Is Cinram Trust Worthy?

While some industry watchers suggest things are looking up for Cinram, others are more skeptical.

Despite troubling signs that consumers' love affair with DVDs may be waning, investors are betting that Cinram International Inc.'s intention to become an income trust will give the Toronto-based DVD and CD manufacturer its own just-like-in-the-movies happy ending. Cinram stock (TSX: CRW) rose to more than $26 in early August from about $24, bolstered by the company's positive comments about the income trust potential (first brought up in the spring) and the release of second-quarter results that were stronger than most analysts expected. But while some industry watchers suggest things are looking up for Cinram, others are skeptical. They question the company's growth prospects and wonder if it is a suitable candidate for conversion to an income trust, given that its volatile revenue and earnings aren't a good fit with a trust structure that requires monthly cash distributions.

Adam Shine, analyst at National Bank Financial, says in a research report that Cinram's second-quarter conference call on Aug. 5 “hit all the right notes.” Overall revenue for the quarter ended June 30 increased by 6% over the same period last year, to US$449.6 million, while earnings of US$4.6 million (8¢ a share) were down from US$8.5 million (15¢). Still, that was higher than consensus estimates of 7¢ a share and double Shine's forecast of 4¢. DVD sales increased by 10% while VHS revenues dropped 78%. Margins were hurt by increasing production costs.

Cinram chief financial officer Lewis Ritchie and chief operating officer David Rubenstein stopped short of saying the trust conversion is a done deal, but told analysts the company's legal, financial and tax advisers don't see “any insurmountable issues.” Ritchie said Cinram would be better valued “if it's recognized for its cash flow” as opposed to its earnings per share.

Shine has a $30 target on Cinram shares, with an Outperform rating, and suggests that upon going the trust route the shares “could get revalued toward $35 to $40.” The shares should gain momentum, he says, not only from the potential trust conversion, but solid prospects for a better second half of the year building up to the Christmas holiday season, which will see DVD releases of popular films such as Charlie and the Chocolate Factory, Batman Begins and Fantastic Four.

Analyst Patrick Tomalin at Orion Securities Inc. agrees that Cinram's release schedule over the second half is “shaping up quite favourably.” Still, Tomalin, who has a speculative Overweight rating on the stock and a target price of $32.50, says it's important to keep optimism in check. “While the outlook is clearly positive, in the years of covering this stock we have become all too accustomed to volatility in volumes, a factor that should yield some degree of caution in forecasting.”

Some analysts aren't bullish on Cinram's trust plan. “We do not believe that Cinram's business model fits well with the income trust structure,” says Katharine Dalton at Merrill Lynch in Toronto. She points out the DVD manufacturer “experiences significant volatility quarter to quarter.” Previously, DVD sales were driven mostly by the increasing number of DVD players coming into consumers' homes. But with close to 80% of North American households now equipped with a DVD player, Dalton says the market for DVDs is maturing, which “could result in lower distributions” if Cinram becomes a trust.

Another analyst, Tim Casey of BMO Nesbitt Burns, believes that growth for the DVD format “is clearly abating.” In the conference call, Cinram's Ritchie acknowledged that the “window of opportunity” to garner sales for new releases is getting shorter, especially as store shelves become more crowded with DVD titles. But, he added, “the outlook for DVD is still very good,” especially for studios that have “a rich library of content to service a wide range of consumer preferences.” Ritchie said trade publication Video Business News observed that spending on home DVD/video in North America “remained strong” at US$11.4 billion during the first half of this year, with overall sales increasing 2.5%. He added that when it comes to DVD units sold, “the metric most important to replicators such as Cinram,” growth in North America this year was close to 20%.

Ritchie is confident the next generation of DVDs, whether it is HD DVD (short for “high density digital video disc,” a technology backed by Paramount, Universal and Warner) or Blu-ray disks (another high-definition format, supported by Sony, Disney and Fox), will “represent a significant growth opportunity” for Cinram, adding that “history shows that a new medium expands the market.” To that end, Cinram is purchasing equipment capable of producing both regular and HD DVDs, and installing hardware for limited production of the Blu-ray format. BMO's Casey isn't as optimistic that either new format will have as strong an impact on the market as the first DVD generation. And Merrill Lynch's Dalton says retailers and consumers will likely resist buying either HD DVD or Blu-ray “until a winning format emerges.”

Cinram, founded in 1969 as a manufacturer of eight-track music systems, has survived the many changes in home entertainment technology. The upshot for investors in this latest round of gadget evolution is that they might want to treat the Cinram investing plot line less as a romance than an exciting, high-stakes thriller.