Description

I waited to post this until after earnings were released; because I wanted to make sure that all was still well. Unfortunately, it ran 50% in 2 days. Now that it has pulled back some, I think it is a more ideal time to post this.

Point.360 is an integrated media management services company providing film, video and audio post production, archival, duplication and distribution services to motion picture studios, television networks, advertising agencies, independent production companies and multinational companies. The Company provides the services necessary to edit, master, reformat, archive and ultimately distribute its clients' audio and video content, including television programming, feature films, spot advertising and movie trailers. The Company provides worldwide electronic and physical distribution using fiber optics, satellite, Internet and air and ground transportation. The Company delivers commercials, movie trailers, electronic press kits, infomercials and syndicated programming, by both physical and electronic means, to thousands of broadcast outlets worldwide.

This is an industry with many small “mom and pop” players. I think that PTSX has a major advantage because its size. This allows PTSX to offer many different services through one reliable company. Otherwise, a movie studio would have to use multiple production companies, of differing quality, to fulfill all their needs. PTSX customers are very dependent on quality postproduction and seem willing to pay for that quality. This sets PTSX apart from most other players and creates something of a moat for them which will grow as the company does.

For many years, the company focused on growth at the expense of profitability. Eight small production studios were “rolled up,” but without any integration. While this was happening, CEO Luke Stefanko (Luke) went through a messy divorce that distracted him from running the company. As a result, poor operating results and heavy debt nearly forced the company into bankruptcy.

While all of this was happening, Luke’s finances began to deteriorate. The divorce judge gave half his PTSX shares to his former wife (who still owns 25% of the company). Luke’s existing debts were compounded by margin losses. These losses forced him to first take out a loan with PTSX and then liquidate some of his PTSX shares. Shares were sold on the open market and also back to the company. I am a strong believer that executives run their companies much the same as they run their personal lives. I think that this is a fair assessment of Luke’s management experience at PTSX. Too much leverage and too many distractions.

I am not positive on the details, but Haig Bagerdjian (Haig) seems to have guaranteed some of Luke’s debts and received stock as collateral for the loan. Haig also began buying stock on the open market. During Q4 of 2001 Haig became Chairman, and in October of 2002, he ousted Luke and became CEO as well. As part of the deal to become CEO, he agreed to buy out Luke’s remaining stake of 1.435m shares. Haig also agreed to repay the existing loan that Luke had with the company. This loan was repaid at year-end 2002.

Haig had considerably better success at running the company. You can see from the chart that Haig was successful in cutting costs, raising margins and paying down debt. From when Haig became chairman, operating income as a percentage of revenue has nearly tripled from around 4% in Q3/01 to almost 12% in Q1/03. Strong cash flow has allowed the company to pay down nearly one third of the outstanding debt while accumulating cash on the balance sheet.

Q/Yr Q1/01 Q2/01 Q3/01 Q4/01 Q1/02 Q2/02 Q3/02 Q4/02 Q1/03

Revenue 19.108 16.446 16.905 17.169 16.846 16.710 16.959 17.903 17.293

Gross% 34.02% 31.53% 33.48% 31.56% 37.11% 36.36% 39.97% 39.88% 37.23%

SG&A % 28.78% 33.51% 29.44% 27.19% 27.35% 26.86% 27.75% 28.91% 25.34%

Opp Inc .966 (.599) .683 .751 1.645 1.588 2.072 1.964 2.05

Op Inc % 5.04% (3.64%) 4.04% 4.37% 9.76% 9.5% 12.22% 10.97% 11.89%

OCF 2.398 1.138 2.323 3.596 1.683 2.616 4.026 2.056 3.39

OCF-CapEx 1.073 .617 1.716 2.967 1.423 2.157 3.384 1.042 2.642

EPS (.01) (.07) (.08) (.01) .07 .05 .09 .10 .11

Cash 1.18 .536 1.092 3.758 5.161 4.655 6.381 5.372 6.68

Debt 31.079 30.036 29.356 29.156 29.141 26.528 25.669 23.152 21.882

All numbers in millions except percentages. EPS figures use weighted average shares (not the 11.704m number).

This has obviously been a successful turnaround, but what is it worth? There are 9.035m shares outstanding and 2.799 million options outstanding. 2.669m have an average weighted exercise price of 2.77. The others have strikes much higher, and I will not count those in the calculations, so I arrive at 11.704m fully diluted shares for my calculations.

In 2002, the company was able to earn 2.817m or 24.07c a share. This is a very equipment intensive industry. Therefore, in years without major equipment upgrades, depreciation exceeds CapEx, and FCF- CapEx exceeds EPS. In 2002, FCF was 10.381m (88.7c) and FCF – CapEx was 6.896m (58.92c). This is more than twice EPS. I have included 1.1m in earn outs as part of CapEx, but this will not be recurring in 2003. Without the earn outs, FCF- CapEx would be 7.996m (68.32c). This is over 2.8 times EPS. EPS obviously understates the cash earning ability of this company.

68 cents a share seems pretty attractive for a $2 dollar stock. Here is where it gets interesting. I think that 2003 will be a much better year for PTSX than 2002 was. 2002 included the early stages of the turnaround along with much higher debt levels that led to higher interest expenses. In Q1 2003, the company was able to earn 977k (8.35c). The company had 3.39m in FCF (28.96c) and 2.642 in FCF- CapEx (22.57c). When looking over Q1, keep in mind that it was a slower than normal quarter because of less advertising business due to the war. PTSX also capitalized 411k in due diligence and partial payments for a pending acquisition (more later). This will not be recurring, yet it is included in the FCF and CapEx under “Cash Paid For Acquisitions.”

How will 2003 earnings look? I do not honestly know. Management refuses to provide much guidance. If you assume that Q1 was light because of the war, then maybe income could average 1.2m for the next 3 quarters. This represents slight improvements in margins and interest expense. That would give 4.6m in income or 39.11c per share using the 11.704m shares. Using weighted average shares (excluding stock options) you get 50.98c. I think the first measure is more appropriate, but I am convinced that most investors only look at the second number (which the company is bound to stress).

Looking at the cash flow statement, for Q1 cash provided by operating activities was 3.39m. This includes 411k of due diligence and other costs that will not be recurring. For rough estimates, lets assume that cash from operations will average 3.0m quarterly over the 2003-year. (I use this lower number because I do not know how much more cash flow is possible by reducing working capital). This gives 12.0m in operating cash flow or a 1.6m improvement over last year and a believable number. The company is projecting 3.5- 4.5m in CapEx. Lets use 4m for a midpoint estimate (this is about a million lower than full year depreciation). This would leave us with 8m in FCF- CapEx, or 68.35c (using 11.704m shares and 88.66c using 9.023 weighted average shares outstanding). Keep in mind these are very rough estimates that assume a slight uptick in revenue when we return to pre war advertising levels, lower interest expenses from lower debt levels and better margins and cost controls.

Here is another way to look at it. Keep in mind that like the last example, there are rough guestimates. The CEO said on the last CC that revenue growth of 3% annually (excluding pending acquisitions) is reasonable. In 2002 gross margin was 38.36%. Lets assume that in 2003 it is capable of expanding to 39% and it climbs to 41% in 2004 (as a result of continued improvements and cost cutting). In 2002, SGA was 27.74% of revenues. Lets assume it drops to 26% in 2003 and 25% in 2004 as a result of cost cutting. I think that these are reasonable assumptions, especially when you consider that Q3 and Q4 of 2002 had acquisition costs included in SG&A. You can see the effect of moving these to the balance sheet because Q1/03 had SG&A at 25.3% of revenue. I assume the company continues to pay down 6m in debt per year and most of their debt is fixed by a swap at 6.5%. I assume taxes remain at 40%.

I have computed EPS estimates using the 11.704m shares and a stock price at 2.5 (current quote). To arrive at EBITDA, I will add back interest, taxes and depreciation of 5.3m (2002 figure which should remain constant because of lower CapEx.


2002 2003 (E) 2004 (E)


Revenue 68.419 70.472 72.586
Gross Profit 26.247 27.484 29.76
SG&A 18.977 18.323 18.147
Operating Income 7.270 9.161 11.613
Interest Expense 2.528 1.4 1.0
Income before taxes 4.824 7.761 10.613
Taxes 2.007 3.104 4.25
Income 2.817 4.657 6.363
Fully Diluted EPS
(11.704m shares) 24.1c 39.8c 54.4c
PE at 2.5 quote 10.4 6.3 4.6
EBITDA 12.65 14.46 16.91



I do not like to make price targets on stocks. I like to buy cheap and hold on until something goes wrong, or I find a better bargain. You can use any assumptions you want to create a target selling multiple. My point is that the stock looks very cheap based on my own calculations. I would think that the chairman sees a lot of what I do. He bought 1.436m shares in October. Recently he bought another 5,000 shares, bringing his total ownership to 25% of the company. A director also recently acquired 2,500 shares on the open market.

Let me talk a bit about the pending acquisition. The above calculations do not include anything beyond the costs for due diligence and partial payments for the pending acquisition. This acquisition obviously changes many of my assumptions in ways that cannot be calculated. For this reason, I like to think of them as being Pro Forma calculations. Management has said that because of the added debt and financing costs, this purchase will likely not be accretive. They do not seem to want to elaborate much beyond that however. Since I have established what the company would likely look like without the purchase, lets look at how the purchase will change things.

The movie industry is increasingly moving away from Hollywood. Ever since California decided to go socialist, the costs of doing business, from electricity to workers compensation have skyrocketed. Canada has chosen to capitalize on this trend and has offered tax incentives to the movie industry to relocate. A year ago, management entered into talks with Alliance Atlantic (Nasdaq: AACB) to purchase 5 postproduction studios that they owned. At the time it may have been a great move, but since then, the Canadian Dollar has been very strong. This Canadian dollar strength may now mitigate many of the perceived cost savings that the movie industry had been looking for. PTSX has been in the “due- diligence” phase now for a while. I think it makes sense to review every aspect of the transaction to make sure it is right. Who knows, maybe Haig is trying to play for a better price?

In any event, the price tag, at about 22m in new debt is quite high for a company that already has a lot of debt. I think it makes sense to diversify the business mix, but I do not know if the cost makes it worthwhile. I think that Haig realizes this also, and is trying to make sure he is making the right moves. These facilities were vertically integrated into AACB and PTSX has not really given any firm numbers of what they think the future possibilities are for them once they are disentangled. It is likely that they will be more profitable once they are owned by PTSX because Alliance Atlantic competitors will begin to use them, which should grow their revenue base.

In a past CC, PTSX said that in 2002 those facilities had 11m in revs and 3m in EBITDA. I think this is interesting because if PTSX is willing to pay 22m and 500k PTSX shares for these facilities, then it would value PTSX on last years earnings at around 80-100m enterprise value, or about 2-3X the current enterprise value of PTSX.

This acquisition cloud continues to hang over the company and is partially responsible for the depressed price of the shares. PTSX has already paid with 500k warrants and $300,000 cash. The company will also need to get a larger loan with another bank that is willing to grow with PTSX.

I personally do not know if this is the best move for the company, especially because I expect the US Dollar to continue to fall. At the same time, I trust current management, and they have yet to make any mistakes. Given how much Haig has invested in this company, I think he is just being very methodical and making sure he is making the right moves. This is the wild card however, and the reason that the stock is trading so cheaply currently. Given how cheap the rest of the company is, I do not think it makes sense to give it such a low multiple based on the pending acquisition.

On a final note, I am a huge fan of strong corporate governance. PTSX accounting looks conservative and straightforward. Management salaries are rather low. Most impressive to me is that Haig repaid Luke’s outstanding loan on time and in full. Option issuance is a bit high for my tastes, but most of it happened under Luke. I am hopeful that option issuance is lower in the coming years. Finally, I am really impressed that Haig has bought 25% of the company over the past 2 years. He has taken a big stake and intends to grow the company into a powerhouse. If it all works out right, he stands to win huge.


Risks: Here are a few risks in my eyes. I like to know ahead of time what can go wrong.

1. The acquisition is a mistake or that integration has problems.
2. The acquisition goes ahead and the Canadian Dollar continues to strengthen.
3. The movie or advertising industry is seriously affected by the weakening economy.
4. Option issuance remains high.
5. The movie industry decides to take postproduction “in- house.”
6. Alliance Atlantic or Luke’s wife decide to sell. This could put a lot of selling pressure on a rather thin stock.
7. The thin nature of the stock makes it difficult to enter or exit.

Disclosure: Long

Catalyst

Catalyst: Final decision on acquisition of 5 postproduction facilities. Market recognition of cash flow potential.