Description
Those of you committed to “ethical investing” may want to cover you eyes and skip to the next VIC idea. New Frontier Media, Inc. (“NOOF”) is a leading provider of adult entertainment content distributed through pay TV networks, video on demand services, and over the Internet. The company’s programming is available in the U.S. through top Cable MSOs and a leading satellite direct broadcast satellite operator, though the top supplier of in-room entertainment to major hotels and via C-band satellite, and though its website, www.ten.com (The Erotic Networks). The company has also launched its TEN branded wireless product in Europe and the United States, and plans further launches in North America, South America, Europe and Asia by the end of March 2006.
Summary
The quick thesis on the investment is that NOOF is inexpensive and generates wads of cash flow - relatively large wads for such a small ($141mm market cap) company. It trades at $6.19 per share and has $1.78 net cash per share. The shares took a tumble in February on the arrival of competition from Playboy in the video on demand part of its pay TV business. While this has put a crimp on top-line growth, the markdown in the share price means you have the opportunity to buy into a strong, established adult content brand at a very attractive valuation. The opportunity hasn’t gone completely un-noticed. Noted activist and deep-value investor Steel Partners started buying share in April 2005 and filed its first 13-D in early June with an 11.5% stake acquired at an average price of about $6 per share. It filed two subsequent 13-D amendments, raising its stake to 14% of the company’s outstanding shares with the most recent purchases in early November. Other holders include John Levin & Co. (5.1%) and Fidelity (8.8%).
Business
NOOF’s two main businesses are the Pay TV Group (where it distributes adult entertainment programming networks and video-on-demand (VOD) content through cable TV, C-Band, direct broadcast satellite (DBS) and hotel rooms), and the Internet Group (where it sells adult content through its broadband website).
The Pay TV Group offers seven pay-per-view (PPV) networks with various degrees of “explicitness”, from most edited (tame) to least edited (hardcore), as well as VOD. The Pay TV Group estimates its unique household distribution as 24.1 million digital cable homes, 11.2 million DBS homes, and 699,000 hotel rooms as of September 30, 2005, with another 125,000 hotel rooms added in October 2005. PPV is available to cable, DBS and hotel rooms. VOD is available only to cable TV and hotel rooms – due to current technological shortcomings, it is not yet available over DBS.
NOOF’s three largest customers, Echostar, Time Warner, and Comcast, account for 37%, 15%, and 13% of total revenues, respectively. With the recent addition of Cox Communications, I believe the Pay TV Group is now distributed over all of the top ten cable MSOs in the US.
VOD has only become available in the past few years, and some cable MSOs have been trying to transition viewers from PPV to VOD with the result that revenues from VOD became a significant part of the company’s revenue mix for the first time in the fiscal year ended March 31, 2004. In fiscal 2005, revenue from VOD was 36% of total Pay TV revenue. To highlight, between fiscal 2004 and fiscal 2005, PPV revenues grew 13% while VOD revenues grew 24%. The smallest portion of Pay TV revenue comes from C-Band (a large satellite dish, which is fast going the way of the buggy whip), revenues from which declined 32% in the same period, to comprise less than 9% of total Pay TV Group revenues.
VOD is distributed through 699,000 hotel rooms through an arrangement with On Command and 125,000 hotel rooms (begun in October 2005) through an arrangement with Hospitality Networks.
The Pay TV Group had $43.5mm of revenue in fiscal 2005, which was 94% of total company revenue of $46.3mm. The Pay TV Group had EBIT of $20.8mm (before corporate overhead) in FY2005, up from $16.4mm in FY2004.
The Internet Group generates most of its revenues from selling monthly memberships to its website TEN.com. The Internet Group experiences considerable churn and has flat to declining revenue growth. During Fiscal 2006 the Internet Group has been focused on developing a wireless product. According to Juniper Research, the mobile adult content market will grow by over 50% to $1.01 billion in 2005 and will grow to $2.1 billion globally by 2009. This growth will rise dramatically outside of the US (Europe and Asia) because US providers will initially be reluctant to offer this type of content for fear or regulatory or consumer backlash.
The Internet Group’s FY2005 revenues of $2.76mm accounted for 6% of the company’s total fiscal 2005 revenue. EBIT for the segment in FY2005 was $800K before corporate overhead.
Bump in the Road
With the release of its fiscal Q305 (quarter ended December 31, 2004) results on February 10, 2005, the company lowered its FY2005 revenue and earnings guidance due to a higher effective tax rate and increased competition in the VOD business. The shares fell $1.49 to $8.31 and subsequently drifted lower to settle into a range of $6 to $7 for most of the rest of this year.
The problem for NOOF is twofold: 1) the rapid growth of VOD has caused some cable MSOs to de-emphasize PPV in favour of VOD, causing a bumpy transition, and 2) NOOF’s main competitor, Playboy, has entered the VOD space, gaining distribution on cable systems where NOOF was previously the only provider of VOD content.
The result is that, for example, prior to the fiscal 2005 fiscal year, NOOF was the sole provider of adult VOD content to the two largest US cable MSOs. During fiscal Q305, Playboy was added to Time Warner’s VOD adult platform. This resulted in a large decline in VOD revenue from TWX. Also, during fiscal 2006, Comcast will begin transitioning the editing standard on its VOD platform from most edited to partially edited (i.e., getting smuttier). At the same time, Comcast will add adult content provided by two smaller competitors to its VOD platform. NOOF also expects Playboy to be added to Comcast’s VOD platform during the current fiscal year. The company expects declines in revenue from additional competition will be more than offset by the increased revenue expected from the transition of the editing standard from most edited to partially edited.
While in the short term the above two factors have created some dislocation and uncertainty, the following should augur well for driving revenue going forward:
-Kagan World Media estimates that adult PPV and VOD revenue generated by cable systems and DBS providers will grow from $761mm in 2004 to $1.4 billion in 2014, pointing to growth in the total pie
-Kagan estimates that the number of DBS subscribers in the US will grow from 25.6mm in 2005 to 32.6mm in 2014
-According to the NCTA, over 34% of US cable customers, or 25mm households received digital cable service at the end of 2004. Kagan estimates the number of digital cable subscribers will grow to 64.9mm by 2014, for an 89.8% digital penetration rate
-Kagan estimates there were 19.8mm VOD enabled households at the end of 2004, and projects there will be 62.9mm VOD enabled households by the end of 2014
-As I stated earlier, according to Juniper Research, the mobile adult content market will grow by over 50% to $1.01 billion in 2005 and will grow to $2.1 billion globally by 2009
-Despite the hiccup in VOD revenue growth in the short term, NOOF expects VOD cable revenue will increase as Cable MSOs are expected to a) continue deployment of VOD technology to digital cable customers; b) increase the number of digital cable subs; c) increase the amount of space allocated on their VOD servers to the adult category; d) begin to actively market VOD to their customer base; and e) improve the consumer’s user interface to make the product easier to use
-the potential distribution of VOD by DISH as DISH looks at new technologies for offering VOD
-the possibility of obtaining distribution with the RBOCs as they begin to deploy video content to their customers
-the possibility of obtaining distribution of NOOF’s PPV services with DirecTV
So while the transition to VOD and the arrival of Playboy on the scene has resulted in a hiccup, I believe that in the medium term, the macro factors in the industry will provide plenty of opportunity for the two leading providers of adult VOD content to both enjoy growth.
Financial Overview
With the release of its results for the year ended March 31, 2005 on May 25 (revenue of $46.3mm; EBIT of $15.8mm; net income of $11.1mm; FD EPS of $.48), the company gave FY 2006 revenue and earnings guidance. The company increased this guidance with its fiscal Q106 results release on August 9, 2005: Revenues of $44.5 - $46mm; Net income of $9.1 - $10mm; EPS of $.39 to $.43). By my calculations, the mid point of this guidance implies the following P&L for FY 2006 (year-ended March 31, 2006): $mm, except EPS
Revenues 45.3
Cost of Sales 14.9
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Gross Profit 30.3
SG&A 15.4
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EBIT 14.9
Interest Expense .1
Other
-.2
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Pretax Income 15.0
Tax 5.5
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Net Income 9.6
EPS $.41
Net cash provided by operations (straight off the statement of cash flows) in fiscal 2005 and fiscal 2004 was $15 million and $13.9mm, respectively. Subtracting capital expenditures in each of those two fiscal years generated Free Cash Flow of $13.9mm and $12.5mm in fiscal 2005 and fiscal 2004, respectively.
Pretax Return on Capital - NOOF is very efficient at generating its earnings. Looking at Pretax return on capital shows a return of over 100%. Here is the math: I define pretax ROC as EBIT divided by (net working capital + net fixed assets). For this calculation, I assume $5mm of NOOF’s nearly $41mm of cash and securities is operational cash (very conservative, I believe) and over $35m is excess cash, so I don’t include the excess cash in the net working capital calculation. So, on this basis net WC at 30-Sep-05 was $7.66mm. Net fixed assets at the same point in time were $3.1mm. Therefore, “capital” employed was $10.76mm. Using EBIT data from FY2005, LTM 30-Sep05, or FY2006E all give a pretax ROC of well over 100%. A good company.
Valuation
NOOF has 22.86mm shares outstanding trading at $6.19 for an equity market cap of $141.5mm. There is less than $200K of debt and nearly $41mm of cash and marketable securities, for an enterprise value (“EV”), after deducting net cash, of $101mm.
Earnings Yield - Looking at fiscal 2005’s actual EBIT of $15.3mm, LTM 30-Sep-05 EBIT of $14.6mm, and FY2006E EBIT of $14.9mm, the company is trading on an earnings yield of 15.1%, 14.5% and 14.8% for each of the three periods cited, respectively. I define earnings yield as EBIT divided by EV. By most standards this is a “cheap” company.
Free Cash Flow Yield - 2005’s free cash flow of $13.9mm came to $.604 per share. So on this basis the company is trading at a very attractive FY2005 free cash flow yield of 9.75%. Even if 2006 earnings will be a lower than 2005 earnings, there should be a lower working capital usage (and CapEx continues to be very modest) with the result that the 2006E FCF yield should be equally attractive.
As a last valuation metric, its worth an anecdotal mention that Playboy acquired Spice Entertainment, SPZE, a provider of adult television entertainment, in 1999 at 17x EBITDA. This multiple would imply a value per NOOF share of $14.40. NOOF currently trades at less than 6x EBITDA.
By most any valuation method, this is a cheap company.
Exploration of Alternatives
Management and the board of NOOF know this is a good, cheap company, and they have taken steps to address this. On August 16, NOOF announced it had retained an investment banking firm to consider strategic alternatives to improve the profitability and growth prospects of the company. Most investors would read such an announcement as an admission the company was for sale, but in this case I do not believe a sale is the goal (although it can’t be ruled out). Rather, I think the company is looking at ways to use its considerable cash to generate the greatest value for shareholders. One obvious way to do this is for NOOF to buy back its own shares. On December 13, NOOF announced its board of directors has authorized the repurchase of up to 2mm, or about 9% of its outstanding shares, over the next 30 months. With this announcement the company said it continues to review strategic options to enhance shareholder value and expects additional announcements.
Catalyst
Good, cheap company generating lots of cash flow. Recent hiccup in business due to Playboy’s VOD offering, but medium and long term prospects still look excellent for business. Committed to buying back 9% of its outstanding shares while continuing to review strategic options to enhance shareholder value. Recent arrival of known activist investor Steel Partners as the company’s biggest (14%) shareholder will keep the pressure on the board to enhance shareholder value.