Well crafted

Given the past track record, sound business model, robust order book and reasonable pricing, DQ Entertainment’s IPO is a worthy bet.

Availability of skilled workforce and lower labour costs for developing animation is a boon for Indian companies. As per NASSCOM – E&Y, the Indian animation industry is expected to grow at around 22 per cent during 2008-12, compared to 10 per cent for the global animation industry.

For companies like DQ Entertainment, which have been ahead of the industry curve till now, it would mean better prospects. DQ is planning to mop up around Rs 128 crore through an IPO to give teeth to its growth plans, for investment in co-production deals and development of production units.

Business model

DQ started as a pure outsourcing service model. It produced its first 2D digital project – Delta State. Over the years, DQ has moved up the value-chain. Five years back, it got into 3D animation and gaming. It struck deals with the likes of Disney (‘Mickey Mouse Club House’) and their association is still on.

Skilled manpower and execution capabilities have helped DQ tie-up with large animation studios on a co-production model for content development. It acquires proportionate rights (back-end and/or exclusive territories) for licensing and distribution revenues.

It is a minor partner for ‘Ironman’ (a 3D animation serial) and a major partner for ‘The Jungle Book’ and ‘Lassie’ (other animation series). These co-production agreements not only provide production revenues at usual profit margins, but also helps DQ to obtain equity participations, for a share of the license revenues. The focus on co-production has provided the company an opportunity to leverage its existing expertise in content creation, while at the same time adopting a low-risk approach.

To mitigate the risk of cash flows during the execution phase, DQ ties up a majority of its project funding needs prior to commencement of production (through pre-sales to broadcasters or through co-production arrangements).

As of March 2009, DQ has invested Rs 47 crore in co-productions which have been completed and have generated revenue of Rs 53 crore for the company. Another 33 productions are currently under development. The company proposes to deploy about 45 per cent of the IPO proceeds towards co-production and IP content creation businesses.

The company also plans to enter into strategic partnerships with the existing clientele and collaborate with well known storytellers from the US and Europe in a bid to further boost its portfolio of co-production and own IP content. The latter could open up new revenue streams such as merchandising and publishing rights, in the future.
 

ON THE FAST LANE
In Rs crore	FY09	H1 FY10	FY10E	FY11E
Total income	150.9	69.0	197.1	255.0
EBITDA margin (%)	35.6	37.0	37.0	37.0
Net profit	16.1	10.3	26.0	37.0
EPS (Rs) *	-	-	3.3	4.7
P/E (x) @ Rs75	-	-	22.8	16.0
P/E (x) @ Rs80	-	-	24.3	17.0
Source: DRHP, analyst estimates   * post-issue capital   E: BS SI Estimates

Financials, growing at a fast clip

DQ Entertainment has seen its top-line grow at a CAGR of 35 per cent in the last five years. While revenues have grown at a fast clip in recent years, its operating margins, too, have improved sharply aided by costs control and better revenue mix.

About three-fifth of the revenues currently comes from 3-D animation projects, whilst low margin 2-D accounts for the remaining. A combination of manpower cost reduction and higher revenues from high-end 3D animation should ensure that margins sustain at these levels.

Within animation, the revenues accrue from television, movies and merchandising. In terms of revenue mix, the television segment contributed around 90 per cent in 2008-09. But, its share would decline to around 75 per cent in the next 2-3 years as the company intends to increase its share from movie content and merchandise.

The order book currently stands at Rs 450 crore, and provides revenue visibility for the next two years. However, the order book is skewed towards European and American geographies, which together account for over 90 per cent of revenues. In light of the strong order book, DQ’s revenues are expected to grow by about 29 per cent in 2009-10 and 2010-11. At the operational level, the company is expected to do well; this would help deliver faster growth in net profit.

Conclusion

While ability to deliver quality service helps to reduce customer attrition, acquisition of IP rights and increase in volume of higher-end work leads to better margins for DQ. Currently, the company has a library of 350 hours of international animated programs.

The company proposes to spend Rs 52 crore from the IPO proceeds for the development of office premises, including the infrastructure at the SEZ Unit in Hyderabad, for which the AP government has allotted an 11 acre plot. This would help the company save on taxes when it moves into the new premises in 2012.

DQ has around 2800 employees, and has been able to meet manpower requirements and upgrade employee skills using its in-house training facilities (DQ School of Visual Arts), which helps in containing manpower costs. In the near-term though, with 600 new employees joining in the next few quarters, expect these costs to rise to some extent.

While the flip side is DQ’s limited track record of realising revenues from licensing and distribution, collaboration with international partners and its past performance stand it in good stead. The strong order book also provides confidence and revenue visibility.

In terms of stock valuations, DQ has no major comparable peers. At the upper price band of Rs 80, the stock trades at 17 times its 2010-11 estimated earnings and appears fairly priced. Investors with a long-term perspective can consider this IPO.

Clarification

With regards the IPO review of DQ Entertainment published in The Smart Investor edition dated March 8, 2010, the table “On the fast lane” carried FY10 and FY11 financial projections of the company. The figures have been estimated by Business Standard and not by the company.