Hollywood Entertainment's Reel desperation deal

The acquirer? Cash-strapped Hollywood Entertainment Corp., the company that ranks behind Blockbuster Video as the operator of the second largest chain of video rental outlets in the U.S.

If you haven't been following the Hollywood Entertainment saga lately, this Wilsonville, Oregon company ($616.7 million in revenues) has been digging itself deeper and deeper into debt in a frantic drive to catch up with Blockbuster in the video retailing race. The company's merger-takeover of Reel.com thus represents an effort to climb out of its hole by establishing itself as a virtual retailer on the Web, where costs are thought to be lower than out there in the real world of actual bricks and mortar buildings.

Yet in one of Wall Street's trickiest financings of the summer, the deal appears to have been artfully structured to hide the fact that Hollywood Entertainment - desperate to diversify into Internet retailing but lacking the cash to do so - actually agreed to raise the needed funds by selling stock in itself at a stunning 50 percent discount from its own currently quoted price on the Nasdaq electronic stock exchange.

Transactions of this sort - representing off-the-floor equity sales at huge discounts from the market price - have become an almost commonplace occurrence on Wall Street lately. As such they raise obvious questions about the pricing mechanisms that have driven stocks to current lofty levels - especially on the Nasdaq - to say nothing of which way stocks will move next.

The rich get richer
In this particular case, the winners in the deal are easy to spot. They're a group of Reel.com investors including Microsoft Corp. co-founder Paul Allen and one-time head of Boston Markets, Inc., Scott Beck. Together with a Massachusetts venture capital group, CMG Information Services, Inc., the Reel.com investors sheered Hollywood Entertainment as if it were nothing more than a trembling sheep, picking up an 11 percent stake in Hollywood for a mere $7.50 per share when the company's shares are currently trading on Nasdaq for nearly $16.

The company was ripe for the sheering. Like a weight lifter on steroids, Hollywood Entertainment has been getting bigger and bulkier - and less maneuverable - with every passing day. Beginning with two stores in 1988, the Hollywood Entertainment now operates more than 900 outlets in 42 states, and says it plans to open 400 more in the year ahead.

But this kind of growth has come at a price. In 1993 the company earned $2.1 million in net income on revenues of $17.3 million. By 1997, revenues had exploded to $500.5 million - but net income had risen to only $4.9 million. Even adding back in a 1997 one-time charge related to litigation involving the company, total net income would have stood at only about $14.4 million, down sharply from the $20.6 million level of the year before.

Main reason for the decline: steadily growing interest payments on a debt load that has by now risen to $275.6 million - a burden taken on to finance the expansion in the first place.

That debt load, which works out to a worrisomely high debt-to-equity ratio of 0.92 - that is, debt equal to 92 percent of shareholder equity, as compared to barely half that for the average of its competitors in the field - has cast a shadow over the company's growth strategy. After all, what's the point of getting big if your profits keep falling further and further behind?

Debt limit
Moreover, there's an obvious limit to how much more debt the company can take on. Though Hollywood has a $300 million line of credit available to it, much of that appears destined to be devoured by plans to open 400 new stores this year alone. After that, what?

Internally generated cash seems a doubtful bet. Though the company appears - at least at first glance - to be a hefty generator of cash flow, the picture on that score is not as bright as it might seem.

For one thing, two-thirds of Hollywood's assets are invested in video tape inventories and the retail stores that house them. Thus, the company's 1997 depreciation and amortization write-offs, which totaled $140 million, in fact represented real expenses. (That tape inventory has to be kept current, and the buildings themselves have to be maintained.) Add those costs back into the picture - as they properly should be - and the company turns out to have burned through $163 million of cash during 1997.

It is against that backdrop - of a company growing like gangbusters but in fact strapped for the cash to keep that growth going - that Hollywood Entertainment has now decided to establish itself as a virtual retailer on the Web.

Yet if ever there was a deal designed to fog up the true, cash-strapped state of the acquiring company, this one is it. As explained in a joint press release from both companies last week, Hollywood will be taking over Reel.com by paying $30 million in cash, as well as issuing 5 million new shares of Hollywood stock, in return for 100 percent equity ownership of Reel.com. The deal is said to value Reel.com at "approximately $100 million."

A sweetheart-type arrangement
In fact, the transaction is built around a clever, sweetheart-type arrangement that will effectively give Reel.com's investors an 11 percent stake in Hollywood for 50 cents on the dollar.

The key to unraveling the ploy involves what the press release artfully describes as a "separate and concurrent" transaction. In it, the Allen/Beck group will be investing $67.5 million in cash in Hollywood, while getting back 5 million shares of Hollywood stock in return. According to the press release, that works out to an effective purchase price of $13.50, representing a 24 percent discount from Hollywood's public market price, which was hovering at $17.675 last week.

In fact, the discount will actually turn out to be much greater - though to see why you have to keep your eye on the pea in this shell game. Reason? A look at Hollywood Entertainment's most recent quarterly report to shareholders, for the period ending March 31st, reveals that Hollywood Entertainment doesn't actually have the $30 million in cash that it is proposing to spend as part of the Reel.com purchase. In fact, Hollywood Entertainment doesn't have anything even close to $30 million.

Strange dealing
What's actually appears to be taking place here is that, to acquire Reel.com, Hollywood will be using $30 million of that $67.5 million that it is expecting to get from none other than Reel.com's owners. In other words, Reel.com's owners will be giving $67.5 million in cash to Hollywood Entertainment - so that Hollywood can turn around and, in effect, give $30 million of it right back to them via the company they collectively already own: Reel.com. This is responsible finance? It looks more like a street corner game of Three Card Monty!

As a result, Allen, Beck and the others will, in reality, thus be paying not $13.50 per share for those 5 million Hollywood shares they'll be getting for their cash infusion. Instead, they'll actually be paying only $7.50 per share - or a total of $37.5 million - when outside investors on the Nasdaq market are currently paying more than twice that amount for the same thing.

Whether Reel.com itself will turn out to be worth the $97.5 million that Hollywood is paying for it remains, for now at least, an open question. The company is privately held and has so far published no financials. As a result, it's hard to say whether Reel.com is worth even the $30 million in cash that Hollywood is paying for it, let alone the $67.5 million more in stock that Hollywood is tossing into the pot.

Then again, we've already seen that Reel.com's own backers don't think 5 million shares of Hollywood are worth anymore than even $37.5 million - so maybe they figure that, plus $30 million in cash, is really all their own company is worth also. In any case, we'll be watching when Hollywood Entertainment publishes its full year financials next spring, to see just what Reel.com turns out to be bringing to the party. Drop by, it should make fun reading.