Description

This is a stock that was last written up in 2001. At at least 10x its earnings power and 0.5x enterprise value to sales, Integrity Media is far too cheap in my view. To get a bit more background on the business, you may want to refer to pelican362’s write-up. Some things have changed since then, namely the Time Life arrangement has slowed and they made a strategic move into the book publishing arena by launching Integrity Publishers. This is a better company now than 2 years ago.

Today, Integrity Media announced somewhat disappointing earnings for their 2nd quarter. I feel that now is a great opportunity to pick up a solid business at a cheap price.

First off, some basic background, Integrity Media is a music and book publisher that operates in the Christian-based market niche. They sell their products through a number of venues, such as independent Christian bookstores, mass-market stores like Target or Wal-Mart, as well as the “affinity” mail order clubs. Most recently and most visibly to many of you who don’t immediately flip channels when a commercial appears, they teamed up with Time Life Music and offered a group of albums via TV commercials. This was a big winner, especially in past 2 years (it has slowed considerably but helped them build both their market and affinitiy club lists) and was one of Time Life’s most successful offerings in its history.

Overall, Integrity Media brings in revenues of about $75 million (latest guidance for 2003) and is a profitable company. This year, after this announcement today, they expect to make about $2 million in net income which is less than their most recent three year average. We feel this company has the ability and the strategy to make more money over the next couple of years. Not only that, I feel that earnings are still significantly understated due to a very conservative accounting treatment of their song library (aka product masters).

Integrity Media pays for the development of their recordings (staff time, studio time, artist costs, etc) and writes this cost over the unit sales of those recordings. Each items sold is a separate line of business and the amortization of the “product masters” is very quick. In my
view, too quick. Overall, the product masters sit on the balance sheet for far less than a year. To give you some numbers, from 2000 to 2002, Integrity spent about $11 million developing more recordings and expensed about $14 million. It is as if they are amortizing as fast as developing, essentially expensing as they go. This treatment, while accurate from an accounting standpoint, is not quite right from an investment point of view. These recordings, especially in their market niche of “Praise and Worship” which is not as artist focused as other segments, are worth something farther into the future than just its current use. How far? I don’t know, but to give you an example, the Time Life Songs for Worship discs utilized a lot of library material at no cost to Integrity to re-record. Simply used the library and sold the music. What should the amortization speed be? Somewhere slower than a few months, but not as slow as 3 years. A change in this assumption would significantly alter earnings per share numbers.

Integrity Media is a small company, no doubt, with a market cap of $25 million. With sales of $75 million expected for this year and net debt by year end of around $13m, it sells for around .5 ev/sales levels. With a current earnings power of around 40-50 cents per share (I believe that will return to it soon), it sells today for around 10x its earnings power. Its balance sheet is strong with very manageable debt levels that will significantly fall over the coming year or so due to its strong cash flow generating abilities.

A couple of issues are important to expand on to give a fuller picture of Integrity Media. First, in 2002, Integrity launched a new division in the book publishing arena, very creatively called Integrity Publishers. It seems a natural fit with their music business in the sense that the end customer is the same and the places they sell the two products ties together nicely. Additionally, they have hired right. Rather than slowly entering this industry with a few people focusing on it, Integrity made the wise move of hiring talented, experienced executives right out of the shoot. It has helped them sign more artistic talent by sending the strong signal that Integrity is committed to success in the publishing industry.

Additionally, Integrity has made selective acquisitions over the past 2 years, one being M2 Communications that broadens their music offerings beyond “Praise and Worship” (think, non-artist specific, general feelings-based music centered around things like “Love” or “Faith”) christian music. M2O Communications specializes in a different area of more popular, pop-oriented music within the Christian music market. A much larger sub-market than Integrity has traditionally played in.

Lastly, from a standpoint of the numbers, Integrity Media has spent heavily on two things; a new headquarters and a new computer system. Over the past 18 months, they spent a considerable sum building out their headquarters in Atlanta. While generally I hate to see companies spend a lot on their offices, I do understand the need to impress customers, artistic talent and distributors. The company has wisely stated that the building is nice, but not too nice. This helps ease my pain, but that fact that these costs are done as of today certainly eases it more. We won’t see these costs or cash flow drains going forward. They spent about $5 million on these two projects. While it hurts it does bode well for Integrity’s ability to pay down debt and invest in more productive things going forward.

Lastly, to address an issue that is certain to come up, piracy. They made mention of the peer to peer downloading issue in their recent announcement. Management on the call stated that they can't even quantify it, but think it may be affecting things. I really don't think this is a big issue today for them. Older buyers, more honest customer base etc. It is an issue. But I don't think a big one in my opinion.

Catalyst

At 10x earnings (likely overstated given its accounting) with a strong balance sheet, Integrity is too cheap given its reasonable growth prospects. The company has the ability to continue to grow its revenues without matching that growth on the expense side. They spent on the publishing build up of talent and now it is ready for margins to flow through. This is an investment that will take some time to develop, but given the fundamentals of the business, I feel at today’s levels, there is an opportunity to pickup shares on the cheap. For a 10% grower, with a current earnings power of 40 to 50 cents, and nice cash flow characteristics, Integrity should be more appropriately priced in the $7+ range.