Cinedigm (NASDAQ:CIDM) enters 2013 with one of the largest independent film content libraries and a stream of upcoming new releases. This year the company will shift its content business from "investment mode" to "harvest and invest" mode. This dynamic will help increase revenue growth and expand margins.
Cinedigm is taking a low-risk/high-return approach in the film business by acquiring distribution rights to completed films with critical acclaim and knowable market opportunities. As an asset class, films with relative low production budgets offer the highest ROIC. Our tables show returns of 7-8x for the most successful big films compared to 26x for the small ones on which Cinedigm is focused.
Their software business continues to be the de facto platform for distributing, programming and managing filmed content for both theaters and studios. New customers have continued to help propel the business forward and their new releases will begin to tap the power of "big data" in the industry. Cinedigm has been working on a cloud-based solution that brings together the disparate data sources used to run the business today. This will take time but has tremendous potential not just for Cinedigm but the industry overall. This would be the first real application of big data and cloud computing to this space.
After years of upgrading theaters to digital this work is basically done (Cinedigm is still actively converting theaters outside of North America for some time to come) and now the downstream cash flows will be used to fund further expansion in software and content and reduce the debt used to fund those capital investments. This process started in 2012 and will continue. The balance sheet will continue to improve and an upcoming rating of the debt from Moody's is likely to highlight a potential upgrade to investment grade. This will accelerate the progress the company has already been making.
The formula for a much higher stock price is in place with 1) faster growth in content and software which are "higher multiple businesses" and 2) a relative decline in the theater servicing business and the debt levels linked to the upgrade to digital systems during the last few years.
Investors can expect a steady stream of generally positive news regarding development in software, content deals, and new cloud/SaaS offerings. Debt will come down steadily and there is always the chance that a restructuring could accelerate that. Note that our valuation above includes the debt and related expenses.
Investors who can look beyond a quarter or two should be moved by the opportunity to own what will be one of the leading digital content and software businesses in entertainment at a very depressed valuation. Our intrinsic valuation model suggests a stock price of $7.34, which is well over a 300% increase from current levels.
Software Reigns Supreme
Investors have figured out that proprietary software is often the key to maintaining industry position and extracting profits. Companies ranging from Oracle (NYSE:ORCL) to Apple (NASDAQ:AAPL) have demonstrated this beyond all doubt.
Cinedigm software dominates what might be called the "back office" of the film business. Cinedigm has multiple products that cover essential operations for film studios, theaters and theater chains. Here's a simplified description of the major components and functions:
Major studios and distributors use the Cinedigm Theatrical Distribution System (TDS) for planning, booking, delivery, payments, accounts receivable, and reporting. Although it's a separate module we'd group the Cinedigm Royalty Transaction Solution (RTS) in this segment. It handles the licensing, royalties and management for titles, copyrights and trademarks, which can get very complex, especially internationally.
Theaters rely on the Cinedigm Exhibitor Management System (EMS), the Theater Command Center (TCC), and larger chains also rely on the Cinedigm Enterprise offering for integrating the operations of many theaters into a unified operational system.
EMS handles the "other side" of the studio bookings on behalf of the theaters. So it has parallel functions for planning, booking, payments and reporting from the perspective of the theater. Once they have films scheduled they use the TCC to basically "program" all their screens with content including films, trailers, advertising and track status of what's going on within the theaters.
The Cinedigm Enterprise software allows large exhibitors to tackle the complexity that comes from many locations, lots of screens, and overall consolidation of diverse operating elements. Besides being necessary for visibility this software also provides automation features and business process optimization for the exhibitor.
The Cinedigm software is analogous to some well-known examples in other industries, like airlines (Sabre (NASDAQ:SABR)), automotive (DealerTrack (NASDAQ:TRAK)), communication services (Amdocs (NASDAQ:DOX), CSG Systems (NASDAQ:CSGS), and Synchronoss (NASDAQ:SNCR)), and residential real estate (MLS). Most well-developed industries have software backbones that make all the basic interparty functions work.
Reinventing Content & Distribution
To paraphrase an old saying - "the new digital entertainment infrastructure is willing but the industry players are weak."
The filmed entertainment business basically still follows the same "big bang" model it has used for decades; Toy Story, Hunger Games, Zero Dark Thirty, and so on. This means big budgets, big films, big stars and heavily promoted releases. For a small number of films this works. But for the vast majority of films this model doesn't work at all.
It's common knowledge that "the content and distribution model for the industry is broken" but now digital distribution and multiple content models provide the tools to fix it. The specialized and "long tail" parts of the content market opportunity are substantial.
Take an example like Enlighten Up! which is a quality movie about yoga, a growing topic of interest to many but it's certainly not a film that's going to pack people into multiplexes across the country. But by keeping costs low and being smart about distribution such a film can turn a nice profit.
Smarter distribution can enhance revenue generation and lower distribution costs. This cuts across all the channels including the theaters. In some places like New York City, Santa Barbara, California, and Boulder, Colorado, a film like Enlighten Up! will fill a theater. For any "niche film" there are dozens to hundreds of theaters which have the demographic profile that's a good fit. A theatrical release (even a limited one) is a big deal for people who make movies. Films that have to bypass the theaters and go "direct to DVD" still have a stigma attached to them.
Beyond the theaters there is of course iTunes, Amazon (NASDAQ:AMZN), Netflix (NASDAQ:NFLX), VOD and various other digital services. These services are all very immature, especially with respect to the use of data, targeting and social networks. This creates a big opportunity to use these powerful platforms to generate demand for specific content.
Cinedigm is already a dominant player in this channel with relationships with iTunes, Amazon, Netflix and most of the dozen or so other online outlets. Today they are acquiring more content to continue to build their library and position here. But the big payoff will come from exploiting more of the data to target effectively. For a broader overview of big data in the media industry please refer to our November 2012 presentation "Big Data" for Media (see note #1).
Going back to Enlighten Up!, there are about 16 million people doing yoga in America, with over 100,000 employed in the yoga business which generates about $7B in revenues. This is a pretty impressive market opportunity for a niche film if you can effectively reach that group. Taking some reasonable assumptions - let's say that 10% of the market might want to rent or buy such a film - an average price of $5 translates into an $8M gross. In the world of independent films this is a home run since costs are often well under $1M.
But there are innumerable opportunities for this type of content/market model right now which in aggregate reaches into the billions of dollars. And that's only in what some might consider the documentary format in areas from car racing to skate boarding to biking, baseball, travel, etc.
This approach is by no means limited to documentary style content and is effective for all major genres. Some samples are included in the section below.
Cinedigm has over 12,000 movies and shows available in digital formats and is a major contributor to online venues like iTunes where they offer 1,700 of their feature films.
The new part of the story, though, is their recent acquisition program where they are acquiring and releasing a dozen or so top-flight films a year. Investors will see these releases coming regularly this year and we expect the number and quality to increase to 20 to 25 features per year over time.
Here are some examples of newer Cinedigm content:
Arthur Newman tells the tale of a man who fakes his own death to escape his unhappy life. The film stars Colin Firth, Emily Blunt and Anne Heche supported by a screenplay from Oscar-nominated Becky Johnston.
Violet & Daisy brings two teenage female girls to the screen as assassins with a screenplay by Oscar-winning Geoffrey Fletcher. The two female leads have received strong reviews already and are joined by film star James Gandolfini in the cast.
In the "feel good" category we have Don't Stop Believin': Everyman's Journey about a guy discovered on YouTube who became the new lead singer for rock band Journey. Major festival buzz and critical acclaim add to a promising demographic appeal.
Citadel is a good old-fashioned horror movie with a father fighting off a twisted gang of feral children intent on killing his baby girl. Kind of a "Children of the Corn" meets "The Walking Dead." It may not win Oscars but it's got an audience appeal.
Like Water is an up-close-and-personal feature about a champion "Ultimate Fighter" caters to a growing audience for the sport. UFC championships have become increasingly popular world-wide and are seen by four to five million viewers.
Up for an Oscar this year is The Invisible War, which has changed the awareness of the plight of many women in the US Military. This shocking and uncomfortable film has moved viewers up to and including US military leadership who may finally take action.
These are high quality films with talented (and often acclaimed) actors, writers and directors. The movies may not be "blockbusters" but in aggregate they generate considerable sales at attractive margins and low risk. One of the things Cinedigm needs to develop more is the discovery process. There are many high quality films here that viewers won't discover since they won't be heavily promoted. Thankfully, social media will change that.
Advantages & Challenges
- Cinedigm has a long-standing incumbent in the development of the software that the film industry has used to manage their business. It is developing and extending this into a broader family of products, data sets and services from a strong position.
- The acquisition of New Video in 2011 has given the company at a stroke a massive content library, experienced content acquisition team and relationships with all digital paths to small screens from Amazon to iTunes to Netflix to Wal-Mart (NYSE:WMT).
- A growing base of over 12,000 cinema screens provides cash flow plus a critical element to combine with online distribution to disrupt some of the age-old conventions in filmed entertainment.
- Management has been substantially upgraded to support a company 2-3x as large as the current Cinedigm. In addition to determination and skills they bring to the day-to-day management they have a long-term perspective with substantial stock ownership.
- Many equity investors don't like to see debt. The level and complexity of the debt used to finance the digital cinema build-outs can put off some. However, debt will continue to decline on both a relative and absolute basis as part of the normal course of business.
- The economics of the content business (management will refer to the "J-Curve") means that Cinedigm recognizes up-front costs on new releases before they get the revenue. This tends to understate success the more aggressive they get at building the business it increases near-term costs to support additional revenues two or three quarters in the future.
Cinedigm has proven itself very effective at both divestitures and acquisitions. Given the size of the opportunity combined with their existing position investors should expect strategic acquisitions to be an important element going forward.
We wouldn't expect to see any direct acquisitions into distribution since that would be competitive with the existing Cinedigm customer base.
There are some areas, though, which appear to offer some significant strategic advantage to the company. We've no idea which if any might unfold over time as management no doubt has their own agenda and must be price conscious as well. But here are some thoughts:
Social search - The concept of social search has been around for years but thus far has been poorly implemented, if at all, even by leading companies like Facebook (NASDAQ:FB), Apple, Amazon, Twitter and LinkedIn (NYSE:LNKD). Movies are a classic case where input from friends or people with similar tastes is a home run. But so far even the basic "collaborative filtering" is not very impressive. There are opportunities to foster much better content discovery (and revenue) here.
Sourcing - The creation of content is going through a revolution of its own thanks to services like Indiegogo and Kickstarter. Cinedigm already gets a benefit from this with more quality content being made and looking for distribution but they could find an advantage with either a partnership or some related initiative to help smooth the path from creative idea to watching with popcorn on the big screen.
Marketplaces - Lots of industries are finding ways to "route around" traditional paths including rights acquisition and marketplaces. Cinedigm already has some pieces of this in place on the software side but having a more robust online marketplace that can handle rights around the world might be a significant opportunity at some point.
Data - Everyone is keen on data analysis these days and Cinedigm is already building a set of products and services around it. However, there are additional sets of data along with tools that could enhance the ability to target films geographically and source content for small screens.
Geographic coverage - Cinedigm is generating sales around the world from their US base but there are also other companies in foreign markets that might be complementary, especially if they can be had at the right price.
360 Degrees - This concept may be a little out there with films but there are additional opportunities for filmmakers if they license elements of their content. This can be music, video segments, games, characters, rights to use in education or specialty markets.
Channels - Management has talked about the opportunity to "develop some channels" of content that can provide regular incremental viewing and revenue. The whole industry has struggled to figure out what these can be. Some examples include sporting events, concerts and cultural entertainment. A partnership in this area with content that "clicked" and had critical mass might prime the pump.
We considered areas like front-end reservations and ticket sales in the past but they no longer seem attractive now that Cinedigm is a major content player.
For all of these we should also keep in mind that Cinedigm likes to use a "date before marriage" approach so we should have some opportunity to evaluate their strategy as it unfolds.
Theaters & new revenue streams
Theaters have always struggled to break out of their limited hours of productive operation - evenings and weekends. Matinées, occasional film festivals and one-off business events are practiced generally today but don't do much to move the needle. It all still comes down to Friday night and Saturday.
So far theaters have fought the more visible battle against watching movies at home with better stadium style seating, upgraded concessions and high end digital projection and sound systems; the big screen still makes a difference in terms of experience.
Advertising has become common to the irked displeasure of theater goers. Besides the fact that watching commercials is painful, a special indignation is justified since the viewer has paid for a ticket and feels entitled to an advertising-free performance. This dynamic probably puts a limit on how much theaters can push advertising without creating a risk that they might drive people back home to iTunes.
The elephant in the room is the fact that the vast majority of consumers can't go to the theater during the day. Other than the occasional rainy day matinee or a chance to "play hooky from work" once in a while this market doesn't really exist.
One area that Cinedigm is working on that could develop into something meaningful for independent theaters is an ability to participate in the "downstream" revenue from other viewing channels like iTunes and Netflix. Theaters agree to show new films slated for a targeted theatrical release and enjoy some small percentage of the downstream revenues generated. The number for an individual film will be small but the numbers accumulate both over time and the number of releases. It's also important to note that these revenues would expand margins as they come with little to no incremental cost.
Two of the giant theater chains, AMC and Regal, set up their own film distribution company called Open Road Films in 2011. Their move provides a pointer to where the independent theaters will go using a company like Cinedigm as a partner. Structurally, this is the solution that makes the most sense and while it will take some time, the theater owners will be drawn to it.
Initially the driver is more content to support their existing model but in time they will come to the additional step of participating in downstream revenues. Cinedigm can pull this off because of their existing relationships with these exhibitors and their steady and diverse mix of high quality films scheduled for release. This gives the theaters the quality and diversity they need.
Cinedigm is blazing some new territory here but getting exhibitors to be part of the network and give them a play in the downstream revenue is a step in bringing more disruptive innovation to a somewhat moribund industry. Hard as it sounds it might be easier than trying to find people who will sit in a theater during a weekday.
The Small Film/High Return Secret
There's a fundamental truth in the film industry that most creative types and studios prefer to ignore rather than embrace - small budget films generate the highest returns on investment with lower risk than big budget movies.
The industry is obsessed with big films costing $200M to $300M to make because it's more about ego, power and prestige than profit. Although they offer the chance of making high absolute profit (Avatar), they come with the same outsized risk (John Carter). Even when they are successful, the percentage returns are limited to some degree by the sheer size of the investment needed.
Any film, large or small, can end up losing money. But the smaller films are the ones that have the best chance of making very high percentage returns. The biggest successes have outlandish returns of 100 times the original budget. These are rare events and can't be predicted, let alone expected. In the aggregate one way to make money in films is to keep budgets small.
The point isn't that all small films have a good chance to make money. Many fail to even make it through production and many of those never earn back their production costs.
We put quotes around "profit" since there are many additional costs for promotion and distribution that can be substantial, especially if a big marketing push is justified. It's a tricky decision since it adds to losses initially in the hopes that it will drive enough incremental audience to help profits.
The Cinedigm target films fall into the $100K to $1M range where returns are very attractive on average and occasionally offer a "home run" that can generate a multiple of the capital invested. As the business grows the revenues and profits add up. Since the number of films distributed will also go up over time the likelihood of hitting a home run in any fiscal year will also rise.
As long as Cinedigm sticks to their knitting and runs the business effectively it will generate a virtuous circle of economic benefits for the company and shareholders.
Cinedigm recently reported results for the December quarter, which is its fiscal Q3. Generally speaking, investors would classify the quarter as "inline with expectations" with the company remaining on track to meet the full year guidance they have articulated. All the information is readily available via the detailed press release and the conference call transcript. There are a few notable points as the quarter relates to our long-term theme:
Revenue from software and content is growing much faster than total revenue. Non-deployment revenues of $9.6 million were up 53% YoY versus 17% growth for total revenues.
Cinedigm released two solid but not spectacular films during the quarter (Citadel and In Our Nature) and these films are doing as planned and entering digital channels in the current quarter.
The next two releases are scheduled for this quarter and look like they will add to the momentum based on initial reviews.
Critical acclaim and an Oscar nomination for The Invisible War, combined with a major library, has made Cinedigm the "go-to guys" for documentary films.
Management again articulated a clear vision of the changes underway in filmed entertainment and their strategy to create and capture value there.
When we look at results we don't use EBITDA as our metric (although management does.) For Q3 we take revenues of $23M less direct costs, including interest expense of $6.7M, to reach our proxy for operating income of $6.9M which is just under 30% of revenue.
Business Models & Valuation
For a relatively small company Cinedigm has a few business models deployed.
The way we see it, there are three types of revenue:
Cinema servicing where Cinedigm gets some combination of installation fees, service fees and software fees per screen or as a percentage of total revenue.
Software which is sold to enterprises with an upfront license fee + maintenance and theaters on a per screen basis. Over time the business may evolve to have a greater SaaS component.
Content where Cinedigm gets distribution fees of 20-30% plus residual ownership, which can be exploited for some "long tail" revenue opportunities.
We have substantially reworked our intrinsic valuation model to account for the new business mix and restatements of past periods to reflect the currently operating parts of the business (note #2).
It's worth noting that we model the company our own way in order to use our intrinsic valuation (IV) model. Cinedigm management talks about EBITDA as its core metric, which is what investors will hear on conference calls. EBITDA has never been the cornerstone of how we evaluate and value companies. Interest payments and taxes are, after all, real costs so in our models they are always included. Conversely we do "look through" non-cash expenditures and account for stock based compensation in the shares outstanding rather than the P&L. The result is basically in line with other methods as long as the business is creating real economic value.
Our Cinedigm IV model is included here so that investors can understand the assumptions and methods that lead to the $7.34 IV estimate. As the size of the software and content businesses grow we will understand the longer-term growth and margin dynamics of these businesses better.
The one element of the model where we have been obviously, perhaps overly, conservative is in the multiple. With an average top-line growth rate of 17% driven by margin-expanding businesses like software, a 10x P/E multiple is very low. As we see it this is the easiest way to settle arguments about whether SG&A will trend to 20% or 25% of sales over time. Nobody has clarity on that yet so our low multiple gives us plenty of room for parts of the model to adjust and still support our IV estimate.
There's an expanded table of comparable but different public companies included as an appendix to this report along with some thoughts about how they fit into our thinking. Looking at the valuations and different businesses it's difficult for anyone not to see that Cinedigm looks relatively undervalued on traditional metrics like TEV/revenue and TEV/income.
Cinedigm has been undervalued for some time now but the combination of multiple factors is setting up catalysts for 2013 for investors.
The software and content businesses are growing much faster than the overall company. Revenues from their cinema servicing business are reducing debt and the balance sheet is improving to the point where the debt will become investment grade.
As this report went to "press" we couldn't help notice that the don of entertainment investing, Kirk Kirkorian, is preparing to return to the movie business (note #3). His timing has been impeccable in the past and now he sees the opportunity that technology and industry change is bringing as being irresistible, even at 94.
We expect to see shares of Cinedigm move up towards our IV estimate during 2013 and 2014. It will take time but when it occurs the small market capitalization may result in sharp moves.
Appendix - Extended List of Comparable Companies
The Cinedigm mix of businesses makes it hard to point to a "direct comparable" company and use it as a valuation yardstick. As the company grows its software and content business it will span more related companies.
Theaters - Although their business model is different from Cinedigm, these companies are clearly in the same industry. We've included Cinemark (NYSE:CNK), Carmike (NASDAQ:CKEC), IMAX (NYSE:IMAX) and Regal (NYSE:RGC).
Theater Supply Chain - These companies supply products and services into theaters. At the bottom of the food chain (and with the lowest valuation) we have Ballantyne Strong. As we move up we get to Technicolor, Barco, RealD (NYSE:RLD) and Dolby Labs (NYSE:DLB). The bigger firms have meaningful business outside of theaters and filmed entertainment.
Content and Distribution - We've included some content owners like Lions Gate (NYSE:LGF) and MSG (NASDAQ:MSG) along with distributors like Bona Film Group (NASDAQ:BONA) in China. Although we acknowledge that Netflix has been a horse of a different color their recent foray into acquiring content gets them on the radar screen.
Advertising & Data - Rentrak (NASDAQ:RENT) is a long-standing provider of film industry data that is working on expanding and improving their capabilities and analysis. National CineMedia is a leader of in-theater on-screen advertising.
Operational Support Software - Now we're getting a little technical but the software business of Cinedigm is very much like that built upon operational software from companies like Amdocs, CSG and Synchronoss. These companies are focused on communication services but as a software business model they provide useful data.
Online Infrastructure - The last category is the "sexiest" and provides the online software and services to support business processes. The back-end business of Cinedigm could evolve far in this direction over time. At the consumer level the example of OpenTable (NASDAQ:OPEN) is instructive. What some investors don't realize is that the restaurant industry relies on the OpenTable back-end software to manage the customer portion of their business.
2 Historical numbers and restatements sourced from S&P/CapitalIQ.