It's no secret that compact discs are on the way out as the preferred method for distributing music, and their decline has continued to accelerate. According to Nielsen SoundScan, 500.5 million albums sold as CDs, cassettes, LPs and other formats were purchased last year, down 15 percent from 2006's total.

Including digital music download sales and music videos, music purchases were up 14% from 2006. What should investors be looking at here?

Perhaps paradoxically, I don't think digital music is the way to play this. The fast-growing innovator often lags that declining old-economy company in terms of stock market returns because investor sentiment can be overly negative. For instance, railroad stocks outperformed airplane stocks (and the broader market) by a wide margin, even as railroads lost their status as the major method of travel. The reason? Railroad stocks were beaten down so badly by the headlines about their demise that they became tremendously undervalued.

The music equivalent of the railroad is Handleman (NYSE: HDL), a stock that has frustrated bottom-fishers for years. The company manages the music category for retailers like Wal-Mart, and well-known value investors like Joseph Harrosh and Marty Whitman have accumulated stakes in the company, even as the stock has continued its decline.

The stock trades at a huge discount to its (probably overstated) book value, and has had trouble adapting to changing trends in the industry. But at its current price, it may be worth a look for contrarian investors who aren't afraid to own stocks that other people snicker at.

I've been following Handleman (NYSE: HDL) from the sidelines -- literally for years -- wondering how much lower the stock could fall. In late July, I wrote that super-investor Marty Whitman had acquired a large stake in the company. Since then, the stock has continued its march of death and investors can again ask "Is the stock done tanking?"

The company reported its first quarter results for FY 2008 today and, while they're certainly not impressive, they may be a sign of some positive things to come. The company's pre-tax loss was $17.7 million, compared to $22.4 million in the same quarter last year. However the company booked a tax benefit of 16.5 million in the prior year quarter, so the comparables don't look good. The total loss for the quarter was 88 cents per share compared with 30 last year.

CEO Stephen Strome commented that in 2007, the company implemented "programs" to save $20 million per year, and will add another $20 million to that savings this year.

Total revenue increased 14% to $274.2 million, giving the stock a minuscule price/sales ratio to go along with its tiny price-book ratio. Now if only they can do something about the lack of a price/earnings ratio.

Gross margins improved slightly, and the company is looking to transition away from dependence on the dying business of music distribution into greeting cards, video games, and DVDs. Handleman is hoping its expertise in logistics and category management will help it make in-roads in these and other products.

Will it work? Only time will tell but, if it does, investors will be richly-rewarded. The stock is trading right around its net asset value, and may present an opportunity for patient investors who aren't afraid of uncertainty -- which is exactly what Whitman is, and probably a key reason his firm is invested.

Any deep value investor who labors late into the night in search of really cheap stocks has heard of Handleman Co. (NYSE: HDL), a distributor of CDs, DVDs and video games for companies including Wal-Mart Corp. (NYSE: WMT). Its anemic price to book ratio of 0.43 lands it near the top of any screen for net-current asset value plays, but there's just one problem: Handleman has been showing up on those screens for more than a year. I first started looking at it when it was trading around $12 per share; it hit a new low today of $4.96.

But now there's a reason to look anew at Handleman, and it's another name every deep value investor has heard of: Marty Whitman (author of one of my favorite books, The Aggressive Conservative Investor) and his firm Third Avenue management recently reported a 17.2% stake in the company, up from the 15.6% it first reported in April.

I've always thought Wal-Mart (NYSE: WMT) was a master of merchandising, but this seems pretty bonehead. According to the Wall Street Journal, Wal-Mart embarked on a plan to sell Yiddish music CDs last year and, miracle of miracle, wonder of wonders, they didn't sell.

"Within months of shipping thousands of CDs to Wal-Mart, the classical music distributor's loading docks were swamped with unsold copies of "Klezmer Concertos & Encores" and "Great Songs of the Yiddish Stage," according to the article. Since they hadn't sold quickly enough to meet the retailing giant's standards, 80% of the CDs Naxos shipped to Wal-Mart were returned. Record stores typically return only 20%."

OK then. Something tells me that any 8-year old could have told you that "Great Songs of the Yiddish Stage" wasn't going to be a big hit at Wal-Mart.

But it isn't just obscure titles that are having trouble at the big-box stores. Stores like Wal-Mart, Target, and Best Buy account for over 65% of U.S. music sales (including downloads), and they are cutting back on the floorspace alloted to music. CD sales have plunged another 20% so far this year.

Want a contrarian stock pick on this trend? Handleman Co. (NYSE: HDL) manages the music departments for numerous Wal-Mart locations. As you can imagine, owning shares has been a doozie for the past few years. But with the stock currently trading at a 50% discount to its book value, is all the bad news already priced in?

While the record industry continues its death-spiral, evidenced by declining share-prices of companies like TransWorld Entertainment (NASDAQ: TWMC) and Handleman (NYSE: HDL), there is at least one bright spot: Sales of Latin music are on the rise. As a big fan of contemporary Latin music, I'm going to make a confession here: I first got interested in Latin Music in 1999 when Ricky Martin sang "The Cup of Life" at the Grammys. Yeah, good stuff. I also liked Latin pop singers like Enrique Iglesias and Marc Anthony. But at the Latin Invasion faded out of mainstream American pop culture, a new breed of Latin stars are cropping up, demanding attention: groups like Bacilos and rappers like Daddy Yankee are providing edgier, more interesting music for a more mature audience.

According to Enrique Reyes of Reyes Musica, Latin Americans haven't yet become interested in downloading music, preferring the now old-fashioned CDs. While Latin music may buy some time for traditional record stores, ultimately it will move online. As Latin Americans earn more money and gain access to technology and credit cards, they too will buy their music online. As they have more money and access to the Internet, companies like iTunes and Napster will move quickly to provide them with the more obscure tracks from their native countries that they are looking for.

With the outlook for music retailers looking so bleak, might these make an interesting contrarian play? I don't think so. Handleman, which currently trades around its net current asset value, is losing money and recently eliminated its dividend. Most of its assets consist of inventory and the whole point is that CDs aren't selling. If the inventory was worth what it's listed at, they wouldn't be in trouble.

TWMC, for better or for worse, has chosen to go all-in. The operator of music retail outlets acquired Sam Goody and the Suncoast Motion Picture Company last year, and narrowly missed out on its bid to acquire the assets of Tower Records out of bankruptcy. The company is trying to refocus itself as an "Entertainment Store" and with its Mix&Burn service consumers can download songs at the store and burn them onto a CD or iPod, for a fee. Problem: Why would you go to a mall to do something you can do at home? I don't see in-store CD burning as being the future of music delivery. But I could be wrong.

I enjoy a contrarian play as much as the next guy, and music retailers certainly qualify. But while many newspapers (another interesting contrarian play) continue to generate excellent cash-flow, these music companies have stopped doing that. Perhaps this is why there has been a lot of merger and acquisitions activity surrounding newspaper companies and none to speak of around the music retailers.

Today, Handleman Company (NYSE:HDL), a provider of category management and distribution operations for CDs for companies like Wal-Mart Stores, Inc. (NYSE:WMT), suspended its quarterly dividend, wiping out a 4% yield. Shareholders reacted quickly and angrily, sending the stock down 7%, good for the 4th biggest loser on the NYSE for the day, as of this writing. Was the sell-off justified? I don't think so. As an introduction, I don't like dividends. While the allure of a high yield stock can be tempting, I believe that it is mostly illusory. For an explanation of why I don't like dividends, read my piece A Rally of Declining Yields: Should you Care?

Back to Handleman. They discontinued their dividend as part of an amendment to their credit facility. They will also no longer be able to repurchase stock. In the typically optimistic press release, Chairman and CEO Stephen Strome said "At this time it is prudent for us to protect our balance sheet and preserve our cash for the execution of our business plan. We are in the process of expanding the Company's category management, distribution and in- store service operations in the United Kingdom to accommodate new customers and products, and are undertaking other activities to improve our performance and streamline our operations."

Eliminating the dividend makes sense. Why not use cash flow to pay down debt rather than return it to shareholders and have it taxed twice? And since the company isn't making money anyway right now, paying a dividend was essentially borrowing money to return it to shareholders. That doesn't make sense. On the Yahoo! Message board for HDL, poster Horatio_of_camden writes "If you own a non-profit that pays a dividend, sell the non-profit until it stops paying the dividend. " This is sage advice. While I generally avoid stocks paying big dividends, if you like those stocks, remember that rule.

Note: I would not buy Handleman here. The company is not profitable, and its long-term outlook appears bleak. I'm just saying that I don't think the elimination of the dividend is a good reason to sell if you are long the stock.