Description

Singing Machine (SMD) is an “interrupted earnings” story which could double or triple in the next year, having been dumped by growth investors and funds that grew impatient with the former management’s operational mis-steps and misguidance in the last two quarters of FY2003 (ended March 31, 2003). In my view the current stock price also reflects a misperception by the market surrounding the company’s technical default under its credit facility, and ignores the substantial cash flow generation capacity of the company which has continued to experience significant revenue growth.

There are currently 8.12MM shares outstanding (current market cap is about $28MM). At March 31, 2003 there was $300K of local credit line borrowings and $6.8MM drawn on the company’s credit facility with LaSalle. Unrestricted cash was about $250K.

In FY2002, EBIT was $8.2MM (13.2% margin) and EBITDA was $8.6MM (13.8% margin). In FY2003, which was riddled with operational mistakes and mishaps, EBIT was $1.6MM and EBITDA was $2.2MM (i.e., the company was free cash flow positive even in its “disaster year”).


Business Overview

SMD develops, produces, distributes and markets consumer karaoke equipment, accessories and music. The machines retail for $30-$400. Manufacturing of the electronic equipment is done in Asia. Karaoke music sales, comprised of CDs and CDs with graphics (CD+G) represent about 9% of sales. The company has a song library of over 3,500 songs which are licensed from publishers. SMD is the only karaoke manufacturer that mass-produces the CD+G software, which is very popular with the MTV crowd. The company holds about 40% of the karaoke machine market (based on mgmt assessments of worldwide karaoke machine sales in 2002).



Background

Several events which have contributed to the depressed stock price are worth reviewing:

1) In mid-July, company announced its 10-K for FY2003 would include a going concern uncertainty paragraph, which shocked the market. The reason for the qualified opinion was that SMD incurred a technical default under its $7MM credit facility due to violation of a net worth covenant in March 2003.

As discussed in more detail below, I believe the qualified opinion has been substantially mischaracterized and misunderstood, with de minimis likelihood of “insolvency” (as has been alluded to in press articles which were poorly researched). Since March, LaSalle has requested that the company obtain $2MM of subordinated debt financing (which it is currently finalizing, $1MM of which is personally coming from mgmt and board members) and LaSalle has increased the company’s availability to provide the company with additional flexibility to sell excess inventory (described below).

2) In June, the company announced it would need to re-state earnings to include an increase in SMD’s tax provision, per the assessment of its new auditors (company rotated accountants in March 2003).

There were effectively two adjustments to the financials. The first occurred because SMD’s Hong Kong subsidiary, which generates most of the profits, didn’t provide for any foreign income tax because mgmt assumed it would get an exemption (still pending). Mgmt’s argument for the exemption is that all profits of the Hong Kong subsidiary come from exporting to customers outside of Hong Kong. The exemption may still be approved (seems to be 50/50 far as I can tell), but mgmt has restated the numbers already to assume it is denied, leaving room for some positive news/upside (tax expense of up to $750K in FY2002 and up to $470K in FY2001 would be reversed).

The other adjustment to the financials involves mgmt’s reversal of its position regarding U.S. taxation of SMD’s foreign income. The language in the 10-K and the recent CC hints that there is also the possibility of the taxing authorities taking the company’s original view on this matter and allowing SMD to reverse the charges, but it seems less likely in this instance.

3) Management changeover

In March 2003, the COO (and the CEO’s successor according to much speculation), John Klecha, abruptly stepped down and was replaced by YP Chan, a director of the company.

In 2002, Ed Steele - the chairman and CEO since 1988- announced his intention to step down as CEO in 2003. Last week the company announced Steele was resigning (amidst the criticism the company was receiving for various operational blunders described below) and would be succeeded by board member Rob Weinberg on August 3, 2003. In addition, another director, Howard Moore, took over as Chairman. Both Weinberg and Moore are former Toys R Us execs. Based on my preliminary research and talking to people familiar with these guys, Weinberg and Moore are extremely well-qualified managers with strong marketing and merchandising backgrounds.

Note: Weinberg, Moore and two other directors have been buying shares in the past few weeks. Inside ownership in this company is quite significant, with directors and officers owning about 33% of the shares.


4) Announcement of revised sales figures, excess inventory and the “bonehead” contracts. A few things in particular caused massive shareholder indigestion (the good news of course is that they are non-recurring and are lessons learned by the company):

a) SMD entered into a guaranteed margin contract (completed in January 2003) in which the customer was basically given no incentive to try to sell the machines, and SMD ended up having to pay the customer $2.6MM. This arrangement appears to be one of the dumbest things I have seen a company agree to, and SMD’s investor relations firm explains the company’s agreement in such contract as being a function of the former mgmt’s hubris. FWIW, I was also informed that SMD would never have signed up this contract if YP Chan or the new CEO was in charge at the time.

b) Consignment inventory contracts entered into by SMD, including one with the above customer, have contributed to the excess inventory problem by leaving the company with unsold product. Except for a current Best Buy contract, all consignment inventory contracts have now been completely exited.

c) A Los Angeles port strike cost the company $3-5MM in sales and also contributed to the ‘excess inventory’ problem because of goods that never got to distributors in time

d) As a result of the above factors and mgmt’s failure to gauge the softness of last Christmas’ selling season, the company’s inventory at 3/31/03 was $25MM, which is probably about $20MM too much. The company insists that this inventory (which is conservatively worth 65% of the Company’s current market cap) will be sold at market levels in FY2004.

e) Increased advertising expense of $2.7MM over FY2002, primarily due to cooperative advertising with SMD’s customers (under which the customer has complete discretion over the use of the funds) and direct advertising expense.

5) Sale of approximately 200,000 shares by Ed Steele in 2003. The insider selling looked bad from the outside, but Steele sold these shares due to a margin call and was forced to sell his shares at approximately $3.10. He still owns approximately 765,000 shares.


Fiscal 2004

I believe there are several positive developments that will unfold in FY2004, addressing many of the issues above:

1) The inventory problem will be resolved. Shortly.
Management announced on July 15 conf call and subsequently confirmed that: a) the $25MM of inventory is ‘good’ inventory and should NOT require a significant markdown to be sold, b) they already have orders for $12.5MM of the inventory at mkt. levels and c) the remaining amount is expected to be sold in the next two quarters.

The $3.7MM inventory reserve currently on the balance sheet (about a 15% writedown) was taken in 4Q FY2003 under the assumption that this inventory had to be sold on an extremely rapid basis to address SMD’s problems with LaSalle and cure the default. It looks like the inventory writedown will make gross margin will look that much better when this inventory is sold (or perhaps the company may even decide to reverse some or all of the reserve instead).


2) The LaSalle/financing issues will be put to bed; net debt by the end of FY2004 will not be significant.
SMD’s stock plunged when the company announced it was in technical default under the facility back in March, and I believe a cloud will be lifted as soon as this issue is materially resolved (i.e., long before the next audit in 2004).

From LaSalle’s perspective there is simply no reason/upside to accelerating on the loan. The company is in technical default and is not delinquent on principal or interest payments. More important, the company is probably paying LaSalle some juicy fees in addition to default interest rate (note that for a $7MM loan, a 1% amendment fee and a 2% default interest rate bump for a few months is not a big deal for SMD).

Banks seek to avoid the tremendous reputational damage of being perceived as liquidating a company unnecessarily, let alone potential lawsuits of lender liability. Most important, if LaSalle wanted to foreclose on the collateral and force a chapter 11 filing, the end goal would be to liquidate the current assets and get out. Given that the banks (and everyone else) have already pushed the company to reduce working capital and use these proceeds to repay the bank debt, the banks are better off having mgmt do this out-of-court, and not at firesale prices or having to go through the lengthiness of a chapter 11 process. Remember, the company already has orders for $12.5MM of the inventory, and plans to sell the rest without significant markdown.


3) Sales will continue to display robust growth due to new customers, distribution arrangements and penetration of new markets
New customers including Radio Shack, Walgreen, KB Toys, Whirlwind and other household names have recently placed orders and are not reflected in the FY2003 results. The company has also continued to grow sales through Toys R Us (which sells online through Amazon). My recent survey of the machines available at the online sites for Amazon, KB Toys, Wal-Mart, etc. reveals that a range of Singing Machine’s products are abundantly available (or is that a bad sign?)

The company’s licensing agreements with MTV and Nickelodeon, pursuant to which SMD creates branded MTV and Nickelodeon machines represent unique growth opportunities into these demographic areas (teenagers and parents buying for their kids, that is) and have been very successful to date.

Growth in Europe and other international markets continues to be a strong growth area. Confirmed orders for international sales in FY2003 already exceeds $32MM (vs. $18MM in FY2002); the margin on these machines is not substantially lower than U.S. sales. The software business (the CDs with graphics) grew 41% in FY2003 to $9MM and will continue to grow as more karaoke machines are placed (a little like the razor-razorblade model).

In FY2003, revenue was comprised of $78MM from North America and $18MM from international markets ($15MM of which is Europe). Factoring in the data point on international sales being at least $32MM and likely to be reasonably larger, my (very) conservative low-end sales estimate for FY2004 is $120MM, which is:
- less than 15% year-over-year growth in North America (vs. 25-50% revenue growth/year in North America in the last four years)
- far below the 75% CAGR of total revenue over the last four years
- not factoring in the several new major customers who recently signed up, a new Motown contract, or the weak dollar vs. Euro


4) Resolution of tax issues.
Difficult to say when this will happen or the chances of whether the company obtains the exemption or if they were overly conservative about the taxation of foreign income in the U.S., but there’s only upside at this point.


5) Credibility is restored.
If the new management team is even partially effective in controlling SMD’s distributors and cost structure, restoring working capital to normalized levels, fixing the financing issues and building a perception as shareholder-friendly, the extremely cheap valuation and cash generation ability of this company will be hard to ignore.


Valuation

Gross margin was 36.4% in FY2001, 34.6% in FY2002, and 30.9% in FY2003 after backing out the $2.6MM loss on the guaranteed margin contract and the $3.7MM inventory writedown. SMD has not lost any customers in the last year and there is no indication they will need to under-price to remain competitive. The only guidance I’ve been able to glean from the company about gross margin going forward is that some of their new customers and distributors are asking for slightly lower prices but the tradeoff has been a significant boost in volume.

Even with extremely conservative assumptions about margins going forward, SMD is significantly undervalued relative to FY2004 FCF. In the interests of getting this out to VIC before the July 31 announcement on the credit facility (and possibly other important disclosures/updates by the company) I am providing the following 'rough cut'.

In order to assess margin of safety, I’ve developed an extremely conservative ‘low case’, under which FY2004 FCF (EBITDA less CapEx) estimate is $5.8MM, based on:

- Sales of $120MM

- 26% gross margin

- Other operating expenses (excl. D&A) of $25.4MM (based on the average operating expenses as a % of sales in FY2002 and FY2003, and backing out $2.5MM of expenses (primarily advertising) incurred in FY2003 which I believe will be avoided)

- CapEx of $1MM

Assuming that by the end of FY2004 the inventory is restored to a normalized level, net debt should (easily) be zero and payables greatly reduced to normalized levels. A conservative 5.5x multiple of FCF would imply a share price of $4.10.

My ‘more realistic’ estimate for FY2004 FCF estimate is $13.4MM, based on:

- Sales of $135MM

- 31% gross margin

- Other operating expenses of $27.5MM (about 20% of sales, based on historical % of OpEx to sales)

- CapEx of $1MM

At a 7x multiple of FCF (quite reasonable for a company with a 50+% revenue CAGR over the previous five years), the stock would be worth $11.55.

Rather than delve into an extremely detailed operating and financial forecast, I’d rather wait for the company get out of the woods first by cleaning up the balance sheet. Once there’s some reasonable clarity about FY’04 and ‘normalized’ margins, I’ll take another look at FMV. Current levels seem extremely attractive to get into the stock while watching the drama unfold.


Risks

1) Risk: “Karaoke is a fad.”

Response: Its impossible to predict with great confidence how popular karaoke machines will be in 3 - 10 years from now. The company and the karaoke market has been growing for several years now, with plenty of international markets being opened. Karaoke has been around for over 20 years now, and while the karaoke market may eventually go the way of disco and shrink down to a few diehard fans (who won’t admit to it), there is no current indication the market is either saturated or shrinking.

As a data point, today in Asia, where karaoke took off in the late 80s, karaoke is still extremely popular. Its also not hard to appreciate the demand for a $50 machine that lets your 12-year old sing each of Britney Spear’s and ’N Sync’s latest hits, and likewise the demand for the new karaoke CD each time another Britney album or hit is released.

2) Risk: Management raises equity capital/attaches a boatload of warrants to the subordinated debt it has raised

Response: Directors and officers of SMD own over 30% of the company and aren’t going to intentionally do something that will likely damage the stock like dilute it heavily. The return they are seeking to make by lending money to the company is expected to come from an enhancement in the share price.

Moreover, given the high level of scrutiny on the company and new mgmt from investors, the SEC and law firms looking for any evidence of insider dealings or material to fuel the current shareholder lawsuits, I think it would be extremely unlikely that new financing with warrants struck below or very close to the current share price would be arranged.

3) Risk: Company is not able to obtain necessary financing for the current and following quarter, when the vast majority of its sales takes place.
Response: Paydown of the current LaSalle facility with proceeds from inventory reduction should still leave plenty of current assets for SMD to borrow against with a small asset-based facility. Moreover, vendors/factories have been extremely supportive of the company’s efforts to date by extending payables terms. I believe that this company, despite the recent operational hiccups, should be able to raise more than $2MM of sub. debt.


Conclusion

SMD is a misunderstood value story with significant upside once margins are restored to more normalized (let alone FY2002 and FY2001) levels. Bad contracts have been exited and a new senior management team (primarily comprised of directors of the company) is in place. Mgmt and board members have been actively buying shares and have recently lent money to the company.

Throughout the last several months, the company has received strong support from its suppliers, has not lost any customers and has signed up new major customers such as Radio Shack, which should ensure solid U.S. sales for a while. Excess inventory is equal to about 50% of the current enterprise value and is in the process of being sold; the proceeds of which will sharply benefit shareholders via the repayment of debt and the use of proceeds to finance acquisition of new inventory for the current selling season. International sales (19% of FY2003 sales) in FY2004 have already exceeded the entire FY2003 level, and software sales should also provide a healthy growth component.

Catalyst

Resolution of credit facility issues (announcement due on July 31, 2003 when current waiver on LaSalle facility scheduled to expire)

Earnings release in early August should provide update on sale of the excess inventory

Impact of new U.S. customers and new agreements with international distributors

Growth in international markets and software reflected in financials