MAKEMUSIC INC MMUS
June 06, 2011 - 12:57pm EST by
4maps
2011 2012
Price: 4.92 EPS $0.00 $0.00
Shares Out. (in M): 5 P/E 0.0x 0.0x
Market Cap (in $M): 24 P/FCF 0.0x 0.0x
Net Debt (in $M): -9 EBIT 0 0
TEV ($): 15 TEV/EBIT 0.0x 0.0x

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Description

MakeMusic is a beautiful little thing: a software company with a franchise and technology moat, high margins, growth potential, catalyst coming AND a margin of safety.

Adib Motiwala has done a yeoman's job of writing up the long form background story of MMUS over on GuruFocus so I will spare you many pages of background. You can see his writeup here:  http://tinyurl.com/3vcyz58

MMUS has two main lines of business.

The first line of business is the software package Finale which is used for music notation. This is a mature market with one major competitor. MMUS takes in about $10mm per year from this business with 91% gross margins. This revenue stream has been shrinking about 1-3% per year due a generally stagnant market for music notation and composition tools. After fixed costs and SG&A but before R&D spending (which is not for this business line), this business line throws off about $6m/year in free cash flow.

The second line of business is SmartMusic. This started as a program for practicing alone by using software to provide accompaniment and has evolved into a home practice solution that can provide music to work from, accompaniment, and can evaluate and grade the playing of a musical piece as schoolwork. They now have an Educator portal where music teachers can assign work and get back grades from the software without having to try to attentively listen through every piece. They can listen if they want and even clip out pieces of the music to email the parents to show how well the child is doing, all in a couple clicks from a laptop. They've been signing up about 133 independent educators and 160 school sites per year recently (and 30,000 total students and educators per year). Once hooked the schools tend to stay on and the pricing on both the student and school versions has been rising steadily, showing pricing power. The SmartMusic business is generating about $5.4m in revenue but gross margins are only 69% and after fixed costs like SG&A the SmartMusic business is barely profitable right now, no doubt leading to the current bargain status. This is because the company is investing the SmartMusic income into more sales and a larger library of music. The SmartMusic business has power of scale in that each subscriber reduces the cost per subscriber to add music or features, network effects in that educators use results in student use and the more students are used to it the more educators want to use it, revenue predictability through annual membership fees, customer switching costs as it becomes the built in grading and records system, strong margin on each added customer, no customer concentration, and high growth. By my count that's 7 of the 10 distinguishers of a great business.

Valuation and Margin of Safety:

The stock price has been bouncing around $5, which is a $24.4m market value. The company has $9.8m in current tangible value (much of it cash) plus a $5.7m tax loss carryforward for a tangible/liquidation value of $15.5m or $3.18 a share, 64% of the purchase price. If we assume a mere 3% FCF growth from now on (far below expectations) and apply an aggressive 12% discount rate we get an earnings-only discounted value of $5.55 (with current tangible assets removed). So in this aggressively discounted assumption of poor performance the current value with cash is $7.58 , fully 54% above the current purchase price.

Right now the SmartMusic sales push and software R&D engine are in full overdrive and the company is still throwing off $3m per year for the last two years in FCF on an EV (including NOL tax asset) of $8.75m Even without the tax asset the FCF yield is 21% while the company is still spending on growth.

============================================

The Bear Case:

Finale is a shrinking product that could be throwing off prodigious cash, but that cash is being invested in SmartMusic, which has lower margins. The company CEO is a currently a board member doing temporary duty.

The Bull Case:

SmartMusic is growing strong and should throw off free cash flow for the forseeable future. The market position of SmartMusic is strongly defended by patents, technology, and network effects and shows pricing power. A conservative estimate of the available FCF is worth far more than the current EV (see calculations above). Additionally, management made clear on the most recent conference call that they intend to take advantage of their market power and access in the educational music market to use their software as a platform for new offerings (unspecified but presumably along the lines of offering the purchase of popular music so kids can play along with current favorites). The current stock price of MMUS is so low that SmartMusic could fail after several years more of investment and buyers would still come out ahead.

=============================================

SWOT:

Strengths - The most likely path appears to be for SmartMusic to keep improving in both revenue and margins. Current growth is about 20% per year in subs and revenue. The company says the total market of youth music students is 6 million students (and my demographic research suggest this will grow strongly for 3-5 years at least). Even if we assume they plateau at roughly 10% of TAM they reach $23m in revenue without the teacher copies (and assuming the same sort of large scale discounting they do for district level sales now). That should drop $10m or more to the bottom line per year. If they get 20% penetration, it looks even better. If the new platform strategy enables $20/user additional sales per year with a 30% margin (similar to a phone app store), that's another $3.6m+ per year (still using only 10% penetration). Their Finale sales should also see some gains from the integration with SmartMusic, and if that simply stops dropping it will represent $6m more in FCF for a very reasonable potential of about $20m/year FCF available in the future compared to a current EV of $6.9m and market value of $24.4m.

Weaknesses - The CEO has stated they are increasing R&D (see opportunities) so right now cash is being reinvested in the company and not, for example, returned in a dividend. Ultimately one must believe in the market and eventual realization of value as the company does not seem to be inclined toward returning the cash to shareholders (at least until a new CEO comes in). I take this as a serious consideration and if the margin of safety weren't as big would consider this a significant weakness.

Opportunities - In addition to the ongoing 20% annual SmartMusic growth, the CEO on the last few conferences calls discussed that their software guys are working on making the technology a platform for the delivery of other products. If you get the transcript you'll see that he thought it was not a very long project (1-2 years maybe). Depending on your expectations of the SmartMusic market penetration (600K-6m users in a few years), platform sales (I guess a low $20 per user), and margin (30% being an app/content store typical value for the platform provider), one comes out with an additional $3.6m to $20+m per year. Solid SmartMusic growth in itself may provide $2+m in free cash flow soon.

Threats - The company is small and we must worry about competitors and predators.

Competition: the Finale area is under competition from AVID (product:Sibelius). The whole market is less money than AVID needs to stage a turnaround to profitability and is outside AVIDs sweet spot so it seems likely that pricing will remain rational.

Smartmusic "competitors" -

Starplay - no grading or evaluation technology, no school tie-in or educator management, not really a competitor.

iPAS from Pygraphics - iPAS comes from a background of providing marching band diagrams to show people where to march as they play to make formations and this is still their main market, but they have added in a grading and evaluation component once they saw the market MMUS has discovered. Various channel checks suggest they have about  6,000 users vs 162,000 for SmartMusic. MMUS has superior funding, technology (with some relevant patents), music library, and sales force.

Blackboard Inc (BBBB) - The granddaddy of school enterprise software. They have no music accompaniment or grading technology. Indeed, BBBB is an acquisition addict and seems more likely to try to buy MMUS to give BBBB a "sticky" technology edge to get their other software into schools.

============================================= 

Ownership and alignment:

4.88 million shares total

1.36 million owned by the equity group that launched the company (28%)

1.69 million owner by the executives (35%)

0.2 million owned by investors we know, long term

1.63 million left for trading (about $8.15m worth)

Note on trading: Building a substantial position in MMUS took quite a while.

Long term expectations:

A company can't generate tens of percent FCF yield for too long before getting noticed. If not for their reinvestment in SmartMusic and their platform they would already have more cash than market value and I think they have found a very nice growth path to invest in (pricing power is good) so I'm happy to see that growth. If neither of the catalysts above pan out I expect a very good chance that within 2-3 years they will be able to generate $10m plus in FCF (derating further even the conservative numbers above) and should have a market value at least 2x the current value.

Even if they give up and kill SmartMusic R&D they can sit back on $6m+ in FCF and send out dividends equal to about 100% of the current EV each year.

Catalyst

This one comes with catalysts:

Buyback - the board recently authorized $10m in authorized buyback on a $24.4m market cap. This could be paid from cash by the company over the next year or so. They specifically authorized that these buybacks could be through 10b filings and the like, so I actually expect that much of the buyback will go toward giving some liquidity to the equity group that launched the company and the execs. It has to, in fact, as there aren't $10m worth of shares circulating outside those parties! Demand is demand, though, and it should also give the execs motivation to get the cash flow going.

New CEO - The current CEO is an interim guy from the equity group that funded the company and they are actively recruiting.  A new CEO will clearly be looking to make his mark and something like a sale to BBBB would have the potential to do that at a substantial markup. The new product descriptions are also clearly being held until the new CEO arrives. MMUS could also announce a significant dividend with no pain to the balance sheet due to their impressive free cash, and that would likely draw some attention.

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    Description

    MakeMusic is a beautiful little thing: a software company with a franchise and technology moat, high margins, growth potential, catalyst coming AND a margin of safety.

    Adib Motiwala has done a yeoman's job of writing up the long form background story of MMUS over on GuruFocus so I will spare you many pages of background. You can see his writeup here:  http://tinyurl.com/3vcyz58

    MMUS has two main lines of business.

    The first line of business is the software package Finale which is used for music notation. This is a mature market with one major competitor. MMUS takes in about $10mm per year from this business with 91% gross margins. This revenue stream has been shrinking about 1-3% per year due a generally stagnant market for music notation and composition tools. After fixed costs and SG&A but before R&D spending (which is not for this business line), this business line throws off about $6m/year in free cash flow.

    The second line of business is SmartMusic. This started as a program for practicing alone by using software to provide accompaniment and has evolved into a home practice solution that can provide music to work from, accompaniment, and can evaluate and grade the playing of a musical piece as schoolwork. They now have an Educator portal where music teachers can assign work and get back grades from the software without having to try to attentively listen through every piece. They can listen if they want and even clip out pieces of the music to email the parents to show how well the child is doing, all in a couple clicks from a laptop. They've been signing up about 133 independent educators and 160 school sites per year recently (and 30,000 total students and educators per year). Once hooked the schools tend to stay on and the pricing on both the student and school versions has been rising steadily, showing pricing power. The SmartMusic business is generating about $5.4m in revenue but gross margins are only 69% and after fixed costs like SG&A the SmartMusic business is barely profitable right now, no doubt leading to the current bargain status. This is because the company is investing the SmartMusic income into more sales and a larger library of music. The SmartMusic business has power of scale in that each subscriber reduces the cost per subscriber to add music or features, network effects in that educators use results in student use and the more students are used to it the more educators want to use it, revenue predictability through annual membership fees, customer switching costs as it becomes the built in grading and records system, strong margin on each added customer, no customer concentration, and high growth. By my count that's 7 of the 10 distinguishers of a great business.

    Valuation and Margin of Safety:

    The stock price has been bouncing around $5, which is a $24.4m market value. The company has $9.8m in current tangible value (much of it cash) plus a $5.7m tax loss carryforward for a tangible/liquidation value of $15.5m or $3.18 a share, 64% of the purchase price. If we assume a mere 3% FCF growth from now on (far below expectations) and apply an aggressive 12% discount rate we get an earnings-only discounted value of $5.55 (with current tangible assets removed). So in this aggressively discounted assumption of poor performance the current value with cash is $7.58 , fully 54% above the current purchase price.

    Right now the SmartMusic sales push and software R&D engine are in full overdrive and the company is still throwing off $3m per year for the last two years in FCF on an EV (including NOL tax asset) of $8.75m Even without the tax asset the FCF yield is 21% while the company is still spending on growth.

    ============================================

    The Bear Case:

    Finale is a shrinking product that could be throwing off prodigious cash, but that cash is being invested in SmartMusic, which has lower margins. The company CEO is a currently a board member doing temporary duty.

    The Bull Case:

    SmartMusic is growing strong and should throw off free cash flow for the forseeable future. The market position of SmartMusic is strongly defended by patents, technology, and network effects and shows pricing power. A conservative estimate of the available FCF is worth far more than the current EV (see calculations above). Additionally, management made clear on the most recent conference call that they intend to take advantage of their market power and access in the educational music market to use their software as a platform for new offerings (unspecified but presumably along the lines of offering the purchase of popular music so kids can play along with current favorites). The current stock price of MMUS is so low that SmartMusic could fail after several years more of investment and buyers would still come out ahead.

    =============================================

    SWOT:

    Strengths - The most likely path appears to be for SmartMusic to keep improving in both revenue and margins. Current growth is about 20% per year in subs and revenue. The company says the total market of youth music students is 6 million students (and my demographic research suggest this will grow strongly for 3-5 years at least). Even if we assume they plateau at roughly 10% of TAM they reach $23m in revenue without the teacher copies (and assuming the same sort of large scale discounting they do for district level sales now). That should drop $10m or more to the bottom line per year. If they get 20% penetration, it looks even better. If the new platform strategy enables $20/user additional sales per year with a 30% margin (similar to a phone app store), that's another $3.6m+ per year (still using only 10% penetration). Their Finale sales should also see some gains from the integration with SmartMusic, and if that simply stops dropping it will represent $6m more in FCF for a very reasonable potential of about $20m/year FCF available in the future compared to a current EV of $6.9m and market value of $24.4m.

    Weaknesses - The CEO has stated they are increasing R&D (see opportunities) so right now cash is being reinvested in the company and not, for example, returned in a dividend. Ultimately one must believe in the market and eventual realization of value as the company does not seem to be inclined toward returning the cash to shareholders (at least until a new CEO comes in). I take this as a serious consideration and if the margin of safety weren't as big would consider this a significant weakness.

    Opportunities - In addition to the ongoing 20% annual SmartMusic growth, the CEO on the last few conferences calls discussed that their software guys are working on making the technology a platform for the delivery of other products. If you get the transcript you'll see that he thought it was not a very long project (1-2 years maybe). Depending on your expectations of the SmartMusic market penetration (600K-6m users in a few years), platform sales (I guess a low $20 per user), and margin (30% being an app/content store typical value for the platform provider), one comes out with an additional $3.6m to $20+m per year. Solid SmartMusic growth in itself may provide $2+m in free cash flow soon.

    Threats - The company is small and we must worry about competitors and predators.

    Competition: the Finale area is under competition from AVID (product:Sibelius). The whole market is less money than AVID needs to stage a turnaround to profitability and is outside AVIDs sweet spot so it seems likely that pricing will remain rational.

    Smartmusic "competitors" -

    Starplay - no grading or evaluation technology, no school tie-in or educator management, not really a competitor.

    iPAS from Pygraphics - iPAS comes from a background of providing marching band diagrams to show people where to march as they play to make formations and this is still their main market, but they have added in a grading and evaluation component once they saw the market MMUS has discovered. Various channel checks suggest they have about  6,000 users vs 162,000 for SmartMusic. MMUS has superior funding, technology (with some relevant patents), music library, and sales force.

    Blackboard Inc (BBBB) - The granddaddy of school enterprise software. They have no music accompaniment or grading technology. Indeed, BBBB is an acquisition addict and seems more likely to try to buy MMUS to give BBBB a "sticky" technology edge to get their other software into schools.

    ============================================= 

    Ownership and alignment:

    4.88 million shares total

    1.36 million owned by the equity group that launched the company (28%)

    1.69 million owner by the executives (35%)

    0.2 million owned by investors we know, long term

    1.63 million left for trading (about $8.15m worth)

    Note on trading: Building a substantial position in MMUS took quite a while.

    Long term expectations:

    A company can't generate tens of percent FCF yield for too long before getting noticed. If not for their reinvestment in SmartMusic and their platform they would already have more cash than market value and I think they have found a very nice growth path to invest in (pricing power is good) so I'm happy to see that growth. If neither of the catalysts above pan out I expect a very good chance that within 2-3 years they will be able to generate $10m plus in FCF (derating further even the conservative numbers above) and should have a market value at least 2x the current value.

    Even if they give up and kill SmartMusic R&D they can sit back on $6m+ in FCF and send out dividends equal to about 100% of the current EV each year.

    Catalyst

    This one comes with catalysts:

    Buyback - the board recently authorized $10m in authorized buyback on a $24.4m market cap. This could be paid from cash by the company over the next year or so. They specifically authorized that these buybacks could be through 10b filings and the like, so I actually expect that much of the buyback will go toward giving some liquidity to the equity group that launched the company and the execs. It has to, in fact, as there aren't $10m worth of shares circulating outside those parties! Demand is demand, though, and it should also give the execs motivation to get the cash flow going.

    New CEO - The current CEO is an interim guy from the equity group that funded the company and they are actively recruiting.  A new CEO will clearly be looking to make his mark and something like a sale to BBBB would have the potential to do that at a substantial markup. The new product descriptions are also clearly being held until the new CEO arrives. MMUS could also announce a significant dividend with no pain to the balance sheet due to their impressive free cash, and that would likely draw some attention.

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