Creative's Destruction

This column was originally published on RealMoney on July 17 at 7:26 a.m. EDT. It's being republished as a bonus for TheStreet.com readers.

Shares of Creative Technology ( CREAF) have declined about 26% since I wrote about it last August and it's now trading at a seemingly dirt-cheap valuation of 0.3 times sales. However, the fact that I'm using an enterprise value to sales metric is a sign of the company's problems -- it can't generate profits despite red-hot end markets. I believe Creative is likely to experience more pain going into this holiday season.

Creative's margins have been obliterated by its massive push into MP3 players, where it, along with many others, has been unable to make headway against Apple's ( AAPL) iPod.

In the fiscal year ended June 2004, Creative's gross margins were a very strong 35.5%, but they dropped to 13.9% over the last 12 months. Note that the 13.9% figure includes inventory writedowns, which I chose to leave in because I believe the company may have to continue writing down inventories going forward. The company is aiming to return gross margins to 20%.

Creative's balance sheet has also deteriorated. At the end of March, the company had had $102 million in net cash, down from $238 million at the same time last year and $390 million two years ago, when the company had very little long-term debt.

That net cash balance has been fairly steady for the last three quarters, but the company's cash flow statement shows it hasn't been from any kind of operational strength. A great deal of the cash came from falling inventories: Since the company had so much inventory in the past, it didn't have to buy a lot of new stuff. Besides, inventory is still high at current levels. Plus, the company received a boost from the sale of some long-term investments, the balance of which includes a big slug of Sigmatel ( SGTL) stock, which is down over 65% year to date.

Creative actually makes some excellent media players, but anyone who believes it will get any easier for the company this holiday season is in for a rude awakening. Recall that last year, every MP3 player maker was targeting the hard-drive based iPod Mini for destruction. That story ended with Apple hitting the self-destruct button on the Mini and releasing the Nano, which nobody saw coming. Apple is likely to repeat the trick this year -- it's expected to release a new iPod with a bigger screen for an improved video experience or possibly one with wireless capabilities. Whatever it is, you can surely bet that every media outlet in the world will provide Apple with all the marketing it needs.

But it gets worse. Microsoft is reportedly planning its own MP3 player, bringing yet another heavyweight into a very crowded market. And then there is the distinct possibility that music-enabled cell phones will take off in the U.S. this year, providing a ton more competition for the MP3 segment. Cell-phone service providers like Verizon Wireless ( VZ) and Sprint ( S) are aggressively pushing music phones from manufacturers like Samsung. And Sony Ericsson just reported that it shipped 3.9 million music phones in the second quarter. The music phone boom is primarily a European trend now, but 3.9 million units in a quarter is no small number for premium-priced phones, and it's more than half the number of iPods analysts are expecting Apple to sell in the second quarter (Apple's fiscal third quarter).

There are three risks to my negative thesis: The first is that somehow Creative's media players really take off with strong pricing. The second is that Creative gets taken over. The third is that it will score a big win in its patent litigation against Apple.

These possibilities require more hope than I'll ever have.

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In keeping with TSC's editorial policy, Michael Comeau doesn't own or short individual stocks. He also doesn't invest in hedge funds or other private investment partnerships. Comeau is a research analyst at TheStreet.com. In this role he performs stock analysis for TheStreet.com Breakout Stocks, and is also a regular contributor to RealMoney.com. Prior to his arrival at TSC in June 2004, Comeau worked as a Consultant to Toyota Motor North America, performing in-depth research on automotive industry issues, primarily in the areas of alternative engine technologies, competitive analysis and macroeconomics. His primary market interests include consumer technology, specialty retail, and small-caps. Comeau received a bachelor's degree in Finance from Brooklyn College, and has completed Level 1 of the CFA program.. He appreciates your feedback; click here to send him an email.

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