Wow Unlimited Media (WOW.V) – Merger Arbitrage – 19% Upside

Current Price: C$1.40

Offer Price: C$1.66

Upside: 19%

Expected Closing: Q1 2022

The idea was shared by Dan.

 

US animated content creator Genius Brands to acquire Canadian peer/content producer Wow Unlimited Media. Consideration stands at 0.271 GNUS + C$1.169/share in cash for a total of C$66m. Current spread stands at 19% with plenty of cheap GNUS borrow for hedging. The buyer is flush with cash desperately needs this merger to refresh its growth story and therefore is unlikely to walk away – GNUS has raised a ton of cash last year, promised to do transformational acquisitions, however, has done very little so far. Shareholder approval is likely given merger consideration mostly in cash and acquisition multiple at 11xEBITDA seems fair and in line with peers. Management with 11% ownership is already in favor whereas the support from other major shareholders owning a combined stake of 27% is also likely. Consent from the Canadian foreign investment regulator is required. GNUS wants the combined company to remain eligible for various media production tax credits. There is some risk to that, as Canadians are protective of their cultural assets, however, given several similar precedents over the last few years, I think the approvals will be granted eventually. Shareholder meeting is expected in early Q1 2022 and the merger should close shortly afterwards.

I might be missing something, but the spread likely exists due to GNUS not appearing as a credible buyer at a quick glance and questionable valuation of its shares. Additionally, this is a nano-cap cross-border nature of this transaction as WOW primarily trades on the TSX Venture stock exchange with limited liquidity. The company also has an even less liquid OTC listing. A few more potential reasons for the spread are detailed below.

 

Risks

There are two major caveats worth considering:

• Probably the biggest is that GNUS so far is mostly an empty company built on retail investor hype and subsequent capital raises. The stock price is disconnected from fundamentals and is strongly driven by retail investor sentiment. GNUS had a few squeezes in the past and continues to be very volatile – share price jumped 50%+ after the company scheduled a conf. call to discuss positive business updates two days before the merger announcement. Shares were halted and then quickly returned to previous levels. This might pose issues with regard to shareholder approval as well as hedging. The offsetting factor is that merger consideration is mostly in cash and GNUS stock comprises only a quarter of it. GNUS stock is trading at current levels already for the whole year and the merger will create only 4% dilution ($16m in total value of new GNUS shares) and are unlikely to cause material post-closing selling pressure. Also, GNUS liquidity is multiple times higher with an average trading volume at US$6m vs WOW’s C$60k.
• There is plenty of cheap GNUS borrow right now but that might change till the merger closes. It’s worth noting that the merger timeline is quite short and historically, all of GNUS squeezes were short-lived. And again, only a quarter of merger consideration is in stock.
• Although the downside to pre-announcement prices is negligible, if failure of the merger coincides with failure to pass certain legislature, WOW stock might drift lower. Most Canadian content creators have rallied up in the last 2 months after Liberals have won the elections in September. The reason is that Liberals are pushing a Bill C – 10 which should even the current rules between Canadian broadcasters (which are required broadcast 60% Canadian content in the evenings till midnight) and streaming companies. The bill has so far failed in the Senate in Jun’21, however, Liberals said to continue pushing it if the elections are won (which they did on the 20th of Sept). Markets have viewed it positively – Wow was up +40% since the elections to merger pre-announcement, while peers Wildbrain and Thunderbird Entertainment were up +17%-20% in that timeframe. There are two things that at least partially offset this risk – the merger should close in Q1 (likely the early part of it) and I don’t think that there will be any major decisions made on the bill in due time. Second – the whole sector is riding positive macro tailwinds due to the increased demand for quality content – WOW financials are expected to continue improving. Q3 results are due by the end of November and might provide further support to the share price if the merger breaks.

Overall, in light of the high probability of successful merger closure and substantial upside/IRR, the risks are tolerable.

 

Regulatory approval

The merger has to be approved under the Investment Canada Act (foreign investment watchdog) and is subject to the pre-acquisition restructuring of WOW Canadian operations to ensure that they will continue to satisfy Canadian control regulatory requirements regarding tax credits.

Film and video production tax credits were introduced in 1995. There are two types – CPTC (provincial) and PSTC (federal). CPTC allows subsidizing 25% of the qualified labor expenditure and PSTC for 16%. WOW is eligible for both (but it’s impossible to receive both for a single project). Requirements for application can be found here.

Importantly, there have been several similar mergers completed recently. These precedents suggest that GNUS will manage to structure the deal in a similar way in order to receive regulatory concent.

• Hasbro (US) bought Entertainment One in Dec’2019. A pretty similar (also required consent under Investment Canada), only a much larger deal for about C$6bn. Closed in one month from the announcement.
• Rainbow (Italy) acquired Bardel in 2015. Merger was of a similar size as the current one

WOW’s CEO Michael Hirsch is also a very experienced industry player/producer and has sold several media companies before (Nelvana, Cookie Jar, etc.).

 

WOW

WOW operates two business segments – animation production, which produces content for its own IP (e.g. Castlevania, Bravest Warriors, etc) and provides services to third parties (Netflix, Amazon Prime, Sony, Hulu, Dreamworks, etc.). WOW has worked on such names as Adventure Time, FairlyOdd Parents, PowerPuff Girls, Dexter’s Laboratory, Barbie, etc. The company owns two studios – Mainframe Studios (Canada) and Frederator Studios (US). Animation production comprises 60% of total revenues. The second segment comprises advertising revenues from proprietary Youtube channels (around 2500 advertiser-supported channels with over 1bn views per month) and administration of third-party Youtube channels (ad. revenue split).

Historical performance:

The company in its current form was built in 2016 (former Rainmaker Entertainment + Hirsch Entertainment + Frederator Networks). Since then, WOW managed to grow its top line considerably, however, the profitability was overhung by a “not great” Youtube business segment. In Dec’19, WOW announced termination with one of its key channel affiliates for which it had administrated Youtube channels – hence the revenue drop and higher profitability in 2020. In 2020 the company has also started restructuring Frederator (studio and YT networks) for which it expects annual C$1.9m EBITDA accretion. H1’21 has been quite strong so far, with Animation Production revenues growing due to IP delivery. WOW has stopped burning cash. Still, the company’s cash position is not strong with C$2.3m  in cash and C$7.7m in debt as of Q2’21. Assuming increased growth, it might encounter problems with funding needs for production expansion as production tax credits are only received after the project is completed. Apparently, raising funds is not easy as well as last year WOW raised pretty expensive C$4.5m convertible debt (C$0.55/share conversion price, WOW share price at the time stood at C$0.45/share) at a 9.5% yield.

Current acquisition offer values WOW at 11.3x LTM adj. EBITDA. In comparison, its peers TBRD.V trades at 11x LTM adj. EBITDA and WILD.TO at 13x adj. EBITDA. I think the offer is fairly valued given that TBRD.V is a better, higher-margin, more profitable performer with a much stronger balance sheet, while WILD.TO is a 10x larger and a rather well-known company, also with higher margins.

 

Major shareholders

Merger PR stated that non-minority shareholders (directors) own 11% of total outstanding shares (common stock + convertible notes). Aside from the directors, other major shareholders include (as of May’21):

• PenderFund Capital – 6.3%. PenderFund built the stake between Jan’19 and May’20 (share price range of C$0.20-C$1.20). PenderFund is mostly a mutual funds manager with around C$1.5bn+ AUM. WOW position used to be held in the Small Cap Opportunities Fund. However, this September, PenderFund has also launched a new merger arbitrage fund called Pender Alternative Arbitrage Fund (ref. PAAF). Interestingly in October’s letter of the PAAF, the arb fund has highlighted the WOW merger as a good example of a merger arbitrage case saying that it now holds an arb position in WOW (see quote below). I’m not sure if the PenderFund just switched WOW ownership from the previous mutual fund to the new arb fund or acquired additional shares (so its actual total ownership could be bigger than 6.3%), but fund management clearly states that they consider the situation attractive and are going to support it.

Pender equity portfolios continue to provide a steady stream of investment opportunities with 2021 being a record year for take-outs within our equity funds with eleven take-outs completed or announced. Even in the short period since launch, we are already seeing the benefits of the Fund being an organic extension of our equity ecosystem. The successfully closed acquisition of Cloudera, Inc. (CLDR) and recent investments in GreenSky, Inc. (GSKY), AgJunction Inc. (AJX) and WOW Unlimited Media Inc. (WOW) are examples of investments made by the Fund in companies that Pender’s equity funds either hold or recently held a position.

• Frederick Seibert – 11.5%. Used to be WOW’s Chief Creative Office, but left in August’20.
• BCE – 9.3%. Acquired shares in Sep’18, when WOW bought certain BCE’s broadcasting license in WOW shares. Each share was valued at C$2/share, so theoretically BCE has lost money so far. However, BCE is a major Canadian media conglomerate with C$58bn market cap, so this is a negligible position to them and I think BCE will support cash-out and conversion of a smaller part of the investment into a much more liquid stock (GNUS) at a decent premium to recent market prices.

So overall, I expect that major shareholders, with a combined stake of 27%+ of outstanding shares, will support the merger. Given a seemingly fair offer price and decent premium to historical levels (3-year high price) I expect that the remaining required votes won’t be hard to get as well.

 

GNUS

The company creates and distributes its IP video content, but outsources the production to China. Pretty much until COVID, GNUS used to be a half-dead stock with business operations resembling a start-up and a serious threat of getting delisted from Nasdaq. The company operated its two digital content platforms – Kid Genius Cartoon Channel and Baby Genius TV. The company had a few IP assets – e.g. two small/old shows, Warren’s Buffet’s Secret Millionaires Club and Thomas Edison’s Secret Lab, and was developing/pushing two new prospective shows Rainbow Rangers (on Nick Jr.) and Llama Llama (Netflix). However, the company generated very little revenue – $5.9m in 2019 and started 2020 with around $4m market cap, $0.3m cash, $2.4m debt, and 11.9m shares outstanding. Then in May’20, the company announced that it is merging its two digital platforms into one network brand – Kartoon Channel and will significantly expand its distribution reach to over 100M television households and 200m users via OTT and mobile devices. Probably because it was still the peak of COVID fears and everyone expected at-home entertainment to do very well, GNUS share price skyrocketed 6x over the next two weeks and was up 30x by Jun’20. The squeeze took a few months and the share price has finally settled at around $1.20/share in Sep’20 still substantially higher compared to pre-pandemic levels.

Right after the Kartoon Channel announcement (in fact, the next day), GNUS began a spree of secondary offerings the company immediately began secondary offerings raising about $100m in 2020 and without any major business improvements ended the year with a $400m market cap (after tenfold increase in share count), $100m cash, no debt and hardly any revenues ($2.5m for the whole 2020). In Q1’21 GNUS raised another $57m from warrant exchange. As of Q2’21, the cash balance stands at $139m.

The company has done very little with the cash pile so far. In 2020 it acquired Stan Lee’s post-Marvel IP (some of his later work and rights to his name) in a joint venture with POW! for $2m. Later, in Nov’20, acquired media advertising firm ChizzCom for $12m. On the operational side, things did not go very well – the Llama Llama show has pretty much failed (season 3 was canceled) and Nick Jr./Shanghai Senuy Media discontinued season 3 of Rainbow Rangers. The company is now creating a season 3 of Rainbow Rangers exclusively for its own Kartoon Channel platform, while Netflix has recently picked up Season 1. Additionally, GNUS has finally launched (after 10 years) the Superhero Kindergarten show (voiced by Arnold Schwarzenegger) and has announced another animated show Shaq’s Garage (voice by Shaq). Aside from licensing, GNUS own Kartoon Channel platform generates revenues only through advertising as the subscription model attempts have failed. During 2021 revenues have picked up somewhat – $3.4m in H1’21, mostly due to the launch of Superhero Kindergarten and the addition of ChizzComm (media advertising), however, based on fundamentals the stock is still incredibly overvalued and is basically alive on its promises alone.

Due to high short interest (currently 18%) the stock has received some attention from Reddit/WSB – there was a short-lived squeeze from $1.60/share to $3/share in Jan’21) – and remains pretty volatile.

GNUS’ brands:

GNUS CEO is extremely promotional, calls Kartoon Channel “the Netflix for kids” and always compares GNUS with other media/streaming giants putting it in their league. However, shares have been going sideways for over a year now (aside from a few temporary spikes) and the CEO has many times promised that the company will use its cash to make transformative acquisitions and grow the business. None of that has been done so far and given lackluster financials, sooner or later the company had to start delivering. Apparently, the acquisition of WOW is the first big step in that direction (source):

This last year, Genius raised a lot of money and we promised our shareholders we would deploy our cash and stock to grow our company and make smart acquisitions. I can think of no smarter acquisition than Wow Entertainment

Basically, the merger will allow GNUS to continue its hype story and will finally add some sizeable revenues. No wonder the PR’s are highlighting that GNUS “grows Pro-forma LTM revenues by over 1100%”, which is kind of funny given the context. On top of that, the merger should be synergistic and will vertically integrate GNUS with in-house content production capabilities from WOW. That’s why it needs those tax credits – to be able to switch from the current Chinese producers. Additional benefits include significantly increased content library, cross-stocking opportunities, as well as several names that WOW has worked on (e.g. Madagascar, Barbie, etc.) that GNUS management will be able to use to continue pumping the stock. Also, GNUS expects to improve WOW brands’ monetization with its recently acquired media advertisement division.

Given the position GNUS is in I think it is very unlikely the buyer will walk away from this merger.