Shemaroo Entertainment Valuation: The Netflix of Bollywood?

Gone are the days when Indian families rented out VCDs/DVDs on a quite Sunday afternoon and sat down to watch a movie with samosas and hot chai. Every day, more and more set of eyes are turning towards the internet. That online content making and distribution is an emerging macro trend in India is undeniable. Shemaroo Entertainment is a niche player in such a niche industry. Does the market under-appreciate its merits or does it overshoot its possibilities? Let's explore these questions further.

The Company

Shemaroo Entertainment's journey began over 5 decades ago when they started as a book circulating library. Today, they are an established filmed entertainment content house in India, active in content acquisition, value addition to content and content distribution with a large content library of over 3400 titles. Shemaroo has successfully transformed itself from a family-run enterprise to become a professionally managed Company.

Shemaroo commenced India's first video rental business and thereafter forayed into distribution of content through the home video segment in the video home system (“VHS”) format. Over the years, the company has successfully adapted to changing content consumption patterns by expanding into content aggregation and distribution for broadcasting on television platforms. They are continuing the expansion into new media platforms.

The name 'Shemaroo' is a play on the words 'Shethais' and 'Maroo', the two families which started the original book library in 1962. Apart from their core business of acquiring, curating and selling content, Shemaroo also runs a successful YouTube channel with a little over 9 million subscribers.

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The Industry

This article from Bloomberg Quint offers insight into the Content Industry in India. The 'trend' is very much palpable:

A direct quote from the article:

The winners: providers of over-the-top media streaming services like VOOT, Hotstar, Netflix, Amazon Prime Video and others. There are over 30 video OTT platforms in India that offer paid subscriptions. Digital subscription income rose 50 percent to Rs 390 crore in 2017. That’s expected to hit Rs 2,010 crore by 2020, the report said. “With data charges at their lowest ever rates, consumers are beginning to consume subscription content, particularly when OTT services are bundled with data packages.” Streaming services too are preparing to cater the growing appetite. A number of global and local players have struck distribution partnerships, while Netflix is even considering setting up studios in India. The differentiator in the already crowded space, EY said, is going to be who can provide more original localised content. Three out four new internet users in India will be from rural areas who will consume data in local languages.

The last few lines especially point towards Shemaroo's potential to become successful, because the company is focused on becoming the Netflix of Bollywood. So, has the market already priced in these positives or is Shemaroo biting off more than it can view (*cough*)? Let's take a look.

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The Numbers

This is usually the boring part where I enter numbers from the company's financial statements into my model, but with Shemaroo we are met with a roadblock.

Inventories

In 2017-18, out of the Rs. 734.79 Crores worth of Assets held by the company, Rs. 529.71 Crores worth of Assets are 'Inventories' alone. That's almost 72% of the total Assets of the company. This warrants a special investigation in order to understand the true nature of this Asset.

The company's 2016-17 Annual Report offers some insights:

It is clear now that 'Inventories' are their Copyrights, Movies under Production (Similar to Capital Work-in-Progress, I presume) and DVDs/VCDs. This is weird at best. Content companies usually capitalize their 'Content'-- that is to say, Copyrights is to a Content company what Plants & Equipment is to a Manufacturing company. Won't you find it weird if Tata Steel built a new plant and categorized Rs. 1000 Cr (Say) as 'Inventory'? In order for this classification to make sense, we have to make the assumption that the company is going to act as content distributor alone (As it has done in the past), thereby making sure that their 'inventory' is dispensed within a year or so. However, the fact that they aim to become a Content Host themselves, brings several questions upon their Accounting Practice.

On top of this, investors have to rely of the management's projection of how much a specific content is worth and whether the cost of acquisition makes sense at all. Unless someone is an insider in the industry, it would be very difficult to make an objective decision on this topic.

So, for the sake of making this Valuation simple, I'm going to create 3 over-arching scenarios and assign probabilities to them:

Scenario 1 (30%): The management is excellent at acquiring good content at a discounted cost. In this case, a percentage of their inventory -- say 25% is considered Cash Equivalents.

Scenario 2 (50%): The management has no special skills at acquiring content at a discounted cost. Nothing changes. Everything is taken at face value.

Scenario 3 (20%): The management is poor at acquiring content at a discounted value, so much so that they over-pay for it, by say 25% (The same percentage as in Scenario 1).

This is how it would look like on an aggregated basis:

Not only will I include this amount as 'Cash Equivalents' in my model, but I will historically consider Cash Equivalents to be 2.5% (1324.28/52971.00) of Inventories. This assumption would impact my calculation of Capital Turnover, which we will use later in the model.

Minority Interest

Shemaroo also holds stakes in certain companies which, directly or indirectly, contribute to its bottom-line. Hence, in order to ascertain the value of Shemaroo itself, we should remove the Minority Interest of Shemaroo's stake in these companies (i.e. The Value of the stake which Shemaroo does not hold in these companies):

With those out of the way, let's see how the numbers look like based on Shemaroo's Q4 Results for 2017-18:

If you'd been following my Valuations, you'd know that some of the numbers here, such as the Risk-free Rate, Company Beta, Industry Beta, Industry D/E and Indexed Returns are obtained through simple online searches.

I usually include a section called 'The Capital Conversions' after entering the financial information. But Shemaroo has no investment specific to R&D, very little long-term debt, no long-term lease commitments and no outstanding Stock Options. So, I'm going to go ahead and skip right to the section after that: the assumptions.

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The Assumptions

This is how my story for Shemaroo Entertainment's future unfolds as numbers:

Here is my further substantiation for some of the key assumptions:

Sales Growth and Operating Margin

Since Shemaroo wants to build itself into the 'Netflix of Bollywood', it is only fair that the company will grow and earn like Netflix itself -- if not immediately, at least in the coming years. It's also reassuring to know that Netflix pretty much started out the same way as Shemaroo, renting out movies DVDs at retail outlets. Let's take a quick peek at how Netflix's Sales Growth and Operating Margin have evolved over the years:

(Source: GuruFocus)

In essence, Netflix has grown at an amazing pace in the past few years, at the cost of sacrificing its Operating Margin. I have simply tried to emulate this with Shemaroo as well, making it grow substantially from its long-term average Sales Growth (17.54% for the last 7 years) to 20%-25%, only to later stagnate around 5% -- the long-term expected growth rate of the Indian economy.

In the Terminal Year, the 13% OPM matches the average current OPM of Netflix and Amazon Prime. Once again, a valid assumption given what Shemaroo is trying to achieve.

Tax Rate

The Corporate Tax Rate has been reduced to 25% in India. However, since Shemaroo already pays around 35% tax when the Corporate Tax Rate is around 30%, it's not too far-fetched to assume that it will pay 30% when it is 25% in the next several years. The additional tax expense are possibly due to some kind of additional duty or cess.

In the Terminal Year, the Corporate Tax Rate drops to the Global Average Tax Rate (22.96%), along with an additional 5% as discussed above.

Capital Turnover

Since we've already watched two Content giants, Netflix and Amazon Prime, evolve over the years, we know that it's a cut-throat industry. The chances for improving one's Capital Turnover is slim to none. So, I've assumed Shemaroo's Capital Turnover to be stable at 1.15, which is roughly its long-term average Capital Turnover (Considering our above assumption on Inventories).

Depreciation

Once again, 1.45% is Shemaroo's 7-year average Depreciation-to-Sales figure. Since the company isn't Asset-heavy, I'm not going make any additional assumptions here and let it be the same until kingdom come.

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The Diagnostics

The Diagnostics section is a control section of sorts, which tells you whether any of the assumptions are over the line (or under).

Since there are no red flags, I'm going to skip right head.

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The Cash Flows

This is how Shemaroo's Cash Flows would look like, provided the assumptions I made earlier were to pan out exactly:

Not much to see here, but observe. Notice the periods where there are negative Free Cash Flows? Those are the periods when Shemaroo will face stiffening competition from the already crowded Content market. According to our assumptions, Shemaroo makes it out, but not without its fair share of bruises (Which even the giants such as Amazon Prime and Netflix have gone through).

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The Value

Here we are, at the fag end of our endeavor. A minor assumption I made here is that Shemaroo has a slightly high chance (10%) of failure. Let's face it. Shemaroo is sailing on uncharted waters. We're only hoping to see the Netflix of Bollywood. The chances of a catastrophic failure, while not very high, still exist.

Provided a small Margin of Safety of 5%, I believe that Shemaroo Entertainment is fairly valued at around Rs. 483 per share. At the moment of my writing this, the share trades at around Rs. 460, signifying roughly a 5% undervaluation.

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The Sensitivity of Value

A stress test, however, paints a gloomier picture. The 'Sensitivity of Value' tool in my model simulates various Cost of Capital and Growth Rate figures and assigns a range of values to the stock.

The Median Value, Rs. 276, shows that Shemaroo's stock is substantially overvalued. Why the discrepancy between the last section and this one? Well, the Content business is inherently risky. Hence the Cost of Capital is bound to be higher. If Shemaroo somehow manages to mitigate the inherent risk in the industry, it would make sense to consider the values to the right-hand side of the tool.

But wait, this tool is far from being the perfect solution to account for randomness in the model.

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The Monte Carlo Simulation

In a Monte Carlo Simulation, I will simulate a lot of our assumptions (Sales Growth, OPM, Capital Turnover, Cost of Capital) to the extent of +/- 15% (A nominal spread). Then, using a Normal Curve, I will substantiate the Value of Shemaroo Entertainment once and for all. Here is how the output looks like:

After some excel magic, we end up with this:

These are the range of Values for Shemaroo, given random up-and-down fluctuations in its Growth, Reinvestment and Risk assumptions. If you have some insight in to what a Normal Curve represents, you will appreciate that this is what the above picture shows (Behold my awesome MS Paint skills and despair):

First off, the Values are the far end of the graph, < Rs. 303 and > Rs. 703 are the wrong Values to assign to Shemaroo Entertainment (Meaning you should consider Buying/Selling immediately if and when the stock reaches these Values respectively).  Anything below Rs. 403 is the 'definitely undervalued' territory and anything above Rs. 603 is the 'definitely overvalued' territory. The most accurate estimate of Shemaroo Entertainment's Value is Rs. 503 (Which is a 8.5% undervaluation when compared to the CMP of Rs. 460). If you require a substantial Margin of Safety, you should purchase Shemaroo Entertainment between Rs. 403 - Rs. 503 (The higher the Margin of Safety required, the lower should be the purchase price). Likewise, if you are optimistic about Shemaroo Entertainment's future, you could consider buying anywhere between Rs. 503 - Rs. 603, but you would also risk overshooting its Value.

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Don't trust the numbers? Think I missed something crucial that could dramatically alter the Value of Shemaroo Entertainment? Fret not. You can download the model and try changing the inputs for yourself, based on your own story:

(Download Numbers & Narratives - Shemaroo Entertainment Limited)

If your Value differs drastically from mine, do let me know in the comments below. That could make way for an interesting conversation.

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That's all I've got to tell you about Shemaroo Entertainment (At least Value-wise, anyway). Be warned that Shemaroo hasn't nearly begun implementing its Business Model. We have no way of knowing whether it will become successful or not. Considering how its Content and Copyrights form a major part (70%+) of its Assets, Shemaroo's success will be attributed, on a large part, to how effectively its management can sell off acquisitions quickly or start monetizing them (By streaming them on its own platform, for instance).

While the demographic lottery and the business environment is on Shemaroo's side, the company is yet to prove how a David such as itself will fend off Goliaths such as Netflix and Amazon Prime, which are already growing their roots deep inside India's 250 Crores odd, content-hungry eyeballs.

Could we witness the rise of Bollywood's own Netflix or would relentless Capitalism claim yet another victim? We will just have to wait and watch.