FOOL ON THE HILL

Faith in Management

Every good company must occasionally survive a transition year along the road to long-term value creation. When it comes to sticking around for the uncertain ride, investors need to consider the company's prospects and the management's integrity and previous track record in overcoming obstacles. In the absence of obvious financial improvement, one sometimes has to trust good managers to do the right thing.

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By Zeke Ashton
November 12, 2002

In the real world, business can be unpredictable. Unlike those smooth, perpetual earnings growth models that often appear in Wall Street research reports, real-world businesses wax and wane.

Whether it's the flow of economy and natural business cycles, interest rate trends, or the process of replacing aging products with newer ones, most businesses don't offer the perfectly smooth trajectory many investors would like. Even well-run companies with successful track records may occasionally need a consolidation year to build a new base from which it can resume value creation for shareholders.

For a company in transition, it's often practically impossible for several quarters to tell whether the company is making progress from the financial data. Sometimes an investor has to have faith that the management team is leading the company where it needs to go. The better the management's track record of success and honest communication with shareholders, the more leeway the company will probably get from investors. It's not easy to do -- even the legendary Warren Buffett came under strong criticism in early 2000 after a disappointing year for Berkshire Hathaway (NYSE: BRK.A)  Investors who didn't keep the faith and sold did so at the worst possible time.

For Christian music and book publisher Integrity Media (Nasdaq: ITGR), 2002 has been a transition year, a year in which the company will need to successfully establish a new base for growth or face an uncertain future. Not long ago in this column, TMF's own Matt Richey played the devil against Integrity's tough year. Matt identified several risks in its business and came to the following conclusion:

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.

Integrity's success story
Integrity produces praise and worship music in different styles for specific audiences, such as children's music, urban music, youth music, and live worship for adults. It also makes software and printed music products, such as sheet music and songbooks, designed primarily for distribution to churches and choral groups.

Originally spun out of a non-profit agency by founder and CEO Michael Coleman, the company started as a worship music club and enjoyed many years of profitable 20% average annual growth from 1987 through 1994, when it encountered its first real test. Integrity's worship music niche had, by then, grown large enough to attract such major competitors as Columbia House and B&G. After a couple of years of bloodletting and price wars, the major record companies admitted defeat and exited the market. Integrity emerged from its scrape with the big record companies in 1996 alive but burdened with a mountain of debt it had taken on in order to survive those tough years.

From there, its market share in the praise and worship industry rose to an estimated all-time high of 64% at year-end 2001, more than five times the nearest competitor's share. The company again resumed its profitable ways, growing revenues and free cash flow (FCF) and paying down debt.

Integrity's Financials 1998-2001 ($ thousands)

Year    Revenues     FCF      Total Debt
1998    $38,847     $2,615    $12,968 
1999    $45,236     $4,036    $8,705
2000    $51,819     $4,040    $4,034
2001    $70,958     $9,274    $4,878

In 2001, Integrity had a record year, primarily based upon the launch of a product with Time Life Music called Songs 4 Worship, a series of popular praise and worship music albums. Time Life launched a $30 million television advertising campaign in support of the series, and the result was a huge hit that contributed $20 million of Integrity's $71 million in 2001 sales.

The transition begins
In the midst of its record 2001 year, Integrity CEO Michael Coleman and the management team announced the company would establish a new business entity, Integrity Publishers, to develop and publish Christian book titles.  

The book publishing business, it hoped, would extend the company's brand name and create another revenue stream in addition to the music business, where product cycles were extremely short and successful albums hard to predict. 

In February of this year, the company announced that revenues and earnings in 2002 would likely be flat versus the previous year, as Integrity ran up against very difficult comparisons in the first half (due to the success of the Songs 4 Worship launch in 2001) and the absorption of costs to build the publishing business.  Management noted it would expect improvement in the second half of 2002, when the publishing unit would begin contributing to revenues and the company would release several new music offerings. Predictably, the stock sold off on the news.

Like Matt, I had owned the stock for some time and had gotten to know the company pretty well. In late February, I even flew down to visit Integrity's headquarters and meet the management team. I came away impressed and convinced this business had long-term value.  

In July, the company announced a further twist in strategy with the acquisition of M2 Communications, an independent record label specializing in adult contemporary and rock Christian music. These niches represented new markets for Integrity and should prove to compliment its established dominance in praise and worship music. The second-quarter financials, as expected, weren't pretty, but consistent with expectations.

Evidence of a turn
Integrity's third-quarter financial results last week offered evidence that the second-half improvement CEO Coleman predicted will materialize. Third-quarter revenues increased 26% to $22.6 million, fueled by a strong first quarter of revenues for the book publishing unit, which contributed $2.4 million, and M2 Communications, which added $4.8 million in sales during the period. Net income more than doubled to $0.23 per share, up from a dime in the 2001 third quarter. Most importantly, operating cash flow in the quarter came in at about $3 million, and the company turned FCF positive once again. Finally, the company's balance sheet appears to be much stronger than it guided investors to expect earlier in the year. 

Building credibility
It seems our faith in Integrity's management team was justified, at least based on the early progress evident in the third-quarter results. The publishing business appears to be off to a great start, with 13 books now published to date, and four of the first eight books hitting the Top 20 on several Christian bestseller book lists. M2 released several well-received albums in the third quarter, and Integrity has announced some interesting new product launches for Q4.

The stock registered only a slight positive blip on the news, but Integrity's not exactly a widely followed stock, and it's not completely out of the woods yet. But I'm keeping the faith -- and my Integrity stock.

Zeke Ashton has been a long-time contributor to The Motley Fool. Zeke is also the managing partner of Centaur Capital Partners, LP, a money-management firm in Dallas, Texas.  At the time of publication, Zeke had (and owned shares of) Integrity. Please send your feedback to zashton@centaurcapital.com.