DQ Entertainment (International) IPO Analysis

Riding the animation bandwagon

The company has large customers and good order book but the low stake of main promoter and low market cap of ultimate holding company at AIM is of concern

DQ Entertainment (International), promoted by Tapaas Chakravarti & DQ Entertainment (Mauritius), is one of the leading producers of animation, visual effects, game art and entertainment content for the Indian as well as global media and entertainment industry. The company is a producer of animation videos and creators of game art. It has forayed into production and distribution of live action television and feature films. It has an asset base of over 350 hours of animation content from which it can earn revenue through licensing and distribution activities.

The company was originally incorporated in 1987 as Dataquest Management and Communications Private Limited, which was changed to DQ Entertainment in 1993 to engage in IT training & consultancy. In 2000, it established an in-house training centre to training production staff. In 2002 established a traditional two-dimensional (2D) animation studio. In 2004, it established three-dimensional (3D) animation process. Its first commercial 3D animation project was a French TV series, Les Gnoufs. It started game assets development in 2007. The company has since launched its own IPO in 2009, with the launch of the first homegrown 3D computer generated imagery (3D CGI) television series, The Jungle Book, based on Rudyard's Kipling epic novel as well as three special TV features, Balkand, Omkar and Ravan, based on Indian mythology, for India and the Indian diaspora across the globe.

The company has moved up the animation value chain and entered into co-production. It has at least 14 co-production projects going on. The global budget is about Rs 1104.28 crore of which the company's investment would be Rs 152.55 crore funded through pre-IPO placement, IPO proceeds and debt.

Its production capabilities include 10 production facilities in India (eight in Hyderabad and one each in Mumbai and Kolkata), a pool of over 2,851 employees, and worldwide third-party sales representatives in Paris, Tokyo and Los Angeles.

The DQ School of Visual Arts was set up in FY 2008 to address the demand for high quality animation and gaming professionals. It took over from the in-house training division of the erstwhile DQ Entertainment. The school has centres in Hyderabad, Mumbai and Kolkata. Since its inception in FY 2008, the school has trained 715 people.

Revenues accrue either through outsourced production or co-production arrangements. Under outsourced production, the company is remunerated on a fixed fee basis for content produced. Under co-production, the company is remunerated on a fixed fee basis and it invests a certain percentage of the overall cost of producing the complete series in exchange for grant of distribution rights. In certain arrangements, the company might be able to retain the IP.

The company has a client base of over 90 companies, which include internationally recognized brands such as, inter alia, the Disney Group, Nickelodeon, American Greetings, BBC, Moonscoop Group, ZDF-Germany, Australian Broadcasting Corporation and NBC Universal.

The company has planned investment in co-production agreements, focusing on IP content creation of Rs 104.97 crore. Of this, the IPO and re-IPO proceeds would finance Rs 54.96 crore and the balance would be financed through debt of Rs 45.64 crore and internal accruals Rs 4.37 crore. The company also plans to develop SEZ facility at Kokapet Village at Rs 51.92 crore. Of this, IPO and pre-IPO would be Rs 39.23 crore, debt Rs 11.25 crore and the balance through internal accruals. The company also plans to invest in its subsidiary for own IP creation of Rs 14.59 crore. This will be financed through IPO proceeds.

DQE plc: the ultimate Holding Company

The company's corporate promoter, DQ Entertainment (Mauritius) Limited, is incorporated and registered in Mauritius. It is a wholly owned subsidiary of DQE plc, an Isle of Man incorporated entity. In December 2007, DQE plc listed on Alternative Investment Market, London (AIM) at an issue price of 136 pence and raised funds for investment in strategic alliances, global and local IP development and partnerships, and foraying into live action and expansion of production facilities and workforce. The company had raised GBP 26.8 million through the AIM listing. The main reason was to give an exit to the hedge funds, which have to be liquidated on completion of investment life.

The individual promoter (Mr Tapaas Chakravarti) holds about 12.66% of DQE plc through his company Zenithal Pvt Ltd, thereby holding 11.9% (pre-issue) and 9.5% (post-issue) of DQ Entertainment (International).

Certain existing shareholders of DQE plc have entered into a performance incentive agreement with Zenithal. These specific existing shareholders have agreed to transfer an aggregate of 1690895 shares to Zenithal at par value if either of the following performance criteria are met by DQE plc: the closing market price of DQE plc's shares being at or above a certain percentage of the placing price (136 pence) for a consecutive period of 30 days or a bona fide purchase offer being made for all the ordinary shares held by the vendors at or above the threshold price (136 pence). On expiry of the performance period of 13 months, Zenthil has written to the vendors for further extension of the period by 13 months.

As on March 4, 2010, the closing price of equity shares of DQE plc was 98 pence, which is below their issue price of 136 pence. The 52-week low price of DQE plc is 57.50 pence and is 42.28% of its issue price. The market capitalization works out to Rs 243.16 crore (Rs/GBP at 68.99). However, liquidity at AIM is poor.

DQE plc has acquired a 20% stake in method animation for a total subscription price of euro 2.5 million. In case of any animated TV series being developed and produced by Method Animation as a delegate producer and fabricated by Method Animation, the company shall be offered the first right to enter into production services agreement with Method Animation.

Strengths

* The global animation industry is one of the fast growing components of the global media and entertainment industry. The global animation market was estimated at US$ 68 billion in 2008 and is expected to grow at a CAGR of 10% to reach US$ 100 billion by 2012. The Indian animation industry, estimated at US$ 494 million in 2008, is miniscule as compared to the global animation industry. However, the Indian animation industry has been growing with an estimated CAGR of 25% during 2006-08 and is estimated to reach a size of about US$ 1095 million by 2012.

* The company has a strong order book worth about US$ 95.07 million, providing high levels of earning visibility. More than 80% of FY2010 revenues are identified with over 40% of the order book in various stages of production and the & balance to commence during the year. Orders worth US$ 28 million are to be executed in FY2010 and US$ 33 million and the balance beyond FY 2010.

* The company has strategically moved along the animation value chain, gaining greater exposure to intellectual property ownership and distribution. It has adopted a low-risk approach, entering into co-production arrangements. As a result, the company would not only continue to receive production revenues generating its usual production margin, but also acquire rights to earn license revenues. It is at a strategic advantage to leverage its position within the production chain by acquiring and/or developing intellectual properties through international co-partnerships.

Weaknesses

* The direct/indirect shareholding in the company of the individual promoter is very low at 11.9% (pre-issue) and 9.5% (post-issue). Also, in future, if the management decides to de-list the ultimate holding company, i.e., DQE plc from AIM, the options might include using funds from DQ Entertainment (International) to buy back the shares or issue shares of DQ Entertainment or DQ Entertainment (Mauritius) to the existing shareholder of DQE plc, thereby diluting the stake of the shareholders of DQ Entertainment (International), the company coming out with IPO.

* The market for animation entertainment is characterised by short product lifecycles and frequent introduction of new products. The company would run the risk of committing resources for the creation of such products and eventually fail to realise anticipated revenues.

Valuation

At the price band of Rs 75 – Rs 80, on consolidated basis EPS of FY2009 of Rs 2, the PE works out to 37.5 – 40 times and on the half yearly annualised EPS for FY2010 of Rs 2.6, the PE works out to 29.2 – 31.2 times. The EV/sales is at 3.4 – 3.6 times, EV/EBITDA is at 9.6 – 10.2 times and market capitalization/sales is 4 – 4.2 times.

The price is 10 – 17% higher than the pre-IPO placement price of Rs 68.11 end December 2009. The company had filed its draft red herring prospectus (DRHP) in September 2009.

Comparing with like companies (FY2009 consolidated numbers), Crest Animation Studios (outsourced production & own IP) had reported a loss in FY2009 with revenue of Rs 57.11 crore and is trading at market capitalisation/sales of 2.8 times, EV/sales of 2.7 times and EV/EBITDA of 2.9 times. Compact Disc (outsourced production and own IP) is trading at PE of 1.3 times and is trading at market capitalization/sales of 0.3 times, EV/sales of 0.4 times and EV/EBITDA of 1.3 times. Prime Focus (VFX, post production and animation) is trading at PE of 18.3 times and is trading at market capitalization/sales of 0.8 times, EV/sales of 1.9 times and EV/EBITDA of 12.9 times.

The market capitalization of the ultimate parent at AIM works out to Rs 243.16 crore (Rs/GBP at 68.99). However, liquidity at the AIM is poor. Against this, market capitalization of DQ Entertainment (International) at the offer price band works out to Rs 595 to Rs 634 crore.