Thursday, October 5, 2017

Special Update: DHX Media 5.875% Convertible Debentures (DHX.DB)

Here at the Canadian Convertible Debentures Project, we've been writing about DHX Media's 5.875% convertible debentures since May 19.  This was about a week after the Halifax-based children's media content and brands company announced the US$345 million acquisition of the entertainment division of Iconix Brand Group Inc., which effectively brought an 80% interest in Peanuts (i.e. Charlie Brown and Snoopy) and 100% of Strawberry Shortcake under DHX's control.

From the beginning, we thought the deal was transformative.   As such, the 5.875% convertible debenture issue associated with the acquisition has been highly anticipated, and if you've been a regular reader of this blog (sidebar: we thank you for your loyalty!), you know that the issue has been consistently featured in the Top-5 of our Peanut Convertible Debenture Power Rankings throughout the summer.   Well, it's been a long wait, but the issue has finally started trading on the TSX, hitting the market on October 2 with the ticker of DHX.DB.


In our last update, which was current to September 22, we ranked the DHX 5.875% convertible debenture at #3 in our coverage universe.  However, in the relatively short period of time between the the update and today, a surprising amount has happened with DHX, all of which has an impact on the convertible debenture issue. Consider:
  • First, on September 19, DHX's common voting shares (ticker: DHX.B) hit a 52-week high of $7.33.  Presumably, shares of DHX.B had been trading higher in anticipation of good earnings and lofty expectations for Peanuts and Strawberry Shortcake.
  • Unfortunately, on September 27, DHX released its financial results for their 2017 fiscal fourth quarter and year and, to be blunt, the results were terrible.  Full-year revenue declined slightly from $304.8 million in FY2016 to $298.7 million in FY2017, and EBITDA missed expectations by a country mile, tumbling from $103.7 million to $87.3 million.  However, the company did increase its dividend to 2 cents per quarter.
  • On September 28, analyst downgrades and price target slashes ensued. DHX.B got crushed in trading, and at one point the shares traded at a 52-week low price of $4.75.  DHX.B had essentially taken a complete 180-degree turn from the week prior. 
  • At market open on October 2, the 5.875% convertible debenture (DHX.DB) was made available for trading on the TSX.  So far, liquidity for the issue has been quite decent, which is allays our previous fears that liquidity for the issue might be limited.
  • At 2:18pm (EST) on October 2, all exchange-listed securities of DHX were halted from trading.  At 2:45pm, it was announced via press release that the company had initiated a strategic review to "evaluate potential strategic alternatives focused on maximizing shareholder value. These alternatives could include, among other things, the sale of part or all of [DHX], a sale of some of the assets of [DHX], a merger or other business combination with another party, or other strategic transactions."
This is a lot to digest.  Obviously, the market clearly views DHX as a "show me" story, and the market appears skeptical of the company as the common shares (DHX.B) closed today at $5.00 a share.  Here are our thoughts on the situation and the 5.875% convertible debenture:
  • The earnings news had me feeling a little bit like Charlie Brown after Lucy pulled away the football.  It was a big miss, and management copped to it.  The company has been very acquisitive in recent years, and the results (which, importantly did not include Peanuts or Strawberry Shortcake, as that deal closed on June 30, the last day of DHX's fiscal year) raised questions on management's ability to execute on its suite of brands and assets. 
  • This said, we maintain that Peanuts (and to a lesser extent, Strawberry Shortcake) are transformative assets, from which material licensing revenues and cash flow can be derived.
  • The open question is whether management can execute efficiently on the integration of Peanuts and Strawberry Shortcake.  The market currently seems to lack confidence in management, and is also concerned about the amount of leverage in the company.  
  • Notwithstanding the aforementioned strategic review, assuming the company continues with its business with current assets intact, it will need to wring out the synergies it previously promised in conjunction with the Peanuts acquisition and rapidly pay down debt.  If it can succeed on doing this, the underlying common shares of DHX should rebound nicely. 
  • Announcement of the strategic review this soon after the Peanuts acquisition was surprising.  On the upside, a sale of the company could fetch a premium given the space the company operates in.  There is a definite demand for the type of children's media content that DHX can deliver, and there should be several potential suitors (e.g., Bell, Rogers, Shaw, Disney, Netflix).  DHX has significant institutional shareholder ownership, and may have been nudged into conducting this review.
  • There are varying estimates as to what DHX would fetch in sale if it were sold today. Canaccord Genuity indicated that a sale could be as high as $8.55 per share.  A Globe and Mail article quoted figures between $5.50 and $8.50 a share.  For what it's worth, we would ballpark a sale price in the $8 to $10 range given DHX's unique stable of assets, but this is just our (very) rough estimate.
  • The strategic review throws a bit of a monkey wrench for investors in the 5.875% convertible debenture.  According to the indenture for the convertible debenture, in a change of control situation, the convertible debenture is redeemable at par ($100.00) plus accrued interest.  As such, if DHX is sold for an amount that is less than the debenture conversion price of $8.00, there could be some downside risk for a debenture-holder that purchased his or her position at a premium to par.  
  • We've run the numbers through our quantitative model for the convertible debenture and, current to today, October 5, we get a theoretical model price for DHX.DB of $110.18.  In review, DHX.DB closed today at $100.00 even, the annual coupon is 5.875%, the issue has superior redemption options (from the perspective of an investor) when compared to the standard Canadian convertible debenture issue, the conversion price is $8.00 a share, and the DHX.B common shares closed at $5.00 a share.  As such, DHX.B needs to move up 60% from current levels to hit the conversion price of the debentures.
  • In spite of DHX's difficult fiscal 2017, we still maintain that DHX has one-of-a-kind media content assets, and that Peanuts is a once-in-a-generation asset.  As such, we think there is significant value to be unlocked in both the common shares and the convertible debentures despite the risks.  In the past, after its acquisition of Cookie Jar Entertainment (i.e., Caillou), DHX management successfully de-levered the balance sheet so there is precedent for this type of execution in the company.
Bottom line: in crisis, there's opportunity.  We've initiated a position in DHX.DB at $101.00, and also retain a long position in the common shares (DHX.B).

As always, remember this blog is for information only.  Please remember to consult a professional investment advisor before making any investment decisions.

Picture of the Day

http://www.dingobear.com
Snoopy to the rescue.  For DHX Media's sake, let's hope so.  Saskatoon, Sasktachewan. Copyright © 2013 Felix Choo / dingobear photography

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