Description

Investment Summary

 

Cinram International Inc., the principal wholly-owned subsidiary of the Cinram International Income Fund (CRW), is a non-cyclical, duopolist, possessing barriers to entry, strong FCF/EPS correlation, long tail CapEx characteristics, and above-cost returns on capital trading at 5.5 FCFE and 5.1x EV/EBITDA expected 2007 results.  The current distribution yield is 14.13%, and the company’s balance sheet strength, payout ratio, and underlying FCF imply the distributions are safe.  In addition, management owns 6.5% of the company and has recently undertaken a corporate restructuring to maximize the generation and distribution of the company’s free cash flow.

Despite a favorable industry structure, inherent competitive advantages, and attractive underlying economics, the company has become excessively undervalued because its main end market, DVD sales, faces the risk of slowed growth under benign assumptions and obsolescence under a more extreme scenario.  While electronic content distribution is a legitimate threat, a number of structural and financial impediments suggest physical media’s decline in video will differ substantially from that of audio.  As such, the rates of decline implied in CRW’s valuation are excessive.  In addition, the company trades on the overlooked Toronto exchange, and suffers from a lack of Wall Street-based coverage.  Adding to the potential for investor informational shortfall, seven of the eight/media analysts covering CRW are tech analysts with limited income-trust experience.  Further, the recent change in Canadian tax law has added confusion surrounding the tax status of Cinram’s distributions.  However, its distributions are considered dividends under the law, and as such the new taxable status beginning in 2011 does not apply to Cinram.

Given the company’s sustainable trust structure and payout ratio, a dividend discount model is an appropriate valuation framework to estimate intrinsic value.  Assuming an 11% cost of equity, no growth in the distribution between now and 2015, and a -2% terminal growth rate, all conservative assumptions, CRW is trading 21% below intrinsic value.  In conjunction with its 15% yield, under-levered balance sheet, and active board involvement in unlocking shareholder value, both a significant margin of safety and identifiable catalysts exist.

 

Company Description

 

The DVD replication process is straightforward.  Cinram receives the master copy of a DVD from the movie studio, and then uses its manufacturing process to produce the DVDs, copy the image of the movie to the discs, print the accompanying packaging, manage the logistics of delivering and replenishing retail supplies, and handle the redistribution of the unsold DVDs into and from the rental and consumer markets.  Using logistics as a loss leader, studios benefit through significant cost reduction, while Cinram gains a significant barrier to entry by weaving its business seamlessly into the studio’s back office.

Why The Business Is Attractive From a Private Owner Mentality

 

Cinram operates in a virtual duopoly.  Technically, there are three large players: CRW, Technicolor, and Sony.  However, Sony’s replication and distribution business operates as an in-house unit, with only Sony-produced titles utilizing its facilities.  Due to the obvious conflicts of interest a competing studio would have with using Sony as its replication and distribution partner, as well as constrained capacity at Sony, it seems unlikely that Sony influences supply and demand dynamics within the industry or serves as a viable competitor for future contracts.

 

With CRW and Technicolor essentially splitting the major studios, ex-Sony, as customers, both seem fully cognizant that it remains in their best interest to maintain rational pricing.  In fact, the two companies have been known to “help” each other out from time to time when one of the two becomes capacity constrained.  As long as CRW and Technicolor continue to perform satisfactorily, it is in the studios’ own best interest to maximize their bargaining power by maintaining the even split of business between the two replicators.  Aside from maintaining bargaining power, studios maintain their respective significance to each replicator.  As a result, they gain access to the flexibility inherent in having studio-dedicated replication capacity (such as the facility built specifically for MGM) and logistical flexibility at their disposal.

 

In terms of barriers to entry, the 2-6 year length of contracts generally employed by industry participants represents a significant and most likely overlooked, barrier to entry to this relatively capital-light business.  While installing a new DVD replication and packaging line is a one-time cost, a new entrant would immediately have to land a major studio contract or enough smaller long-term contracts to provide it with the scale necessary to compete on a cost parity basis.  Given the length and level of involvement implicit in the current relationships, and noting that the long term contracts do not all come up for renewal at the same time, it is highly unlikely a new entrant could set up shop and immediately convince a studio to transfer its business while lacking a tangible track record and reputation. 

 

In a hypothetical situation where the barriers to entry are somehow overcome and a new competitor establishes a credible alternative to CRW and Technicolor, there are several reasons studios rarely switch between existing replicators:

(1)     Back office integration – A replicator’s logistic systems are deeply integrated within its studio-customers.  Receiving hundreds of orders each day, CRW for example, seamlessly handles the production, printing, packaging, and shipping of ordered goods.  By handling additional back office activities including inventory management, returns processing, and cash collection, CRW represents a significant portion of its customers’ supply chain management systems.  The back-office logistic services provided in addition to replication are meaningfully value-added, and are priced as a loss leader.

(2)     As a result of their scale and operational experience, CRW and Technicolor are the low cost producers.  Given the wide-reaching integration described in the last point, it is hard to envision a new entrant providing a large enough cost advantage to prompt a studio to abandon its heavily relied upon, longstanding, and trusted relationship.  A replicator’s logistics track record continues to gain in importance as a competitive advantage as retailers continue moving towards just-in-time inventory methods.

 

In addition to the favorable industry structure and low cost position, the underlying business possesses attractive economics.  Free cash flow generation is both larger and less volatile than accounting earnings.  Exhibiting long-tail capEx characteristics, the company is characterized with a low run-rate of maintenance capEx ($20 million), total capEx of $120 million reserved for any one year, $190 million in D&A, and the scale and flexibility to structure manufacturing runs to maximize overhead absorption.  Additional working capital needs are nearly non existent (10-year median value of 0 additional net working capital needed per additional dollar of sales) because CRW generally does not begin production until after an order has been placed.  As such, if we can assume a conservative estimate of sustainable revenue is $2 billion, a 19% EBITDA margin suggests free cash flow to the firm of $227-$327 million, depending on capEx levels for the year.  While debt is likely to continue to be worked down, the current sustainable FCFE yield is 15%-24% depending on the capEx schedule management employs.  With returns on capital looking to grow from the 12% level as the company continues to work down debt, Cinram is earning in excess of its estimated 8.6% weighted average cost of capital, while recognizing its strength as a mature cash heavy business and appropriately paying FCF out to shareholders.

Optical Media is likely to persist longer than the market expects

 

 

A direct substitute to purchasing a DVD, is downloading to own a studio-produced movie.  While this is the form of technology that has placed the CD in a secular decline, the music downloading experience offered at least parity to the CD buying experience, while the movie downloading experience is currently, and likely to remain sub par.  Download times are prohibitive even using a T1 line, stretching several hours from start to finish, and then requiring time to burn the file to a blank DVD if it is to be played on the users Television and DVD-player.  Second, the picture and audio quality of the downloaded files is often below current generation DVDs.  This quality differential will widen as high definition DVDs are more widely adapted, and will become a larger sticking point as more consumers upgrade to high definition capable televisions and surround sound entertainment systems. 

 

At the same time, download times will expand.  For example, Sony’s Blu-ray format can hold up to 50 gigabytes of data.  Aside from the fact that an exceptionally large hard disk could only hold 20 of these movies, downloading 50 gigabytes is likely to take over 5.5 times as long as a current-generation DVD.  Over time telecoms could upgrade the existing infrastructure.  It just isn’t going to happen over night.  Additionally, by the time the then upgraded infrastructure is widely in place, there is no guarantee we won’t be moving on to yet another “next generation” media.  This is not to say that electronic distribution of video will never steal market share from physical media, however, it is to say that it won’t necessarily capture a meaningful share in the next 5 years

 

A more legitimate threat, video on demand (VOD), possesses widespread availability, a growing selection, and the convenience of never leaving your sofa.  However, at $3.95 for a one time use, VOD is a substitute for renting, not purchasing DVDs.  However, it is still unclear what percentage of the rental market VOD will ultimately represent.  VOD suffers from lower quality video and sound, as well as a lack of the extra material regularly loaded on DVDs.  There are end users who value the higher quality viewing experience as demonstrated by the growth in home entertainment solutions.  Similarly, there are users who value the extra content as demonstrated by the faster adoption of DVD as the medium of choice relative to VHS adoption.  While it is possible for VOD libraries to expand significantly, and for the extra content to ultimately be made available, it is unlikely that VOD can fully replace optical media within the rental market as the combination of quality issues and breadth of availability necessary for complete VOD adoption is prohibitive.

 

In addition to these structural barriers favoring DVD consumption, financial incentives at the studio and retail level are clearly aligned to support physical media consumption over electronic distribution.  Studios generate 56% of a movie’s revenue through the home video market vs. only 2.5% for ppv/vod.  We recognize electronic distribution will grow significantly over the coming years.  However, the growth rates would have to be astronomical for it to be worthwhile to the studios to sacrifice their current income stream.  Given that most of the sell-through experienced by a DVD happens during the initial marketing push surrounding the DVD release, and new releases tend to retail for $17-$25, its hard to imagine a $3.95 VOD provides the same operating profit dollars to the studios regardless of the margin.  More so, if we can assume replication costs the studios $4/disc and that a retailer such as Costco takes a 13% markup, the studios are capturing $10.79-$17.75 per DVD sale.  At these levels, electronic distribution would not only have to replace DVDs as the medium of choice, but it would have to expand the market more than three-fold.

 

As Microsoft has demonstrated with Xbox Live, it is possible to structure electronic distribution in ways to compensate for some of its shortfalls.  Under Microsoft’s new program, users are allowed to download previously paid for content that was deleted to free local memory for additional downloads.  While this places VOD/download as a more direct substitute to purchased media, it is hard to imagine consumers paying equal price for this good, and hard to see studios undercutting DVD pricing given the unattractive volume/operating profit tradeoff.

 

Retailers also have a vested interest in the continuation of physical media distribution.  Wal-Mart represents a third of the domestic DVD sales, and uses the product aggressively to drive traffic in its stores.  If the studios compromise this revenue stream Wal-Mart will not be shy in using its negotiating leverage through the potential combination of reduced orders, shelf space, and on air and in store advertising.  Given the diverse and relative size of the revenue streams Wal-Mart and like retailers enjoy, the studios need the big box retail channel more than the retailers need them.  Already both Wal-Mart and Target have begun working with the studios towards a “level” playing field relative to electronic media’s distribution timing and pricing.

 

Finally, consumer preference and buying habits would need to change dramatically for electronic distribution to replace physical media.  Presently, a significant level of DVD sales are either impulse buys or gifts.  It’s not as conducive to give a gift in electronic format, nor is it as conducive to promote impulse buys.  Additionally, the results experienced by CinemaNow after rolling out a download-to-burn product strongly augur for the consumer’s desire to collect and display a collection of physical media.  While the download-to-burn category could take share over the long term, the professional design and packaging currently provided are a clear advantage over home produced materials. 

 

 

Given CRW’s income trust structure and payout ratio, it is reasonable to assume the fund’s distributions will track the underlying economics of Cinram over a long time horizon.  As such, the underlying free cash flow available for distribution and the corresponding payout ratio are the most important aspects to valuing the shares.  At present levels, the shares yield 18% on FCFE and 15% on an FCFF/EV.  Further, a sensitivity analysis suggests the distributions are safe from a cut, and more likely will rise over time through increased earnings performance, a higher payout ratio, or a more aggressive use of the company’s balance sheet. 

 

Cinram’s current valuation implies its business is in a severe, secular decline, and its distributions are not sustainable.  However, if it turns out that the pessimism is overdone and Cinram is able to pay out its current 3.25 CAD distribution for ten years, and then assuming a -2% terminal growth rate, the shares are worth 21% more than current levels.  In conjunction with the 14% dividend yield, there is clearly a significant margin of safety in the shares.  It is not possible to predict when the growth rates of optical media will potentially shift, but the odds of CRW paying its distribution, forget for the moment growing it, seem highly probable given the industry structure and economic incentive for the studios to continue to maximize one of their most important revenue streams.

 

Additionally, the firm has engaged a financial advisor and has noted potential acquisitions that could portend higher payouts.  On the other hand, a meaningful share repurchase or increase in leverage are all feasible ways to increase shareholder distributions.  Most likely, if the board and its advisors decide to back management’s current strategy, CRW could use some of the $109 million in cash on its balance sheet to make strategic acquisitions diversifying into DVD-ROMS, used by next generation console games.  This business is not in direct competition with Technicolor, and is not threatened by electronic distribution.  Following the acquisition CRW could use its increased cash flow to systematically pay down debt and increase distributions.  This seems particularly attractive given the timely convergence of $20 million in tax savings through the conversion to the income trust, as well as the depressed valuations within the replication industry.

 

If you can conclude the recent weak results, largely due to a below-average Warner DVD lineup, are not the beginning of a secular decline, you have the chance to own an industry leader that could meaningfully grow its distribution over the long run (while currently collecting 14% in dividends).  If for example, CRW begins growing its distribution in year 4 by 3% and then grows at this rate until assuming a -2% terminal rate, the shares are worth $31 CAD, or 35% more than current levels.

 

Finally, while a DDM is the appropriate valuation method given the current corporate structure, the recent political risk introduced by the Canadian government’s decision to begin taxing income trusts in 2011 brings into question Cinram’s long-term corporate structure.  While the new tax law most likely does not affect Cinram (its distributions are considered dividends, not income distributions, under the law), it is possible that at some point the law could be changed to incorporate the loophole Cinram is exploiting.  In this case Cinram's 18% free cash yield, and current leverage of only 2X EBITDA strongly suggest a private equity purchase could yield in excess of 20% at a high 20’s takeout price.

 

Key Risks/Contra Case

 

In terms of potential downside to CRW shares there are several key risks.  The largest risk is that the analysis regarding the staying power of optical media is wrong.  If this is the case, the formidable industry structure and attractive economics of Cinram’s business will be possessed by a business in secular decline.  Assuming a steep decline in distributions of 5% for the first two years and 14% thereafter, CRW shares are worth 13.39 CAD, or 42% less than current levels. 

 

Second, MGM could be fully owned by Sony when its contract comes up for renewal in the next 12 months.  If this is the case, it is possible Sony would bring MGM’s replication and distribution in house.  However, it is unclear if Sony and its private equity partners would come to terms, and whether Sony would want to invest in additional capacity.  It is worth noting CRW has a facility dedicated to MGM and is prepared to produce both Blu-ray and HD-DVD.  This is noteworthy because MGM has been pleased with CRW’s performance, dissatisfied with Sony’s management of MGM films, and Sony didn’t acquire a partial stake in MGM for the replication business, but rather to promote Blu-ray as the next generation format.  MGM’s contract with CRW requires the company give CRW a significant level of warning, so Cinram can attempt to replace the lost business.

 

Catalyst

Catalysts

- CRW raises its distribution.
- Optical media (DVD/HD DVD) sales grow on a year over year basis. For
every quarter that online media remains a niche product, is another
quarter for the market to recognize the inherent advantages and
barriers protecting Cinram’s business.
- A stronger than expected fourth quarter.
- Sale of the fund to a private investor.
- Accretive all-cash acquisition at attractive valuation leading to
upside surprise in 2007.
- Market closes yield spread between CRW and its peer trusts. While the
tax law affects U.S. investors, it does not change the effective tax
rate for Canadian investors, and as such does not change the value of
the shares to a Canadian investor.