Description
Investment Summary
At current prices, the stock of Thomson offers an attractive risk/reward opportunity to bet on management’s ability to execute its business plan. If management is successful in achieving it’s 2006 objectives, the company will earn about EUR 1.80 per share and will generate EUR 2.25 of free cash flow in 2006. As investors become more comfortable with the prospects for the company, the stock to re-rate and trade at a 15 to 17x price to earnings. This is based on what I think a business service company with 12-14% revenue and earnings growth would trade. That would imply EUR 27 to EUR 30.60 per share or roughly an upside of 45 to 65% over the next 12 to 18 months. If management disappoints, the EUR 1.45 to 1.80 free cash flow per share that the core continuing operations are currently generating should provide a floor to the stock around EUR 15, resulting in 18% downside.
Brief History
For a more detailed description of this company’s history and operations, I suggest going the investor relations website of the company at www.thomson.net and reading about the history of the company. The 2004 20-F filed with the SEC is an excellent source of information on the business. Some sell side reports , such as the Morgan Stanley June 2004 and the Citigroup July 2004 initiation reports provide some very useful background information as well.
Thomson is a French corporation with a EUR 5 billion market capitalization. It trades in Paris (EN Paris) and has a NYSE listed ADR, which is very illiquid. The Bloomberg ticker symbol is TMS FP for the local share and TMS for the ADR.
Thomson was nationalized by the French Government in 1982 and it was again opened to private investors in 1999 via an IPO in Paris and NYSE. In 2003 the French Government sold its last remaining stake. From 1999 to 2004 made some important acquisitions that make up a large part of today’s core operations: Technicolor (2001), Alcatel’s DSL CPE business (2002), Grass Valley (2002). However, this period is characterized by continuous restructurings and dissapointments. After peaking in 2000 at EUR80, the share went into continuous decline, bottoming along with the market in March 2003 at EUR 9.23 per share.
In the Summer of 2004 a major restructuring was announced and subsequently approved by shareholders in September 2004. The restructuring consisted of the following:
1. The return of Frank Dangeard as CEO and Chairman.
2. Re-setting of senior management’s compensation package, mainly resetting the strike price of stock options at EUR17 per share.
3. A strategic investment by Silver Lake Partners via a EUR 400 million convertible bond, non-hedgeable until 2009. This instrument has a 3% coupon and a conversion price of EUR 17.50.
4. Nomination of David Roux, managing director and co-founder of Silver Lake Partners, to the board.
5. The establishment of a “2 year plan” and of “5 strategic priorities” the primary objective of which is to divest the loss making TV and cathode ray tube businesses and to strengthen and grow the core businesses, repositioning the company as a provider of services, systems, and technologies, to the media and entertainment industry.
More specifically, management set the following goals for itself:
1) Add EUR 1.5 to 2.0 billion to the base of “core” sales of EUR5.9 bn in 2004 by 2006. EUR 1.0 to 1.5 billion of which should come from organic growth and the rest from acquisitions.
2) Maintain an EBIT margin of around 10% in the core businesses.
3) Complete the share buy back program of EUR400 million with the proceeds of the Silver Lake investment by March 2006.
4) Generate EUR 1.2 to 1.5 billion of free cash flow from core operations between 2004 and 2006.
5) Complete the restructuring of the money losing tubes business and TV businesses.
6) Increase core R&D spend by 50% in 2005 and 2006.
7) Broaden the product offerings to existing clients and expand the client base, with an emphasis on Asian media groups and new categories of content creators and distributors.
Business Segments
In 2004 Thomson had EUR 8 billon of revenues. EUR 2.1 billion of the revenues were related to the “non core” TV, CRT, and Consumer Electronics businesses which are being divested/wound down. As per company guidance the “non-core” consolidated revenues should decline to around EUR880 million in 2005 and further to EUR 250 million in 2006. EUR 5.9 billion were related to “core operations.”
Below I have attached a table with my estimates for 2004 and 2005 revenues and EBIT by division. The company does not disclose the breakdown of revenues within the divisions nor the profitability. So, these are my estimates based on what the company has disclosed in various presentations available at their website. Given the complexity and diversity of the business units, I suggest reading the detailed description in the 20-F for a better understanding of the various businesses, customers, and competitors. It would take too long to include that information in this write up.
Projected
Sales 2004 2005E
Services
Physical Media: DVD Services 1,508.0 1,508.0
Physical Media: Film Services 562.5 573.8
Post-Production Services 262.4 301.8
Network Operations Services 115.5 132.8
Electronic Content Dist. Services 0.0 4.5
2,448.4 2,520.8
Systems & Equipment
Access Platforms & Gateways 1,314.0 1,609.7
Broadcast & Network "Grass Valley" 419.0 460.9
Connectivity 1,266.0 1,234.4
2,999.0 3,304.9
Technology
Licensing 417.0 417.0
Software & Tech. Solutions / Silicon Solutions 112.0 120.4
Research / Other 0.0 0.0
529.0 537.4
Other 21.8 21.8
Core Business Sales 5,998.2 6,384.9
EBIT % of EBIT 2004 2005
Services
Physical Media: DVD Services 28.1% 162.9 158.3
Physical Media: Film Services 7.9% 45.8 54.5
Post-Production Services 3.2% 18.7 30.2
Network Operations Services 0.3% 2.0 13.3
Electronic Content Dist. Services -0.3% -2.0 -0.5
Total Services 39.2% 227.5 255.9
Systems & Equipment
Access Platforms & Gateways 12.8% 74.0 104.6
Broadcast & Network "Grass Valley" 5.7% 33.0 36.3
Connectivity 7.4% 43.0 18.5
Total Systems & Equipment 25.9% 150.0 159.4
Technology
Licensing 56.0% 325.0 333.6
Software & Tech. Solutions / Silicon Solutions -11.5 -3.6
Research / Other -8.6% -50.0 -75.0
Total Technology 45.4% 263.5 255.0
Other -10.5% -60.7 -60.7
Core EBIT 580.3 609.6
EBIT Margin 9.9% 9.5%
Derivation of 2006 EPS and FCF Per Share
Revenues
Core revenues in 2004 were EUR 5.9 billion. Management’s two year plan is to grow revenues by EUR 1.5 to 2.0 billion. If we take the mid-point we get to EUR 7.65 billion in revenues.
EBIT
Management’s goal is to keep margins at 10%. Even the margins of individual subsidiaries fluctuate, the overall margin of the core businesses combined has been pretty steady. Furthermore, even though margins in DVD replication and licensing are coming down, certain operations that have been losing money because they are in the ramp up stage, mainly within technology, are starting to become profitable. Furthermore, access platform margins are in an uptrend. A 10% margin gets you to EUR 760 million of EBIT.
Interest
EUR 120 million of interest, in line with current levels. Even though the company is generating cash, most of that is going into share buybacks and acquisitions.
Taxes
The company has guided me to EUR120 million in 2006. The company should go back to a 30% tax rate in 2007.
Net
EBIT of 760 -140 of interest -120 of taxes = 500
500 divided by 275 million shares = 1.81 eps
Free Cash Flow
Net income 500 + 280 depreciation and amortization + 40 non cash interest (IFRS treatment of convert) – 200 capex = 620
580 mm of free cash flow divided by 275 million shares = 2.25 fcf per share
Working capital should not have a big impact in 2006. If anything, management is targeting a reduction in working capital over the next couple of years.
Silver Lake Partner’s Role
This is Silver Lake Partner’s largest single investment. Their track record is not impeccable and they are above the common stockholders in the capital structure. However, the fact that this is their largest investment and that it is non-hedgeable is encouraging. SLP’s involvement, as per presentations to investors in their funds, is to help in: strategic planning, M&A evaluation and business development, technology roadmap definition, investor relations assistance, public relations assistance, and recruiting.
Why has the stock performed so poorly?
• The businesses are diverse and difficult to understand. Furthermore, they are not easy businesses to model and predict. It is very labor intensive to get to know the company in detail.
• The company is not comparable to one single company but rather to a collection of companies.
• There has been a lot of noise related to the exit of the CRT and TV businesses.
• There has been a lot of noise related to the transition to IFRS.
• There has been a dislocation in the shareholder base. US institutions have been buying it. European institutions don’t buy into the story having been burned many times since the IPO. The company is transitioning from being a consumer electronics company to being a media and entertainment service provider.
• Management still has to execute on its plan. The company has a history of disappointments.
• 2Q05 was confusing even though it was good beneath the surface.
• Analysts and potential investors are concerned that Technicolor (DVD replication) and Licensing, which combined account for an estimated 84% of revenue are not sustainable businesses and are prone to technology risk .
What will improve performance of the stock?
• Clean 2006 numbers combined with a low PE and price to free cash flow multiple.
• Evidence of FCF generation capability. This is already happening, but it is not easy to discern.
• Complete turnover of shareholder base. Management is working on this. The company was recently reclassified by Dow Jones from consumer electronics to media.
• Simplification of business presentations. Management is working on this.
• Management delivering on the plan and investors viewing this company as a high ROE service company growing at 12-14% per year.
Catalyst
• Clean 2006 numbers combined with a low PE and price to free cash flow multiple.
• Evidence of FCF generation capability. This is already happening, but it is not easy to discern.
• Complete turnover of shareholder base. Management is working on this. The company was recently reclassified by Dow Jones from consumer electronics to media.
• Simplification of business presentations. Management is working on this.
• Management delivering on the plan and investors viewing this company as a high ROE service company growing at 12-14% per year.