Background

DHX Media, through a series of acquisitions and organic production, is the largest independent owner of children’s content with a library of over 10,000 half-hours pro-forma for all pending acquisitions. Some of its properties include current shows such as Yo Gabba Gabba! (airs on Nick Jr. in the US), Ella the Elephant (airs on Disney Jr in the US) and Johnny Test (airs on Cartoon Network in the US) and library shows such as Inspector Gadget, Teletubbies, Caillou and Arthur.

Historically DHX has generated revenue through 3 primary business models. They are currently in the process of closing a transaction that will create a fourth business model:

• Content production and miscellaneous production/service fees (~20% of PF gross profit). TV networks globally pay DHX Media to create original children’s animation for first-run cycle.
• Library distribution (~30% of PF gross profit). Sells library content (both acquired and created) through various viewing windows and platforms globally.
• Merchandising and licensing (M&L) (~20% of PF gross profit). Sells brand license of owned and represented IP. Also generates revenue from ancillary revenue streams, e.g., Yo Gabba Gabba! Live! (concert series).
• Canadian pay-tv network (pending transaction closing) (~30% of PF gross profit). Monthly affiliate fees from Canadian BDUs, i.e., equivalent to US MSOs, for the distribution of their 4 cable networks, incl the Family Channel, which is the #1 Canadian kid’s channel. Limited advertising revenue.

I think DHX Media is an undercovered and underappreciated media asset that is a pure play beneficiary of the structural trend in content value repricing higher. Through  tax advantages as a Canadian production company and changes in children’s TV viewing behavior, I think DHX Media over the next 3-5 years will be able to sustainably grow EBITDA 15-20%+ before layering additional accretive acquisitions, which I would expect the company to continue doing.

DHX Media currently trades at ~9.5% and ~11% CY15 and CY16 FCF yield and ~8x and ~6.5x CY15 and CY16 EV/EBITDA, which materially undervalues the quality of its portfolio and the broader secular trends. My base target price is $10 vs $5.29 at the time of this note.

Thesis

While DHX’s production studio is not the core driver of the story, it is worth having an appreciation for the competitive advantage of a Canadian production studio, especially one as large as DHX. Due to a favorable regulatory environment in Canada which seeks to protect the creative industry and to retain jobs, Canadian producers such as DHX are able to cover 85-100% of its production cost upfront through Canadian broadcast commission payments, Canadian federal and provincial tax credit and subsidies and select international market presales. This dynamic allows DHX to add new content to its library with minimal capital risk.

Through this low-risk production business model and an extensive library, DHX is very well positioned as a premiere supplier of children’s TV content as viewing behavior evolves with the adoption of over-the-top (OTT) subscription services. While smaller than the likes of Disney, Viacom and Time Warner, I think DHX has an advantage as an independent studio in working with OTT platforms as it has much less risk of cannibalizing a traditional linear pay-tv revenue stream.

My conversations with industry contacts, including former employees at Hulu and Netflix, support the view that children’s genre is one of the most important genres for building an OTT subscription service. I expect the number of OTT platforms globally to continue to grow and the demand for children’s content to rise.

In addition for expectation for rising demand, based on my checks, I believe children’s genre is one of the most underpriced genres in the OTT space, of which DHX is even further underpriced. My checks indicate that children’s genre in aggregate can be ~35% of viewing hours on OTT platforms but its cost can be only ~20% of total content cost spend. The expectation is for this to reach parity over time (pricing coming up) which would allow the entire genre to reprice at a theoretical ~75% increase. In addition, conversations I have had suggest DHX content can be priced as much as 7.5x lower than the average children’s genre. All in, this would imply a theoretical repricing of over 1,000%.

There are a number of likely factors that explains why this mispricing exists today and why I think it will narrow.

First, there has been information asymmetry between the OTT distribution platforms and content owners. I think content owners are becoming better equipped to understand the value of their content. More importantly, as Netflix proves out its business model, more entrants will enter the space on a global scale, which will shift the balance of power in negotiations from distributors to content owners. I believe this is similar to the phenomenon we have been witnessing in the US linear TV landscape where network owners have had increasing leverage in retransmission and affiliate fee pricing. 

Second, the utility and viewership of children’s library content has likely surprised to the upside as adoption of OTT services has risen. There are multiple facets that pertain to children’s content worth mentioning and include the view that 1) children’s content travels well geographically, i.e., it is easy to translate content to another language plus content is often universal across cultures, 2) children’s content has much longer shelf-life, i.e., there is a higher propensity to watch more current shows in adult genres due to the ‘water cooler effect’ where there is a social element in adult viewership that does not often exist in children and 3) parents often watch TV with their children and may be inclined to select older library content that the parents remember from their own childhood.

Our understanding of the mispricing in the industry, combined with our top-down estimates for the long-term children’s OTT content spend, allows us to believe that DHX could sustainably grow their digital distribution revenue north of 40% CAGR for the next 3+ years and contribute at least ~$30M of incremental EBITDA off of a PF CY13 EBITDA of ~$65M. There is the potential for material upside if we take into context the estimated ~$200M 2-year digital output deal between Viacom and Amazon.

In addition to the incremental digital revenue stream, I think the rest of the business can sustain a high-single digit growth based on the broader structural trends in the media landscape. For example, I think the production studio could see an acceleration in revenue growth as the company moves closer to the high end of their annual target of growing their library organically by ~75-150 half-hour episodes of year.

Lastly, I think the company will continue to be a successful accretive acquirer. As the largest independent children’s content studio, there are both cost and revenue synergies DHX brings to the table which management has shown an ability to take advantage of through a string of accretive acquisitions.

Valuation

DHX fiscal year ends in June. On a PF basis, I think DHX will generate ~$90M and ~$105M of EBITDA in FY6/15 and FY6/16. Normalizing for working capital adjustments in the production business, I think DHX will generate ~$50M and ~$60M of FCF in FY6/15 and FY6/16. My $10 base target price assumes it can trade at 20x and 16.5x CY15 and CY16 FCF which implies 14x and 11.5x CY15 and CY16 EV/EBITDA.

The speed in which DHX is able to reprice its content to fair value could drive meaningful upside to my target price as could further accretive acquisitions, which I expect to occur but am not modeling given the unpredictable nature of those deals. I think the company will also increasingly become an attractive take-out candidate as the company grows organically and scales through acquisitions of their own which is not factored into my base target price.

Risks (and Mitigants)

• Uncertainty around Disney content output deal with the Family Channel (acquisition pending for close in June 2014). DHX is in the process of acquiring the largest linear TV children’s network in Canada, the Family Channel, and 3 other smaller Disney branded cable networks. The Family Channel is effectively the Canadian Disney channel as they are the main output distributor for Disney who is unable to own a network directly in Canada due to foreign ownership rights. The current output deal between Disney and the Family Channel expires in August 2015 and the market has expressed some concern on whether or not Disney will choose to renew the output deal or if Disney may try to be more radical and create a straight to consumer OTT product themselves. While I cannot predict what Disney will ultimately decide to do, I think the market may be overstating the financial impact in a scenario where Disney chooses not to renew. My base case continues to be that the Family Channel and Disney will ultimately renew their output deal. This is based on the premise that the Family Channel and Disney have had a successful 20+ year relationship, Disney’s current output deal is likely around high-$20s millions a year vs Nickelodeon’s current output deal is likely are the mid-$10s millions a year and DHX themselves has had a 15+ year relationship with Disney. From a downside scenario, in the event Disney chooses not to renew its output deal, the Family Channel could actually see an improvement in EBITDA. From a cost perspective, the Disney output deal is ~30% of total revenue on a FY6/13 EBITDA of ~$27M (coincidentally also ~30% margin). If the output deal were not renewed, I think DHX would be able to replace the Disney content at a materially lower cost (and also self-produce additional content) which would have minimal revenue impact given the Family Channel does not have advertising exposure and has Canadian must-carry status.
• Netflix creates a global monopoly in OTT services and dictates content value. I think this is a low risk scenario as there are multiple players with deep pockets that have shown interest in establishing a competing product. On the other hand, content, especially children’s content, is increasingly more concentrated among few key players who will be able to ultimately dictate pricing trends.
• Yo Gabba Gabba! merchandising and licensing exposure. Yo Gabba Gabba! is the largest M&L property for DHX and contributes estimated mid-single digit percent of PF gross profit. I think this revenue stream will become an increasingly smaller percent of the business. Any significant decline, especially in the attendance of the Yo Gabba Gabba! Live concert series would hurt near-term operations but would have less of an impact on my long-term expectations. I do not assume any breakout M&L properties in my base case assumption although this could be a significant opportunity, especially as management looks to relaunch some of their older properties.
• Changes to the favorable Canadian regulatory environment. While any potential changes would have limited to no impact on the digital distribution repricing that we think DHX is not getting credit for, an unfavorable change to the regulatory environment would increase the risk/lower the appeal of the production business. The favorable regulations have been in place for decades.

• Potential for US dual listing. I think DHX is a candidate for a dual listing which would attract more exposure and institutional interest. The company is under the radar as it was less than a $50 million market cap at the end of 2011 but has now grown to a $600M market cap through a combination of capital raises for accretive acquisitions and stock appreciation.
• Announcement of large digital OTT deal. While this can be difficult to predict, and not in my base case assumptions, DHX has the portfolio to potentially announce a significant digital distribution deal that would exceed even our current expectations.
• Additional acquisitions. Management has demonstrated the ability to execute accretive roll up of both large children studios and single properties.
• Break-out hit driving material M&L upside. Any significant success on the M&L front would be upside optionality.
• Take-out candidate. While I think management is confident in the outlook of DHX as a standalone entity for the foreseeable future, DHX’s children’s oriented content library and production capabilities could be a strategic fit for both traditional and new entrants in the media space. Management and the board owns ~14% of the equity. The CEO successfully sold Salter Street Films, a public media company, in the early 2000s. Like DHX, the CEO was also a co-founder of Salter Street Films.