This post is my entry for the GuruFocus Value Ideas Contest
Make Music Inc. (MMUS, Financial) Jan 21, 2010
Price: $4.84
Diluted Shares Out: 4.97 million (September 2010)
Market Cap: $24 million
Net Cash: $9.8 million (September 2010)
EV: $14.2 million (estimated)
MMUS SELECTED FINANCIALS 2001-2009
Note: All figures in millions except for EPS. Data from CapitalIQ
* - In Q4 2009, MMUS had realized a $2.5million tax benefit. Net Income and EPS excluding the benefit would have been $1 million and $0.21 respectively.
Company Description:
MakeMusic, Inc. founded in 1990 develops and markets proprietary music technology solutions under the Finale and SmartMusic brands. The company’s products provide alternatives to traditional practice, education, and composition techniques. Its software product sales are made through traditional distribution channels and MakeMusic’s Web sites.
The well-established Finale® family of music notation software products provides a solid base business that serves a large customer base, and generates consistent revenue through sales of new products, annual upgrades and trade-up campaigns. Music notation software is a niche business, with limited growth opportunity since only a small percentage of musicians ever notate music.
MMUS growth potential lies with SmartMusic®, a subscription-based software product directed towards the very large and constantly renewing market of music students and their teachers. SmartMusic combines a software application, a library of thousands of music titles and skill-development exercises, and a web service to provide students with a compelling experience and teachers with the realistic means to document the progress of every student. SmartMusic key differentiation is music accompaniment.
History
MakeMusic was organized in November 1990 under the name Vivace, Inc. On December 31, 1992, the Company acquired Coda Company and subsequently changed its name to Coda Music Technology, Inc. Coda Company was a partnership started in 1988 that developed the established music notation software called Finale, and a reputation for producing quality music technology products. Coda Company also had established distribution relationships and an existing infrastructure with product development, sales, marketing and administrative capabilities. Following the acquisition, the primary business of the Company consisted of enhancing, marketing and selling Finale products while developing Vivace products. In June 1994, the Company introduced the Vivace system, an innovative musical accompaniment system that responds to the musician in real-time. Fast forward to 2010, the Finale product has grown into a market leading product family with six distinct products and price points. The Vivace system underwent several transformations as discussed later, and started experiencing rapid growth once it was re-incarnated in its current form which is a subscription based software business.
There is a bit of rough history around the 2000 time frame. Net4Music SA a French company, completed the acquisition of MakeMusic (then Coda Music Technology, Inc. - NASDAQ: COMT) in a reverse merger transaction on October 19, 2000. The combined company was then renamed to Net4Music Inc. Net4Music S.A.'s core business was focused on marketing digital sheet music. The combined company had operations in France, New York, Madagascar and Minnesota. The employee count went from 45 at the end of 1999 to 205 at the end of 2000. All these years, the company had not profitable and the merger exacerbated the losses even further. The company closed it NY and Lyon operations in 2001 and in 3Q 2002 MMUS discontinued the digital sheet music business which was primarily the business of the Net4Music SA subsidiary. At this point, the company was in the mode of reversing everything that came along with the reverse merger transaction. In 2002, the company recorded a goodwill impairment charge of $13.7 million and another impairment charge of $1.7 million of its intangible assets. In its AGM held in May 2002, shareholders approved the name change to MakeMusic Inc. MakeMusic went back to its original areas of focus namely the Finale notation software and SmartMusic accompaniment system.
Finale: Music Notation software
MMUS is the market leader in music notation software with their Finale family of products for use with Macintosh® and Windows® PC operating systems. Music notation software enables a musician to enter musical data into a computer using either the computer keyboard, a MIDI- (Musical Instrument Digital Interface) equipped electronic music keyboard or other MIDI-equipped instruments, and contemporaneously display the data on a computer screen as a musical score. The dramatic improvements in speed and flexibility provided by software programs like Finale have made such software the dominant method for composers, arrangers, publishers, and music teachers to create printed music.
The Finale product is a powerful and comprehensive notation software product which is sold worldwide. Finale music notation software has a suggested retail price of $600.
MMUS also produces an Academic/Theological Edition of the Finale product that is sold exclusively to schools, teachers, college students, and religious organizations at a suggested retail price of $350. It reaches a market that is continuously replenished with new student users.
The Finale product is currently translated into German, French, Italian, and Japanese. All transactions with international customers are completed in US currency.
The Finale Allegro® product, a value-priced version of the powerful Finale music notation software product, was introduced in 1993. The Allegro music notation software product currently retails for $199 and contains a subset of the notation tools contained in the Finale product.
Finale PrintMusic® and Finale SongWriter® are entry-level music notation software products, retailing for $119.95 and $49.95, respectively. Each contains a subset of the notation tools contained in the Finale and Finale Allegro products. These products allow MMUS to offer entry-level products to the retail customer, thereby expanding the base of registered users and increasing the potential for sales of notation software upgrades.
Finale NotePad® is sold as an introduction to the Finale notation family and provides a quick and easy method to transform musical ideas into printed music. Finale NotePad is available via download for $9.99. Finale Reader™ was introduced in 2008 and is a free download to view, play and print Finale files”. – Source: MMUS 2009 10-K
The SmartMusic Solution
SmartMusic software is a comprehensive music teaching and learning solution for band, orchestra, and vocal students to use at school and, more importantly, at home. SmartMusic enhances and transforms the hours spent practicing by putting students inside a professional band or orchestra, so that they can hear how the music is supposed to be performed and how their part fits in. This makes practicing much more engaging, causing students to practice longer and more often. SmartMusic also offers a rich variety of effective practice tools that make practice time more efficient and productive. The combination of making practice time more engaging and productive leads to rapid student skill-development, increased student confidence, higher student retention, and stronger music programs.
Teachers use SmartMusic Gradebook™, the web-based grade book that comes with each teacher subscription, to post assignments to students, receive completed assignments from students, assess student achievement, and manage student records.
Synergies between SmartMusic and Finale products
From a technology perspective, there are considerable synergies between the SmartMusic business and the Finale notation business because the products benefit from shared technologies. The Finale notation technology, for example, is used within SmartMusic to display, among other things, sheet music, exercises, and beginning band method songs. It is this technology that puts red and green notes on the screen to show SmartMusic students what they played incorrectly and how to correct their mistakes. Likewise, the ability to create SmartMusic repertoire using the Finale product is a major benefit for SmartMusic customers.
History of SmartMusic
In June 1994, the first test version of the Vivace product was launched with a modular system at a suggested retail price of $2,295. In the spring of 1996, the Company released new configurations of the Vivace product at lower suggested retail prices, as well as an application and repertoire for vocalists. In the early versions, the system was made up of hardware, software and its library or repertoire. In July 1997, the Company announced the introduction of a software version of the product with a suggested retail price of $199 and repositioned the product as a complete practice system, the Vivace Practice Studio(TM). The Company announced in April 1998 that it would introduce SmartMusic Studio, a new and renamed version of the Vivace Practice Studio product. SmartMusic(TM) products began to ship in the second quarter of 1998, and included the basic software application at a nominal price and the full system sold under the name SmartMusic Studio which included accessory items at $99. In 1999, MMUS began the process of rebuilding the business on a direct to consumer model.In 2002, MMUS discontinued the Net4Music digital sheet music website and transitioned SmartMusic from a packaged retail product to an online subscription product.
The Company launched its website www.smartmusic.com and started to market SmartMusic on a licensed subscription basis to schools in the United States in December 2001 with a decreasing price scale ranging from $90 per year for the first subscription down to $20 per year for the fourth and more subscriptions. The home subscription program, priced $9.95/month or $90/year, was launched in spring 2002. In response to teachers’ requests to have an offer which would encourage all their students to use SmartMusic at home, the Company developed and launched its new school-sponsored home subscriptions offer in October 2002, which allows participating students to get a subscription for $20 per year as long as the school signs up at least 25 students. The Company also sold a one-year subscription plus accessories in a packaged box through dealers as a Subscription Starter Kit for a retail price of $119.95.
With a limited budget for marketing in 2002, more than 1,600 schools were subscribing to SmartMusic as of March 7, 2003, with schools initially ordering an average of 2.6 subscriptions for school computers. In addition, more than 100 of these school accounts had purchased school-sponsored home subscriptions with an average of 33 students per account.
In 2005-2006, MMUS conducted beta-testing of a web-based service product that would provide an easy-to-use service for music educators that enables them to electronically deliver SmartMusic assignments to students, automatically receive SmartMusic assessed grades and/or recordings of the assignments, and manage the student grades. MMUS released SmartMusic 10.0 in April 2007 which also included SmartMusic Impact™, a web-based service designed to manage student assignments, grades, and recordings while documenting the progress of each student. In 2008, SmartMusic Impact®was renamed to SmartMusic Gradebook. The renaming of the product was to clearly define its grade book capabilities for teachers.
Competition
The notation market is highly competitive and includes competitors such as Steinberg Media Technologies GmbH, Sibelius Software, NOTION Music, Inc., and Voyeur Turtle Beach, Inc.
SmartMusic created a new product category for teaching and learning music. It entered the market with no direct competitors. iPAS from Pygraphics, Inc. has been in the market for several years and provides on-screen music notation and assessment. StarPlay™ from In the Chair® is a recently introduced competitor which provides accompaniment and on-screen music notation. None of the competing products have the assessment and Gradebook capabilities.
Licensing of Content
Content is critical to SmartMusic’s success. No matter how exciting and useful the technology may be, if the SmartMusic library does not have the titles teachers want to perform with their student ensembles, they may not subscribe. While the SmartMusic library contains many titles and exercises that are either in the public domain or copyrighted by MakeMusic, the vast majority of SmartMusic content is licensed. These rights are licensed from a wide range of music publishers, including industry leaders such as Hal Leonard Corporation, Alfred Publishing, and Music Sales, Ltd.
In 2009, developing a typical band title that did not require engraving cost approximately $440 per title and the typical orchestra title was approximately $220. If engraving was required, the cost was approximately $2,270 per band title and $480 per orchestra title. Engraving is the process of taking hand written music notation and converting it into publishable format.
Partners
MMUS has developed SmartMusic Intelligent Accompaniment software for Hal Leonard’s Essential Elements®, the world’s best-selling method books for beginning band and strings students. This is part of a strategic partnership with Hal Leonard Corporation, the world’s largest sheet music publisher. This relationship is very important because students usually start to play in a school band in the fifth grade. In the United States alone, there are approximately 2.5 million students starting band every year. If many of these students have a successful experience starting out with SmartMusic, they will likely continue with SmartMusic and possibly become users of Finale software. As a result of a special marketing and licensing agreement, Hal Leonard offers SmartMusic in its Essential Elements Book One for band and orchestra students, reaching approximately 1 million students per year. Students receive a free trial offer giving them access to accompaniments to the first half of the book; and they may acquire access to the second half of the book at a discounted price as well as become regular subscribers thereafter.
Software Development
Application development is done by an internal team of software programmers and testers. Certain technologies are licensed from third parties and then adapted for use within SmartMsic. Development priorities are set by researching how teachers and students use SmartMusic, noting what improvements and additions are required. At December 31, 2009, there were 54 employees involved in product development for SmartMusic and Finale products at MakeMusic.
Release schedule:
Finale: has an annual release around July / August of each year
Allegro: typically released every other year
SmartMusic: upgrades to the SmartMusic app and the web based GradeBook are typically released each year.
Licensed Technology
Certain pitch recognition software incorporated into SmartMusic for purposes of music performance assessment is licensed from Institut de Recherche et Coordination Acoustique/Musique (IRCAM) which is based in Paris, France. The license agreement continues in perpetuity and was exclusive to SmartMusic through November 24, 2009.
SmartMusic Patents
MMUS licensed, from Carnegie Mellon University (“CMU”) on a worldwide basis for the life of the patent, the use of the U.S. patent that covers the automated accompaniment developed by MakeMusic that listens to and follows tempo changes from a live performance. Although this patent expired in 2005, MMUS has further developed this technology and patented additional features.
SmartMusic Accessories
The primary SmartMusic accessories are the instrumental microphone and the vocal microphone headset. These microphones are inserted into the microphone input of the computer and their audio signal is routed to the SmartMusic software for recording and assessment analysis. The instrumental microphone has a plastic-coated tip that allows it to be clipped onto a musical instrument or the student’s clothing. MMUS outsources the microphone manufacturing to suppliers who can meet the specifications. During 2009, the suggested retail price of the SmartMusic microphones was $19.95. Over 70% of new subscription purchases include a microphone.
Manufacturing
Manufacturing for hardware accessories such as mikes and headsets is outsourced and based on standard specifications. Printing of user manuals, packaging, and the manufacture of related materials are performed to specifications by outside subcontractors.
Infrastructure
The MakeMusic! Inc. data center is operated internally, offering extensive uptime and connectivity to the Internet backbone via dual dedicated T1 connections. For maximum reliability, all the servers utilize redundant arrays of independent disks for information backup as well as redundant power.
In the Q2, 2010 management said that MMUS will be moving their infrastructure to a Microsoft Azure cloud based solution which would be cost effective and highly scalable.
Revenue Sources
Revenues by Country
As can be seen in the table above, about 85% of MMUS revenues come from N. America. MMUS does not bear any currency risk since all sales are in U.S Dollar.
Segment Analysis
Numbers are in $ thousands.
Effective January 1, 2009, MakeMusic began reporting results of operations by two unique reportable segments, Notation and SmartMusic. Historically, net revenue has been reported separately for these two product lines. However, direct and operating costs had not been previously assessed or reported by segment and therefore, prior year comparative costs are not provided.
Clearly, Notation segment contributes almost the entire income from operations. SmartMusic provides lower gross margins than notation products due to the amortization of software and repertoire development, royalty payments to publishers and accessory sales. MMUS has been spending heavily in SmartMusic in terms of development and selling and marketing expenses. Management feels that the development expenses will be stable or may go down from these levels. In 2009 – 2010, MMUS spent heavily to re-write the Gradebook feature as well as made significant user interface changes to the SmartMusic application. As subscription sales continue increasing, MMUS will see benefit from these investments and operating income from SmartMusic should increase much faster. From Q3 2010 10-K, for the nine months till September 30, 2010, income from SmartMusic operations was $350k compared to $10k for the corresponding period in 2009.
Segment sales 2001 - 2009
Numbers are in $ thousands. SM stands for SmartMusic
Total sales had a CAGR of 8% from 2004 to 2009. In the same period, Notation sales had a low CAGR of 2% while SmartMusic sales had a high CAGR of 38%. SmartMusic sales increased from $1 million in 2004 to $5 million in 2009 while Notation sales went from $9.7 million to $10.6 million in the same period. As a result, SmartMusic represented 32% of sales at the end of 2009. I expect this trend to continue over the years and in a couple of years, we could well see SmartMusic represent more than 50% of total revenue.
History of price increases:
Finale: $545 (1997) ---- $600 (2001)
Academic: $275 (1997) ---- $300 (2001) ----$350 (2005)
Alegro: $199 (since 1997)
PrintMusic: $70 (1999) ---- $100 (2005) ---- $120 (2010)
NotePad: Free (2000) ---- $10 (2008)
SongWriter: $50 (since 2006)
SmartMusic Student edition: $20 (2002) ---- $25 (2005) ---- $30 (2008) ---- $36 (2010)
SmartMusic Educator edition: $100 (2002) ---- $130 (2008) ---- $140 (2010)
As can be seen from above, MMUS has been able to raise prices for most of its products gradually over the years. It has kept the price for the Finale and Alegro products steady at $600 and $199 respectively for a decade now. Pricing for the SmartMusic product has been raised gradually as more features have been added and it has gained wider acceptance in the schools and teaching community.
Growth in SmartMusic Subscriptions
Cost structure
Selected financials from MMUS’s Income statement FY 2009 – FY 2010
As MMUS has spent heavily on SmartMusic, COGS has increased over the years. R&D costs have also increased as a result. As subscription sales continue to grow, one should see the R&D becoming a smaller % of sales.
Balance Sheet Analysis (as of September 30, 2010)
Management
Jeffrey A. Koch joined MakeMusic as a director on July 20, 2006, and was elected the Chairman of the Board on October 19, 2006. He was made CEO recently after the previous CEO resigned. From 2005 to 2009, Mr. Koch was the Chief Executive Officer of LaunchEquity Partners, LLC, a firm that specializes in investing in early stage companies with high growth potential in both the public and private markets. Mr. Koch has an MBA from Washington University in St. Louis and is a Chartered Financial Analyst.
Karen L. VanDerBosch joined MakeMusic as Chief Financial Officer and Treasurer in December 2006. Ms. VanDerBosch was most recently the CFO of Sagebrush Corporation, a privately held developer of library automation software, and services, analytical software and book re-binder for the K-12 education market.
Likely reasons for the cheap price
Potential catalyst
Stock Repurchase Program
The Board of Directors also has adopted a plan to repurchase up to $10 million of MakeMusic common stock. This program will allow MakeMusic to repurchase stock over the next two years in open market transactions (including through 10b5-1 plans) or private transactions at the discretion of management. Repurchases will be subject to applicable SEC rules and to certain price, market, volume and timing constraints specified in the plan. These repurchases may be commenced or suspended at any time or from time to time without prior notice.
Valuation
With a recent price of $4.84, MMUS appears cheap trading at a TTM P/E of 7.4. Note that the P/E is based on a TTM EPS of $0.66 which includes a non-recurring tax benefit relating to a reduction in deferred tax valuation allowance of $2.5 million in Q4 2009 that added $0.51 to the EPS. If we were to ignore this tax benefit, then we are left with a TTM EPS of $0.15 resulting in a P/E of 32. MMUS has experienced steady sales growth since 2004 and has been cash flow positive since then. Using an average EPS for MMUS to compute the P/E is not really useful.
In my opinion, the best way to value MMUS would be to rely on free cash flows. Software companies typically exhibit consistent free cash flow generation. MMUS is not only a software company but increasingly its sales and cash flow has been driven by the growing subscription based SmartMusic platform. MMUS is debt free and sports a solid balance sheet with increasing levels of cash year over year. Cash and equivalents stood at $9.8 million ($2 per share) at the end of the 3rd quarter ending Sept 30, 2010. MMUS has a market cap of $24 million and backing out the excess cash gives us an Enterprise Value of about $14.2 million. The average FCF over the last 3 years was $2.3 million. On an EV/ average FCF basis, MMUS appears cheap trading at 6 times FCF. FCF over last twelve months was $2.8 million, lower than 2009 FCF of $3 million but higher than the three year average number. Using the TTM FCF number, we arrive at an even lower FCF multiple of 5x for the enterprise. If MMUS can maintain the sales level of its Finale products and continues to grow its subscription revenue from SmartMusic, I would expect the FCF to steadily increase year over year. Every incremental subscription would be accretive to FCF after accounting for sales/commissions related expenses. A subscription based software enterprise should be worth much more than the current 5x multiple on its free cash flows.
Assumptions: 5 million diluted shares, $10 million cash and $3 million FCF.
Price range ($8 - $11). Even at the low end of the valuation, the current stock price represents a 40% margin of safety.
Tax Assets
As of December 31, 2009, MMUS had U.S. net operating loss carry-forwards of approximately $17.8 million, Minnesota net operating loss carry-forwards of $6.4 million, and research and development tax credits of approximately $1 million. The federal NOLs expire in 2023 which work out to approximately $3.6 per share. As of Dec 31, 2009 MMUS maintained a valuation allowance of $5.7 million.
Comps
While there is no comparable public company, the closest one I feel is Blackboard Inc (BBBB, Financial). BBBB provides a Web-based teaching and learning platform, which comprises Course Delivery Module that allows educational institutions to support an online teaching and learning environment. Although BBBB is much larger in terms of revenues and market cap, you can see the high multiple (22x) assigned to its FCF.
Risk Assessment
Summary:
MMUS is a profitable company with a solid balance sheet where cash makes up 41% of the market cap. This provides us a margin of safety. It has an attractive subscription based business model that has been getting excellent traction over the last five years supported by stable revenue albeit flat revenues from its notation products. Average total sales growth has been around 8% for the last few years fueled by sales from SmartMusic that have grown 38% CAGR. MMUS trades at an attractive valuation of 6x three year average FCF or 5x TTM FCF. MMUS has been profitable since 2006 and cash flow positive since 2004. MMUS has executives and board members who have a good mix of music industry experience, business experience and experience at smaller public companies. MMUS software products have leading market positions and enjoy good pricing power as seen by the history of price increases over the years.
Disclosure: I have a Long position in MMUS at the time of writing.
Make Music Inc. (MMUS, Financial) Jan 21, 2010
Price: $4.84
Diluted Shares Out: 4.97 million (September 2010)
Market Cap: $24 million
Net Cash: $9.8 million (September 2010)
EV: $14.2 million (estimated)
MMUS SELECTED FINANCIALS 2001-2009
| Year | Sales | Op Inc | Net Inc | EPS | OCF | Cap-Ex | FCF | Shares |
| 2001 | $7.5 | $ (10.1) | $ (12.4) | $ (5.8) | $ (6.4) | $ 0.4 | $ (6.8) | 2.2 |
| 2002 | $7.7 | $ (5.5) | $ (19.8) | $ (8.6) | $ (2.5) | $ 0.2 | $ (2.7) | 2.3 |
| 2003 | $7.4 | $ (4.3) | $ (4.5) | $ (1.4) | $ (1.7) | $ 0.1 | $ (1.8) | 3.2 |
| 2004 | $11.2 | $ (0.6) | $ (0.5) | $ (0.15) | $ 1.0 | $ 0.2 | $ 0.8 | 3.4 |
| 2005 | $11.8 | $ (0.5) | $ (0.5) | $ (0.14) | $ 0.5 | $ 0.3 | $ 0.2 | 3.5 |
| 2006 | $13.0 | $ 0.4 | $ 0.3 | $ 0.06 | $ 1.2 | $ 0.6 | $ 0.6 | 3.9 |
| 2007 | $14.6 | $ 0.5 | $ 0.7 | $ 0.15 | $ 2.2 | $ 0.2 | $ 2.0 | 4.2 |
| 2008 | $15.2 | $ 0.4 | $ 0.5 | $0.10 | $ 2.4 | $ 0.4 | $2.0 | 4.6 |
| 2009 | $16.4 | $ 0.9 | $ 3.5* | $0.72* | $ 3.2 | $ 0.2 | $3.0 | 4.7 |
| TTM | $ 17.1 | $ 0.7 | $3.2* | $ 0.66 | $2.9 | $ 0.1 | $ 2.8 | 5.0 |
* - In Q4 2009, MMUS had realized a $2.5million tax benefit. Net Income and EPS excluding the benefit would have been $1 million and $0.21 respectively.
Company Description:
MakeMusic, Inc. founded in 1990 develops and markets proprietary music technology solutions under the Finale and SmartMusic brands. The company’s products provide alternatives to traditional practice, education, and composition techniques. Its software product sales are made through traditional distribution channels and MakeMusic’s Web sites.
The well-established Finale® family of music notation software products provides a solid base business that serves a large customer base, and generates consistent revenue through sales of new products, annual upgrades and trade-up campaigns. Music notation software is a niche business, with limited growth opportunity since only a small percentage of musicians ever notate music.
MMUS growth potential lies with SmartMusic®, a subscription-based software product directed towards the very large and constantly renewing market of music students and their teachers. SmartMusic combines a software application, a library of thousands of music titles and skill-development exercises, and a web service to provide students with a compelling experience and teachers with the realistic means to document the progress of every student. SmartMusic key differentiation is music accompaniment.
History
MakeMusic was organized in November 1990 under the name Vivace, Inc. On December 31, 1992, the Company acquired Coda Company and subsequently changed its name to Coda Music Technology, Inc. Coda Company was a partnership started in 1988 that developed the established music notation software called Finale, and a reputation for producing quality music technology products. Coda Company also had established distribution relationships and an existing infrastructure with product development, sales, marketing and administrative capabilities. Following the acquisition, the primary business of the Company consisted of enhancing, marketing and selling Finale products while developing Vivace products. In June 1994, the Company introduced the Vivace system, an innovative musical accompaniment system that responds to the musician in real-time. Fast forward to 2010, the Finale product has grown into a market leading product family with six distinct products and price points. The Vivace system underwent several transformations as discussed later, and started experiencing rapid growth once it was re-incarnated in its current form which is a subscription based software business.
There is a bit of rough history around the 2000 time frame. Net4Music SA a French company, completed the acquisition of MakeMusic (then Coda Music Technology, Inc. - NASDAQ: COMT) in a reverse merger transaction on October 19, 2000. The combined company was then renamed to Net4Music Inc. Net4Music S.A.'s core business was focused on marketing digital sheet music. The combined company had operations in France, New York, Madagascar and Minnesota. The employee count went from 45 at the end of 1999 to 205 at the end of 2000. All these years, the company had not profitable and the merger exacerbated the losses even further. The company closed it NY and Lyon operations in 2001 and in 3Q 2002 MMUS discontinued the digital sheet music business which was primarily the business of the Net4Music SA subsidiary. At this point, the company was in the mode of reversing everything that came along with the reverse merger transaction. In 2002, the company recorded a goodwill impairment charge of $13.7 million and another impairment charge of $1.7 million of its intangible assets. In its AGM held in May 2002, shareholders approved the name change to MakeMusic Inc. MakeMusic went back to its original areas of focus namely the Finale notation software and SmartMusic accompaniment system.
Finale: Music Notation software
MMUS is the market leader in music notation software with their Finale family of products for use with Macintosh® and Windows® PC operating systems. Music notation software enables a musician to enter musical data into a computer using either the computer keyboard, a MIDI- (Musical Instrument Digital Interface) equipped electronic music keyboard or other MIDI-equipped instruments, and contemporaneously display the data on a computer screen as a musical score. The dramatic improvements in speed and flexibility provided by software programs like Finale have made such software the dominant method for composers, arrangers, publishers, and music teachers to create printed music.
The Finale product is a powerful and comprehensive notation software product which is sold worldwide. Finale music notation software has a suggested retail price of $600.
MMUS also produces an Academic/Theological Edition of the Finale product that is sold exclusively to schools, teachers, college students, and religious organizations at a suggested retail price of $350. It reaches a market that is continuously replenished with new student users.
The Finale product is currently translated into German, French, Italian, and Japanese. All transactions with international customers are completed in US currency.
The Finale Allegro® product, a value-priced version of the powerful Finale music notation software product, was introduced in 1993. The Allegro music notation software product currently retails for $199 and contains a subset of the notation tools contained in the Finale product.
Finale PrintMusic® and Finale SongWriter® are entry-level music notation software products, retailing for $119.95 and $49.95, respectively. Each contains a subset of the notation tools contained in the Finale and Finale Allegro products. These products allow MMUS to offer entry-level products to the retail customer, thereby expanding the base of registered users and increasing the potential for sales of notation software upgrades.
Finale NotePad® is sold as an introduction to the Finale notation family and provides a quick and easy method to transform musical ideas into printed music. Finale NotePad is available via download for $9.99. Finale Reader™ was introduced in 2008 and is a free download to view, play and print Finale files”. – Source: MMUS 2009 10-K
The SmartMusic Solution
SmartMusic software is a comprehensive music teaching and learning solution for band, orchestra, and vocal students to use at school and, more importantly, at home. SmartMusic enhances and transforms the hours spent practicing by putting students inside a professional band or orchestra, so that they can hear how the music is supposed to be performed and how their part fits in. This makes practicing much more engaging, causing students to practice longer and more often. SmartMusic also offers a rich variety of effective practice tools that make practice time more efficient and productive. The combination of making practice time more engaging and productive leads to rapid student skill-development, increased student confidence, higher student retention, and stronger music programs.
Teachers use SmartMusic Gradebook™, the web-based grade book that comes with each teacher subscription, to post assignments to students, receive completed assignments from students, assess student achievement, and manage student records.
Synergies between SmartMusic and Finale products
From a technology perspective, there are considerable synergies between the SmartMusic business and the Finale notation business because the products benefit from shared technologies. The Finale notation technology, for example, is used within SmartMusic to display, among other things, sheet music, exercises, and beginning band method songs. It is this technology that puts red and green notes on the screen to show SmartMusic students what they played incorrectly and how to correct their mistakes. Likewise, the ability to create SmartMusic repertoire using the Finale product is a major benefit for SmartMusic customers.
History of SmartMusic
In June 1994, the first test version of the Vivace product was launched with a modular system at a suggested retail price of $2,295. In the spring of 1996, the Company released new configurations of the Vivace product at lower suggested retail prices, as well as an application and repertoire for vocalists. In the early versions, the system was made up of hardware, software and its library or repertoire. In July 1997, the Company announced the introduction of a software version of the product with a suggested retail price of $199 and repositioned the product as a complete practice system, the Vivace Practice Studio(TM). The Company announced in April 1998 that it would introduce SmartMusic Studio, a new and renamed version of the Vivace Practice Studio product. SmartMusic(TM) products began to ship in the second quarter of 1998, and included the basic software application at a nominal price and the full system sold under the name SmartMusic Studio which included accessory items at $99. In 1999, MMUS began the process of rebuilding the business on a direct to consumer model.In 2002, MMUS discontinued the Net4Music digital sheet music website and transitioned SmartMusic from a packaged retail product to an online subscription product.
The Company launched its website www.smartmusic.com and started to market SmartMusic on a licensed subscription basis to schools in the United States in December 2001 with a decreasing price scale ranging from $90 per year for the first subscription down to $20 per year for the fourth and more subscriptions. The home subscription program, priced $9.95/month or $90/year, was launched in spring 2002. In response to teachers’ requests to have an offer which would encourage all their students to use SmartMusic at home, the Company developed and launched its new school-sponsored home subscriptions offer in October 2002, which allows participating students to get a subscription for $20 per year as long as the school signs up at least 25 students. The Company also sold a one-year subscription plus accessories in a packaged box through dealers as a Subscription Starter Kit for a retail price of $119.95.
With a limited budget for marketing in 2002, more than 1,600 schools were subscribing to SmartMusic as of March 7, 2003, with schools initially ordering an average of 2.6 subscriptions for school computers. In addition, more than 100 of these school accounts had purchased school-sponsored home subscriptions with an average of 33 students per account.
In 2005-2006, MMUS conducted beta-testing of a web-based service product that would provide an easy-to-use service for music educators that enables them to electronically deliver SmartMusic assignments to students, automatically receive SmartMusic assessed grades and/or recordings of the assignments, and manage the student grades. MMUS released SmartMusic 10.0 in April 2007 which also included SmartMusic Impact™, a web-based service designed to manage student assignments, grades, and recordings while documenting the progress of each student. In 2008, SmartMusic Impact®was renamed to SmartMusic Gradebook. The renaming of the product was to clearly define its grade book capabilities for teachers.
Competition
The notation market is highly competitive and includes competitors such as Steinberg Media Technologies GmbH, Sibelius Software, NOTION Music, Inc., and Voyeur Turtle Beach, Inc.
| Finale | $599 |
| Sibelius Professional | $599 |
| Notion 3 | $249 |
SmartMusic created a new product category for teaching and learning music. It entered the market with no direct competitors. iPAS from Pygraphics, Inc. has been in the market for several years and provides on-screen music notation and assessment. StarPlay™ from In the Chair® is a recently introduced competitor which provides accompaniment and on-screen music notation. None of the competing products have the assessment and Gradebook capabilities.
Licensing of Content
Content is critical to SmartMusic’s success. No matter how exciting and useful the technology may be, if the SmartMusic library does not have the titles teachers want to perform with their student ensembles, they may not subscribe. While the SmartMusic library contains many titles and exercises that are either in the public domain or copyrighted by MakeMusic, the vast majority of SmartMusic content is licensed. These rights are licensed from a wide range of music publishers, including industry leaders such as Hal Leonard Corporation, Alfred Publishing, and Music Sales, Ltd.
In 2009, developing a typical band title that did not require engraving cost approximately $440 per title and the typical orchestra title was approximately $220. If engraving was required, the cost was approximately $2,270 per band title and $480 per orchestra title. Engraving is the process of taking hand written music notation and converting it into publishable format.
Partners
MMUS has developed SmartMusic Intelligent Accompaniment software for Hal Leonard’s Essential Elements®, the world’s best-selling method books for beginning band and strings students. This is part of a strategic partnership with Hal Leonard Corporation, the world’s largest sheet music publisher. This relationship is very important because students usually start to play in a school band in the fifth grade. In the United States alone, there are approximately 2.5 million students starting band every year. If many of these students have a successful experience starting out with SmartMusic, they will likely continue with SmartMusic and possibly become users of Finale software. As a result of a special marketing and licensing agreement, Hal Leonard offers SmartMusic in its Essential Elements Book One for band and orchestra students, reaching approximately 1 million students per year. Students receive a free trial offer giving them access to accompaniments to the first half of the book; and they may acquire access to the second half of the book at a discounted price as well as become regular subscribers thereafter.
Software Development
Application development is done by an internal team of software programmers and testers. Certain technologies are licensed from third parties and then adapted for use within SmartMsic. Development priorities are set by researching how teachers and students use SmartMusic, noting what improvements and additions are required. At December 31, 2009, there were 54 employees involved in product development for SmartMusic and Finale products at MakeMusic.
Release schedule:
Finale: has an annual release around July / August of each year
Allegro: typically released every other year
SmartMusic: upgrades to the SmartMusic app and the web based GradeBook are typically released each year.
Licensed Technology
Certain pitch recognition software incorporated into SmartMusic for purposes of music performance assessment is licensed from Institut de Recherche et Coordination Acoustique/Musique (IRCAM) which is based in Paris, France. The license agreement continues in perpetuity and was exclusive to SmartMusic through November 24, 2009.
SmartMusic Patents
MMUS licensed, from Carnegie Mellon University (“CMU”) on a worldwide basis for the life of the patent, the use of the U.S. patent that covers the automated accompaniment developed by MakeMusic that listens to and follows tempo changes from a live performance. Although this patent expired in 2005, MMUS has further developed this technology and patented additional features.
SmartMusic Accessories
The primary SmartMusic accessories are the instrumental microphone and the vocal microphone headset. These microphones are inserted into the microphone input of the computer and their audio signal is routed to the SmartMusic software for recording and assessment analysis. The instrumental microphone has a plastic-coated tip that allows it to be clipped onto a musical instrument or the student’s clothing. MMUS outsources the microphone manufacturing to suppliers who can meet the specifications. During 2009, the suggested retail price of the SmartMusic microphones was $19.95. Over 70% of new subscription purchases include a microphone.
Manufacturing
Manufacturing for hardware accessories such as mikes and headsets is outsourced and based on standard specifications. Printing of user manuals, packaging, and the manufacture of related materials are performed to specifications by outside subcontractors.
Infrastructure
The MakeMusic! Inc. data center is operated internally, offering extensive uptime and connectivity to the Internet backbone via dual dedicated T1 connections. For maximum reliability, all the servers utilize redundant arrays of independent disks for information backup as well as redundant power.
In the Q2, 2010 management said that MMUS will be moving their infrastructure to a Microsoft Azure cloud based solution which would be cost effective and highly scalable.
Revenue Sources
Revenues by Country
| 2009 | 2008 | |
| N. America | 85% | 84% |
| Europe | 8% | 9% |
| Japan | 4% | 4% |
| Other | 3% | 3% |
Segment Analysis
| Notation | SmartMusic | |
| Revenue | $11,060 | $5,382 |
| Cost of revenues | $940 | $1,658 |
| Gross Profit (GM %) | $10,120 (91.5%) | $3,724 (69%) |
| Op Expenses: | ||
| Development | $1,898 | $1,937 |
| Selling and marketing | $1,816 | $1,607 |
| General and Admin | $ 77 | $ 70 |
| Total Op Expenses | $3,791 | $3,614 |
| Income from Operations (%) | $6,329 (57%) | $ 110 (2%) |
Effective January 1, 2009, MakeMusic began reporting results of operations by two unique reportable segments, Notation and SmartMusic. Historically, net revenue has been reported separately for these two product lines. However, direct and operating costs had not been previously assessed or reported by segment and therefore, prior year comparative costs are not provided.
Clearly, Notation segment contributes almost the entire income from operations. SmartMusic provides lower gross margins than notation products due to the amortization of software and repertoire development, royalty payments to publishers and accessory sales. MMUS has been spending heavily in SmartMusic in terms of development and selling and marketing expenses. Management feels that the development expenses will be stable or may go down from these levels. In 2009 – 2010, MMUS spent heavily to re-write the Gradebook feature as well as made significant user interface changes to the SmartMusic application. As subscription sales continue increasing, MMUS will see benefit from these investments and operating income from SmartMusic should increase much faster. From Q3 2010 10-K, for the nine months till September 30, 2010, income from SmartMusic operations was $350k compared to $10k for the corresponding period in 2009.
Segment sales 2001 - 2009
| Year | Notation Sales | SmartMusic Sales | Total Sales | Total Sales Growth | Notation Sales Growth | SM sales growth | SM as % Of sales | SM Subs |
| 2001 | $ 6,873 | $ 558 | $ 7,431 | |||||
| 2002 | $ 7,477 | $ 229 | $ 7,706 | 4% | 9% | -59% | 3% | |
| 2003 | $ 6,688 | $ 585 | $ 7,273 | -6% | -11% | 155% | 8% | 18k |
| 2004 | $ 9,685 | $ 1,002 | $ 10,687 | 47% | 45% | 71% | 9% | 37k |
| 2005 | $ 9,762 | $ 1,533 | $ 11,295 | 6% | 1% | 53% | 14% | 46k |
| 2006 | $ 10,267 | $ 2,164 | $ 12,431 | 10% | 5% | 41% | 17% | 57k |
| 2007 | $ 10,980 | $ 2,900 | $ 13,880 | 12% | 7% | 34% | 21% | 87k |
| 2008 | $ 10,289 | $ 4,070 | $ 14,359 | 3% | -6% | 40% | 28% | 107k |
| 2009 | $ 10,617 | $ 5,014 | $ 15,631 | 9% | 3% | 23% | 32% | 134k |
Total sales had a CAGR of 8% from 2004 to 2009. In the same period, Notation sales had a low CAGR of 2% while SmartMusic sales had a high CAGR of 38%. SmartMusic sales increased from $1 million in 2004 to $5 million in 2009 while Notation sales went from $9.7 million to $10.6 million in the same period. As a result, SmartMusic represented 32% of sales at the end of 2009. I expect this trend to continue over the years and in a couple of years, we could well see SmartMusic represent more than 50% of total revenue.
History of price increases:
Finale: $545 (1997) ---- $600 (2001)
Academic: $275 (1997) ---- $300 (2001) ----$350 (2005)
Alegro: $199 (since 1997)
PrintMusic: $70 (1999) ---- $100 (2005) ---- $120 (2010)
NotePad: Free (2000) ---- $10 (2008)
SongWriter: $50 (since 2006)
SmartMusic Student edition: $20 (2002) ---- $25 (2005) ---- $30 (2008) ---- $36 (2010)
SmartMusic Educator edition: $100 (2002) ---- $130 (2008) ---- $140 (2010)
As can be seen from above, MMUS has been able to raise prices for most of its products gradually over the years. It has kept the price for the Finale and Alegro products steady at $600 and $199 respectively for a decade now. Pricing for the SmartMusic product has been raised gradually as more features have been added and it has gained wider acceptance in the schools and teaching community.
Growth in SmartMusic Subscriptions
| Total Subscriptions | Educator accounts | Site agreements | |
| FY 2003 | 18K | ||
| FY 2004 | 37K | ||
| FY 2005 | 46k | ||
| FY 2006 | 57k | ||
| FY 2007 | 87k | ||
| FY 2008 | 107k | ||
| FY 2009 | 134k | 9,269 | 322 |
| FY 2010 | 162k | 9,402 | 485 |
Cost structure
Selected financials from MMUS’s Income statement FY 2009 – FY 2010
| 2009 | 2008 | 2007 | 2006 | 2005 | 2004 | |
| COGS | 10% | 10% | 11% | 11% | 9.6% | 3.6% |
| SGA | 48% | 51% | 52% | 58% | 58% | 63.4% |
| R&D | 31% | 31% | 29% | 27% | 28% | 24% |
| Op Income | 5.4% | 3% | 3.6% | 1.2% | (4.5%) | (5.6%) |
| Net Income | 21% | 3% | 4.5% | 2% | (4.2%) | (4.5%) |
Balance Sheet Analysis (as of September 30, 2010)
- MMUS has $9.8 million in cash. Cash balance has increased steadily over the years from $1.5 million at the end of 2002 to its current balance of $9.8 million end of Q3 2010.
- Receivables stood at $1.5 million and have been around that level from 2006.
- Goodwill has been constant at $3.6 million since 2002.
- MMUS has no ST and LT Debt.
- Accounts payable was only $0.6 million.
Management
Jeffrey A. Koch joined MakeMusic as a director on July 20, 2006, and was elected the Chairman of the Board on October 19, 2006. He was made CEO recently after the previous CEO resigned. From 2005 to 2009, Mr. Koch was the Chief Executive Officer of LaunchEquity Partners, LLC, a firm that specializes in investing in early stage companies with high growth potential in both the public and private markets. Mr. Koch has an MBA from Washington University in St. Louis and is a Chartered Financial Analyst.
Karen L. VanDerBosch joined MakeMusic as Chief Financial Officer and Treasurer in December 2006. Ms. VanDerBosch was most recently the CFO of Sagebrush Corporation, a privately held developer of library automation software, and services, analytical software and book re-binder for the K-12 education market.
Likely reasons for the cheap price
- CEO resigned recently. The company was trying to sell itself but it did not like the indications of the price it was being offered.
- Micro cap stock with low trading volume and no analyst coverage
- Finale sales have been stagnant.
- Despite rapid sales growth in SmartMusic, bottom line earnings have not grown as fast as investors would have liked.
- MMUS does not pay a dividend or buy back shares despite a large cash balance.
Potential catalyst
Stock Repurchase Program
The Board of Directors also has adopted a plan to repurchase up to $10 million of MakeMusic common stock. This program will allow MakeMusic to repurchase stock over the next two years in open market transactions (including through 10b5-1 plans) or private transactions at the discretion of management. Repurchases will be subject to applicable SEC rules and to certain price, market, volume and timing constraints specified in the plan. These repurchases may be commenced or suspended at any time or from time to time without prior notice.
Valuation
With a recent price of $4.84, MMUS appears cheap trading at a TTM P/E of 7.4. Note that the P/E is based on a TTM EPS of $0.66 which includes a non-recurring tax benefit relating to a reduction in deferred tax valuation allowance of $2.5 million in Q4 2009 that added $0.51 to the EPS. If we were to ignore this tax benefit, then we are left with a TTM EPS of $0.15 resulting in a P/E of 32. MMUS has experienced steady sales growth since 2004 and has been cash flow positive since then. Using an average EPS for MMUS to compute the P/E is not really useful.
In my opinion, the best way to value MMUS would be to rely on free cash flows. Software companies typically exhibit consistent free cash flow generation. MMUS is not only a software company but increasingly its sales and cash flow has been driven by the growing subscription based SmartMusic platform. MMUS is debt free and sports a solid balance sheet with increasing levels of cash year over year. Cash and equivalents stood at $9.8 million ($2 per share) at the end of the 3rd quarter ending Sept 30, 2010. MMUS has a market cap of $24 million and backing out the excess cash gives us an Enterprise Value of about $14.2 million. The average FCF over the last 3 years was $2.3 million. On an EV/ average FCF basis, MMUS appears cheap trading at 6 times FCF. FCF over last twelve months was $2.8 million, lower than 2009 FCF of $3 million but higher than the three year average number. Using the TTM FCF number, we arrive at an even lower FCF multiple of 5x for the enterprise. If MMUS can maintain the sales level of its Finale products and continues to grow its subscription revenue from SmartMusic, I would expect the FCF to steadily increase year over year. Every incremental subscription would be accretive to FCF after accounting for sales/commissions related expenses. A subscription based software enterprise should be worth much more than the current 5x multiple on its free cash flows.
| FCF multiple | 10x | 12x | 15x |
| Enterprise Value | $30 million | $36 million | $45 million |
| Expected share price | $8 | $9 | $11 |
Price range ($8 - $11). Even at the low end of the valuation, the current stock price represents a 40% margin of safety.
Tax Assets
As of December 31, 2009, MMUS had U.S. net operating loss carry-forwards of approximately $17.8 million, Minnesota net operating loss carry-forwards of $6.4 million, and research and development tax credits of approximately $1 million. The federal NOLs expire in 2023 which work out to approximately $3.6 per share. As of Dec 31, 2009 MMUS maintained a valuation allowance of $5.7 million.
Comps
While there is no comparable public company, the closest one I feel is Blackboard Inc (BBBB, Financial). BBBB provides a Web-based teaching and learning platform, which comprises Course Delivery Module that allows educational institutions to support an online teaching and learning environment. Although BBBB is much larger in terms of revenues and market cap, you can see the high multiple (22x) assigned to its FCF.
| MakeMusic (MMUS) | Blackboard Inc (BBBB) | |
| Market Cap | $24m | $1345m |
| Enterprise Value | $14.2m | $1420m |
| Revenue (ttm) | $17m | 430m |
| P/E (ttm) | 7.4x | 59x |
| EV / FCF (ttm) | 6x | 22x |
| EV/ Sales (ttm) | 0.8x | 3.3x |
Risk Assessment
- Possible risks include a slowdown in the adoption of SmartMusic in schools in the US, subscription cancellations by schools, teachers and students, cuts in funding for music programs around the country.
- Software issues/ bugs/outages/stability of the system
- Sales and FCF do not grow as expected while expenses keep increasing as in the recent quarters.
Summary:
MMUS is a profitable company with a solid balance sheet where cash makes up 41% of the market cap. This provides us a margin of safety. It has an attractive subscription based business model that has been getting excellent traction over the last five years supported by stable revenue albeit flat revenues from its notation products. Average total sales growth has been around 8% for the last few years fueled by sales from SmartMusic that have grown 38% CAGR. MMUS trades at an attractive valuation of 6x three year average FCF or 5x TTM FCF. MMUS has been profitable since 2006 and cash flow positive since 2004. MMUS has executives and board members who have a good mix of music industry experience, business experience and experience at smaller public companies. MMUS software products have leading market positions and enjoy good pricing power as seen by the history of price increases over the years.
Disclosure: I have a Long position in MMUS at the time of writing.
