On November 22nd, Handleman announced results for its second quarter of fiscal year 2006. Despite a 6% drop in industry sales, revenues for the quarter increased 2.3% to $302.2 million compared to $295.3 million last year. Net income increased 27% to $9.8 million or $0.46 per share, from net income of $8.2 million or $0.36 per share last year. In fact, Handleman is on track to earn close to $1.40 per share this year. Despite these projections, Handleman shares are trading at less then ten times earnings and below its book value of $13.86. To its credit, the company has recognized that its shares are undervalued and has been buying them in the market. As a matter of interest, over 688,000 shares were repurchased in the quarter and approximately 1.4 million have been repurchased year to date. As we head into Handleman’s seasonally strongest quarter, we could see the stock strengthen assuming that its sales and earnings are within management’s previously stated guidance.

March 24, 2006

On February 24th, Handleman Company (HDL) reported third quarter net income of $14 million or $0.68 per share compared to net income of $28 million or $0.94 per share for the same quarter last year. Earnings were negatively impacted by lower sales of serviced accounts in the U.S which typically carry higher margins. In addition, the general weakness in overall music industry sales, particularly during this past holiday season, also impacted revenues. U.S. music industry sales during Handleman’s fiscal third quarter were down 6.2% compared to the same period the prior year.

We believe Handleman shares remain attractively valued. They are currently trading at under eight times 2007 expected earnings of $1.15 and at a 40% discount to their book value of $14.60. Handleman’s directors seem to agree as the company continues to be active in repurchasing its shares in the market. In the third quarter alone, Handleman bought back 500,000 shares at an average price of $12.97. This brings the total number of shares repurchased under its program to 1.9 million or 57% of the total authorization. Given Handleman’s attractive share price and shrinking share base, we are surprised that an offer has not been made to take the company private.

August 11, 2006

On June 30th 2006, Handleman reported fourth quarter and full year results. For the quarter, Handleman reported a net loss of $6.5 million or $0.35 per share which fell short of investor expectations. However, for the year Handleman was profitable. The Company earned $13.6 million or $0.65 per share compared to earnings of $34.2 million or $1.51 per share in fiscal 2005. It appears that a slowing US economy, and the lack of a “big hit” artist or album recently, is taking its toll on music sales at mass merchant retailers. In addition, record high gas prices are undoubtedly beginning to eat into consumer’s disposable income. This is particularly harmful to music sales at retailers such as Wal-Mart, a prime customer of Handleman, where music purchases tend to be impulse driven. It should also be noted that like most distributors, Handleman operates on small margins with a high operating leverage. Therefore, even a small decline in sales can have a large impact on the bottom line.

However, with the stock now trading at less than 50% of its $14.87 book value, and a 35% discount to its tangible book value of $10.85, we think Handleman is oversold. Having taken this into consideration, we believe that an eventual economic recovery, a decline in gasoline prices, or the release of a hit album are all potential positive share price catalysts. Finally, given Handleman’s shrinking share base, good balance sheet and attractive share price, we would not be surprised if eventually we see an opportunistic takeover of privatization offer.

December 29, 2006

Before investing in a security, we make a basic assumption that the company’s business model will not change dramatically after we purchase it. In most cases it doesn’t. On occasion however, a company will venture into new, perceived complementary products or services. Although these moves are designed to increase sales and profitability, in reality, they are usually more costly than anticipated, and take longer than expected to bear fruit. The result can be prolonged share price underperformance, and in severe cases, permanent loss of capital. Therefore, we try to identify these problems before they get out of hand.

Recently, we noticed this happening at Handleman, a stock we had purchased in the summer of 2005. When we originally purchased Handleman, the company was solely a category manager of music. Most of its business was done with Wal-Mart, a company we knew well and understood. In addition, they serviced some K-Mart stores and had recently been awarded the category management and distribution at Circuit City. Management was focused on winning new contracts to service other mass merchant retailers. This was a business model that made sense to us.

We calculated that if Handleman could add a few new customers, net margins could return to its historic average of around 2.5%, and earnings could reach $1.75 per share within a few years. Although music sales were softening, we were not overly concerned as Handleman had been through periods like these in the past. In addition, the Company was debt free, generating free cash flow and had enough credit available to carry it through a prolonged slowdown.

Unfortunately, after we purchased Handleman the company’s business model and financial condition changed significantly. Rather than focus on growing its category music business, the Company instead acquired Reps, a category manager of DVDs, music and greeting cards, and Crave Entertainment, a publisher and distributor of video games. The Crave acquisition was supposed to be accretive to earnings and allow Handleman to cross sell its music capabilities to Crave’s existing customers. Sadly, Handleman has not signed any new customers through this arrangement and Crave’s financial results have been below management’s expectations.

Handleman’s balance sheet, moreover, has also weakened since making these acquisitions as over 28% of its equity is now in the form of goodwill and intangibles. As a result, tangible book value has been reduced from nearly $14 to just $10 per share. In addition, the Company now has close to $100 million in debt. Given Handleman’s new assortment of products and services, we’ve found it increasingly difficult to forecast future earnings per share. Finally we can’t be sure that management won’t make more acquisitions. We are concerned about increased financial leverage and a decrease in tangible shareholder’s equity.

While we do not usually take a loss simply because of a share price decline, we eventually reached a sell decision with Handleman, as we can no longer be confident in our valuation based on a deteriorating balance sheet, changing business model and uncertainty with respect to future earnings and book value per share. While it is possible that Handleman can improve upon its prospects, we are concerned that the risk/reward of this security is no longer attractive according to our investment model.