Value Library

The following is an excerpt from the ABC Perspective - October 2005 - Pg. 3

LEGACY HOTELS REIT

Legacy Hotels REIT owns 24 hotels with over 10,000 guest rooms in both Canada and the United States. The REIT owns several of Canada’s landmark hotels, including the Fairmont Chateau Frontenac and Toronto’s Fairmont Royal York. In addition to its luxury properties, Legacy’s portfolio includes 11 Delta hotels and the Sheraton Eau Claire in Calgary, Alberta.

We believe Legacy Hotels REIT is an example of the market failing to see the forest for the trees. True, Legacy’s recent operating performance has significantly lagged its Canadian peer group and its core hotel business has suffered in the wake of the 9/11 terrorist attacks, SARS, an appreciating Canadian currency and the NHL lock-out. We also acknowledge that Legacy’s uninspiring results are not entirely due to factors outside the REIT’s control. As other REITs have recovered from these events, Legacy’s upscale properties have struggled to find their own identity and position in an increasingly crowded luxury hotel market. Clearly, investors have not been impressed with the performance of the Trust; Legacy’s units are down 40% from its $10/unit 1997 initial public offering.

Despite the Trust’s near-term challenges, we believe the units are fundamentally undervalued at current prices. Legacy’s most recent balance sheet lists the hotel portfolio’s cost at $1.763 billion (giving the Trust a book value of around $7 per share). Recent market data suggests that asset values in many of Legacy’s markets have appreciated significantly since its 1997 offering. Using very conservative assumptions, we derive a net asset value (NAV) of at least $8.50 per unit on a “per key” basis.

While we believe that the Trust’s current hotel properties are worth at minimum $8.50 per unit, we see an opportunity to unlock even greater value. During the hotel industry’s extended downturn, Legacy purchased three hotels and raised over $400 million in debt and equity. Unfortunately, business has been below plan since these hotels were acquired. We believe the time has come for Legacy to focus on its current assets and examine strategic alternatives that will surface their hidden value.

One potential initiative, which has been very popular south of the border, is condo conversions. In addition, Legacy has excess lands adjacent to many of its hotels that could be developed with partners or sold outright. For example, excess land next to the Fairmont Chateau Laurier, situated next to the Rideau Canal, would be an ideal location for a condominium project. We believe that development projects and condo conversions could add between $0.50 to $1.50 per unit in incremental value, leaving us with a total NAV between $9.00 and $9.50 per unit.

HANDLEMAN COMPANY

Handleman is not well known to a lot of people however it could very well be the largest seller of music in the world. Based in Troy, Michigan, Handleman is a distributor and category manager of pre-recorded music for mass merchants in the United States, United Kingdom and Canada. Essentially, Handleman is the link in the supply chain between the record labels (i.e. Warner, Sony, Universal), and large mass retailers (Wal-Mart, K-Mart, Best Buy). Handleman works behind the scenes by managing the selection, acquisition, delivery, retail ticketing, display and return of music products for its customers.

Handleman has fallen from favour lately on Wall Street. This can be attributed to sluggish pre-recorded music sales, lower margins due to promotional pricing and a reduction in the number of Wal-Mart and K-Mart locations serviced by the company. Subsequently, shares of Handleman have fallen to under $14, or roughly half of its peak price of $26.60 reached in April 2004. But investment sentiment towards Handleman could be too negative. While the company did lose 25 Wal-Mart stores in August, it has been awarded the servicing contracts for 65 new Wal-Mart locations scheduled to open later in the year. In addition, Handleman is winning new customers. Last month it was awarded the category management and distribution of Latin music for Circuit City. With respect to declining industry sales of pre-recorded music, Handleman’s customers have actually increased sales of pre-recorded music in each of the last five years.

At these levels, we feel shares of Handleman are oversold and in fact, represent an attractive investment opportunity. With earnings expected to reach $1.32 this year and $1.73 in fiscal 2007, its shares are trading at just ten and eight times this and next year’s earnings respectively. This multiple is low when compared to its publicly traded peers, and is below the company’s historical average of between 12 and 13. In addition, Handleman trades at a 9% discount to its book value of $13.93. It should also be noted that Handleman has an excellent balance sheet. The company is virtually debt-free and is expected to generate close to $1 per share in free cash flow in each of the next two years. This cash could be used to increase the dividend or to buy back the company’s stock. In fact, since 1997, Handleman has reduced its shares outstanding from 32 million to fewer than 20 million today. Finally, we feel Handleman could become the object of a takeover given the company’s low stock market valuation, high cash flow and solid balance sheet. It could attract the interest of a strategic buyer wanting to expand its product line or a financial player looking to take the company private via a leveraged buyout (LBO) strategy.

Irwin A. Michael, CFA