Weak Numbers on account of overall ad revenue decline by 3.6%. Increase in employee cost and publicity expenses leads to losses.

Market Cap 24,927 Cr
CMP 260
P/E 31

Key Highlights -

·        Ad-Revenue segment faced a decline due to viewership loss, removal of ZEE Anmol from Free to Air (FTA) and lower ad spends.

·        EBITDA margin at 14.7% declined by 6.1%. ZEEL has changed amortization policy for music rightsto 10 years (in line with global standards, as per management) from 3 years. Reducing content costs and increasing EBITDA by 32 Cr.

·        PAT declined due 46.6 Cr exceptional items related to merger and debt service guarantee.

Management Outlook -

·        ZEEL will be exclusive TV destination for ICC events, in deal done with Disney+Hotstar.

·        Management guided on merger with Sony to be completed by FY23, with shares being delisted for 5-6 weeks.

·        Management doesn’t expect to be around earlier 24-25%, while Zee5 loss margins to continue in H2FY23.

Movie business dragging margins low, management guided on reallocation to higher margin movie language segment.

Event update:

The Board of Directors of ZEE Entertainment Enterprises Limited (ZEEL) unanimously provided an in-principle approval for the merger between Sony Pictures Networks India (Sony India) & ZEEL. Sony India will also infuse capital for pursuing growth opportunities.

Based on the merger ratio, 47.07% of the merged entity will be held by ZEEL shareholders and the remaining 52.93% by Sony India’s shareholders. In a statement, Zee said its board has evaluated the merger not only on financial parameters, but also on the strategic value which Sony brings to the table. The board concluded that the merger will be in the best interest of all the shareholders & stakeholders.

Zee entertainment stock recorded a steep decline of 31% on Friday post an article in The Wire, which alleges Zee’s promoter’ Essel group is associated with Nityank Infrapower. The company is currently being probed by Serious Frauds Investigation Office (SFIO) for depositing over Rs 30 billion in cash during or after demonetisation.

Zee's response to the article: Zee's management stated Nityank is an independent company and does not belong to either Zee or the Essel group. Zee is also not involved in the ongoing SFIO investigation into Nityank.

 Essel group has also initiated a legal action and filed defamation case against 'The Wire'. It plans on pressing criminal charges against 'The Wire'.

Risk of pledged shares being invoked: Essel Group have pledged 59% of their ~42% ownership in Zee to group lenders. While promoter pledging of Zee’s shares is not new, its rise from 42% five years ago to 59% in Dec-18 and Zee’s stock price fall have aggravated risk of pledges being invoked.

Zee’s management mentioned there might have been some invocation by lenders, however it does not have details on the sale of pledged shares. It also believes the sale was majorly driven by Futures and Options, as delivery percentage was 25% of volumes traded.

Deleveraging plan: The good news for investors is that promoters are already close to a stake sale, which should help bring down the promoter group’s leverage significantly. Zee’s CEO said the group is working on selling three infra assets (one deal is almost done). The deals are expected to realise Rs200bn of EV and Rs80bn of equity value. Sale of the Infra assets would remove a significant part of the pledge, only a small amount would be left to take care of.

Promoter's strategic stake sale: Zee promoters/Essel Group in Nov-18 had also announced plans to sell up to 50% of the 42% ownership in Zee Entertainment to a strategic partner which should further aid deleveraging at the group level.

Zee is in active dialogue with two strategic partners one being Domestic. However, it prefers to have a foreign strategic partner, which will give access to international markets. Talks are at an advanced stage, and management are confident of meeting the deadlines of March/April ' 2019, with possibility of early announcement.

Though strategic stake sale is being done to bring down group level debt, it could be a blessing in disguise if Zee gets a partner to scale up its digital piece.

Impact on stake sale: The management highlighted they have not had discussions with interested parties post the sharp fall in Zee's stock price. They believe Friday's stock price movement would not have a bearing on the stake sale process as fundamentally nothing has changed in the company.

Business Fundamentals remain intact

1.       Zee Entertainment has recorded a 19% YoY growth in revenues for 9M FY19

2.       The company expects its ad revenue to continue to grow at a robust pace ahead of industry growth of 12%

3.       It expects subscription revenues to grow in the low teens (below the current run rate of mid-/high teens) as it expects the new tariff order to affect near-term subscription revenue.

4.       Its new investment ZEE5, its digital platform progresses well. It has 56.3mn monthly active users spending 31 min/day on it, and it has launched 31 original content shows till Dec'18. It expects to launch 72 new shows in FY20.

5.       The company has maintained its EBITDA margin guidance of 30%+ despite continued heavy investment in ZEE5 as Digital content creation is front loaded till a library gets created

We believe the promoters' intention to sell up to 50% of their shareholding to a strategic partner is a big positive for minority shareholders and will act as an important catalyst in rerating of the stock. The Group’s Chairman Subash Chandra has also reiterated in his open letter that all group companies are performing well at an operational level.

Thus, we advise customers holding Zee Entertainment not to panic and to continue holding the shares. However, we believe just like margins were kept high, are there some other things done to keep Zee highly profitable. Thus, investors are advised not to rush to buy the stock till clarity emerges.

For more details on how pledging affects investors read, ‘How to Choose a Good Stock: Look at Pledging of Shares to avoid Losing your Money’

Zee Entertainment Enterprises reported 15% growth in revenues and 30% in earnings. This was aided by lower base year. But still it is very impressive.

We like Zee Business as it has sticky viewership, scale to produce content, good lingual subscriber base and fixed cost model. Zee’s operating leverage comes from advertising revenues which means that revenues directly add to profits as there is not incremental fixed cost for Zee to advertise. Despite making losses in digital business, the company has been able to maintain its EBIDTA margins thanks to operating leverage from advertisement revenues.

Will new digital library ruin Zee’s future prospects?

i) Cost: First advantage for Zee’s viewership is low cost. TV provides very low cost for entire family viewership ~ Rs. 150/month. Besides, there are no internet charges. 1 Hour of content viewing consumes 1 GB data. Even after considering Jio cheaper plans, just 1 hour of entertainment would cost very high for an average Indian Household.

ii) Content library: Zee has existing content library in hindi and regional languages. Barring Urban educated class, most of the Indian consume data in Hindi or regional languages. Netflix, Amazon, etc would take time to scale up as content creation takes time and burning cash. Zee already has scale and agility to produce good content till the time others roll out new series. This will make Zee one of the strong contenders in digital space too.

iii) Advertising Cash Cow: Advertising revenues from TV broadcasting provides cash flows to fund digital content creation which bodes well for Zee. Other players have to rely on subscription revenues only. If Zee execution well on content creation, it will remain strong player in India.

Considering the above parameters, we believe Zee can withstand competition and new technology. We continue to be positive about Zee but current valuations are already factoring the most optimistic scenario.

Excerpts from Zee Entertainment Enterprises (ZEEL) annual report:

Zeel is a worldwide media brand offering content in multiple languages, with a strong presence in 171 countries and a total viewership of over 1 billion people around the globe.

…[Zeel] it is amongst the few brands from the emerging markets to have gained worldwide traction.” - STEPHEN MEZIAS, PROFESSOR OF ENTREPRENEURSHIP AND FAMILY ENTERPRISE AT INSEAD

Dr. Subhash Chandra says, “Today’s media environment has evolved dramatically - with the proliferation of multiple channels on one side and increasing number of viewing platforms on the other. Yet ZEEL’s objective remains providing viewers with high-impact entertaining content that enables happier lives.

In the digital space it is no longer about just viewing content on multiple devices. On-demand viewing patterns have resulted in newer content formats, crisper episodes and differentiated content packaging tailor-made to audience preferences.

[India] has an attractive GDP growth rate and rapidly growing disposable incomes. However, the share of wallet that entertainment commands today is lower than the global average presenting a great opportunity for growth.

The introduction of BARC has been a welcome addition to the Indian Media Industry. Rural audiences who represent a significant chunk of the population are included for the first time in the viewership ratings. This is an important reset for all players as strategies are being revisited or drawn afresh.”

Puneet Goenka, MD & CEO says, “[ZEEL] We intend to concentrate on the entire entertainment value chain of content creation from television to films to live events.

[ZEEL] We are also creating dedicated teams for content development to ensure a more robust show pipeline. Our focus is on creating new IPs in non-fiction genres through newer formats such as game shows and cookery shows among others.

The world over, audiences are seeking engaging content. The demand for ‘what’s trending across the world’ coexists with audience preferences for content in their language and genre of choice.”

ZEEL’s regional language offerings within India are performing extremely well. [ZEEL] We are able to leverage content strengths across the network by replicating successful formats. Our understanding of audiences is reflected in our leadership and improving network performance.

Zee chose ‘Consistency and Change’ as the theme of the annual report and detailed its strategic objectives and priorities.

Key strategic objectives are to (1) be a media conglomerate, (2) attain global consumption leadership, and (3) consistently enhance shareholder value. Its priorities are to (1) attain leadership in key genres, (2) continue expansion in new markets and verticals—Zee has expanded in movie production, theatres, live events and music over the past three years and as per media articles it mulled radio acquisition (Reliance Broadcast). (3) Aligning with emerging consumer preferences—essentially, higher emphasis on digital platforms and content for digital audience, (4) sustainable profitable growth. Interestingly, sports does not feature in key priorities.

Zee’s overall ad revenues grew 29% in FY16; Domestic subscription revenues grew 14% while overseas subscription revenues grew about 16%. EBITDA margin at 25.8% were flat due to new &TV losses. PAT growth was weak due to increase in effective tax rate to 35% from 30.5% and lower other income.

Zee’s operating cash flow increased 7% to Rs 7.3 bn; CFO/NOPAT was down 300 bps to 79% in FY2016. Capex of Rs 3.1 bn (3X usual run rate) and outgo of Rs 1 bn for acquisition of Sarthak (Odiya channel) impacted FCF. FCF declined 40% to Rs 4.4 bn and FCF/PAT dropped to 42% from 74%. The bulk of the capex was non-recurring led by new office, investment in studios. Zee is setting up two production facilities to augment its in-house content production capabilities.

ZEEL has invested Rs 3.9 bn in Bermuda based Poseidon Opportunities fund (flat yoy). ZEEL parks foreign-currency accruals in overseas funds, intercorporate deposits (non-related party) reduced to Rs 1.75 bn from Rs 4.25 bn, (3) investment in high-yield debt securities of real estate entities was flat at Rs 1.25 bn. These investments are in line with Zee’s high-yield focused cash management approach. Interest income (including profit on sale of current investments) was down 23% in FY2016; average yield on cash and cash equivalents declined to 6% from 8.8%.

Reversal of provision on doubtful debts/advances/investments aided margins by 90 bps in FY2016. The sale of an old aircraft fetched Rs 367 mn. Subsequent acquisition of 100% stake in aircraft charter services firm, Fly by wire, for Rs 610 mn will reflect in FY2017 balance sheet.

We expect earnings to grow at 15-17% over next 5 years and cash flows to grow at lower CAGR due to high capex in content creation. Based on our DCF model, we estimate company is valued at ~Rs 290-300/share.

At current price of Rs 436/share, the market is factoring growth of 24.5% to 27.5% CAGR EPS growth over next 5 years which looks quite ambitious. We gave SELL on ZEEL on 30^th Oct 2015 at Rs 408/share.