Jacques Massicotte, cfa, is vp director communication & media research with RBC Dominion Securities.

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During the last two years, Canadian investors have been given a chance to participate directly in the content side of the so-called information superhighway, without looking south of the border to Walt Disney, Paramount or other big u.s. companies.

Alliance Communications, Atlantis Communications, Cinar Films, Nelvana Enterprises, Malofilm Communications and Paragon Entertainment have raised over $130 million of fresh equity since 1993. As a result, the industry has been able to partially cut the link with traditional funding agencies that, to a degree, have restricted its opening to the world.

On the other hand, investors have been introduced to a completely new and unique industry, at least in Canada. Both individuals and financial institutions have built position in these shares at ipo time. The institutions’ presence is interesting to note as they usually like to invest in liquid stocks, so their impact on share price is limited when they change their stance.

Attraction as an investment

The film production and distribution business definitely has some appeal for investors. Lots of new channels are expected to hit television screens in the future, international markets are receptive to Canadians’ quality production (and cheap dollar), and Canada has a growing pool of recognized human and technical resources.

Perception is therefore that of a high-growth sectorÉand investors love growth. (Investors may dream of reaping the windfall of profits one of their new holdings would generate if they have a hit movie, tv series or animated film, but of course, nobody invests for that reason alone.)

Key issues in investing in the sector

Investment decisions have to be based on thorough analysis of the financial situation of a company, as well as its competitive position and industry trends.

Looking at film entertainment companies is somewhat refreshing in that most traditional valuation techniques go overboard. Price/ earnings, price/book, enterprise value/operating cash flow and others have to come to grips with the accounting practices which give companies a significant degree of flexibility in the treatment of production costs and estimation of the revenue stream for each production.

Investors have very limited access to detailed information pertaining to individual productions, which creates a dependency on management’s estimates. We believe it will remain an issue until the public companies have established a credible track record in the marketplace.

Therefore, investors have a tough time comparing the relative valuations of the companies. To make things worse, the companies are all different: their product mix (live-action, animated, tv series or mows, feature films), their revenue mix (production, distribution, licensing, merchandising, broadcast licences, etc.), their funding (tax shelters, government grants, third-party funding, internal cash flow, etc.).

From the general concept of buying ‘content,’ investors have had to adjust the multiple they are prepared to pay for earnings coming from life-lasting animated series (with little ethnic bias, easily dubbed) versus locally oriented tv series. The process is still going on.

As is often the case in relatively small companies, management credibility is a key issue for investors. Like some other businesses, the real assets are walking in and out the door every day, and the ability to attract and keep talented people has to be assessed. The creative track record has to be complemented with sound financial performance in order to provide a stable and enthusiastic shareholder base.

Performance to date

Share performance has been mixed. Alliance, Cinar and Coscient were up in 1994, while Atlantis, Nelvana, Paragon and Malofilm came down.

Most companies have met the financial expectations of investors, as set in their prospectuses or financial reports, but those that did not, paid the price.

If investors had to learn how to evaluate a new industry (for them), entertainment companies also had to learn how to deal with outside shareholders. Being public brings the obligation to report earnings, disclose information that used to be confidential and, maybe more difficult in the first few years, educate investors on the industry.

Public investors can be in and out of a company within minutes, yet their collective judgment has a determinant impact on the access and cost of capital of the firm. Management has to balance the excitement they usually have about their business with the danger of building up unreasonable expectations. We have probably gone through some of that adjustment period in the last year.

Key issues for the future

Investors have learned a few things since these companies became public. Although it’s difficult to track the actual financial performance of companies, investors have been in a position to compare accounting policies and management’s accuracy in their forecasts.

Investors have also learned that this industry is a lot more capital-intensive than originally thought. Growth in production requires solid cash flow because of timing differences.

Recent media attention related to the introduction of new specialty channels on cable has somewhat diminished expectations of a guaranteed increase in production, and refocused investors on quality productions.

Market reception to new issues and new companies in the sector will likely remain high for quality-production houses with track records. The market will also be expecting potential industry consolidation and the emergence of dominant players, both within Canada’s industry and globally.