Description

As other VIC participants have noted, John Malone has recently been quite vocal about his view regarding the importance of quality content production to serve as a differentiating feature for distributors (COTB’s recent write-up of STRZA nicely summarizes Malone’s commentary.).  In our view, Malone should focus his attention to DHX Media, an asset we would argue is as well-positioned as any media asset and cheaper than Malone-owned LGF.

In our view, DHX checks the boxes on an investor’s wish list for an attractive content producer:

• Low-cost provider primarily monetizing distribution in the OTT space, insulated from disruption in linear video ecosystem

• Extensive library of content that translates well to OTT/SVOD environment across the world

• Diversified customer base with limited exposure to any single distributor globally

• Focused solely on being great at children’s content which is key to the global content ecosystem

• High margin, capital-lite licensing business that enables company to further monetize content production

• Cost advantage that allows for new content production with limited capital at risk

• Advantaged acquirer of assets due to structurally low tax rate (and potential acquisition target)

• Hidden asset value that is underappreciated and offers additional upside

• Solid management with a good track record and aligned interests due to significant stock ownership
  
  

Thesis

DHX is an under-appreciated compounder within the media content production and licensing industry.  DHX distributes primarily in the OTT ecosystem, insulating it from many of the secular challenges other content providers face.  DHX has a long runway for organic growth with incremental upside from a large slate of new shows, notably the global re-launch of Teletubbies.  As a Canadian domiciled entity, DHX’s effective tax rate is lower than US-domiciled entities, which makes it an advantaged acquirer (higher synergies due to lower taxes) or a target for an inversion transaction.  Given the strength of the company and its high growth rate, DHX is undervalued on an absolute basis, trading at 9x 2016 EBITDA and 15x P/E despite organic revenue growth approaching 20%.  DHX also has significant upside optionality:  if Teletubbies were to match its past success on the licensing front, for example, it would more than double EBITDA over the next couple of years.  In our base case, we think shares will trade at $12 to $15 a year from now (50% to 90% higher than current levels). We believe EBITDA will be meaningfully higher than consensus.  Some investors are concerned about disruption to the linear TV ecosystem in Canada where DHX controls the Family Channel, but we think these fears are overblown as it is a smaller component of aggregate profits and skepticism is more than priced in at the current value.  In fact, we think DHX TV offers upside, as there is a likelihood that DHX performs above its current guidance for this segment.  DHX is under-followed with limited sell-side coverage and a solid management team that has managed expectations conservatively. There are numerous catalysts including incremental acquisitions or joint ventures, partnerships or contract re-pricings, performance above expectations and the introduction of a share repurchase program which we expect in the coming quarters.

Business Overview

• DHX controls one of the largest libraries of children’s content with titles including Yo Gabba Gabba!, Teletubbies, Caillou, Degrassi and Inspector Gadget.

• DHX operates four segments: production, distribution, licensing and DHX Television (operates The Family Channel in Canada.)

• Distribution accounts for about 40% of gross profit, while production, licensing and DHX Television each account for about 20% of profit.  From an incremental profit perspective, mix skews toward distribution and licensing, the two highest-quality and margin components of the mix.

• Almost 2/3 of distribution comes from deals with OTT players including both SVOD and AVOD players (YouTube).

• Within distribution, DHX strikes non-exclusive deals with multiple players (Netlflix, Amazon, Hulu), exclusive deals with superior economics (Inspector Gadget with Netflix) and commissions new productions for distributors (Degrassi:  Next Class for Netflix).

• The licensing segment partners with toy manufacturers to produce items related to DHX’s characters, collecting a licensing fee from the sale of each toy.

• DHX Television is a Canadian linear television channel that monetizes through subscriber fees and advertising.  It is the number one ranked independent channel in Canada and also the leading children’s channel.

• DHX benefits from a structural advantage—dedicated funding and tax credits for Canadian-based content producers.  In Canada, federal and provincial regulations promote the domestic content industry. Tax incentives vary by province and are not limited to Canadian entities, yet as a Canadian company, DHX is best positioned to benefit from these tax credits to cover a portion of its production costs.  In addition, by partnering with Canadian broadcasters, DHX has access to incremental production funding sources, such as the Canadian Media Fund, which is dedicated to the development of proprietary Canadian content.  As a result, DHX is typically able to cover most of the production costs before greenlighting a new project.  
  
  

Growth opportunities

• The re-launch of Teletubbies globally in 2016 can materially add to content distribution and merchandising revenue, with a major impact on licensing.  Previously, at peak in the late 1990s, Teletubbies generated almost $2 billion of retail sales in licensed merchandise, making it one of the most successful brands for children.  Our checks indicate that DHX was able to negotiate royalty rates toward the high end of the typical 5-10% rate.  Thus a return to peak levels would generate almost $200 million of incremental EBITDA, or almost double current EBITDA.  More conservatively, at 20% of prior peak sales, Teletubbies merchandising can grow EBITDA by more than 30%.  Early indications are positive, as the initial global launch is positive with Teletubbies capturing significant share of the UK pre-school TV market (66% share of ages 0-3 audience, 33% share of ages 3-6) in the month following launch.

• Incremental co-production, distribution and merchandising deals such as the recently announced partnership with Dreamworks.  DHX and Dreamworks will produce 130 episodes of new content.  Content will be produced at DHX Studios, air on DHX TV and DHX will handle distribution in Canada, including NFLX.  Merchandising and licensing revenue will be shared.

• Continued expansion of SVOD and AVOD deals in China.  DHX recently announced 3 SVOD distribution deals with Alibaba, Baidu (iQiyi and Letv).  DHX also has an AVOD partnership with CNTV (state-controlled broadcaster).  Revenue contribution is small with opportunity to grow significantly.
  
  

Financials/Valuation

DHX trades at 15x 2016 P/E and 11x 2017 P/E, multiples that are too low given the strength of the company’s business and its growth profile. I expect the Company to grow at a solid clip (10-20% organic growth) for multiple years to come driven by re-pricing of its legacy SVOD deals, incremental deals for its content library, licensing growth driven by Teletubbies and other titles.  We think there is also reasonable visibility into the revenue stream:  legacy content deals may re-price higher driving organic upside to the distribution business; about half of licensing is in the early stages offering upside as sales increase; expectations for DHX TV - we believe there will be greater profit contribution in this segment from cost savings than expected

Other Relevant Points

• Children’s content is critical to the OTT ecosystem, as it accounts for a significant portion of OTT viewing, influences the family’s choice of distributor and keeps viewers engaged from an early age (anyone with young children likely appreciates how they prefer the on-demand and repetitive offering of the OTT environment.)

• DHX has been a disciplined acquirer and producer of content.  More than 80% of DHX’s library was built via acquisition and most assets were purchased at 4-5x EBITDA prior to synergies, allowing for significant value arbitrage.  DHX has a relatively strong balance sheet, with about 2x net leverage, falling to 1.5x next year, which leaves dry powder for further acquisitions (management has guided to about 2 content acquisitions per year) and buybacks.
  
  

Risks

• Competition for content in the SVOD ecosystem is a potential risk for DHX.  However, as a focused producer of only children’s content, with a low-cost production position and a broad library, we think DHX is well-positioned as a disruptor and insulated from threats given its low-cost position.  In fact, we believe there is a chance DHX continues to see significant pricing uplift as it renews SVOD distribution deals.

• Canadian market move to “pick and pay” or a la carte TV pricing is a concern for some investors.  We think this risk is overblown and largely priced in to current expectations.  First, the Family Channel is the number one rated independent channel and Canadian regulations mandate the inclusion of independent channels, such as DHX, in content bundles. Given its strong ratings position, we therefore think it is highly likely to be included in bundles. DHX has also significantly reduced the content costs for DHX TV, and management has indicated they passed a portion of the savings onto distributors as they negotiate to extend their distribution deals.

Catalyst

• New content acquisitions or partnerships

• Teletubbies ratings and merchandising roll out

• Share repurchases

• Takeout bid