Technicolor is a seemingly distressed French-HQ media and technology company with 1 of 3 business segments which more than justifies its current share price.  The European sovereign crisis has lead to a unjust dumping of TCH shares, and short-sellers betting on the dilution from an upcoming maturity of an equity convertible are adding to this short-term selling pressure.  For a company which derives less than one-third of its revenue from Europe, the 80% plummet in equity value since April is far overdone.  With an eye towards long-term value, I would recommend both the equity and bank debt.  For the purposes of this write-up, I will focus on the equity and if anyone is interested in more details on the debt thesis, we can discuss further.

Company Overview:

Technicolor (f.k.a. Thomson S.A.) is an entertainment and media conglomerate which emerged from French bankruptcy (comparable to US Chapter 11 as opposed to Ch. 7) proceedings in February 2010.  TCH became insolvent largely as a result of empire-building (~100 acquisitions) and a special shareholder dividend financed through significant debt issuance, a secular shift in the media industry away from TCH’s products, mismanagement, poorly managed divestitures and the slowing macroeconomy

The Company operates three business segments (from least to most important):

- Entertainment Services - A dying and bad business - (€1.6Bn of 2010 revenue, 2-4% Adj. EBIT margins)1: 78% of segment revenues from distribution of physical media such as DVDs and film reels of which TCH is #1 in DVDs and #2 in film.  Remainder is content preparation including visual effects & animation and digital media services

- Digital Delivery / Connect - Probably worse business than people believe - (€1.4Bn of revenue, NEGATIVE 2% EBIT margins): Access products such as video set-top boxes for satellite and cable (½  hardware, ½ software), modem/gateways and WiFi tablets.  TCH is #3 in set boxes and #1 in gateways.  Software programs for VoIP and other services for network operators

- Technology - A phenomenal business -(€0.4Bn of revenue, 68% margins with negligible capex): Monetizes research through licensing.  42% of revenue from MPEG-2 video compression and an estimated 10% of revenue from MP3 audio licenses.  Next set of core licenses derived from LCDs and other videoscreens

Balance Sheet: TCH currently has about €1.27Bn in debt and about €320MM of cash.  You could further add in about €360MM of pension obligations, but if you do that, I would also give them credit for about €240MM of tax NOLs.  So let's call it total net adjusted debt of €1.4Bn resulting in net debt of €1.07Bn.  I'll point out that this debt resulted from the French bankruptcy process and is quite expensive--the average interest rate is over 9% and the company has a mix of fixed and floating debt.  I haven't received a recent pricing run, but the yields for this debt is likely in the mid-to-high-teens.

Mandatory Convertibles: Below the debt, the company also has two mandatory convertible notes called the NRS or ORA notes.  The ORA II's mature in 12/31/31 with a face of ~€201MM and the ORA IIC's with a face of ~€119MM may mature at 12/31/31 but can be extended under certain circumstances.  These ORA notes were designed to yield a 10% PIK rate to the common, and so would be the ideal investment instead of the equity if you can track it down.  If both notes are converted, the share count will rise from ~175mm to ~226mm.  In Dec. 2010, the ORA I notes and some other asset disposal notes matured, and similar to that maturity point, a number of short-sellers are adding to downward share pressure in anticipation of the imminent dilution.

Basic Investment Thesis:

If you completely ignore the two 'bad' businesses and ascribe zero value, I believe the technology licensing business covers the debt and leaves considerable free value remaining for shareholders. 

As a first check, we can look at the trading comps to derive a value for the technology business.  Comps are difficult, but as a sampling of 2011E EV/EBITDA multiples, some potential comps trade at the following:

Adobe - 7.8x

Dolby Labs - 5.5x

DTS - 9.8x

Acacia Research - 13.3x

Mean - 9.1x / Median - 8.8x

Applying the median multiple to a conservative €315MM of tech/licensing EBITDA and a similar burden for a conservative €95MM of corporate expense, you get to an enterprise value of just over €1.9Bn, equating to a €4.36 share price versus today's price of €1.15 (nearly 280% upside).  A quick way to think about downside may be to take the industry laggard (Dolby) which has perhaps a better industry overlap (but not perfect).  Applying a 5.5x EBITDA multiple will get you right about to today's share price of €1.15.  Again, this assume ZERO value for any other portion of the business and burdens that spend for corporate overhead which could mostly be eliminated if the company aimed to just monetize its tech patents.

Another valuation technique could be to look at giving some credit to the other two businesses.  The Entertainment business doesn't have any legitimate comps as Cinram (the other major producer of DVDs) is imploding due to the secular decline in hardcopy media like DVDs and the loss of contracts to Technicolor, but over time, it has traded above 1.0x EBITDA.  This would add roughly €200MM of additional value or about €0.88 per share if the debt is covered by the licensing division. 

The Digital Delivery / Connect business also faces immense headwinds due to the potential elimination of set-boxes altogether in favor of connections through TVs, X-boxes, computers, etc. as well as stiff competition from the other set-top manufacturers like Motorola, Pace, Sony, Apple, Cisco, etc.  I wouldn't be surprised to see that the smart tech money has profited well from shorting the pure play (Pace) as it has also tumbled 80% since its peak in February.  While we may disregard this data point, Pace paid $475MM (0.7x revenue) for 2Wire in 2010.  Since 75% of 2Wire's business is with AT&T which is likely a better business than the amalgamation of TCH's customers which include more troubled European media co's, even a 0.5x revenue multiple to just the modem business (a subset of the total Connect division) would add another €265MM of value or €1.17 per share.  That said, if you throw out that data point as an overly frothy strategic multiple, Pace currently trades at about 0.2x revenue.  Because TCH's Connect business is actually losing money, we can't use Pace's 2.4x 2011E EBITDA multiple.  So let's use 50% of Pace's revenue multiple for the whole Connect division, and that would add about €140MM of value, or €0.61 per share.

As a sanity check, the high-level valuation of this company appears cheap.  While management and the sell-side seemed to be expecting 2011 EBITDA to end around €475MM or €500MM, I believe the business will perform worse than that and it would be better to assume something in the neighborhood of €450MM.  As such, you could say TCH is trading at 3.0x EBITDA where the majority of profit is produced by a 70%+ margin licensing business with significant barriers to entery (e.g. patents and technology).

From a cash-flow yield basis, TCH has recently not been cash flow positive.  Due to the divestment (or giving away of) a number of poor businesses and restructuring initiatives, this has started to change.  While this was a business that threw of €150MM+ of FCF in 2007 under a 2x debt burden, my guess is that even if you assume the traditional back-end weighted cash flow year is zero and we only work with the 1H11 Levered-FCF of €32MM, you'd be looking at a 12% LFCF yield. If they keep the 1H11 pace for the year and do ~€60, LFCF = 23% on what is arguably a trough / inflection point.  For reference, some of the sell-side predicts €100-200MM of FCF in 2012 or 2013, and if that even hit the low-end range, you would be at a 38% LFCF range.

Alternatively, let's look at a run-off scenario, which is potentially what a PE or distressed buyer may be looking at today.  But before that, we need some background on this segment.

TECHNOLOGY SEGMENT DEEP DIVE:

The division’s activities are two-fold:

(1) Corporate Research: Treated as a cost center in the Technology division.  Interacts with other divisions but applied R&D is also conducted and expensed within other divisions, particularly the Connect division.  Goal is to create competitive advantage and generate patents to create continuous flow of licensing revenues

300+ employees based in 5 research centers (Rennes, France; Paris, France; Hanover, Germany; Princeton, US; and Beijing, China).  TCH closed a 6th site in 2009. 

3 R&D Focus Areas:  (i) Enhanced Media Program (3D & Content Coding): Delivering new 3D technology and improving audio/video quality.  R&D includes image rendering, animation, 3D and compression technologies (ii) Media Production Program (Workflow & Content Access): Digital production tools to improve content preparation, restoration and indexing (iii) Media Delivery Program (Home Networking): Innovative and reliable content delivery to homes and consumer devices

(2) Licensing: Monetizes intellectual property of ~42,000 patents derived from ~6,000 inventions, 1,100+ licensing contracts and 14 core licensing programs.  220 employees based in 13 locations (France, US, Germany, Switzerland, Japan, S. Korea, China, Taiwan).  Activities require minimal infrastructure

Patent focus areas: digital decoders, HD and digital TV sets, optical module patents for DVD and Blu-Ray, MPEG video compression, mp3 audio compression, interactive TV, storage and LCD & plasma flat-screens

TCH has migrated the majority of licenses from analog to digital to match evolving product markets

Licensing agreements are typically with consumer electronics companies, are renewable with an average 5-year life, and are primarily based on sales volumes

MPEG-2 is licensed through the MPEG-Licensing Authority (“MPEG-LA”) of which TCH is a member and represents 42% of Technology Segment sales

The Top 10 licensees account for 76% of 2009 Licensing revenue (MPEG-LA counts as just 1 licensee)

Sell-side estimates ~10% of segment revenue is attributable to the MP3 (a.k.a. MPEG-1 layer 3) and Technicolor receives an estimated 70% of MP3 revenue collected globally

MPEG-2 and its replacement MPEG-4 cohabit the same products today and TCH does not believe the replacement from MPEG-2 to MPEG-4 will create significant revenue risk

MPEG-4 is an evolution of MPEG-2 and was originally targeted to low-bandwidth purposes like smart phone.  However, while incomplete, it has expanded to more bandwidth uses

MPEG-2 OVERVIEW:

MPEG-2 is licensed through the MPEG-LA pool and represents 42% of TCH’s Technology Segment sales

MPEG-2 and its replacement MPEG-4 cohabit the same products today and TCH does not believe the replacement from MPEG-2 to MPEG-4 will create significant revenue risk

What is MPEG-2?  MPEG-2 describes the algorithms which permit the efficient storage and transmission of audio & video.  For example, to reduce data demands in a video, the sky can be blue and constant in multiple frames and therefore compressed.  Other attributes that a high-power camera detects may be invisible to the human eye and those can be ‘thinned out’.  Finally, coding can detect patterns in images and save redundant memory usage

Where is MPEG-2 used? MPEG-2 is a coding standard used in:

MPEG-2 Decoders: Set-top boxes, DVD players, TVs, personal computers, game machines

MPEG-2 Encoders: Cameras, DVD recorders, digital video recording (DVR) devices

Consumer Products: Encoders and decoders for direct sale to consumer market

Packaged Medium: DVDs and data streams

Media equipment is designed with the MPEG-2 standard in mind, creating high inertia, switching costs and switching delays

There are almost 1,600 licensees of MPEG-2

What is MPEG-LA?  MPEG-LA is a patent aggregating service which combines multiple patents/inventions to improve adoption and functionality and simplifying an otherwise complex licensing process with multiple patent-holders (e.g. overcoming the patent “thicket”)

Historically, multiple MPEG-2 patent holders created a patent thicket and threatened the compression standard’s adoption.  MPEG-LA formed to allow MPEG-2 usage through a single license

Through successfully aggregating the MPEG-2patents, the MPEG-2 standard is now required for digital television applications such as DVDs and has become one of the most successful standards adoptions in consumer electronics

Reduced transaction costs allow for lower combined prices while maintaining profitability. Patent pooling also increases the bargaining power with customers as it could effectively create a cartel

When was MPEG-2 Developed?

The Movie Picture Experts Group (“MPEG”) was formed in 1988 as a group within the International Organization for Standardization (“ISO”) to standardize digital compression of audio & video.  MPEG began with MPEG-1 which coded VHS / stereo audio quality which sufficed for CDs

Note: MP3’s for audio files are actually a subset of the MPEG-1 technology and is an area with conflicting intellectual property ownership but where Technicolor asserts a strong legal position

During 1990, MPEG began working on MPEG-2 to handle higher data needs and finalized the product by 1995.  While the bulk of the MPEG-2 patent base is complete, occasional updates are added

How are royalties allocated?  900+ patents comprise MPEG-2 (155 are “essential”) and are held by 26 companies including GE, Panasonic, LG, Mitsubishi, Philips/NXP, Samsung, Sony, Toshiba, Alcatel Lucent, HP and Technicolor.  Technicolor held at 12+ of the core patents (3 are now expired) within MPEG-LA and as many as 18 external to MPEG-LA

While MPEG-LA administers the alliance, the members determine the royalty splits

However, while indicative, it is difficult to determine the value attributed to Technicolor on the number of patents alone.  Sell-side estimates TCH receives between 15%-30% of the total MPEG-2 royalty pool

It is possible to view patents publicly, but difficult to discern the value without industry expertise

MPEG-2 royalties are stipulated publicly by the MPEG-LA license terms and are generally volume based with some adjustments for broadcast lengths. Pricing has fallen by 50% to 66% depending on end-product category since 2002.  The basic pricing schemes are:

Decoders: Historically was $4 / unit prior to 1/1/02, then $2.50 prior to 1/1/10, and $2 / unit since.  (50% decline)

Encoders: $4 / unit prior to 1/1/02, then $2.50 prior to 1/1/10, and $2 / unit since (50% decline)

Consumer Products: $6 / unit prior to 1/1/02, then $2.50 prior to 1/1/10, and $2 / unit since (66% decline)

Packaged Medium: More convoluted mechanisms, but roughly $0.04 per copy prior to 9/1/01, $0.035 prior to 2/28/2003, $0.03 prior to 1/1/10, $0.0176 during 2010 and $0.016 after 2010 (56% decline)

Other provisions apply to Packaged Medium including $0.01 for each 30 minute block exceeding 133 minutes, $0.03 caps on single movies, $0.01 for <12 minute clips, and a simplified “Event rate” per disc

Despite these significant pricing reductions, the Technology Segment’s revenue declined only modestly in 2008 and stayed roughly flat in 2009 indicating MPEG-2 volumes picked up, product mix improved, or other new licenses have been able to compensate for the gradual melting of the MPEG-2 ice cube

Sell-side suggests other patent expirations also have increased TCH’s share of the total royalty pool

When are substitutes or displacement threats for MPEG-2?

Other compression and transmission systems or ‘codecs’:

MPEG-4 is an evolution of MPEG-2 with improved functionality

H264 / AVC is used by flash players (e.g. YouTube and other internet video) and is backed by Apple and Microsoft

MPEG-4 has two components: Part 2 and Part 10.  Part 10 is integrated into H264

H264 requires a license from MPEG-LA, but is free or cheap for most users

Thus far, Technicolor has not, but may, join the H264 patent pool through MPEG-LA

VP8 which was purchased by Google (so could migrate into YouTube) and is backed by Firefox, Google Chrome, Opera (an independent web browser) and Adobe.  Apple and Microsoft may at some point

Developer-designed formats like Apple’s Advanced Audio Coding (“AAC”) system or publisher-designed formats like James Cameron’s system from Avatar

There are also thousands of other codecs ranging cost from free to $100s, each with a variety of functionality, compatibility and obsolescence issues

Improved transmission and storage capacity, though the amount of memory that content fills will likely continue growing as well

A secular shift in the revenue model for content distributors.  There is no royalty if services are provided free-of-charge or if revenue is collected indirectly (e.g. advertising-based revenue models)

Technology’s unknown substitutes

Institutional resistance to standards / patent protection.  For example, the tide is turning on simple protocol patents (e.g. click-on advertisements) as US patents are being successfully challenged in court or never accepted internationally, but will likely hold for engineering-based signals processing patents like MPEG

MPEG-2 patent expiry.  TCH does not disclose the expiration dates of key patents, but patents are publicly searchable and initial reviews suggests most essential patents expire between 2012 and 2018

TECHNOLOGY DIVISION CONCLUSION: The biggest concern for the technology business is it's expiration of patents.  Hopefully the discussion above gives context why I think TCH's pricing power is unique and it probably can extend the life of its licensing business, but even if it can't, let's think about a run-off.  If you had nothing to this investment but the patent pool to the very early edge of expirations, we could think about a DCF.  Assuming an even more conservative level of €300MM with minimal sustaining capex, you get to roughly €780MM of value at a 10% discount rate.  That said, you wouldn't want to touch the equity with a 10 foot poll if that's what you believe because that would imply no equity value and about 82 cents on the dollar recovery for the debt excluding restructuring costs.  If you add another 5 years to the patent pool's life, apply the tax shield benefit, but cut its EBITDA by 40% beginning in 2017 (e.g. the entire MPEG-2 stream), you basically get €1,140MM of value which covers your debt and leaves you with about €190MM of equity value for 226mm shares.  Thus, if you agree this is sufficiently draconian, you could say the downside equity valuation here is about €0.74 / share which represents about 27% downside.

I don't present the numbers below just to avoid making this too messy, but if you could realize the tax NOLs you could cut out the first 3 years of taxes here.

                2012       2013       2014       2015       2016       2017       2018       2019       2020

EBITDA 300.0     300.0     300.0     300.0     300.0     180.0     108.0     64.8        38.9

Capex   5.0          5.0          5.0          5.0          5.0          5.0          5.0          5.0          5.0

EBIT less Capex 295.0     295.0     295.0     295.0     295.0     175.0     103.0     59.8        33.9

Taxes @ 30%      88.5        88.5        88.5        88.5        88.5        52.5        30.9        17.9        10.2

EBT         206.5     206.5     206.5     206.5     206.5     122.5     72.1        41.9        23.7

PV Factor             0.89        0.80        0.71        0.64        0.57        0.51        0.45        0.40        0.36

Rate       12%        12%        12%        12%        12%        12%        12%        12%        12%

PV Factor             0.91        0.83        0.75        0.68        0.62        0.56        0.51        0.47        0.42

Rate       10%        10%        10%        10%        10%        10%        10%        10%        10%

PV - 12  184.4     164.6     147.0     131.2     117.2     62.1        32.6        16.9        8.6

PV - 10  187.7     170.7     155.1     141.0     128.2     69.1        37.0        19.5        10.1

NPVs through 2016                                                                                                                                        

NPV-12 744.4                                                                                                                    

NPV-10 782.8                                                                                                                    

NPVs through 2020 with 40% EBITDA fall-off in 2017                                                                                                                                        

NPV-12 864.5                                                                                                                    

NPV-10 918.5                                                                                                                    

NPV's with Tax Shield                                                                                                                                    

NPVs through 2016                                                                                                                                        

NPV-12 956.9                                                                                                                    

NPV-10 1,002.9                                                                                                                 

NPVs through 2020 with 40% EBITDA fall-off in 2017                                                                                                                                        

NPV-12 1,077.1                                                                                                                

NPV-10 1,138.6                                                                                                                 

CONCLUSION:

Bottom line, you have the worst-of-the-worst optics and a classic baby thrown out with the bathwater.  It's French.  It's a post-reorg.  It has a confusing balance sheet.  It has a short-term dilution catalyst.  Its top two holders are Societe Generale and RBS, so shareholder base is anything but stable.  But it has been oversold.  You don't have to believe much to find significant upside for equity holders, and the downside has some cap through its licensing business.  With 27% downside, I think this is a double or triple if investors "remember" the underlying value.  This offers not a very favorable risk/reward in exchange for the highly volatile nature of the security.

The largest concerns here are:

(1) TCH could trip its leverage covenants in 2012.  The 12/31/12 net debt/EBITDA covenant is 2.25x.  That implies EBITDA needs to be above ~€420MM of EBITDA which leaves a thin cushion.  The covenant tightens to 1.95x by the end of 2013, so it's highly likely the company faces a technical default.  I cannot believe that debt holders would want to put the company back into French bankruptcy.  That process led to a significant contraction in the business due to customer fears, not to mention the unknowables of the French equivalent of Ch. "22".  Debt holders will take their pound of flesh in a fee, and the company will work through that.  In fact, I hope the covenant encourages the company to get their act together.

(2) Incompetent management.  I can't disagree too much here.  These guys just don't get it.  Despite the clear history lesson of what goes wrong with empire building in this industry, they might be at it again.  They just amended the debt to allow for acquisitions and increased strategic flexibility.  Fortunately, this is capped at €50mm annual cash acquisitions and up to €200mm equity-funded acquisitions subject to 20% max dilution.  Fortunately, given the share price decline, this caps the equity-funded acquisitions at about €50MM as well for the time being.

Furthermore, management clearly is not on pace to meet its original EBITDA targets.  During 2011, it made an odd announcement during one of the dark European trading days saying nothing significant has happened and guidance is on track.  Subsequently on its earnings call, it clearly did not perform in line with guidance to date and shrugged off the notion that is was misleading investors.