Investment Thesis Lodge Net (NASDAQ:LNET) might be a candidate for bankruptcy filing probably for mid-2012. The current balance sheet deleveraging efforts are putting a cap on expenditures, which are vital element for a tech Company. These efforts cannot last long because technology rapidly changes and the Company will eventually be forced to spend again or profitability will be eroded and margins will start to decline. Lodge Net also records on its balance sheet a large amount of goodwill and intangibles, which will eventually have to be written down as a rapid shift in technology will cause these intangible assets to be worthless.
Company description Lodge Net is a dominant provider of interactive television and media solutions solution to the hospitality industry in the US. The Company is divided in four main segments: Guest Entertainment, which provides a wide range of guest-paid entertainment options including movies, games, music and other interactive services delivered through the televisions, the Hotel Services segment, which provides services to hotels at a monthly fee, the System Sales segment, which delivers advertisement and TV commercials, and the Healthcare segment, which sells entertainment solutions to hospitals.
The levering up period For the last couple of years, Lodge Net has been trying to deleverage its balance sheet. In 2007, Lode Net acquired two competitors through a debt offering, creating a highly leveraged Company. The deleveraging efforts have been successful so far, mainly due to reduced capital expenditures. However, this trend is not sustainable because rapid technological changes, which are inevitable, will force Lodge Net to upgrade its systems, increasing capital expenditures and decreasing free cash flow significantly. At that point, Lodge Net will be force to stop pay down debt, affecting the compliance with debt covenants under its Credit Facility.
Misconception For the past 12 months, the company has shifted focus from increasing operating performance to optimizing its free cash flow, which has grown from 15mm in early 2009 to 23mm in Q110. The FCF is being used to reduce its long term debt which is currently at 417mm. Management is forced to undertake this strategy otherwise high leverage will cause non compliance with debt covenants in the near future. However, there is a flaw in the Management’s decision. Positive FCF is generated from reduction in capital expenditures and not from earning growth. Once Lodge Net will need to spend to keep up with new technology, capital expenditures will rise again, putting a dent on FCF and on the deleveraging efforts. The technology shift process is already in place. Lodge Net provides HD television system solutions, but its customers will eventually shift their taste, prefering 3D over HD TV for example, forcing Lodge Net to upgrade it system and write down intangibles.
Scenarios A shift in technology and consumer taste, which I assume will occur in the next 2 years, will put the company at a crossroad. If the Company does nothing and continues to keep cap ex low and use FCF to reduce leverage, profitability will be eroded. If the Company starts spending, it will be able to keep up with demand, but at the expense of leverage, which will remain high. Either scenario doesn’t look too good. I am working on crunching some numbers to show how the two scenarios will affect the Company.
Goodwill and Intangibles Lodge Net has a significant amount of Goodwill and Intangibles on its balance sheet, approximately 206mm or 42% of all the assets. Considering tangible book value alone, the Company is highly overvalued at these levels. Impairment of goodwill or intangibles will be warranted if technology or customer taste shift rapidly.
Company vs. Peers It’s not easy to find a true comparable in the industry as the Company provides a unique product not offered by competitors. Relative valuation is not meaningful in this case.
Conclusion Deleveraging is coming at the expense of profitability as the Company will not be able to increase its capital expenditures for some time. However, for a tech Company, R&D is vital as the industry shifts quickly. Not being able to adapt to new technologies, it will put a dent on profitability. In the next post I will get into more details and work the valuation.
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August 13th, 2010 on 23:29
LNET is a media company like cable companies. They provide TV and entertainment service. Technology is a enabler much like it is for cable companies. True it has cut capex in the downturn to generate free cash flow but debt has stepped down below the 3.5x covenant level giving them plenty of opportunity to start deploying capex for HD upgrades. They have held back upgrades because they want hotels to share in the expense. Hotels are doing it because Lodgenet is the only game in town. The Company is generating $60M in FCF per year to continue paying down debt and keep upgrading the rooms as hotels start to open up the spigot on capex sharing. Upgrade costs have come down to one third of what they were a couple of years ago. The upgrade from HD to 3D does not need to be hardware upgrade (ask your local cable provider they can choose to provide it without upgrading your box. Thats how most cable companies did the 3D world cup soccer). Also look at the 2009 annual report filing. Their interest rate hedges roll off June 2011 which will provide an extra $20 million of free cash flow/yr (thats a 33% increase). Lastly, looking at the book value and saying it is full of goodwill is not the accurate way to value every company (a common example used by Buffett is Coke. The value is in the brand). LNET’s value is in the moat they have built with relationships and contracts with the hotel industry and studios and a proven infrastructure to serve entertainment content to hotel guests . A upstart competitor will have to spend a lot of money and incur losses (resulting in negative book value) to starting putting together the elements needed to compete with Lodgenet.
The bear thesis on this story has been driven by those who believe that ipad and laptops will kill their guest entertainment revenue (on demand movies and adult content which is a meaningful portion of their revenues and EBITDA). However, the movies they offer are not yet on DVD so it is generally not possible to get it elsewhere legally by downloading it or from DVD. Laptops have been around for a while and may not explain the softness that has accompanied the downturn. While there is likely cannibalization, revenue declines have abated and EBTIDA has already stabilized. They are not completely out of the woods but at 1.2x free cash flow valuation, and what I believe to be sustainable leverage, this thing will be a 2x-3x (stock is at $2.57) if revenue continues to decline modestly, 5x if revenue is stabilized.