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New Frontier Media “is a free cash flow machine that Mr. Market has left for dead”

from – SEX.

Got your attention? Ok, let’s look at New Frontier Media (NASDAQ: NOOF). The company is a producer and distributor of *ahem* adult films. I’ll try my hardest to leave the childish jokes out, but first, let’s also take note of the wonders of our universe that led a man by the name of Michael Weiner to be the company’s CEO. I kid you not.

Ok, once more unto the breech, dear friends, once more.

The company distributes content via pay-per-view and video-on-demand, via websites and through cable and satellite operators. The company trades (as of 7/21) for a market cap of $28.4 million, but has nearly $19 million in cash on hand versus a tiny amount ($500k) of short-term debt. The company is trading at a massive 45% discount to the book value of its equity.

Sure, the company has a significant amount of intangible assets, and I can tell what you are thinking “I won’t pay for intangibles – I want HARD assets!” (I said I would stop making the jokes. I didn’t say you would). If we subtract out the intangible assets, we still end up with a price to tangible book value of 0.88x, comprised largely of cash and accounts receivable.

You: “Yeah, yeah, so you can buy the tangible assets for a slight discount. If the company is losing money hand over fist, investors may never see that gain.”

Me: “Let’s check out how the company has been doing.

The net margin shows the company has dipped into losses quite frequently in the recent past. So perhaps you are right; maybe investors will never recognize that tangible book value. Before we jump to that conclusion, let’s first look at the cause of these losses. Turns out, the losses we see in 3Q 2009, 4Q 2010 and 4Q 2011 are the result of impairments, which are non-cash charges. Here’s what the company had to say about these write-downs (emphasis added):

During fiscal year 2009, the film markets were significantly impacted by the economic downturn. As a result, the Film Production segment’s customers reduced their content acquisition budgets. We believe this occurred because our customers were relying upon their existing libraries to reduce spending and costs. … [W]e determined that the goodwill associated with the Film Production segment was impaired and recorded a $10.0 million goodwill impairment charge during the quarter ended December 31, 2008. We also recorded a film cost impairment charge of approximately $1.1 million during the quarter ended December 31, 2008 primarily as a result of the economic downturn.

… [W]e determined that the goodwill associated with the Film Production segment was impaired and recorded a $4.9 million goodwill impairment charge during the fourth quarter of fiscal year 2010. We also recorded a film cost impairment charge of approximately $1.2 million and a recoupable costs and producer advances impairment charge of approximately $0.8 million during the fourth quarter of fiscal year 2010 associated with the unfavorable film market conditions. It is reasonably possible that future unfavorable economic conditions could cause the operating results of this segment to remain depressed or decline.

Who knew that the adult movie industry would take it on the chin in a recession? Regardless, I am alright with these impairments for a few reasons. First, I attribute very little value to goodwill even in the best of times, so write it off all you want and it won’t affect my valuation. Second, I’ve already shown that the company’s tangible assets are greater than its market cap, and there is little question what the value of the tangible assets. Third, the value of the company’s assets isn’t how I justified buying NOOF (did I just give away the ending?)

On the flip side, I love noncash charges. They are sometimes enough to scare away investors who rush for the exits when they see red ink. I think free cash flows tell a much better story (but beware, not all free cash flow is what it seems):

Yes, free cash flows have declined over the last few years (2011 declined largely as a result of a $2m capital expenditure on storage equipment for international growth – more on that in a second), but keep in mind that 2011′s reported $2.5 million in free cash flow is still around a 9% yield, and if you subtract the company’s cash balance, you are looking at more like a 26% yield. Keep in mind that these figures are using trough free cash flows. A return to more normal free cash flows (in the range we see from 2008 – 2010) exceeds a 50% yield!

How likely is it that the company’s free cash flows will return to historical levels? From the company’s recent conference call,

From a capex standpoint, for fiscal year 2012, there’s a couple of pieces that you have to consider in what our expectations are. So the first one is, if you recall we mentioned on the previous call, we’re in the process of combining two of our facilities into a new single facility. And in connection with that, we have some tenant improvement as well as some equipment spending. The expectation currently is that we’ll spend about $2 million in tenant improvements and approximately $300,000 on equipment associated with that move. Now, the piece that’s a little more tricky is that we will receive a reimbursement associated with those tenant improvements, and our expectation is that will be around $1.7 million. But from a cash flow standpoint, the tenant improvements and equipment spend will run through the investment line item in cash flows whereas the $1.7 million of reimbursement for the allowances will actually run through the operating section of the cash flows.

So, the net effect on free cash flow is about $600,000. But this is only one element. What about ongoing needs? Later on the same call, they discuss their ongoing capital expenditure needs, and suggest that only about $300,000 will be needed ongoing. It seems to me that these capex needs (roughly $900,000 net) should be well below historical levels, and barring a massive decline in business, one could expect pretty strong cash accumulation again this year.

What about the company’s future? Besides roasting in eternal damnation, there are some bright spots. Remember the $2m spent on storage equipment for international growth? Turns out the rest of the world loves porn too: international revenue grew by 64% last year. Let’s look at the company’s growth in various international markets (beginning in 2007, when the company’s international sales became significant for the first time):

New Frontier Media’s International Sales, 2007 – 2011:

As a Canadian, this chart makes me blush (Look at those prudish “others”). As an investor, this chart gives me reason to be excited about the company’s future. Let’s take a stab at valuing the company.

In valuing NOOF, I created a few different scenarios, using various assumptions about future growth. The shocker was that, even when using free cash flows below last year’s trough levels (which, as detailed above, there is little evidence to justify), the company is undervalued. In any more normal situation, the company appears grossly undervalued. Add in future international growth potential for free and wild horses couldn’t hold me back from this company. At least one insider, Alan Isaacman, appears to agree with this assessment, as he bought 20,000 shares just over a month ago (in fact, unlike many executives over the last year or two, NOOF insiders have only bought shares through the recession, and most of these purchases were higher than the current price – this is a good sign).

Here’s the bottom line: If you assess NOOF based on the income statement, you are missing out on its true value. To assess it properly, strip out the noncash charges and focus on free cash flows. You’ll have a tough time justifying the current price while keeping your assumptions reasonable. I think you’ll reach the same conclusion that I have: NOOF is a free cash flow machine that Mr. Market has left for dead. This is what happens when you are a micro-cap with zero analyst coverage and operate in an industry most investors aren’t willing to look at.


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