Wednesday, March 14, 2007

Reviewing an idea gone wrong: Madacy Entertainment

Today, Madacy reported very disappointing Q4 earnings. This has been a large holding of mine for over a year now, and one on which I have been dead wrong. I still believe the name is trading at an attractive valuation (about 3.5x EBIDTA), but am more concerned now about the long-term prospects than I was one year ago. This is one of the few ideas I've sourced from valueinvestorsclub that has gone sour.

Madacy entertainment is the largest seller of discount music. Have you ever been to Wal-mart and seen oldies compilation CDs selling for $5 or $6? Chances are its a Madacy product. The company is the exclusive discount music distributor for Best Buy, and takes up most the shelf in Wal-mart and other big music stores. I bought at about $5.60, when the stock had a 19% dividend yield and was experiencing double digit growth in revenue and profits. It had been beaten down due to concerns over recorded music, but I was comfortable with the risk for several reasons:
1) Madacy's target customer is 50 year old women. I did not expect them to be flocking to the internet anytime soon to download music.
2) Madacy has been gaining share in its market
3) Profit margins for these products are very high for retailers vs. traditional music. For this reason, I did not expect them to cut floor space.
4) Despite negative trends in recorded music over the last couple eyars, sales were increasing
5) Management had been a large buyer of shares on the way down, and owned about 40% of the company.

So, what has changed?
A few months ago, Madacy reported abysmal Q2 earnings. Wal-mart, their largest customer, was attempting to reduce inventory on-hand, and as such had not ordered product from Madacy in over a month. In addition, they received massive returns on existing products. THe income trust structure requires Madacy to pay most of its income as dividends. With little cash in the bank, Madacy had nothing to pay its dividend with, and went in violation of its banking covenents. The stock dropped over 65%.

I viewed this largely as a one-time issue and an excellent buying opportunity, though I was of course rattled. Despite a decrease in sales (remember, Madacy sells to the reatilers, not to the public), actual retails sales had increased during the quarter. Companies were selling through existing inventory rather than purchasing more from madacy, resulting in this discrepency. Management again was aggressive buyers of shares. If this was truly a one time blip, and the company could re-instate dividends, then the stock would have yieled about 60% in annual dividends from these lows!

The stock has bounced about 33% from its lows. I recently took some profits just before this most recent announcement, which suggests material weakness in the business. Q4 revenues were down 15% YoY, and EBIDTA was down 38%. Madacy is selling lower margin product, and selling less of it.

What to do from here
I still believe a return to prior levels is feasible. A 5x EBIDTA mutliple,which seems reasonable, would have the name trading about 40% higher. That said, I am afraid that the name will continued to get dragged down by the digital music revolution, even though sales of its products (at least until this quarter) appeared strong. I will be listening to the conference call later this week, and likely re-evaluate from there. These have been ugly the last couple years, and I expect this on to be no exception. Mostly likely, I will be cutting my position down to something more appropriate to the new risk profile, and would consider adding on substantial weakness.

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