China Digital TV Holding - More Questions Than Answers

| About: China Digital (STVVY)
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To receive a special dividend is always a nice gesture from a company. Most shareholders love dividends. But why give away such a large stack of your cash value on your balance sheet?

In a press release from Monday, China Digital TV (STV) announced that it is declaring a special cash dividend of $2.30 per share. It is to be paid in two installments of $1.00 and $1.30 on or around Dec. 3, 2012, and Feb. 4, 2013, respectively.

The Company

Founded in 2004, China Digital TV is the leading provider of CA systems to China's expanding digital television market. CA systems enable television network operators to manage the delivery of customized content and services to their subscribers. China Digital TV conducts substantially all of its business through its PRC subsidiary, Beijing Super TV Co., Ltd., and its affiliate, Beijing Novel-Super Digital TV Technology Co., Ltd., as well as subsidiaries of its affiliate.

More Questions Than Answers

Disclosure problems: The company seems to have had disclosure problems since September 2011. One of the issues is the contractual arrangements with the parent company N-S Digital TV.

The SEC is worried about the company's VIE contractual arrangements:

We note from your response to prior comment three that certain contracts require consent of both Super TV and the operating company to be renewed. Since this provision requires the operating company's approval for contract renewal upon expiration, please provide your analysis of how you considered whether this right represents, in substance, a kick out right for each of the contracts.

That is, explain whether the renewal rights essentially give N-S Digital the unilateral ability to remove Super TV, giving the operating company the power to direct the activities of variable interest entity that most significantly impact the entity's economic performance.

Quite a few letters have been exchanged between Sept. 20, 2011 and March 13, 2012. As mentioned before, the main worry of the SEC is about the control of the company and if things can be enforced when VIE contractual arrangements expire.

Our contractual arrangements with our operating company, N-S Digital TV, and its shareholders may not be as effective in providing operational control as direct ownership and may be difficult to enforce.

In order for our CA systems not to be deemed by the PRC government as non-PRC CA systems, which may result in a competitive disadvantage for us in the PRC market, we have established N-S Digital TV, which is wholly owned by PRC persons, to produce and sell our CA systems in the PRC. As a result, we generate a significant portion of our revenues through N-S Digital TV. We do not have any equity interest in N-S Digital TV and instead enjoy the economic benefits of, and have substantive control over, N-S Digital TV through contractual arrangements with N-S Digital TV and its shareholders. N-S Digital TV also holds the licenses and approvals that are essential to our business. For a description of such contractual arrangements, see 'Item 7. Major Shareholders and Related Party Transactions-B. Related Party Transactions.' These arrangements may not be as effective in providing control over our operations as direct ownership would be. In particular, N-S Digital TV could fail to perform or make payments as required under these contractual arrangements, and we would have to rely on the PRC legal system to enforce these arrangements, which may not be effective.

Source: Form 20-F (page 17).

Recurring revenues almost non-existent: Most of the company's revenues come from shipping smart cards, which is non-recurring income.

We derive substantially all of our revenues from customers who are installing new CA systems, and if we are unable to continue attracting new customers to install our CA systems or persuade existing customers to purchase our system upgrades or value-added applications, our revenues, profitability and prospects may be materially and adversely affected.

CA systems vendors in more mature digital television markets, such as the United States and Europe, derive revenues not only from the purchase of new CA systems by television network operators who are switching from analog to digital transmissions, but also from the purchase of new and replacement smart cards, system upgrades and new value-added services by existing customers. In the PRC, however, cable television network operators are still in the process of purchasing CA systems and introducing digital content and services to their subscribers. To date, none of our customers have made a follow-on purchase for system upgrades or card replacements. As a result, the success of our business depends primarily on our ability to attract a continuing stream of customers who are switching from analog to digital transmission. As the digitalisation process in the PRC continues to progress in light of the targeted completion in the year 2015, the number of cable television network operators who have not switched from analog to digital transmission, who are the prospective customers of our CA systems, has decreased significantly. If we are unable to continue attracting sufficient numbers of such customers, or to develop a significant additional source of recurring revenues, our revenues and profitability may be materially reduced and our prospects may suffer.

Source: Form 20-F (page 7).

Shareholder Value

In the press release, the company mentioned that a special dividend is an efficient use of cash to maximize shareholder value. I agree with that, but not if a company is in a transformation phase. China is transforming from analog to digital TV. Huge investments have to be made to become a winner.

To maximize shareholder value, management needs to prioritize the use of a company's capital among balance sheet repair, new investments (organic or M&A), increasing liquidity, and shareholder distributions. The allocation of capital depends on several key factors. Management need to account for the macroeconomic and capital markets environments, as well as the company's specific capital structure, financial flexibility, cash flow, and growth profile.

China Digital TV has to invest in the development of industry-leading technologies. So why not obtain a sustainable dividend policy? Investors prefer companies with sustainable dividends (i.e., dividends that increase regularly with little risk of being cut). Excess cash flows can be used for buybacks or special dividends.

The dividend will cost STV approximately $135.7 million, a large chunk out of its $180.2 million cash position. Its cash flow could become insufficient if it doesn't expand its recurring revenues.

So why not invest in value added services with a monthly subscription? Learn something from Netflix (NASDAQ:NFLX).

Final Note

The special dividend could be a goodbye premium to leave the U.S. capital markets. I see it as an incentive for management to take the company private. A sustainable dividend policy would attract institutional investors and private investors looking for yield. I would ask myself the following question: Who is the big winner? The shareholders or management?

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.