Monday, May 24, 2010

Natural Barriers To Competition

Value investors are constantly on the look-out for businesses with "moats" that the competition cannot displace. Usually, this is the result of a competitive advantage that cannot be copied. But perhaps it can also be the result of being in a business that is shunned to the extent that no quality management wants to copy it.

Consider New Frontier Media (NOOF), producer and distributor of pornographic movies. The company has deals in place with the major cable providers which allows them to beam millions of dollars worth of adult pay-per-view content into homes throughout America and the world. Despite being a business that appears to be easily replicated, the company has enjoyed surprisingly good margins (approaching 20% on average) and returns (5-year ROE > 12%), beating up on its primary competitor, Playboy Enterprises (PLA).

Despite this, the company appears to trade at a substantial discount. New Frontier's market cap is just $38 million, while the company has earned operating income far in excess of that in the last four years alone, even after including a $12 million goodwill write-down that caused the company's 2009 net income to be negative. In addition, the company has $15 million of cash against just $3 million of debt.

The future is not without challenges, however. As consolidation in the cable industry throughout the United States has taken place, New Frontier's customers have become more concentrated and powerful. As a result, New Frontier's business would take a substantial hit if one of these operators switched to a different provider. More immediately, however, this has allowed the cable operators to push New Frontier on price, reducing domestic margins.

Furthermore, while the company's founder Michael Weiner (which could also pass for a screen-name in this business) is still the chief executive, his annual salary and bonus dwarf his stock ownership in the company, which doesn't say a lot for the company's incentive structure. Nevertheless, the company has succeeded for years with Weiner at the helm, and shareholders appear to be offered a price at this level with a substantial margin of safety.

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We first discussed this company a few months ago here.

Disclosure: Author has a long position in shares of NOOF


Wide Moat said...

I used to hold this and sold in March.

The gross margin on their renewed contracts with domestic providers is significantly lower than the past.

The gross margin on new contracts with international providers is much better, and revenues in those markets are growing nicely.

I don't really know what to make of the nearly 5m they have spent on these recent producer-for-hire deals. A big investment relative to the market cap, and too little public disclosure for me.

rayhaan said...

yo saj, i do hope u ve sufficient reasons 4 being able to ignore the concerns highlight by wide moat. (sorry saj, but i gotta admit dis is my all time fav post, investing sure is a gr8 biz!lol) how is d free cashflow position of dis co.?

Turar said...

Not an opinion on the particular idea, but more of a macro view: It seems that porn business is in secular decline with no clear solution in sight.

Saj Karsan said...

Hi WM & R,

I agree that US margins will be pressured, but it looks like NOOF will be able to push back on content providers as well. Also, since it is a scaleable business, as international revenues increase, margin pressures should also alleviate.

They do expect to recover the $5 million in producer-for-hire cash (plus a profit margin) in the next two quarters (half this quarter, half the next quarter).

Adam Sues said...


Nice writeup on NOOF - I originally found your analysis on Greenbackd.

I think the stock is woefully undervalued and under followed, probably due in part to the nature of the business. The goodwill writedown last year really cut into the price but I haven't seen any news for the recent decline.

I've written an analysis on my blog as well. Value should be at least $3.50

-Adam Sues

Saj Karsan said...

Thanks, Adam!