Don't Give Up On Technicolor Just Yet

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About: Technicolor SA (TCLRY), THNRF
by: Vince Martin
Summary

Technicolor has been left for dead by the market after a 2018 performance that suggests a business in permanent decline.

But there are some green shoots here that suggest ~stable performance - and thus upside for TCH/TCLRY shares.

Risks abound, admittedly; there's a reason the stock is at a multi-year low.

That said, there's still an intriguing value case here.

The market has left Technicolor SA (OTCQX:TCLRY) (OTCPK:THNRF) for dead. It's not hard to see why. After divesting its patent licensing business to InterDigital (IDCC), Technicolor has three businesses left. All seem to have significant challenges. Adjusted EBITDA in 2018 declined over 20% year over year; free cash flow was negative. Net leverage, based on 2018 numbers, sits at 2.75x.

But I'm not quite ready to write Technicolor off just yet. I wrote in a Top Idea last year that everything couldn't go wrong forever - and indeed, Technicolor showed some signs of life in the second half. There are growth drivers in all three businesses - and potential for margin improvement this year, and particularly in 2020.

The stock admittedly has a catalyst problem - and the risks here are real. This is a classic deep value play, and will require patience. But the upside is tremendous if Technicolor can pull off a turnaround - and the likelihood is greater than investors might believe at the moment.

(Author note: figures in this article will be based on Paris-listed TCH shares, rather than the OTC-traded ADRs. TCH closed at €1.17 on Friday.)

A Disappointing 2018

From a headline standpoint, Technicolor's 2018 results look disastrous - and yet perhaps not that surprising. There's only one obviously attractive business here. The company's Production Services group supplies production and post-production services for movies, TV, advertising, and video games. Revenue growth continues to be solid - but top-line increases have slowed of late, while higher spending and a labor-intensive model have pressured margins.

The rest of the business seems to be in secular decline. Over half of volume in the Connected Home business comes from set-top boxes, which are at clear risk from 'cord-cutting'. The other part of the Entertainment Services segment is the DVD Services business, which manufactures, packages, and distributes DVDs, CDs, and Blu-Ray discs. There, too, the growth of streaming services like Netflix (NFLX) seems to augur a steady, persistent decline going forward.

In that context, consolidated 2018 results don't seem all that surprising. Revenue declined over 6%. Adjusted EBITDA from continuing operations dropped a concerning 22%, with margins shrinking to 6.7% from 8.0% in 2017. Free cash flow turned negative (-€43 million) - an obvious concern given the leverage on the balance sheet.

This looks like an ugly year. And while a €1.17 share price might suggest that TCH shares are 'cheap', that's actually not quite the case. The market cap still is €483 million. Enterprise value is over €1.2 billion. For a declining business burning cash, that valuation hardly looks attractive on its face.

Looking Closer at the Numbers

That said, the news isn't nearly as bad as it appears, both on a consolidated and unit-by-unit basis.

First, currency had a significant, and negative, impact on both revenue and profits. In constant currency, revenue fell just 2% on a consolidated basis - and Technicolor grew sales in the second half.

The EBITDA decline came in part due to FX as well. The Q4 earnings slides cite an €18 million impact - a 5-point-plus headwind to growth. The February agreement to transfer the Research & Innovation business to InterDigital shifted those costs to discontinued operations, boosting 2017 Adjusted EBITDA by €28 million and the 2018 figure by just €17 million, another €11 million impact. And 2017 EBITDA was re-stated with a €22 million gain, as patent licensing revenue that was originally planned to go to InterDigital instead stayed with Technicolor. Combined, those two factors drove €51 million of the €75 million y/y decline from the re-stated 2017 figure.

That leaves €24 million, admittedly. And per the annual report, higher component costs - memory and MLCCs (multi-layer ceramic capacitors) - hit EBITDA in the Connected Home business by €45 million.

In other words, the underlying business grew profits last year - save for external and one-time factors. To be clear, that's not necessarily a good thing. Technicolor initiated a heavy cost-cutting program last year: sales and marketing spend fell 23%, G&A dropped 12%, and R&D declined 15%. Combined, Technicolor generated about €80 million of reductions on those three lines - but only a quarter or so made it through to EBITDA, even backing out currency and component costs.

Still, it's clear that 2018's performance was affected by external headwinds - and could have looked much better without them. And looking forward, there's still potential for some growth - at a valuation which suggests upside if Technicolor can drive any growth at all.

Business by Business

Connected Home

Set-top box weakness is a real threat for the Connected Home business. Video still represented 56% of 2018 volume in the segment, according to the annual report. The rollout of Charter Communications' (CHTR) Worldbox helped sales through the first half of last year - but with that launch now over, STB sales are going to see pressure. Segment revenue in North America dropped 24% last year. Worldwide, video sales declined 32%, according to the Q4 earnings presentation.

But that doesn't mean the segment is destined for steady declines. First, outside of North America, Connected Home is growing. Revenue in EMEA increased 6%. Reported growth in Latin America was 1% - but excluding FX, sales in the region rose 11.6%. Strength in Japan and South Korea led to 34% reported, and 39% constant-currency, growth in Asia-Pacific.

As CEO Frederic Rose put it on the Q4 conference call, "it's clear [in] the video market, there's North America, and the rest of the world... Now, the rest of the world is a different environment." ASPs are dropping as simpler, Android-based boxes are taking market share. But Technicolor, outside North America (and away from the pressures facing U.S. satellite operators in particular) should be able to keep unit counts reasonably stable. And with North America now less than half of total segment revenue, growing markets outweigh the shrinking one.

A similar trend is at play in the video/broadband split. STBs still drive the majority of volume - but broadband devices drive the majority of revenue. And Technicolor appears to have an excellent position in the shift to DOCSIS 3.1. It's clearly moved well ahead of ARRIS (ARRS) (in the process of being acquired by CommScope (COMM)); per the annual report, Technicolor is the sole supplier to Comcast (CMCSA) and is "shipping important volumes to Charter".

ARRIS, on its last call (after Q2 in August) cited a potential "ramp" in its DOCSIS 3.1 shipments leading to revenue growth in Q4. But fourth-quarter revenue in ARRIS' CPE segment rose just 1% - and ARRIS doesn't mention DOCSIS 3.1 as a 2018 revenue driver in its 10-K, only for 2017. What can be gleaned from ARRIS' performance suggests that Technicolor isn't overstating its lead.

So now broadband - 51% of 2018 revenue - can drive revenue growth, as can business outside of North America. And it's not as if the business had a terrible 2018; backing out component cost increases, Adjusted EBITDA would have risen 3%. Technicolor has renegotiated agreements to pass most of those costs onto customers starting in the second half - which should benefit 1H 2019 margins and limit the company's exposure going forward. (Memory prices have come down, but the MLCC shortage is expected to persist for some time.)

This isn't necessarily a declining business; in fact, it likely shouldn't be. Constant-currency revenue grew nearly 5% in the second half, and while EBITDA still declined, margins improved - and should do so further in 2019. With a more normalized environment, growth could return as soon as this year, particularly with easier first-half comparisons.

DVD Services

The DVD Services business - obviously - is a 'cigar butt'. Per figures from the annual report, the number of discs sold fell 11%+ in 2018 on top of a 14% decline the year before. And DVDs still account for ~two-thirds of the total (CDs are 5%, and Blu-Ray discs 29%, per figures from the annual report).

But here, too, 2018 saw some external pressure - and performance has room to improve going forward. Rose on the Q4 call said the "demands of the largest DVD retailer in North America" (which should be Walmart (WMT)) led to a huge rush ahead of the holidays - which impacted profitability in the business. And at the end of the quarter, one "major customer" saw a "very significant downturn" in sales.

This is not to say that revenue would have risen year-over-year. But in fact, top-line declines are modest: just 4.6% in constant currency, as Blu-ray discs offer more revenue per unit. Sony (SNE) has agreed to outsource its production to Technicolor - and this year will include distribution - and that leaves Technicolor pretty much in charge of the market, particularly in the U.S.

That gives Technicolor an opportunity starting next year. The company's major contracts begin to expire in January - and, per the call, Technicolor wants to renegotiate those deals to incorporate volume changes. As Rose put it, that way Technicolor "no longer takes the risk of any cost structure with volumes that move faster than we can adapt".

Technicolor should have a strong negotiating position as it tries to move to variable-cost pricing - because, as Rose pointed out, "every major studio in North America" is a customer. At this point, there isn't anywhere else for them to go.

In the annual report, the company also cited the possibility of moving into other markets, among them "supply chain solutions, including transportation management and direct-to-consumer fulfillment services" in other industries such as education, consumer electronics, and even gift cards. What those plans entail isn't clear - and neither is whether those plans make sense, as opposed to simply maximizing cash flow from discs. (Like many value investors, I'm always nervous when managers try to grow declining businesses - it's a strategy that usually works much better on conference calls than in reality.)

But with revenue declines likely to stay in the mid-single-digits thanks to the Sony deal and Blu-ray pricing, and profitability potentially improving in 2020, Technicolor still should be able to wring some cash out of this business regardless.

Production Services

The Production Services business ostensibly is Technicolor's strongest. The client list includes major studios including Warner Bros. and Disney (NYSE:DIS) (the annual report cites multiple awards from Disney for work in 2019), Netflix, game developers Electronic Arts (EA) and Activision Blizzard (ATVI) (including work on the Call of Duty franchise), as well as independent TV, film, and advertising producers. Trends seemingly favor the business as more outlets produce more content - with animation a particular driver in the coming years.

The question is on the margin front. To compete across all of the categories, the PS business has steadily increased headcount. The total number of Production Services employees has risen 63% in three years, per figures from annual reports. Technicolor closed 2018 with 7,900 digital artists - a nearly 150% increase from the end of 2015.

Management has characterized the hiring as investments in the segment's growth. The problem, however, is that revenue growth hasn't been that impressive. Constant-currency growth was 5.6% in 2018 - but EBITDA in the Entertainment Services segment (which includes DVD and Production Services) fell 15%, again excluding FX. The annual report cites improvement in profitability for the film and TV businesses - but also notes "capacity increases and related investments" that should continue into 2019. Commentary on the Q4 call seemed to suggest that the DVD business was responsible for more of the decline, however, with CFO Laurent Carozzi noting that EBITA (including depreciation) was up in Production Services year-over-year.

Even assuming that Connected Home can drive non-U.S. and/or broadband growth, Production Services is the business that has the most potential to create real value. Content demands are only going to rise - and Technicolor is a leader in the industry. The question - literally, as this was the first question of the Q4 Q&A - is whether the company can accelerate revenue growth back to the high-single-digits, at least, and start leveraging the investments it's made in headcount.

Certainly, industry demand isn't going anywhere - and with Technicolor a leader in its field, there should be a way to drive margin improvements eventually, and there should be real value here going forward. But commentary on the pace of investments in the business suggests investors will have to be patience: margins are unlikely to improve much in 2019.

Valuation

In conjunction with Q4 earnings, Technicolor didn't provide 2019 guidance. In justifying the decision, Rose on the call cited feedback from "a large number of [the company's] key shareholders". But he did give one piece of "qualitative guidance", as he termed it: "we need to pursue leverage reduction by improving profitability and cash generation".

It does seem unlikely that growth is on the way in 2019. Spending is going to rise in Production Services. Renegotiated contracts won't help DVD margins until 2020. And Rose cited a focus next year in gaining market share in Connected Home - which might suggest some upfront costs as well.

That said, a multi-year focus on deleveraging can help the story here - and Technicolor does have time. Debt doesn't mature until 2023. Gross debt (3.85x 2018 EBITDA) is nearing a 4.0x covenant cited in the annual report, but with €291 million in cash, Technicolor has plenty of flexibility. Net leverage is below 3x based on 2018 numbers. Consolidated EV/EBITDA is below 5x.

And that's cheap enough to make the numbers work - if business holds up and if Technicolor indeed focuses on deleveraging going forward (note that corporate spend has been cut through the InterDigital deals and since re-allocated to the individual segments):

Segment Valuation Notes
Connected Home €600M €87 million in EBITDA in 2018; 7x multiple is discount to ~8x takeout multiple for ARRIS and in line with ARRS' historical multiple of 7x+; also potential for help from lower component costs. Still sub-0.3x P/S multiple
Production Services €800M 8-10x estimated €80-€100M in EBITDA, 1x revenue
DVD Services €400M 4-5x estimated €80- €100M in EBITDA, 0.42x revenue
Patent Licensing €100M future royalties from InterDigital. Per management, former NPV of €215M reduced by ~50% in second deal
Net Debt €733M
Equity Value €1,167M €2.82 per share, 140% upside

This might look like a bull case - and it is to some extent. DVD Services can head south quickly this year. The valuation assigned Production Services might be too aggressive if the labor-intensive nature of the business undercuts profitability - and it's hard to see how Technicolor could sell the business given how diverse its client base is. (Would, say, Disney outsource to a unit owned by Netflix - or vice versa?) Public competitors are tough to find as well. (One interesting data point: an analyst estimated that Disney saved $20 million a year by acquiring Industrial Light & Magic; that suggests some real value to someone for the larger Technicolor business.)

Still, Technicolor is valued below 5x EBITDA - and the outlook simply isn't that dire. Connected Home has a real opportunity in broadband. The Production Services business has value. The DVD business will have something close to a monopoly. The debt load is concerning - but manageable, and Technicolor has time to deleverage ahead of a refinancing 2-3 years from now.

Patience is going to be required, particularly since a catalyst doesn't necessarily seem to be on the horizon in 2019. But the upside here is substantial if Technicolor can even stabilize operations - and gain some confidence from the market. That's a goal Technicolor might be able to achieve this year.

Disclosure: I am/we are long THNRF, TCLRY. 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.

Additional disclosure: I am long the Paris-listed TCH shares, not the US OTC tickers.