Steinway Musical Instruments (LVB) has many of the attractive elements I look for in an investment: a dominant market position in its core business, solid downside protection, hidden asset value, smart and incentivized insiders, and several foreseeable catalysts all rolled into a small-cap, underfollowed stock. I believe this $25 stock is worth ~$47 (88% upside) and that there are several probable catalysts (as early as Q3 this year) that could drive the share price closer to my estimate of intrinsic value.

Since its founding in 1853, Steinway has dominated the high margin, high ticket ($130,000+) concert piano market by making the finest pianos in the world. They also have a “band business” which sells non-piano instruments, which is a less lucrative, more commoditized business. Finally, they own two properties in NYC that are listed on the balance sheet at ~$3 mm and $26 mm, but were appraised at $200 mm and $100 mm respectively during a debt refinancing in 2006. This stock has always traded at a discount to the sum of the parts because the company formerly had a dual class share structure that prevented activism. With management that did not have the urgency, willingness, or experience to realize the full value of their assets (particularly their real estate assets), a discount to the sum of the parts was appropriate.

However, in 2007, ValueAct Capital began building a significant position in the stock. ValueAct is a very successful activist hedge fund that has averaged ~13.5% returns since 2000 (versus an almost flat S&P). Their process typically entails building a large position in a stock, divesting non-core assets, and ultimately, negotiating sale of the business. Just in the last year, ValueAct successfully sold BigBand Networks to ARRIS Group (Nasdaq: ARRS), Immucor to TPG Capital, and S1 Corp to ACI Worldwide (Nasdaq: ACIW). ValueAct has been involved with Steinway since 2007 and it appears this investment is following their typical script. Current investors have an opportunity to invest at a lower cost basis right before several key catalysts, which should drive a tremendous IRR.

On June 2, 2011 ValueAct along with Samick Instruments, a Korean instrument company, purchased the Class A voting shares from the former CEO and Chairman of the board at $56/share, which was a 100%+ premium to the common share stock price at the time. As part of this process, ValueAct and Samick took control of the company and board, placing Private Equity veteran, Michael Sweeney, as Chairman and CEO. ValueAct currently owns 9.6% of the stock and Samick, which is a Korean instruments company, owns 32.31%.

The stock currently trades at $25, which is roughly the same price as in June 2011 prior to elimination of the dual class share structure. I believe that this discount is no longer warranted, especially given the high probability of multiple value driving catalysts over the next year. These potential catalysts include:

• A sale of the lower-margin band business, which would allow them to focus all of their efforts on their dominant Steinway brand and other piano operations. The company reached a tentative deal with Kyle Kirkland and Dana Messina, the two former directors who had previously owned the voting rights. While negotiations are still ongoing, the company was reportedly seeking around $76 mm for this division.

• Monetization of their NYC real estate properties. Their 450,000 sq. foot Steinway Factory was opened in the 1870’s and is listed on the balance sheet for only $3 mm, but was appraised for $200 mm in 2006. Their 217,000 sq. foot showroom in Midtown Manhattan is only carried on the books at $23 mm, but was appraised at $100 mm in 2006. These are prime real estate assets (look here for street view of Steinway Hall: bit.ly/RBbYwh). It is a waste for the company to own an 18 story building in the heart of Manhattan where it occupies only a fraction of the building and manufacture their Steinway pianos at such a valuable waterfront Queens property.

• A sale of the main piano business to Samick or other interested buyers. Samick paid a huge premium to gain control of the company, owns over 30% of the stock, and has their CEO on the board of Steinway for a reason. Adding the dominant piano brand worldwide into their portfolio is the next logical step. With a sale of the band business and the real estate, Samick could more easily bid for the whole company. This would also fit right with ValueAct’s typical strategy of using a sale of the business as an exit strategy.

• On the latest conference call, Chairman and CEO, Michael Sweeney (the PE veteran), said, “The special committee has been very active in evaluating a variety of strategic alternatives, and we expect the committee to complete its work during the third quarter. We will have an announcement as soon as possible.” ValueAct has been in this stock since 2007 and Sweeney has been working actively on this since 2011. I think that current investors have an opportunity to maximize their IRR by investing right before the culmination of this 5-year process by ValueAct is readily apparent to the market.

Of course, this opportunity is only attractive if the sum of the parts discount still exists. I think there is overwhelming evidence to suggest that it does. Before digging into the numbers, I think it is important to note that the stock price has essentially not moved since the dual class share structure was eliminated in June of 2011 despite very solid results from operations. That decision by Mr. Market does not make much sense to me, especially since management is suggesting that there will be an announcement about strategic alternatives soon. Perhaps this opportunity exists because there is very little analyst coverage and investor relations to publicize the several sources of hidden value to a largely retail investor base (e.g. see this recent seekingalpha article that says the 61 P/E is too expensive but mentions nothing of ValueAct or their real estate holdings, which are clearly pertinent to the investment: bit.ly/RBjHL0).
Here is how I think about the low and high valuation components for Steinway. I tried to err on the side of conservatism even for the high valuation.

1) Piano Business: I took the 4-year avg EBIT for this division. This is a pretty good division with strong margins (especially for their premium Steinways). Revenues and operating income have been increasing and there is still a significant growth opportunity in Asia. I chose 8X EBIT for the low estimate and 12X EBIT for the high estimate. I think both of these are fairly conservative, especially considering rival Yamaha trades at ~13X EBIT. Steinway’s core businesses have been slow growers with ~10% EBITDA margins and boast the world famous Steinway brand. Yamaha has had slightly negative top line growth, ~5% EBITDA margins, and is a more commoditized brand. Given these factors, I think giving Steinway’s Piano Business a Yamaha-like multiple is, if anything, conservative.

Piano Business EBIT 4-yr avg (mm) $19.90

Multiple   Value (mm)

6             $119.40
8             $159.20
10           $199.00
12           $238.80
15           $298.50

2) Band business: The company is in serious negotiations to sell this business, and they were reportedly seeking $76 mm. I used this for the high estimate and took a 50% haircut on that valuation for the low estimate. Note that this business does ~$130 mm in sales/year, so the high and low estimates are about .6X and .3X sales respectively. Those do not seem too aggressive for a pretty consistent and profitable business.

3) Real Estate: As mentioned, Steinway Hall and their West 57th Street manufacturing facility were appraised for $200 mm and $100 mm respectively in an 8K filed February 10, 2006.

I used the 2006 appraised values of $200 mm for the Steinway Factory and $100 mm for the West 57th Street building for the high estimate. I took a 50% haircut to each of these values for the low estimate. I think both of these are pretty conservative given that most rent prices in Midtown NYC have actually increased since 2006 (~30%) and the Steinway Factory could be worth multiples of the appraised value if the company was able to get it rezoned to a residential area.

Item                        Low Value      High Value

Piano Business          $159.00         $238.00
Band Business           $38                $76

Steinway Factory        $100               $200
West 57th Street         $50                 $100

Net Cash                    ($31)               ($31)

Value                             $316               $583
Value/Share                  $25.44            $46.94

Upside/Downside (%)    1.77%            87.76%

I think the assumptions made in the Low Value Scenario are pretty draconian. With a buyer lined up for the band business (former directors Messner and Kirkland with a tentative deal), a logical buyer for the core piano business (Samick) that paid $56/share to take control, and a proven activist in ValueAct to maximize the real estate value, I think the market price should be much closer to the “high value” scenario than the low value scenario, which the market is currently implying with the $25 stock price. Furthermore, the assumptions made in the “High Value” scenario are far from aggressive:

• The 12X EBIT for the Piano business is below competitor Yamaha’s valuation, even though Yamaha is a less attractive business.

• NYC midtown asking rent prices are up ~30% since the 2006 appraisal values (which I used in the “High Value” estimate), which should make the West 57th street property more valuable.

• The Steinway Factory could potentially be reclassified as a residential area, which would more than double the value of the waterfront Queens Steinway Factory real estate.

• I am giving zero value to their 221,000 sq. foot manufacturing facility in Hamburg, Germany: This factory was opened in 1880 and is carried on the books at $1MM but is probably worth substantially more today.

For all of these reasons, I think the “High Value” estimates are very reasonable.

Steinway is trading almost exactly where it was a bit over a year ago, but the investment is undoubtedly much more attractive today. ValueAct and Samick have showed a significant vote of confidence and “tipped their hand” as to their intentions by paying $56/share to remove the dual-class share structure and investors today have an opportunity to invest below their average cost basis. This move, along with the appointment of a PE veteran as CEO and Chairman are a game-changer for the stock. I think it no longer deserves to trade at a discount to the sum of the parts with ValueAct and their history of success leading the way to value realization. I think the stock with very reasonable assumptions is worth much closer to the “High Value” case of $46.94/share than the current price of $25.

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