Entertainment One — PJ Masks catching Peppa

H117 revenues decreased by 1% to £396m with very strong growth in Family (+64%) and Television (+17%) offsetting declines in Film (-29%). On a constant currency basis, revenues decreased 5%. While revenues were broadly stable, the mix effects of the shift in group revenues towards higher-margin divisions meant that adjusted EBITDA increased by 36% to £51m, and despite a higher adjusted finance charge flowing from last year’s re-financing of £13.1m (H117: £11.5m), adjusted PBT increased by 53% to £36m and adjusted EPS by 85% to 4.8p. Reported PBT of £0.8m (H117: £2.5m loss) includes £3.3m of one-off charges, mainly relating to the set up costs of its new Film venture MAKEREADY, contingent consideration related to the Renegade 83 acquisition and the re-shaping of the Film and Television divisions. It also includes a one-off finance charge of £6.5m relating to losses on currency hedges. The group’s policies have subsequently been tightened as £5.2m of these losses related to contracts that were not in compliance with the group’s policy.

Net debt was £312.8m and production finance £141.8m, up from £187m and £118m, respectively, as at end March 2017.

Television revenues increased by 17%, supported by a 29% increase in investment. EBITDA increased by 11% with margins down slightly to 12.2% (H117: 12.8%) due to a lower margin at eOne Television, as well as mix effects with a greater proportion of MGC revenues now derived under an independent studio model. Across the three sub-divisions:

Revenues increased by 64% driven by an exceptional performance from Peppa and PJ Masks. Peppa generated £37.4m of revenues (+18% y-o-y) with growth driven by the brand’s performance in China where licensing and merchandising increased by over 700%. Asia remains a key growth opportunity; the number of licensing arrangements in China is expected to grow from 20 (end FY17) to 60 by the end of FY18. A further 117 episodes are in production for delivery over the three years to December 2021 and its addition to Merlin Entertainments’ theme parks (first ones to be opened in 2018), as well as the success of last year’s film support the fact that the Peppa brand remains on a firm footing in its more mature markets, and signal that it has achieved evergreen status.

PJ Masks has had a stellar performance and is fast approaching Peppa’s scale, but in a much shorter period of time. Revenues increased over 600% to £22.3m in H118 and PJ Masks now accounts for more than a third of divisional revenues. This growth was largely driven by the global roll-out by master toy partner Just Play and new licensing deals. Building on this early momentum, deals are being signed across Europe, Australia and Asia with a full launch in China planned for next year. It is broadcasting in all key territories on Disney Junior and France TV. A second season (52 episodes) is in production and a third has been greenlit.

The Film division’s revenues were affected by a weaker cinema slate (theatrical revenues -45%), which featured fewer high-profile films (H117 included Spielberg’s The BFG) as well as the generally challenging marketplace across all other distribution channels (home entertainment revenues -39%, broadcast and digital -28%). Growth was also affected by the group’s retrenchment from physical distribution of music in the US. The pipeline for the second half of the year is stronger, including Spielberg’s The Post, A Bad Moms Christmas and Molly’s Game. Nevertheless, the £150m spend targeted for investment in acquired content at the start of the year has been reduced to £130m, while investment in productions is still expected to increase year-on-year.

The re-shaping of the Film division started in 2016 and has seen the division move away from physical distribution towards digital, and has now delivered the targeted £10m run rate of savings, which meant that the EBITDA performance was broadly maintained despite the weaker top line. Management has also identified a further £8m of savings, to be delivered by 2020 as a result of the integration of the Film and Television studios, announced at the end of last year.

Net debt of £312.8m was reported (year to March 2017: £187m) and production finance of £141.8m (£118m).

The level of production finance is broadly in line with our expectations. The group invested £229.8m in content and productions, a 16% increase on H117 with the vast majority of the increase seen in the Television division. Almost two-thirds of this now relates to produced rather than acquired content (H117: 45%), in line with the group’s strategy to create a more balanced content business and to move closer to the creative process. This is reflected in the greater use of production financing, which we view as a positive signal that the group is delivering to its strategy.

The increase in net debt (corporate debt) was higher than we expected. Cash conversion was affected by the £41m exceptional costs announced in 2017 related to the restructuring of the Film division. In addition, variance in the timing of major film releases in the Film division compared to FY17 resulted in a £36m investment in content gap as well as a working capital outflow of £25m. This should reverse in part in the second half of the year although management now expects year end gearing to be approximately 1.3x EBITDA (up from its previous guidance of 1.2x).

With 82% of Television budgeted margins committed or greenlit for the year, strong momentum being generated by PJ Masks and Peppa around the world, and a better slate in the second half in Film, management has confirmed that the company remains on track to deliver its full year expectations.

We have updated our forecasts to reflect the lower anticipated investment in content in Film and Television, as well as for revenue mix effects (raising our estimates for Family, offset by lower Film). This results in a reduction in our revenue forecasts, but at the EBITDA level overall we leave our forecast broadly unchanged. We raise our year-end net debt forecast to £223m (from £204m).

A straight EBITDA peer comparison in this sector is complicated by the fact that while eOne and some of its larger Film peers include amortisation of programming costs in their definition of EBITDA, the smaller film companies, television and brand licensing groups do not. We believe an EBIT comparison is a more consistent metric. On this basis, eOne trades on a 10.8x EV/EBIT multiple in FY18e and 9.5x in FY19e (this is based on a more conservative definition of EV that includes the value of IPF debt. Excluding this financing, the EV/EBIT multiple is 10.0x and 8.9x in FY18e and FY19e, respectively).

While the shares have increased by c 25% since the FY17 results in May, eOne’s valuation rating remains at a considerable discount to its peer group average of 14.6x FY18 EV/EBIT and 12.5x FY19e.

Given the diversity of content it now produces and distributes, as well as the differing margins and performance of each division, a sum-of-the-parts valuation is appropriate. There are considerable synergies now being generated across the group and we do not believe that a discount to this value is deserved. On this basis, we believe the share could be worth up to 362p.