NOOF -- Final

The key bearish case for NOOF is that the company has no bargaining power against the cable/satellite companies and any above average profit margins will be constantly eroded which means the stock deserves a low multiple. Also, the company is allocating a lot more cash to the very volatile content creation business essentially trying to build a tiny movie studio. Due to the nature of the “content creation” business, movie studios have generally been very poor investments.

The key bullish case is the recent positive earnings news and trading at 7.3x EV/FCF the company continues to look cheap. Also, all indication point that NOOF is the premier name in the business and should continue to win distribution partnership with brand owners like Penthouse.

Based on my estimates of FCF, the $0.50 per share annual dividend is safe. However, there will be nothing left to reinvest in the business which stifles future earnings growth and any future dividend increase.

Keeping in mind that NOOF is hostage to the cable/satellite companies, I have a hard time envisioning any valuation expansion from current levels. Even if growth returns to 10% annually and I assume a multiple of 10x FCF/EV in 3 years, I get an implied 3 year total return of 80%.

While 80% upside over 3 years certainly looks attractive, the downside is also substantial. I think NOOF will continue to face both long term and short term revenue pressure from its other 3 customer who will expect to renegotiate their contract and get the same deal as EchoStar. Any abnormal earnings return will be taken away by the network providers.

Adding to this company specific issue is the fact that traditional media companies will continue to face pressure from online players and while they will adjust their business models I have a hard time seeing much valuation expansion in a more competitive operating environment.

Simply stated, I don’t feel the downside justifies the upside and since I am not willing to buy more shares at this price I have now choice but to take the loss and liquidate my position.

* DISCLOSURE: I or accounts I manage may be long or short any and/or all stocks mentioned in this post. This is not a recommendation to buy or sell any security. For informational and educational purposes only.

NOOF -- “Da Bulls” (improved earnings + very low valuation)

The Bull case for the stock is that there has been some positive earnings news recently and the fact that the stock continues to look tantalizingly cheap based on free cash flow.

NOOF has come off the $4 lows on the recent positive earnings news released on Feb. 5. Total sales were up 8% while the market expected a double digit slide experienced in the previous two quarters. EBITDA was up slightly which compares favorably to the 40%+ decline in EBITDA experienced in the previous two quarters.

Looking at the revenue breakdown in detail, one notices that the company’s largest business – Pay TV –is still experiencing double digit revenue declines. The upside came entirely from huge increase in revenue in the Film Production group as the company completed a “producer-for-hire” arrangement which was not there last year.

The CEO, Michael Weiner, stated on the latest conference call that he believes that the YoY revenue decline in Pay TV is over and next quarter will show positive YoY revenue growth. This implies that the company has been able to offset the re-rate with new products which is a very good sign.

The stock also continues to look very cheap despite the huge decline in profitability. Here is how I am looking at free cash flow:

Reported EBITDA $5.43M
Adjust for large one time deliverables in Film Group $(0.4M)
CAPEX $(0.5M)
Tax $(1.8M)
FCF* $3.0M
Annualized FCF* $12M
EV / FCF 7.3x
Cash Yield 14%

*Excludes “Content Amortization” expense and “Cash Investments in Content”. NOOF uses “film accounting” where they capitalize NOT expense the cash costs spent to produce films and than expense it over time in the form of amortization.

There has been some insider purchases recently as 3 different directors bought a combined $50K of NOOF on the open market. It should be noted that one of the largest shareholders, an activist fund called Steele Partners, has been dumping shares recently.

If NOOF can string together a few consecutive quarters of free cash flow growth, the stock would look even cheaper.

* DISCLOSURE: I or accounts I manage may be long or short any and/or all stocks mentioned in this post. This is not a recommendation to buy or sell any security. For informational and educational purposes only.

NOOF -- “Da Bears” (The Hammer Comes Down)

The Bear case is simply that NOOF has no bargaining power with its distribution partners – the cable and satellite companies – and future earnings will continue to be eroded by tough negotiations with these network owners.

The hammer came down in the first fiscal quarter of 2008 (6/2007) when the company reported that total revenue fell by 21% and decline by 17% in Pay TV segment, the company’s largest and most profitable. On top of the sharp revenue decline, administrative expenses actually INCREASED so EBITDA fell by a staggering 49% and operating eps declined by 47% to $0.08 per share (eps declined slower than EBITDA due to slightly lower depreciation).

The market did not take this news lightly and the stock cratered from approximately $8.50 to $6 in the first two weeks of August.

Why the sharp drop in revenue and earnings?

The company renegotiated its contract with EchoStar and under the new terms they will be receiving less of the revenue split. While not much more about the deal other than the 3 year duration was announced, it appears that EchoStar was able to increase its share of the split by 20%-25%.

Because the company has such high operating leverage—high operating leverage means that a larger portion of each dollar of revenue drops to the bottom line—a 20% decline in revenue caused a much larger decline in operating earnings.

The following quarter (second fiscal 2007) the performance was not much better. Revenue was down 23%, EBITDA fell by 40% and eps was down 40% YoY. On a free cash flow basis, NOOF earned $2.8M from $5.6 generated the previous year.

The recent fundamental and stock performance has clearly highlighted NOOF’s Achilles heel. Despite all indications that NOOF is the premier adult entertainment content distributor in the business, the company has no pricing power with its distributors. Future above average earnings will continually be eroded by cable/satellite operators.

* DISCLOSURE: I or accounts I manage may be long or short any and/or all stocks mentioned in this post. This is not a recommendation to buy or sell any security. For informational and educational purposes only.

NOOF -- First Signs of Future Problems

Looking back, the first signs of problems to come appeared in fiscal 2007 (fiscal 2007 ended in 3/2007 calendar) despite the fact that by all indications fiscal 2007 was a great year for NOOF. Total revenues were up 35%, EBITDA increased 19% and the stock had a total return of 26% (3/2006 to 3/2007) and traded above $10 for a little while.

So where is the problem?

Per the 10K, total Pay TV revenue in fy2007 grew by 9.5% while the number of households reached increased by 39%. While you can’t simply assume that total Pay TV revenues and network households are immediately and perfectly correlated but such a huge divergence in reachable households and revenue should have set off warning bells that NOOF has no pricing power.

In the 2007 10K, NOOF stated that network households increased due to addition of new channels to a current platform (good sign) but they also renegotiated a rate split in place since 2000 with that platform provider.

Clearly, one of the bullish aspects regarding NOOF at that time was the valuation. Based on the stock price in June 2007 (when the fy2007 10K was filed) and the last 12 months of free cash flows the stock looked abnormally cheap:

Market Value at $8.5 per share = $209
Enterprise Value = $181
Latest 12M FCF = $22 (EBITDA-Cash Tax-CAPEX)
EV / FCF = 8.2x

When taking into account the fact that NOOF has grown revenues and EBITDA in each of the last 4 years and that average EBIDA margins for the last 4 fiscal years were north of 40%, NOOF seemed like an abnormally cheap stock.

* DISCLOSURE: I or accounts I manage may be long or short any and/or all stocks mentioned in this post. This is not a recommendation to buy or sell any security. For informational and educational purposes only.

NOOF -- First Look

Share Price: $4.5
Market Value: $107M
Enterprise Value: $88
Investment Type: Value Investment

New Frontier Media, Inc (NOOF) is one of the largest distributors of adult entertainment (aka porno) through U.S. cable and satellite networks. The company estimates that it can reach almost 140 million households. Recently, NOOF has started creating its own erotic and mainstream content.

The company is made up of several business lines:

1) Pay TV (recently renamed “Transactional TV”) has historically been NOOF’s largest source of revenue and income. This business unit has provided content for cable/satellite operators either in the form of subscription channels or Video-On-Demand (VOD). The company makes money buy paying the content providers and splitting the revenue with the network operators. It’s key to understand that historically NOOF has not created the content, primarily serving as a middle man between the content creator and owner of the distribution network.

2) Film Production is a new business segment for NOOF, created almost exactly two years ago when the company acquired MRG Entertainment. This group creates original erotic content, acts as a representative for content created by others (porno agent), or as a “producer-for-hire” hired by major studios to deliver a movie or TV series. NOOF paid $21.1M for MRG in an all cash transaction in February 2006.

3) The Internet Group does exactly what the name implies – sell porno on the internet—and is the smallest revenue and profit generator for NOOF. NOOF provides the large cable/satellite networks with new channels and selected content and splits the revenue generated based on negotiated rates. Growth comes mostly by adding new channels to current networks.

Historically, NOOF has not created the content or own the network allowing for very little working capital and Capex costs. Due to low investment requirements, the company has produced an average ROE over the last 4 years of 27%. The other side of that coin is that NOOF has very little bargaining power when renegotiating revenue splits with the network providers.

I purchased NOOF in 3 parts between June 2006 and May 2007 for an average cost basis of $9.09. In that time I have received $0.875 in dividends (one of my 3 purchases occurred after the special dividend of $0.60) which brings my costs basis to $8.215. With the stock so much below my initial purchase price I can no longer just hold it, I have to make a decision to either buy more or start liquidating the position.

* DISCLOSURE: I or accounts I manage may be long or short any and/or all stocks mentioned in this post. This is not a recommendation to buy or sell any security. For informational and educational purposes only.

Thornburg’s Pain will be Chimera’s Gain

Thornburg Mortgage (TMA) has declined from $3.56 two days ago to $1.65 today. The stock traded at $26 in May 2007. The company is in technical default and it appears to be heading towards an actual default.

Thornburg Mortgage has historically been one of the best managed mortgage REITs in the world. These have always owned AAA rated paper and did not change their stripes in the go-go days of the housing market to boost short term profits. The management is dedicated, transparent and has put their own money on the line by buying in the open market.

There is no better way to describe what is happening to TMA other than a Black Swan event. Make no mistake about it, we are witnessing a dislocation in the credit markets that can be best described as tectonic plates shifting against each other and causing all kind of havoc with TMA caught in the middle.

What is happening to TMA?

The market for non-agency paper is all but closed. Trades that are completed price these mortgages at lower and lower levels. That means that large holders of non-agency paper—like TMA which owned a $36B portfolio of non-agency, AAA rated, ARM loans at the end of the last quarter—have to constantly mark-to-market at lower prices. At some point the portfolio gets marked so low the people lending money to TMA get scared and start asking for some of it back.

This is where things get interesting, since the repo provider can either try to work out a deal with TMA and avoid a forced liquidation or ask for their money back NOW (a.k.a. margin call).

It appears that one or more of TMA’s lenders got spooked. Faced with a margin call, TMA was than forced to sell at the worst possible time which caused further price erosion and decline in the stated value of the rest of their portfolio. JP Morgan may have dealt the fatal blow, putting the company into technical default and triggering a waterfall of other debt covenants. The rating agencies lowered their ratings on the company (not the mortgages they own) further into junk making it impossible for the company to borrow more money.

So how does all this effect CIM?

Well, for every seller forced at gun point to liquidate there is a buyer with cash and time. When TMA and others--and there are many others, just today it was announced that UBS is dumping its Alt-A loans and Citi will be liquidating $45B in mortgages over the next 12 months--are selling CIM will be buying at better spreads than they were even a month ago.

The short term price drop of CIM and other mortgage REITs does not change the thesis I laid out in these posts.

CIM is still managed by some of the smartest people in the business. They are still one of the only buyers in the market and can set their own price. They have only been in operation since November 2007 and still have a very small portfolio that was already bought at the discount. And now CIM is trading at below book value of $14.25.

I have added to my initial position in the “Best Ideas” portfolio as well as my personal accounts. I will continue to add to my position if the stock continues to fall.

* DISCLOSURE: I or accounts I manage may be long or short any and/or all stocks mentioned in this post. This is not a recommendation to buy or sell any security. For informational and educational purposes only.