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Summary

  • Emerson Radio was a buy because of the likelihood of growth and profits in a company trading below cash.
  • However, the latest earnings report compromised both growth and profits.
  • As such, I have turned temporarily neutral on Emerson Radio.

Not so long ago, I wrote a positive article on Emerson Radio (NYSEMKT:MSN). The long thesis I presented revolved around 3 factors:

  • Emerson Radio being a profitable company;
  • The stock trading below the cash in the balance sheet;
  • And importantly, the fact the company was about to turn into a growing company in the very short term. This was due to the fact that revenue was dropping by less, year-on-year, than what the company was losing from ending sales of discontinued products. And this effect was just 2 quarters away from disappearing.

Meanwhile, Wednesday the company reported FQ4 and FY2014 earnings. These were significantly worse than I expected on the revenue front, and somewhat deceiving on the earnings front. Let me explain.

Recap

To understand the problem, it helps to repeat how Emerson Radio produces its revenues and earnings. Emerson basically has two segments:

  • A segment selling its own products with its own brands, making use of OEMs to produce the products ("product sales"). These include wine coolers, small refrigerators, microwave ovens, alarm clocks and small appliances;
  • A segment licensing the use of its brands to third parties ("licensing revenues").

The first segment, selling its own products, has very low margins. As of FQ3, gross margins were just 13.3% of revenues, and for the first 9 months of FY2014, they were just 11.1%. These gross margins, calculated using just "product sales" and cost of sales, were barely enough to cover the remaining operating costs. In my valuation I didn't even consider any value for this segment - I just considered that it would be used to pay the running costs of the company.

The second segment, licensing revenues, has very high margins - indeed, for all purposes, 100% gross margins. It is this segment and the cash in the balance sheet that produce the value of Emerson Radio.

Revenues in FQ4

Emerson Radio reported $14 million in revenues for the quarter, a decrease of $9 million from the same quarter the year before. The quarter the year before included $4.1 million in revenues from discontinued products.

Here, we already have a problem: The logic which stated revenue was about to turn positive is gone. This happened because product revenues continued to fall hard, much harder than during the previous quarter. According to the company, not only were the microwave ovens which had been discontinued a factor, but sales of wine coolers and refrigerators suffered as well. Either way, the drop in revenues exceeded the effect which was expected from the discontinued products, and called into question the thesis that when this effect was over revenues would grow.

Furthermore, what seems to be a positive - the company reported licensing revenue of $2.9 million versus $1.2 million in the same quarter the year before - is actually a negative. Why? Because this $2.9 million number includes a non-recurring amount of $1.8 million in previously unreported and unpaid royalty fees. So the correct comparison is $1.1 million versus $1.2 million the year before, a drop in very important high-margin revenues, due to a drop in sales at the licensees.

Earnings in FQ4

As I showed, in the revenue front, part of the long thesis was already invalidated. A further part of it is invalidated when we look at earnings. Emerson Radio reported a positive EPS $0.04 in the quarter, coming from $0.9 million in net profits.

However, as I have previously said, licensing revenue is very high margin revenue. Indeed, it's 100% margin before tax. And licensing revenues included $1.8 million in non-recurring revenues. This means that the earnings for the quarter without this non-recurring event would have been negative. And there goes another part of the long thesis - the company would no longer be profitable without these non-recurring high-margin revenues!

This happens both due to a drop in revenues, and a drop in gross margins -- the product revenue gross margin in the quarter was just 6%, down from 13.3% the quarter before and 11.1% in the first 9 months of the fiscal year. Due to this, the product margin can no longer sustain the remaining costs of the company.

This would thus create a problem in my valuation, because at these revenue and gross margin levels, part of the licensing revenues would have to be used to pay operating costs (this alone could remove much of the valuation upside).

Things are not so bleak as they seem, though, in the sense that SG&A costs are still inflated by legal costs and ought to go somewhat lower. But still, the conclusion remains: the thesis is at risk.

Anyway, what matters is that this negative development was not entirely evident on first sight because the non-recurring licensing revenues clouded it for this quarter. But in the next quarter, if revenues and gross margins don't improve, this negative development would become readily evident. But for my part, I thought it wise to take the chance to retreat under the cover of the non-recurring high-margin revenues.

Stock below cash

The only part of the thesis which saw some improvement was the one saying that the stock is trading below cash in the books. At $1.80, Emerson Radio has a market capitalization of $52.144 million, already including Series A preferred stock. This compares to cash in the books of $58.5 million, up from the previous quarter's $55.9 million. This happened because as the company saw much lower activity, it recovered cash from running down accounts receivable. Not exactly the best of reasons.

Cash in the books might give Emerson Radio stock some support, but without growth and profits the stock is likely to turn into dead money, losing its potential upside.

Conclusion

The latest Emerson Radio earnings report significantly affects the long thesis on the stock. For now, the reasons to expect a growing and profitable company trading below cash in the books to emerge in short order are compromised.

Furthermore, if the unexpected revenue and gross margin deterioration remain, they'll become much more evident next quarter because of the absence of the non-recurring high-margin licensing revenue which took place in this quarter.

Both growing revenues and earnings are at risk given what Emerson Radio reported. The stock is still trading below cash but that's not enough to ensure upside.

Given these facts, I have dropped my long position in the stock. I will keep monitoring the company to see if the next earnings report reestablishes the possibility of growth and profitability. The next earnings report will be the first where discontinued products no longer affect the previous year's revenues, making for an easier path to growth in revenues.

Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.

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Source: Emerson Radio: Update, Going Neutral

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