Description

Navarre Corp (NAVR)

Navarre Corporation (NAVR) is a depressed microcap stock left for dead by the market with its solid cash generating abilities clouded by huge non-cash impairment charges taken during fiscal 2009 (ended 3/31).  We believe as the clouds lift during fiscal 2010 (ended 3/31) several facts will become more apparent to the market and likely lead to a higher valuation, including:  (a) the company's strong cash-generating ability, (b) the company's major cost reduction actions taken in Q3 of fiscal 2009, and (c) the company's attractive, proprietary publishing business which its primary cash flow generator (75% of EBITDA).   The company incurred about $111 million of restructuring charges, impairment charges, and other charges in fiscal 2009 (only $1.1 million of which were cash charges) as it reduced corporate overhead and exited its weaker businesses.   At this point, the company has written its goodwill down to zero.

The company is a distributor of software, DVD titles, and videogames to major retail customers and, through several acquisitions since 2003 (discussed below), has diversified into a publisher of licensed software with a strong emphasis on licensing anime product from Japan. 

The company has a market cap of $56 million ($1.55 per share x 36 million shares) and net debt of $24 million as of 3/31/09 for an enterprise value of about $80 million.  While net debt is seasonally low at 3/31/09, we expect substantial free cash flow generation in fiscal 2010 ($15 million to $20 million or 45 cents to 55 cents per share) and, in addition, the company expects to receive a tax refund of $4 million (or 11 cents per share) in Q2 of fiscal 2010.  The company trades at about 14% of LTM revenues, 3.5x LTM EBITDA, and 4x free cash flow. 

In response to a brutal Q3 of fiscal 2009 (ended 12/31), the company exited two weaker businesses: its BCI budget content licensing business and its children's DVD business, taking significant non-cash impairment charges.  It also sharply reduced its overhead and operating expenses.  These major cost reductions should show up in improved profitability and cash flow during fiscal 2010 (ended 3/31/10).

Business Overview

The company's two business segments are distribution and publishing (see Segment Analysis below).  Distribution net revenues (before intercompany eliminations) in fiscal 2009 were $593 million and publishing net revenues were $103 million. 

As one would expect, the distribution segment generates most of the company's revenue but the publishing segment generates the EBITDA (75% of total).  The Segment Analysis below shows that fiscal 2009 income from continuing operations before taxes for publishing was $8.1 million versus $0 for distribution.  Publishing's segment earnings were after $8.3 million of non-cash D&A expense versus only $0.6 million of capital expenditures.  Distribution D&A expense was $2.6 million versus $3.0 million of capital expenditures.  In fiscal 2009 distribution contributed $5.7 million of EBITDA and publishing contributed $17.0 million.

In our view, the publishing business is the true gem in the company and the company is much more a publishing business (75% of EBITDA) than a distributor (25% of EBITDA).  However, we think the company's position as a distributor gives them an interesting and strategic view into what types of software are selling in their retailer channels which may help them be smart about how to focus their acquisitions of publishing properties.

Distribution Segment

The company's distribution business primarily provides value-added distribution services to Best Buy (35% of sales), Wal-Mart/Sam's Club (15% of sales), Target, Costco Wholesale, Staples, Office Depot, OfficeMax, etc. which are part of more than 19,000 retail stores and distribution centers in the U.S.  About 80% of distribution sales are software and about 10% are DVDs and 10% are videogames.  The company believes it is continuing to increase its shelf space and market share in the stores of its retailer customers.  While we certainly recognize that distributing to these large retailers may not be the greatest business in the world, we do think the company provides value-added services to both its retailer and vendor customers in terms of order and sales monitoring of boxed software and similar products as well as other customized services.  The company's major investment in its ERP system over the past few years (close to $20 million) has helped cement the company's relationship with these retailer customers.  The company's major vendors in its distribution business are Symantec, Kaspersky Lab, Adobe Systems, Trend Micro, Webroot Software, Warner Bros. Home Entertainment, LucasArts Entertainment, McAfee, Corel, and the company's publishing business.  Symantec is the largest vendor and did over $100 million of distribution sales with the company in fiscal 2009.  For these vendors, distributing products through the company allows them to outsource their retail distribution and benefit from economies of scale not possible through self-distribution.

It is interesting to look at how the company handled the Circuit City bankruptcy in Q4 of fiscal 2009.  Essentially, the company told its vendor customers that they would retain the risk and ownership with respect their inventories, which were placed in Circuit City on a consignment basis as this retailer struggled.  The company points out that its vendors have gross margins of close to 80% as compared to the 10% range gross margins realized by the company in its distributor role.  Vendors were willing to accept more of the risk in this situation because their high gross margins justified it.  The company's losses on Circuit City's bankruptcy were minimal as a result.

Publishing Segment

The company has made multiple acquisitions on the publishing side in recent years to build up this higher-margin segment.  Publishing gross margins have been in the 36% to 38% range versus distribution gross margins in the 10% range.  Publishing acquisitions have included Encore acquired in July 2002, BCI in November 2003, and FUNimation in May 2005.  Encore licenses and publishes entertainment, personal productivity, genealogy, system utility, and education products including Print Shop,  Print Master, Family Tree Maker, Monopoly, Scabble, etc.  FUNimation, acquired in May 2005, is the leading anime content provider in the U.S. and licenses and publishes titles such as Dragon Ball Z, Fullmetal Alchemist, Samurai 7, Afro Samurai, Claymore, Shin Chan, Robotech, etc.  BCI which publishes budget DVD content, has struggled with profitability in recent years and was exited as part of the company-wide restructuring in Q3 of fiscal 2009.  For fiscal 2010 the publishing segment will primarily be the Encore and FUNimation businesses.

FUNimation (about 2/3 of publishing sales) is by far the largest, most profitable, and most important part of the publishing segment.  FUNimation is the leader for licensing anime properties and repurposing them for the U.S. market.  Anime is a very large business in Japan and also has a large following in the U.S.  (Google "anime" and you will get a lot of background info.)  FUNimation has recently acquired the properties of two of its largest competitors for these anime properties and is continuing to take market share and strengthen its position in the U.S. market.  Management estimates that FUNimation's market share is about 40%.  FUNimation typically pays an upfront advance against future license fees and recoups its advance from royalty rates.  Its management team knows the U.S. market well in terms of what will sell and has long-established relationships with the Japanese anime producers.  Roughly 80% of FUNimation's revenues are generated by DVD sales in retail customer stores and 20% are from licensing, videogames, and TV broadcasting.  FUNimation's anime revenue base has become more diversified over time but its best-known series, Dragon Ball Z, still represents a large percentage (close to 50%) of total sales. 

License fees and production costs are amortized as expenses in cost of goods sold in the company's income statements.  These license fees and production costs amortizations are added back as non-cash charges in the cash flow statements while cash used to acquire new licensed or produced titles shows up as a use of cash in working capital changes.  If the company is growing its publishing content, then cash spent on license fees and production costs will exceed amortization of those items and there will be a net use of cash in that fiscal year.

FUNimation has a loyal customer base, an established brand name, and requires limited maintenance capital expenditures.  Since acquiring FUNimation in May 2005, the company's cash from operations results have been consistently strong with $22 million in fiscal 2007, $18 million in fiscal 2008, and $17 million in fiscal 2009.  Adjusted EBITDA results have also been strong with $27 million in fiscal 2007, $29 million in fiscal 2008, and $23 million in fiscal 2009.

However, the company paid a high price for FUNimation including close to $100 million in cash and 1.8 million shares of common stock and this put significant leverage onto its balance sheet.  The company went from a net cash position of $14 million at the end of fiscal 2005 to a net debt position of $66 million at the end of fiscal 2006.  Since then the company has used its free cash flows to reduce debt levels and net debt was $24 million at fiscal year-end 2009.

Encore (about 1/3 of publishing sales) has similar margins to FUNimation (in the mid to high 30's range) and has recently expanded into higher margin direct-to-consumer and OEM segments which should help gross margins in fiscal 2010.

Solid Business Strategy and Some Decent Competitive Advantages

The company's business strategy includes the following:

• Acquisitions of attractive content, especially for higher-margin publishing segment;
• Deepening long-time relationships with retailer customers by distributing a broader range and larger volume of products to them;
• Integrating its technology systems between retailer and vendor customers; and
• Providing value-added services to publisher and distributor customers.

Competitive strengths are as follows:

• Established content in publishing business;
• Established relationships with retailers and publishers;
• Publisher relationships and efficient distribution of their products which should lead to future product distribution opportunities;
• Value-added services, including distribution services and procurement solutions, and a distribution infrastructure that enables the company to provide customized procurement programs for retail customers at a lower cost than competitors;
• Broad product offering to its retailer customer base; and
• Efficient operations and operating leverage, where competitive position is enhanced by extensive automation in distribution facility and ERP system is expected to further enhance operational efficiency.

Operating Expenses Should be Sharply Lower in Fiscal 2010

We expect sharply reduced operating expenses in fiscal 2010 for the company.  Q4 of fiscal 2009 gave us a strong indication (see below), with operating expense (before one-time items) down 22% versus prior year.  This decline of almost $4 million basically represents the entire operating expense decline for fiscal 2009 versus fiscal 2008.  We believe the company should be able to sustain quarterly operating expenses during fiscal 2010 near the $15 million per quarter level.   If this happens, operating expenses for fiscal 2010 could be closer to $60 million as compared to $70.2 million for fiscal 2009.  Although some of these reduced operating expenses may be offset by lower revenues and gross profit dollars, we believe a large portion could drop to improved EBITDA results versus fiscal 2009, especially when the company rolls over its very weak results for Q3 of fiscal 2009 (see Quarterly Results), when the full impact of economic crisis hit the company's retailer customers and they reacted accordingly by managing their inventory exposures.

• (1) Represents operating expenses before depreciation and amortization expenses.

Despite a very difficult retail environment in Q4 of fiscal 2009, during which Circuit City, a top five customer, went out of business, the company achieved decent results, with Q4 adjusted EBITDA up 30% to $7.4 million.

We find it interesting that management is guiding to a flat EBITDA year despite EBITDA for Q4 of fiscal 2009 up 30% versus prior year.   We believe the company's performance in Q4 of fiscal 2009, with EBITDA up 30% as compared to the prior year Q4, may be a better harbinger of fiscal 2010 results than the company's fairly conservative projection of flat EBITDA for fiscal 2010.  Q4 of fiscal 2009 was the first quarter to realize the benefits of the company's streamlined cost structure due to aggressive management actions taken in Q3 of fiscal 2009.  Q4 also had imbedded within it the impact on sales and gross profits of the Circuit City bankruptcy and the closing of the BCI budget publishing business and the children's DVD business of FUNimation.

Solid and Improving Balance Sheet

The company's balance sheet is reasonable with leverage at 1x to 1.5x EBITDA and we expect leverage to come down further by the end of fiscal 2010, when net debt may decline to under $10 million.  Strong free cash flow generation has enabled the company to steadily reduce its net debt position on a year-over-year basis to a recent low point of $24 million at 3/31/09.  Although we expect seasonal working capital needs to increase the company's net debt position over the next few quarters, we expect net debt to continue to be down significantly on a year-over-year basis each quarter in fiscal 2010, ending fiscal 2010 (ended 3/31) possibly under $10 million.  The net debt reduction since the FUNimation acquisition is impressive:  net debt was $66 million at FYE 2006, $54 million at FYE 2007, $36 million at FYE 2008, and $24 million at FYE 2009.

The company currently has a $65 million revolving credit facility with GE Capital.  The company used this facility to retire an expensive $10 million separate loan in June 2008.  At the end of fiscal 2009 the company had about $17 million of excess availability on its revolver.

Free Cash Flow Generation Should be Strong

The company is a strong generator of cash flow.  Q2 and Q3 typically represent peak levels of borrowing (ahead of the Christmas season) and Q4 (ended 3/31) generates a very substantial amount of cash.   Cash from operations was $25 million in Q4 of fiscal 2009 and $21 million in Q4 of fiscal 2008.

During fiscal 2009 (ended 3/31), the company generated about $12.5 million of free cash flow or about 33 cents per share and the company was able to reduce its net debt position from $36.5 million at end of fiscal 2008 to $24 million at end of fiscal 2009.  During fiscal 2008 the company generated close to $15 million of free cash flow, excluding the one-time expenditures for the ERP system build out, or about 40 cents per share.

During fiscal 2010 we expect $15 million to $20 million of free cash flow, or 45 to 55 cents per share, as:  (a) the major reduction in operating expenses implemented in Q3 of fiscal 2009 should help earnings and cash flows in fiscal 2010; (b) the company has only maintenance-type capital expenditures requirements of about $1 million per year, (c) working capital is expected to be neutral, on a year-over-year basis, with respect to cash flow, and (d) the company will not be a cash taxpayer.   The company does not expect to pay taxes in the near term and actually expects to receive a tax refund of approximately $4.5 million in Q2 of fiscal 2010.

Capital Expenditures Should be Minimal in Fiscal 2010

Capital expenditures were higher in recent years due to an extensive ERP system which was completed in mid-fiscal 2009.  Capital expenditures in fiscal years 2007, 2008 and 2009 were $9 million, $10 million and $5 million, respectively.  Over the last few years, the company has spent over $20 million on its ERP system in both expenses and capital expenditures but the ERP system project is now producing significant benefits.  In any case, capital expenditures going forward are going to be much lower and capital expenditures were less than $250k in Q4 of fiscal 2009.  The company expects capital expenditures to be $1 million or less in fiscal 2010 since the ERP project is complete and there are very limited expenditures required for the distribution segment.

Fiscal 2010 Estimates May Prove Conservative

Guidance for fiscal 2010 is for revenues of $550 million to $600 million, adjusted EBITDA of $20 million to $23 million, and positive cash flow from operations.  We think these estimates may prove to be conservative.  One major reason is the operating expense reductions discussed above that we expect to cycle through fiscal 2010 results.   Fiscal 2009 operating expenses were $70.2 million and we believe fiscal 2010 operating expenses may come in closer to $60 million ($10 million less than fiscal 2009).  Sales in both the company's distribution and publishing segments will likely be lower in fiscal 2010 than fiscal 2009.  Publishing sales will be lower due to the exit from the company's BCI publishing operation and the children's DVD market.

Distribution sales will be lower in fiscal 2010 also, since this business is driven by end-product sales at the company's retailer customers, and these retail sales will certainly be lower in Q1 and Q2 of fiscal 2010.  The financial crisis really hit hard in Q3 of fiscal 2009 (ended 12/31).  Q3 is also the company's strongest quarter (see Quarterly Data chart below), as the company's profitability follows retailer seasonal patterns.  The company's results in Q3 of fiscal 2009 were respectable given the environment but were sharply below historical levels of EBITDA generation.  Fiscal 2009 Q3 EBITDA was $4 million versus $11 million in Q3 of fiscal 2008 and $11 million in Q3 of fiscal 2007.  While some of the Circuit City sales are certainly not coming back, we do expect some of them to migrate to surviving retail competitors.  We think there is a good chance that the company will successfully roll over Q3 of fiscal 2009 with a stronger EBITDA result in fiscal 2010 due to the reductions in operating expenses which were put in place in Q3 of fiscal 2009.  Further, while revenues for fiscal 2010 will be lower than prior year, we think that gross margins in both the publishing and distribution segments are likely to improve.  The remaining publishing units, Encore and FUNimation, have gross margins in the 40% to 45% range, so publishing gross margins should trend up during fiscal 2010 from the gross margins achieved in fiscal 2009.  We also think gross margins can improve on the distribution side as the completed ERP system is driving additional efficiencies. 

Consequently, while net sales for both the publishing and distribution segments are likely to be lower for fiscal 2010, we think the gross margin rates for both segments may increase to partially offset the lower sales, with the result that gross margin dollars could remain fairly stable, or at least not decline too much.

If we are correct and gross margin dollars are relatively stable in fiscal 2010 with a lower base of operating expenses, then EBITDA for fiscal 2010 could improve to the high $20's or more and also have a very positive impact on free cash flow.

Target Price

Even in this extremely difficult economic environment, we believe the company could achieve EBITDA in fiscal 2010 in the high $20's range and could reduce its net debt at fiscal 2010 year end to under $10 million.  Based on an EBITDA multiple of 5x, which we think is reasonable for a company with 75% of EBITDA from a proprietary publishing segment, we believe the company stock could reach $4 per share or higher as compared to near $1.50 today.

Financial Summary Information

Catalysts

• 1. Cost reduction actions from Q3 of fiscal 2009 cycle through fiscal 2010
• 2. Continued net debt reductions through fiscal 2010 on year over year basis.
• 3. Increased investor focus on the more attractive publishing segment.
• 4. Low valuation of below 3x our fiscal 2010 EBITDA for a company with 75% of EBITDA from a proprietary publishing business.

Risks

• 1. Not a lot of growth in revenues over past few years.
• 2. Gross profit has declined over past few years.
• 3. Customer and vendor concentrations.
• 4. Software distribution could become increasingly digital.
• 5. An SEC investigation was initiated in 2006 and has not been closed (see Risk Factors in 10K)
• 6. Exposure to retailers in a recessionary economy.
• 7. Company still has some debt, although it has been declining.

Disclaimer

Disclaimer:  We own shares of NAVR.  We may buy or sell these shares at any time without notice.  The information in the write-up is believed to be correct as of the date written but VIC members should do their own verification of this information and analysis of this potential investment.  We undertake no obligation to update this write-up if new information arises at a future date.

Catalyst

see above