Everybody in the US hates their cable company. Customers have been leaving in droves for the greener pastures of streaming services like Netflix. So why invest in Technicolor SA (ENXTPA:TCH), a business closely aligned with the fortunes of the cable industry?
Spoiler Alert: The price is deeply depressed and there’s more to the company than the obvious headlines.
A world leader in digital technology within the media and entertainment industry, Technicolor operates four rather distinct businesses, the largest of which it calls ‘Connected Home’. This division manufactures and sells pay-TV set top boxes and broadband modems and routers. Cable and telco companies purchase these products on behalf of customers of their services.
As Technicolor’s largest business, Connected Home tends to command the most attention. The cord cutting trend in the US bodes ill for the company. Fewer customers mean fewer set top boxes. Adding to that long-term challenge, a recent spike in the price of a key input has squeezed profit margins. DRAM chips is the name of that key input, and Bitcoin mining partially explains the spike.
This division is more than just a set top box business exposed to the stagnation of cable, though. Positively for Technicolor, the number of broadband internet subscribers has been increasing. That has led to increased sales of broadband hardware. As providers upgrade their networks, Connected Home should see a boost as customers upgrade their modems.
The intensity of competition in this business has also eased relative to where it was several years ago. A wave of consolidation has left Technicolor as the clear number two player with few peers. Facing less competition, the company won some new contracts recently. Most of them won’t commence until 2018 or later. There are challenges, but Connected Home also has plenty of unappreciated value.
Technicolor’s next most important business involves creating special visual effects for the movie and entertainment industry. It owns several leading visual effects (VFX) studios which create high-end digital content for blockbuster movies, television, advertising and video games. Demand for computer-generated imagery and related content is so great that the business is completely booked through to the end of 2018. We view this business as a hidden gem.
One of Technicolor’s oldest businesses involves the replication and distribution of physical disc media (CDs, DVDs and Blu-Rays). Of course, this is anything but a growth industry. Just about everyone involved in manufacturing DVDs has closed shop, with Technicolor and Sony the exceptions. A lot of clients do not want to deal with Sony, who they view as a competitor. We see Technicolor benefiting from a ‘last man standing’ strategy. So while the absolute number of DVD sales will continue to shrink, Technicolor’s strong position will enable it to generate healthy cash flow.
Technicolor’s last business develops intellectual property (IP) in the field of digital technology for the media industry. The company, a leader in Hollywood’s transition to colour, has pioneered a range of technologies and standards related to image processing, colour rendering, video compression, and connectivity. The company employs hundreds of research scientists who patent these technologies and license them to makers of all types of consumer electronics devices. Over half of the world’s manufacturers of TVs, DVD and Blu-Ray players, cameras, and smartphones utilise Technicolor’s IP.
This segment is currently undergoing a transition that has temporarily depressed its earnings. For most of the past decade, the segment’s most valuable IP related to the MPEG-2 video compression format. Those patents expired in 2015 leading to a major drop in revenue over the last 18 months. The market seemingly believes this segment has no further value. We disagree.
The value in Technicolor
First, it has recently established a joint venture with Sony which we think will lead to growing revenues in the future. The technology this joint venture will licence is proven IP, related to digital television, that Technicolor has licensed by itself in the past. In partnering with Sony, the company believes it has improved its negotiating position and that the combined portfolio will yield more royalty income.
Second, Technicolor has planned for a future beyond MPEG-2 and helped develop the next generation video format, HEVC. This format enables a more efficient transmission of ultra high-definition content and is only beginning to be deployed. Key industry players support it and the data suggests it has already become the de facto standard. Technicolor’s efforts to licence this technology will determine whether it can match MPEG-2 as a profit engine. But we view things as encouraging.
Interestingly, the week before Christmas management disclosed that it’s in ‘negotiations for a strategic transaction’ relating to the IP business and is confident of reaching an agreement. We don’t know if the proposal is related to the whole division or part thereof. But there are some assets in the division that might prove more valuable in the hands of a bigger player like Samsung or Sony.
Several ducks lined up to make Technicolor an attractive investment for the Fund. We mentioned the recent trends working against it—these served both to depress current earnings and sentiment. Numerous recent contract wins in both the Connected Home and DVD businesses had yet to begin generating revenue and profit. And the licencing business owns some technologies that are not being ‘monetised’ today but could prove very valuable. Any strategic transaction could bring forward that value realisation.
We think the VFX and the licencing business as it currently stands justify the entire market valuation for Technicolor. The shrinking but cash-generative Connected Home and DVD businesses are thrown in for free. We were also getting a free option on any future growth in licensing from potential hits such as its HEVC IP. With multiple ways to win, some optimism in the face of market pessimism is cautiously warranted.
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