I had an ethical dilemma in writing this article: Should I buy Steinway Musical Instruments
I decided in the end that the right thing to do would be to tell Fools about it first, especially because of the company's limited market cap ($310 million) as well as the dislocating nature of my prediction. This seems most consistent with Foolishness. Therefore you have a chance to buy it before me.
So unlike most of my articles, I'm hoping you don't listen to me. I'm hoping this article gets ignored, or is downright scorned, so that that way I can buy the stock at today's price (or lower). And as you'll see a bit later on, I'm not the only one who feels this way. So if you're thinking of doing something else other than reading this article, please do so...Game of Thrones is calling!
Before we begin there is something else I should tell you: I rarely make a trade. I take the buy-and-hold school of investing very seriously. The last time I bought a new stock was Dell back in November 2010 (before I was first published in the Fool). Therefore, at least to me, this is a big deal.
So without further ado here's why I plan on buying Steinway.
Activists in the company
The short answer is I think there is a very high likelihood that the company is going to be sold at a substantial premium. But I don't think the market has figured this out yet. No Wall Street analyst covers Steinway due to its limited market cap. I'm hoping no one reads this so it doesn't get priced correctly prior to my buying.
But if you connect the dots, using publically available sources, I think it's blatantly obvious what's really going on here: 9.64% of Steinway is owned by an activist value hedge fund called ValueAct SmallCap Management. The fund is managed by David Lockwood, a former Goldman Sachs managing director who now teaches corporate governance at Stanford's business school. Lockwood got a seat of Steinway's board back in January 2008.
It's difficult to find information on ValueAct and Lockwood. Unlike many activist investors, ValueAct keeps a low profile. When it buys a stock, it doesn't go in Carl Icahn-style and tell everyone how undervalued it is and what changes need to be made.
ValueAct takes advantage of the lack of media attention. According to a rare interview with ValueAct founder Jeffrey Ubben, what they almost always do is persuade management to divest poor-performing divisions from a company. They then use the proceeds to buy back tons of stock at a cheap price.
This gives them an incentive not to tell everyone how great they think a company really is. As Warren Buffett touched upon in Berkshire Hathaway's latest annual letter, if a company is planning (secretly or openly) on buying back stock, it wants the shares to stay down in price. That allows management to buy back more shares per dollar, which in the long run leads to a higher share price.
And when ValueAct does this divest-and-buy-back move, the result is a highly concentrated industry pure play that can then be easily sold to an acquirer. Yes, that's how ValueAct exits a position. It sells the whole company to a buyer for a sizable control premium after improving operations and usually buying back stock.
And Lockwood has done a tremendous job of this. Just in the last year, Lockwood got BigBand Networks sold to ARRIS Group
Lockwood now has only two open positions: Steinway and Energy Solutions.
According to Barron's, the average company ValueAct, Icahn Capital, Trian Fund, and Pershing Square had filed an SEC 13D on went up 144% in 2010. While it's hard to find performance numbers for the small-cap fund, we know from looking at documents released from the state of New Jersey that ValueAct's large-cap fund delivered returns of 17.66% annualized from December 2000 through June 2011.
Lockwood first started buying Steinway back in August 2007 at $33 and ValueAct's average cost basis is $26.76. The shares now trade at around $25; so you can get in at a better price than it did.
A bloodless coup d'etat
Some of you may be saying: "Chris, if Mr. Lockwood has been on the board since 2008, and if he's been secretly planning on selling the company, why hasn't he gotten the company sold yet?"
That's not ValueAct's style. As the company founder put it to OpalesqueTV, "I don't need the quick hit." It sticks around as long as it takes to get top dollar for the company. And Lockwood is just one board member. The activists in the company haven't been in position to call the shots -- until now.
You see, up until recently, Steinway was a controlled company. The (now former) CEO and chairman, Dana Messina and Kyle Kirkland, held 80% of the voting power.
But then, in a stunning move, ValueAct and another activist investor, Samick Musical Instruments, bought the supervoting shares from Messina and Kirkland at a gigantic premium to market -- $56 a share! With the sale of the supervoting shares, they converted to normal voting shares. So now every shareholder gets one vote, giving the activists around 43% of the voting power (10% for ValueAct and 33% for Samick).
But what is perhaps more important is that the deal led to the resignation of three board members. They probably saw the writing on the wall. Three new directors were then put on. One of the three people put on was Michael Sweeney, a private equity veteran. Stay with me here...
A bit later on, the company announced that it was selling the company's lackluster band instrument division. (Hmmm...selling off bad divisions, where have we heard this before?) The prospective buyers of the band division are none other than Messina and Kirkland.
So, in order to avoid a conflict of interest, Messina and Kirkland had to resign from their CEO and chairman positions. And guess who replaced them as chairman and CEO -- Michael Sweeney, one of the people put on the board as part of ValueAct and Samick's deal with Messina and Kirkland!
So my read is that the activists now have de facto control of the company. And it appears they're more or less executing ValueAct's proven game plan (e.g. divesting off the bad band division). Steinway is also looking into selling Steinway Hall in Manhattan, perhaps in a hotel conversion. Steinway Hall could be worth a ton of money -- as much as $300 million (the entire stock price) based on comparables -- although it only owns the building and not the actual land.
They haven't yet said what they'll do with the proceeds of any asset sale, but if I were a betting man I'd say they will first pay off the debt (due to restrictive covenants) and then do the whole buyback thing I wrote about earlier. After that, I think they'll work on operations before trying to sell the whole company.
Why would anyone want to acquire Steinway?
So if the secret game plan is to sell the whole company, it might be good to know why someone might want to buy Steinway. After all, if no acquisition ever occurs, you don't want to be stuck with a turkey.
For one, Steinway is a virtual monopoly. As I've written previously, 97% of the world's major piano concerts are performed on a $130,000+ Steinway concert grand. The company's major competitor, according to its own 10K, is its own used product. (The DeBeers diamond monopoly had a similar "competitor.")
As a result, the company has pricing power: A Steinway grand piano sells for around $80,000+ brand new. They raise the price about 5% virtually every year and never discount.
The reason why Steinway buyers won't simply trade down to, say, a cheaper Yamaha is because of how a Steinway is built: by hand, over the course of a full year in New York City or Hamburg, Germany. That's what gives the Steinway its mojo. It's a very expensive way to do things, but it allows them to charge six digits on some models.
The other advantage to doing things by hand is that you can fire people. You can't fire machines. This allows Steinway to match revenues with costs during downturns. The result is that Steinway has generated positive free cash flow for as long as it's been publicly traded.
And finally, the company has accumulated some valuable real estate. While it's only listed on the balance sheet for $3.4 million, the 10-acre factory in New York City was estimated by the company at $200 million in 2005. That's roughly $450 per square foot, which seems reasonable for waterfront Queens real estate.
Similarly, Steinway Hall in Manhattan is only carried on the books at $26 million, but its value in 2005 was estimated at $100 million and, as mentioned earlier, the company is actively trying to sell it.
Taking this into account, the company is trading below liquidation value (essentially add an additional $270 million to the stated book value). And it generates consistent free cash flow, including $16 million in 2011 and $32 million in 2010. This could be attractive to many buyers, including Samick Musical Instruments, which already owns 33% of the company.
Fortunately, the board put in place a poison pill to ensure any buyer, including Samick, has to pay a control premium.
Put this all together and I think Steinway is an unusually compelling opportunity. Which is why I plan on breaking my 18 months of trade celibacy.
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