Description

Madacy is a Canadian unit trust whose price collapsed when it suspended distributions in August. To add insult to injury, the company retracted its July distribution, which investors had already been expecting.

Background

Heffer504 wrote up this company in March when it was yielding 17% at a much higher price per unit. That writeup contains a good description of the business, its industry and some of the unusual features of its financial structure. To summarize, Madacy sells low-priced compilation CDs through a number of retailers, including WalMart and Best Buy. While online music sales are clearly the growth segment of the industry, Madacy's products represent an impulse-type purchase and have not suffered the same downtrend as more mainstream CD sales. Madacy has an unusual capital structure in that management owns 35% of the company through Class B units which are subordinated to the public A units.

Madacy's currently suspended cash distribution is set at 9.375 Canadian cents monthly. At a C$2.36 price per unit, that's an annual payout of 48%. Before management can pay themselves a penny on their B units, they must make sure the A units have received full distributions for the past 12 months. I believe it's unlikely that management will resume any distributions until they have built up enough cash to meet that requirement, since it could harm management financially to have months when the A units receive money but the B units receive nothing.

What went wrong

According to management, during Q2 a "significant" retailer decided to cut its inventory and therefore returned more product to Madacy than the company expects. Channel checks and public data indicate that this retailer was WalMart, which indeed has been cutting inventory as part of its business strategy. Madacy expects a certain level of product returns as part of its regular operations. However, in Q2 the returns were high enough to push the company out of compliance with its lending syndicate. The lenders forced Madacy to stop all distributions to unitholders and reduced the company's lending facility from $17M to $12M effective 1/31/07. The facility was only increased from $12M to $17M in May 2006, so the company has operated fine in the past with a smaller facility.

Madacy IPOed its units in Q2 of 2005 at C$10 per unit. Because of the company's unit trust structure and small size, the units were likely marketed to smaller investors looking for income. On the company's conference call to discuss suspending distributions, management received complaints from these investors. I believe investors' income-sensitivity helps explain the severe decline in price post-announcement.

Management uses weekly SoundScan data to track the actual retail sales of its products. On conference calls, the CEO has repeatedly stated that product sales are actually up, adding credibility to the argument that the returns are a result of inventory reductions and not poor sales. Because Madacy's products are relatively diverse and eclectic, doing channel checks is significantly more difficult than, say, tracking the sales figures for the latest top-10 single. That said, having spoken with folks at numerous retail outlets and done what I can to track the sales of some of Madacy's CDs, it appears to me that sales are not significantly worse than in past periods. This should be something that we will learn very shortly when the company releases its numbers for Q3, as one would expect WalMart and other retailers to have purchased strongly to replenish their inventory and to prepare for the holidays.

Management purchases

Management has been purchasing A units since 2005. With the decline in price, purchases have accelerated. They now own 12.3% of the A units, in addition to their ownership of 35% of the company through B units. In the past month alone, the CEO purchased more than $400K worth of units at prices up to C$2.15.

Madacy is a situation where I believe the management purchases are a key indicator. This is because we know management knows what the sales data for Q2 is looking like. If they believed the high level of returns was due to problems with the core business, it's hard to understand why they would be in the market to buy more units. Most likely, management is telling the truth, and results are going to be in line with their version of events. Here is a link to the past month of insider trading data for the company: http://www.canadianinsider.com/coReport/allTransactions.php?ticker=MEG

Seasonality

Madacy's business is significantly seasonal--so much so that their expectation each year is they will have to borrow money to pay their Q1 and Q2 distributions. In Q3 2005, the company generated US$3.8M in earnings and US$5M in free cash flow. That compares to a loss of about US$2.2M and positive free cash flow of US$320K for the first half of 2006. Looking at the company's past performance, it's reasonable to expect cash flow in the US$5M to US$10M range.

The seasonality is explained by people purchasing holiday-oriented music compilations in Q4. Since retailers begin their inventory build in Q3, it affects both quarters.

It is likely that Madacy's CD sales will eventually succumb to the digital music revolution, so I would assign a conservative multiplier to the company's cash flow. Even so, the current multiplier of 2 to 4 seems too low. Keep in mind that new cars still ship with standard CD players, and even as music sales shift to some other kind of medium, there's nothing preventing Madacy from selling its music on that medium.

Margin of safety

Madacy has items on its balance sheet that help give an investor comfort. As of the end of Q2, Madacy had net current assets (current assets - all liabilities) of US$3.8M. Adding in other liquid assets such as royalty advances gives a net liquid asset position of US$8.4M. In addition, the company owns a catalog of songs with a depreciated value of US$8.9M. According to management, the catalog cost about US$20M to purchase originally. Given that Madacy's songs are more likely to be timeless classics and holiday tunes, I would be inclined to consider depreciation less important to their catalog than to a typical record label.

Using the two numbers for the music catalog gives a net asset value of somewhere between US$17M and US$28M. At a US$23.8M market cap, Madacy is probably not trading for much more than the assets on the books.

The subordination of the B units provides still more safety. Since the A units' distributions are cumulative up to 12 months, an investor who purchases the units today and holds for a year has accrued something like US$1 per unit which must be paid out before the B units can receive anything. This should provide the A units with a significant preference were the company to liquidate.

Bottom line

Madacy is a very profitable company which experienced an unexpected setback when WalMart chose to decrease its inventory in Q2. Purchasers of the A units are buying into a company with somewhere between US$5M and US$10M in annual free-cash flow, significant assets on the balance sheet and a subordination structure that increases margin of safety. Management purchases show they strongly believe in the company and suggest they are telling the truth. Results in the coming two quarters should clarify the company's financials significantly and help the unit price rise.

Catalyst

* Management buybacks either generate investor interest or culminate in MBO or sale.
* Seasonally strong Q3 and Q4 produce improved financial results. Also, coming results should demonstrate the product returns were a one-time event.
* Resumption of distribution.