The Fender IPO – Good News for Guitarists?

The announcement this past week that Fender is releasing its Initial Public Offering¬† may sound like the American Dream come true. After all, isn’t it the goal of every company to someday go public and cash in big? That’s the image of an IPO anyway. However, not all IPO’s are glamorous get rich stories, and the numbers behind the Fender IPO are not all that rosy.

Disclosure: I am not a professional financial analysis, these are just my own observations from my experience in business over the past 25 years.

In rough terms, Fender had $700 million in sales in 2011 and a net profit of $19M. That’s an improvement from 2010 when the company posted a $1.7M loss. But a net profit of $19M on sales of $700M is a return of only 2.7%. If a 2.7% profit ratio sounds rather unexciting, that’s because it is. Whether private or public, a 2.7% profit ratio is concerning. In a private company while there might be pressure from an investor group (if there is one) their is are requirements to make the company’s performance public. Actually, the financial performance of many privately held companies may not be that great in Wall Street terms. To do some degree if the boss is happy, then everybody is happy. The true financial performance is known only to the person or group that controls the company

Once the company goes public, the financial performance is there for all to see, and of course stock price is closely tied to financial performance. Going public is a great way to raise capital, but the company is obliged to show its dirt laundry. How many investors can you attract with a 2.7% net profit, unless you have plans to do much better. And soon, because it’s Wall Street and they hate to wait.

The second issue with the Fender IPO is debt. The company has $700M in sales, but also about $240M in debt. The stated goal of this IPO is to pay down about $100M in debt, and the balance is for operating capital. There are a couple concerns with this: First, that’s a pretty high debt ratio, and as with any debt there are interest payments on the debt. Also, if the company is selling stock to raise additional operating capital, it could have a cash flow problem too. Cash flow essentially is: Are you taking in money fast enough to cover what you are paying out every month. Debt servicing costs, high inventories, and of course the pace of sales can all have dramatic affects on cash flow. It’s good to sell lots of stuff, but it’s cash flow that determines whether a company lives or dies.

The third factor is the role of Private Equity Capital (PE), in this case an organization called Weston Presidio. Weston Presidio is a major investor in Fender, with about a 40% ownership prior to the IPO, and plans are to retain a similar level of ownership afterward. Weston Presidio is not in the music business. They invest in everything from Restaurant Chains to Movie Theaters to Fender. The goal is to invest in a company, “help” it become more profitable, and then exit that company hopefully at a substantial gain. It’s not very romantic, but if done properly the investors make a lot of money.

Being “helped” can sometimes cause the company being invested in quite a lot of pain. Often a PE group will buy into a company with some amount of their own cash, and money they have borrowed. Once they have control of the company, the company will borrow money to pay the PE group back, effectively putting the company in debt. This is the classic case of Guitar Center, which was bought by Bain Capital and is now loaded with over a billion in debt. Guitar Center loses money every quarter because the cost of debt servicing wipes out its profits. Here is what Moody’s said about Guitar Center last May, “A Moody’s analyst concluded that growth in sales, comparable store sales, and profits will not be sufficient to trim the company’s approximately $1.6 billion debt load to a more manageable level.” ¬† So while I don’t know for certain, part of Fender’s debt could be a by-product of Weston Presidio’s involvement. Companies may seek out PE because they need cash to fund R&D, expand their product lines, or maybe the founder just wants to sell out and go fishing. But PE companies are rarely in it for the long haul, the desire to cash out at a profit in 3-5 years can place an enormous amount of stress on the company.

One last quick measurement of a company’s overall health is their revenue dollars per employee (Total Sales/Number of Employees). A good rule of thumb for both manufacturing and retail organizations is a number somewhere in the range of $300 – $400K. If it is a privately held company, the Revenue per Employee (RPE) number can be substantially lower as long as the major stake holders are in agreement on the definition of success. However if the company is publicly traded, Revenue per Employee — and more importantly Earnings per Share — are critical metrics. Publicly traded companies are all competing for investor dollars, and weak performance metrics makes it hard to attract investors and depresses the stock price. Using 2010 data, Fender’s RPE was $223K. Gibson’s is even more worrisome at $99K, while some Pro Audio companies like Harmon and Audio Technica are $331K and $556K respectively. Of course we are not taking margin into consideration. If you have very high margins you can be financially successful with a lower RPE (because you keep more of each dollar you earn). Still, a low RPE is not a good sign, and Fender’s 2011 net income of $19M strongly suggest that they have a problem with margins, debt, overhead, or some combination of the three.

WHAT DOES THE FUTURE HOLD FOR FENDER AS A PUBLIC COMPANY?

Fender has some strong assets: Good market share, tremendous brand recognition, famous artists that endorse their product, and two of the most classic guitar shapes in history. But it’s clear that they are not that financially healthy. It’s likely that conditions will improve as the economy continues to strengthen, but they have basic issues of profitability and long term debt. Weston Presidio likely wants to get out in the near future — at a profit — which means that the company needs to be attractive to investors so that people will want to buy stock. To compete for investor dollars Fender will have to demonstrate that they can increase their profitability: Lowering costs, raising prices, and/or reducing debt. Increasing sales will help too, provided that sales can be increased without increasing fixed costs. It’s that simple. People invest in company stock because they they think the value of the company will increase. The big question for music lovers is whether increasing shareholder value result in better product. All options are likely on the table: Outsource more products to low cost countries, use less expensive materials, raise prices, or sell off under performing brands (Guild, Charvel, Hamer, etc). Some Guitar-Loving White Knight could always come to rescue and infuse Fender with both cash and a love for the products and the company history. Or a group of demanding investors could force the company to implement severe cost cutting measures in order to improve profits and increase stock value. Unfortunately, the latter scenario is more likely, since if there was a White Knight with deep pockets, Fender would have not needed to go public in the first place. Let’s all hope for the best, but even for the optimists the prognosis is lukewarm.