Check out the financial characteristics of a small cap that's been climbing the charts of late: revenue growth in excess of 100%; net income growing even faster; and all this growth coming organically (without acquisition) and without debt -- for only 14 times trailing earnings. Such a low price tag for eye-popping growth has many investors excited about karaoke equipment maker Singing Machine (AMEX: SMD). It's a great growth story, but I see more reason for skepticism than enthusiasm. Let's take a look.
Singing Machine markets and distributes a line of consumer-oriented karaoke equipment and music. The Coconut Creek, Florida-based company got its start in 1982 with professional karaoke equipment, but switched its focus to the home-use consumer market in 1988. After going bankrupt in 1997, the company emerged like the mythical Phoenix from the ashes and began growing its revenues at a triple-digit pace as U.S. demand for karaoke machines began to take off.
If you haven't heard of Singing Machine, just go to Amazon.com and type in "karaoke" in the product search field for Toys & Games. You'll find that Singing Machine dominates its niche: Out of Amazon's 40 karaoke product slots, Singing Machine occupies more than half of the total, including 6 of the top 10 and the 3 "most popular" promotions at the top of the page.
Singing Machine's karaoke equipment ranges from $30 for a basic model that attaches to a TV up to over $400 for a semi-professional unit with a built-in full-size video screen. The company also sells special graphics-enabled karaoke CDs ("CD+Gs") that display lyrics on the video screen.
During 2001, Singing Machine generated $58.9 million in revenue, up 79% from the $32.9 million reported in 2000. Profits also soared in 2001, reaching $9.1 million -- more than five times higher than the year prior. Net profit margin for 2001 was 15.4%, although that figure is slightly overstated by the absence of taxes due to tax-loss carry-forwards.
The company has accomplished its growth over the past several years almost entirely without the help of debt financing. The first use of debt came in the December quarter of 2001, when the company tapped its credit line for the first time. This resulted in $7.6 million of short-term debt, which appears on the year-end balance sheet. But by the time earnings for the December quarter were announced on February 1, management reported that it had already paid off this balance.
Management explained that the credit line was tapped in order to accommodate the high level of accounts receivable that built up during the holiday season. As late as early December, top customers like Target (NYSE: TGT), Best Buy (NYSE: BBY), and Toys "R" Us (NYSE: TOY) were ordering additional Singing Machine inventory to sate the strong consumer demand. Singing Machine actually sold out on six of its items during the holiday season. Regarding the high receivables balance that built up, management reported on February 1 that $15 million of the $27 million A/R balance had already been collected, and the remainder was on schedule for collection.
The most interesting aspect of the conference call came during the question-and-answer session when management was asked to discuss the critical question of competitive advantage. Given the company's triple-digit growth and return on equity in excess of 75%, it's inevitable that well-heeled consumer electronics competitors will flock to provide competing karaoke products. So, how will Singing Machine protect its position? COO John Klecha cited three factors working in the company's favor:
- Through the company's financial success, it is building up a considerable budget to advertise karaoke in general and the Singing Machine brand in particular.
- The company is innovating year in and year out to expand the features of its karaoke machines.
- The company has established strong relationships with the leading consumer retail distributors.
Fools, if these "advantages" represent the moat protecting Singing Machine's business, it's a moat that's about one inch deep, one foot wide, and filled with no creature more dangerous than an over-aggressive minnow or two. How long will it be before the likes of Sony and Panasonic swoop in to this market with their already-famous brands, relentless innovation, and long-established retail distribution channels?
Even if management reaches its FY03 (ended March 2003) goal of $110 million to $120 million in revenue and $1.60-$1.70 in earnings per share, I think investors can place no confidence in the future of such results. At the current low P/E of 14 times trailing earnings, the market is already suggesting doubt at the company's future profitability. For a company growing as fast as Singing Machine and with such high returns on capital (59% ROIC in 2001), the market would pay a much higher multiple to current earnings if it thought these results were at all sustainable. The reality is, however, that if Singing Machine's profitability gets squeezed in a few years, it might only make sense to pay a few times current earnings.
Let's be generous and say Singing Machine earns $1.70 next year, $3 in 2004, but then profits evaporate after that due to competition. How much is that earnings stream worth? Well, discounted at 15%, it's worth only $3.75. The lesson: Without a sustainable competitive advantage, a company is worth very little. At a recent price of $15.40, this stock, despite its low P/E and remarkable growth to date, could in fact be incredibly overvalued. That said, I wouldn't short it, either, because a stock like this could continue to run up on investors' fantasies. Stocks like this are best left alone.
Matt Richey is a senior investment analyst for The Motley Fool. He'll be performing all week at the Old Town Karaoke Bar -- please come out and see him. At the time of publication, Matt had no position in any of the companies mentioned in this article. Matt's personal portfolio is available for view in his profile. The Motley Fool is investors writing for investors.
