Description
Summary
DGFastChannel (DGIT) offers an inexpensive opportunity to participate in the structural industry shift from Analog & Standard definition digital programming to High Definition digital programming over the next 2-3 years. DGIT owns and runs a dedicated digital network of fiber and satellites to electronically deliver spot & network video advertising from advertising agencies to traditional broadcasters and cable and satellite headends.
While the company is currently trading at a little over 7x 2007 EBITDA, the significant industry shift from Analog and SD to HD currently happening should increasingly benefit DGIT and be reflected in 2008 and 2009 numbers. The company has a large fixed cost base, with 25% EBITDA margins currently, which should expand close to 40% as higher margin HD revenue replaces lower margin, SD revenue. The company has rolled up this industry into a duopoly, where pricing has firmed and continued consolidation by the company should continue to benefit pricing trends. The revenue trends have just started to improve, after a long period of revenue stagnation.
How quickly this fundamental business shift happens will determine the true valuation of the company, however on both an EBITDA and FCF basis, the market is not currently valuing any of this business change in. Based upon aggressive management estimates or my conservative estimates, the valuation of this company in 2008 could be trading currently between 2.1x and 6.4x EBITDA and 2.8-7.0x FCF, creating an attractive opportunity to participate in the growth in HD programming. I believe there is significant upside in the shares of DGIT – between 30% and 200%, depending on the timing and pricing of how the HD opportunity materializes, which will become evident during 2007.
Additionally, the company has not to date focused on the online video advertising marketplace, which could present upside potential and would be directly complementary and require little investment to go after.
Industry Overview
Ad agencies and advertisers use third party companies to deliver their content to broadcast distributors on a time-sensitive basis. Historically, the industry has been focused around “dub and ship” houses, where companies specialized in physically making multiple copies and shipping all these copies to the appropriate distribution outlet, in addition to other interested parties (the client, local offices etc.). This is obviously a highly inefficient means of distribution, and the industry has slowly been migrating towards digital distribution. Currently, about 50% of all video spot advertising and almost 95% of radio advertising is sent digitally from advertising agencies to media outlets. Compounding this shift is the government mandated conversion from analog to digital broadcasting. Congress has passed legislation establishing the deadline of February 17, 2009, where broadcasters need to terminate broadcasting in analog. At this point, in order to maximize quality, all video advertising will be sent digitally, rather than through “dub and ship”.
Competitive Landscape
The company is the leader in what is now essentially a duopoly industry. DGIT estimates that they transact about 2/3 of all digital advertising video in the United States. The leading competitor in the industry is Vivyx – a company now owned by Level 3 (after their acquisition of Wiltel) - management estimates it is about 2/3 the size in the video business of DGIT. The industry in the past has been plagued by a heavily fragmented market, causing pricing competition, hurting margins and causing stagnant revenue growth despite the ongoing conversion from analog to digital. DGIT has been a key consolidator in this market, and has acquired 4 different companies in the past 3 years. In 2004, they acquired AGT Broadcast, Source TV (not a distributor – an online database of over 350k TV commercials), in 2005 they acquired Media DVX and most recently in May 2006, they acquired FastChannel Network. FastChannel was a newcomer to the industry in 2004, and was financed with $50 mm of venture capital. They entered the market and rapidly cut prices, driving pricing from north of $20 per transaction (a transaction is when a video is delivered to a media outlet) to its current level of $13 per transaction. As DGIT was taking market share from competitors, they were seeing little growth in their top line as pricing continued to decrease. DGIT acquired FastChannel for roughly $30 mm.
Clancy836 recently wrote up Point.360 and described them loosely as competitors to DGIT. PTSX competes with DGIT in that they do traditional “dub & ship” and some electronic distribution, but they are far from the scale of DGIT, and are in various business lines including post-production which DGIT is not engaged in. I do not think the scale of DGITs electronic distribution is sizeable enough to be a good comp to DGIT, and there other business lines are also plagued with heavy competition.
This business is essentially a fixed cost scale business. DGIT has given guidance of annualized cost synergies of $12 million (which was recently raised from initial guidance of $6-$9 mm, as they consolidate networks, and move FastChannel’s business over to the DGIT network, eliminate all overhead, R&D and G&A budgets. Pricing has now returned to rational levels as the only sizeable competitor in the market – Vivyx has not been competing on pricing, and being a duopoly, it wouldn’t be rational to do so. In the latest quarter, the company returned to growth, with 9% year-over-year growth in pro forma core Ads business.
Network & Business Description
DGIT has made significant investments in the past to upgrade its delivery platform and technology. In addition, the company has invested heavily in placing highly sophisticated Spot Box servers in TV stations, cable systems, and TV and Cable networks which enables the “stickiness” of the customers and is a significant barrier to entry. These boxes are provided free of charge – they are owned by DGIT and are fully upgraded currently for the HD opportunity. There are more than 5,000 advertisers & agencies with more than 4,500 TV, cable & network broadcast destinations, over 10,000 radio stations and 6,500 print publishing destinations connected through the network.. The company is in 99% of all TV stations, cable & satellite offices in the United States. Comparatively – Vivyx is only in 75% or so of these offices. Management thinks that Vivyx distributes 55%/45% digitally/physical.
The company has its Network Operating Center in Dallas, and utilizes both fiber & satellite distribution methods. The company receives the video content electronically in the NOC or at various regional offices via a proprietary FTP software from video production studios and agencies. The content is verified, and the various combinations of video are sent via Satellite uplink to the Spot Boxes at television stations and cable interconnects.
The company’s customer base includes thousands of the nation’s largest agencies, advertisers and brands. DGIT’s clients are 18 of the top 25 advertisers in the country, and 60 of the top 100. The top 20 clients represent 40% of the company’s revenues. Their market share has also been steadily increasing vs Vivyx. This year they have answered 24 RFPs, and DGIT won 20 of them. Contractually, the company has long term contracts (2-3 years) with its 12 largest clients. It also has a preferred client agreement with Omnicom – where OMC moves its clients towards DGIT’s services, rather than competitors.
Another key point about this industry, is that it is necessary to be a strong service oriented business. This is not a core competency of ad agencies to bring this distribution in-house, because they don’t want to be hassled with answering issues, dealing with network downtime, transmission issues etc.
HD Opportunity
As broadcasters, MSO’s and DTH companies are continuing to shift towards digital distribution and specifically HD distribution, media companies are increasingly delivering their content in HD. Magna Global projects that HD subscribers should grow at a CAGR of almost 25% from now until 2011. The supply of HD content is surely leading the subscriber demand, increasing this growth rate. Advertisers are beginning just recently to film their video ads in HD. A normal video ad costs roughly $400k to produce, creating it in HD is only 10% or so more than this. A SD or analog advertisement pieced together with a HD broadcast looks pretty awful – especially as the widescreen TV box shrinks to a 4x3 screen during the commercial. This year, the market for HD advertising is small, with about $1 mm of market revenue.
The company gets paid per “transaction” – which is defined as when a commercial is transmitted over the network to a distribution channel. Last year, and for the past several years there has been between 8,000,000 and 9,000,000 transactions / year in the market. DGIT will have about 3,600,000 video transactions this year – about 3.3 mm in Standard Definition digital, ~5,000 and about 295,000 “dub and ship”. 91% of the company’s video traffic was delivered electronically during this calendar quarter, up from 87 percent a year ago and 75 percent two years ago.
The company is paid by the advertiser only – there is no payments by the distributor or the ad agency. The pricing is highly variable between SD/HD and Electronic vs. Physical distribution, creating the large opportunity for the company to grow significantly in the near-term.
| DISTRIBUTION TRANSACTION PRICING |
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Distribution Method |
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Electronic |
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"Dub & Ship" |
| High Definition |
$110.00 |
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$275.00 |
| Standard Definition |
$13.00 |
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$25.00 |
| Analog |
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NA |
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$25.00 |
This massive discrepancy in pricing is where-in lies the opportunity for DGIT to take advantage of in the next few years. Management projects that within 30 months, 80% of the video transactions they do will be in High Definition. In addition, the management team believes that while industry transactions will be stagnant, they will continue to take market share away from its competitors.
I believe that management is being extremely aggressive in this estimate, and I also believe that pricing on HD will decline dramatically from the current price of $110 – however I do believe this is a real trend that is happening over the next 2-3 years – from checks with advertising agency contacts – and I think there is an enormous opportunity for DGIT to leverage its fixed cost basis to generate a large amount of value to shareholders in the next 2 years.
Before I move into my assumptions on pricing and penetration – which is entirely what the growth & value proposition of DGIT is based upon, there are a few other business lines which are complementary but I have not touched on yet.
Video Distribution Services (56% of revenue) – discussed above
Video Production Services (20% of revenue) – These services are complementary to the transaction based distribution services that make up the majority of the companies revenue. The company essentially offers services around the value chain of delivering video ads which include online creative research, media production, duplication, management of existing advertisements and broadcast verification. These services make the core business extremely sticky among its advertiser base.
Media Asset Management – Integrated with distribution system and enables automatic archiving of spots, online search, send for review and “review and approval” capabilities, digital storyboarding, previews, order and market history of each spot, online retrieval and other services. Other services include storage of client masters, storyboards, editing of materials, tagging content, dubbing, video duplication and copying of media onto various physical multimedia formats, such as CD, DVD or tape.
These services, add a level of accountability to video advertising – they can track when and how many times an advertisement was played.
Audio Distribution Services – (11% of revenue) These services are directly comparable to the video distribution services – however the transmission is from agency & advertiser to radio station
Online Media – (6% of revenue) SourceTV maintains the largest database of content and credits of US TV commercials. This includes all information relating to commercials, individuals and companies. The online database is used by the ad industry to find information about specific spots, identify resources, see what has been done before etc.
Publishing – (1% of revenue) Same as audio and video distribution – but for newspapers
Production Sales – (6% of revenue) This is comprised of the StarGuide Digital Networks division. They are in the process of monetizing this asset. StarGuide Digital Networks is a leading provider of digital multimedia distribution systems, providing state-of-the-art integration of satellite, Internet, and traditional telecommunications delivery technologies.
Valuation
I have looked at three different cases in order to understand the impact of the SDàHD conversion, sensitizing the HD penetration, prices & market share increases.
| DG FastChannel — Summary |
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| HD Pricing |
2006 |
2007 |
2008 |
2009 |
2010 |
2011 |
| Base |
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$100.0 |
$75.0 |
$55.0 |
$40.0 |
$32.5 |
$25.0 |
| Management |
$110.0 |
$100.0 |
$85.0 |
$70.0 |
$50.0 |
$40.0 |
| Bear |
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$70.0 |
$60.0 |
$50.0 |
$40.0 |
$30.0 |
$20.0 |
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| HD Penetration |
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| Base |
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0.1% |
3.0% |
15.0% |
30.0% |
50.0% |
70.0% |
| Management |
91.9% |
5.0% |
30.0% |
50.0% |
75.0% |
90.0% |
| Bear |
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8.0% |
3.0% |
12.5% |
25.0% |
37.5% |
50.0% |
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I am assuming nominal growth in the rest of the business lines, anywhere between 0% and 5%.
On the cost structure – management has commented that after synergies continue to take out costs through April 2007 (when they will be fully baked in), the company will have a fixed cost structure of between $50-$55 million / year. I have assumed a cost base of about $60 mm / year to be conservative, on revenues of about $79 million this year. Almost all of the company’s costs are fixed. Cost of goods consists of satellite transponder, internet access, transmission, network support and is about $40 mm / year, I am assuming that $32.5 of this is fixed (although that maybe conservative as well). All their G&A, R&D costs are fixed and I model them growing at 3% / year. Sales & marketing is roughly ½ fixed / ½ variable for sales commissions. Lastly, Capex is roughly fixed at about $2 mm / year – and should not increase north of $2.5 mm. All upgrades necessary for the network have been done previously. The company has at least a $50 mm NOL (from FastChannel), although it may be more from other acquisitions (On my list of follow-ups for the company)
Margins should increase dramatically in my base case scenario from about 25% last quarter to 38% while FCF should also ramp, although based upon my $50 mm NOL scenario should moderate in 2009/2010 b/c of cash taxes.
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| Revenues |
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2006 |
2007 |
2008 |
2009 |
| HD Digital |
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0.4 |
8.1 |
29.8 |
43.4 |
| SD Digital |
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36.5 |
35.4 |
27.1 |
21.5 |
| Hard Copies |
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7.3 |
7.2 |
5.4 |
3.6 |
| Video |
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44.2 |
50.7 |
62.4 |
68.5 |
| Audio |
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8.7 |
8.9 |
9.0 |
9.2 |
| Production Services |
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15.8 |
16.3 |
16.8 |
17.3 |
| Online Media |
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4.7 |
5.0 |
5.2 |
5.3 |
| Production Sales |
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4.7 |
4.7 |
4.7 |
4.7 |
| Publishing |
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0.8 |
0.8 |
0.8 |
0.8 |
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79.0 |
86.4 |
98.9 |
105.8 |
| % Growth |
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9.4% |
14.5% |
7.0% |
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| Cost of Goods Sold |
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40.0 |
41.7 |
43.9 |
45.6 |
| Gross Profit |
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39.0 |
44.7 |
55.0 |
60.3 |
| EBITDA |
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19.0 |
23.9 |
33.2 |
37.7 |
| % Growth |
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26.0% |
38.9% |
13.4% |
| Margins |
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| Gross Profit |
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49.4% |
51.8% |
55.6% |
56.9% |
| EBIT |
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8.9% |
13.4% |
20.7% |
23.2% |
| EBITDA |
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24.1% |
27.7% |
33.6% |
35.6% |
| FCF |
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18.4% |
23.1% |
30.5% |
29.6% |
| Flow Through |
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66.6% |
74.5% |
64.0% |
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| Growth |
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| Revenue |
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9.4% |
14.5% |
7.0% |
| Gross Profit |
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14.7% |
23.0% |
9.5% |
| EBIT |
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65.3% |
77.2% |
19.8% |
| EBITDA |
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26.0% |
38.9% |
13.4% |
| FCF |
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37.5% |
51.3% |
4.0% |
Continued Consolidation & Follow-on
The Company just completed a follow on offering today of 3.0 mm shares of common stock – 400k of which was secondary, the rest was primary. The 400k secondary was from CrossPoint ventures which was an early investor in FastChannel. The company is paying down its current bank facility, taking out a new $40-$50 million acquisition revolver. The company clearly has plans to continue consolidating the industry, which has led to much more positive economics with fewer competitors. I have asked management about any intent on acquiring Vivyx – would LVLT be a willing seller, and would the Justice Dept take a look – and I get the sense this is a possibility, that the since this is not a consumer facing business and the ad agencies effectively do have other less effective choices (traditional internet, dub & ship), the Justice dept would not care. They have also expressed an appetite about small acquisitions of the some of the “dub and ship” competitors where they could acquire a large customer base, and move them onto their electronic platform, eliminate all the overhead and create large synergies. The capital structure PF for the follow-in is as follows:
| Stock Price |
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$11.40 |
| Common Shares Outstanding |
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15.443 |
| Options & Warrants Treasury Method |
- |
| Fully Diluted Shares |
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15.443 |
| Equity Value |
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$ 176.1 |
| Less: Cash |
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(21.6) |
| Plus: Debt |
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20.5 |
| Enterprise Value |
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$ 174.9 |
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| DG FastChannel — Summary |
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| Summary |
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| Multiples |
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Implied Price @'08 EV/EBITDA |
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% Upside |
| EV/EBITDA |
2006 |
2007 |
2008 |
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7.0x |
8.0x |
9.0x |
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7.0x |
8.0x |
9.0x |
| Base |
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9.2x |
7.3x |
5.3x |
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$ 12.34 |
$ 14.49 |
$ 16.64 |
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8.2% |
27.1% |
46.0% |
| Management |
9.2x |
5.5x |
2.1x |
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$ 34.81 |
$ 40.18 |
$ 45.54 |
|
205.4% |
252.4% |
299.5% |
| Bear |
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9.2x |
7.8x |
6.3x |
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$ 9.85 |
$ 11.64 |
$ 13.44 |
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-13.6% |
2.1% |
17.9% |
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Implied Price @ '08 P/FCF |
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% Upside |
| P/FCF |
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2006 |
2007 |
2008 |
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10.0x |
11.0x |
12.0x |
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10.0x |
11.0x |
12.0x |
| Base |
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12.1x |
8.8x |
5.8x |
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$ 19.53 |
$ 21.48 |
$ 23.43 |
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71.3% |
88.4% |
105.6% |
| Management |
12.1x |
6.3x |
2.8x |
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$ 40.74 |
$ 44.81 |
$ 48.88 |
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257.3% |
293.1% |
328.8% |
| Bear |
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12.1x |
9.5x |
7.1x |
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$ 15.97 |
$ 17.56 |
$ 19.16 |
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40.1% |
54.1% |
68.1% |
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Exit Multiples @ 14.5% WACC |
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% Upside |
| DCF |
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6.0x |
7.0x |
8.0x |
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6.0x |
7.0x |
8.0x |
| Base |
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$13.49 |
$14.82 |
$16.15 |
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18.3% |
30.0% |
41.7% |
| Management |
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$29.65 |
$32.72 |
$35.78 |
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160.1% |
187.0% |
213.8% |
| Bear |
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$9.14 |
$9.87 |
$10.60 |
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-19.8% |
-13.4% |
-7.0% |
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The management team is led by Scott Ginsburg – former CEO of AMFM, which he sold for $16 billion back in radios heyday to ClearChannel. He helped consolidate the radio industry, and has created significant value for shareholders in the past. He definitely is a salesman – so I think some of the numbers thrown out need to be taken with a grain of salt or discounted as some level, but I think the management team is strong. He owns about 25% of the shares outstanding. Other large shareholders include CrossPoint Ventures (still has 1.3 mm shares), Kinderhook Partners and Costa Brava.
I believe there is significant upside in the shares of DGIT – between 30% and 200%, depending on the timing and pricing of when the HD opportunity continues to materialize. During 2007, this opportunity will begin to present itself more clearly, and which “case” the company is on track will become more evident. Although this industry seems basic, and relatively boring, there is a clear opportunity for them to benefit in the medium term from a strategic shift in the distribution of video advertising. Lastly, there is an added upside of online video advertising which the company has alluded to, yet not gone after yet. They are clearly focused on their core business, however the opportunity for delivering content from the advertiser directly to the internet publisher could create another large growth opportunity in the future (although I have assessed no value to this).
Catalyst
1) HD Opportunity begins to materialize in 2007 numbers, creating huge flow-through of revenues >70%, and raising margins from current levels of 25% to 35-40%
2) Continued market share increases, and general growth in SD marketplace away from physical "dub and ship" competitors
3) Further accretive acquisitions where signficant amount of synergies can be realized like the FastChannel acquisition
4) Increased liquidity due to recent offering
5) Sell-side research coverage