The Image Entertainment (OTC:DISK) merger has been terminated again, but before the announcement, a reader, PlanMaestro, left a very detailed analysis of the company as a standalone and I felt it was a waste to leave it in the comments. If you follow his calculations, you’ll get an understanding that the company is cheap.
[Regarding DISK] Up to this point, I wish I had been just a spectator of this circus; instead I have been one of the company clowns. Well, here are my thoughts, including an amateur try to valuate Image Entertainment:
1. Probability of Closing: This deal is almost a perfect example of Knight’s uncertainty so I won’t dare to throw a guesstimate. It could be anything. However, uncertainty is our friend because it scares momentum players and arbitrageurs. I would say that at this moment most of the big shots are long gone.
And what weapon do we have small players have against this uncertainty? Klarman’s golden glove to catch falling knives: margin of safety.
2. Margin of Safety: Most people buying DISK do not even know what they are buying. They just see recent sell-offs and use that as a proxy for downside risk.
Since when do we value investors trust Mr. Market? Especially since film libraries are assets that time and again are being underestimated by our bipolar partner. P/E ratios lack accounting of the heavy non-cash depreciation and amortization expenses, aAnd M/B ratios usually undervalue the library because it is not marked to market.
At the same time the library has some particularly favorable economics:
Growth potential across formats and internationally with marginal investments
Low maintenance CAPEX
Steady royalty cash flows
In other words, they are the perfect LBO or acquisition target. The only problem is the risky film production. But once you have the rights, no sweat! Buffett likes, or used to like, newspapers. I like film libraries.
I prefer to use equity free cash flow and in this case, EBITDA is a good proxy for FCF because of the low maintenance CAPEX. And because of the steady cash flow, compared to real estate for example, a multiple of EBITDA is a good estimate of asset value.
VALUATION Q3 2008
I used Q3 numbers because the company has changed for good in a hostile financial environment.
Expand theatrical distribution rights to higher-profile feature films.
Conservative prints and advertising expenditures to cap risk in the event of theatrical failure and greater focus on the rental marketplace
Acquire “direct-to-video” content and distribution opportunities from the closing of the independent and specialty divisions of major studios
Reduced distribution expenses through agreement with Arvato for replicating, warehousing and fulfilling retail orders
I did not include working capital in the valuation because it was very volatile quarter to quarter. If someone has insights into that, they are very welcome.
Earnings from Operation: 2.0 million
Amortization and Depreciation: 1.8 million
Interest Expense: 0.9 million
- Taxes: 0.0 million
Other Expenses: 0.8 million (just in case, mainly $561,000 M&A)
EBITDA: 3.9 million per quarter, 15.6 million annually
4x EBITDA62.4 million (a low multiple even for industrials)
- Debt: 20.3 million
Value Standalone: 42.1 million
Market Cap: 31 million
Margin of Safety 27%
Another way of thinking about this is trying to estimate the rate of return for the un-levered firm. For that I am going to assume a conservative 30% tax rate given they NOL carryforwards:
After tax free cash flow 10.9
Enterprise value (Market Cap + Debt)51.3
FCF / EV yield 21.2%
That is right, a wide moat business with an un-levered 21.2% annual rate of return after taxes. And consider that international and digital is less than 4% of current sales, 2.5 M USD in cash from the escrow release, no value added from potentially being acquired player with global distribution, and short term catalyst at twice its current price.
In my opinion it looks very compelling even if the deal does not close … if it would survive maturities, covenants, capital requirements to finance working capital and a blundering management.
One point that PlanMaestro and a few of us have discussed over twitter is the lack of interest and enthusiasm shown by Wall Street for media companies. Note that it took Seth Klarman’s big stake in RHI (RHIE) to drive the price up.
It’s also possible to compare business models of Disney (DIS) with DISK. They both own exclusive rights to movie titles which don’t require any capital expenditure to maintain. Receiving royalties for its assets is also an excellent source of revenue and we can see how they have a consistent stream of revenue. Although Disney is on a different scale, you get the idea of the business.
What surprised me more Tuesday was that I was fully expecting it to drop to the mid to low 80c range, but it rose back up to end the day above $1. I think it’s because people are speculating that Nyx will return to the table or another company will come along with an offer.
Disclosure: I own shares of DISK at time of writing.