Playing the Devil Against Integrity

A key tenet of investing is not falling in love with a stock -- even if you love the company. Maintaining a critical stance toward the company's business and valuation is paramount. Especially when a company faces difficulties, it's important not to be a cheerleader, but rather be willing to put the company through the paces and consider whether it still makes sense to own the stock.

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By Matt Richey (TMF Matt)
September 3, 2002

An old rule of investing is never to fall in love with a stock. If you're honest, you know that's tougher than it sounds. Simply by owning a stock, you and I, as investors, have a certain commitment tendency that predisposes us to seeing our stocks in a rosy light. The only antidote to this natural tendency is to purposefully take a critical view of the companies we own.

Because it's my job to practice what I preach, today I'm playing devil's advocate against one of my favorite companies, Integrity Media (Nasdaq: ITGR). When I first discovered Integrity about a year ago, I was enamored with its strong free cash flow, its track record of paying down debt, and its impressive revenue growth.

Plus, this is a buy-what-you-know investment for me. I'm an avid fan of Christian praise and worship music, a niche Integrity dominates with a 64% market share. Christian music has grown larger than jazz and classical, and Integrity has become the undisputed leader in praise and worship music, the fastest growing segment of the Christian music industry.

After a record 2001, in which Integrity grew revenue by 37%, 2002 so far looks like a transitional year. Year-to-date revenue is down nearly 28%. And profits have been hit even harder. Last year's record free cash flow profit margin of 13% has shrunk to negative 6.6%. The culprit is sharply lower sales of the Songs4Worship and WoW Worship series. These two successful multi-release CD product lines came to the end of their product-life cycles last year. Through the first half of this year, Integrity had no replacement products, and thus sales have tumbled.

Management has laid out a plan for new products, beginning in the second half of this year. I'm personally excited about the company's upcoming iWorship product series, which will feature a collection of multi-artist CDs and DVDs.

Thus, while I am hoping for the best, this is no time for blind faith. The current decline in sales, while not unexpected, is a bit deeper than what I'd anticipated this year. A critical reassessment is in order. My goal here is to look at Integrity not as an owner of the stock, but as an unbiased skeptic. The question isn't, "Should I hold this stock?" but rather, "Would I buy this stock today, if I didn't already own it?" With that mindset, below are five areas of concern I see for Integrity:

1) Reinvent-the-business risk
Media is a complex business. Integrity's lumpy revenue demonstrates the difficulty of keeping a product pipeline stocked with popular music. Every year or two, Integrity has to design new products from the ground up, complete with new branding, partnerships, and distribution. In order to be successful, each new product-development effort requires a fresh investment of creative energy. This is no easy task. And anything that's not easy is, by definition, potentially unreliable. The reality for Integrity is that its product development carries with it an ever-present risk of failure. This risk keeps a lid on the type of valuation multiple the business merits.

2) Intellectual property risk
Napster may be dead, but there's no doubt music copyrights continue to face grave threats these days due to the ease of burning CDs and sharing MP3 files. On Integrity's July 23 earnings conference call, an analyst asked management, "To what extent is intellectual-property protection an issue in your market?" Management gave a rather unsubstantial answer, saying the Internet is "both an opportunity and a threat." They also said they "haven't seen a lot of direct impact."

My interpretation is that management doesn't really know the full extent of lost sales resulting from the proliferation of CD burners. While it may not be possible to pin down precisely how large a risk this represents, I bet it's a large one. The risk of unmitigated intellectual-property violation is difficult to quantify on the company's valuation, but it's a risk that inevitably weighs on the stock's P/E multiple because of the implications for reducing the company's future growth.

3) Rising debt levels
At the end of 2001, Integrity had positive net cash (that is, cash minus debt) of $2 million. But so far this year, the company has posted operating cash flow losses, along with expenditures for an expanded headquarters and a small acquisition. All told, as of June 30, Integrity had net debt (that is, debt minus cash) of $4.7 million. Even more disconcerting is that on the most recent conference call, management stated they expect to end 2002 with approximately $8.25 million in net debt (~$10 million debt minus ~$1.75 million cash). In other words, management expects to spend more cash than they take in for the next six months.

Given that positive cash flows were a key part of my original thesis for owning Integrity, I'm not happy to see debt accumulating. So far, the debt is modest, and the expenditures necessitating the debt may prove well worth their cost. But this is by no means a favorable trend.

4) High expectations for H2 '02
Despite the rough start to 2002, Integrity's management continues to guide investors toward earnings per share that "should be comparable" to last year's $0.45. That's a tall order given that, through the first six months of this year, the company has earned only $0.04 per share. It's unclear exactly how the company plans to come up with $0.41 per share over the next six months in order to meet its guidance. New CD and book releases are expected to help this year's third and fourth quarters, but $0.41 still appears to be a high target, compared to last year's $0.15 in the second half. I have no basis to refute management's guidance, but this situation stands out as something of a risk.

5) Valuation
In 2001, Integrity generated $1.49 in free cash flow (FCF) per share. All year, based on that $1.49 figure, the stock has looked cheap at its prevailing price of $5.00 to $7.50. At those prices, the stock has traded at only three-to-five times last year's FCF. But now after two lackluster quarters, Integrity's trailing 12-month FCF sits at only $0.27 per share. At that figure, the stock currently trades at 20.6 times FCF.

So, which is more relevant -- the per share FCF of $1.49 or $0.27? That depends on which number was the aberration. Was $1.49 a fluke based on short-term, higher-than-normal results in early 2001? Or is $0.27 a depressed result based on the temporary profit drought between product cycles? Only time will tell. In my assessment, if sales and profits remain depressed, the stock isn't especially attractive at 20.6 times trailing FCF. Sales and profits for the remainder of the year need to meet management's guidance for the stock to not be overvalued.

I admire Integrity Media for both the quality of its products and its mission. Yet even as a fan of the company, I'm not willing to fall in love with the stock. Integrity is at a crossroads. Over the next several quarters, the company will either live up to its promises and resume growth or suffer from the risks that are part and parcel of its business model.

As an investor, I'll watch the next two quarterly reports with extra scrutiny to determine which direction the company will take. Based on the real potential for a strong rebound in revenue and free cash flow, I continue to hold the stock, believing there's strong upside if the company proves successful.

Matt Richey is a senior investment analyst for The Motley Fool. At the time of publication, he owned shares of Integrity Media. Matt's personal portfolio is available for view in his profile. The Motley Fool is investors writing for investors.