On September 22, 2020 Technicolor announced the “successful completion of the final steps of the financial restructuring of the company.” In plain terms, Technicolor – #1 market position for film & episodic production services according to its investor presentation – has completed an effective bankruptcy restructuring. To avoid the term ‘bankruptcy’ – when every action of Technicolor is consistent with the term – is to refrain from the inner reflection a bankruptcy event demands.
This is a complex topic and by extension a lengthy article. We discuss the restructuring event, the lead up, impact of COVID, and what the event says about the media technology ecosystem. Taken together with the Deluxe bankruptcy less than twelve months ago, we (read: the media technology sector) must confront some uncomfortable realities about the state of the content production marketplace.
For those without the requisite attention span to weave through the delightful details (we cast no judgement), the summary is Technicolor has fixed its temporary liquidity issue and bought itself some time to fix its larger solvency issue. A solvency issue stemming from the inescapable conclusion its business model – the business model of post-production writ-large – is broken. This observation is only hinted at within the voluminous Technicolor filings, solicited outside opinions, and third-party observations.
The fundamental flaw with the post-production business model is every incremental $1 of revenue is matched by an equal and opposite $1 (at least) of cost. Consider the 2019 annual results of Technicolor’s Production Services business. 2019 revenue was €893 million, a 13.7% growth above 2018 revenue levels. Despite double-digit revenue growth, operating income declined in 2019 by 81.2% (versus 2018) to a level of €3 million. A 2019 revenue level of €893 million (remember 13.7% growth) then resulted in an operating margin of 0.3%, requiring the employment of €411 million of capital assets (and 10,500 employees), equating to a return on assets of 0.7%. Such return levels make it awfully difficult to service debt. (Those preferring a discussion of Adjusted EBITDA must acknowledge it is in practice a discussion of ‘Adjustments.’)
There is then no evidence in Technicolor’s recent results that scale results in greater levels of efficiency. In fact, the evidence supports the contrary observation that scale results in lower levels of efficiency.
It is tempting in the current environment to avoid confronting challenges by ascribing to a once-in-generation anomaly troubles rout by the COVID market disruption. But as we have repeated across several podcasts, COVID is NOT so much causing issues in the media technology sector, as it is revealing long-present structural issues. In this instance the structural issue is the fundamentally flawed business model of post-production.
How else do we explain bankruptcies by two of the largest post-production services at a time of unprecedented levels of content production? Deluxe filed for bankruptcy on October 3, 2019, and Technicolor was planning a rights issues to address its debt situation in early February of 2020. All the current disruption has done is accelerate Technicolor restructuring and amplify its magnitude. Said again for effect: COVID is exposing structural issues.
We will keep the discussion of the mechanics of the restructuring relatively brief since it is well covered by the broader analyst community following Technicolor.
For the 2019 financial year, Technicolor recorded a free cash flow result of negative €111 million, which was well beneath the prior year’s negative free cash flow result of €48 million. This operational performance left Technicolor with a cash balance of €65 million to start 2020. Because of a recent accounting change (affecting the recognition of certain leases) Technicolor’s stated debt went from €1,026 million to €1,298 million. Its market capitalization to start the year was just under €300 million, by the end of February 2020 Technicolor’s market capitalization would drop below €100 million.
Below is a graphical presentation of these values at the start of 2020.
To address its immediate liquidity needs, Technicolor announced a 2020 – 2022 Strategic Plan on February 13, 2020. The plan called for raising €300 million (larger than its then market capitalization) through a preferential subscription rights offering to shareholders. In form, this is an offer to existing shareholders to buy more stock – at an advantageous price – to maintain their relative equity position in the business. If an existing shareholder declines to exercise the rights, then the shareholder’s equity position is diluted.
By late May, the economic fallout from COVID prevented Technicolor from moving forward with the original rights issue. As described by Technicolor’s CEO Richard Moat in a May 26, 2020 release, “Since then [February 13, 2020] the world and our industries have faced an unprecedented crisis due to the Covid-19 pandemic.” Technicolor decided to instead seek a larger €400 million financing and a more long-term beneficial debt for equity swap.
In early June Technicolor entered negotiations with its creditors about a restructuring. The result was an initial agreement with creditors (akin to a pre-packaged bankruptcy in the US) announced on June 22, 2020. The proper term for these proceedings is sauvegarde financière accélérée within the Commercial Court of Paris. Concurrent with the legal process in France, Technicolor filed for Chapter 15 protection in US Bankruptcy Court to protect its United States assets (i.e. a bankruptcy filing in bankruptcy court seeking bankruptcy protection under bankruptcy law).
The restructuring contemplated reducing gross debt from the €1,444 million to €1,102 million. A €110 million bridge loan taken out in advance of the rights issue was responsible for most of the debt balance growth.
The proposed plan (discussed below) was then presented to shareholders for vote at a July 20, 2020 meeting. Technicolor’s positioning of the proposal to shareholders deserves some attention. A July 6, 2020 press release from Technicolor states “… a positive shareholder vote in favour of all the resolutions at this meeting, are of the utmost importance for the Company’s future.” Management indicated in the same press release that if the plan is not approved by shareholders then Technicolor would need to liquidate.
Shareholders in “a very large majority” approved the plan. We suspect a full description of the mechanics of the plan exceed the attention span of the readers. A short description is €420 million of new debt is raised and existing debt is reduced by €660 million through (1) a €330 million rights issue to existing shareholders and (2) a €330 million debt to equity swap with lenders. If no existing shareholders participated (i.e. 0% subscription rate to rights issue), then existing Technicolor shareholders would see their respective equity ownership diluted to just 6.5% of pre-restructuring levels. At the same subscription level, creditors would then own 93.5% of equity of Technicolor. The actual subscription rate by existing shareholders was 18.1%.
Nothing about the restructuring is particularly intuitive. An example might help to clarify. Imagine you bought €1,000.0 of Technicolor stock on the Paris Euronext exchange on January 2, 2020 (first day of trading in 2020). Had you decided not to participate in the rights issue, then on October 1, 2020 your stock position in Technicolor would have declined to just over €60.0, an almost 94% drop in the first 10 months of the year. (Note: an existing shareholder did have an opportunity to sell the warrant it received in the rights issue).
As for what the restructuring means for the future, Technicolor’s Richard Moat offered the following,
“Today we are opening a new chapter, paving the way for bright prospects for Technicolor. Our business units are well positioned to take advantage of the increased demand for original content, the strong increase in digital media consumption, and the significant growth in residential broadband access and we will take advantage of our position and be a stronger company for our employees and a stronger partner to our suppliers and customers.”
Background on How Technicolor Got Here
It is curious to us why people attribute the state of bankruptcy to a casual decision of debt and blithely disregard the broader import. Daydream with us for a moment. Why does a technology-enabled service business borrow money? It is a source funds to invest in business operations or a means to increase equity returns. If the business in the future cannot service the debt, then the business model was flawed or the market opportunity over-estimated or both.
A brief discussion on the past will help inform an understanding of the present.
Thomson Multimedia rebranded to Technicolor in January 2010. A month later Technicolor shareholders would approve a restructuring plan with creditors (stemming from events in late 2009). As part of the restructuring Technicolor divested PRN, Grass Valley, and related head-end and compressions business units. It would also subsequently sell its broadcast services business to Ericsson in 2012.
In November 2015, Technicolor closed its acquisition the Cisco Connected Devices business for €498 million and integrated into its Connected Home segment. Technicolor would next sell its Patent Licensing business and then Research& Innovation activities to Interdigital in 2018 and 2019, respectively.
To give the reader a sense of the financial profile across the past decade, below is a table with the annual revenue levels, operating margin, and net debt profile for 2010, 2016, and 2019. Managements base case forecast does not anticipate exceeding 2010 revenue levels until 2022.
Technicolor Annual Performance
Revenue (€ mil)
|Operating Margin %||
Net Debt (€ mil)
At the start of 2020, Technicolor employed 17,189 individuals across three separate divisions.
- Production Services – Provider of a full range of production and post production services for feature films, TV, advertising, and games
- DVD Services – Services for the mastering, replication, packaging, and distribution of DVD, Blue-Ray and Discs
- Connected Home – Broadband and video customer premise equipment solution provider to Pay-TV operators and network service providers
Technicolor’s annual report describes the DVD Services as a “Last-man Standing Business, in a Long Tail Business.” In 2019, the DVD Services business was 16% smaller than in 2015. Management’s base case forecast for the DVD Services business is for negative 10% compound annual growth (“CAGR”) through 2022.
Technicolor’s management views the Connected Home division with a bit more optimism given its portfolio of solutions for broadband gateways and Android TV. The optimism has Management using a base case forecast through 2022 of 0% CAGR and a high case of 3%. Connected Home has declined by 25% since the 2016 calendar year.
A large percentage of third-party observers might view the DVD Services and Connected Home divisions as going-out-of-business businesses. There is some support for this perspective based on the sum-of-parts valuation analysis commissioned by Technicolor during the restructuring. Despite Production Services representing slightly less than 25% of revenues, it was determined to contribute 75% of the value of the enterprise.
Given the disproportionate amount of value ascribed to Production Services, the remainder of the post focuses on this division.
Production Services, in contrast to the other two divisions, has enjoyed strong historical growth. For the fifteen years ending 2019 Production Services achieved an impressive revenue CAGR figure of 22%. Technicolor has been an active acquirer of production service business beginning with MPC in 2004, and continuing with Mr. X (2014), OuiDo! Productions (2015), The Mill (2015), Cinram (2015), and Mikros (2015). Even when adjusting for acquisitions the growth figure is only reduced to 19% on an organic basis.
Again, the problem with the business model has not been revenue growth. Rather, it has been the incongruence between the profitability of the revenue streams and the financing activities supporting the revenue. The Mill transaction is representative. Technicolor acquired The Mill in September 2015 for a total consideration of €253 million (1.87x annual revenue). The breakdown of the consideration was €66 million to the equity owners of The Mill and repayment by Technicolor of The Mill’s €187 million outstanding debt balance. Technicolor funded the acquisition through the combination of incremental borrowings and a rights issue to shareholders (these activities also help fund the Cisco Connected Device acquisition).
While it is easier to highlight in the case of an acquisition event, it is important to recognize it is equally true in the case of organic growth. The €108 million of revenue growth in 2019 (at 0.3% operating margin) by Production Services was supported by capital expenditures of €62 million.
Technicolor remains enthusiastic about the market environment for Production Services. Here is an except from the 2020 – 2022 Strategic Plan:
“Technicolor is well placed to benefit from the burgeoning growth of streaming platforms and the unprecedented demand for original content and is well positioned to capture outsized market share in Film & Episodic, Advertising, and Animation”
Even after the disruption of COVID, there is little denting the enthusiasm for content production growth. In Technicolor’s investor presentation from September 2020, the key mid-to-long term growth opportunity for Production Services is listed as “Capture future explosive growth in demand for premium content: film, episodic and animation.”
In the context of the current content production environment Management provided a base case forecast for Production Services of 3% CAGR thru 2022 with a high case of 10%. Using a justification of ‘streaming platform demand’ – and only a justification of ‘streaming platform demand’ – the third-party valuation commissioned by Technicolor extends this growth for an additional two years at a 6% growth figure per annum and adds two points of margin expansion.
It is important to interject a degree of skepticism about the impact of growth in the content ecosystem because seemingly all media technology businesses forecasts cite the market condition. We would remind the reader unprecedented levels of content production growth happened last decade. How then did the phenomenon impact the business environment? And absent a change in business model practices why would the business result change?
Within its Chapter 15 US filing, Technicolor describes (included below) the market impact of the past decade as having been a negative development for the business environment.
“Over the past decade, Technicolor has encountered significant and unexpected macroeconomic and industry-specific headwinds that limited its ability to generate cash flows, grow its businesses, and satisfy obligations under its capital structure.”
Had you invested €1,000.0 in Technicolor on January 4, 2010 and re-invested the cumulative dividends of €0.17 issued in the 2015 – 2017-time frame then on January 1, 2020 your investment would have been valued at just over €100 (an approximately -90% cumulative return). The maximum value of your investment was reached April 2010 at €1,231. Over the same time frame the SBF 120 (index tracking 120 most actively traded stock on Paris exchange) returned 28.5% prior to the consideration of dividends (and reached a high above 50% in late 2019). A comparison against the NASDAQ 100 is even less flattering.
The point is how an organization’s business model benefits from the market environment is the true determining factor of building value. As observed at the outset, ‘more’ has been the problem for Technicolor’s Production Service business.
COVID Impact to Production Services
For those readers viewing the discussions above as harsh, we would note Technicolor’s Management has been making similar points both before and after the COVID impact to the content production environment.
Technicolor’s Strategic Plan 2020 – 2022 released on February 13, 2020 outlined an initiative to cut €150 million of run-rate costs with €100 million coming in 2020. In late June, these goals became more than €160 million of cost savings in 2020 and €300 million by 2022. 1,300 employees were let go during the first half of 2020 and another 1,600 were scheduled to depart by the end of the third quarter. The extreme of the cost cutting has extended to a measure requiring purchase order approval by the CEO.
The February Strategic Plan cited the following key initiatives for Production Services:
- Focus on growing episodic content and continue to secure volume commitments
- Maximize potential of Indian base
- Enhance proprietary technology to drive differentiation
- Rigorous approach to business selection
As part of Technicolor’s September 2020 presentation to investors the following key initiatives are cited for Production Services:
- Exploit burgeoning demand for VFX content: secure volume agreements with key players in film and episodic
- Optimise headcount allocation to individual projects
- Advertising: improve margins/continue agency disintermediation
- Maximise use of resources in India
Those bullet points roughly group into three categories: (1) refrain from less profitability projects, (2) negotiate better business deals, and (3) deliver services at a substantially reduced cost. Also, as you can see in the consistency of the initiatives in September as in February, COVID has not meaningful adjusted Technicolor’s activities – rather accelerated in time and magnitude.
Admittedly, the present environment is making these tasks more challenging.
Technicolor was already anticipating a soft first half of 2020 in Production Services given delays associated with the Disney and Fox merger. COVID caused a much more severe negative development, pushing back most live shoots to at least October (a timeline reiterated in late July by Technicolor management).
It is worth reflecting on how fluid the situation was in early 2020. 50 movie sets stopped shipping dailies to Technicolor overnight in March. In early May on an earnings call, Richard Moat (CEO) characterized the likely timing of filming restart as follows:
“…it is very difficult to know what is going to happen with respect to resumption of filming in Hollywood. The optimists would say that it could resume in June or July. And the pessimists are talking about the end of the year with maybe the realist somewhere in between September and October. And when filming does resume, it is definitely not going to be the same as it was before.”
Due to the reliance on live shooting, Post-Production activities were immediately impacted. According to FilmLA, Q2 2020 shoot days decreased 98% in Los Angeles versus 2019 levels.
Film & Episodic VFX has a similar dependence on live shoots. Moreover, a requisite 3-4 months lag is expected from the time of return of live shoots until Film & Episodic VFX activities resume. LA film permits only resumed processing in mid-June.
The result was first half revenues in Production Services were down 34.8% versus 2019 levels. Management guidance is full year 2020 revenue levels may decline more than 50% depending on the speed filming returns.
Advertising activities fared better given the lower-levels of crew and on-location shooting required. Animation & Games, which has a negligible dependence on live shoots, grew double-digit year-over-year in the 1H 2020 for Technicolor.
Longer-term, Technicolor’s Management is not expecting peak production levels to return until the second half of 2021. “I don’t think there is going to be any catch-up effect. In my opinion, there is not going to be some sudden tsunami of work. It is going to pick up very slowly. And I think that is probably going to be into the middle of 2021 before we start to get back to any form of normality” stated Richard Moat on July 30, 2020.
What Restructuring Says about Content Production Ecosystem
The below chart is excerpted from Technicolor’s Capital Market Days. It highlights the Production Services market position across a variety of media verticals.
During Technicolor’s Q1 2020 earnings call, David Cerdan, analyst with Kepler Cheuvreux SA, inquired with management whether Technicolor’s market dominance positioned it with Studios as ‘too big to fail.’ The comment highlights the market position of Technicolor in the global media industry.
A global service provider with the above market position is now aggressively restructuring all aspects of its business from its contractual relationships to its technology infrastructure to its work environment.
Technicolor’s Management estimates 80% of the Production Services staff is now working from home. If broadband speeds in India were accommodating, then 100% of the staff would work remotely. This reflects the broader environment. Checklist item one of the LA County Department of Public Health reopening protocols for Music, Television and Film Projection reads “Any employee who can carry out their work duties from home has been directed to do so.”
Technicolor’s Management is targeting a 10% cost reduction across its vendors and is having the CEO approve purchase orders. It will spend less and on different technologies. Last year Technicolor began a strategic partnership with Microsoft to use its Azure cloud computing platform. Technicolor’s annual report cites the rationale as limiting capital-intensive hardware investments. These are significant expenditures. For the full 2019 year, a €16 million expense is attributed to IT capacity use for rendering in Production Services.
In summary, Technical is changing its business because its prior model did not work. Extending the point, the market for content production is changing because the prior model no longer works.
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