Just over two years ago I started a thread on Boston Acoustics (BOSA). At the time I thought that BOSA presented a value opportunity at ~ $11/share. The shares had recently declined due to deterioration in their OEM business with Gateway computers. I believed that at $11 BOSA was trading at fair value for its core speaker business, with its rapidly deteriorating OEM business thrown in for free. The ensuing discussion raised concerns about my valuation conclusions, the wisdom (or lack thereof) of paying full price for the core business under the assumption that the OEM would work out, and the appropriate margin of safety. Despite the excellent feedback I received I went ahead and bought shares for ~$9.80. At the time I thought the price provided a small margin of safety, much less than the margin the $8 entry price Zenvestor and Trepanne suggested would have provided. I also thought that the 3.4% dividend yield that price provided would help ease the wait for a turn around. Since then the price has fluctuated between $8-13, most recently settling in at $11/sh. I thought it might be useful to look at this decision two years later.Operational PerformanceHow has BOSA done these past two years? In a word: horribly. Revenues have been in steady decline, falling from ~$120 million in 1999 to $70 mil in 2002. The last two quarters have accelerated this decline, with revenues falling over 30% yoy in each of the first two quarters (from $20.6 to 13.4 mil in the 1q, and from $18.3 to 12.6 mil in the 2q). While the deterioration of the OEM business has been as dismal as predicted (fallinG 64% in 2002) the decline in the core business is worse than anticipated, falling 17% YoY in the 2q. Unfortunately, the unanticipated happened, the recession of 2001 hit the core business as well, with core revenues declining from $55.5 mil in 1999 to $50.1 mil for 2003 (and on pace to come in even lower for 2003). With revenues collapsing faster than I ever imagined you would expect earnings to take a dump as well, but that is where I've learned the importance of excellent management.The Importance of Good ManagementAndrew Kotsatos, the founder and CEO of BOSA, is also a major shareholder, with insiders owning 32% of the shares outstanding. Fortunately for me he has managed the company like a major shareholder, slashing costs and repositioning the OEM business in ways that have preserved profitability, eliminated debt, and charted a path to recovery. While revenues have fallen precipitously since 2001, cost cuts have managed to keep pace. What is truly amazing is that BOSA has managed to cut costs without slashing R&D, allowing the company to launch new products and pursue a new OEM strategy as a major supplier of the automotive industry. This is the big gamble on which the future growth of BOSA hinges. A failure here and I think the company may be headed for oblivion (I'm quite certain that the assets are marketable, suggesting a rock bottom price somewhere below book value at which even the most conservative investor might be tempted). In summary, without the keen management leadership of Kosatos I think this investment might have turned out to be a lot worse than the mediocrity I currently find myself holding.Balance SheetThe other silver lining in the dark clouds is the balance sheet. BOSA has managed to eliminate its debt during this downturn while buying back shares. They also reduced inventories and increased cash, all while paying a 3% dividend. They have shown a keen ability to cut costs and manage cash flow to the benefit of shareholders.The FutureAs I have already noted, BOSA has charted a new path for its OEM business by winning a contract to provide Visteon with automotive audio equipment. How large and profitable this business is likely to be is any ones guess right now. What I like about it though is that BOSA moved very quickly to salvage their bad OEM investment by leveraging it into a product area they already had experience with: car speakers. BOSA has already announced that this automotive OEM contract will materially impact earnings beginning in 2005 when they start delivering product to Visteon. This possibility is one of the reasons I am tempted to hold the shares.The problem I see is the deterioration in the core business. Revenues have dropped precipitously in part due to the loss of a retail distributor. BOSA cannot afford to have its core business deteriorate as the OEM business, even if successful, is likely to be much lower margin and much more dependent on the well being of a single customer. One hopes that the decline in the core business was a function of the 2001 recession, but high debt levels, rising interest rates, higher unemployment rates, and fierce competition do not bode well for a purveyor of discretionary consumer durables. I will be watching the core business very closely the next two quarters.ValuationIn hindsight, my valuation proved too liberal (mirroring my politics) given that revenue and earnings have declined. My initial valuation was based on growth assumptions of 6%, net margins of 10% and a 15% discount rate. Only the discount rate proved to be right, for without it my estimates of IV would have been way off. Earnings have shrunk, margins stink, and the prospects for a return to growth look dismal. Having said that, the shares have held up surprisingly well. The lowest price reached in the past two years was $8.50 with the shares sticking pretty close to $10 throughout the period. Perhaps my valuation wasn't that bad after all. With book value at $8.15 and the dividend yield approcahing 4% at that price I think the shares are unlikely to trade below book unless the economy (and BOSA's business) go completely into the tank. The market never presented the conservative investor an opportunity to buy BOSA at the $8 price Zenvestor suggested. Perhaps the conservative investor would have been better off avoiding the shares altogether.ConclusionLooking back I think my entry price was a bit rich, and I certainly wasn't conservative enough when forecasting the future growth of the business. Right now BOSA bears very close watching. If the core business fails to stabilize then I think it will be time to jump ship. Even if the Visteon OEM business is successful, BOSA will need its core speaker business to keep margins up. As it stands, I am sitting on a 19% total return after two years including dividends. While this is better than the S&P it is not as good as I would like to see. I would like to hold on until at least 2005 to see how the Visteon deal plays out, but I will sell if there is any further deterioration in the core business.All in all I have learned the importance of a margin of safety (which was good enough in this purchase, but far from optimal), and more significantly the importance of good management. In this case, I lucked out.PhoolishPhilip
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