IPO

Gibson – Out of Bankruptcy: Now the fun begins

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les paul shotAfter declaring Chapter 11 bankruptcy and parting ways with the sometimes controversial Henry Juszkiewicz, Gibson will emerge from bankruptcy protection on November 1st with a new management team and funding from private investment firm KKR.

It’s safe to say that the future of Gibson the guitar company was never really in doubt. As a brand it is healthy and well-respected, and annual sales of Gibson and associated brands like Epiphone are somewhere in the $300 million range. But while Mr. Juszkiewicz can be credited with taking Gibson from a struggling brand in the 80’s to the giant it is today, his quest to build Gibson into a “lifestyle brand” was also Gibson’s financial undoing.

The Gibson acquisition 1986 was Juszkiewicz’s home run, but nearly every other attempt to build the brand — Stanton, Phillips, Baldwin Piano, Garrison Guitar, Gibson branded restaurants, etc — were essentially financial drags that puffed up the top line, did little to grow the bottom line, and added piles of debt. And when Gibson skipped the 2018 NAMM show and instead attended the CES (Consumer Electronics Show) in Vegas, things had gotten truly weird. In the end, Gibson’s bonds were rated at near junk status, and the “lifestyle brand” was brought down by what kills most distressed companies: They ran out of money to pay their debts.

With KKR funding and shedding some of the under-performing dead weight, Gibson guitars and Gibson Pro Audio will enter a new chapter of ownership, and has recently announced their new management team. You can read about the new team here: https://tiny.cc/wzsi0y

It would appear that things are looking up for Gibson: They have a great brand, loyal customers, formidable financial resources, and if you look past the buzzword-gibberish of their resumes, a capable management team. But their are some things to watch for with the New Gibson.

KKR is a Private Equity (PE) firm, meaning that they have their own funding to invest with, and are not a publicly traded company. PE firms tend to target companies that they believe are under-valued, with the goal of increasing their financial worth, and selling them at a profit down the road. PE firms are typically not in it for the long haul. They want to get their initial investment back, and hopefully drive up the value for a future sale.

So while the new CEO professes to be a personal fan of Gibson guitars — make no mistake — this is about making money, and preferably quickly. PE firms are not touchy-feely organizations, and they are not always particularly patient. There will be plenty of pressure to perform and create solid financial returns. Hopefully, they will do this by making great guitars that musicians love and want to purchase. But this is not a labor of love, and at some point KKR will want to recoup their investment.

From personal experience, one of the tricky things about Gibson is the steadfast traditionalism of their fan base. In contrast to Fender, Gibson fans have less tolerance for deviating from tradition (no Gibson “Parallel Universe” guitar, that’s for sure). Silly things like robo-tuners aside, Gibson fans push back rather swiftly — sometimes even making personal YouTube complaint videos — when they feel that Gibson has strayed off course. So when the new management team talks about “innovation” they have to keep in mind that their core customer may not be looking for something different. Technology has revolutionized recording, pro audio and even guitar amplifiers, but guitar players tend to like their instruments just as they’ve always been, and are slow to change.

Also, while the internet is a powerful selling tool, many guitar players still like to have a personal shopping experience. The “old” Gibson made it pretty much impossible for smaller stores to do business with them, and put all their chips in with major big box and internet retailers. While Sweetwater is the major exception, most of the big internet retailers don’t know the product well, frequently have inaccurate descriptions, pricing and sometimes even the wrong photos. You do yourself no favors when your chosen retail channel does not know what they are talking about. Feeling good about where you bought the product is part of the ownership experience (premium car brands focus intently on this aspect of the sales process)

So best wishes to the new Gibson management team. The music business really is different and more emotionally-linked than other products. Guitar Center and Mars Music were supposed to be the future of music retail. Mars folded eons ago, and Guitar Center has struggled for years to turn a profit (they are also in junk bond territory and routinely flirt with insolvency). The great thing about selling musical instruments is that it’s not like selling blue jeans, and a great many of our customers are emotionally invested in the product. Let’s hope they take that into consideration.

Fender: 25 Years at the Ensenada Factory

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We sometimes like to take pleasure in kicking the big guys when they are down. GM, Goldman Sachs, Microsoft…the Yankees. Seeing the seemingly invincible struggle sometimes makes us little guys feel better. In the world of guitars, certainly the two electric heavyweights Fender and Gibson have had their share of troubles. Fender has been in headlines for their struggling profitability and the much publicized IPO that never happened (probably because the Private Equity people realized that the stock value just wasn’t there). Gibson of course hit the papers with their government raid and fines related to the improper importation of restricted hardwoods. I still maintain that if everyone else in the industry can manage to buy fingerboards legally, then Gibson most likely was doing something not kosher. Also there’s just something about a $3500 guitar with lacquer drips, but that’s for another day.

Fender however recently hit a real milestone with the 25th anniversary of their manufacturing facility in Ensenada, Mexico. What is so great you say about celebrating a factory that makes guitars in Mexico rather than in the USA? The importance of the Fender Ensenada factory is that over two decades ago Fender realized that as global competition would continue to drive manufacturing to low cost countries, that is was better to control their destiny rather than subcontract it. The Fender factory in Mexico now employs over 1000 people and occupies over a quarter million square feet, turning out electric guitars, acoustics, and amplifiers.

It would be nice to think that this manufacturing could have stayed in the US, but by nature guitar making is labor intensive. And with 80% of the worlds guitar market being under $600, nearly all this market is going to be fulfilled by suppliers in low cost countries. In a recent Music Trades article about the Fender plant, it was pointed out that in 1990 China produced 0% of the world’s guitars. Now China produces over 70% of the world’s guitars, but only 45% of the total market value. In other words, they make a boatload of inexpensive guitars. And most of these China factories don’t have names that we would recognize. They are contract manufacturers that produce guitars and then brand them with names that we do recognize. This is how much of the consumer product world works, but it’s hardly the image we like to have of guitar making as a craft.

Fender deserves a lot of credit for investing to maintain control over their intellectual property, their manufacturing processes, designs, materials and product quality. Building a factory is a huge undertaking, and it would have been much less expensive for Fender to just find a factory to build their designs. However, when we stop manufacturing, we also lose touch with the skills and technology to actually create the product. Product designers who know how their designs are made invariably design better products. Take a guitar pickup for example: Here is a product where several companies can take the same wire, magnets and bobbins but all get different results. It’s the process of making the pickup as much as it is the actual design. When manufacturers and designers work together, products and quality naturally improve at a faster rate. The pace of product development increases too, and it takes less time to bring a new product to market. Although the factory is in Mexico, it’s a day trip from the Fender HQ in Arizona. They are in the same time zone and the same continent, and it makes a difference.

As a lot of people already know and appreciate, a “MIM” (Made in Mexico) Fender is a good quality product. It’s not a cheap guitar; it’s a guitar that delivers top value for the price point. As the factory continues to increase its capabilities, the price point and value of the MIM products  will continue to rise. From the standpoint of brand equity, the Fender MIM products are largely embraced by the guitar playing public, and while some would rather be playing a true USA Fender, nobody is being done a disservice by playing an Ensenada product.

Whether it is Foxconn producing the iPad or whoever actually makes Nike footwear, there is increasing separation between the creators of products and the manufacturers of the products. Some pundits will argue that owning the design is the only true value, and that manufacturing is strictly a matter of finding the lowest cost source. That’s how we get Barbie Dolls with lead paint, and why it’s hard to buy a Toaster Oven that will last more than three years. Guitars are not appliances or toys, and should not be built that way.

Fender has its share of troubles, and for some purists the only real Fender guitars are those made before 1965 when a man named Leo ran the company. But for people of normal means, Fender Ensenada products are the pathway to owning what are arguably the most recognizable shapes in rock and roll. Kudos to Fender for keeping the dream of rock and roll alive.

The Fender IPO – Good News for Guitarists?

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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.