Overview

New Frontier Media (NOOF) reported 4Q and 2010 fiscal year results last week. The Company continues to struggle with a decline in domestic revenue and the impairment of intangible assets. There is no doubt that the economic downturn is negatively affecting the company, but the Company remains in solid financial shape, especially from a cash flow and balance sheet perspective.

Sales Results

Net sales decreased to $50.4m, a 4.4% drop from the prior fiscal year. In the Transactional TV segment, sales decreased by 12%, partially offset by a 40% increase in the Film Production segment. Profit margins in the TV segment average around 70%, compared to margins around 50% for the other business segments – if the trend continues, the Company will need to closely monitor costs, or bottom line profitability could erode further.

However, several bright spots remain from a top-line analysis:

The 4.4% sales decreased was moderate compared to the 11.7% drop in revenue from 2008 to 2009, the (hopeful) start of a positive trend. Q4 revenues of $15.1m were the highest quarterly revenue since Dec 2007. Although domestic business has stagnated, international sales increased 61.7% and now makeup 14% of total sales.

Owner Earnings

In the past two years, the Company has been forced to write down a significant portion of their intangible assets (writedowns of $11.31m in 2009 and $7.19m in 2010). Overall, goodwill and other intangible assets have dropped from approx $22m in 2008 to approx $4.3m in 2010.

As an investor, this shows the danger of investing in companies with a substantial balance of intangible assets – the value of those assets can be fleeting when compared to hard assets like cash or PP&E.

The good news is that the Company has written off all of the goodwill from the Film Production business, so further writedowns are unlikely.

Despite the non-cash charges, NOOF continues to generate healthy Owner Earnings (OE), with $6.04m in 2010:

Add back the non-cash impairment charges, and a clear uptrend in ‘normal’ owner earnings over the past two years can be identified, despite the net losses.   In most cases, cash flow is usually a better indicator of the financial health of the business.

Balance Sheet

Although the company’s topline performance will probably continue to struggle, the balance sheet is solid – especially since the majority of the intangible assets have been eliminated.

The Company’s quick and current ratio is 3.2 and 3.5 respectively, the highest numbers since 2005. Total liabilities dropped almost $5m, as the Company reduced accounts payable by 29% and paid off $3m off their outstanding credit line.

Valuation

Even with no growth, the company looks extraordinary cheap. At current levels, NOOF is trading at 5.5x OE. With conservative topline estimates going forward (and no writedowns), the business should generate roughly $12m in owner earnings in 2011, or 2.6x OE at current price levels.

Conservative Valuation: $2.5-$3.5

Aggressive Valuation: $5-6

Disclosure

Long NOOF

In addition to merger arbitrage and going private transactions, another type of special situation is tender offers. A self-tender offer is a form of share repurchase where a company offers to purchase a portion of its outstanding shares from those shareholders who vote to ‘tender,’ or turn in, their shares in exchange for cash.

This is another area where small investors have an advantage over the bigger guys. Many self-tender offers include an ‘odd-lot’ provision for shareholders holding less than 100 shares. It basically guarantees that the company will repurchase these odd-lots before the rest of the offer is fully subscribed.

One example of this sort of investment opportunity is Validus Holdings (VR).

Announcement

On May 6, VR announced a Modified Dutch Auction Tender Offer for $300m of common shares. The price range for the auction was set for $24-$27.50 per share. The offer will be paid for with cash on hand (so no financing risk) and includes the important ‘odd-lot’ provision.

Entry Point

Since the tender offer announcement, the stock traded below $24 several times over the past month. A strategic entry point at or below the minimum range of the tender offer, combined with taking full advantage of the odd lot provision, will likely recent in a profitable trade, with potential for decent upside.

Return Scenarios

Final Tender Price

TBD. The tender offer expired yesterday so hopefully results will be announced in a few days.

Results – *Updated*

On June 9, 2010, the Company announced the results of the dutch auction tender offer:

Validus Holdings Announces Preliminary Results of Dutch Auction Tender Offer

“Based on these preliminary results, Validus expects to purchase 12,000,000 common shares, subject to proration, at a price of $25.00 per common share for a total cost of $300.0 million”

Obviously, this is at the lower end of the given range.  Still, if you picked up shares two weeks ago for $24, the transaction still resulted in an annualized return of 110%!

Disclosure

Long VR

Lately, my normal screening tactics have returned very few investment opportunities that satisfy my traditional ‘bargain bin’ value investment philosophy. Because of this, I’ve been doing more and more research on arbitrage opportunities and other special situations to round out my portfolio.

(See analysis example of the PBCI & BCBP merger)

I’m happy to report that I officially completed my first special situations investment last week, when CHDN merged with UBET. For more background, check out my initial writeup on the merger.

Announcement

Filed on Wednesday June 2:

“Churchill Downs Incorporated (“CDI”) (NASDAQ: CHDN) announced today that it has completed its merger with Youbet.com, Inc. (NASDAQ:UBET). As a result of the merger, each share of Youbet.com common stock was converted into the right to receive 0.0591 shares of CDI stock and $0.99 in cash.”

The initial terms of the deal called for a conversion ratio of 0.0598 in CHDN stock and $0.97 in cash.  However, the conversion ratio was open to adjustments in order to limit the number of shares CHDN was required to issue.

Investment Breakdown

Based on my initial entry points, the arbitrage opportunity was offering estimated gains of approx. 12.5%.  I’ve included my timeline below.

1. May 5 – I entered an initial position in UBET at $2.90. At the same time, I entered a corresponding short position in CHDN at $38.29, based on the conversion ratio of 0.0598.
2. May 7 – I added to my position in UBET at $2.80, balanced with a short position in CHDN at $36.51.
3. June 2 – Official merger announcement
4. June 5 – My UBET shares were converted into shares of CHDN at the new conversion ratio and I received cash considerations of $0.99 per share.  Due to the slight difference in the conversion ratio on closing, I ended up with a few extra shares of CHDN which I quickly covered at $32.35.  I then closed out long/short position in CHDN to end the trade.

Return

To wrap my head around the accounting, I considered the two trades as separate positions. Overall, I gained 12.25% and 12.45% respectively, or 308.15% and 317.02% annualized.

Takeways

-This was my first time shorting stock and I was never aware that brokers charge “hard-to-borrow” fees on all but the most liquid stocks. Since most of my investments will be in obscure opportunities, this is definitely something to keep in mind.

BTW, does anyone have brokerage recommendations? I’m using currently Zecco  (the free trades are great) but might need to expand if I continue with these more complicated transactions.

-Merger arbitrage, especially stock & cash mergers, involve much more complicated gain/loss scenarios than standard stock investments. I spent way too much time figuring out my final tally on this position.  In hindsight, it might have been prudent to start with a simpler transaction but I’m happy I forged ahead – the return was too good to pass up!

-As in all investment scenarios, it is important to have a margin of safety in any transaction. Too many things can go wrong with merger arbitrage  – entry points, commissions, market timing, fractional shares, etc. all make the real world outcomes of these types of trades different than how they appear on paper.

-Successful special situations investments have the potential for truly eye-popping annualized gains.