Financial Reporting Analysis Final Project - CFA Institute

CFA Institute Research Challenge Hosted in

Beijing

Tsinghua University

CFA Institute Research Challenge November 29th

, 2013

1

Huayi Brothers (300027.SZ)

Sector: Consumer Cyclical

Industry: Media – Diversified

Investment Highlights

Fundamentals and valuation methodologies indicate BUY. Based on Discounted Cash Flow

valuation methodologies, we arrive at the target price of RMB 46.9, a 48.3% upside from close

price as of Nov. 29, 2013. We believe Huayi Brothers will outperform due to the promising

prospect of its integration of business line, which successfully mitigates content quality risk from

vertical integration and creates synergy across different business line through horizontal

integration.

Huayi’s vertical integration of film business can effectively reduce its exposure to content

quality fluctuation and increase gross margin. The company has established a synergetic

business line from vertical integration in its film business, consisting of production and

investment, distribution, film exhibition and talent agency. The distribution business successfully

smooth content volatility and thus provides stronger downside protection via (1) advanced

decision of the best timeslot in releasing films, (2) provision of sufficient screening schedule rate,

and (3) effective advertising campaign to attract customers, while the theatre business provides

its distribution business strong negotiating power with theatre circuits, maximizing the return from

the film production.

Huayi has the best horizontal integration in the industry, enabling it to largely diversify

content risk and fully utilizing its content resource, and brings huge positive synergy. The

integration of mobile gaming with film allows Huayi to fully utilize premium film and drama

resources, on a recursive basis. Integration of TV drama series and music with film allows

sharing of resources, and gives Huayi positive synergy. Integration of travel with film has a huge

potential with a downside protection.

Current stage of development of the Chinese film industry remains the growth period,

providing a good opportunity in investing in industry leader. In recent years, China’s film

industry has been growing steadily. The industry continuously grows overall with high profits and

low levels of competition. But it is still marginal in the media industry, implying a huge room for

future expansion. The immature state of the market provides potentials for investment and a

good sign for the industry leader, Huayi, due to its occupation of first-mover advantage.

Business Description

Huayi is one of the largest private-owned listed media companies in China

Founded in 1994 by the Chairman & CEO Mr. Wang Zhongjun and President Mr. Wang Zhonglei,

Huayi Brothers (“Huayi”) is one of the largest private entertainment players in China. Huayi got

listed on ChiNext in 2009 with a current market capitalization of approximately RMB 33bn,

among the largest companies listed on ChiNext.

Emphasis stressed on integration and aiming at full coverage of media industry

The Beijing-based company first started out with film production, and later expanded into talent

management and TV drama production. In July 2013, the company announced its acquisition of

mobile game developer Yinhan Technology to expand into game content creating, showing an

attempt to execute a broad entertainment strategy consisting of 6 components, namely, film

production and distribution, TV drama production, talent management, movie theatres, music,

gaming and derivatives (i.e., theme parks). (Figure 1)

Film business chain: Huayi itself produces and distributes films. It also has an interest in

Assault Films (founded by Wu Yanzu and Feng Delun) and Eastern Legend (a joint venture with

Legend Film Company). Huayi has several overseas companies to help distribute their films.

Additionally, Huayi holds theater subsidiaries to occupy whole produce-distribute- show value

chain.

RECOMMENDATON: BUY

PRICE TARGET: ￥46.90

Market Data

Huayi Brothers (SZSE:300027)

Market Capitalization 36,675M

Shares Out.（mn) 1,209.60

Main share Holders:

- Zhongjun, Wang 23.90%

- Zhonglei, Wang 7.32%

- Tencent Holdings Ltd. 4.60%

Free Float (%) 64.18%

Last Share Price 31.6

1 year Range 12.09-79.30

Beta 0.9

P/E(TTM) 151.6

EPS(TTM) 0.2

EV/EBITDA (2013E) 52.5x

ROE 12.6

BV per share (2013E) 17.8

0%

10%

20%

30%

40%

50%

60%

70%

80%

90%

100%

2007 2008 2009 2010 2011 2012

Film TV drama

Talent agent & music Theater

Game

Figure 1: Huayi’s revenue structure

Source: Huayi annual reports


, 2013

2

Talent management: Huayi’s subsidiary Shidai Agent manages talent agent business; Lanhai

Huayi, a joint venture with Jiangsu broadcasting and TV bureau, organizes vocal live shows.

Shishang Media engages mainly in super model agent.

TV drama production: Huayi’s subsidiary Yule Investment produces and distributes TV drama

series. Besides studios incorporated, Huayi also have subsidiaries named Zhengjiang Tianyi and

Zhejiang Film Investment.

Music: Subsidiary Huayi Music engages in music.

Derivatives: Huayi holds an interest in Ourpalm Technology, an A-share listed mobile game

company; Huayi announced acquisition of Yinhan Technology, also a mobile game maker; Giant

Information conducts the online game business; Shijing Entertainment takes part in theme part

and tourism business; Huayi Vision does advertising business.

Successful and sustainable production of high-quality movies

On the back of first-in-class talent management franchise and near exclusive relationship with

highest-grossing directors in China, Huayi is China’s most accomplished and consistent movie

producer with a track record of delivering regional blockbusters including, If You Are the One

(2010), After Shock (2010), Painted Skin (2012), CZ12 (2012) and Young Detective Dee (2013),

all with box office results in the region of multi-hundred million RMB.

Industry Overview & Competitive Positioning

Industry overview

Current stage of development of the Chinese film industry remains the growth period,

but still marginal in the media industry, implying a huge room for future expansion

In recent years, China’s film industry has been growing steadily. (Figure 2) Despite a gradual

decline since 2010, the industry continues to grow overall with high profits and low levels of

competition. Compared with the film industry in North America, China’s film industry may not be

as stable, due to the lack of capital. However, the immature state of the market provides

potentials for investment. Moreover, revenue for the film industry only makes up 3% of the entire

cultural industry, implying a huge room for future growth and expansion. (Appendix 1)

Highly competitive and volatile nature of the movie production and distribution industry

As in the production side, in 2012, China's top ten movie companies took 37% of market share,

with the most remarkable of these companies being Enlight Pictures, Huayi Brothers and China

Film Group. Looking at both the number of productions in which they were involved and their box

office shares, these companies have shown considerable stability. (Figure 3)

Figure 3: Market share in film production industry

2011 2012

Company

Market

share

No. of

films Company

Market

share No. of films

1 China Film Group 4.39% 18 Enlight Pictures 7.23% 10

2 Bona Film 3.81% 10 Huayi Brothers 6.82% 8

3 Huayi Brothers 2.42% 8 Yingyitong 3.14% 1

4 Galloping Horse Film 2.20% 4 Zhengledao Media 3.14% 1

5 Movie Channel Center 1.98% 14 H/B Studio 3.14% 1

6 Shanghai Film Group 1.60% 7 China Film Group 2.70% 17

7 Zhonglian Jinghua 1.64% 3

Hangzhou Culture

Radio Film 2.35% 3

8 Henan Film Group 1.63% 2 H&R Century 2.30% 2

9 Guoli Changsheng 1.58% 2 Huashu Media 2.30% 1

10 Anhui Media Group 1.49% 2 Sichuan Zhonglan 2.30% 1

In distribution side, five companies with the largest market shares in distribution accounted for

82.7% of the nationwide market, which was a noticeable increase over the 77.6% concentration

0%

10%

20%

30%

40%

50%

60%

2006 2007 2008 2009 2010 2011 2012 2013

Chinese film industry growth

Figure 2

Source: Enn


, 2013

3

in the market in 2011. (Appendix 2) Notably, private companies are becoming more active and

four companies split market share for each season. (Appendix 3)

Content exposure remains the theme of risk in film industry

The fate of film companies largely depend on the unpredictable quality of content

The inherent nature of the film industry is the co-existence of high investment, high risk and high

return, with the risk largely owing to the unpredictability of the boxing performance, which in

essence is the uncertainty of content quality and creation. Also, the impact of such exposure

would be enhanced by the increasing requirement of initial capital of the film production.

Cases include MGM’s failure on Wingtalkers, which later induces the resignation of senior

management and acquisition by SONY Corp. While Enlight used Lost in Thailand to jump from

number 15+ in 2011 to the first place in 2012 among China's movie companies. (Figure 4)

Figure 4: Enlight Media stock performance

In 2012, beside the top 3, the remaining 7 companies all rose to top 10 solely because of their

participation in one of the hottest movies, with 3 of them in Lost in Thailand and the other 4 in

Painted Skin: The Resurrection.

The downside potential of content exposure could be mitigated by vertical integration

An example would be a business model that combines the film production and distribution. As

the film industry is quite similar to the cosmetics industry in the demand end, where the

consumers’ perception of the quality of goods and movies play an important role. Such nature

determines that the loss from a poorly produced film could be partially compensated by the

subsequent marketing effect. Thus if a group has substantial interest both in the production and

distribution, it could leverage the marketing advantages in distribution to provide a downside

protection for the content exposure, and consequently mitigate the risk aroused from the content

quality. (Figure 5)

The upside potential of the content quality could be magnified by horizontal integration

Under the horizontal integration of film with other forms, one single theme or topic can be

transformed into different products, maximizing the business value of the same theme. With

horizontal integration, artificially selected premium content would be fully utilized, and the content

would be magnified.

Sino-US comparison

Integration is a trend if benchmarking on the evolution of American movie industry

A common practice of media industry study would be benchmarking on the evolution of the

American movie industry, due to the maturity of Hollywood and the similar nature of the film

industry across border.

In the US, firms with premium brands expanded very rapidly, causing smaller firms soon to

vanish, or only live in dependency of the big firms. Since the beginning when thousands of film

makers competed, the evolution has led to a rather concentrated market. Using the data of 2012

box offices, the United States film industry CR8 has reached 88.4%—indicating that the market

is basically divided up by some oligarchs.

Case study: Disney Corp

Film industry FMCG

High screening

schedule rate Intensive sales web

Massive

advertising

campaign

Massive advertising

campaign

Optimal timeslot

in film releasing

Optimal timeslot in

product launching

Figure 5: The similarity in marketing

methods between the two industries


, 2013

4

Name Description

China Film Group

The biggest and oldest film company in China; have

biggest annual production

Huaxia Film Distribution

Company

One of the two companies that can distribute foreign

films (the other is China Film)

Local SOEs, e.g.: Shanghai

Film Group

Provincial film makers, e.g.:

Shanxi Film Studio

Huayi Brothers

A-share listed; full value chain coverage, the most

famous media group in China

Bona

Focusing more on distribution; have many self-own

theaters

Hengdian Film Group

The only national film experiment district; has film

toursim industry

Enlight Media

A-share listed; prestigious in TV programs; Lost in

Thailand is the No.1 gross box office in China

SOEs

Private

enterprises

0

5

10

15

20

25

0

100

200

300

400

China FilmGroup

HuayiBorthers

Enlight Media

Box office, 2012

Average box office per film shown in theater (MM RMB)

Average box office per film invested (MM RMB)

Film made (right axis)

Film shown in Mainland China (right axis)

When compared with S&P index, we can conclude 3 high-speed growth periods for Disney:

1967-1973, 1984-1991 and 1994-1997. All of the growth was triggered by Disney’s whole value

chain integrations. (Figure 6)Since November 1994, total return on Disney stock was about

400%, or 150 percentage points above S&P. Currently, Disney is a fully diversified, whole value

chain media empire. (Appendix 4)

Competitive landscape of film industry

Business coverage of major players

The Chinese film industry consists of two types of players: SOEs and private enterprises. The

two giant SOEs, China Film and Huaxia, have been dominating Chinese film industry, and are

still playing very important role due to their scale, as well as monopoly in film import. The private

enterprises diverse in their operation along the film value chain. (Figure 7)

Figure 7: Chinese film companies

By comparing the business models of the competitors, we may conclude that Huayi is the most

integrated film company with broadest coverage involving film, TV drama, talent agent, and

derivatives etc. within the industry. (Figure 8)

Figure 8: Chinese film companies business models

Market share of Huayi

Huayi is the leading player in production and distribution, with sizable share in TV and music

market. In 2012, average box office result of Huayi’s film was much better than its peers,

indicating a strong content and distribution ability. (Figure 9) Huayi ranked 2nd

and 3rd

in

production and distribution market, respectively, in 2012. (Appendix 5 & 6)

Investment Summary

Vertical integration of film business can effectively reduce its exposure to

content quality fluctuation and increase gross margin

By the construction of the vertically integrated business model, the content volatility in the film

can be reasonably mitigated. At the same time the integrated business line also create synergy

CompanyHuayi

Brothers

China Film

Group

Huaxia

Film

Enlight

MediaBona Wanda

Film making √ √ √ √ √ ×

Film distributing √ √ √ √ √ ×

Film showing √ √ √ × √ √

Import films × √ √ × × ×

TV drama making

and distributing√ × × √ × ×

Talent agent √ × × × √ ×

Music √ × × × × ×

Game √ × × × × ×Figure 9

Figure 6: The integration of Disney

Year Disney’s integration

1967 Theme park commenced construction

1984 Touchstone Pictures was established

1985 Started to make TV carton

1993 Acquisition of Miramax

1996 Acquisition of ABC and Jumbo Pictures


, 2013

5

form cost internalization and revenue cross-boosting that we believe has not been fully reflected

in its price currently.

The company has established a synergetic business line from vertical integration

Huayi’s expertise and relatively complete construction and participation throughout film industry

value chain create massive synergy surrounding its core film production business (Figure 10).

Production and investment: Through its experience in the movie industry, the company seeks

movie projects that can generate best returns. It can secure distribution rights in high potential

movies through investing or participating in film production.

Distribution: The company uses its distribution experience to decide the best time schedule to

produce films, ensuring quality films are released in every peak season. Additionally, distribution

experience also enables the company to discern Chinese audiences’ taste and selectively invest

in film production, thus reducing investment risk. Also the distribution business would reduce the

exposure to the content risk from the production business (elaborated later).

Film exhibition: The film exhibition business strengthens the distribution business by giving it

significant bargaining power with theatre circuits. Theatre circuits form an important part of the

film value chain between film distribution and film exhibition.

Talent agency: Talent agency business helps it secure key talent for its in-house production

movies. Additionally, it helps in obtaining desirable films for distribution, additional insights into

film projects and other source / contacts for promising film opportunities. The company

represented over 100 artists at the end of 3Q13 and grows at a 10% growth rate per year. The

company is the largest talent agency in the mainland China.

Figure 11: Synergetic business line

The distribution business successfully smooths content volatility and thus provides

stronger downside protection

Huayi’s strong film distribution business may serve as a marketing department for

self-produced films and thus smooth the content volatility. Huayi Brothers has emerged as

the largest private film distributor in China. The company’s market share in the distribution

business is only behind China Film Group and Huaxia, both are government-owned players. As

documented in the industry analysis, there is similarity across film industry and the fast-moving

consumer goods industry, where the perceived quality of the products plays an essential role,

given the prerequisite that the combination of film distribution is strong to create marketing

power.

Huayi’s distribution business is actually providing a guarantee for the films which it has

participated in the production. Noteworthy, almost all the films Huayi distributed are those they

Figure 10: Huayi’s full value chain

creates synergy


, 2013

6

have been participating in production. According to Huayi’s CFO, this trend won’t change in the

near future, which is quite different from its competitors, whose decision to acquire the

distribution rights was supported by the analysis on a variety of factors that typically include a

film’s expected critical reception, marketability, and potential for box office success. Thus, there

would be clear evidence that such business model would provide a guarantee for the films which

it has participated in the production.

The theatre business provides its distribution business strong negotiating power with

theatre circuits, maximizing the return from the film production

The theatre business assists companies in securing preferred scheduling rights. The film

exhibition business strengthens the distribution business of Huayi by giving it significant

bargaining power with theatre circuits. Theatre circuits form an important part of the film value

chain between film distribution and film exhibition. (Figure 12) The increasing investments in

movie theatres assist in securing the preferred scheduling rights, including timeslot and

screening schedule rate of films. The scheduling rights are key drivers to increase selected films’

market share as well as their box office. In 2013, the movie Tiny Times broke the records of the

whole Chinese film history by gaining a 45.01% first day screening schedule rate in over 20

major cities. Although the viewers’ opinions mixed, the extremely high screening schedule rate

still drives the box office broking RMB 2bn in the first three days of the film releasing. We believe

by enhancing control power in scheduling tights, the company will have a stronger capability to

provide a premium movie-going experience for the Chinese audience and increase the desire for

Chinese-oriented content. (Appendix 7)

Figure 12: Presence across film value chain

The theatre business also assists companies in securing more favorable revenue split,

and prompt and accurate payments by theater circuits. In 2012, revenue generated by the

Chinese film industry totaled $3.3 billion, an increase of 18%. Of this total, box office accounted

for $2.7 billion. (Figure 13) Due to the policy bonus in China, the box office split is highly

leveraged to theatres (Figure 14) by allocating around 50%. At the same time, theatre business

also profit from other sources of income, such as the sales of goods, rental of on-site advertising

space, and the preshow ads before films are shown. These sources of added income contribute

to the daily operational proceeds for each movie theater. Without considering the acquisition of

other theaters, assuming that starting in 2012, Huayi Brothers maintain the speed of opening 10

theaters a year, for each movie theater, its main operating revenue includes ticket sales and

Figure 13: Scale and growth of

Chinese film industry


, 2013

7

other revenue (sale revenue, advertising revenue, etc.), the main operating costs include (box

office spilt to producers and distributors (39.4%), rent, business tax and surcharges (3%), movie

special fund (3.5%) and others. We expect the theater business can achieve operating income of

458 million in 2013.

Figure 14: Box office split on an average

Huayi has the best horizontal integration in the industry, enabling it to largely

diversify content risk and fully utilizing its content resource, and brings huge

positive synergy

The current horizontal integration of Huayi is well positioned

Huayi has already stretched to talent agent, TV drama series, films, music, and other derivative

businesses. (Figure 15) In the United States, post-window distribution (such as online TV, cables,

DVDs etc.) and derivatives has become the majority of the revenue in the film industry, whereas

the ticket box revenue accounts for only 20%. (Appendix 8) Film productions have to be run in

connection with other media platforms to produce synergy, thus value of the films could

be fully utilized. Several recent acquisitions, such as Times Warner’s acquisition of Turner

Broadcasting, Viacom’s acquisition of Paramount and DreamWorks, and Disney’s acquisition of

ABC, have all proved this idea.

Integration of mobile gaming with film allows Huayi to fully utilize premium film and

drama resources, on a recursive basis.

In 2013, Huayi announced its acquisition plan for Yinhan Technology, a mobile game producer,

at a total consideration of 0.67 billion comprised of cash and stock.

Mobile game industry is growing fast with a promising future. Mobile game theme has been

a hot topic in China’s capital market due to its high growth potential. Chinese online game market

size reached 66.2 billion RMB in 2012, an increase of 24% from 2011, according to iResearch.

Mobile game accounted for 7.8 billion, or 11.9% of revenue of online game industry, and will

witness very fast growth in the following years. It is forecasted that the mobile game market will

reach 25 billion in 2016, indicating a CAGR of 35%.

The acquisition of Yinhan reflects no obvious synergy in stock price. Huayi paused its

trading on Shenzhen Stock Exchange on June 4, 2013, until July 24, when it released its

acquisition plan and continued its trade. We try to observe the return in the window from June 4

to August 14, the day before Huayi announced its Q2 earnings. During this period, the market

capitalization of Huayi increased by 2.51 billion (net of the industry effect, as measured by

culture and broadcast composite). We compare this additional market capitalization with the

anticipated fair value of the 50.88% investment in Yinhan, which we have estimated through a

comparable P/E multiple analyses to be at 3.57 billion. Since there is about 1 billion short in the

increase of market capitalization, our analysis suggests that no obvious positive synergy was

recognized in the acquisition by the market. (Figure 16)

However, the mutual and recursive promotion between gaming and film should provide

significant positive synergy to Huayi. It’s very common in industry practices to make sequels

for both popular films and games. When a film and a game share one common theme, the

mutual and recursive promote between them can be expected: for example, good topic depicted

in the film raises demand for the theme game, and the theme game leverages the theme of the

topic to fill fans’ imagination, pushing the topic even hotter. Case: Harry Potter series are famous

for the recomposing of film to the game. In the Harry Potter game, the players could control the

character and explore the magic world, which serves as a perfect complement for the film. The

Harry Potter series have been the most successful films series in the history, totaling over 7

Figure 15:

Computation of Yinhan synergy

Stock price of Huayi 6/4 14.275

Return from 6/4 to 8/14, Huayi 42.91%

Return from 6/4 to 8/14, Culture industry

index 28.36%

Huayi abnormal return 14.55%

Total outstanding shares of Huayi (MM) 1,210

Increase in Huayi market value (MM) 2,512

Yinhan comparable companies P/E on 8/14

Shunwang Technology, 300113 67.5

Bestv New Media, 600637 58.1

Peoplecn, 603000 40.3

Ourpalm Technology, 300315 89.3

Average Yinhan comparable companies

P/E on 8/14 63.8

Yinhan 2013E profit (MM) 110

Huayi's holding interest 50.88%

Implied Yinhan market value (MM) 3,570

Figure 16:

Figure 17: Harry Potter’s film and game

interaction


, 2013

8

billion box office earnings. (Figure 17)

Integration of TV drama series and music with film allows sharing of resources, and

gives Huayi positive synergy.

Under the horizontal integration of film with other forms of art, one single theme can be

transformed into different chains of Huayi, maximizing the business value of the same theme.

Case: Aftershock (Tang Shan Da Di Zhen) was initially a Feng Xiaogang film that was shown in

2010. As the poll reflected positive ticket revenue, Huayi recomposed the film to a TV drama

series to be shown in major TV stations in 2013.

Integration of travel with film has a huge potential with a downside protection

Huayi has already launched its travel program in cities of Shanghai, Suzhou etc., and we believe

this act provides both upside potential and downside protection, thus worth a high valuation.

Traveling and film business can motivate each other, Huayi especially benefiting from

strong contents. Disneyland and its animations being the best example, the tour site that is

based on films can in turn promote value for the film themes, and at the same time make

considerable profit through tickets and commercial estates. As one of the best content provider in

China, Huayi is most possible to translate the contents into attractions in the tour sites, and

consequently economical earnings.

Huayi’s investment in tour sites has a solid downside protection from licensing of the

contents, and no upside limit. Taking the Suzhou Film City as an example, Huayi has only

acted as coinvestor in the project, and has an option to increase its share in the future. Plus,

before the film city commenced its construction, Huayi could charge a license fee for using the

copyrights of its content.

Valuation

Discount Cash Flow Method

The base price from this model is RMB46.9 per share. With 1 year forward EBITDA of RMB

1,087mm, which implies 52.4x EV/EBITDA FY1, in line with comparable companies. See

appendix 9 for FCF calculation.

Five Year Projected Cash Flow Assumptions

We start our projection at Sep. 30, 2013 to Dec. 2017. Five year EPS CAGR is estimated to be

39.57% as a result of strong synergy realized from vertical and horizontal integration, safe

margin and continued monetization on well-established competitive positioning.

Revenue Projection

We identified 7 segments for the purpose of revenue projection, Film Production, Film

Distribution, TV Drama Production, Talent Management, Movie Theatres, Gaming and

Derivatives.

In projecting revenue from film production, we assumed a reasonable average film production

cycle of 2 years and built a film premier schedule (Appendix 10) to project number of films put

into marketplace per year. Subsequent segment revenue was the product of this number and

average box office result, estimated from prior Huayi movies growing at a conservative rate of 20%

per annum (gradually moving down to 10% per annum).

Our film distribution revenue was taken as a percentage of film production revenue, basing on

our understanding that Huayi primarily distributes its own productions. The share of distribution

revenue against production revenue reflects synergy realization achieved by production and

distribution integration.

Our TV drama production projection was based on a bottom-up approach, stemming from a

conservative estimation of number of studios and equally conservative production rate

estimation (as low as 1 production per studio per year). Average price per production projection

was based on historical numbers and a reasonable 15% annual increase due to increasing

competition among online video services and TV channels for broadcasting rights, bringing

Enterprise Value Implied Equity Value and Share Price

Cumulative Present Value of FCF $3,483.5

Exit EBITDA $2,035.8

Exit Multiple (1Y Forward) 39.8x

Terminal Value $80,941.3

Discount Factor 0.66

Present Value of Terminal Value $53,484.6

% of Enterprise Value 93.9%

Enterprise Value $56,968.1

Terminal Value

Implied Equity Value and Share Price Implied Perpetuity Growth Rate


Less: Total Debt (1,598.7)

Less: Preferred Securities -

Less: Noncontrolling Interest (3.7)

Plus: Cash and Cash Equivalents 1,402.1

Implied Equity Value $56,767.8

Shares Outstanding 1,210

Implied Share Price $46.9

Implied EV/EBITDA


2014E EBITDA 1,086.8

Implied EV/EBITDA 52.4x


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9

ever-high return for TV drama producers.

Revenue from movie theatres was projected basing on a conservative estimation of new theatre

addition rate and revenue realization schedule. Gaming revenue projection was based on

consensus annual growth rate of 30% and an conservative additional 10% due to synergy

realization from game development and Huayi’s ample content reserve that would not have been

achieved if Yinhan remained a standalone entity. Since derivative revenue cannot be reasonably

estimated, we safely assumed same annual growth as 2012.

WACC

We use the Chinese 10-year government bond risk-free rate of 4.5%, the expected market return

of 11% and the adjusted beta of 0.9 to reflect the Cost of Equity of 10.4%. While the Cost of Debt

is 4.8% from the company short term borrowing filings. Also we assume a constant capital

structure of Huayi in the following years with a Debt to Total Company Value of 2%. Then we

come to the Weighted Average Cost of Capital of 10.24% in the coming years for valuation

purposes.

Terminal Value Component Assumptions

Since Huayi is in an ultra-high growth sector, its valuation enjoys stellar multiple (the EV/FY1

EBITDA we used in our model was 39.8x, the median EV/FY1 EBITDA from Huayi’s 10 closest

comparables) which resulted in terminal value taking ~90% of total enterprise value. We believe

this is well justified as the implied perpetuity growth rate was a mere 8.5%.

Financial Analysis

Earnings

Stable rise in revenue created by the vertical value chain: Movie production revenue is

always the largest composition of the company’s revenue, 557.2 million RMB in 2012 and

contributing 40.19% of total revenue. Surrounded by the movie production business growth rate

of 20.3%, the movie distribution enjoys an increase rate of 79.8% to 55.7 million RMB in 2012,

while revenue contributed by the movie theatres increased at 73.08% to 128.5 million in 2012.

Gaming business enjoys the highest gross profit margin as a new growth engine: The

gaming business has reached a gross profit margin of 92.31% and 94.62% respectively in the

past two years, the highest one in all business segments. We believe the gaming industry would

continue its rapid growth in the coming five years.

Moderate ROE and ROA: Huayi Brothers return on asset reached 4.9% in December 2012, due

to large assets generated by abundant cash.

Balance Sheet

Increasing capacity in short term liquidity: The stable decline trend in three short-term

liquidity ratios indicate that Huayi is becoming increasingly capable of paying back its short-term

liabilities with its short-term assets (Appendix 14).

Aggressive CAPEX to fight in new business fields: The expansion into both vertical and

horizontal film business chain cost Huayi Brothers high investment, implying high CAPEX. The

capital expenditure was CNY￥156.8, 141.2 million in 2011 to 2012, respectively. We forecast

the CAPEX would still maintain a stable growth rate in the coming five years. In the movie

theatres investments, since 2010, the number of the newly constructed theatres increased by

about five per year. CAPEX to develop them will be CNY￥40-50 million per theatre in 2012-15.

Although we forecast aggressive CAPEX, CAPEX to sales ratio tend to be stable due to the rapid

growth of sales correspondently.

Risks

Upside risk

National policy reemphasis on accelerating development of the film industry

The Third Plenary Session of the 18th Central Committee ended in late November this year

reemphasis on accelerating development of the culture sector. In the past three years, the

Implied Perpetuity Growth Rate

Terminal Year Free Cash Flow $1,315.0

WACC 10.2%

Terminal Value $80,941.3

Implied Perpetuity Growth Rate 8.5%


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central government has released over ten policies to support and help the film industry to

maintain the high growth rate. On the December 1st last year, three new policies are published.

The government will subsidize domestically produced and distributed 3D, IMAX and high-tech

films, based on box office revenue, refund policy for newly developed theaters and subsidize the

installation of digital projection system - Theaters with a 45% or more box office gross revenue

within the last year may also enjoy special subsidized refunds. We believe in the near future,

national policy will become more and more leveraged to the support film industry. Huayi diversify

this risk by making ongoing investments to keep paces with national trend.

More common cross-board M&A stronger competitiveness in the international market

As China’s economy becomes stronger, mergers and acquisitions are becoming the most

effective way for Chinese companies to enter into and compete in the international market. Data

show a total of $11.7 billion USD in foreign investment in 2012, which was a 4.5% decrease over

the previous year. Huayi diversify this risk by relying on the fast growing China market to exploit

the opportunity of international coinvestment and co-production, becoming the bridge to connect

Chinese films with Hollywood as well as comprising pioneers in the international distribution of

films produced in China. It has leveraged this advantage in international distribution to cultivate

strategic alliances with distributors for foreign markets.

Moviegoer numbers reach 470 million as audience tastes mature

The total number of moviegoers reached 470 million in 2012, an increase in 27% over the

previous year. Between 2007 and 2012, admissions peaked in 2009 and 2010, and were

followed by a slowing in growth, which indicates market saturation. In 2012, the domestic

slapstick comedy Lost in Thailand was the highest grossing film in China, with total admissions of

over 35 million, well surpassing Hollywood blockbusters like “Avatar” and “Titanic 3D”. This is

evidence that Chinese viewers are eager for high-quality domestically produced films. Films from

a wide range of genres are now able to meet the needs of Chinese audiences and increase box

office revenue. Huayi respond to this trend by building up a film library to obtain sustainable

revenue.

Downside risk

Increasing reliance on in-house production adds to business volatility

The company has increased its presence in film investment and production, which adds inherent

risks to the business. However, Huayi Brothers has a “portfolio” approach to film production,

diversifying film investment across genres and reducing economic interest through “film

participation”. The company diversifies its capitalat-risk in film investment by syndicating film

investment to other investors while trying to keep its stake not more than 50% of the total

investment amount.

Revenue concentration—Top 5 films comprised over 70% of revenue in 2009

Top 5 films accounted for more than 70% of revenue from the 16 films distributed by the

company in 2009. However, as the company continues to seek an overall higher-quality movie

portfolio, we expect revenue concentration to be lowered.

Potential change in the supportive regulatory landscape

Apart from the consensus optimistic view on the national policy in culture industry, overall the

government is supportive of the film industry development in China. However, if the government

reduces tax breaks or becomes more vigilant on film content, the profitability of the company

could be affected.

Departure of key management likely to affect distribution and production

Film distribution and production business are highly human-centric. The top management of the

company significantly uses its influence and reputation to source distribution rights as well as

source quality artists for the films it produces. The departure of key management may also affect

the execution capabilities of the company, in our view.


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Appendices

Appendix 1

China’s cultural consumption

Film revenue accounts for less than 3% in cultural industry

36%

61%

2% 1%

Chinese culural expenditure, 2012

Publishing and printing Tourism Gaming Film


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Appendix 2

Chinese film distribution market share


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Appendix 3

Chinese film market has seasonality


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Appendix 4

Disney has grown to a media empire with full diversification and coverage


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Appendix 5

Huayi’s leading market share in film production


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Appendix 6

Huayi’s leading market share in film distribution


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Appendix 7

Huayi is the leading film distributor in China film industry

Huayi maintains a healthy relationship with most of the theatre circuits in China. Huayi distributed 8, 6 and 7 domestic

films in 2010, 2011 and 2012, respectively. Although the total number of distributed movies was less than its nearest

competitors, the numbers of blockbusters distributed is far beyond its competitors. Thurs, it remains the largest private

distributor in China in terms of revenue market share. Total box office revenue for Huayi Brothers in 2012 totaled over $333

million.

The company had a steady track record of distribution, especially blockbusters distribution over the past three years. We

believe it will be able to maintain its strength in distribution given its relationship and ability to secure distribution rights.


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Appendix 8

US film industry relies very few on box office


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Appendix 9


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Appendix 10


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Appendix 11


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Appendix 12


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Appendix 13


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Appendix 14


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Disclosures:

Ownership and material conflicts of interest:

The author(s), or a member of their household, of this report does not hold a financial interest in the securities of this company.

The author(s), or a member of their household, of this report does not know of the existence of any conflicts of interest that might bias the content

or publication of this report.

Receipt of compensation:

Compensation of the author(s) of this report is not based on investment banking revenue.

Position as a officer or director:

The author(s), or a member of their household, does not serve as an officer, director or advisory board member of the subject company.

Market making:

The author(s) does not act as a market maker in the subject company’s securities.

Disclaimer:

The information set forth herein has been obtained or derived from sources generally available to the public and believed by the author(s) to be

reliable, but the author(s) does not make any representation or warranty, express or implied, as to its accuracy or completeness. The information is

not intended to be used as the basis of any investment decisions by any person or entity. This information does not constitute investment advice, nor

is it an offer or a solicitation of an offer to buy or sell any security. This report should not be considered to be a recommendation by any individual

affiliated with CFA Beijing, CFA Institute or the CFA Institute Research Challenge with regard to this company’s stock.

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