Here's a little more sordid history:
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An Investment Opinion
by Louis Corrigan
A Spin on K-tel
Speculators in music marketer K-tel International (Nasdaq: KTEL) are still boogeying to Gloria Gaynor's "I Will Survive." They just don't realize it's a tale of heartache. Last night the company announced that third quarter sales fell 11% to $16.4 million, resulting in a loss of $0.24 per share based on 4.08 million current shares outstanding. The really devastating news, though, came from president David Weiner. He said that while it was encouraging that K-tel's new online music store received one million hits in three days, "[T]o achieve further participation in this market will require substantial additional financial resources, development and acquisition of technology, investments in marketing, and contractual relationships with third parties."
Woaaa, baby, guess what? Those things cost a bunch of money that K-tel doesn't have. It seems just a matter of time before this disco duck is plucked, with the feathers used to burst this bubble.
Since April 9, when K-tel announced the May 1 launch of its Web store, the company best known for kitschy compilations of '70s hits has seen its shares dance straight up from $7 to Tuesday's high around $79. A number of factors have fueled this furious rally. Yahoo's terrific first quarter earnings report sent investors scurrying to bid up any and all online businesses. K-tel's small float of about 800,000 shares has made short-sellers susceptible to forced buy-ins with each well-timed press release.
Incredibly, K-tel's Chair/CEO Philip Kives poured on liquid nitro by announcing a laughable 2-for-1 stock split amidst this frenzy. Then the company struck a non-exclusive deal with streaming audio innovators RealNetworks (Nasdaq: RNWK) that will allow customers to create compilation disks based on their own selections. K-tel also signed another non-exclusive deal to use Billboard magazine's hot 100 lists.
Also, what some might view as genuine Internet hype has come from an Austin, Texas outfit called Stock Investor Trading News, which issued two "strong buy" reports via the PRNewswire naming a target price of $100 a share. SITN's "fundamental analyst" Louis Riley is a fairly well-known trader around the Fool message boards. I couldn't access SITN's overall track record posted on its website, but Riley was a vocal Premier Laser (Nasdaq: PLSIA) bull on the Fool's AOL message board when that stock was around $15 last May. It's now at $6. SITN's reports and website carry warnings about the need for investors to do their own research and includes commendable disclosure about their own "long" position. Nonetheless, Riley and company have used K-tel's rise as a chance to publicize their own website and subscription product ($959.95 a year!), even though their argument was absurd.
Too harsh? Consider that the two leading online CD vendors CDNow (Nasdaq: CDNW) and N2K (Nasdaq: NTKI) have literally spent tens of millions of dollars to lease crucial online real estate held by the likes of AOL, Netscape, Yahoo!, etc. Then there are the awesome first-mover advantages of online commerce heavyweight Amazon.com (Nasdaq: AMZN), which has just started selling CDs. Think about the odds against K-tel pulling off a $326 million bond issue! No cash for advertising, no e-commerce traffic. No traffic, no business. Yet Riley has argued that K-tel was cheap compared to these rivals and that the king of music compilations could do well without paying big bucks for such deals. "We think a smart and innovative marketer like K-tel may pioneer more cost-effective ways of capturing eyeballs," he wrote. Weiner is now saying that Riley is wrong. Big surprise.
While the stock's ascent has helped publicize K-tel's website, the sad truth is that aside from a catalog of licensed hits, the company has little to bring to online music sales but its brand name. Whatever it can do, other companies with the eyeball-enhancing real estate and deep pockets can also do. Its name is fairly well-recognized among boomers, but it is a little too associated with kitsch to be very valuable. What would it cost to generate an equally valuable brand from scratch? Maybe $20 million, or about $4.90 per share. So what's the rest of K-tel worth?
Riley has pointed to the company's nicely profitable and fast-growing revenue from music sales. The company's public filings tell a different story. For FY97 ended June 30, K-tel reported $75.5 million in revenue and $3.2 million in net income, or $0.81 a share. A huge chunk of those sales had nothing to do with music. For example, 25% came from the sale of "consumer convenience" products such as low-priced housewares, automotive accessories, and exercise devices. In addition, these earnings weren't adjusted for the new accounting standards requiring options-related compensation to be expensed. Doing so would have produced fully diluted earnings of just $2.76 million, or $0.70 per share.
We also need to back out the $0.85 million K-tel pocketed from a legal settlement. Additionally, due to K-tel's net operating loss (NOLS) carryforwards, the company's reported earnings were taxed at just 6.4%. An investor needs to recalculate the tax to avoid putting an earnings multiple on a fixed tax savings. Roughly, expensing options would have led to pre-tax income of $2.94 million. Subtracting the one-time gain gets us to $2.09 million. Taxing that at 35% gives us $1.36 million, or $0.34 per share, good for uninspiring net margins of 1.8%.
Business did pick up in the first half of FY98 as revenues soared 48% to $48.4 million. However, 70% of the $15.6 million in added sales came from a new media buying and infomercial subsidiary launched in the latter half of FY97. In this business, K-tel collects a fee for buying media services for third parties. As the 10-K says, "media buying revenues carry small margins." Indeed, cost of goods sold (COGS) in this unit were 63% of revenue in the first half of the year, pushing the total COGS to 56% of revenue versus 49% in the first half of FY97. This unit also accounted for most of the 26% real increase in selling, general and administrative expenses (SG&A) in the first half of this year as well as most of the 43% jump in advertising expenses.
The result of a low margin business boosting sales by starting another low margin business was -- surprise -- a bigger, really low margin business. Net income plunged 37% for the first half of FY98 to $1.65 million, or $0.40 a share versus $0.68 for the comparable period of FY97. Taxing the $1.78 million in pretax income at 35% gives us adjusted net income of $1.16 million, or only $0.28 a share. Given that K-tel essentially broke even during the latter half of FY97, this $0.28 adjusted EPS might be a good guess at real, fully taxed annual earnings without the online expenses but with the media-buying unit operating.
Of course, K-tel has now curtailed this lousy infomercial marketing business to focus on the costly new website. Yet based on the above numbers, we might assume adjusted annual EPS of $0.28 to $0.34 and use a P/E multiple between a reasonable 10 and a generous 20 to arrive at $2.80 to $6.80 per share for the ongoing business sans website. Add an undiscounted $0.82 per share to account for the $6.7 million in taxes that the NOLs (as of last June, $16 million U.S. and $3.1 million international) could potentially save K-tel. Now add in $4.90 for the brand/website. The result is a target price of $9.34 to $13.34 per share, or a market cap of $38.1 million to $54.4 million.
That's more than the $27 million K-tel was valued at four weeks ago. Arguably, the Web launch has uncovered some legitimate brand equity that had been undervalued given the possibility of leveraging K-tel's business into a new marketing and sales channel. But these numbers check out pretty well against K-tel's March '97 deal (since scrapped) to sell its worldwide music business except for its European operations to Platinum Entertainment (Nasdaq: PTET) for $35 million. Total U.S. revenues accounted for 63% of FY97 sales. Checking all the numbers, then, it's hardly shocking that K-tel's Weiner sold 16,000 shares of the stock back in February and March when it traded near $8 a share. Unlike the speculators, Weiner seems to be grounded in the realities of the business. >>
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