Digital Music Group IPO Inches Closer: Simply Mind Boggling Valuation

Correction:  the original post below did not correctly calculate the number of shares outstanding in the merged company of DMG.  The new market cap is actually closer to $75M, vs $270M, lowering the ratios described below, although not changing the overall thesis.

When I wrote about the S-1 filing of Digital Music Group in late 2005, I assumed that it was the last we would hear about it since it's such a ridiculous concept, even in today's increasingly bubble-like atmosphere.  However, amazingly enough, the IPO appears to be moving forward based on the recently filed amended S-1. 

There is no point in completely rehashing the first post since nothing has changed to make this offering any less ludicrous.  However, we can at least look at the valuation justification now that they have released expected pricing.  At the median offering price of $9, this would value the company at approximately $270M, based on a total of almost 30M shares, fully diluted.  To put it in context, the average price to sales valuation paid for large, fast growth digital media companies has been approximately 5x sales - that would be JamDat, IGN, MySpace, etc.  That's a rich, but defensible valuation assuming market leadership, high growth and high gross margins.

So how does Digital Music Group stack up?  The revenue in the most recent quarter (Q3 2005) was $235K,  giving it an annual run rate of $1M.  Therefore, we're looking at an astonishing 270x Sales valuation with a gross margin of 39% for Q3.  Another metric would be valuation per employee - since DMG has a grand total of 12 employees, each one is apparently worth $22.5M+, a slightly higher number than you would find at most other companies :)  A final way to look at it would be to consider that in August & again in late September 2005 (just 4-5 months ago), the DMG Board of Directors decided that the fair value of the company stock was $.01 a share when it sold 775,000 common shares to insiders for the grand total of $7,750 - yet now the stock is $9 a share?  A more correct valuation would be in the $5-10M range, so avoid this one like the plague, or short it like crazy if possible.  There are too many other better investments in the private sector with larger, more established players such as IRIS, DRA, IODA, and The Orchard.

Other interesting tidbits in the filing are:

• iTunes (which accounts for 92% of their revenue) pays them $.70 per single download and $7.00 per album, and that appears to be a standard rate in the industry.
• In short term agreements with content owners, DMG pays the owner 80-85% of revenue
• In longer term agreements, DMG pays the publishing royalties, and then pays 25-50% of revenue to the content owner, as well as advances to secure the rights
• Peter Csathy, the former President of MusicMatch, is joining DMG's Board, as is John Kilkullen, the Publisher of Billboard
• DMG has borrowed $500K on a $750K line of credit from a Director/Shareholder's company in order to fund the costs of the IPO
• DMG has paid royalty advances of $1.150M as of 9/05, yet amortized only $10K of it in the last 9 months with another $50K now payable.  Luckily these deals are long term deals since this amortization is going to take a long time at anything close to the current rate.

Comments

[Daniel James]

Re: Price/Sales for media companies, was myspace doing ~$120M a year in sales...? I have trouble imaginging how.

It looks like JMDT was nearer $80M for '05, so ~8x.

Looks like IGN did ~$40M in '04. Even if they doubled in 05 (which I doubt), still ~8x.

That said, the Fox acquisitions were imho overpriced.

[dan]

you are missing some facts
DMG has a catalog of 200,000 songs but has only converted 35,000. once converted they will have approx 5x the content therefore possibly 5x revenues. also the proceeds from the offering will allow them to purchase additional content
we estimate the catalog could be between 1.3 million and 1.5 million songs which would represent approx 40x their current properties. it is possible that 40x content could mean 40x revenue.apply the 5x multiple you used that would give this company a 200 million dollar market cap or $20 plus per share.

[Sean Ryan]

Regarding Dan's comment. Logically one would assume that the first 35K songs converted would be the highest value ones, so the next 165K shouldn't be valued at the same level.

As to the possible future size of the catalog vs current/possible revenues, the accepted 5X current revenue multiple already assumes massive growth - much of that is already built into these projections.

Following Dan's logic though, if a lower tier player like DMG in this space can be worth $75-$200M, then I guess the 3+ players (Orchard, IODA, DRA, and maybe IRIS) above it are vastly undervalued since they should be worth $200-500M+ each, which is where the thesis explodes in the face of reality.

DMG has a real business - it just shouldn't be a public company and should be valued in the $10M range, even by today's lofty standards of market leading players.