Description

OVERVIEW
Media Arts Group is a manufacturer, marketer and retailer of art reproductions and decorative items based primarily on the work of Thomas Kinkade.

At $3.00 per share, and with 13.2mm diluted shares outstanding, the company has an equity market capitalization of just under $40 million and net debt of roughly $10 million (9/30/01). Book value is close to $5.40 per share. Revenues for the fiscal year ending 3/01 total $132 million and earnings were $8.9 million. On revenue of $49.2 million during the first half of the current fiscal year, the company produced a net loss of $4.8 million (inclusive of a write-down on an internet asset). As a result of large investments in leasehold improvements to a new campus headquarters, FCF was negative and the company has had to draw down on a line of credit. This campus project is near completion and CAPEX requirements for the rest of 2002 should be significantly less than the first half.

An average of 13,000 shares traded daily over the past month, so this is a micro cap that one can actually buy.

The co-founders of this business, Thomas Kinkade and Kenneth Raasch, collectively own about 49.5% of the stock and have treated this business as their personal property. As you read through the 10-K take notice of self-dealing, questionable accounting, and investments of dubious merit, most of which I’ll also outline below. Recent financial performance, as indicated above, has also deteriorated during the last few quarters. Finally, there is some financing risk as the company has a credit line that expires shortly and must be renewed.

INVESTMENT THESIS
Despite all of the hair on this thing, there are two key assets here that I think are far from being impaired and should support improved financial performance as the economy turns. Those assets include the artwork of Thomas Kinkade and a growing roster of licensors, and a network of independent licensed dealers located in malls throughout the country (though largely on the West Coast).

Assuming that MDA can keep the distribution network intact and that the economy shows continued signs of improvement, I can see this stock trading at book value before year end. Getting to book represents appreciation of about 80%. When you consider the impressive footprint this business made during the 1998-2000 period, it is entirely possible to do significantly better. Furthermore, I think the downside risk from currently levels is relatively limited.

Despite the issues described later, I recommend MDA nonetheless because I am convinced there is a huge market for “middle class art” and MDA has created the means with which to tap into this rich vein.

Thomas Kinkade attempted to buy the business for $6.25 in cash in 2001 but apparently ran into problems financing the acquisition.

PAINTER OF LIGHT
The researchers for 60 Minutes dubbed Thomas Kinkade “the world’s most collected living artists” (11/21/01). He has become so by developing a process for mass producing “touched up” framed lithographs, marketing himself masterfully, and convincing others to invest in one of the franchise gallery formats that hawk his work.

The art itself defies adequate description. Subjects include landscapes, churches and gardens and typically some source of light. The work is clearly formulaic but Middle America likes it. See the following link for examples : http://www.thomaskinkade.com/.

Selling prices range from a couple hundred to thousands of dollars framed. Since most pieces are hand accented lithographs, the cost of production is modest (aside from the “license fee” paid artists). At the core of the value of this business then is MDA’s ability to sell mass produced framed art at a significant premium relative to the price of a framed “poster”. This is accomplished by creating a celebrity out of the artist, controlling product distribution, and encouraging and developing a collectors mentality.

DISTRIBUTION
MDA distributes the bulk of its product through licensed independent dealers, having sold most company stores to entrepreneurs during the last year or so. During the 2001 fiscal year about 50% of revenues were generated through this channel. There were 357 licensed Signature Galleries stores at 3/01, the bulk of which were in the US. All stores carry a quota and incentives and sell Kinkade products exclusively.

The company just launched the Masters of Light Galleries. This license concept sells the works of Kinkade and other artists published by MDA. There were three stores in operation as of 3/01. Other licensed concepts will be designed around the new roster of artists under publishing agreements with the company.

MDA also sells to a purported network of 5,000 independent gift and collectible dealers, frame shops, and galleries, and through the Internet.

MDA intends to grow through the expansion of its distribution network, the addition of new published artists (Howard Behrens, Simon Bull, Robert Lynn Nelson), and entering new product categories.


WHAT’S NOT TO LIKE
As indicated, there’s a fair amount not to like. Here’s a sampling :

Accounting and Valuation Concerns
- Revenue recognition guidelines are unclear. “The company recognizes revenue from gross product sales, including freight charges, when a definite arrangement exists, upon shipment to the customer, upon fulfillment of acceptance terms, if any, when no significant contractual obligation remains outstanding, price is fixed and determinable, and collection is probable.” ...HUH?
- Significant levels of returns and bad accounts. In 2001, charged about $10.9million and deducted about $9.6 million from reserves. A fair amount of trade receivables, some to family members of Kinkade, have been converted to notes.

Insider Self-Dealing
- Kinkade received $8.2 million in license fees in 2001 and larger amounts in prior years, in addition to 600,000 options at $12.375 for renewing the art licensing arrangement in 1997.
- MDA fired Raasch, a founder, in 1999. Subsequently paid him $2.0million in consulting fees and buys $300,000 in services from a company he owns.
- Sweetheart deals on sale of stores to a relative of a Kinkade.
- Two year severance agreement with former Chairman of the Board, who resigned 6/01. Also offered a lucrative incentive for finding a replacement within a certain period of time.

Poor/Untimely Investment Decisions
- Write-down of an investment in the Internet distribution business (2001 operating loss of $10.8mm including a $2.5mm asset write-down. Wrote off $1.8 million more in 2002)..
- Leasehold improvements on new campus facility in Morgan Hill, CA (2001 $7.8mm, 2002. $15mm)

Other Issues
- CEO turnover.
- Line of Credit expiration in early summer months. There was $10mm drawn against it at 9/30/01 but I think the majority of that balance has since been repaid.

MEA CULPA
I typically run away from a company that exhibits such poor governance, accounting red flags, and deteriorating fundamentals. I initially did run away from MDA but, mea culpa, the cleverness and scalability of this business model, particularly considering that most stores are now independently licensed, drew me back. Let’s take a closer look at a couple of things.

First, despite the muck, there are a couple of interesting assets as mentioned. Art marketing is extremely cyclical When the economy turns consumers will have more disposable income with which to adorn new homes. Some of what consumers spend will be on art. Furthermore, there is no indication that Kinkade’s popularity has been impaired (QVC and Ebay sales give good clues) so as we turn the corner his sappy works will, I believe, continue to be snapped up.

Second, the company recently hired a new CEO and added independent board members. I don’t know enough about the CEO to guess at his management capabilities, but do expect some of the more egregious self-dealing to be reigned in.

Third, the company would be profitable was it not for the licensing fees paid founder, controlling shareholder, and grand daddy of light Kincade.

Fourth, Kinkade saw over $6 in value here just last year.

FINAL THOUGHTS
This opportunity is not for the squeamish. I recommend it only for the most enterprising.

Catalyst

Macro catalyst is improvement in the economy and disposable incomes.