The search for value in this market has caused some investors to become captured by the high-growth, low-P/E mystique of The Singing Machine Company (AMEX: SMD). Some of you will remember that this is the karaoke equipment company I picked apart back in May ("Singing Machine's Pitch"). In that piece, I concluded that the company's main weakness was its vulnerability to competition. Now, having reviewed the company's recently filed 10-K and listening to its most recent conference call, I'm noticing some other warts as well. Singing Machine's shortcomings are representative of the types of issues Fools should watch for in every company.
To briefly review, Singing Machine is a consumer karaoke equipment company. Its karaoke models are sold at most electronics retailers, with prices ranging from $30 to $400. Sales have grown rapidly in the past year, and management is guiding investors to expect earnings per share of $1.60 to $1.70 in the current fiscal year (which ends in March 2003). At a recent price of $11.50, the stock would appear to be cheap at only seven times forward earnings. But you don't have to dig too deep to see that the value here is just a mirage. There are five issues in particular that should give a Fool pause:
1) Cheerleading management
It's a bad sign when management is reluctant to talk about the real problems facing the company. In the case of Singing Machine, the company came out on June 26 with its announcement of FY02 earnings. Almost every word in the press release is devoted to the company's growth. But just a cursory glance at the numbers reveal a sharp year-over-year decline in gross margins (we'll discuss in a moment) -- with not a word of explanation.
The conference call was more of the same. In the company's formal remarks, there was no mention of the gross margin situation, nor of any other problems. Then, just a few days later on July 1, the company filed its 10-K, revealing that its top customer, Best Buy (NYSE: BBY), was no longer purchasing the company's inventory and was instead taking it on a consignment basis. This is a pretty major development considering that Best Buy represented 35.7% of Singing Machine's revenues in the just-completed fiscal year. Taking inventory on consignment suggests that Best Buy either has too much Singing Machine inventory or doesn't have much confidence that it can sell Singing Machine's products. Both of these conclusions are also supported by the fact that Best Buy is currently discounting all karaoke products.
But was any of this mentioned on the conference call? Nope. That kind of evasiveness from management slaps shareholders right in the face. Good management teams are willing to openly discuss their honest flaws.
2) High inventory risk
If Best Buy's inventory situation isn't troubling enough, consider also that Singing Machine's inventories have now outgrown sales for five consecutive quarters. That's a lot of inventory building up in the channel. Any time inventory is outgrowing sales for more than a few quarters, investors should be on guard.
Singing Machine may have a partial explanation, at least for the most recent quarter: A strike has been threatened by the California longshoremen and other West Coast dockworkers. Such a strike would disrupt Singing Machine's supply chain from the Far East. The company says it's increasing inventory to avert any potential sales disruption.
But this explanation only applies to the most recent quarter's inventory. That still leaves five prior quarters with higher and higher levels of inventory. The bottom line is that regardless of the reasons, a build-up in inventory is a major risk. If Singing Machine doesn't accurately forecast end-user demand for its products, the company could be left holding the bag on electronics that probably have little redeemable value. Such a scenario could result in major losses from inventory write-offs.
As I see it, the chances of an inventory glut here are fairly high for two reasons: 1) Singing Machine must commit to production with its Far East suppliers well in advance of customer orders, which leaves the company exposed if hoped-for demand doesn't materialize; and, 2) demand for karaoke machines is prone to the fickle tastes of kids who are likely to gravitate from one hot toy to the next.
3) Deteriorating gross margins
On the conference call, the CFO stated that gross margin for the year was "about unchanged from the prior year." Only a cheerleading management team would stretch the truth this far. Gross margin actually declined from 34.5% in FY01 to 33.0% in FY02. That difference amounts to almost $1 million in gross profit -- not exactly an immaterial figure for a company that reported around $8 million in net income.
Interestingly, the company's gross margin declined even while it improved its mix of higher-margin music sales (which have a gross margin of around 60%). Music sales for the year accounted for 10.2% of total sales, up from 9% in the prior year. If the karaoke device margins had held steady, we should've seen an increase in overall gross margin. The fact that the overall gross margin declined indicates that the device margins must've taken a hit.
I did some back-of-the-envelope math to figure out what the hit to the karaoke device gross margins may have been. Here's what I came up with: If you assume that music margins held steady at 60% for both years, then the device margins must've declined from around 29% to around 27%. The implication for karaoke devices is that either the material input costs are increasing or the average selling prices are decreasing. Neither of these is good.
4) Massive dilution from options
Another black eye on the financials is the large year-over-year increase in diluted shares outstanding. If you look at the diluted shares for Q4 '02 versus the year-earlier quarter, you find that the diluted share base has increased by 13.9%. It's hard for shareholders to earn a decent return when management is diluting the shares at this pace.
Share dilution from options is typically higher for small companies than large companies, but an increase of this level is egregious. Most small companies I look at have share dilution of 2-5%, and anything above 10% is ridiculous. The culprit here is the company's option program. A glance at last year's proxy reveals that in fiscal 2001, Singing Machine issued approximately 675,000 options, or about 9% of the diluted shares as of March 2001. It'll be interesting to see how many options management grants themselves this year when the 2002 proxy is filed sometime later this month.
5) Accounting profits that overstate economic profits
The final flaw in Singing Machine's financials is the fact that cash flow from operations has lagged behind reported net income for each of the past three years. Any time this happens for more than a year, watch out! If net income isn't translating into actual cash, there's a problem. Only cash profits are of any economic significance. In Singing Machine's case, cash from operations over the past three years hasn't even come close to reported net income:
Fiscal Year Net Income Cash from Ops. 2002 $8.07M $2.95M 2001 $4.16M $1.24M 2000 $0.74M -$0.08M
As a result, the company's net income-based P/E ratio looks very low, but cash flow-based valuations are much higher. At the current price of $11.50, and with 8.49 million diluted shares, Singing Machine's market cap is $97.7 million. Relative to its reported net income of $8.1 million, the P/E ratio is only 12.1. But the price-to-cash from operations multiple is 33.1. And if you subtract out capital expenditures from operating cash flow, the price-to-free cash flow ratio is even higher at 41.8. Suddenly, Singing Machine doesn't look so cheap after all, especially when you take into account all the other ugly factors we discussed.
The only way Singing Machine is possibly an attractive investment is if we're in the early stages of a karaoke boom in this country. But I don't see it. Not with Best Buy running sales on its karaoke boxes.
This is the type of company that I'd seriously consider shorting. Do beware, however, because the stock is already heavily shorted. With 9.7% of the float short, the stock's short ratio (the number of days it would take to cover all the shorted shares) is almost 10, which is pretty high. Many highly shorted companies end up falling very far, but a highly shorted company does open you up to the potential of a short squeeze.
As I suggested in my earlier article on the company, this stock is probably best left alone.
Matt Richey is a senior investment analyst for The Motley Fool. At the time of publication, he 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.