A Bollywood Bargain?

Published in Company Comment on 1 September 2010

This AIM-listed share is tightly held but looks cheap.

"Invest in what you know" is a familiar tenet of investment strategy. So a company which produces and distributes Bollywood films is straying well outside my comfort zone.

But as the centre of gravity of the world's wealth shifts eastwards, private investors must become more familiar with powerhouse economies such as China and India -- either as the growth markets for UK companies, or as the incubators of future multinationals. It is our good fortune that many of those newly emerging companies choose to list their shares in London.

That, at least, was part of the reason I looked at AIM listed Eros International (LSE: EROS): that and an entirely erroneous but predictable supposition about the kind of film a company called Eros might produce, over which I shall draw a discreet veil.

What does it do?

Eros was founded in 1977 to distribute Indian films to foreign markets. It has since expanded vertically, to include film production, and horizontally, to include television syndication and distribution of music and other media.

It now has three segments which are roughly equal in size:

  • Theatre -- the production and distribution of films in India and internationally. Typically Eros co-produces, contributing part of the production cost in return for international and other distribution rights. It now has a substantial catalogue of films (content);

  • Television -- syndication of content to Indian language TV networks; and

  • Digital and New Media -- including video on demand, internet channels and mobile technology.

The company floated on AIM in 2006, but over 85% of shares are controlled by its founders: a significant negative factor. Plans are well advanced for a listing of its Indian subsidiary on the Bombay Stock Exchange, and the company intends to move to the main market after that.

Around two thirds of revenues come from India.

Financials

Year ended 31 March2007200820092010
Revenues ($m)66.4113.0156.7149.7
Operating profit ($m)32.046.351.051.9
EPS (cents)29.933.535.136.5
Operating Margin48.1%41.0%32.6%34.6%
ROCE43.8%42.9%41.0%35.5%
     
Net operating cash flow ($m)41.879.868.2108.3
Purchase of content ($m)92.0170.2129.781.5
     
Net assets ($m)140.9215.0257.4307.2
Intangibles ($m)111.7256.1328.6365.8
     
Net gearingn/a27.3%50.3%34.0%
Interest cover15.1x15.5x16.6x14.4x

Some observations:

  • revenues dipped in 2009/10, partly due to a stand-off with the Indian cinema chains;

  • operating margins and return on capital have weakened from their initial high levels, as the market place is becoming more competitive;

  • the company has built up its catalogue, and now generates more cash than it is investing in new content;

  • content represents investment in productive, but intangible, assets. This results in negative net tangible assets; and

  • the company is not yet paying a dividend.

The investment case

Eros has many of the characteristics of an emerging market growth company, in which large potential upside opportunities are balanced by the attendant risks:

  • the market is driven by the rise of the middle classes and increasing discretionary income. The Indian entertainment industry is forecast to continue growing at a rate of around 15% per year;

  • Eros has moved early to secure a solid competitive position, which should enable it to capitalise on the maturing (and likely consolidation) of the sector;

  • the back catalogue and established international relationships and joint ventures should provide some barriers to new entrants;

  • the company has diversified income streams, including film, TV, new media etc, but is focussed on the Indian entertainment sector; and

  • it generates cash.

Risks

So what are the risks? Four spring to mind:

  • in addition to the economic and political risk of investment in India, the emerging competitive landscape is less predictable than in a developed market;

  • revenues are mainly earned in rupees and reported in US dollars, resulting in considerable exchange rate volatility for a UK investor. Long term, if the Indian economy prospers, then the rupee should be strong;

  • film production is a risky business: but the strategy of co-production and the number of releases (83 in 2009/10) mitigates the risk; and

  • as mentioned earlier, the company is controlled by its founders.

Valuation

The prospective PE of 9 reflects the risks, and perhaps especially the tiny free float (£34m of a total market cap of £252m) which is too small to attract much institutional interest. The shares are trading at a discount of 30% to DQ Entertainment (LSE: DQE), the Indian animation studio which shares some characteristics.

I think an Indian listing and move to the main market, hopefully accompanied by a dilution of the controlling shareholders, would raise the visibility of Eros and lead to its re-rating.

More from Tony Reading:

Tony has shares in Eros.

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