Description

As a U.S. investor, I see Rainmaker as a way to get a 12%+ yield while waiting for the unit price to double in the next year or two.  This a well-run group of quality media businesses whose true profitability is being masked by a bunch of one-time stuff.  Given that and the small size ($48M market cap in USD = 54.7M in CAD – all subsequent amounts in CAD), it’s not surprising to me that this thing is so cheap.

At first glance it might look like the profitability of these businesses has gone down the tubes in the last couple of years.  In fact, the company even did a couple sale-leasebacks on some buildings recently to fund the distributions.   In reality the profitability is just fine. 

Admittedly, Rainmaker had a tough 2005 due to currency issues.  Vancouver has emerged as the 3rd biggest center for TV and film production in North America since it's generally cheaper to film there than in LA, and some feel the lifestyle is better.  When the USD/CAD rate dropped in 2004 this cost advantage lessened and it hurt Rainmaker as less work was outsourced from LA.  Eventually, the government responded by increasing the tax breaks granted to production companies and revenues rebounded.  EBITDA margins in 1H06 were back to 30%, not far from the 36% average.

This currency issue is in my opinion the only significant concern in this story, and I note that I think futher depreciation is more likely than not.  But I'll note two things:  the film industry in Vancouver seems to have a pretty strong political lobby (I believe they upped the tax breaks once before, around 2002 for similar reasons.  Second, at these prices all sorts of macro stuff could go wrong and I think you'll do fine.

Margins in 2006 have been depressed for an entirely different reason: discretionary growth spending related to the Mainframe merger.  The company could report distributable cash flow per unit (DCFPU) of $0.73 in 2007 if they just took their foot off the gas in terms of growth spending and went back to business as usual.

The businesses:

1. Rainmaker LP – provides post production and visual (i.e. special) effects services to film and TV producers in Vancouver, Canada.  Rainmaker has been around since 1979 and profitable every year since.  It's a good business: even if you assume full taxes in the years this has been an income trust, I estimate that the "core" Rainmaker has averaged an ROE of just under 16%. The visual effects business within LP is now being merged with Mainframe, a CGI shop (think mini-Pixar).  Mainframe was recently cast off from IDT Entertainment, which in turn was recently purchased by Liberty Capital.  With this deal, the company is looking take on bigger and better projects.  So far it seems to be working: they recently landed some impressive jobs, including work on "the DaVinci Code" and "Night at the Museum".

 

2. Canada’s Film Capital (CFC) – this is a factoring business that basically gives producers and advance on expected tax credits for labor costs incurred in Canada.  Financially, this is a cash-cow that requires minimal capex.
3. EP Canada (EP) – provides payroll and other back office services to producers.  Also a cash-cow.

Cutting to the chase, my estimate of $0.73 in normalized DCFPU goes like this:

29,992  Rainmaker LP 06E revenue                                                           

X 35.7% EBITDA margin  (avg EBITDA margin 97-1H06)

= 10,715  Rainmaker LP normalized EBITDA                                                

+ 4,658  CFC & EP EBITDA  (last 4 year avg EBITDA)                                                      

+ 4,000  Mainframe EBITDA  (avg last 2 years cash from ops excl working capital)  

= 19,373  Total normalized EBITDA                                                                                                              

 - 687   Interest expense, net                                                   

 - 2,000  Overhead                                                      

 - 4,500  Capex  (mgmt guidance: 4-5M/year)                         

+ 500    Synergies  (reduced legal, operational costs)                                        

= 12,685   Dist CF                                                      

/ 17,459  Units                                                

= $0.73  DCFPU                                

= $0.62  (proforma for 15% withholding for U.S. investors thru 2010)

= $0.50  (proforma for 31.5% corp tax for Canadian investors from 2011 onward)                  

= $0.43  (proforma for corp tax and 10% withholding for U.S. investors 2011+)

In other words, I basically just take the businesses as they currently stand and factor in a normalized EBITDA contribution from each one.  Then I give them credit for $500K in annual savings coming from the merger with Mainframe.  ($500K is a low-ball estimate – more on this below)

I think it will take them about a year before all synergies have been achieved from the Mainframe merger and the growth spending is complete.  So maybe they pay the same $0.48 distribution again in 07, then $0.73 in 2008-10.  In 2011 the trust must pay a 31.5% tax, so it drops to $0.50.  If you assume zero real growth and discount at a real discount rate of 8% (similar to a nominal 11% less 3% inflation), you get a value of $6.41 to a Canadian investor.  It’s the Canadians who, at the margin, will set the price here (seems like almost the entire unit-holder list is Canadian already).  U.S.investors are subject to a 15% withholding tax, so the current distribution works out to “only” a 12.6% yield.  Thus, I say I'm looking to pick up a 12%+ yield while waiting for the units to double (from $3.23 to the NPV of $6.41).

Factors confusing the issue:

• Acquisition of CPC and EP on 8/04/05 (about a month into 3Q05). 
• Acquisition of 61.8% of Mainframe on 7/31/06 (about a month into 3Q06), followed by acquisition of the remainder subsequent to quarter end 3Q06.
• Growth spending at Rainmaker’s Visual Effects Unit and Mainframe (being merged) in the form of both capex (new equipment) and opex (opening of a new office in London as well as increased hiring at the Vancouver HQ) 

Looking at historical results for these businesses, you need to be careful to understand how the company is allocating G&A costs.  They’ve changed their methodology twice – first in 3Q05 upon the purchase of CFC and EP (when Rainmaker finally had more than just one business), and then in 3Q06 upon the purchase of the first chunk of Mainframe.  I simply took all the historical results I could find on each business and made them proforma for this second approach (used 3Q05 through 2Q06).  As such, the company has an unallocated G&A expense of $2M a year, as well as the normalized EBITDA figures shown above.

If there is interest, I can show you the detail of all these adjustments.  It’s nothing anyone here couldn’t do, but I could probably save you some time.

Realistically, my $500K for merger savings is probably too low, possibly by a lot.  For example, there is no longer any need to incur public company costs for two companies now that Mainframe is being merged.  You could probably save half a million right there.  There are other resources (capital equipment, etc.) that can now be shared, since Mainframe and the legacy Visual Effects businesses have been doing some similar types of work all these years, and since both are headquartered in the same city.   For perspective sake, the combined businesses had about $38M of COGS and SG&A in FY05, so $500K is a paltry 1.3% of that.  This management understands ROI, and I seriously doubt they would be going through all this trouble if there weren't more upside.

More importantly, however, the merger should allow Rainmaker to go after larger projects – i.e. developing an entire animated feature or movie, rather than just working on bits and pieces of one.  A big attraction here is capacity utilization: when you are doing smaller projects you run the risk of having a gap in your work load between projects.  Historically, Visual Effects has had a number of quarters where margins are far below average due to these gaps, since you’ve still got to make payroll and pay rent whether you are doing work or not.  With larger projects lasting a year or so each, you stand a far better chance of keeping everyone busy. 

Futher, I would imagine that having this large-project ability will place Rainmaker a bit higher in the media food chain, which could mean a smaller number of competitors and as a result, less sensitivity to forex movements.  But we’ll see.

A word about capital allocation: with all the acquisitions and growth spending, you obviously have to have some comfort on this issue.  Thankfully, there’s good reason to believe the money is being well spent.  All of these acquisitions look to have been done on attractive terms.  Further, the top 3 shareholders – Tim McElvaine, Francis Chou, and Jeffrey Stacey – are all deep-value types, and Stacey has a seat on the board.  All of these guys, along with management, have participated in additional unit offerings over the years.  As far as I can tell, the unit-holder base is largely deep value folks who understand how cheap this is.  The way I see it, this growth spending either results in satisfactory revenue & profit growth or falls away.  They can always just go back to status quo and you still get your lousy 100% return.

www.rnkincomefund.com

http://www.fin.gc.ca/news06/06-061e.html
New income tax rules (note that the tax rates for Canadian investors shown here include personal income taxes).  Understandably, there has been a lot of confusion and irritation at the newly proposed law, and admittedly there is still some uncertainty as to how all this will shake out.  But I think any changes from here are likely to be in the direction of lower or more delayed taxes.  In general, it seems as though the U.S. investors I hear are overestimating the negative impact.

For a U.S. investor, there will likely be no change from the current 15% withholding (which you can credit against other taxes) until 2011, at which point the trust will have to pay a 31.5% tax, and the withholding drops to 10%.  So, the rate is a combined 41.5% from 2011 onward.  I factor this fully into my numbers and conclude that these units are still cheap.

One more tax issue: if you are an offshore fund (Caymans, etc.) note that the withholding MIGHT be 40%, as Canada typically does not have tax treaties with these offshore tax havens.  You should check before you invest.

Finally, if you are buying through a retail brokerage account, note that some brokers won't let you hold this in one of their accounts.  The reason has to do with this being an open-ended trust, which I think means there is some legal issue relating to disclosures on additional unit offerings that bugs the brokers. 

 

Catalyst

1) 1Q07 will be first quarter in which all businesses have been owned the entire time.
2) Growth spending should be complete and merger synergies fully realized by YE07. Other things equal, I would expect the distribution to approach an annualized rate of about $0.73 by this time.
3) Cramer pump (just kidding)