Technicolor is a leading global player in each of its three core businesses: Production Services, DVD Services and Connected Home, all of which have challenges and opportunities. Our view is that management has a strategy to mitigate the former and take advantage of the latter. H119 will likely prove the earnings nadir, with capacity constraints in Production Services and component pricing pressure – now unwinding – in Connected Home, which will also be reflected in the cash flow. We expect cash flow and operating margins to start to rebuild in H219 and through FY20. The current price is well below peer- and DCF-derived valuations.
Production Services is at the forefront of industry innovation and its creative and technical expertise is in high demand from the film, TV, animation, advertising and game sectors. The group is now stepping up investment to ease the bottlenecks from capacity constraints, which should allow revenues to grow and margins to improve. The DVD sector is in continuing decline, but the group’s strong market position puts it in good stead for augmenting margins as it renegotiates its large contracts on renewal. Meanwhile, segmental cash generation benefits the rest of the group. The Connected Home market remains highly competitive. Financial progress here is predicated on a three-year cost-saving programme slated to deliver €140m of annualised savings by FY21e.
Given the market dynamics over the year to date within Production services and Connected Home in particular, we expect both profits and cash flows to be weighted to H2. Our full-year forecast indicates net debt increasing to €741m by the December year-end (which would be 3.1x our forecast EBITDA) before starting to unwind in the following year as the group returns to being net cash-flow positive. Term loans run to FY23, with modest interest payments in the intervening years.
We have looked at the valuation on a sum-of-the-parts basis split between Entertainment Services (Production and DVD Services businesses) and Connected Home, citing quoted peers (although none are directly equivalent) and at relevant M&A. On conservative valuation metrics, using averages of FY19e and FY20e EV/EBIT for Entertainment Services and EV/EBITDA for Connected Home (EBIT data is not available for relevant transactions), our base-level fair value of €1.10 is above the current price. At a WACC of 8% and terminal growth rate of 2% our DCF indicates a price of €2.74.