Eros International May Be Worth A Nibble With Its 3.3/1 Reward/Risk Profile

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About: Eros International Plc (EROS)
by: Finsight Funds
Summary

Eros International is an Indian entertainment company with a business model somewhat similar to Netflix. Its primary value propositions are 1) its content library and 2) its distribution network "Eros Now."

Several short reports, alleging accounting and liquidity issues, have targeted the firm over the last five years; the company has repeatedly denied these claims.

The equity has traded largely sideways over this time frame, but several more unfortunate events this summer caused the stock to drop 80%.

Since the drop, though, management has maintained confidence in the business and operations are progressing as normal.

The stock is still trading 70% below the "pre-error" price. At just over $2, we calculate the risk/reward profile at ~3.3/1 and worth a small position for risk-tolerant investors.

Overview

Eros International, PLC (EROS) is an Indian entertainment company, describing itself as a "preeminent co-producer and distributor of Bollywood films."

Its primary value proposition is "Eros Now", essentially a Netflix-like distribution service in India and the broader globe for Eros' owned content library. The Eros Now website is worth a view.

SA contributor Pinxter Analytics wrote this overview piece on the company in July; investors looking for more background on the company can read more there.

This article covers recent events at Eros and why we believe it is quite possibly severely undervalued. We think the risk/reward profile gives risk-tolerant investors reason to take a small position. We are LONG Eros at a very small weight.

A Bad Indian Summer: Short Reports, Rating-Agency Downgrade, and Late Filing

Quick background: since 2015, EROS has been the subject of several short reports alleging:

  1. Accounting issues with respect to revenue recognition and accounts receivable
  2. Concerning related-party transactions, and
  3. An impending liquidity crunch.

The company has defended itself against the claims, and even attempted to sue the short sellers earlier this year for defamation. This suit was dismissed in March, due to

  1. The statute of limitations on defamation being 1 year, and most attacks occurring from 2015-2018, as well as
  2. The underlying facts behind the short thesis (high levels of accounts receivable and significant related party transactions) being undeniably true.

Fast forward to June 6th of this year, when India's second largest bond rating company, CARE ratings, dropped EROS' bonds 10 notches from BBB- to junk status D, citing Eros' accounts receivable as concerning for a liquidity crunch and also noting one of Eros' subsidiaries recently missed a debt payment.

As a result, the stock dropped almost 60% in the span of a week, from ~$7.50 to over $2:

Chart Data by YCharts

In addition to the CARE downgrade, other bad pieces of news soon hit Eros:

First, U.S. credit rating firm Moody's removed its corporate family ratings for the company.

Secondly, the company announced it would be filing its annual report late as it was no longer an "emerging growth company," and lacked effectiveness over its internal controls for the new reporting requirements.

Management's defense evidences the sell-off was likely overdone:

Management responded to the ratings downgrade by defending itself, saying the accounts receivable have been investigated, including by its auditors, several times over the last few years without fault-finding. It also said the subsidiary's missed payment was 1) an error, 2) only worth $2m compared with $130m on the balance sheet, and 3) the amount was being paid.

According to the latest Eros short report by Hindenburg Investment Research, investment banking firm Macquarie put out a note after the downgrade saying the missed payment was likely a "clerical error."

Seeking Alpha member Inflexion described the missed payment this way:

"If you thought your [spouse] paid the credit card bill but didn't, and then after receiving the missed payment notice you pay the bill, does that make you worthy of default[/downgrade]?"

Eros has recently announced several other pieces of good news:

  1. Eros announced Moody's withdrew its rating at the company's own request since Moody's no longer reviewed its cap stack.
  2. The company announced a $20M share buyback.
  3. It filed its annual report and its auditing firm confirmed the accuracy of its financial statements.
  4. Eros announced the commencement of a strategic-alternatives review, engaging Citigroup as its financial advisor.

Also of note, Eros has announced the continued progression of its business, with three large distribution partnerships taking place over the last several weeks: one to expand its presence in India, one to distribute its content in Qatar, and one to distribute its content in China.

While these announcements have caused the stock price to rise ~50% in the last few weeks, most investors are still on the sidelines, and the stock still trades just over $2, a significant discount from its "pre-error" price:

Chart Data by YCharts

Valuation in a "Non-Zero" Scenario - What Could Eros be Worth?

Assuming that Eros is not fraudulent, its financial statements are correct, and it is not experiencing any liquidity issues, a quick back of the envelope calculation shows the company's potential upside:

  1. The company reported ~$100m in adjusted EBITDA this year.
  2. With net debt of $145m and a market cap as of writing of $215m, Eros' EV is $360m - giving it a current EV/EBITDA of ~3.6.
  3. An appropriate multiple in a "non-zero" scenario could be ~12x EV/EBITDA, making the EV worth $1.2B or more - translating into more than 3.3x upside.

We believe the EV/EBITDA would be worth 12x in this scenario because of Eros' growth rates and potential margin profile. In FY 2019, reported ~7 weeks ago, the company grew its Eros Now user base by 55% yoy, its Eros Now digital revenues by 45% yoy, and grew its adjusted EBITDA margin to nearly 40%. Management estimates it still has a long growth runway ahead and can continue improving margins with the expansion in digital revenue. These metrics would afford the company a premium multiple.

Conclusion: It's Confusing, But the Risk/Reward Profile Is Worth a Nibble

It doesn't seem possible to "know" the truth about Eros at the current moment, but we do know that the current situation lends itself to an extreme risk/reward play.

In the downside scenario, if EROS runs into liquidity problems and/or has accounting problems, the equity could be worth 0, and in short order, too.

In the upside scenario, however, assuming the company's financial statements are correct and it does not have liquidity problems, the equity is probably a multi-bagger, with our calculations putting the upside at ~3.3x or more.

If the bull and bear cases each have a 50/50 chance of being accurate, the expected value of EROS stock is, by our calculations, more than a 75% return going forward.

To be clear, we are not recommending investors make any large bets on EROS. The company does have large accounts receivable, several related-party transactions, and a management team that clearly does not know how to interact with the capital markets.

However, with several avenues/catalysts for upside realization (including an impending sale of the company), we think Eros' risk/reward is favorable. Management seems more likely incompetent than fraudulent, and like they are simply learning to play ball in the big leagues.

We suggest risk-tolerant investors take a small (perhaps ~1%) position. Appropriately-sized to be a thriller but not a horror, investors can make some popcorn, sit back, and enjoy the show.

Disclosure: I am/we are long EROS. 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.