Shares of Peppa Pig maker Entertainment One Ltd (LSE: ETO) rose by 3% on Friday morning, after the company confirmed that its full-year results should be in line with expectations.
On the face of it, the numbers seem impressive. Reported revenues for last year have “almost doubled” while earnings before interest, tax, depreciation and amortisation (EBITDA) are expected to be “materially ahead” of the previous year.
I’m not totally convinced. The firm’s statement suggests to me that there’s been a sharp fall in Entertainment One’s profit margins.
If EBITDA had almost doubled, then Entertainment One would surely have said so. So I can only conclude that the increase in EBITDA is much smaller than the increase in earnings. Hence profit margins must have fallen.
Here’s what really worries me
Entertainment One is growing fast. The group’s operating profit has risen by an average of about 30% per year since 2011. However, this impressive growth hasn’t resulted in the kind of shareholder returns you might have expected.
Today’s share price of 238p is only 50% higher than it was five years ago, even though adjusted earnings per share for the year just ended are expected to be more than double 2012 earnings.
Investing in a FTSE 250 tracker would have provided a better return, as the mid-cap index has risen by 64% over the same period.
In my view, the main problem with Entertainment One is that it doesn’t generate any surplus cash. All of the group’s operating cash flow — which comes from selling its content to television networks — appears to be reinvested in acquisitions and buying new content.
This kind of growth might be attractive if the firm was only using its own cash to fund these investments. But net debt has risen from £165m to about £400m over the last three years. It looks to me as if the firm’s earnings can only be sustained with a constant supply of expensive new programming.
If this is the case, then there’s unlikely to ever be much spare cash for shareholders. That’s certainly the case at the moment. The group’s dividend of 1.2p per share equates to a yield of just 0.5%.
Although the stock may look cheap on 12 times forecast earnings, I feel that future performance may disappoint. I’d sell into the current strength.
I might buy this stock
Television group ITV (LSE: ITV) has some similarities with Entertainment One. ITV has invested heavily in acquiring content producers over the last few years, in order to reduce its dependency on uncertain advertising revenues.
This strategy has been successful for ITV, but I think that’s partly because it’s able to sell the same content twice — once to advertisers on its own channels, and then again when it sells programmes to other television networks.
ITV is certainly far more profitable and cash generative than Entertainment One and has much lower levels of debt. The group’s operating margin was 19.7% last year, compared to 9.4% at Entertainment One.
Shares of ITV have risen by 140% over the last five years, but they’ve pulled back a little over the last 12 months. With a forecast P/E of 13 and a prospective yield of 3.9%, ITV stock now looks quite attractive, in my opinion.
