Handheld Entertainment: Outlook Remains Cloudy

Jul. 5.07 | About: ZVUE Corp. (ZVUE)

Shares of San Francisco based Handheld Entertainment Inc. (OTC:ZVUE) rose 40% Monday, purportedly due to a June 25th comment by Sony Pictures CEO Michael Lynton indicating that Sony Pictures will consider buying an internet company that provides "user-generated content" and has a clearly defined target group (source: Bloomberg/Handelsblatt). Investors apparently dotted the lines between Sony and Handheld; Handheld has a distribution agreement for Sony/BMG's music library and also owns a handful of user generated content sites. In doing so, investors seem to have swept under the rug the deteriorating fundamentals at ZVUE.

ZVUE became a publicly traded company last year through a reverse merger and made a splash on November 14th 2006 with its first quarterly conference call for investors and the announcement of its purchase of Dorks, a user generated content site. The company outlined its dual tracked strategy for revenue generation from hardware sales - Personal Media Players ("PMPs") and Mp3 players - and advertising and content download revenues generated from its content sites. Its hardware, generally priced for the Wal-Mart customer - at the sub-$100 price point, was primed for the 2006 holiday season. The company announced a new version of its PMP player, and also announced an Mp3 player that would come pre-loaded with Sony/BMG top hits from 2006, to be sold in Wal-Mart stores, online at www.walmart.com, and at Inmotion Pictures stores at major U.S. airports. The company's hardware strategy is meant to complement its online strategy by providing users with an inexpensive unit to download content to.

The hardware side of the business has been a challenge for ZVUE. The company has not been able to scale this business, due to significant competition from Apple's (NASDAQ:AAPL) iPod franchise, Microsoft's (NASDAQ:MSFT) Zune products, and a litany of other suppliers of handheld media players. The company's gross margins have floated between negative and essentially breakeven for several quarters, and unit sales are significantly skewed towards the holiday season. Furthermore, Eastech Electronics Inc, Handheld's Taiwanese hardware supplier, has secured rights to Handheld's assets - excluding certain intellectual property items - in the event that Handheld is unable to meet payments, and also has escrow claims on Handheld's receivables, which severely limits ZVUE's financial flexibility.

The user generated content side of the business has not done much better. Aided by capital raised through several private placements in the November '06 to March '07 time frame, ZVUE went on a buying spree, tucking in content properties that they hoped would lead to advertising based revenues. Despite the dramatic rise in reported monthly unique visitor traffic resulting from these newly purchased properties, ZVUE was only able to generate $77,000 in advertising revenue in Q1 2007.

Here's where the picture gets cloudy. Management did a decent job on the November 14 , 2006 conference call to outline its goals, with a relatively transparent discussion of both strategic and fundamental outlooks for the company's business lines. Management also drew two lines in the sand, claiming that it would not need to raise more capital to support the growth of the business, and indicating that the company would be cash flow positive by the end of 2007. The first claim was quickly swept aside as the company proceeded to raise more capital in Q1 of 2007, which was used to purchase several more internet content sites, and the second, as will be outlined below, appears to be all but unattainable in the forseeable future.

Since the Q3 2006 conference call on November 14, the company has held one subsequent conference call - in early February 2007, to discuss Q4 2006 results. During the call, management reiterated its strategy, especially highlighting its expectation that advertising revenues would increase due to higher traffic and higher advertising rates. Management declined to provide any operating results or financial position information to investors, deflecting these questions by saying "you'll have to wait for our 10-Q filing." It wasn't until this filing that investors learned the truth on the performance for the quarter - in particular the negative gross margin results for the hardware side of the business - during their strongest quarter of the year. Worse yet, SG&A for the quarter increased 70% YOY, despite a reduction in force during the quarter which dramatically reduced corporate headcount. The company also declined to provide unit sales numbers for both the PMP and Mp3 hardware, an ominous sign that they may face serious issues here. More on this later.

After this conference call, the company has gone silent. Management failed to hold a conference call following its Q1 2007 earnings press release, and has since failed to provide public updates on its business. It has appeared at several conferences, where it has essentially reiterated its claim for cash flow breakeven results by the end of 2007, and a revenue ramp from advertising, based predominantly on increased advertising rates which have yet to materialize. During Q2 and the start of Q3 2007, it again has sought financing from external sources, which purportedly will be used for acquisitions and general corporate purposes. In Q2, one of the founders of the company provided 250K in cash in exchange for privately place shares priced at $1.66, which was probably used to meet payroll for the company, as the only other immediate sources of cash available to the company was its balance of $2.598 million and the accounts receivable line of 234K (54% of which was owed to them by one customer - probably Wal-Mart - who also accounted for 44% of sales in Q1). With quarterly SG&A of 2.4 million in Q1 (up from 1.7 million in Q4 2006 - an increase of 41% QOQ), its not hard to extrapolate that a cash crunch is underway at the company. Today's announcement of an additional 1.4 million in funding in the form of unsecured notes boosts the argument that the company is not generating any significant cash from operations, and that things are very tight.

Furthermore, management has misrepresented, and failed to correct in a public forum, claims that it has made about the scope of its relationship with Inmotion Pictures, which is has sited as a key distribution partner for the Mp3 player. On the November 14th conference call, an investor asked management to provide the number of locations Inmotion Pictures in airports around the country. Management's answer was 150. In its 2006 10-K filing, ZVUE cited that the Mp3 player was being sold through 125 Inmotion locations. Curious - had Inmotion closed 25 stores in the November 14-December 31 2006 time frame? Well, as it turns out, anyone with an internet connection could have gone to the Inmotion website on November 14, 2006, and would have found 48 locations listed (count for yourself). It appears that management pulled a number out of the hat for investors on the call, and also for the 10-K, and have failed to correct this misrepresentation. Calls placed independently to Inmotion, as well as visits to Inmotion stores, confirm the 48 location number. Calls to Inmotion also revealed a further material misrepresentation: Inmotion claimed that its purchasing department has not placed any follow-on orders for the Mp3 players in 2007, despite management's recent comments at conferences that a distribution relationship still exists with Inmotion. Visits and calls to stores also revealed that the product has not been carried since the holiday season. Could this be yet another reason why management failed to hold a conference call following Q1 results?

Adding fuel to the fire, several insiders have filed to sell shares recently, including Eastech, its Taiwanese supplier, which has registered a total of 383,142 shares for sale. This represents all of the shares Eastech acquired in 2004 and were converted from series B convertible preferred stock to common stock in the reverse merger. Clearly, Eastech is throwing in the towel (Eastech is an operating subsidiary of Eastern Asia Technology, Ltd., a Singapore based firm with a $42 million USD market cap). Other insiders, notably Gordon Page (no relation to ZVUE founder Carl Page) has been selling shares as quickly as he can, subject to market window limits specified in the acquisition agreement for Putfile.com.

Back to the advertising revenue issue. In recent presentations, as well as on the February Q4 2007 conference call, ZVUE claimed that advertising revenues per visitor would increase from $0.005 to $0.025-$0.03, a 5 to 6 fold increase, by the end of 2007. Q1 2007 revenues per visitor appear to have come in BELOW the lower end of the range. The company cites 13.7 million unique visitors per month in Q1, and an advertising revenues of $77K for the quarter. This equates to about 25k in ad revenue per month for Q1; if one divides 25K by 13.7 million unique visitors per month, the result is $0.00182 per unique visitor. The company also outlined its goal of reaching 17-20 million unique visitors per month by the end of 2007. Without a significant increase in ad revenues per unique visitor, this goal will become harder to attain due to the increase in the denominator. It appears that the same funny math used to arrive at the number of Inmotion locations is at work here.

Finally, the company's auditors issued a going concern statement in the 2006 10-K, which was reiterated in the Q1 07 10-Q. So far, the company's operating activiites have not been able to generate any substantial cash flow from operations, calling into question whether the company's stated goals can be attained, most importantly the cash flow breakeven goal by the end of 2007. In the past 8 months, the fully diluted share count has balooned from 10.8 million to 17 million shares and debt is now around 2.2 million dollars. With no operating model leverage, continued cash burn and reliance on outside financing, not to mention a significant revenue concentration coming from Wal-Mart (does anyone want to consider what would happen to ZVUE if Wal-Mart discontinues sales of ZVUE products?) one has to wonder if this company was ready for the rigors of the public equity markets.

Disclosure: Author has a short position in ZVUE

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