on the previous year. Virgin recently announced the closure of its US download service, while HMV wrote off its downloading investment in 2006. In comparison, HMV's Guernsey-based mail order operation was up by 200 per cent in Christmas of the same year as its mainland shops suffered a continued drop in sales.
VAT-free retailing remains by far the biggest threat to the entertainment market, with the download market accounting for barely £350m of sales compared with the physical CD market, which was worth £31,600m to the year ending December 2006. DVDs remain untouched by downloads and are the mainstay of the highly successful VAT-free retailer Play.com, which continues to dominate the VAT-free mail order market with an estimated transaction volume of over 100,000 transactions per day in December 2006.
So in these circumstances was Music Zone overexposed to risky borrowing? Colin Gillespie, corporate finance partner at PricewaterhouseCoopers, who was not involved in the business, thinks not.
"It's a bit of a leap to say that Music Zone went out of business just because it was highly leveraged. You just can't predict that market," he says. "But there are bound to be some businesses that suffer because of overleveraging. Our business recovery team has rubbed its hands every year for the last three years saying this is the year. But so far it's not been.
"People are smarter at refinancing when times are good. It's about how well structured a deal is and how much flexibility there is in the structure so you can restructure easily. It used to be that you could only sell or float to get out, now you can refinance or do a secondary buyout. There are so many different ways. It's about timing and where you are in the cycle."
And what of the future? Deloitte closed 31 stores initially, making 325 people redundant, part of the roller coaster of emotions that Oliver has been on since the letter from the Bank of Ireland changed his world.
According to Deloitte's Bill Dawson a number of parties expressed an interest in the business. He wasn't able to confirm if one of those working on a plan was Oliver, but Insider understood one was.
As Dawson says: "During the first week of trading, the administrators spent a considerable amount of time assessing the viability of the business and the difficult decision was taken to close a number of stores."
But as Insider went to press, Deloitte announced that it had not been possible to find a buyer and the business was no longer viable to continue trading. Discussions continue but there is no certainty of a sale.
