Description

The Singing Machine (SMDM), “creating Joy through music”™, is the leader in consumer karaoke machines with about 60% U.S. market share. Partly due to Trump raising China trade-war/tariff concerns, SMDM shares have fallen in the last few weeks from $0.76 to $0.54, now trading at 7.7x F17E (March) EPS and 3.4x F19E (March) EPS.

Since 1988, SMDM has been the American innovator in consumer karaoke. As an innovator, SMDM introduced consumer karaoke machines with CD-Gs (karaoke CD format), then embedded monitors, then large multi-color light effects, then USB and Bluetooth, and, recently, digital downloads. Other manufacturers (generally from China) tend to copy SMDM a year (or two or three) later, though SMDM believes that its Download Karaoke Machines (introduced in summer 2015) remain the only ones on the U.S. market.

The company has three different product lines (with over 50 models):

·         Classic Karaoke Machines represent 65+% of sales. These machines incorporate traditional karaoke features such as CD+G (standard karaoke CD format) playback, voice enhancement (e.g. echo), built-in monitors, and A/V (HDMI) out connections to TV to display scrolling lyrics/video. Some models have built-in cameras for recording. Almost all models have Bluetooth, so the user can synch the karaoke machine to their iPad/iPhone with the 100+ available Karaoke apps (including the company’s app). The retail price range is from $49 to $199, with especially good traction in $69-79 (with its best-selling unit “SML835” selling 250k units per year). The gross margin is around 20-25%. The target audience is usually a boy or girl aged 5-10. F16 (March) sales for this category (including accessories like microphones) was around $44 m.

·         Download Karaoke Machines (August 2015 launch) are America’s first consumer karaoke machines with digital downloads. SMDM partnered with Stingray (publicly traded in Canada) on a 3-year exclusive license (renewable), making SMDM Stingray’s exclusive karaoke hardware provider for its catalog of 12,000+ karaoke songs (with HD video and lyrics that can be displayed on your TV with a HDMI cable). As background, Stingray is a leading music platform with its own storefront (website) and various offerings for smart TVs and cable boxes (like AT&T U-Verse). All of SMDM’s models have Bluetooth, so in addition to downloading the songs/videos, the user, like with the Classic series, can synch the karaoke machine to their iPad/iPhone with the 50+ available Karaoke apps (including the company’s app). SMDM’s download machines consist of: $79 Remix (available year-round at Target and selling well at Amazon.com), $129 Vibe and $199 Carnaval (which my family has been testing to a few laughs). In F17, CEO expects to sell roughly 100k Remix, 30-40k Vibe and 60-70k Carnaval. That implies total units of ~200k. The gross margin is 30-35%. The target audience is families with kids (especially teenagers) as well as married couples. In F16 (March), SMDM sold 40k units, $5.3 m in sales. In F17, based on selling the 200k units, sales should be ~$25 m, up 5x from F16.   

·         Streaming Karaoke Machines are a very small experimental series. These machines use Wi-Fi to stream high-definition songs/videos from a library of HD karaoke music, accessible on a subscription model. The retail price is $199.  This product line accounted for less than 1% of sales in F16 and in F17. The company, based on demand from retailers, may introduce this line, perhaps with a lower price point, in the holiday season of 2018. The target audience is early adopters, often men aged 30-50.

GROWTH DRIVERS

1.     “iTunes of Karaoke.” A big catalyst is music (software) sales from download karaoke machines. As the only such product available in U.S. retail, SMDM has a self-proclaimed opportunity to be the “iTunes of Karaoke”. Generally, SMDM’s karaoke machines are used by consumers for an average of two years. Currently, customers get 10 free HD songs with the Download series. Customers go to the website, select their songs (which includes HD video with lyrics) and download them to a USB drive, which is then inserted into their Download Karaoke Machine. One year from today, with an installed base of 400,000-500,000 machines (after two years of its current run-rate of 200+k machines per year), with 60% of consumers buying an average of $33 in music (16-17 songs on average at $2 per song), with a 33% revenue share, would imply $2.6 to 3.3 m in annual online (software) music sales, which is virtually 100% profit. (Please see F19 (March) estimates below for the big impact this trend could have on EPS.)

2.     Future innovation. As the innovator in consumer karaoke, SMDM could introduce voice/pitch effects and a Streaming Karaoke Machine in 2018.

3.     New kids line. Staring this summer in stores like Toys R’ Us, these cheerful singalong toys for kids (aged 5-6) cost under $50. They can play CD+G or Bluetooth (again, synching with iPhone, iPad, etc.). Sales contribution is unclear for this new kids line, but the systems seem superior to the more one-dimensional (e.g. Disney only) singalong products on the market. Importantly, the kids line could improve the massive seasonality (85+% of sales occur in 3^rd and 4^th quarters of fiscal year). Management, of course, is very bullish. 

4.     Amazon.com. In F17, Amazon.com could be $6 m in sales, up +40% y/y. That would represent about 10% of overall sales. By comparison, SMDM generates very little sales on its own website.

5.     Continued growth in U.S. retail. SMDM has about 80% market share (shelf placement for consumer karaoke) with large retailers. Toys R’ Us and Wal-Mart are each about 25% of sales. Target’s account has also been growing, with Target now carrying the Remix digital download product year-round.

6.     International sales. In F16, there was a $1.7 m increase in international sales due to growth from a U.K. distributor and the introduction of a new distributor in South America. CEO sees continued international growth. 

SOME MORE INSIGHT ON THE BUSINESS

SMDM’s consumer returns represented 5.9%, 8.8%, and 8.8% of sales in F16, F15, and F14, respectively. Historically, consumer returns are 5-8% for karaoke machines (e.g. families buy a unit for a party and then return it). Some retailers like Costco have liberal return policies, allowing consumer returns for open-ended reasons.

Karaoke equipment in the U.S. is generally made in China. Walking the floor of CES, you will find 10+ other karaoke manufacturers, likely all of which use factories in China. Similarly, SMDM used 5 China factories in F16 and is using 8 China factories in F17. Arts Electronics (based in HK) operates one of SMDM’s China factories and is also a large shareholder (3.7 m shares, 9.8%).

In F16, 47% of sales were fulfilled directly (from China) and 53% of sales were fulfilled domestically (shipped from China to the port of Long Beach, then to the 86,000’ warehouse in Ontario, CA, and then onward to ~23 retail customers). This 50/50 fulfillment ratio should persist going forward. Like Amazon, the Ontario warehouse also has a 3PL (third party logistics) business, fulfilling shipping for other (non-competitive) large retailers. 3PL offsets roughly half of the cost of the warehouse and reduces the company’s seasonality.

Orders are generally placed 3-6 months before the holiday season. As is standard practice in the retail industry, SMDM gives advertising allowances (e.g. circulars, guides and ads) of $2.7 m during F16 and $1.3 m during F15. Overall, SMDM spends 8-9% of sales on sales expense and expects modest creep (“a few new hires”) in G&A as it grows.

COMPETITION

SMDM has 60% market share in the U.S. for consumer karaoke machines and perhaps 80% market share in large U.S. retailers. There are no direct competitors that have decent market share and focus on consumer karaoke. Competitors include GPX, Audiovox, Vivitar, Ion Audio, Karaoke USA (licensed products), Sakar (licensed products, like with Disney), QFX (QFXusa.com), Magic Sing, and SingTrix (a $350 system with voice controls, as seen on Shark Tank in 2014). Other potential offerings include DigiTrax’s Karaoke Cloud (a $49.99 streaming service that has struggled). Perhaps YouTube could develop quality karaoke channels (unclear if it could be a long-term threat or a boost to sales). These days, consumers prefer the large karaoke units with quality speakers, multiple functions (screen, Bluetooth, USB) and large lighting effects. Of course, a persistent risk is that U.S. consumer tastes could change (yes, there’s fad risk).

MANAGEMENT

CEO is Gary Atkinson, who joined the company in January 2008 and is the nephew of Philip Lau (Chairman of Starlight, which indirectly owns 51% of SMDM). Though relatively young (35), he has been with the company for almost ten years. He seems to have good energy and appears to be strong in product ideas and driving sales. He has a modest salary (for a public company) and 343k shares. VP of sales is Bernardo Melo, who joined the company in February 2003, and has 512k shares. Altogether, officers have 2.5 m shares (6.6%). There are about 30 employees, and the company is based in Fort Lauderdale, Florida.

CATALYSTS

·         Continued growth in sales, EPS

SMDM could continue to grow (see 6 “GROWTH DRIVERS” listed above).

·         Little/No change to China tariffs by Trump

It’s unclear if Trump will implement a tariff on goods made in China, which would shake-up many U.S. retailers. About 50% of U.S. toys are made in China. A trade-war not happening would be a big potential catalyst (as the shares have fallen from a high of $0.76 to $0.54 in recent weeks, perhaps due to this tariff concern).

·         Removal of conflict-of-interest and overhang of 51% HK company

Shihua (which acquired Starlight) affiliates own 19.6 m shares (51.4%). Philip Lau, Chairman of Starlight since 1989, is a Director of SMDM and, since February 2015, SMDM’s Chairman. Philip Lau is the uncle of CEO Gary Atkinson. Importantly, the potential conflict-of-interest in manufacturing has been removed: 15% of SMDM’s karaoke products were made by Shihua/Starlight in F16, but none of SMDM’s karaoke products are made by Shihua/Starlight in F17. Recently, SMDM heard that Shihua has expressed a desire to fully exit its 51% position, and, although there is no concrete timing or plans for it, such a move could occur soon (perhaps calendar 2017). That would remove the overhang of the 51% HK company effectively controlling the company.

·         Net cash position (not net debt position of past)

In the past, Starlight (before being acquired by Shihua) provided financing by funding inventory. Now, SMDM uses PNC Bank (Pennsylvania). Last week, SMDM fully paid off the revolving line of credit with PNC Bank, which indicates that the company did a good job managing inventory in the 2016 holiday season.

·         Nasdaq listing at some point (SMDM wasn’t even available for trading on IBKR until a month ago)

VALUATION

Today, the stock is cheap, trading at 7.7x F17 (March) EPS of $0.07.

Looking out two years, the stock looks really cheap!

Under a bear case (no growth from F17 but more digital downloads due to the installed base), stock trades at 5.7x EPS of $0.09.

Under a base case (modest growth of 10% for two years), stock trades at 3.4x EPS of $0.16.  

Under a bull case (20% growth persists, fueled by new kids’ line and international growth, etc.), stock trades at only 2.6x EPS of $0.21.

A 12-15x multiple on our base case (within two years) puts the stock at $1.90-2.38, a triple or quadruple from here. 

Catalyst

·         Continued growth in sales, EPS (see GROWTH DRIVERS)

·         Little/No change to China tariffs by Trump

·         Removal of conflict-of-interest and overhang of 51% HK company

·         Net cash position (not net debt position of past)

·        Nasdaq listing at some point