Description

After reaching $25.10 on October 9, 2007, DGIT stock has corrected about 28% to current level of $18.09. We believe this decline creates is a good opportunity to acquire a stock that can be $30+ based on (1) roll-out of commercials in High Definition (HD), instead of Secure Digital (SD) and (2) rising advertising spend in 2008 due to the presidential election and Olympics.

 

As background, DGIT has a commanding 60+% market share in electronically delivering commercials from advertisers and their ad agencies to cable and TV stations. The company has made significant up-front investment in its network (including installed servers in 95+% of cable and TV stations) and has close relationships with over 5,000 advertisers.

 

New guidance given on 3Q07 conference call (November 12, 2007)

 

Guidance
		2007		2008
Revenue (in $ mn)		110- 113		122- 126
EBITDA (in $ mn)		37 - 39		41- 44

 

Considering the two trends above, we believe 2008 guidance is conservative. If we take the midpoint of guidance, 2008 revenue of $124 m indicates organic growth of 11% over 2007, but interestingly, the expected 2008 EBITDA margin of 34.3% is roughly the same as for 2007. Given that DGIT’s business is fixed cost (current fixed cost structure around $72-75 m annually, after the three recent acquisitions of Pathfire, Point.360 and GTN), there should be significant operating leverage and EBITDA margins should improve in 2008. In fact, the CEO admitted on the recent conference call that F08 guidance was “what we would like to call a minimum performance budget here.”

 

Valuation based on 2008 mid-point EBITDA guidance

 

Given that DGIT will generate significant free cash flows going forward, we prefer P/FCF valuation more than other measures. So, if we start with a $42 m EBITDA and subtract interest and capex of $4 m each and minimum taxes of $2 m (the company has more than $80 m in NOLs and will not be paying full taxes for several years), we get a FCF of $32 m for 2007. With a 15x TTM multiple and 18 m shares, we arrive at a valuation of $26.5 per share at the end of 2008. The company currently has $36 m net debt and owns about 10 m shares of Viewpoint (VWPT), valued at about $8 m. We believe that with FCF in 4Q07 and 2008 and with stock value of VWPT, the company will have about $1 per share in net cash by 2008. So, excluding value for the $80 m+ NOL, we arrive at a $27.5 target for YE08.

 

What is the upside?

 

We continue to believe that upside to the story is in conversion from SD to HD deliveries. During first 9 months of 2007, DGIT recorded HD revenues of $3.6 m ($1.3 m in 3Q07) up from only $125k in the first 9 months of 2006. HD now represents about 5.4% of YTD sales. Given the significant price difference between SD and HD (SD is priced around $20 and HD is priced around $80-90 on average, though prices vary by customer and volume), almost 90% of incremental HD revenue becomes EBITDA and free cash flow.

 

In the table below, we assume 11% organic growth in 2008, 2009 and 2010, starting with company’s 2008 guidance. We expect HD revenues to represent about 7% of total sales for 2007, growing to 10% of total sales in 2008, 12% in 2009 and 15% in 2010. For every SD to HD conversion, almost 90% of incremental HD revenue falls into EBITDA because both SD and HD have almost the same fixed cost of production. Per the company recently, each 1% shift from SD to HD could result in perhaps $5 m incremental revenue. Although HD prices may fall as volumes rise, the following table indicates how EBITDA (and, most importantly, EBITDA margins) may expand when more SD deliveries get replaced by HD ad deliveries. Drivers for digital TV (which accelerate the eventual move to HD commercials) include: 1) continued growth in flat panels that are HD-compatible and 2) legislation that ends analog TV broadcasting in February 2009.

 

Year	Cum. 3Q07	2007	2008	2009	2010
Total revenue (in $ mn)	66.7	112.0	123.0	136.5	151.5
% of revenue from HD	5.4%	7%	10%	15%	20%
HD revenues ($ mn)	3.6	7.8	12.3	20.5	30.3
Incremental EBITDA (at 90% of HD rev)	3.2	7.1	11.1	18.4	27.3
Expected EBITDA (in $ mn)		38.0	42.0	49.4	58.2
% growth in EBITDA			11%	18%	18%
EBITDA margin (%)		33.9%	34.2%	36.2%	38.4%

 

If we try to value the stock using 2009 EBITDA, we will arrive at a much higher stock price. Potential F09 EBITDA of $49 m, after capex of $4 m, no interest, and taxes of $2 m, implies FCF of $58 m, or $2.4 per share. That implies that DGIT shares at $18.09 with $1+ per share in cash at YE08 are trading at 7x times F09 FCF. That’s really cheap for the clear market leader in a growing area of technology/ digital advertising!

 

Acquisition(s) possible

 

During 3Q07 DGIT closed about $85 m of credit facility (a 5-year, $40 m senior secured revolving credit facility and a $45 m term loan, maturing in 2012 and 2013 respectively). Additionally, DGIT filed a shelf registration to issue 3.5 m shares at a maximum offering price of $23.83, or approximately $83 m. The collective availability of $168 m financing means DGIT could acquire something substantial, possibly their major competitor, Vyvx). We believe that Vyvx, which is a unit of Level 3, has sales of about $125 m and could be acquired for $80-100 m. Since 2004, DGIT has spent $154 m in acquiring seven companies, giving the company 60% market share. Importantly, Vyvx would add about 20% market share. While the possibility of a large acquisition has recently cast a shadow on the company’s stock price, the CEO (who personally owns 17% of stock) confirmed he will take every step to increase shareholder value.

 

Conclusion

 

Overall, we believe the stock is cheap based on F08 guidance and really cheap as we look at F09. Unless we are aggressive with our assumptions regarding revenue growth and SD-to-HD conversion rate, EBITDA margins can only go up and cash flows will rise, benefiting the over the next two years. Also, with its partnership with Viewpoint (VWPT), the company has started launching online Internet advertising capabilities for clients, which is a free option.

 

Risks:

 

1. SD-to-HD conversion happens much slower than our assumptions
2. Advertisers cut their budgets due a significant economic decline or recession in U.S.
3. Competition reduces HD prices faster than volume growth
4. A costly and bad acquisition

 

 

Catalyst

1. Ramp-up of HD revenues begin in 2008. If that happens, EBITDA margins and FCF should expand
2. Even if US recession occurs in 2008, it is still election year, means higher ad spending. Revenue growth may be higher than the company expects
3. The company already has 60% market share in electronic ad delivery space. Acquisition of a major competitor that gives another 20% or more market share would mean greater pricing power
4. Long-term, 3-4 year play, not very cyclical, no direct exposure to U.S. consumers
Can be acquisition candidate when FCF growth becomes visible
5. Strategic alliance with Viewpoint for Internet advertising is a free option
6. CEO owns 17% of shares