Madacy MEG-U CN
March 09, 2006 - 10:02am EST by
2006 2007
Price: 6.67 EPS
Shares Out. (in M): 0 P/E
Market Cap (in $M): 67 P/FCF
Net Debt (in $M): 0 EBIT 0 0

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Madacy Entertainment yields 17% and has a subordination feature that allows cashflow to decline 35% before any impact to the distribution. The company produces and distributes “budget” CD’s—e.g., a 3 CD set of “Hits of the 70’s” for $10. The stock went from $10 to $6 and is currently at $6.75, yielding roughly 18%. Obviously, the market believes that the negative trends affecting recorded music will force the company to reduce its dividend. I believe differently, for the following reasons:

1) The category is stable
While the recorded music category as a whole declined in 2005, this was mostly concentrated in new releases, which are under pressure from a younger consumer who is substituting digital downloads. The core consumer for Madacy is a fifty-year-old woman who shops at Walmart, who I contend is unlikely to start downloading music any time soon. In addition, these CD’s are low-ticket impulse purchases, and the per-song prices are far below those of downloads. Having done channel checks on all of Madacy’s major retail partners, I can confirm that the category is flat to up slightly for 2005, while the recorded music category as a whole was reported to be down 7%. In addition, year-to-date for 2006, the category is up sharply at Best Buy and flat at Target.

2) Madacy is gaining share within the category
Madacy sells largely to Walmart, Best Buy, and Target (60% of sales). These companies grow their store base roughly 8% per year, and Madacy participates in their growth. Thus, Madacy should have a ~5% revenue tailwind from this exposure. The specialty music store, which still comprises roughly 35% of the industry, will continue to lose share as lower CD prices make it difficult to cover overhead expenses; Madacy has roughly 2% of its sales to this distribution channel.

3) There are other areas that could provide upside
Madacy is currently putting its catalog online through all the major online sites. This is 100% margin with no costs, and management is extremely encouraged with the initial reaction. Madacy is also selling customized CD’s to specialty retail chains (such as Victoria’s Secret), which is another avenue for growth. In 2005, this was only for a holiday collection, but 2006 should have releases throughout the year. There are also special edition DVD sets about which management seems excited.

4) A subordination feature protects the distribution until cashflow deteriorates over 35%
Income trusts have a subordination feature which benefits public unit holders to the detriment of the private holders (frequently the previous owners of the company). For this reason, cashflow can decline 35% and the reduced distribution will be borne by the Class B (non-public) unit holders. I think cashflow will grow, not shrink, but it is nice to have this insurance in place nonetheless.

5) Management is buying stock and seems comfortable with the current business environment
Management bought $700,000 worth of stock in December at higher prices than current levels. They have stated on the most recent conference call that they will be buying stock when permitted, starting tomorrow.

I believe Madacy will gain the confidence of the market as it continues to post stable results and will ultimately yield roughly 10%, in-line with other stable business trusts. At this yield, the stock should roughly double. Another way of thinking about this is that the combination of the 18% yield and subordination feature means that EBITDA could decline roughly 60% before there would be any impairment to capital (assuming investors demand a 10% yield).


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