Cyber rivals prove too powerful for HMV as it plummets down charts

HMV has rested on its laurels, confident that acting as a gig venue on the side would protect it

The rise of the cyber high street has claimed its first major victim after HMV, the music and books group, admitted it failed to cope with intense competition from its internet rivals over its crucial Christmas period.

The phenomenon cost the company its first-half profits, much of its festive profit margin and the resignation of Alan Giles, its respected chief executive, it announced yesterday. It also prompted speculation that the group could opt to separate its core music chain from Waterstone's.

The combined onslaught from online retailers and supermarket chains has left HMV in a strategic vacuum. Its status as a specialist music retailer hung in the balance after it warned that internet rivals were decimating not only its sales of chart music but also back catalogues.

The task of solving HMV's conundrum will ultimately fall to someone other than its chief executive, who will stay on until the end of December before taking early retirement. After 30 years of worrying about like-for-like sales at Christmas, Mr Giles said he was quitting the retail sector to start a career as a serial non-executive director.

His decision to announce his departure, alongside the group's worst results since it floated in May 2002, shocked the City and further undermined confidence in the company's future. Shares in HMV dived 9 per cent to 178.5p as analysts took a knife to their forecasts for the third time since September.

Matthew McEachran, a retail analyst at Investec Securities, said: "There are a million and one different theories [about why he is leaving] but whatever the reasons are it is disappointing because he is well regarded by the investment community and will be missed."

In an attempt to stop haemorrhaging sales, HMV sacrificed its margin and slashed the prices of thousands of DVDs, CDs and books in the run-up to Christmas. Underlying group sales during the five weeks to 7 January fell 2.7 per cent after declining 6.1 per cent during its first half. The worst culprit was its core music chain, which Mr Giles said was "under pressure at both ends of the spectrum". Competition on chart titles from supermarkets, which have long sold new releases for as little as £7 or £8, is nothing new but it was the first time shoppers have sought out cheaper copies of artists' back catalogues from online retailers such as CD Wow and Amazon.

Mr Giles said: "There was a quantum jump in buying CDs and DVDs on the internet. Over the past six months the internet has taken a huge jump forward. Maybe there has been a tipping point in adoption of the new technology with the penetration of broadband." He said the problem did not stretch to the downloading of digital music, a market HMV entered belatedly in the autumn. Mr Giles said just 2 per cent of all music is purchased electronically.

At the HMV music chain, like-for-like sales were 5.5 per cent lower, a recovery from the 12.1 per cent decrease in interim sales, but at the cost of 200 basis points of its margin. As well as heavy discounts on chart CDs and box-sets of DVDs, the chain also sold lower-margin computer games.

Analysts tended to blame a structural shift in HMV's markets rather than cyclical weakness for the retailer's disappointing interim results, pointing to the rising trend for shoppers to make their purchases online rather than in store. But Justin Scarborough, at Panmure Gordon, said the distinction was still blurred. "It is difficult in the very short term to get a better feel for what part each is playing," he said. "Was the price-cutting and impact on the gross margin down to a generally more promotional sector over Christmas or was it more cyclical?"

Mr McEachran said HMV's status as a specialist music retailer was under threat. "The product has become so commoditised now that HMV is on a slippery slope to becoming a discounter," he said. "Their specialist qualities have been diluted by the need for all these promotions."

In the past, HMV has rested on its laurels, confident that its ability to plug new bands and resurrect old masters by acting as a gig venue on the side was enough to protect its position. But figures from the British Phonographic Institute, the industry body, show supermarkets and internet players controlled almost as much of the market as specialists in 2004 (see pie chart). And the situation is bound to have got much worse in 2005.

Over at Waterstone's, which was recently blocked from acquiring its smaller rival Ottakar's, the underlying sales fall over Christmas was 2.4 per cent after a 6.4 per cent decrease in the first six months. This improvement, which was not enough to stop Waterstone's losing market share, came at the expense of 120 basis points of gross margin.

It was the Christmas of the half-price hardback, with booksellers from Waterstone's to Books Etc offering unprecedented bargains on titles such as Jamie's Italy, Jamie Oliver's latest cookbook, and Alan Bennett's Untold Stories.

"The battleground was predominately in the top 50 hardbacks," Mr Giles said. "Supermarkets were very aggressive in that area." Deflation in December alone was 3 percentage points across the book market, making the 8 per cent rise in volumes come at a heavy price.

Ottakar's excused itself from the battle before Christmas through a profits warning, making the flat underlying sales it announced yesterday over the four weeks to 7 January unsurprising. The book chain, which faces an uncertain future while the Competition Commission decides whether to allow Waterstone's to swallow it up, is expected to make profits of less than £3m in its current financial year, down from £7.14m last year.

HMV's Christmas trading update accompanied its interim results, which showed pre-tax profit for the six months to 29 October was virtually wiped out at just £200,000 compared with £10.5m the previous year. The group's overseas operations, which contribute just 10 per cent of its profits, fared better than the UK, but this was of scant comfort yesterday.

Answering accusations that his impending departure would leave his company in the lurch strategically, Mr Giles said: "I accept that there are challenges. I'm not saying that those are someone else's problems because they will be dealt with in the next year." He pointed out that had the company forced him to pay the price for its poor performance, he would "be at home now, in my garden, and not staying until the end of the year".

He said he would be leaving a well-entrenched management, after the recent appointment of Gerry Johnson to run Waterstone's. HMV's new chairman, who was unveiled yesterday, will have had 11 months in the role by then. Carl Symon, 59, formerly the chief executive of IBM UK, will take over from HMV's interim chairman, David Kappler, on 1 February.

But Mr McEachran said it would not be easy to concoct a new strategy. "There will be some fallout. There may be strategy disagreements, personality conflicts, management-style differences," he said.