Description

DHX Media is a developer, producer, distributor and licensor of children’s video content. The company was written up as a long in 2015. Please refer to that write-up for a good overview of the business. I’m less sanguine about its prospects and the stock’s valuation.

Organic revenue growth is anemic and content pricing power is eroding.

DHX Media has historically grown through acquisitions (almost $900 million of acquisitions since 2007), so it is important to tease out organic growth from acquisitive growth.

In the distribution business, the company has benefited from the rapid growth of Wildbrain, DHX Media’s Youtube platform. However, 65% of distribution revenues still come from other channels including SVOD services such as Netflix and Amazon Prime Video. In FY 2016, distribution revenue grew $8.9 million. $6.4 million of the growth was from Wildbrain, and $1.6 million came from acquisitions. This implies that on an ex Wildbrain organic basis, distribution revenue only grew 1.4%. In FY 2017 which did not benefit from acquisitions, distribution revenue ex Wildbrain declined 2.6%. This anemic growth is contradictory to the thesis that DHX Media is currently in the sweet spot of increasing demand for high quality content.

Moving to the content production side - DHX Media discloses production revenue associated with producing proprietary titles as well as proprietary titles delivered. Production revenues include initial broadcast right sales and pre-licensing of broadcast territories. Using past 10 years of data, we can get a pretty good sense of the company’s content pricing power, which started declining in 2014.

Proprietary production revenue/episode ('000):

2008 2009 2010 2011 2012 2013 2014 2015 2016 2017

147   174    98     134    144    176    216   213    201   190

There isn’t much growth in the royalties side either. From 2013 to 2017, the company added $8 million of royalty revenues through acquisitions. However, revenue was $24.9 million in 2017, compared to $15.8 million in 2012. Again this implies almost zero organic growth, which contradicts a great IP portfolio.

This leaves us with “producer and service fee revenues” and DHX Television revenues. There is some good growth in the producer and service fee revenues, which are derived from producing shows for third parties. But I don’t think a contract TV production business is what investors own the stock for. I’ll talk about DHX Television below.

Poor performance of DHX Television does not corroborate great content story.

In 2014, the company bought the Family Channel business from Bell Media for $170 million, or 6x EBITDA. This is a pay TV business and subscription is 90% of its revenue. The Family Channel traditionally relied on Disney (40% of programming). In Jan 2016, DHX did not review the programming content agreement with Disney and since then the channel has carried an increasing amount of DHX owned content. DHX management says owning a TV channel allows them to quickly greenlight shows and test its new content. Let’s see how that strategy has worked out.

DHX Television:

                             Aug 2013   2015   2016     2017

Revenue                         81.0      76.2   69.1   57.4

Subscriber revenue         N/A       66.6   61.2   53.2

Promotion and advertising N/A        9.6    7.9    4.1

Lack of real free cash flow generation makes deleveraging goal unrealistic.

DHX Media capitalizes costs of producing content. When revenues are derived from the content library, the capitalized costs are amortized (40% to 90% at the time of initial episode delivery and 10% to 25% annually thereafter). Investments in content are accounted as inventory so net change in the capitalized content balance is shown in the working capital section of the cash flow statement (amortization of content is a source of cash flow and capitalized cost of new content is an use of cash flow). This line (“net investment in film and television programs”) is typically negative as the company invests more than it amortizes. With content - DHX’s primary capital investment - already accounted in operating cash flow, there’s relatively little investment in the investing section (about $10 million of additions to PP&E and intantgibles).

I define the company’s Free Cash Flow as CFFO minus additions to PP&E and intangibles. Below are company’s revenue and FCF in the past 10 years:

                      2008   2009   2010   2011   2012   2013   2014   2015   2016    2017

Revenues   52.4    62.0    40.5    54.7    72.6    97.3    116.1  264.0  304.8   298.7

FCF            (5.5)   (0.3)    15.9    9.9      13.2    (11.9)   3.5     16.9   (41.6)   (16.5)

Despite growing revenue to $300 million from $50 million 10 years ago, DHX Media has generated cumulative 10-year free cash flow of negative $16.4 million.

Longs could argue that other content companies such as Corus Entertainment and Entertainment One are not particularly strong in the free cash flow department either. However, Corus and eOne are showing organic growth and are less leveraged.

For FY 2018, DHX guides “free cash flow” of $58 million to $82 million to assure shareholders that they can delever from 5.6x net debt/EBITDA to 3.5x in 2019. Some companies tend to be liberal with the use of Non-GAAP/IFRS financial metrics. But DHX Media’s definition of free cash flow is one of the most egregious I’ve seen. (1) It excludes net content investment of $20 million to $30 million which is substantially lower than recent two years’ numbers. (2) It includes changes in interim production financing. In the past three years, the company received about $15 million/year on average in interim production financing. Frankly, including new debt in free cash flow is a little ridiculous - you can’t generate free cash flow by borrowing more.

Excluding $40 million of frivolous add-backs ($25 million of net investment in content and $15 million of proceeds from interim production financing), real free cash flow is $30 million at midpt of guidance. Net debt of $780 million dwarfs this amount, and makes 2 turns of deleveraging in 2 years unrealistic unless they can materially speed up organic growth. The inability to delever can be disastrous, particularly if credit markets turn less accommodating, given the company’s B rating by the S&P.

What makes content Canadian?

DHX Media is advantaged as a Canadian content producer and benefits from various government incentives for Canadian content (“CanCon”). The company says it covers 35% of its production cost from license fees from broadcasters, which are required to spend 30% of their revenue on CanCon. 15% of production cost is covered by the Canadian Media Fund, a Canadian government entity that promotes CanCon. 35% of production cost are covered by federal and provincial tax credits.

So what qualifies as Canadian content for broadcasters? Canadian Radio-Television and Telecommunications Commission (CRTC) lays out the criteria. Essentially, the producer and some key personnel have to be Canadian citizens, and at least 75% of the expenses and post-production expenses have to be provided by Canadians or Canadian companies.

And who qualifies for CMF incentives? CMF’s program guidelines say it has to be a for-profit company headquartered in Canada and controlled by Canadians. Investment Canada Act has criteria for what makes an entity Canadian controlled. Importantly, a company majority owned by non-Canadians can still be regarded as Canadian controlled if Canadian minority owners get to elect the majority of the board. This allows foreign companies to create Canadian controlled subsidiaries by creating two classes of shares. Similarly, the eligibility requirements for receiving Canadian Film or Video Production Tax Credit (CPTC covers up to 25% of labor expenses) do not preclude Canadian subsidiaries of foreign companies.

All this is a long winded way of saying that it is not impossible for non-Canadian companies to enjoy some if not all benefits of creating Canadian content.

Last month, Netflix announced that it will establish Netflix Canada, its first production company outside the US, and will spend at least $500 million in original productions in Canada over the next 5 years. DHX shareholders should not be complacent about its low cost advantage which can also be accessed by foreign companies. By the way, in Canada streaming services are not required to the carry a certain amount of CanCon like broadcasters. If some demand for DHX’s content purely originates from it being CanCon, as more Canadians shift viewing to SVOD, DHX shareholders should be worried. Finally, if more foreign streaming services enter Canada’s content production industry, which the current Liberal government seems to embrace, there could be increasing competition for talent.

Integrating Peanuts and Strawberry Shortcake can be challenging.

DHX Media’s latest acquisition (and its biggest ever) was US$345 million for 80% of Peanuts and 100% of Strawberry Shortcake from Iconix Brands. Iconix bought its 80% stake in Peanuts in 2010 for US$175 million and Strawberry Shortcake in 2015 for $105 million. While under the ownership of Iconix, these brands generated low single digit of revenue growth. While the Peanuts franchise (Snoopy etc) is strong, Strawberry Shortcake is more problematic as indicated by Google Trends. Teletubbies and Caillou, two of the company’s franchises, are declining in popularity as well according to Google Trends. All three have suffered multi-year, if not decade long, declines. Historically brand owners just sat back and collected royalties, but today they realize they need to get more involved in managing their brands.

With DHX’s debt load, there is very little room for error in integrating and maintaining the Peanuts and Strawberry Shortcake brands.

Strategic review in my view will unlikely yield positive results.

On October 2, DHX Media announced that it would explore strategic initiatives to maximize shareholder value. Given the problems I outlined above, I think interest in buying the company would be limited.

Furthermore, non-Canadians can own only up to a third of a broadcasting entity, so non-Canadian buyers would have to divest DHX Television. The rules around Canadian content would also likely make non-Canadian buyers hesitate (assuming buyers want control). Corus and Entertainment One are headquartered in Canada, and could be potential buyers. Corus recently completed a $2 billion acquisition, and I find it unlikely that it will do another big deal. So overall, I don’t think the buyer pool for the company is particularly deep. I believe at this point DHX is at best a show me story - they need to demonstrate organic growth and free cash flow before the stock could get re-rated.

Valuation

Corus and eOne are two good comparables. Corus trades at 8x forward EBITDA (fiscal year ended August 2018). Entertainment One trades at 9.5x forward EBITDA (March 2018). I believe DHX Media should trade at lower forward EBITDA multiples given the lack of organic growth and free cash flow, as well as its high leverage. In addition, the DHX Television business should trade at an even lower multiple given the multi-year decline in revenue and subscribers.

I use a simple SOTP approach to value the company. I value the content business ($118 million FY 2018 EBITDA) at 8.5x, and the DHX TV business ($22 million EBITDA) at 6.0x. Together I get $1,135 million of enterprise value on $140 million of EBITDA (midpt of next year’s guidance). Subtracting $783 million of net debt, I get $352 million of equity value, or $2.6 per share. The Peanuts acquisition also created $86 million of minority interest related to Schulz family’s 20% interest in Peanuts. If we get technical and subtract that as well, it’s another $0.64/share hit to the share price. So I think the fair value of the stock is around $2/share, implying 60% downside from current price.

Catalyst

Lack of outcomes from the strategic review

Inability to pay down debt

Failure to show organic growth

Integration problems post acquisition