April 28, 2010 - 10:20am EST by
2010 2011
Price: 8.34 EPS ($0.25) $0.58
Shares Out. (in M): 269 P/E N/M 14.4x
Market Cap (in $M): 2,240 P/FCF N/M N/M
Net Debt (in $M): -833 EBIT 198 423
TEV (in $M): 1,407 TEV/EBIT 7.1x 3.3x
Borrow Cost: NA

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Thesis: Short EK.  Here is an opportunity to short a broken company whose stock is up 100% YTD but with no meaningful improvement in their underlying business.  We see the opportunity to pick up a quick 35% of stock downside in the near-term, and a potential zero in the long-term.

Most VIC readers are probably familiar by now with EK's failure to profitably transition away from the dying film business towards digital imaging (where most end markets are highly competitive and/or commoditized).  We will not re-hash this history here, but note that current mgmt has been failing to deliver on digital for years now and EK has endured serial restructurings.  Our focus here is on how significant one-time IP licensing benefits are currently clouding the shockingly weak underlying reality of EK's operating businesses.  We believe this confusion has helped the stock move up substantially in recent months.

A cursory glance at EK's 4Q09 results and the Street estimates for 2010 would have one believe that EK is in the midst of a major turnaround in profitability.  However, these numbers are massively goosed by one-time IP licensing payments from LG and Samsung, as EK squeezes deals out of the last few handset makers who have not yet licensed their aging patent portfolio (the patents in question cover "innovations" like previewing a digital picture).  We note that a recent sell-side initiation on EK seems to miss the one-time nature of these large licensing payments and instead effectively capitalizes them at more than 5x EBITDA. 

Specifically, 4Q09 included $421mm of one-time licensing payments (including $414mm from LG) and we estimate that excluding this and other one-time tax and gain-on-sale benefits, 4Q09 EPS was at best zero (vs. the $1.36 claimed by mgmt) in the quarter.  4Q09 revenues, excluding one-time licensing and forex benefits, were down 15% yoy vs. a claimed 6% headline revenue increase.  For the full year 2009, EK received $622mm in cash from one-time licensing deals, vs. $150mm cash received in 2008.  2009 full-year FCF of ($288mm) includes the $622mm of one-time licensing payments; EK's underlying businesses burned a staggering $910mm of cash during 2009.

The $650mm-$750mm of guided 2010 EBITDA (analyst day 2/4/10) includes $550mm of 100% margin Samsung IP licensing revenue and $75mm of pension income (somehow EK is earning pension income despite annual pension/OPEBs cash payments projected at $300mm/yr through 2012); this implies core business EBITDA, pre-restructuring charges, of just $25mm-$125mm.  The FCF guidance of ($100mm)-($150mm) includes $450mm of cash coming in from Samsung (the other $100mm was collected in 4Q09 but no revenue recognized at the time); implies the core business will do ($550mm)-($600mm) in FCF in 2010.  This is not a healthy company.  From an earnings perspective, we estimate one-time licensing will contribute $1.42 to 2010 EPS; the Street is at $0.58 for 2010, including this benefit.

While bulls argue that recent patent suits filed against AAPL and RIMM hold the potential for further licensing upside, the reality is they will likely be worth much less than Samsung and LG.  The simple reason is that Samsung and LG have a combined approximate 30% share of global handsets, vs. AAPL and RIMM at a combined ~6%.  In addition, AAPL has responded by filing counter claims of patent infringement against EK, suggesting a higher likelihood of a cross-licensing deal, rather than a fat cash payment from AAPL to EK as bulls are hoping.

Regarding KKR's involvement in this company, we note that at this point, KKR's $300mm loan has been repaid, but they still retain two board seats and 40mm warrants, so they continue to retain an upside kicker but are now playing entirely with "house money" - in a way that materially dilutes equity holders.

So how much should one pay for this declining, cash-burning business?  We'll be generous and apply a 5x EBITDA multiple to the high end of implied 2010 core business EBITDA guidance of $125mm = $625mm in EV on the underlying business, plus $833mm net cash as of 12/31/09, plus $450mm Samsung cash coming in 2010, plus $400mm? NPV of all future IP deals (we think we're being very generous here), less $600mm cash that will be burned in 2010, is equity value of $1708mm or ~$5.30/share on 323mm fully diluted shares, with further downside over time as more cash is burned.

Disclaimer: We are currently short EK shares but could change our position at any time without further disclosure.  This is not a recommendation to buy or sell any securities.


Continued revenue declines and cash burn, greater market understanding of the one-time nature of IP licensing benefits to EBITDA.
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