Introduction
Going into a full evaluation of a company which entails writing an article, I am reasonably optimistic that I am going to find a company to invest in and add to my personal portfolio and the portfolios that I manage. There are only two ways that I get to this point of writing an article either 1) I am reasonably confident that it is going to turn into an investable company or 2) That it is a very interesting company for some reason. Almost 100% of the companies I do full research on and write an article about start out as the former. Koss Corporation (KOSS) was no different because after looking over its balance sheet and profitability numbers I found substantial NOL’s, little debt, and reasonable profitability levels which usually are good signs that the company may be a good investment if the company is undervalued. This however is not an article about a company that I will ever invest in due to it being a grossly overvalued, dying company, which has major management concerns.
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Koss Corporation is a manufacturer of headphones and related accessories. Its products are sold through national retailers, international distributors, audio specialty stores, the internet, direct mail catalogs, regional department store chains, discount department stores, military exchanges and prisons under the “Koss” name. Its products are carried in approximately 17,000 domestic retail outlets and numerous retailers worldwide. Ninety-nine percent of the Company’s products are stereo headphones for listening to music. At the time of this writing KOSS is a $35 million market cap company that has huge competitors such as Apple, Samsung, Sony, Beats By Dre, and others.
Management
The Koss family: John C. Koss; current chairman of the board, founder, former CEO, and father of Michael, Michael J. Koss; current vice chairman of the board, president, COO, CEO, and son of John C. Koss, and John Koss, Jr.; current vice president combined own ~75% of the Koss Corporation of course meaning that they control everything the company does. I have evaluated companies with egregious pay structures before but I have never evaluated a company that loves options like KOSS does. Just on July 26, 2013 the company released four form 4’s that said that members of KOSS were “acquiring” or could acquire a combined just fewer than 2.1 million options. The company’s total number of outstanding shares are only 7.4 million. While overall executive compensation is reasonable at about 9% of overall market cap the awarding of a lot of options worries me because of the many horror stories I have read that talk about the shenanigans that companies have perpetrated in the past with options. The company has become less profitable, or even unprofitable in some recent years, has lost nearly 80% of its overall value since 2007, and continues to become less and less of a factor in the headphone market in recent years while its management continues to be compensated very well with options and overall pay. Not very shareholder friendly.
Speaking about options I found this nugget in the companies most recent proxy report that I have never seen in any other companies financials. Emphasis is mine.
The Exercise Price of each share of Common Stock which may be purchased upon exercise of any Option granted under the Plan shall not be less than 100% of the Fair Market Value of the Common Stock on the day immediately preceding the Date of Grant; provided, however, that the Committee shall have discretion, with respect to a Non-Qualified Stock Option, to establish an Exercise Price at less than the Fair Market Value on the day immediately preceding the Date of Grant to the extent that such Option is designed to comply with the requirements of Section 409A of the Code.
To me this sounds a lot like the option repricing which is outlined in very good detail here. For those of you who do not want to read all that here is a cliff notes version quoted from that page. Again emphasis is mine.
Options backdating is the practice of altering the date a stock option was granted to an earlier or later date, usually a date on which the underlying stock price was lower. This is a way of repricing options to make them valuable or more valuable when the option “strike price” (the fixed price at which the owner of the option can purchase stock) is fixed to the stock price at the date the option was granted. Cases of backdating employee stock options have drawn public and media attention.[1]
While options backdating is not always illegal,[2] many options in corporations are granted to upper management. Backdating has been called “cheating the corporation in order to give the CEO more money than was authorized.”[3] and a way of “rewarding managers when stock prices fall”.[4] According to a study by Erik Lie, a finance professor at the University of Iowa, more than 2,000 companies used options backdating in some form to reward their senior executives between 1996 and 2002.[5]In an “uncanny number of cases,” the “companies granted stock options to executives right before a sharp increase in their stocks.”[1]
Even if what they are doing is not illegal, and it does not seem to be, it is something that I want no part of as an investor because of how unseemly it is. Especially in a completely controlled nano cap that has struggled in recent years, is declining rapidly, and has had corporate governance issues in the recent past.
Major Self Inflicted Issue and Overall Decline
In 2009 Koss found out that its vice president of finance Sue Sachdeva was embezzling money after being told by American Express that there was an odd transfer of $4 million plus transferred from Koss to Ms. Sachdeva’s personal account. It was later determined that Ms. Sachdeva embezzled around $35 million over five or six years, or about $6 million a year. The quoted area below is from this article that was published before the full extent of the embezzlement was found.
“That’s a staggering figure, especially when you consider that the company had net sales of only $38 million in fiscal 2009 and $47 million in fiscal 2008. Net profits in fiscal 2009 were only about $2 million. How does a company of this size not notice losses averaging $5 million per year, more than 10% of net sales?
The signs were apparently there. Sachdeva earned an average of $190,000 in total annual compensation in fiscal 2008 and 2009. Yet allegedly she spent millions at Milwaukee area boutiques, and the federal criminal complaint against her says there were “several large piles” of clothing with tags attached sitting in her office at Koss. Several individual price tags were in excess of $2,000.
Who allegedly found all that clothing in Sachdeva’s office, and when? CEO Michael Koss, after American Express gave him the heads up.
What strikes me as odd is the fact that Koss hadn’t seen these apparently unconcealed piles of couture before. I would consider finding so much clothing in an office unusual and noteworthy; does the fact that he’d never noticed it mean that Koss never went into Sachdeva’s office before he received the call from American Express? Koss did not respond to a request seeking comment on the situation.”
Here is a case study I found that talks about the situation in-depth for those who are interested in how things like this can happen. I completely agree with the above quote though, how do other members of the company not notice something like piles of expensive clothes with tags still on them lying around the office? Did she work in a dungeon of their corporate offices or did she have complete autonomy to do as she pleased? I am betting on the latter and of course someone in power receiving zero oversight is never a good thing.
The case has mostly been settled now with the perpetrator being sent to prison and the company receiving some money back in recent years. The below quoted area is from the most recent settlement that added to this past years results. This recent update will be talked about more later.
The settlement of the lawsuit that resulted in gross proceeds of $8,500,000 added $6,380,000 to unauthorized transaction related recoveries net after accounting for the related legal fees.
The above combined with KOSS’ overall decline and loss of market share which will be talked about next, has helped it go from a high market cap in 2007 of $157 million to now only having a market cap of ~$35 million as of the time of this writing, or a decline in the value of the company of nearly 80% in the last six years; an absolutely staggering loss of capital.
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To help facilitate this destruction of value has been that Koss has bought back a lot of its shares as the company has been overvalued. The below quoted area is from its most recent annual.
In April of 1995, the Board of Directors approved a stock repurchase program authorizing the Company to purchase from time to time up to $2,000,000 of its common stock for its own account. Subsequently, the Board of Directors periodically has approved increases in the stock repurchase program. As of June 30, 2012, the most recently approved increase was for additional purchases of $2,000,000, which occurred in October of 2006, for an aggregate maximum of $45,500,000, of which $43,360,247 had been expended through June 30, 2012 . No purchases were made during the year ended June 30, 2012. The Company intends to effect all stock purchases either on the open market or through privately negotiated transactions and intends to finance all stock purchases through its own cash flow or by borrowing for such purchases.
| 2003-06 | 2004-06 | 2005-06 | 2006-06 | 2007-06 | 2008-06 | 2009-06 | 2010-06 | 2011-06 | 2012-06 | TTM |
|---|
| 21.18 | 19.98 | 21.21 | 19.78 | 21.79 | 22.99 | 27.90 | 24.31 | 27.53 | 32.00 | 33.80 |
As the company’s revenue and profits have continued to falter the company has continually spent a bigger share of its sales on SG&A expenses and has continued to fall farther and farther behind competitors while destroying value. This is the first company I have evaluated that has been at a very clear competitive DISADVANTAGE.
The quote below is from investopedia’s definition of SG&A, emphasis mine:
High SG&A expenses can be a serious problem for almost any business. Examining this figure as a percentage of sales or net income compared to other companies in the same industry can give some idea of whether management is spending efficiently or wasting valuable cash flow. For example, in the television industry businesses that depend on a great deal of advertising must carefully monitor their marketing expenses. A good management team will often attempt to keep SG&A expenses under tight control and limited to a certain percentage of revenue by reducing corporate overhead (i.e. cost-cutting, employee lay-offs).
Apparently Investopedia thinks that Koss’ management is not doing a very good job either.
The only other time I have seen a company at a competitive disadvantage like this was when I took Aswath Damodaran’s free online course on valuation where he talked about an Indian company that was at a huge competitive disadvantage and to try to keep up they continually spent more and more money on advertising and research and development and only dug themselves a bigger hole faster which is exactly what Koss is doing as well. Beats By Dre has completely changed the headphone industry and how it operates with its gigantic market share and competitive advantages and are helping to put companies like Koss towards extinction since it apparently does not know how to stem the tide and is only making things worse.
Competition
Even though headphones had been invented back in the late 50’s, they were not thought of as cool or something that music listeners had to have until Beats By Dre came along. Introduced in 2008 by rapper Dr. Dre, Beats By Dre now owns an estimated 64% of the $100+ headphone market and an estimated 51% share of the $1 billion premium headphone market. Brand is by far the biggest differential in this premium (And higher margin) market and Dr. Dre has led Beats to becoming the king of cool with commercials with the likes of basketball champion and MVP LeBron James and musician Robin Thicke.
Let us look at the difference between in looks over the two companies products that have the same regular list price of $400.
Which one would you pay $400 to wear outside around friends?
KOSS does not estimate what its market share of the market is and doing a quick Google search only brings up a news clipping from 1973 that talks about KOSS increasing its market share. Another shocking illustration of how badly KOSS is getting dominated in this arena is that Beats’ founder Dr. Dre earned an estimated $110 million last year mostly from the Beats line. KOSS’ entire market cap is only around $35 million. As mentioned above KOSS also faces competition from other heavyweights like Sony, Samsung, Apple, and other smaller ones. Combining the previous with some of its own mistakes which will be talked about later have helped to push KOSS close to extinction in my opinion.
Valuation
All numbers are in thousands of US$, except per share information, unless otherwise noted.
Low Estimate
| Assets: | Book Value: | Reproduction Value: | ||
| Current Assets | ||||
| Cash And Cash Equivalents | 506 | 506 | ||
| Accounts Receivable (Net) | 3,619 | 3,076 | ||
| Inventories | 10,000 | 6,000 | ||
| Deferred Income Taxes | 919 | 460 | ||
| Prepaid Expenses | 799 | 400 | ||
| Total Current Assets | 15,843 | 9,986 | ||
| PP&E Net | 2,415 | 1,449 | ||
| Equity and Other Investments | 4,576 | 3,432 | ||
| Intangible Assets | 3,139 | 1,570 | ||
| Deferred Income Taxes | 991 | 496 | ||
| Total Assets | 26,964 | 17,387 |
Number of share are 7,383.
Reproduction Value:
With IA
- 17,387/7,383=$2.36 per share.
Without IA
- 15,817/7,383=$2.14 per share.
Base Estimate
EBIT and net cash valuation
Cash and cash equivalents are 506
Total current liabilities are 6,672
Current number of shares are 7,383
Cash and cash equivalents + short-term investments – total current liabilities= 506-6,672=-6,166/7,383=
- -$0.84 in net cash per share.
KOSS has a trailing twelve month EBIT of 2,520.
5X, 8X, 11X, and 14X EBIT + cash and cash equivalents + Net Operating Losses (Total NOL’s are $11,481 discounted 50% for conservatism sake which equals $5,751):
- 5X2,520=12,600 + 506=13,106 + 5,741=18,847/7,383=$2.55 per share.
- 8X2,520=20,160 + 506=20,666 + 5,741=26,407/7,383=$3.58 per share.
- 11X2,520=27,720 + 506=28,226 + 5,741=33,967/7,383=$4.60 per share.
- 14X2,520=35,280 + 506=35,786 + 5,741=41,527/7,383=$5.62 per share.
From this valuation I would use the 5X EBIT + cash and cash equivalents + net operating losses as my estimate of value.
High Estimate
I am using its TTM numbers in this valuation.
| Numbers: | ||
| Revenue: | 36,747 | |
| Multiplied By: | ||
| Average 6 year EBIT %: | 12.64% | |
| Equals: | ||
| Estimated EBIT of: | 4,645 | |
| Multiplied By: | ||
| Assumed Fair Value Multiple of EBIT: | 5X | |
| Equals: | ||
| Estimated Fair Enterprise Value of KOSS | 23,225 | |
| Plus: | ||
| Cash, Cash Equivalents, and Short Term Investments: | 506 | |
| Minus: | ||
| Total Debt: | 0 | |
| Equals: | ||
| Estimated Fair Value of Common Equity: | 23,731 | |
| Divided By: | ||
| Number of Shares: | 7,383 | |
| Equals: | $3.21 per share |
Relative Valuations, ROIC, and Earnings Yield
TEV=Market cap + all debt equivalents (Including the capitalized value of operating leases, unfunded pensions, etc) – cash, cash equivalents, and short-term investments – long-term investments – net deferred tax assets.
- TEV=35,700 + 2660 – 506 – 4,576 – 2,662=30,616
- TEV/EBIT=12.15
- EV/EBIT=13.97
- PE=21.9 versus an industry average PE of 12.5
- P/B=2.3 versus an industry average P/B of 2.6
- EBIT/TEV (Earnings yield) = 8.23%
ROIC=EBIT/(Equity-goodwill+debt-cash)
Calculated using total obligations and commitments.
- ROIC=2,520/(17,027-0+2,660-506) = 13.14%
Valuation Thoughts
Koss is overvalued on an intrinsic and relative basis sometimes in extreme cases. Normally I use the 8X EBIT + cash valuation as my base estimate of value but due to the problems I have listed throughout this article I think that they are only worth 5X EBIT + Cash and NOL’s. On a relative basis it is equally overvalued with a PE well over its industry average and EV/EBIT and TEV/EBIT over the threshold of 8 which is what I normally like to buy below. Its earnings yield is also quite a bit lower as I like it to be in the 12-15% range and a lot lower than some of the other companies I have evaluated. It does have a pretty good ROIC but the overvaluation and management concerns far outweigh that one metric being decent.
Conclusion
I had a few other sections that I was going to write and normally include in my articles but in this case management, competition, and valuation are all that matter and Koss is not doing well on any of those. Its management has major issues in my opinion, has the potential to do unseemly things with options and its repricing like provision in its proxy report, issues a ton of options which I am not fond of, and pays themselves too well with options and overall pay while the company has lost nearly 80% of its value since 2007. Its management has also bought back a substantial number of shares while the company has been overvalued that has led to the destruction of value at the company. Competition has completely disrupted this industry and Koss has been fighting an uphill battle to try to keep up which has led to further value destruction at the company. To top it off the company is grossly overvalued on an intrinsic and relative basis.
Suffice it to say I will not be investing in this company for any of the accounts I manage. Even though I do not short sell due to the risk of potentially infinite losses but if I did I would short KOSS and feel very secure about my decision to do so.
Update
While I was writing this article KOSS released this 8K saying that they have received more settlement money from the embezzlement situation and updated its numbers to reflect the change. I did not change its numbers in the calculations and valuations above and I will show you why below. The table was taken from Yahoo Finance.
| Three Months Ended | Twelve Months Ended | |||||||||||||||||||
| June 30 | June 30 | |||||||||||||||||||
| 2013 | 2012 | 2013 | 2012 | |||||||||||||||||
| Unauthorized transaction related recoveries, net | (6,543,977 | ) | (333,782 | ) | (7,587,047 | ) | (1,470,818 | ) | ||||||||||||
| Total operating expenses | (2,724,660 | ) | 2,954,268 | 5,366,428 | 10,644,654 | |||||||||||||||
| Income from operations | 6,420,708 | 1,297,866 | 7,642,391 | 3,886,761 | ||||||||||||||||
| Net income | $ | 4,607,433 | $ | 931,891 | $ | 5,427,715 | $ | 2,940,415 |
If you read the 8K you will notice the generally upbeat tone of it. The numbers that are bold above are what I would like to outline here. The unauthorized transaction related recoveries are settlements from the embezzlement issue. You will notice that without those recovered funds, and the update to its numbers, that KOSS would have had operating and net losses in the full year 2013 and the June 2013 ended quarter. To me this is not progress, they are not being very honest with their upbeat tone, and if they are upbeat about having net losses excluding non recurring items than the company still has issues it needs to overcome.
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Disclaimer: The previous analysis and valuations are not a recommendation to buy or sell any stock in any of the companies mentioned. Do your own homework