Handheld Entertainment Inc. Doesn't Stand a Chance: Here's Why

November's best reader idea wasn't a pick; it was a pan. Reader SlimShady [whom I doubt is the real Slim Shady] suggested I take a look at Handheld Entertainment (ZVUE) as a short candidate.

click to enlarge

Hardware

Handheld Entertainment makes inexpensive MP3 and portable video players, trying to carve out the bottom end of a hot retail market dominated by Apple (AAPL) and scads of other well-heeled competitors like SanDisk (SNDK), Toshiba (TOSBF), Microsoft (MSFT), Sony (SNE), Creative Labs, Archos (JXR) and many others. ZVUE is pushing two models this holiday season: PVP-250, a flash-based personal video player retailing for $99.95 and ZP3, a very basic MP3 player that comes preloaded with 30 hit songs and retails for $69.95. Neither unit is going to win any design awards, but C¦Net readers gave the PVP-250 fairly positive reviews.

Handheld sells virtually all of its players at Wal-Mart (WMT), and lists Amazon.com (AMZN) as the only other place to buy its products. Unfortunately, I wasn't able to find any of the products at my local Wal-Mart, and the players are not available on either WalMart.com or Amazon.com. A recent conference call indicates that the product has not been stocked at Walmart.com since at least early November.

For a personal electronics company, product shortages to a top supplier during the key holiday season are a disaster. As this interchange during the conference call's Q&A indicates, ZVUE management is not on top of the problem:

Q: Listen, I have two quick things to cover. One is on the Wal-Mart.com. You don't exist.

A: Yeah, we saw that. We actually just saw that today. We did a while ago, and I believe that we have orders from them. So I don't know why we're not — I don't know why we're not up there.

Q: It was there during the IPO, you're not there now. I even called the local store where I saw you originally as we went into the IPO. You're not there in the showcase, and not that the clerk is going to be that — much of a brain surgeon, but he'd never heard of you.

A: That's possible. And unfortunate, but I know we were another — we're at Wal-Mart in Bentonville, our team made a trip there last week. And spoke with the buyer, and everything was going according to plan. So actually that underscores one of the things that I touched on in the presentation, which is that we need to put most of our emphasis instead of in advertising, for example, to get people in the stores, in doing what's called retail detailing, sending people in stores and making sure we have proper placement. I know we have over the summer we had gone into a number of stores and found that we weren't either properly displayed or there was some confusion about whether or not we were supposed to be in the MP3 case or the portable DVD case. So we're putting a lot more emphasis on just making sure we are displayed properly and that is much more cost-effective, I think, than going through advertising. And now we're going to be in the new MP4 case and that's a great opportunity for us because the value proposition really screams out at you in numerical terms.

Given ZVUE's failure to adequately stock the retail giant that sells 90% of their products, I highly doubt that the company will meet any of the goals it has set. But even if it could, Handheld Entertainment is no baby Apple. Over the next 12 months, ZVUE hopes to sell 75,000 ZP-3 units at a gross margin of 25% and 50,000 PVP-200/250 units at a gross margin of 18%. Multiply out those numbers and you get approximately $1.3 million gross profit on the ZP-3 and $0.9 million gross profit on the PVP models. So if you believe the company's projections, it could generate about $2.2 million in gross profits over the next 12 months. However, ZVUE booked almost $3.4 million in operating expenses last quarter alone. Hardly a recipe for success.

Even those numbers are probably too optimistic. ZVUE's quarterly report didn't show gross profits of 25% or even 18%. Instead, the company reported negative gross margins for the quarter, the year-to-date, the prior year quarter, and the prior year-to-date. Plus, prices and margins in this highly competitive area are far more likely to collapse than expand in the coming year.

Also, even if everything goes well, ZVUE remains hostage to Wal-Mart's continued desire to stock its products. The 10-Q admits:

"We do not have any long term or supply agreement for the sale of our products to Wal-Mart and our business plans are based upon estimates for orders from Wal-Mart that could be inaccurate."

Online

Handheld Entertainment is also trying to compete as an aggregator of online video content. From what I can tell, they are mostly reselling music videos and trying to pinch a small profit off of the goofy videos that are now so popular on YouTube and similar sites. ZVUE did not break out distribution revenues in its 10-Q, but I have no reason to believe they were substantial or profitable. In the past few months, the company has acquired dorks.com [which it believes will be cash flow positive] and funmansion.com. These acquisitions should bring eyeballs, but I don't see them generating much revenue.

Don't expect the ZVUE players to leverage the online business, as Apple has done with its iPod and iTunes music store. ZVUE targets the low end of the market, the segment least likely to purchase online music and other content.

The Stock

ZVUE was brought public on February 10, 2006 via a reverse merger with Vika Corp. As of November 14, 2006, there were 11,424,247 shares outstanding, giving it a market cap just shy of $72M [not including dilution from options and warrants]. The company raised money in a secondary offering this summer, and also just received a $1.4 million one-time payment from settling a trademark dispute with Microsoft. As a result, ZVUE has a few million on the balance sheet. Yet, as the company admits in its 10-Q, that will not be enough to fund operations over the coming year:

"We are seeking additional equity and/or debt financing to sustain our growth strategy. We believe that based on our current cash position, the just completed secondary offering, our borrowing capacity, and our assessment of how potential equity investors will view us, we will be able to continue operations at least through June 2007. It is reasonably possible that we will not be able to obtain sufficient financing to continue operations. Furthermore, any additional equity or convertible debt financing will be dilutive to existing shareholders and may involve preferential rights over common shareholders."

Technically, ZVUE is at an inflection point. After losing over three-quarters of its value, this month it has rocketed higher to retest post-reverse merger highs last seen in February 2006. Trading volume during the recent spike has been enormous, well over a million shares a day since November 14, and two days of over 10 million. Daytraders dominate the stock, but the main beneficiaries of the rise are investors who bought shares in the February 2006 PIPE offering, which just became freely tradeable.

The Verdict

ZVUE management follows a well-worn path of microcaps, promising to take a small chunk of enormous markets. If you think they will succeed, an argument could be made that the shares remain undervalued. I don't. I think this company will never gain traction, will never turn a profit, and is far more likely to return to recent lows than continue skyward. I took a short position between 6.50-6.80, and added a small amount around 6.15.

Disclosure: Author is short ZVUE

UPDATE: Dec. 4, 1:50 PM:

A day after I pointed out the trouble that I and others have found locating ZVUE personal media players in Wal-Mart stores and online, HandHeld Entertainment issues a press release stating that its ZP-3 players would be in Wal-Mart stores starting tomorrow.

Does this mean that distribution issues with Wal-Mart have been resolved? If so, will we see the PVP-250 on Walmart.com? I guess time will tell. The press release raises a few more concerns though.

First, the company just missed out on two of the heaviest shopping weeks of the year. Not a good move.

Second, I don't think $69.95 is a competitive price point for a basic 512MB MP-3 player, even if it is pre-loaded with 30 hit singles. Wal-Mart sells another 512MB MP-3 player for under $25 and Creative's highly rated Muvo100 1GB player for under $50.

Third, for consumers that just bought an overpriced MP-3 player with a handful of songs they may actually like, the company has an even less tantalizing proposition: they get the privilege of buying the videos at the company's online site. Yep, that's the company's strategy to leverage its online properties. Straight from the horse's mouth: "And in addition to the player and the songs, ZVUE MP3 Player owners will also be able to purchase and download the corresponding music videos for each song from our download store at ZVUE.com(TM)."