The market has left Technicolor SA (OTCQX:TCLRY) (OTCPK:THNRF) for useless. It isn’t exhausting to see why. After divesting its patent licensing enterprise to InterDigital (IDCC), Technicolor has three companies left. All appear to have important challenges. Adjusted EBITDA in 2018 declined over 20% year-over-year; free money circulation was unfavorable. Internet leverage, based mostly on 2018 numbers, sits at 2.75x.
However I am not fairly prepared to put in writing Technicolor off simply but. I wrote in a Prime Concept final yr that every little thing could not go mistaken perpetually – and certainly Technicolor confirmed some indicators of life within the second half. There are development drivers in all three companies – and potential for margin enchancment this yr, and notably in 2020.
The inventory admittedly has a catalyst drawback – and the dangers listed here are actual. It is a traditional deep worth play, and would require endurance. However the upside is large if Technicolor can pull off a turnaround – and the chances are better than buyers would possibly imagine in the mean time.
(Creator notice: figures on this article might be based mostly on Paris-listed TCH shares, fairly than the OTC-traded ADRs. TCH closed at €1.17 on Friday.)
A Disappointing 2018
From a headline standpoint, Technicolor’s 2018 outcomes look disastrous – and but maybe not that shocking. There’s just one clearly enticing enterprise right here. The corporate’s Manufacturing Providers group provides manufacturing and post-production providers for motion pictures, TV, promoting, and video video games. Income development continues to be stable – however top-line will increase have slowed of late, whereas increased spending and a labor-intensive mannequin have pressured margins.
The remainder of the enterprise appears to be in secular decline. Over half of quantity within the Related Home based business comes from set-top bins, that are at clear threat from ‘cord-cutting’. The opposite a part of the Leisure Providers phase is the DVD Providers enterprise, which manufactures, packages, and distributes DVDs, CDs, and Blu-Ray discs. There, too, the expansion of streaming providers like Netflix (NFLX) appears to augur a gradual, persistent decline going ahead.
In that context, consolidated 2018 outcomes do not appear all that shocking. Income declined over 6%. Adjusted EBITDA from persevering with operations dropped a regarding 22%, with margins shrinking to six.7% from Eight.Zero% in 2017. Free money circulation turned unfavorable (-€43 million) – an apparent concern given the leverage on the steadiness sheet.
This seems like an unsightly yr. And whereas a €1.17 share value would possibly counsel that TCH shares are ‘low-cost’, that is really not fairly the case. The market cap nonetheless is €483 million. Enterprise worth is over €1.2 billion. For a declining enterprise burning money, that valuation hardly seems enticing on its face.
Wanting Nearer on the Numbers
That mentioned, the information is not almost as unhealthy because it seems, each on a consolidated and unit-by-unit foundation.
First, forex had a major, and unfavorable, influence on each income and earnings. In fixed forex, income fell simply 2% on a consolidated foundation – and Technicolor grew gross sales within the second half.
The EBITDA decline got here partially because of FX as nicely. The This autumn earnings slides cite an €18 million influence – a 5-point-plus headwind to development. The February settlement to switch the Analysis & Innovation enterprise to InterDigital shifted these prices to discontinued operations, boosting 2017 Adjusted EBITDA by €28 million and the 2018 determine by simply €17 million, one other €11 million influence. And 2017 EBITDA was re-stated with a €22 million achieve, as patent licensing income that was initially deliberate to go to InterDigital as an alternative stayed with Technicolor. Mixed, these two components drove €51 million of the €75 million y/y decline from the re-stated 2017 determine.
That leaves €24 million, admittedly. And per the annual report, increased element prices – reminiscence and MLCCs (multi-layer ceramic capacitors) – hit EBITDA within the Related Home based business by €45 million.
In different phrases, the underlying enterprise grew earnings final yr – save for exterior and one-time components. To be clear, that is not essentially a superb factor. Technicolor initiated a heavy cost-cutting program final yr: gross sales and advertising and marketing spend fell 23%, G&A dropped 12%, and R&D declined 15%. Mixed, Technicolor generated about €80 million of reductions on these three traces – however solely 1 / 4 or so made it via to EBITDA, even backing out forex and element prices.
Nonetheless, it is clear that 2018’s efficiency was affected by exterior headwinds – and will have regarded significantly better with out them. And looking out ahead, there’s nonetheless potential for some development – at a valuation which suggests upside if Technicolor can drive any development in any respect.
Enterprise by Enterprise
Set-top field weak point is an actual risk for the Related Home based business. Video nonetheless represented 56% of 2018 quantity within the phase, in line with the annual report. The rollout of Constitution Communications’ (CHTR) Worldbox helped gross sales via the primary half of final yr – however with that launch now over, STB gross sales are going to see stress. Phase income in North America dropped 24% final yr. Worldwide, video gross sales declined 32%, in line with the This autumn earnings presentation.
However that does not imply the phase is destined for regular declines. First, exterior of North America, Related House is rising. Income in EMEA elevated 6%. Reported development in Latin America was 1% – however excluding FX, gross sales within the area rose 11.6%. Power in Japan and South Korea led to 34% reported, and 39% constant-currency, development in Asia-Pacific.
As CEO Frederic Rose put it on the This autumn convention name, “it is clear [in] the video market, there’s North America, and the remainder of the world…Now, the remainder of the world is a unique atmosphere.” ASPs are dropping as less complicated, Android-based bins are taking market share. However Technicolor, exterior North America (and away from the pressures going through U.S. satellite tv for pc operators particularly) ought to be capable of maintain unit counts moderately steady. And with North America now lower than half of whole phase income, rising markets outweigh the shrinking one.
The same pattern is at play within the video/broadband break up. STBs nonetheless drive nearly all of quantity – however broadband units drive nearly all of income. And Technicolor seems to have a wonderful place within the shift to DOCSIS Three.1. It is clearly moved nicely forward of Arris (ARRS) (within the means of being acquired by Commscope (COMM)); per the annual report, Technicolor is the only real provider to Comcast (CMCSA) and is “transport vital volumes to Constitution”.
Arris, on its final name (after Q2 in August) cited a possible “ramp” in its DOCSIS Three.1 shipments resulting in income development in This autumn. However fourth quarter income in Arris’ CPE phase rose simply 1% – and Arris would not point out DOCSIS Three.1 as a 2018 income driver in its 10-Ok, just for 2017. What may be gleaned from Arris’ efficiency means that Technicolor is not overstating its lead.
So now broadband – 51% of 2018 income – can drive income development, as can enterprise exterior of North America. And it isn’t as if the enterprise had a horrible 2018; backing out element value will increase, Adjusted EBITDA would have risen Three%. Technicolor has renegotiated agreements to move most of these prices onto clients beginning within the second half – which ought to profit 1H 2019 margins and restrict the corporate’s publicity going ahead. (Reminiscence costs have come down, however the MLCC scarcity is predicted to persist for a while.)
This is not essentially a declining enterprise; the truth is, it doubtless should not be. Fixed-currency income grew almost 5% within the second half, and whereas EBITDA nonetheless declined, margins improved – and will accomplish that additional in 2019. With a extra normalized atmosphere, development might return as quickly as this yr, notably with simpler first-half comparisons.
The DVD Providers enterprise – clearly – is a ‘cigar butt’. Per figures from the annual report, the variety of discs offered fell 11%+ in 2018 on prime of a 14% decline the yr earlier than. And DVDs nonetheless account for ~two-thirds of the overall (CDs are 5%, and Blu-Ray discs 29%, per figures from the annual report).
However right here, too, 2018 noticed some exterior stress – and efficiency has room to enhance going ahead. Rose on the This autumn name mentioned the “calls for of the most important DVD retailer in North America” (which ought to be Walmart (WMT)) led to an enormous rush forward of the vacations – which impacted profitability within the enterprise. And on the finish of the quarter, one “main buyer” noticed a “very important downturn” in gross sales.
This isn’t to say that income would have risen year-over-year. However the truth is, top-line declines are modest: simply Four.6% in fixed forex, as Blu-ray discs supply extra income per unit. Sony (SNE) has agreed to outsource its manufacturing to Technicolor – and this yr will embrace distribution – and that leaves Technicolor just about in command of the market, notably within the U.S.
That provides Technicolor a possibility beginning subsequent yr. The corporate’s main contracts start to run out in January – and, per the decision, Technicolor needs to renegotiate these offers to include quantity modifications. As Rose put it, that approach Technicolor “now not takes the chance of any value construction with volumes that transfer sooner than we are able to adapt”.
Technicolor ought to have a powerful negotiating place because it tries to maneuver to variable-cost pricing – as a result of, as Rose identified, “each main studio in North America” is a buyer. At this level, there is not anyplace else for them to go.
Within the annual report, the corporate additionally cited the potential of transferring into different markets, amongst them “provide chain options, together with transportation administration and direct-to-consumer success providers” in different industries corresponding to schooling, shopper electronics, and even reward playing cards. What these plans entail is not clear – and neither is whether or not these plans make sense, versus merely maximizing money circulation from discs. (Like many worth buyers, I am all the time nervous when managers attempt to develop declining companies – it is a technique that normally works significantly better on convention calls than in actuality.)
However with income declines prone to keep within the mid-single-digits because of the Sony deal and Blu-ray pricing, and profitability doubtlessly enhancing in 2020, Technicolor nonetheless ought to be capable of wring some money out of this enterprise regardless.
The Manufacturing Providers enterprise ostensibly is Technicolor’s strongest. The consumer record consists of main studios together with Warner Bros. and Disney (the annual report cites a number of awards from Disney for work in 2019), Netflix, sport builders Digital Arts (EA) and Activision Blizzard (ATVI) (together with work on the Name of Responsibility franchise), in addition to unbiased TV, movie, and promoting producers. Tendencies seemingly favor the enterprise as extra shops produce extra content material – with animation a specific driver within the coming years.
The query is on the margin entrance. To compete throughout the entire classes, the PS enterprise has steadily elevated headcount. The full variety of Manufacturing Providers workers has risen 63% in three years, per figures from annual stories. Technicolor closed 2018 with 7,900 digital artists – a virtually 150% enhance from the tip of 2015.
Administration has characterised the hiring as investments within the phase’s development. The issue, nonetheless, is that income development hasn’t been that spectacular. Fixed-currency development was 5.6% in 2018 – however EBITDA within the Leisure Providers phase (which incorporates DVD and Manufacturing Providers) fell 15%, once more excluding FX. The annual report cites enchancment in profitability for the movie and TV companies – but in addition notes “capability will increase and associated investments” that ought to proceed into 2019. Commentary on the This autumn name appeared to counsel that the DVD enterprise was liable for extra of the decline, nonetheless, with CFO Laurent Carozzi noting that EBITA (together with depreciation) was up in Manufacturing Providers year-over-year.
Even assuming that Related House can drive non-U.S. and/or broadband development, Manufacturing Providers is the enterprise that has essentially the most potential to create actual worth. Content material calls for are solely going to rise – and Technicolor is a pacesetter within the trade. The query – actually, as this was the primary query of the This autumn Q&A – is whether or not the corporate can speed up income development again to the high-single-digits, a minimum of, and begin leveraging the investments it is made in headcount.
Definitely, trade demand is not going anyplace – and with Technicolor a pacesetter in its discipline, there ought to be a approach to drive margin enhancements ultimately, and there ought to be actual worth right here going ahead. However commentary on the tempo of investments within the enterprise suggests buyers should be endurance: margins are unlikely to enhance a lot in 2019.
Together with This autumn earnings, Technicolor did not present 2019 steerage. In justifying the choice, Rose on the decision cited suggestions from “a lot of [the company’s] key shareholders”. However he did give one piece of “qualitative steerage”, as he termed it: “we have to pursue leverage discount by enhancing profitability and money technology”.
It does appear unlikely that development is on the way in which in 2019. Spending goes to rise in Manufacturing Providers. Renegotiated contracts will not assist DVD margins till 2020. And Rose cited a spotlight subsequent yr in gaining market share in Related House – which could counsel some upfront prices as nicely.
That mentioned, a multi-year concentrate on deleveraging will help the story right here – and Technicolor does have time. Debt would not mature till 2023. Gross debt (Three.85x 2018 EBITDA) is nearing a Four.0x covenant cited within the annual report, however with €291 million in money, Technicolor has loads of flexibility. Internet leverage is beneath 3x based mostly on 2018 numbers. Consolidated EV/EBITDA is beneath 5x.
And that is low-cost sufficient to make the numbers work – if enterprise holds up and if Technicolor certainly focuses on deleveraging going ahead (notice that company spend has been reduce via the InterDigital offers and since re-allocated to the person segments):
Phase Valuation Notes Related House €600M €87 million in EBITDA in 2018; 7x a number of is low cost to ~8x takeout a number of for Arris and in step with ARRS’ historic a number of of 7x+; additionally potential for assist from decrease element prices. Nonetheless sub-Zero.3x P/S a number of Manufacturing Providers €800M Eight-10x estimated €80-€100M in EBITDA, 1x income DVD Providers €400M Four-5x estimated €80- €100M in EBITDA, Zero.42x income Patent Licensing €100M future royalties from InterDigital. Per administration, former NPV of €215M diminished by ~50% in second deal Internet Debt €733M Fairness Worth €1,167M €2.82 per share, 140% upside
This would possibly seem like a bull case – and it’s to some extent. DVD Providers can head south shortly this yr. The valuation assigned Manufacturing Providers could be too aggressive if the labor-intensive nature of the enterprise undercuts profitability – and it is exhausting to see how Technicolor might promote the enterprise given how numerous its consumer base is. (Would, say, Disney outsource to a unit owned by Netflix – or vice versa?) Public rivals are powerful to seek out as nicely. (One attention-grabbing knowledge level: an analyst estimated that Disney saved $20 million a yr by buying Industrial Mild & Magic; that means some actual worth to somebody for the bigger Technicolor enterprise.)
Nonetheless, Technicolor is valued beneath 5x EBITDA – and the outlook merely is not that dire. Related House has an actual alternative in broadband. The Manufacturing Providers enterprise has worth. The DVD enterprise can have one thing near a monopoly. The debt load is regarding – however manageable, and Technicolor has time to deleverage forward of a refinancing 2-Three years from now.
Endurance goes to be required, notably since a catalyst would not essentially appear to be on the horizon in 2019. However the upside right here is substantial if Technicolor may even stabilize operations – and achieve some confidence from the market. That is a objective Technicolor would possibly be capable of obtain this yr.
Disclosure: I’m/we’re lengthy THNRF, TCLRY. I wrote this text myself, and it expresses my very own opinions. I’m not receiving compensation for it (aside from from In search of Alpha). I’ve no enterprise relationship with any firm whose inventory is talked about on this article.
Further disclosure: I’m lengthy the Paris-listed TCH shares, not the US OTC tickers.
Editor’s Word: This text discusses a number of securities that don’t commerce on a serious U.S. change. Please pay attention to the dangers related to these shares.