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Thursday, November 20, 1997
SRS Labs, Inc.
(Nasdaq: SRSL)
Phone: 714-442-1070
Website: http://www.srslabs.com
Price (11/19/97): $7 1/2
HOW DID IT FIND TROUBLE?
This licensor of 3D sound technology once had a chart-topping stock that doubled in just three months from its August 1996 IPO price of $8 a share. But like a great song that got overplayed, SRS Labs shares have inspired little but channel-flipping disdain for most of this year.
The downfall began with simple overvaluation meeting up with a huge sale by an institutional shareholder happy to take some quick profits, ensuing rumors of trouble, and so-so holiday sales for personal computers. From early November '96 to late January '97, SRS shares spun off track and fell below the IPO price. Decent fourth quarter earnings results of $0.07 per share topped expectations of $0.03 a share and reported consumer enthusiasm over new multimedia PCs aided a recovery to the $11 range.
Then on July 14, SRS Labs lost $1 3/8 to $6 3/4 when management said it expected sequentially flat revenues for the second quarter, though earnings would increase slightly thanks to lower expenses.
The company blamed weak post-Christmas PC sales, manufacturing delays by its semiconductor partners such as S3 (Nasdaq: SIII), and increased competition from other 3D audio technology firms that were frantically sacrificing long-term royalties for quick one-time licensing fees. Soon thereafter, SRS shares screamed to an all-time low of $4 5/8.
BUSINESS DESCRIPTION
With just 21 employees, SRS Labs is a virtual company that develops, markets, and licenses patented 3D audio technologies for use in five markets: consumer home audio, computer multimedia, car audio, professional sound and video, and arcade games.
Its flagship Sound Retrieval System (SRS) was developed from Hughes Aircraft technology acquired in 1993. SRS creates an immersive, realistic 3D sound using as few as two conventional stereo speakers. Plus, a listener doesn't need to be positioned in the so-called "sweet spot" between speakers.
SRS Sound technology is now found in 18 million products made by 115 manufacturers, including Sony, Kenwood, RCA, Pioneer, IBM, Gateway 2000, Micron, and Apple. Packard Bell/NEC accounted for 38% of sales last year, but just a third of that in the third quarter of '97.
So far, most of the firm's revenues have come from original equipment manufacturers (OEMs) of computers and consumer electronics. But the company is moving away from direct sales to OEMs, striking deals with semiconductor manufacturers, which bundle SRS Sound technology with their chips and motherboards.
Chipmaking royalties have so far come mainly from Cirrus Logic (Nasdaq: CRUS) and Seponix, and chips from S3 and Chromatic Research are now beginning to hit the market. Intel, Motorola, and Philips are other licensees.
SRS Labs has over 50 U.S. and foreign patents relating to SRS Sound plus 25 other patents. SRS Sound inventor Arnold Klayman directs the firm's research, helping it add new technologies, including TruSurround, a Dolby-related technology that works well with DVD audio, and Focus, for the car audio market.
While many firms offer audio enhancement products, QSound Labs (Nasdaq: QSNDF) and Spatializer Audio Labs (Nasdaq: SPAZ) directly compete with SRS with their 3D audio offerings, though SRS remains the market leader.
Chair/CEO Thomas C.K. Yuen, also co-founder of Ast Research, is among a handful of insiders who own 45% of the stock. Major holdings by the likes of Packard Bell (9.6%) reduce the float to about 3.5 million shares.
FINANCIAL FACTS
Income Statement
12-month sales: $8.6 million
12-month income: $3.3 million
12-month EPS: $0.32
Profit Margin: 38.4%
Market Cap: $76.8 million
Balance Sheet
Cash: $4.1 million
Current Assets: $7.7 million
Current Liabilities: $2 million
Long-term Debt: N/A
Ratios
Price-to-earnings: 23.4
Price-to-sales: 8.9
HOW COULD YOU HAVE SEEN IT COMING?
SRS Labs has the track record of a technology startup that decided to go public as soon as it started delivering profits. That's often the type of company that inspires investors to pay 76 times trailing EPS of $0.21, or $16 per share, for an ownership stake, as some did a year ago. Few companies deserve to trade near such a multiple, even if it's in line with the firm's current growth rate.
Yet the selling seemed way overdone when the stock dropped below $5, to about 17 times trailing earnings. Although the company's revenue growth had skipped a groove, the stock still seemed ready to bust a move. And the downside risk was minimal considering that SRS Labs was sitting on more than $2 a share in cash and securities. The September 11 announcement that the company might buy back up to half a million shares was also bullish.
WHERE TO FROM HERE?
Multimedia, DVD, the Internet, home theaters, HDTV. Name a promising new development in our converging digital world, and you're probably looking at a market for SRS Labs' technology. Consumers want more sophisticated entertainment products and manufacturers want to deliver it to differentiate their offerings from the competition.
SRS's challenge is to strengthen relationships with licensees so that they continue to serve essentially as the company's sales force. SRS Labs needs to expand use of its technology fast enough to more than make up for what will likely be declining per unit royalty payments. To aid that process, the company has added new offices in Japan, South Korea, and China.
While licensing revenue is currently split evenly between computers and consumer electronics, the PC slice of a growing pie should fall to about 40% next year and drop a bit more in FY99 as SRS Labs attacks the car audio market and then DVD. The company may acquire firms that could aid it in achieving such market diversification.
First Call shows consensus earnings estimates of $0.35 per share for FY97 and $0.44 for FY98. However, the $0.32 per share in trailing earnings and estimate-beating results for the third quarter suggest SRS could turn in $0.37 per share this year, a 76% increase over the $0.21 seen in FY96. Assume the company grows at the estimated 30% long-term clip, and FY98 earnings would be $0.48 per share. That's good for 38% annualized growth over the next five quarters, for a PEG of 0.61. The YPEG fair value would be $14 3/8.
As a technology licensor, SRS really has no costs besides research, sales, and administration -- all of which have been falling as a percentage of revenue. While the company should continue to get a nice boost from interest payments, operating income has been exceptional, rising 139% so far this year. The price-to-sales ratio looks pricey until you realize SRS pockets 38 cents on the dollar as pure profit.
Investors should probably brush up on their knowledge of chipmakers and sound enhancement technologies because SRS Labs looks like a compelling prospect.
-- Louis Corrigan
(TMFSeymor@aol.com)
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