Sunday, January 15, 2006

Barrons Round Table-Thomson (TMS)

Barron’s Round Table features a number of interesting picks, some of which I intend to explore in greater depth.

Link-Barron’s subscription required

Though not discussed per se this week, Thomson (TMS) was one of Oscar Shafer’s selections in July of 2005, and in fact is down about 20% since that time. This is the French company that most of us think is still an also-ran European television manufacturer rather than the former Canadian, but now Stamford, CT based information database company. Two totally different and unrelated businesses!

Thomson trades on the NYSE as an American Depository Share (ADS.) The company is essentially a supplier to the movie-making, television and entertainment industry. The business has completely transformed itself over the last several years, really, since its 1999 listing. It now consists of three divisions:

Services, Systems & Equipment, and Technology

Services- The best known part of Thomson’s biz is a sub called Technicolor, which was acquired in 2001 and has grown through a series of acquisitions. The company provides outsourcing solutions to the movie production and TV distribution industries such as film services, DVD and VHS duplication (tiny and getting tinier), post-production services. Disney, Dreamworks, Universal, as well as Electronic Arts have signed long term contracts with Technicolor. This appears to be essentially a duopoly between themselves and Cinram ( a Canadian company, each with about 40% share. Balance is Sony which supplies its own entertainment division’s needs. The movie business tends to get more revenues from the post-release after life of films rather than the initial release. This business does not seem to have the risks of the movie business itself but is reliant on the continuing demand of consumers (and the Netflix and the Block Busters of the world) to resell content in this format. The post-production and editing biz are a function of Hollywood’s continuing production of movies.

The company has also made inroads into electronic, digital media and I suspect that more and more content will require modification for an HD world as well as the video on demand world.

The businesses within this division appear to have operating margins that range from 7-8% up to the mid-to high teens. I like the contractual nature of the business and the limited number of companies that compete in this arena with the breadth of services.

Systems & Equipment- This is broadcast equipment, cameras and production equipment, as well as video compression and networking equipment. The move to HD should support ongoing demand for their products, though they compete with a large number of competitors here (Sony, Tandberg, Avid, etc.) The company also provides set-top boxes, like Scientific Atlanta or General Instrument, but has achieved success with satellite TV set-top boxes. There is a long term contract with DISH.DISH related revenues represent about one-third of the biz...there is a relationship with France Telecom and BSKYB. This looks like about a 5% margin business.

The entrails of the former consumer TV biz are here too. VCRs, DVD players, MP3 players are sold under the Thomson, and yes the RCA brand in the U.S. They may well exit this business, if they can. They are very much a secondary also-ran in this segment of the biz.

Technology- Revenues here are mostly licensing revenues and hence very high (80% plus) kinds of operating margins. The company’s ongoing R&D efforts continue to build more and more intellectual property that has been licensed. The image that most analysts seem to have of Thomson’s IP is that it is old “his master’s voice” kind of property. Much of it appears to be digital rather than analog.

The result of all of these changes is that Thomson has become a significant free cash flow generator. At current prices, it appears that the company could have a greater than 10% FCF yield for next year, versus a current 4%. Massive restructuring expenses over the last two years have clouded the inherent FCF generation characteristics of what remains. The best evidence is the following: The company has completed over 60% of a €400 million buyback instituted in September of 2004. Returns on capital have trended up from barely 2% to approach 7%. In my view, with a little more restructuring, a 10% return on capital could be attained. The decisions to exit from TV and picture tube manufacturing in 2004 and 2005 establish management’s willingness to drop historical businesses and focus on returns and growth. EV to EBIT is about 12 X.

It should also be mentioned that Silver Lake Partners, a private equity group, made a €500 convertible investment in Thomson in 2004 and can convert its interest into equity in March of 2006.

The free cash flow characteristics, the improving operating margins, and the willingness to restructure and accept short-term pain to achieve long term goals are admirable. The risks that I see relate to the potential decline in DVD’s and the technological risk in the shift to Video on Demand. Institutional ownership in the States is only about 10%, insiders, employees, and the French state own about 9%.


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