Will a Fender Investment Strum a Positive Chord in Your Portfolio?
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Following a clearing up of Facebook’s (NASDAQ: FB) IPO debacle – the stock has recently risen nearly 30% from its post-IPO low – there are now a slew of other enterprises with enough confidence to offer their own shares on the public market. In addition to online travel search engine Kayak Software and network-security firm Palo Alto Networks Inc., iconic guitar and other musical instrument manufacturer Fender has recently set the price of its soon-to-be offered shares. Is it worth looking into?
Company & IPO Information
Fender has had an eventful 66-year operating history. Founded in the mid-1940s by Leo Fender, the corporation was eventually acquired by CBS (NYSE: CBS) twenty years later. Put through a series of massive cost cuts and placed alongside other uncomplimentary firms during CBS’s acquisition streak (also included the New York Yankees in 1964), Fender’s image for quality took a huge hit from a prolonged era of uncharacteristically shoddy products. Fender company management eventually bought out the enterprise in 1985, revitalized the brand, and sold nearly half of the firm to private equity firm Weston Presidio in the early 2000s.
Finally jumping into the public arena, Fender will be selling 10.71 million shares – 7.1 million issued by Fender and 3.6 million from Weston Presidio’s 42% ownership stake. With an estimated per share price target between $13-$15, the corporation hopes to raise as much as $160.7 million and plans to use the majority of the proceeds to pay down its ~$247 million debt burden. Total leverage should be reduced from around 4.7x EBITDA to 3.2x EBITDA (both trailing twelve months) following the debt payment.
Products & Distribution
Fender is obviously known best for its long history of outfitting musicians with quality electric, acoustic, and bass guitars, but the large breadth of its total product portfolio is rather surprising. After acquiring Kaman Music in 2007, the corporation was ample to rapidly expand with the added Jackson, Guild, Ovation, Gretsch, Eddie Van Halen, and Takamine brands. Fender’s portfolio of fretted instruments, amps, percussion instruments, and accessories (strings, picks, cables, straps, etc.) now caters to beginner and professional musicians alike with price points from below $200 to the mid-$20,000s.
Fender’s finished product is distributed to end-consumers through a variety of channels. Nearly 60% of the corporation’s sales are derived from its independent channel, which is comprised of more than 13,000 smaller and independently owned music stores. Another 25% is pushed through larger retailers and the corporation’s own direct channel online. Large, multi-unit musical instrument retailers like Guitar Center (which itself represented around 15.5% of sales over the past three years) and Sam Ash comprise the bulk of this secondary channel, although other big box names including Costco (NASDAQ: COST) and Best Buy (NYSE: BBY), which began rolling out in-store music centers nearly five years ago, do push product to more amateur consumers. The remainder of the corporation’s sales, especially in emerging markets where Fender has a small but growing presence, are driven by a distributor channel whereby equipment wholesalers sell products to smaller instrument retailers.
Fender’s past five year operating history does little to build confidence in its shares’ post-IPO performance. Even after moving a significant amount of its production capacity to lower cost countries, the corporation is mildly profitable and runs on extremely slim margins. The rather promising 56% top line jump enjoyed in 2008 was more of a function of integrating Kaman Music into its operations than it was a meaningful market share increase. Likewise, the double-digit expansion of Fender’s revenues in the most recent fiscal year was artificially boosted due to a supply issue with the corporation’s sole paint supplier in its Corona, California manufacturing facility in the prior year. The almost flat top line between 2009 and 2010, driven by a significantly reduced output in the second half of the latter year, was the result.
Controlling around 13% of the total United States instrument market (and closer to 40-45% of the guitar market), Fender’s recent performance echoes the woes that the broader music industry has faced over the past several years. Musical instruments are, for the majority of non-professional consumers, luxury items whose demand mimics the ebbs and flows of the general economy. Source: NAMM (National Association of Music Merchants) Global Report
With close to 50% of its revenues coming from United States-based instrument sales, and another 25+% coming from a very similar European instrument market, the mid-term outlook for Fender’s top line appears to be rather bleak.
Despite the slow demand growth in the corporation’s key markets, there are several exciting growth platforms from which Fender can showcase a positive post-IPO run.
- Emerging Markets: With 25% of its sales coming from non-North American and European markets, there is a huge opportunity for the corporation to grow its business in countries characterized by a faster growing middle class and an increased level of discretionary consumer spending. The continued westernization of the music cultures in key eastern countries like China, India, Indonesia will be the primary driver of higher guitar demand.
- Build Presence Outside Normal Retail Channels: Over the past 66 years, Fender’s distribution tactics have changed very little. It has, of course, picked up several retail partners including big boxes like Costco and Best Buy, and it has infused some direct distribution via online sales into the mix, but for the most part Fender’s products only have a meaningful presence with consumers who actively shop in music instrument outlets. The corporation recent advertising deal with Volkswagen (NASDAQOTH: VLKAY) highlights an exciting shift to Fender’s traditional practices. With the new Beetle Fender Edition, mainstream consumers will get a taste of Fender’s culture and quality products. A guitar-reminiscent woody sunburst dashboard, Fender logos, and a 400-watt, nine-speaker audio system will emblazon Volkswagen’s new ride.
- Licensing and Co-Branding Activities: Despite the huge worldwide awareness for Fender’s iconic brand, licensing activities accounted for less than 1% of its sales in 2011. The corporation currently has non-revenue co-branding initiatives with big names like Apple and Hard Rock Café, and has a huge opportunity in starting to monetize its valuable brand assets through such avenues in the future.
With an IPO price target between $13-$15 per share, Fender can hit the market with a starting value of around $395 million. Based on the corporation’s 2011 earnings of $19 million, investors will be paying more than 20x earnings to be a part of the corporation’s growth story. The idea of an investment in Fender definitely does not sound as good as the musical instruments it produces…
The reasons to stay away from Fender’s IPO build rapidly:
- The corporation is modestly profitable, with a very average return on invested capital in the low teens in the most recent fiscal year (and sub-10% when averaged over the past five years)
- Fender still relies on big box retailers – both music oriented and other general merchandise sellers – for a meaningful portion of its sales. Big box music retailers, like their cousins in the electronics, books, and office supplies categories, are continuing to report very poor results. The six billion dollar retailer category has shown no revenue growth (-0.8%) over the past five years (source: IBISWorld market research).
- There are really no upcoming catalysts that will significantly change Fender’s mid-term growth story. The mature United States and European markets (represent 75% of Fender’s sales) are projected to continue their disturbing stagnation, and a drastically boosted penetration into higher margin emerging markets is not something that happens overnight.
Fender’s guidance for the current August quarter does little to boost short-term confidence in its shares’ performance. Projected revenues between $166-$168 million and net income between $3-$3.4 million compares with $167.7 million in revenues and $3.4 million in net income for the same period in 2011. Prospective investors are better to sit on the sidelines and wait for the inevitable bargain on Fender shares to arise.
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