We are recommending a long position in Steinway Musical Instruments, Inc. (LVB). Steinway is a classic long term small cap value investment opportunity, offering both an attractive operating business with a premium brand and strong returns on capital as well as a net asset value per share that is worth almost as much as the current share price and has some considerable hidden asset value components (primarily real estate ownership). In valuing the operating business at 10x free cash flow (normalized EBITDA less maintenance cap ex) and the real estate (which can be detached from operations) at $250 mil net of taxes, which we believe to be conservative, we derive a value of approximately $50 per share, a 65% premium to the current share price.
Steinway is the largest domestic manufacturer of musical instruments and is second only to Yamaha globally. The Company’s products include pianos, woodwind, brass, string, and percussion instruments, among others. Although some of the Company’s brands have existed for as long as 150 years, the current holding company was formed via two significant acquisitions: the 1993 acquisition of the Selmer Company, the largest U.S. manufacturer of band & orchestral instruments, and the 1995 acquisition of Steinway Pianos. In 1996, the Company listed its shares publicly on the New York Stock Exchange under the ticker LVB, with a split capitalization structure. Since going public, the Company has expanded its operations both through organic growth and a handful of strategic tuck-in acquisitions in both of its operating segments. Steinway operates under two primary segments: pianos and band and orchestral instruments.
The piano segment operates under the brand names Steinway, Boston, and Essex. The premium Steinway brand represents roughly 80% of the revenue in this segment and an even larger percentage of gross profit. The Company sells over 3,000 Steinway grand pianos annually at a retail price of between $40,000 and $160,000, primarily to professional pianists and institutions. The Boston and Essex brands serve the middle priced piano market, with retail prices ranging from $4,000 to $40,000. Steinway sells roughly 75% of its piano products through 185 dealers that operate roughly 300 showrooms, with the remaining 25% sold through its own network of nine showrooms. The Company also operates a concert and piano bank of roughly 500 Steinway pianos that it leases out to the professional pianist community.
On a trailing twelve month basis, the piano segment generated approximately $227 million in revenue, up approximately 8% year over year, with gross margins of 36.5%. The piano segment has more than offset a weaker market in the U.S. of late with considerable growth abroad, where sales are now in excess of 50% of the total segment sales. Steinway already has dominant market share in the U.S. and Europe for premium pianos, and the Company has targeted Asia as its primary growth market for the piano segment. The grand piano market has grown rapidly in recent years in China, and has become the second largest in the world. Many of the world’s most renowned pianists are emerging in China, and the Company has begun to realize some market penetration there after opening a distribution and selection facility in Shanghai in 2004. Sales at this facility have grown at an exponential rate, including 100%+ in the second quarter of 2007, and are now 4% of total piano segment sales. Given that the Company only has a 3% share in the Chinese premium piano market, this remains a considerable growth opportunity for Steinway.
The band and orchestral segment sells a wide array of other musical instruments and accessories including brass, woodwind, string, and percussion instruments. These products are sold under various brand names such as Bach, Ludwig, and Selmer, maintaining significant market share in almost every product category. The instruments retail for between $300 and $20,000, and are sold through a network of approximately 1,700 independent musical instrument dealers. Roughly half of the revenue in this segment is derived from entry level student instruments, with intermediate and professional instruments representing the balance.
Given that the majority of the band segment products are sold to educational programs and professionals, the business is far less susceptible to macroeconomic factors, but rather to demographic trends and school budgets. The segment has, however, been affected by pricing pressure due to increased competition from lower cost foreign manufacturers. This has in some part been offset by revenue growth in markets outside of the U.S., which currently represent only 20% of the segment’s sales, and through reducing labor costs by moving 35% of band instrument manufacturing offshore. Consolidated sales in the band segment have declined by nearly 10% over the past year, but some of this was the result of a strike at the Company’s Elkhart, Indiana facility (described below), and the Company is projecting a turnaround in this business during the third quarter. Over the trailing twelve months, the band segment has generated approximately $155 million in revenue, with gross margins in line with historical averages of roughly 20%.
The first component to our valuation model is the Company’s owned real estate. In a press release dated February 10th, 2006, the Company released management’s estimates/appraisals of the current value for its assets as part of its debt refinancing. The chart below summarizes management’s adjusted balance sheet valuation from the press release:
|Asset Base ($MM)
||Actual Balance Sheet 9/30/05
|Total Current Assets
|West 57th Street
|Book Value per share
As can be seen above, management estimates that the West 57th Street and Steinway Factory properties are worth considerably more than their book value. In order to confirm management’s estimates, we commissioned a well known, reputable New York based real estate brokerage firm to conduct an appraisal of the real estate assets. At West 57th, Steinway owns a 220,000 square foot, 18 story building in which it occupies the bottom three floors for its highest grossing piano retail store. The remaining square footage is leased to tenants such as the Economist, the National Academy of TV Arts & Science, and XM Radio. The Company purchased the building in 1999 for $30 million and at the same time entered into a 99 year land lease. Since then, the building has depreciated down to roughly $26 million in book value, yet the actual market value has appreciated significantly as rental rates bordering Central Park have increased and cap rates have continue to decline. Comparable transaction analysis suggests that commercial real estate in the area sells for at least $650 per square foot, which implies a value of greater than $140 million for the building and land together. However, an August 22nd article in the New York Post suggested that Steinway and the land owner are in discussions to sell the property to Starwood Capital (which recently bought the property next door) for $225 million. Management was obviously unwilling to confirm the details provided by the article or to elaborate on the potential split between the Company and the land owner, but they reiterated that they were confident in the $100 million value for their ownership of the building quoted in the February 2006 press release. The Steinway Factory offers even more upside to its GAAP book value. The Company’s 450,000 square foot manufacturing facility resides on 11 acres of highly attractive waterfront property in Queens. As a manufacturing facility, comparable transactions in the area suggest that it is worth at least $200 per square foot, or roughly $90 million. The property is currently zoned for manufacturing use, but there is considerable precedence in the area for property getting rezoned to residential use. In this case, prime waterfront property sells for up to $20 million per acre, or $450 per square foot, which would value the property at slightly more than $200 million. Unlike Steinway Hall, it appears less likely that the Company will monetize this real estate in the near term, but it remains an attractive asset that we believe one day will be monetized. Finally, Steinway owns an additional 1 million plus square feet of manufacturing real estate throughout the world. While other PP&E is much less likely to be worth multiples of its current book value, management’s 10% discount to GAAP book value appears to be conservative. We believe that the Company’s real estate portfolio is collectively worth at least $250 million net of taxes. We chose to separate this value from the operational value because the real estate represents ‘leveragable’ assets that are not required to be owned as part of the Company’s operations. In other words, there is no reason the Company needs to manufacture the majority of their Steinway pianos at a prime waterfront location in Queens or own an 18 story building in Manhattan where it occupies only a fraction of the building. It’s also worth noting that the Company’s income statement accounting for their ownership of the 57th street building is reported as if they are leasing the building (with a lease expense line item above the line and rental income below the line), therefore a sale leaseback would not affect the operating results. If the Company were to sell the Queens property and move production elsewhere, however, this would obviously impact cash flow, though this would be a fairly nominal amount.
The second component to our valuation model is the value of the brand / operating business. Over the past ten fiscal years, Steinway has averaged approximately $51.5 million of adjusted EBITDA from its operations, with minimal volatility, having never fallen short of $46 million in adjusted EBITDA and never exceeding $56 million. Over the past year, Steinway has had some one time adjustments to EBITDA, primarily due to a strike at its Elkhart, Indiana brass manufacturing facility which included 230 employees and began on April 1st, 2006. As the strike has dragged on for over a year now, longer than any labor stoppages the Company has experienced in recent years, the Company has hired 100 replacement workers at much more favorable wages, in addition to bringing back 60 union members have crossed the picket line. The Company is just now achieving pre strike production capacity, and we believe the Company is emerging with greater operating leverage than before through both lower wages at the Elkhart facility as well as moving some entry level brass instrument production offshore. As the effects from the strike are now largely behind the Company, it appears that Steinway is poised to return to at least historical unadjusted EBITDA levels during the coming year. Given the Company’s history of consistent profitability, premium brand value, and mid teens normalized return on capital (when isolating the operating business), we believe a 10x multiple of the Company’s normalized free cash flow of $40 million (after adjusting for implied rental expense increases of $6.5 million from monetization of real estate and $5 million in maintenance cap ex) is appropriate, if not conservative, giving the operations a value of $400 million. Although not a perfect comp, it’s worth pointing out that Kaman Corporation recently divested its musical instrument distribution and manufacturing business for $117 million or roughly 10x TTM EBIT (which is essentially the same as EBITDA less maintenance cap ex). Steinway’s operating business has far greater brand value and therefore it can be argued that it should be valued at a premium to Kaman’s musical instrument business.
Our sum of the parts analysis suggests that $650 million represents a fair value for Steinway, and after subtracting out net debt of roughly $220 million, we derive an equity value of $430 million or approximately $50 per share. This represents a 65%+ premium to the $261 million equity value today (or $30 per share). Another way to look at it is that the implied enterprise value of the operations of $230 million (current EV of $480 less $250 for real estate) equates to a normalized FCF yield of approximately 17% at today’s price. Perhaps just as important, while our adjusted book value is far more conservative than the $51 per share value implied by the Company in its February 10th press release, we believe there is in excess of $25 per share of net asset value per share, implying considerable downside protection to our investment.
|LVB Valuation ($MM)|
|Operating Business @ 10x normalized $40 mil of FCF
|Plus Real Estate Value (Net of taxes)
|Implied Enterprise Value
|Net debt (including pension underfunding)
|Implied Equity Value
|FD shares outstanding (MM)
|Implied Equity Value per share
Although we feel that this investment has a lower long term risk profile given the Company’s asset rich balance sheet, it is important to discuss the risks to our investment thesis. One risk is related to the lack of investor control due to the split capitalization structure. Chairman Kyle Kirkland and CEO Dana Messina have majority voting control due to their 100% ownership of class A stock, and therefore have full control of the major strategic decisions faced by the Company. Although management has a solid track record of adding value for shareholders since acquiring the businesses in the mid 90s, there is no guarantee that they will unlock the significant hidden asset value anytime soon. We are confident, however, that management has the best long term intentions for shareholders, and that this value will eventually be realized. In the recent third quarter conference call, upon being questioned by an unhappy shareholder on this very topic, Dana Messina admitted for the first time that the 57th street building is for sale and even followed this up with a statement that ‘everything is for sale’.
In addition to the risks presented by insider control, there are various operational risks faced by the Company, including ongoing labor issues, competition from foreign manufacturers, and customer credit quality issues in the band business. Roughly 40% of Steinway’s labor force is represented by labor unions.
Prior to the current issues at its Elkhart, Indiana
facility, Steinway last faced a brief labor stoppage in 2003, and historically has faced them every so often. While these occasional work stoppages have certainly impacted Steinway’s shorter-term operating success, the Company has historically been able to replace more expensive labor with cheaper alternatives overseas and replacement workers.
The fierce competitive landscape in the industry is also worth noting. In recent years, competition from lower cost foreign manufacturers has increased, which has particularly affected pricing in the mid to lower priced segments of the musical instrument industry. While Steinway has been forced to lower some of its prices and margins have declined in the band segment, the Company has been able to largely offset this by aggressively expanding its international market presence. Finally, the Company is exposed to potential credit issues from some of its customers, particularly in the band segment, where they’ve had to write down receivables on occasion over the years.
Perhaps the greatest risk to discuss is the Company’s exposure to discretionary consumer spending and the weaker U.S. housing market. While we are all aware that the U.S. is in the early stages of one of the greatest housing downturns in its history, an area where the piano business in particular has some exposure, the Company has offset this weakness through considerable international growth. It’s also important to point out that this isn’t a completely cyclical business, as more than half of sales are to institutions, professionals, and students, which have far less cyclical buying patterns than the average amateur musician.
Steinway Musical Instruments is an under-followed small cap value investment opportunity with limited sell-side coverage, an attractive balance sheet with significant hidden asset value, and considerable market share in the niche musical instrument manufacturing industry. While not without risk, we are comforted by the fact that the company trades near our estimate of net asset value, has a normalized return on invested capital in the low to mid teens, and generates a normalized free cash flow yield of approximately 10% at its current price, without consideration for real estate monetization. Furthermore, although the investment thesis is not completely dependent on growth, we are optimistic that the Company is well positioned to capitalize on some positive trends within the industry. Internationally, Steinway is capturing market share both in more mature markets such as Europe as well as rapidly emerging markets such as China. Domestically, although the Company is experiencing weakness in its consumer business, the institutional business remains relatively strong in both professional and school programs. We are confident that Steinway shareholders with a longer-term investment horizon will be rewarded.
1) Monetization of Steinway Hall (57th street)
2) Continued positive momentum in China and other emerging markets
3) Outright sale of the Company