Description

Cinram is a solid growth story with multi-year contractual cash flow and a capital structure that allows for an attractive return if performance is steady and more than a double if the company receives a fair multiple and/or continues to grow rapidly. The company operates in a duopoly environment and has a favorable tax situation thanks to a large D&A tax shield (primarily due to the ability to deduct the amortization on a 6-year contract) and a 30-32% effective tax rate. Also, Cinram is on the front-end of a trend toward lower capex and being able to clearly demonstrate the low maintenance capex that they insist is sufficient to operate their business. Using the company’s maintenance capex guidance, Cinram trades with a 28% FCF yield and at less than 5x EBITDA-maintenance capex whereas the most conservative analysis of maintenance capex would get you to 6.25x or lower. Market cap is approximately $1,020mm (all figures will be in US$) and net debt is approximately $850mm. EBITDA guidance for 2004 is $390-410mm and pure maintenance capex is $15-20mm (2004 gross capex will be $150mm).

Company Overview

Cinram is the world’s largest replicator of optical discs (DVDs, CDs and CD-ROM), with about 40% of the DVD market in the U.S. and Western Europe. Major components of revenue are DVD manufacturing (50%), CD manufacturing (15%) and a DVD/CD promotional printing operation (14%). Cinram manufactures and manages the warehousing and logistics for DVDs, CDs and VHS tapes (and sometimes the cardboard box/package and promotional materials for display). Under the company’s contracts, increases in raw material costs are fully passed-through. Over the last 30 years, the CEO has taken the company through numerous media formats (8-tracks, LPs, audio tapes, VHS and now optical discs) and he owns about 4% of the stock.

The DVD business is crucial to studios’ profits and it’s vitally important to have absolute confidence in the quality and distribution capabilities of your supplier (imagine if Lord of the Rings gets to Wal-Mart two days late or Wal-Mart in Little Rock can’t replenish a hot title quickly enough). The cost to the studios for the DVD (including packaging and shipping) is less than $3 versus a typical retail sale price in the $15-$20 range. These are huge gross margins for the studios and thus while the studios possess some leverage in negotiations with the replicators, they understand that they are risking $12-15 in profit for a nickel of savings. As a result, EBITDA margins (in the high 20% area for DVDs) are higher then what you might instinctively guess for a tech manufacturing business. It is further comforting that the industry has consolidated into two dominant players who have an even split of the major studios and who aim to preserve margins by avoiding price competition.

Cinram has no real inventory risk as its manufacturing is done to order and title is taken by the studio once the product is shipped to one of Cinram’s warehouses or distribution centers. The studio tells the company where to send everything (down to the store level) and when Wal-Mart, Blockbuster, etc. decides to sell excess or used DVDs to another retailer, it often will ship it to Cinram which gets paid to re-package it and send it to the new buyer.

Over the past few years, the company has invested significantly in its distribution and logistics capabilities in North America and Europe and can reliably deliver 3 times a week to all 3,000 Wal-Marts in the U.S. This integrated production and distribution capacity is a valuable asset and creates a significant barrier to entry for new players.

Contracts

On the DVD side, the company has 2-3 year exclusive replication/distribution agreements with Fox, MGM and Lion’s Gate in the U.S., and also does some work for Columbia/Tri-Star (Sony). It has 6-year exclusive agreements with the Warner Brothers and New Line studios and Warner Music Group in the U.S. and Europe.

Time Warner assets

In late October 2003, the company consummated its acquisition of Time Warner’s DVD, VHS, CD manufacturing plants as well as a printing operation called Ivy Hill ($250mm of revenue) and Giant ($150mm revenue; relatively non-core business which does screen printing for concert and promotional T-shirts).

Cinram paid 4.6x 2003E EBITDA for the Time Warner businesses (excluding synergies). TW had previously built DVD manufacturing facilities because there wasn’t sufficient industry capacity at the time, and TW had always outsourced 20% or so of its volume to smaller players. It was not interested in being in the manufacturing or distribution side of the business long-term and was aggressively seeking to raise cash in 2003. Through the TW acquisition, Cinram achieved much greater scale, gained a major foothold in Europe, and TW was assured of reliable service and guaranteed pricing for at least 6 years.

To date, the TW assets have been seamlessly integrated (company says its about 75% done). None of the figures I have used include the achievement of production synergies expected by mgmt.

Three important aspects of the deal are:
(1) Amortization of the Time Warner DVD contract is tax-deductible. Cinram is amortizing the contract at about $60mm/year for 6 years.
(2) There are fixed pricing declines in the Time Warner contract (vs. market-based declines for Cinram’s other contracts). The pricing decline is in the “mid-single digits” in 2005 and is significantly smaller thereafter.
(3) Cinram financed the acquisition entirely with 5-6% floating-rate debt.

Two-Player Market

Cinram and Technicolor (subsidiary of Thomson, ticker: TMS) share about 80% of the DVD and VHS market in North America and Western Europe. The third and fourth largest players are Sony and Deluxe (Rank Group subsidiary) respectively. (Sony is the last studio to own replication capacity). Sony has not expressed interest in replicating for other major studios, nor would the major studios be interested for obvious reasons.

Deluxe has less than 20% of Cinram and Technicolor’s DVD capacity, and announced in May that it lost a contract that accounted for about 48% of its DVD volume. This contract is for Fox in Europe (see below). Deluxe has indicated that if it cannot replace the lost volume, it will exit the DVD replication business altogether and this seems probable given that there are no major mandates realistically available for Deluxe to replace the Fox Europe business.

Besides Technicolor, no-one else has the scale/capacity/distribution capability to service a major new replication/distribution contract. This provides Cinram with excellent negotiating leverage in contract pricing in the future. Moreover, there’s a great barrier for potential entrants: you need a major contract to justify building the production capacity, but to get a major contract you would likely need a demonstrated track record of fast and reliable DVD production and distribution.

Cinram and Technicolor “help each other out” by occasionally producing for the other during peak periods. Cinram’s and Technicolor say they don’t see either company trying to poach the other’s customers nor do they have any interest in a pricing war. Neither player likes to low-ball bids for contracts they’re unlikely to get because it lowers market pricing and hurts them when their own contracts are up for renewal.

Moreover, the studios like to have some ‘dedicated capacity’ and do not like being told their order is at the back of a long queue. The studios don’t seem interested in sharing a replicator with 3 or 4 other major houses, especially when the replicators are running at 100% capacity and a studio might need to throw in a last minute order for a popular title which needs to be replenished ASAP in thousands of stores.

Studios rarely switch replicators for the following reasons:
(1) Difficulty of shifting inventory (although they are property of the studios, DVD inventories are stored in the replicators’ warehouses and distribution centers)
(2) Integration of complex back office systems (Cinram processes hundreds of orders a day from studios)
(3) Studios are making $12-15/DVD and would need extremely high comfort with someone else’s distribution/logistics capabilities to save $0.05/DVD

The three exceptions to this ‘no switching’ trend appear to be: (1) Cinram taking the Fox North America business in 2000 after Deluxe bungled the distribution of Titanic while changing its SAP system, (2) Cinram taking the MGM contract by building a dedicated facility, and (3) Deluxe losing the Fox Europe contract, which looks likely to go to Cinram (Deluxe and Technicolor are telling people that Fox was looking to consolidate suppliers; also, Cinram has begun working for Fox Europe in its France facility).

As confirmed by the studios, production of DVDs is highly unlikely to go to Asia because:
(1) Labor savings from producing overseas would be more than offset by freight costs.
(2) You need to be close to the customer. Cinram is often given a 36-hour turnaround requirement, particularly during 4Q. The mass merchants, Best Buys and Circuit City’s of the world are increasingly focused on just-in-time delivery. Being able to service these customers from across an ocean is impossible.
(3) The studios are paranoid about piracy and have said this will keep them from using overseas production. Enforceable copyright protection is not one of China’s selling points.
(4) Risk/hassle of switching and presence of long-term contracts. Major contracts are generally for 3 years, so the opportunities to win a material contract are limited.

Valuation
(in US$mm)

Net Debt: $850 (as of March 31)
Mkt. Cap: $1,022
EV: $1,872

Net debt is actually about $750mm ($803mm at 3/31/04 and CEO stated in annual mtg. in June that they just prepaid another $50mm), but I have added $100mm to the balance sheet figure to account for a necessary adjustment to w/c and a recent $10mm (conservative estimate) patent settlement.

Mgmt’s 2004 guidance (given in March):
$1,800-2,000 of revenue
$390-410 of EBITDA
$150 of total capex

Mgmt has stated multiple times that the maintenance capex for the business is $15-$20mm per year (rather than replacing machines, they are often repaired with in-house engineers, and this cost is expensed).

Here’s the 2004 cash flow as I see it:
Revenue: $2,000
Gross profit (excl. D&A): $575
SG&A: $170
D&A: $215
EBIT: $190
Net int. exp.: $55
Pre-tax income: $135
Taxes at 32%: $43 (company guides to effective tax rate of 30-32% for '04 and '05)
Net inc.: $92

That gets me to a FCF yield of 28.6% using maintenance capex of $20mm, and 15.9% using full capex of $150mm. EV/EBITDA is 4.6x. Beware that the company’s maintenance capex of $20mm can be ‘misleading’ in the 2005 environment of a 5-6% pricing decline, as some of the additional capacity in 2005 is ‘necessary’ to restore the $50-60mm of EBITDA that will be lost from expected decline in pricing. After 2005, pricing declines are substantially smaller under the TW contract according to mgmt and market-based pricing is assumed to have stabilized given duopoly pricing environment.

Looking at EV/EBIT requires subjective assessment of ‘economic’ D&A, as the reported D&A vastly over-states the capital needs of this business, primarily because:
(1) TW contract is amortized by $60mm/year. (I do not believe Cinram will need to pay for this business when the contract is up for renewal in 6 years given industry dynamics as described)
(2) A major portion of the depreciation is attributable to the VHS, CD and CD-ROM businesses which the company does not plan to reinvest in
(3) In general, the company’s machines are depreciated much faster than their usable life

Besides a reputation for substantial conservatism with respect to its financial outlook, mgmt’s 2004 guidance seems likely to be exceeded in light of the following:

(1) Mgmt’s guidance was given before Fox had secured rights to distribute The Passion of the Christ, the 7th highest-grossing film of all-time. (As a data point on DVDs as loss leaders, Wal-Mart plans to sell Passion next month at $3 below cost)
(2) All of Cinram’s major releases for 1H 2004 have been very successful in the sell-through and rental markets i.e., have met/exceeded expectations
(3) Looking at the box office gross as a rough gauge of popularity, Cinram’s major 2H 2004 DVD releases have exceeded expectations. The Star Wars original trilogy being released in September is the most anticipated catalog DVD of all time (it will be sold in a 4-disc set)
(4) CD volumes appear to have stabilized somewhat, and are actually up 6% year-over-year. Cinram’s mgmt were assuming a 5% decline in CD volumes when they generated their 2004 forecast
(5) 1Q 2004 results were excellent. (2Q results are expected to be lighter than 1Q’s thanks to the inability to recognize certain 2Q production as 3Q revenue). Cinram is expecting that 60% of its revenue will come in 2H and reiterated in June’s annual meeting that it’s very comfortable with its annual guidance.
(6) Cinram has already begun producing for Fox in France. It seems highly probable that this is the beginning of a new mandate (that wasn’t included in 2004 guidance).

Uses of Cash Flow and mid-2005 Scenarios

With expected North American DVD volume growth of 20+% in 2005 and European growth rates even higher, 2005 EBITDA is bound to exceed the 2004 level. Mgmt says that 2005 capex will be substantially lower than 2004’s level (which includes about $20mm for the MGM facility and $30-40mm for the company’s logistics and distribution centers). Operating leverage is pretty good here: the company states that SG&A is 90% fixed and no new facilities need to be built in the near future.

Cinram’s CEO and COO have stated on numerous occasions that they “do not believe in long-term debt” and that they only took on the current credit facility because the TW deal was too good to pass by. At the annual meeting, the CEO frequently said he is “obsessed with debt reduction”, that Cinram recently made a $50mm prepayment on the credit facility, and they were about to make another prepayment.

Scenario 1 – In one year’s time, (1) EBITDA is approximately $450mm through a combination of decent returns on new investments and volume growth, (2) duopoly results in an improved pricing environment (mgmt claims this has happened already but a year should bear it out), (3) growth in DVD sales still appear to be 20+%, (4) VOD/Internet distribution concerns fall into perspective. At that point, net debt will be approximately $600mm. A business operating in a duopoly with solid growth and good returns on future capital deserves at least an 8x EBITDA-maintenance capex multiple (with a tax rate of 31% indicates a 12x cash earnings multiple). With that implied multiple and using $50mm for maintenance capex, you would have a CDN$61 stock.

Scenario 2 – In one year’s time, (1) EBITDA is about $420mm as pricing declines largely offset volume growth, (2) still duopoly pricing environment, (3) DVD sales are still growing in the high-teens. Net debt is around $600mm. The multiple is constricted because market is afraid of VOD and piracy issues, weak returns on capital that is merely replacing lost cash flow due to pricing declines or technological obsolescence. $420mm in EBITDA less $50mm of maintenance cap-ex and a 6.5x multiple (implying 9.5x cash earnings) implies a CDN$42 price.

One could make a case for upside above $450mm of EBITDA in 2005 given the sheer amount of catalog and TV content the studios are sitting on and have only just begun to put on DVD. Putting TV shows on DVD is a phenomenon that didn’t really exist with VHS and provides the studios and replicators with an incredibly deep supply of titles that can be released between major hits. Catalog content (e.g., Season 4 of The Simpsons or the Alfred Hitchcock collection) typically contains 2-4 discs and comes in fancier packaging (read: high margin for Cinram). In short, these are great EBITDA generators for Cinram.

Fox, MGM (4,200 titles), Lion’s Gate/Artisan (8,000 titles incl. TV content) and Time Warner/HBO (6,600 film titles and around 50,000 TV episodes) are all continually releasing catalog/TV content between new releases, which also allows the replicators to rely less on off-loading volume in peak periods. With every TV show that’s even modestly successful, the studios are accumulating catalog content which can easily be sold on DVD along with deleted scenes/out-takes.

If the multiple is just not there, I believe the business makes an ideal candidate for a buyout. With long-term contracts, cheap funding and very clear capital needs based on demand from the studios, the business seems like great LBO material.

Note that these figures are excluding the benefits of the Fox Europe or any other new contracts, or realization of synergies from the TW acquisition.

Significant Cash Flow Growth Ahead

U.S. household penetration for DVD players is in the mid-50% area right now and will probably end the year in the mid-60% range, in part thanks to the abundance of increasingly cheap DVD players (Wal-Mart began selling a $29.95 DVD player last year). VCR penetration reached 90% penetration as an indication of where we are on the curve. Household penetration rates are in the low 20%s for most Western European countries, so the region appears to be about 12-18 months behind the U.S.

As a crude benchmark, VCR penetration in 1988 was basically in the high 50% range and VHS unit sales grew by an average of 20%/year for the following 10 years. In terms of relative popularity, it’s clear that DVDs are a better value proposition and more popular item than VHS for several obvious reasons. Conversations with the folks at Best Buy, Wal-Mart, Borders etc. illustrate that DVDs are incredibly important for them to drive traffic.

Furthermore, on the rental side, (1) the move toward revenue sharing arrangements (which enable the major rental chains to guarantee new releases are in stock) and (2) the fight between Netflix, Wal-Mart and Blockbuster to get DVDs to renters’ homes as fast and affordably as possible, as well as competing on catalog depth, should also help Cinram’s business.

Industry consultants are projecting approx. 20% annual volume growth for DVDs over the next 3 years and Cinram is forecasting a 25% annual growth rate for its own DVD volume (note that about 20% of Cinram’s revenue is from Europe which is growing at a much faster pace).

Adding DVD capacity typically pays for itself within a year (on a pre-tax basis). A new DVD/packaging line may cost $1.5mm and can produce 6mm DVDs/year. At $0.25-30 of EBITDA per disc, Cinram’s investment is fully repaid within the year. The company is adding about 60-70mm DVD/packaging lines this year given the order levels it is seeing from the studios and its desire to minimize outsourcing at peak production periods (in peak periods, the company outsources some production to tiny players and gives up a large part of margin).

Ivy Hill, a printing company that was acquired as part of the Time Warner assets, does about $250mm of revenue. This business makes the inserts in CD and DVD packages (the cover insert, the booklet) as well as cardboard packaging/artwork for DVD box sets and store displays. Ivy Hill used to produce exclusively for Time Warner but under Cinram’s ownership is now free to produce the DVD packaging and promotional materials for Fox, MGM and other Cinram customers, which provides a new source of revenue at similar margins to the DVD business (according to mgmt).

Fox Europe

Deluxe produced about 80mm discs for Fox Europe in 2003. Given the growth of the DVD market in Europe, I think that the Fox Europe contract is conservatively worth 5x 2005 EBITDA of approx. $30mm, or CDN$3.25/share after deducting out the additional capex required by Cinram to handle this business.


Risks/Concerns

Studio Risk

Sony could win the MGM bidding contest and create some risk as to whether Cinram’s 2-3 year contract with MGM (signed in March 2004) will be renewed. Note that:
1) If Sony wanted to take this in-house, it would need to build significant capacity to produce/distribute MGM’s content. Note: Cinram and Technicolor actually do some replication work for Sony right now
2) Cinram built a new facility specifically for MGM replication and distribution and MGM is very happy with this arrangement

Cinram has said that the MGM contract contains significant “protection” in the event that MGM’s new buyer wants to wind-down the contract. Most replication/distribution contracts contain minimum volumes and volume discounts. I think the realistic outcome is that Cinram’s MGM business will likely be unchanged until the contract is up for renewal in 2-3 years time. Mgmt says that if MGM does not wish to renew the contract, it is required to give Cinram plenty of notice, so it can seek out replacement business.

Eventual displacement of packaged media

Here’s the major reasons why I think that VOD/Internet distribution is not a material threat to Cinram’s business (the BBI board covers some of this terrain):

1) The studios typically make $13-15 of revenue for every DVD they sell (sometimes higher with stuff like TV shows and special collector’s edition/deluxe sets). With VOD, the studio typically splits the $3.95 with the cable operator on a 50/50 basis. That means that DVDs are over 5x as profitable for the studios.

The studios control the content and distribution timetable, and are clearly not incented to erode their largest source of revenue (home video comprises about 55-60% of the major studios’ revenues). The studios currently delay VOD/pay per view release by a 30-55 day window (steady average of 45 days over the last 2 years but may slip) after the DVD is released for rental or sale. Similar to the box office, the vast majority of DVD sales and rentals occur in the first three to four weeks of the street release date. If the studios materially shrink the VOD window they risk cannibalizing their $15 profit for a $2 profit, and thus have no economic reason to change this window for home video to less than 30 days.

2) DVDs are a loss leader for the mass merchants; Wal-Mart sells a third of the DVDs in the US. In the hypothetical example where Disney decides it will shrink the VOD window for Finding Nemo 2 from 45 days to 10 days, Wal-Mart would not be shy about reducing shelf space for Disney’s DVDs and other items. The studios have to be very careful about stepping on the toes of their large customers, especially if they harm the attraction and sales potential and of the DVD, their favorite loss leader

3) DVDs are typically impulse buys and gifts. A recent UCLA study (available on Cinram’s website) found that 52% of DVD purchases are an impulse buy and 55% of survey respondents had purchased at least 1 DVD as a gift in the past year. I noticed mack has some interesting stats on ‘impulse renting’ in one of his BBI posts

4) People want the package and they like to own it/build a home collection. There’s plenty of press and data points out there on how much DVD-buyers enjoy collecting DVDs and effectively having their own ‘video-on-demand’ which they can watch multiple times at no additional cost (especially applies for children’s titles). Also, movie enthusiasts like the luxury of the outtakes, behind the scenes, alternate endings, directors’ commentary, etc. which you rarely get with VOD

5) Penetration and cost. I believe that about 12mm households were VOD-enabled at the end of 2003. In rural areas and smaller/medium-size towns the economics of building out VOD is about $600/sub (I believe) which makes it economically unfeasible. Furthermore, there’s a lot of city folks who live in buildings which aren’t wired for digital cable or who aren’t interested in paying the additional expense for digital cable

6) Picture and sound quality are noticeably inferior on VOD than on DVD. Consumers aren’t spending thousands of dollars to upgrade their home theatre systems with big-screen and higher-resolution TVs, surround sound etc. just to watch The Matrix on a cable-quality setting.

Conclusion

Cinram is a free cash flow machine with virtually guaranteed growth over the next few years, a great tax shield, low-cost debt, exclusive contracts, limited competition and a respected mgmt team hell-bent on paying off debt and creating value for shareholders. It looks highly likely that they will meet or beat their 2004 guidance and pick up a new mandate along the way. At the current equity level, your FCF yield is in the high 20% range and free cash flow should grow materially in 2005, even without Fox Europe.

Catalyst

Announcement of Fox Europe contract in next couple of months
Continuous prepayments of debt
Company exceeding its revenue and EBITDA guidance