Point.360 PTSX W
March 22, 2005 - 11:54am EST by
logan884
2005 2006
Price: 3.21 EPS
Shares Out. (in M): 0 P/E
Market Cap (in $M): 34 P/FCF
Net Debt (in $M): 0 EBIT 0 0
TEV ($): 0 TEV/EBIT

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Description

With the stock trading at 3.7x EBITDA, and an unlevered FCF yield of 19% based on ‘05E performance coupled with the leadership of a highly owner-oriented CEO, I am advocating a long position in Point.360 (PTSX).

Summary Company Description
Historically known as just a “dub and ship house”, the reality and perception of the Company’s business has changed. Point.360 provides film, video and audio post production, archival, duplication and distribution services to motion picture studios, TV/cable networks, advertising agencies, independent production companies and multinational companies. Primary users of the Company’s services are entertainment studios and advertising agencies/advertisers that choose to outsource services due to the sporadic demand and the fixed costs of maintaining a high-volume physical plant. Approximately two-thirds of revenue is generated from post-production services and one-third is from spot distribution services (though spot distribution services represents over 50% of the Company’s cash flow).

PTSX provides the services necessary to edit, master, reformat, archive and distribute its clients’ content. When copyright holders need to repurpose or re-distribute a film, TV program or ad spot, they typically call a post house like Point.360. Business is acquired on a purchase order basis (i.e., there are rarely long-term or exclusive service agreements) and is based primarily on reliability, timeliness, quality, and price. The Company’s active client list is comprised of over 2,500 customers, including seven motion picture studios that accounted for over 35% of the Company’s revenues in 2004.

PTSX earns revenue primarily in four ways (approximately half in first two and other half in latter two): I) daily/hourly rental of post-production/editing suites; II) contracted fees (on a project-by-project basis) with major studios, film and TV producers for film and tape finishing/related services; III) markup on broadcast syndication distribution and other usage fees; IV) markup on duplication and physical/electronic distribution services
Since 1997, the Company has completed almost ten acquisitions of companies providing similar services.

The industry is very fragmented as the domestic target market is $1.6B (~10% comprised by spot distribution segment) and PTSX characterizes its position as third (after Ascent and Thomson) with $70m of sales.

Financial Snapshot
10.6m fully-diluted shares
$18m of net debt (includes option proceeds)
$70m of ‘05E Rev (assumes no growth; acquisition of IVC contributes 2x last year’s performance since acquisition closed July 2004)
$14m of ‘05E EBITDA (assumes 20% margin)
$10m of unlevered FCF

Summary of Thesis
The main reasons I am bullish about PTSX are summarized below.

Chairman/CEO/President Haig Bagerdjian is highly owner-oriented with ~25% ownership stake. Since Haig became Chairman in September 2001, he has spent almost $4m of his capital to purchase shares of PTSX. His average basis is $1.81. Since August 2004, he has spent almost $600k and his average basis is $2.71. Haig has purchased shares as high as $3.71 in January 2005. In an environment of unprecedented insider selling activity, it is comforting to invest in a company where the CEO is expressing his level of conviction with skin in the game. Though I’d like to see other members of senior management demonstrating a similar level of conviction through insider purchase activity, management informed me that other members of management have bought shares but their position in the company doesn’t constitute a need to report such. The CFO has not purchased shares but says that at 60 years old he has adequate exposure relative to his risk tolerance at his age.

In addition to owner-orientation being evidenced by the purchase of stock, Haig demonstrates owner-orientation by how he manages the Company. He has institutionalized processes for bottom-up budgeting and capital allocation plus has developed an incentive-based compensation structure. Management encourages a sense of accountability and ownership by sharing monthly P&Ls with its employees. For a company the size of PTSX, I am impressed by the CEO’s methodical approach for allocating capital and his strategic thoughtfulness regarding the industry. Haig was a Board member before assuming the role of Chairman in September 2001; he added the role of CEO/President in October 2002 when he replaced founder R. Luke Stefanko.

Haig’s experience as a senior executive at Syncor (sold to Cardinal Health) in a business that essentially provided commodity-like services to the medical industry is Haig’s framework to operating Point.360. Haig recognizes the commodity-like industry in which he operates (i.e., similar to Syncor as a service provider to the medical industry) and therefore he applies a laser focus on trying to improve operational efficiency, to fortify a customer service orientation, and to attract and most importantly retain (a major challenge historically in the post-production industry) high-quality talent. In each of these areas, the Company has evidenced positive traction and I am asserting PTSX will continue to do so, thereby improving the Company’s performance and ultimately making the Company more visibly attractive in the public market as a well-managed company that is extremely undervalued.

Attractive valuation provides downside protection. At 3.7x ‘05E EBITDA and an unlevered FCF yield of almost 20%, the stock’s valuation provides adequate margin of safety. At the current price, PTSX is highly attractive as an acquisition candidate (by either a private equity firm or strategic industry player as described below); this assertion would be further amplified at lower prices. The only public comparable to PTSX is Digital Generation (DGIT) though not surprisingly it’s hardly a perfect comparable. DGIT’s core business is spot distribution services which represents only a third of PTSX’s revenue. DGIT’s EBITDA margin is estimated to be 26% this year compared to PTSX at 20%. DGIT is trading at 6.7x ‘05E EBITDA. At a 20% discount to DGIT’s multiple (i.e., 5.4x), PTSX is worth ~$5.45. Last week, Liberty Media announced its intention to spin off Discovery and Ascent Media into a new public company. Analysts are estimating Ascent is worth 5-8x ‘05E EBITDA.

I of course also view Haig’s purchase activity as another credible source reinforcing the attractiveness of the current value as downside protection. Assuming $10m of unlevered FCF this year and assuming “conservatively” no growth in FCF, the market is imputing a discount rate of 19% to PTSX’s FCF. Assuming a discount rate of 12% on $10m of FCF with no growth, then PTSX is worth $6.15. PTSX looks like a gift to me from a valuation perspective.

PTSX is an attractive acquisition candidate. In a private market transaction, PTSX is worth more than $6. I know of several private equity firms who would be interested to acquire PTSX. In fact, I know of a multi-billion private equity firm which tried to engage Haig in a going-private transaction but Haig expressed a lack of interest as he is happy to be patient with the public market (“for the time-being”) and to opportunistically purchase shares for his own account.

The CEO is not oblivious that his stock price fails to reflect intrinsic value. I think he decided he wouldn’t own nearly as much of the equity upside in a going-private transaction because it is rare for management to own much more than 20% of the equity (and he would obviously need to share some of the equity with other members of management) in going-private transactions orchestrated by a private equity firm. If I’m Haig and very bullish about the strategic and operational course I’ve developed for the Company, I’d behave in a similar way (assuming I had $4m I could part with to deploy patiently in the company I was leading). I think Haig is acting rationally as he can enhance value creation at PTSX and retain more of the upside as currently structured. However, the option to the private market is an easy one for him to ultimately exercise and one I envision he will exercise when deemed appropriate (e.g., enhance visibility of performance improvements and generation of increasing free cash flow). The net/net is that we get to embrace the path to increased value creation without taking on too much current risk.

The private market option was explored in 1999 when PTSX (then called VDI Multimedia) retained Morgan Stanley to explore strategic alternatives and Bain Capital expressed interest to acquire the Company for $15 per share (implying a ~10x LTM EBITDA multiple). Yes, ~10x. I don’t ascribe any probability to PTSX being a 10x EBITDA business but Ascent Media was rolling up the post-production industry at 8-12x EBITDA then. Bain Capital ultimately terminated the deal during the Spring of 2000 because of both financing and performance issues. As a former investment banker who has some experience with Bain Capital, I know that Bain isn’t shy about re-trading deal terms. The performance in 2000 was in fact poor but I assert that the financing challenges in early 2000 were the main reason for Bain Capital to terminate the transaction; otherwise, they would have simply re-priced the deal based on change in performance. In any event, Bain Capital expressed interest in 1999 and I suspect they and many others would express interest today if PTSX decided to explore strategic alternatives. Symbolic of the likelihood of being sought for acquisition was the announcement of a poison pill last November.

PTSX is incurring approximately $1m (half is Sarbanes Oxley) to be a public company. The elimination of these costs would drive ~$0.50 of value (over 15% appreciation) relatively easily for either a private equity or strategic buyer. On the strategic front, there are several potential bidders; this includes Ascent Media, Thomson, Kodak, and Digital Generation. There is currently an exploratory process being conducted for the post-production business of Rank’s Deluxe. I anticipate increased visibility for the value of PTSX shares once a transaction with Rank’s Deluxe is announced. There is some possibility that PTSX pursues the assets from Rank but such would only occur with an equity infusion from a private equity or PIPE investor to enable the transaction.



PTSX’s performance is at an inflection point for improvement. The Company’s performance was challenged by the exploratory process to sell the Company. Once Bain Capital terminated the transaction, the President of PTSX plus several other senior management members tried to orchestrate an MBO. The MBO attempt failed and those involved in the MBO attempt were told to leave the Company. In addition to the management turmoil that ensued, PTSX’s CEO (Luke Stefanko) at the time was undergoing a difficult divorce and that was a major distraction that further challenged the Company’s performance. PTSX executed several transactions from 1997-2000 but the targets were never effectively integrated; instead, PTSX operated as a loose confederation of post-production facilities. When Haig assumed the CEO role in September 2001, he launched a gradual transformation that has included an improvement in operating systems and processes, a strategic plan that emphasizes the Company’s value proposition as opposed to individual facilities, and a compensation plan that aligns the interests of PTSX’s employee base to the performance of their division, facility and the Company as a whole.

The Company operates in what many would characterize as a commodity-like service business. Management understands that and is maniacally focused on execution. That has been a key emphasis for Haig as he has sought to reposition the Company operationally with a particular focus on improving customer service orientation and attracting/retaining the right people. I believe the Company is now at an important inflection point. The Company is able to better leverage the systems and processes it has put into place. The evidence is apparent in the marketplace--primary research substantiated that PTSX has hired and retained good people and is among the most focused on customer service. On the hiring front, PTSX has intensified its focus on the sales process by recently attracting two high-quality sales people from the competition to oversee Company sales. John Knowles joined PTSX from Ascent Media to lead post-production sales. John LiPuma joined PTSX from Digital Generation (previous to DGIT, he was with competitor Vyvx) to lead spot distribution services. I haven’t met John Knowles yet but John LiPuma is top-notch and has attracted others to join him to leverage the Company’s platform with additional sales to existing accounts and to penetrate new accounts. He has a good relationship with both Disney and Miramax who haven’t done much work with PTSX in the past.

Issues for Consideration

My main concerns are as follows:

Though there are some advantages held by PTSX, the post-production industry isn’t great. The business is service-based with relatively low barriers to entry. A sign of a great business is pricing power but PTSX has exhibited no pricing power. Despite my primary research, which highlights some willingness among customers to pay a slight premium for PTSX’s customer service, the Company hasn’t tried to engage customers in that pursuit. Instead, Haig is focused on efficiency as demonstrated by sales declining 13% from 2000-2003 but sales per employee increasing 8% and EBITDA increasing 9%. The spot distribution business is more attractive but at just $150m of market size, the longer-term value creation at PTSX will come from post-production.

The business can be capital intensive as PTSX must ensure its systems are compatible with the latest production technologies and advancements in production technology can occur relatively frequently. The Company budgets $1m per quarter for potential capital spending. However, the CEO and CFO exercise fiscal discipline when allocating capital by requiring payback analysis before capital is committed to purchase new equipment. Acquisitions sometimes supplant the need to acquire new equipment as evidenced recently when PTSX acquired International Video Conversions to expand the Company’s high definition post-production capacity.

The Company is effectively controlled by two principal shareholders—Haig who owns ~25% and the ex-spouse (Julia Stefanko) of Luke Stefanko who owns ~20%. Resulting from their ownership, either individually or together Bagerdjian and/or Stefanko could significantly influence the outcome of matters required to be submitted to a vote of shareholders. I think the poison pill was instituted partially to confront the possibility of someone buying Julia’s block of shares. As described above, I embrace Haig’s ownership as a significant bullish argument because of the alignment but some people could interpret the absence of minority shareholder influence as an issue.

Net/net, I think PTSX is an attractive stock to own for those of you with patient capital.

Catalyst

Continue generating attractive FCF; market will ultimately embrace stability and potential for growth

New senior sales personnel (Knowles and LiPuma) drive incremental sales among existing customers coupled with penetration of new accounts and exploit PTSX's customer service advantages into some pricing power (clients have said they might pay 5-10% more to PTSX based on exceptional service orientation)

More insider buying by CEO (creeping going-private)

Increased market visibility of industry (sale of Rank's Deluxe; spin-out of Ascent by Liberty Media)

Takeover premium by private equity sponsor or strategic industry player
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