HMV has got the blues, but a darker fate lies in store

If there were any lingering doubts about the battle HMV is facing to remain on the high street in its current form, its third profits warning since September yesterday, as well as worrying developments on its finances, have dispelled them.

Shares in the entertainment group – which owns the eponymous high-street chain and bookseller Waterstone's – sank to a record low of just 16.25p after a dire update.

The group said that "trading conditions remain tough" since 5 January, that it expected to breach a key banking covenant test, and that net debt will not be less than £130m by the end of April. The group now expects full-year profits to be below expectations of £45m, though City forecasts are likely to be below £40m. To cap a miserable day for HMV, the retailer said that Robert Swannell – its chairman, who also holds the same position at Marks & Spencer – was stepping down to become a non-executive in recognition of the time demands of the role.

Most significantly, a growing number of retail experts now fear that while there is no imminent danger, the entertainment group may ultimately suffer a similar fate to Woolworths – especially in an era when the chain is unlikely to get any help from consumer spending.

Richard Curr, at Prime Markets, said: "The well-documented attempts by the group to diversify into live music haven't worked, leaving shares of the group worth a fraction of their market valuation in 2009, and this, coupled with the departure of chairman Robert Swannell today, will probably be the final nail in the coffin for HMV's long-suffering shareholders."

While HMV has diversified its operations into live concerts, festivals, cinema and fashion, these businesses have not been able to compensate for the inexorable decline in the markets for physical music and films.

John Stevenson, an analyst at Peel Hunt, said: "The issue with HMV has not been with management's inability to put change through the business. The underlying market is moving faster than the business has moved."

Simon Fox – who took the helm at HMV in September 2006 – may still be able to work miracles in reversing its trading fortunes, but it now seems he will have to perform painful surgery on the group.

Mr Stevenson said: "Clearly, HMV is going to have to think about a more radical restructuring." Industry observers now expect HMV to swallow some form of pretty unpleasant medicine. The options include a rights issue, selling off its Waterstone's chain for an estimated £70m, or a further dramatic reduction of its store numbers.

A rights issue appears more likely after yesterday's news, but HMV declined to comment on this matter.

Nick Bubb, an analyst at Arden Partners, said that if HMV does not want to sell Waterstone's, an equity call is "more likely than not".

Other options that HMV is likely to consider are selling its operations in countries, including those in Canada or Hong Kong. However, people familiar with the situation played down expectations of selling overseas operations. HMV could also look to offload its Hatchards shop, which has been on Piccadilly in central London since 1797.

The main action around HMV over the coming weeks is likely to centre on Russian billionaire Alexander Mamut's interest in Waterstone's. Mr Mamut, who has built up his stake in HMV to 6 per cent since last year, has appointed Credit Suisse to advise him, and HMV's management are reportedly braced for a bid for the bookseller. HMV declined to comment on Mr Mamut.

But the mood music towards HMV changed sharply yesterday, largely due to admissions on the deteriorating state of its finances. HMV does not expect to meet a key banking covenant test – related to a ratio between earnings before interest, tax, depreciation and amortisation (Ebitda), and its rent bill for the year to the end of April. As a result, the group has kicked off "discussions with its lenders" about renegotiating the covenants.

To address the Ebitda-to-rent-bill covenant, HMV said in January that it would offload 40 of its 285 HMV stores and 20 of its 300 Waterstone's shops. However, it is likely that more stores will have to close, and even before yesterday the word on the street in retail property was that HMV was prepared to listen to offers on many of its stores.

Above all, the City was taken aback by the group's forecasts on net debt, which are usually at the heart of any troubled company's woes.

HMV said its net debt would be no less than £130m at its year-end in April. To put this in context, Mr Bubb had pencilled in net debt of £70m for this year. HMV's actual net debt for the 52 weeks to 24 April 2010 came in at £67.6m.

On the other hand, the company remains profitable and has other factors in its favour which could mean there is still life left in Nipper the dog and his gramophone, which have been the music chain's mascot since its first store opened, on London's Oxford Street in 1921.

Following the collapse of Woolworths and Zavvi, HMV is the last man standing in music and entertainment on the high street. The UK heads of seven record companies, including Universal Music, EMI, Warner Music and Sony Music, also came out publicly in support of the entertainment company after some credit insurers had slashed their cover in January.

However, the ground below HMV's feet is moving quickly. Problems range from the familiar foes of the big supermarkets, the pure-play specialists Amazon and Play.com, as well as punters getting the same entertainment on YouTube for free or illegally on other sites. The growing popularity of video on demand will also become a major spanner in the works for HMV.

Whatever happens at HMV, the group is likely to have to slim down radically. Mr Bubb warned: "There has to be a Plan B because it is pretty clear that Plan A has failed."