Description

(All figures in AUD unless otherwise stated including market cap and stock price above)

Magna Pacific (Holdings) Limited (“MPH”) is a good business that will grow over time selling at a fraction of its intrinsic value. What I view as short-term issues, has presented an opportunity to own MPH at 2-2.5x annual pre-tax free cash flow (EV/annual pre-tax free cash flow). The business sells at about 60% of book value, has zero debt, pays out 50% of earnings in the form of a dividend, has been repurchasing stock (recently bought back about 6% of outstanding shares), and has distinct advantages helping to ensure future cash flow growth and sustainability.

Overall, it is my opinion that MPH offers 80-500% of upside coupled with virtually no downside at current market prices. Further upside can be obtained by holding in AUD if you have similar beliefs as Warren Buffett on the USD’s eventual decline in value against certain foreign currencies (I believe it was mentioned somewhere that he owned a significant amount of New Zealand currency…..but could be wrong on that).

Business Summary:
MPH is the largest independent distributor of feature films, TV series, children’s titles, music DVDs, and documentaries in Australia and New Zealand (MPH has approx. 7% of independent market, nearest competitor has 2%, highly fragmented overall). MPH is mainly a service business that acquires the exclusive rights to distribute the aforementioned entertainment to the Australian/New Zealand markets primarily via the cinema (theatres), rental / retail DVD and VHS market, and TV / pay-TV providers. Product has traditionally been sold via DVD/VHS to various retailers including mass merchant, music stores, home video rental, direct mail houses, and other retailers (to be specific retailers include Blockbuster, Target, Woolworths, Borders, Toys R Us, etc……to name well-known American retailers). However, over the past several years, MPH has expanded itself from primarily a DVD/VHS distributor to retail outlets to an “all rights” content purchaser enabling them to distribute entertainment through several media outlets as described above.

The expansion in MPH’s business includes several agreements with high quality content producers like the Discovery Channel, The History Channel, and Biography; furthermore, MPH has acquired rights to high quality well entrenched brand names such as Lizzie McGuire, The Smurfs, American Chopper, Yu Gi Oh!, and Care Bears. I suggest reading the annuals to learn more about the vast catalogue and agreements MPH has and has in the works (movie catalogue includes classics such as Reservoir Dogs, Dances with Wolves, Dirty Dancing, etc.). Effectively, MPH has expanded itself from a “distributor of titles to a manager of entertainment brands” (2005 annual report).

To better understand MPH’s business I lay out the following processes of distribution…

Process of DVD distribution works as follows:
- A master copy of the title is purchased by MPH paying an upfront and ongoing royalty securing rights for the title to the designated region. Catalogue titles are usually acquired for 5-25 years.
- MPH markets the title and distributes to various retailers and manages inventory risk.
- Retailers are linked to MPH via Electronic Data Interchange which enables automatic ordering after purchases and provides MPH with useful sales data.
- Product can be delivered within 24 hours by MPH.

Process of cinema release agreement works as follows:
- Typically MPH must pay an advance payment (say 20%) and the remaining 80% upon delivery which secures title rights for 15-25 years.
- MPH spends on marketing.
- Releases to the various outlets at various times (cinema, rental, retail, pay TV, and free TV).

Overall, I find it to make the most sense to think of MPH as an intelligent local purchaser of content which can be distributed through any media outlet imaginable. Currently, they have built a decent library of content and will strengthen this over time as they further pursue “all rights” acquisitions. MPH is a somewhat similar business model to the major distributors/producers including 20th Century Fox, Warner Brothers, Paramount, etc. However, the main difference is that the mentioned major distributors/producers concentrate on marketing and releasing their own product worldwide and this is the very reason why independent film (content) makers often prefer independent distributors such as MPH.

Many here may jump to the risks of the various media outlets now available for entertainment and piracy as culprits to the thesis; I think the former is less of an issue with MPH than most businesses in this industry and the latter is an issue I am unsure on the outcome. Below I touch on the subjects but will refrain from making this entire write-up about the issue as I do believe Magna is heavily protected since they are a content owner.

New media outlets & Piracy:
“When they take people to the cemetery, they’re losing readers, but when they graduate from college, they’re not gaining any readers.”- Warren Buffett referring to the newspaper industry at the 2006 Berkshire Hathaway annual meeting

The above statement may very well ring true for the sale of DVD’s via retail looking into the future as more people turn to I-pods and their computer to be entertained (burning movies themselves onto DVD or even watching via computer). However, MPH owns the content for their specific region and thus deserves a royalty should a movie be downloaded from an internet site or any other means. Advances in technology, whether that be high-definition DVD’s or internet downloading, should have a net positive effect on MPH as consumers rush to have the latest and greatest version of their favorite movies replacing their outdated collection.

The main risk I see for MPH in regards to the aforementioned, is an internet based movie provider purchasing future content prior to MPH, but then who will distribute the content via DVD or cinema? Who has the local knowledge to know what this region wants to see? I do think that overall the distributors, such as MPH, add value to the product and for retailers through marketing, storage, etc.. In addition, MPH derives 30-35% of revenue from documentary titles and children’s DVD’s which is an audience less prone to piracy and downloading via new media outlets. For instance, the purchase of a The History Channel series is done more as a collector’s item purchase that the owner wants for a long period of time (hence the party potentially wants the fancy packaging, etc.) and children’s DVD purchases are often gifts or impulse buys at a retail outlet (once again the packaging is important to garner the child’s interest). I do see that internet downloading could potentially be a risk to even this side of the business (once quality improves), but I also think MPH has an opportunity to enter this market as well should they deem it necessary as MPH already owns a decent film library asset for their region and they will continue to purchase additional libraries over time.

I am not going to argue that Magna will not be affected by the various new media outlets or piracy as they most likely will, but I do feel confident in saying that there will continue to be a market for them and keep in mind that they do own the content. Rather than argue until we are all blue in the face (because no one knows the distribution percentages through various outlets in the future and the outcome of piracy) I will just simply say make sure there is a Margin of Safety that makes certain a profit no matter the outcome (outcome within reason that is).


Recent Performance and Valuation:
MPH has recently gone through a half-year time period where not a single major new title was released. The result was EBITDA of $4 million (or $6 million annualized taking into account more cash flow during the X-mas season). Over the past 2 years, MPH’s first 6 month EBITDA has been $6.6 million and $6.2 million in 2004 and 2005, respectively. The drop-off in cash generation was due to not releasing major new titles because its previous relationship with Becker Group prevented it from buying cinema release product (had a distribution agreement). The relationship ended in late 2004 and MPH is now free to pursue any acquisition of movie titles they please including distributing Becker Group’s (which they have an agreement to do). The problem is that there is a 1.5-2 year lag between when MPH purchases a film (sometimes at script level) and when it is able to distribute the title. Thus, this is where we stand, a half year of performance primarily a result of back catalogue sales.

Remainder of fiscal 2006
Management recently released that they expect net income to amount to $4 million for the fiscal year as again major releases are not being distributed yet. Assuming similar growth in EBITDA, MPH will generate approximately $6 million of EBITDA in fiscal 2006 which is again primarily derived from the sale of back catalogue titles. Capital expenditures for the year are estimated at $5 million however the great majority of that is being used to acquire new titles ($3 million was spent in the first 6 months acquiring titles). Non-growth capital expenditure is not exactly easy to figure out as some of the expenditure is actually replacing former cash flow sources (possibly the 5-7 year titles) and some is purchasing cash flow for 15-25 years into the future. I am comfortable assuming half of capital expenditures made are necessary to produce the current and predicted cash flow generation and the other half can be considered growth. Based on past performance, depreciation, and expenditures this seems reasonable to me and to the various analysts following MPH (formerly following as of May 4).

Looking forward
Late fiscal 2007 and beyond look very promising for MPH in terms of potential acquisition of additional titles and building their film library asset. MPH plans to release 7 major new titles to cinema in 2007 and then of course to the rental market, retail, and free and pay TV over time. The major new releases coupled with back catalogue sales should get MPH back close to its 2005 and 2004 EBITDA generation of $9-$12 million with approximately $1-$2 million of non-growth capex leaving $7-$11 million of pre-tax free cash flow. Keep in mind that over time this figure should grow as MPH continues to purchase 15-25 year rights to titles.


Financial Figures

2003 2004 2005 2006 (half-yr)

Revenue $29 $39 $37 $17

EBITDA $6 $10 $11 $4
Non-growth Capex $1 $1.1 $1.2 $1.5

Pre-tax Free Cash $5 $8.9 $9.8 $2.5


Note: 2003-2005 was a time period in which DVD player penetration grew at a pleasant pace in Australia causing many to re-stock their personal film library on the DVD format. The penetration rate is still a good amount lower than the U.S. and MPH should continue to benefit from this trend going forward. However, it is my belief that yes this is a short-term event but MPH was able to also expand their library during this time and thus there normal free cash generation ability is somewhere in the range I lay-out ($7-$11 million).

Facts:
- Australia/New Zealand is considered a well over $1 billion dollar DVD market
- Australia/New Zealand DVD player penetration rate stands at approx. 70% at last check


Valuation Scenarios
It is my view that MPH generates $7-$11 million in pre-tax free cash flow and that can grow moderately over time as their film library is expanded. There will be some titles acquired that do not work out and others that work out much better than expected. Overall, the returns on capital should be decent as long as people enjoy being entertained and MPH continues to enjoy some advantages over local competition, these advantages include:

- Current film library asset rights and the financial position to expand it
- Distribution network throughout Australia/New Zealand which includes a low cost platform (economies of scale compared to other independent producers) for independent producers

At $7-$11 million of pre-tax free cash flow supported over time by the above competitive advantages coupled with the probable growth over time; a reasonable person would be willing to conservatively pay 7-10x that pre-tax free cash flow figure or $50-$110 million (no exactness here!!!) for MPH. Many would argue a higher multiple based on the economics of the business.

The best part is that you do not need the above scenario to make money investing in MPH as the worst-case still provides a great return. Let us say that MPH does an extremely poor job of purchasing new titles and is only able to support the pre-tax free cash flow generation that is occurring in fiscal 2006 primarily based on back catalogue sales or their current library asset. In this scenario, MPH generates approximately $4.5 million of pre-tax free cash flow (including the continuing expenditure of ½ estimated capex on new titles) and would be conservatively worth $32-$45 million.

So what can we buy MPH for in the open market?
MPH has zero debt and approximately $2.5 million of cash on hand as of the latest press release. With around 104 million shares outstanding and a current market price of $.20 per share, MPH sells for an EV of $18.3 million.

We are obtaining a modestly growing 38%-60% pre-tax free cash flow yield and according to the worst-case sale of primarily back catalogue titles only scenario we receive a 25% pre-tax free cash flow yield. I think we are being well compensated for taking on any potential piracy or alternative media outlet risk.

Furthermore, MPH pays out approximately 50% of its income in the form of a dividend and uses the remaining cash flow to buy new titles and lately to repurchase stock (to the tune of 20 million shares…..a little over 6 million have been repurchased in 2006). The dividend last year amounted to .025 fully franked and will likely be .03 in fiscal 2007/2008 (possibly .015-.02 in 2006). The dividend is paid annually and looking forward is a yield of 15% based on my estimates.


Analyst Views:
Just wanted to add this section as I found it advantageous to read analyst reports citing…..“appears fundamentally cheap. However, we believe that there is too much earnings uncertainty” (possible confusion here of uncertainty vs. risk?). Furthermore, it is obvious the reports have a heavy reliance on beta. One can easily view the analyst’s valuation go straight down as beta has gone straight up yet the business has gotten much cheaper.

Overall:
I believe MPH offers 80-500% of upside at current prices and offers further opportunity to an outright buyer who could partially consolidate the highly fragmented independent distribution industry in Australia/New Zealand (primarily via the purchase of catalogues as MPH has the distribution network). Furthermore, I believe MPH could also leverage itself up to some degree to free up cash for a potentially large library asset acquisition (although they do plan to borrow next year in completing their new warehouse facility……3x the size of their old one). However, the roll-up and possible LBO/library acquisition scenario are not necessary to make a good deal of money from an investment in MPH.

Catalyst

Value