In my analytical career, there is a laundry list of things I have studied for investment purposes, including such topics as life insurance, cement, pet products, pension accounting, high speed disc couplings, polymers, mattresses, and urea. So it has only been with undisguised glee that I have welcomed the Fender Musical Instruments Prospectus into my life this week in preparation for the company’s IPO which is likely to debut shortly.

Before I go any further, let me disclose some conflicts of interest. I play guitar and have a substantial personal investment in Fender guitars and amps. If you look carefully you will also notice all Cove Street Capital presentation material is based on the Fender guitar 1960 color chart. There is nothing I would desire more than to have a big, fat, and profitable investment position in Fender, make a lot of money…oh, and coast into a variety of cool music events sponsored by Fender and get discounts at the custom shop. That, my friends, would be good living.

But alas, I fear that is not going to happen at the expected IPO price of “$13 to $15.” That would value Fender at something close to 9.5 times trailing EBITDA, 16 times free cash flow, and on our math something close to 19 times unadjusted earnings, which is very pricey for what truly is an iconic brand in a truly lousy industry. This is a stock that is being sold by private investors under circumstances which are less than ideal in many ways and in the words of the great guitarist Nigel Tufnel, this stock is going to 11…and lower.

I will begin with the positives. Fender is Fender is Fender. It is the largest guitar maker in the world and as the management team will breathlessly and ceaselessly tell you, it has an illustrious history and has been—and still is—associated with some of the greatest musicians in the world. Put that brand in a time capsule and wake it up 25 years from now—it will still be Fender and it will still be coveted by guitar players. One of the many oddities of this industry is that despite a propensity for pink and green hair, vivid tattoos and liberal attitude towards cross-dressing, it is actually suburban in its attitude toward equipment. Take the 19-year-old out of the garage and give him a $25,000 signing bonus, and the odds are pretty good that he will be coming home that day with an expensive Fender or Gibson. (Think Mercedes and BMW.) While you can see hundreds of thousands of square feet of visual and actual innovation at the annual NAMM show—the trade show of the musical instrument industry—the truth is that dollar sales of Fender and Gibson dwarf the collective rest and you would be amazed at how many companies exist simply to make better copies of the two top dogs’ equipment.

I will also give a nod to CEO Larry Thomas. Larry was yet another failed musician who started working at a guitar store and wound up building Guitar Center, which he brilliantly took public, grew, turned over to the next generation and profited handsomely from when it was sold to private equity in 2007 at a top-of-cycle price. (Ask Mitt Romney how that Bain investment is going!) He obviously has good public CEO experience and talks an excellent game about “the brand and the vision.” His pitch is simple: Fender is a continued leader in musical instruments and represents an untapped aspirational lifestyle brand that could achieve 6 percent long term topline growth, 8 to 10 percent EBITDA margins and 15 percent EPS growth. That roughly suggests $1.20 in earnings using a 35 percent tax rate in 2015 and if you slap on a 12x multiple, you would be in the ballpark of a $14 IPO target.

But here, in bullet point format, is what I think the company is prudently not saying during the roadshow:

• The musical industry business is simply a lousy business. This company has 6.5 percent EBITDA margins and it aspires to 8 to 10 percent on a good day. That is not quite Harley Davidson caliber profitability (20 percent EBITDA margins), which the company touts as a brand comp. While this might be cruel, I would say the proper comparison is Callaway Golf, which has a highly respected brand and comes up with dozens of new products a year that capture people’s fancy but still has a tough time making money.
• Part of the profitability issue is that the company is almost as much of a distributor as it is a manufacturer or brand licensor. Some 30 percent of the business is non-Fender musical instruments distribution bought as Kaman Instruments and listed as a separate segment. The business was lousy under Kaman and it doesn’t seem much better now. Distribution is lower margin and a very tough business in musical instruments. There is also a complicated transition going on in distribution, as 60 percent of sales are to “independent retailers,” which are struggling. In Fender’s filings there are consistent references to “gross versus net sales,” with the former including “product returns and cash discounts” as well as “sales returns and rebates.” These are not insidious issues; these represent the costs of doing business with thousands of moms and pops globally as they still are the lifeblood of the industry. That said, distribution is in a state of flux. Online is taking huge retail share, which effects pricing strategies. Fender management hints at change and more of a direct model but it is not clear how this shakes out over time. If being a premium branded instrument maker is hard, much of the rest of this world is in perpetual misery.
• While Fender should be commended for being very early in partaking in the outsourcing game—having established its Ensenada division 20 years ago—the company’s foresight also means that there is a not an obvious cost take-out story here. Almost everything but the high-end guitars are made in Mexico and through an odd manufacturing structure in which OEM’s (original equipment manufacturers) are commissioned all over Asia to produce product. While conceptually providing flexibility to pivot around changes in labor costs (which is actually a live and present issue), there remain quality issues both in the guitars that I have held in my hand and the 11,000 noted in the prospectus as “rejected due to quality standards.” Hello eBay!
• Speaking of eBay and why this is a tough business, if you have almost any idea what you are doing and don’t have money to burn, buying a used guitar is ridiculously attractive versus a new purchase. To put it lightly, this is a huge issue for the manufacturers. At first glance, I count 5100 Fender guitars for sale through eBay auctions, a number that I will use as a proxy for used guitar inventory. In addition, investors cannot forget that Craigslist is another big source of supply. The point is that much of this industry’s products are not “consumed”—they get recycled—and thus the real topline growth is small. You can also insert your favorite joke here about the end customer. (How do you get the guitar player off your porch? Pay him for the pizza.)
• Fender has done a superb job of putting out product for every segment of the market, with prices ranging from $99 to $25,000…and that’s a problem going forward. The conceptually simple task embodied by the statement “I want to buy a Fender Stratocaster,” is the equivalent of walking into CVS with a cold and saying, “I would like to buy cough medicine.” There are dozens and dozens of very similar models and I would argue that there is utter saturation from the perspective of the consumer as well as very few untapped growth niches left, particularly in guitars. As such, I seriously doubt the Fender growth story. Management is touting international expansion, but again, I have a tough time with the “if every teenager with a garage in China bought a guitar” story. Fender has been an international brand for 40 years.
• Acquisitions are touted as a growth avenue but there is no doubt that if Fender opened its checkbook, 75 percent of the manufacturers would run to the glass door and pound to get a piece. Their idea is that Fender has global distribution capabilities and can thus take a small, struggling brand and run it though the network. However, it is not clear that Fender would not simply be buying more low-margin products.
• On top of all the rest, Fender has leverage. A $14 stock price with fully diluted shares of $26.3mm suggests a $368mm market cap. When you include the $154mm of debt, the enterprise value should be about $522mm. Trailing EBITDA is $55mm, implying a multiple that is on the north end of comfortable leverage. This is clearly something to watch carefully if the world experiences more economic problems.
• Like playing golf, playing an instrument is hard and takes a lot of time. I will also throw into the secular mix an argument that youth today has a lot of competing demands on time in the electronic age and there is not as much time spent by 14 year olds sitting in their rooms noodling for 8 hours a day. I would also argue that Fender is also weak or non-existent in “digital.”
• I have a nagging suspicion that part of what makes this industry lousy is that you are constantly faced with fabulously cool opportunities to spend money. Yes, you need to spend and support the brand, but there is always temptation to do more and the question arises regarding where it ends. Who wouldn’t want to have expensive company owned showrooms in California, London and Shanghai? Who wouldn’t want to sponsor cool events and hobnob with artists? How can you say no to Eric Clapton if he told you to ship 10 guitars to this hotel by FedEx tomorrow? Part of the Artist Program is simply core and necessary marketing. For instance, the elapsed time between seeing Jeff Beck at the House of Blues and my ownership of a sea-foam green Stratocaster was “daytradingly” small. But my sense is the business model constantly errs toward higher spending.
• This is the first company I have personally seen file under “emerging growth company” status, an exemption of sorts that happens to be the latest of many really dumb ideas to emerge from Washington that attempt to stimulate business growth. What an investor really needs is less corporate governance and disclosure on a new public company without a long track record to evaluate. Thank you!

“We are an “emerging growth company,” as defined in the JOBS Act. For as long as we are an “emerging growth company,” we may take advantage of certain exemptions from various reporting requirements that are applicable to other public companies that are not emerging growth companies,” including, but not limited to, not being required to comply with the auditor attestation requirements of Section 404(b) of the Sarbanes- Oxley Act, reduced disclosure obligations regarding executive compensation in our periodic reports and proxy statements, and exemptions from the requirements of holding advisory “say-on-pay” votes on executive compensation and shareholder advisory votes on golden parachute compensation. Under the JOBS Act, we will remain an “emerging growth company” until the earliest of: the last day of the fiscal year during which we have total annual gross revenues of $1 billion or more; the last day of the fiscal year following the fifth anniversary of the completion of this offering; the date on which we have, during previous three-year period, issued more than $1 billion in non-convertible debt; and the date on which we are deemed to be a “large accelerated filer” under the Securities Exchange Act of 1934, or the Exchange Act. We will qualify as a large accelerated filer as of the first day of the first fiscal year after we have (i) more than$700 million in outstanding common equity held by our non- affiliates and (ii) been public for at least 12 months. The value of our outstanding common equity will be measured each year on the last day of our second fiscal quarter.”

• Never trust reported earnings, but within that also note a $4mm decrease in depreciation and amortization over two years, an amount that neatly boosts current numbers before the IPO.
• Near term issues noted in the prospectus: Europe represents 20 percent of sales; 17 percent of sales are attributable to Guitar Center (which was just downgraded to CCC and might be an issue worth watching); the lack of well defined compensation targets for senior execs; and a “$34mm backlog” of sales stemming from the bankruptcy of paint supplier to the custom shop—are those real sales?
• 58 percent of the shares outstanding will be held by the selling private equity firm and I have noticed a distinct discount accorded to stocks with the overhang issue.

There is a pretty good rule of thumb (that bewilderingly was new news to the participants in the Facebook IPO) that unless you are in the lucky gene pool, if you can get shares of an IPO, you don’t want them. I think this is exactly the case here. Fender has been rumored to have been shopped unmercifully with no takers over the past few years, and the company has to do something in regard to the ticking of both the private equity timetable as well as the substantial leverage. That is compelling logic for the seller, not the buyer. As a value manager, there is a price for most things for which you are being paid to accept risk, and in this case that is a single digit number.

On a last note, what represent better value are “pre-CBS” Fender guitars. These were made prior to 1965—when CBS bought Fender—and a minty specimen can command up to $50,000. Prices are down materially since 2008, and I would argue that these are beachfront property—whereas the 49th anniversary Fender blah blah, the Keith Urban model, or yet ANOTHER custom shop piece are not.

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