[Member] Klipsch Earning Power has Moat – A Good Acquisition – Part 3

This is a past Premium recommendation and is made available for your reference. For more past trades, refer to our trade history.

For this analysis, you might find it useful to refer to the accompanying 8-KA that Audiovox published. This document provides audited financial statements for Klipsch for the last 3 fiscal years as well as the Proforma statements for the first 8 months ending Feb 28 2011 and comparable period in FY 2010.

This document also has a proforma combined financials for Audiovox and Klipsch. This is essentially management’s attempt to combine these 2 companies on a line item basis and while it should not be viewed as a template for the combined company going forward, it might be quite instructive to look at the combined balance sheet to get a full picture of the assets and liabilities the company is taking forward.

Download the 8-KA here

Analyzing Klipsch Operating Performance

If you review the Klipsch financials, you will notice that there are 2 extraordinary expenses. Klipsch underwent extensive restructuring in 2009, mostly in its European operations and as a result it incurred significant restructuring expenses. You should see an expense of $5.7 M in 2009 and $1.05 M in 2010 for restructuring. The other atypical expense (benefit) is for the income tax.

To smooth out the effects of these “one off” charges, we need to make some adjustments to the income statement. This will give us a truer picture of Klipsch business.

Rather than just take out the restructuring charges, I have assumed that the company needs to undergo some level of restructuring every 7 years. Ideally the company continues to streamline its operations continuously so I have spread out these restructuring charges over 7 years.

For the income tax provision, I have just averaged the amounts for the 3 years and adjusted the annual P&L to use this average number instead of the actuals they have used.

With the adjustments in place, Klipsch P&L looks like this:

Adjusted for Restructuring and Income Tax effects 2011
(8 mths)
2010
(8 mths)
2010 2009 2008 Average
Revenues $ 120 $ 113 $ 162 $ 169 $ 224
Gross Margin $ 52 $ 51 $ 75 $ 76 $ 104
Net Income (reported) $ 6 $ 20 $ 23 $ (18) $ 4
Net Income Adjusted $ 12 $ 13 $ 19 $ (3) $ 7
Gross Margin 43% 46% 46% 45% 46% 46%
Net Profit Margin (adj) 10% 12% 12% -2% 3% 4%
ROE (adj) 28% 59% 85% -8% 16% 31%

As you will notice, Klipsch has consistently generated 45%-46% in gross margin and has averaged 4% in net profit margin or about 10% in net profit margin since the restructuring was completed.

Compare this to Audiovox operations below

VOXX Margins 2011 2010 2009 2008 Average
Gross 23% 21% 18% 20% 20%
Net 4% 4% -12% 1% -1%
ROE 6% 7% -17% 2% 0%

This just goes on to show you that playing in a premium market, even in the same industry, can be very profitable :-). This is not always the case – Ford always had trouble with their Premier Automotive Group and had to dispose off many of their brands, but if a company can develop a brand with loyal following and carve out a moat for itself than it can operate a very profitable business.

So while Audiovox has been performing reasonably well, Klipsch acquisition will add a line of business which is highly profitable.

The question is, how much is this business worth.

Analyzing the Acquisition

Ultimately it all boils down to the cash flow. In this case, we can take a very high level picture of the cash flow for the transaction itself (for the moment we will ignore synergies due to acquisition and all that fuzzy stuff).

Audiovox paid $166 Million for the acquisition, of which $87 Million was financed at Libor + Libor margin that varies between 2.25% and 2.75% based on the collateral. For this analysis, we will be brutally conservative and assume the highest rate. Since 1 yr Libor rate is currently at 0.74%, we will work with 3.5% interest rate on the financed portion of the acquisition capital.

We will also assume a no-growth scenario for Klipsch business. Which means we will use $19 M in net income (as a proxy for free cash flow) per year.

With this, the cash flow this year looks like this:

Acquisition Cost

  • Own Cash: $79 M
  • Financed: $87 M

Cash Flow

  • Inflow (Klipsch Net Income): $19 M
  • Outflow (Interest Payment on financing): 3.5% * 87 = $3.045M
  • Total Return this year: $15.955 M

While it may be very tempting to project out to 5 or 10 years, it is not very helpful as you bring in many unknowns that will make any such projections inaccurate. For this exercise, all we can say for certainty is that Audiovox invested $79 M of its own (shareholder’s) money to generate $15.955 M or 20% in returns for this and foreseeable future.

As far as investments go, a 20% return is very respectable. If Audiovox is able to create synergies and reduce expenses, or if the company is able to grow from here, the annual return on investment becomes better than 20%. Also to be noted that as Audiovox pays down the debt, its interest payments will decline and the returns will go up although this benefit is quite minor.

So to summarize:

  • Audiovox was an attractive value before it purchased Klipsch, with market value less than its Net Current Asset Value
  • The Klipsch acquisition is an attractive investment of its unused cash that will create value for the shareholders
  • With the latest quarterly report in line with company expectations, Audiovox is on track to realize the returns it expects on its investment

At this point I will rate Audiovox stock as a Buy and value the shares at at least its NCAV, which is $233 M or $10 per share. Any price below $10 is a great buy.

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