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by Zena Olijnyk
Canadian Business Magazine
Oct 22, 2003
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The DVD of Ang Lee's The Hulk won't be
out in stores for weeks, but on a steamy July day in Huntsville, Ala.,
workers are churning out thousands of copies an hour of one of this
summer's most hyped movies. A replication machine spits them out with
a rhythmic ka-chunk, ka-chunk, before they're packaged and stacked into
boxes bearing bright-orange stickers warning retailers not to display--or
sell--them until the DVD's official release on Oct. 28. "These
machines run pretty much 24-7," says Michael Goff, director of
DVD operations for Cinram International Inc. and a native of West Virginia,
as he gives a tour of the plant. The facility is huge, more than a million
square feet in total, and has ceilings as high as 40 feet. It's also
the jewel in the crown of Cinram, a Canadian company based in Toronto
that operates DVD, CD and video manufacturing facilities in the US,
Europe and Mexico. If the Hulk were real, the big green monster would
have no trouble fitting into the Huntsville operation.
When The Hulk is finally available for home viewing--and it's likely
to be a huge release for Universal Pictures--a VHS version will be available,
too. But it's becoming clear that DVD is where the real action is these
days, and that the VHS format may be dying. In fact, as Goff and and
his colleague, Bruce Deck, a customer manager at the plant, head into
Cinram's VHS duplication facility, it's eerily quiet compared to the
DVD production area, and a good chunk of the thousands of video duplicators
aren't operating.
Cinram's silent video duplicators are just one indication of how the
DVD format has taken consumers by storm since its introduction to the
home market in 1997. Today, more than half of households in North America
have at least one DVD player; disc sales are growing exponentially.
That has surprised even the most ardent early adopters. "We're
stunned by the numbers," says Kaan Yigit, president of Solutions
Research Group in Toronto, an entertainment industry consulting firm.
Yigit cites research showing that 48% of Canadian households already
own a DVD player--up from virtually none in 1998--and another 17% are
likely going to buy one in the near future. "It took about five
years for DVDs to penetrate one out of two households, in comparison
to CDs and PCs, which took about 12 years," he notes.
When it comes to DVD movies, the number of units sold has skyrocketed
to an estimated 990-million-plus this year from about 11 million in
1997, according to Tom Adams of California-based Adams Media Research.
US households owning DVD players now buy an average of 15 titles a year,
compared with the five or six videos consumers bought at the height
of the VHS boom. (Yigit says his research shows that Canadians per capita
buy an average of two DVDs every six months.) Adams expects that more
than 1.6 billion DVDs will be sold annually in North America by 2007.
"Compared to videos, DVDs offer a much better viewing experience,
with better quality and many extra features," he says.
Cinram has taken full advantage of the trend. It jumped on the DVD bandwagon
early enough to secure a strong foothold in the business, and now commands
about 14% of North American DVD market share, according to Adam Shine,
an analyst with National Bank Financial in Montreal. This summer, the
company came up with its own blockbuster: it announced it will buy the
DVD and CD manufacturing and distribution assets of AOL Time Warner--known
as Warner Advanced Media Operations--for US$1.05 billion. Once the deal
closes, as expected, sometime this fall, it will almost triple Cinram's
annual sales to more than $2.3 billion. According to Shine, its North
American DVD market share will jump overnight to 35%, meaning it's fast
closing in on the industry leader, Technicolor Entertainment Services
of California, which has 41%.
Shine says the deal will help Cinram (TSX: CRW) extract cost and revenue
synergies through "its expanded critical mass, broader scope of
services available to studios and music labels, and enhanced geographic
reach." He estimates the company will have earnings per share of
$2.44 in 2004, reflecting the acquisition, compared to his pre-acquisition
estimate of $1.54 per share. "This deal helps get Cinram to the
next level," says Evan Spiropoulos, portfolio manager at Hesperian
Capital Management in Calgary, who includes the company as one of the
top holdings in the funds he manages.
The acquisition, which sees Cinram taking on more than US$1.2 billion
in debt, firmly put the Canadian company on the radar screens of investors
and business media in the US. In fact, the day it was announced, July
18, Cinram chief financial officer Lewis Ritchie had hundreds of calls
to return--and the company's Web site crashed from the sheer number
of hits. "We never could have imagined the reaction to the announcement
when it came out," says Ritchie. Investors sent Cinram's stock
up by more than 40%--to $24 from $17.05--in the first two days of trading
after the announcement. Analysts who had targets in the $16 to $19 range
boosted forecasts to between $28 and $34 over the next 12 to 18 months.
(Shares now trade at around $27.)
"It's been quite a trip," says Isidore Philosophe, Cinram's
founder and chief executive, as he discusses how the AOL deal came together
following months of negotiations. Philosophe first broached the topic
with AOL execs in March, and spent a frantic few days nailing down details
before it was finally made official. "We hadn't slept for days
before the announcement," he recalls. "I didn't believe the
human body could withstand all that."
Philosophe speaks softly, in an accent that reflects his roots in Lebanon--where
he was raised by a Greek mother and Turkish father--and apologizes when
his English isn't perfect. Cinram was considered an underdog when rumors
began to fly that AOL was planning to sell its manufacturing and distribution
unit to bring down some of its US$26-billion debt and focus on core
businesses. It was up against a bid put together by AOL Time Warner
executive Jim Caparro, head of WEA Inc., the distribution arm of Warner
Music. In the end, AOL went with the Canadian company because of its
34-year track record--during which, says Philosophe, his company never
lost a customer by its own doing. "We've only lost a client if
it was acquired by someone who had their own manufacturing capability."
Cinram, a publicly traded company since 1986, has been underestimated
more than a few times since Philosophe started it out of a 1,500-square-foot
basement in Montreal in 1969 to duplicate eight-track music tapes, then
considered to be the hot entertainment medium. He moved to Canada in
1967 after working for a music distribution business started by his
father, a company not-so-coincidentally called Cinram, a French acronym
for "cinéma, radio, musique." Having seen a prototype
of a cassette tape in 1964, Philosophe began knocking on doors to raise
money to create his own prerecorded music manufacturing business. He
found a silent partner in Sam Sokoloff, co-owner of a Montreal electronics
business, and with his help and a $150,000 loan, Philosophe launched
Cinram with five employees, including his wife and brother.
The company, which focused on vinyl record and cassette production,
moved to Toronto in 1979 to be closer to its customer base. It went
public primarily to finance a complex transition to CD manufacturing,
and completed construction on a Toronto CD plant in 1986. As CD sales
grew, Cinram abandoned vinyl record production entirely by 1991. That
same year, it turned its attention to VHS video duplication at plants
in Toronto and Richmond, Ind. In the mid-'90s, Cinram took steps to
enter the European entertainment media market with the opening of a
VHS duplication plant. With every change in technology--from eight-track
to cassette, vinyl records to CDs, VHS to DVD--there were industry watchers,
investors and analysts who didn't have confidence that Cinram could
adapt. But Philosophe repeatedly proved detractors wrong.
In 2000, for example, after years of earnings and revenue growth in
its CD and VHS business, Cinram was hit by several negatives at once:
an off year for music and movie releases in North America; price pressures
due to industry overcapacity and higher costs for material; and the
need to outsource some manufacturing while it was adding capacity to
its Huntsville plant and gearing up for DVD. All those factors impaired
margins, and the company ended up with a net loss of $28 million on
sales of $652 million, compared with earnings of $19.3 million on revenue
of $646 million the previous year. As well, it began to bear the brunt
of investor apprehension about the impact of Internet music piracy on
CD sales. Cinram stock plunged to as little as $2 in early 2001 from
more than $50 (before a February 1998 stock split). Even as late as
last October, you could have picked up Cinram shares for less than $6
apiece.
Philosophe says the company stuck to its knitting--and did not jump
on the Internet bandwagon even when shareholders derided him at annual
meetings for not doing so. By 2002, Cinram was back on track financially.
For the fiscal year ended Dec. 31, it had revenue of $879 million and
net earnings of $55 million. For the first six months of this year,
Cinram had revenue of $387 million and net earnings of $23 million,
up from revenue of $353 million and profit of $12 million for the same
period last year.
Cinram now produces DVDs, VHS videos, audio CDs, audiocassettes and
CD-ROMs for motion picture studios, music labels, publishers and computer
software companies. In Canada, it has manufacturing and distribution
facilities in Toronto, and in the US has plants in Indiana and its flagship
operation in Huntsville. In Europe, Cinram has DVD and VHS duplicating
capabilities in Britain and France. It's also 50% owner of Latinoamericana
SA de CV, a manufacturer of CDs, DVDs and VHS in Mexico City. With the
AOL Time Warner deal, Cinram will acquire several manufacturing plants
in the US and Germany, along with associated distribution facilities.
It will also enter into exclusive long-term agreements with Warner Home
Video, Warner Music Group and New Line Cinema to manufacture, print,
package and distribute DVDs and CDs in North America and Europe.
One reason Cinram has managed to survive technological change, says
Philosophe, is that it keeps costs down--in a commodity business where
savings of fractions of a cent per unit have a big impact. "We
have invested a tremendous amount of money in people and manufacturing
processes, with a vertical integration strategy that addresses changes
in technology very quickly," he says. Cinram keeps a sharp eye
on new technology that might be around the corner, but "drops into
it big-time when it is mass media," Philosophe adds. "We are
not inventors; we are followers with good technology and good manufacturing
capabilities."
Not to mention good instincts. The company, for example, made some of
its biggest acquisitions in the VHS business when the video market was
already quite mature. Why go that route, given that DVD was around the
corner? Philosophe says Cinram needed to build relationships with movie
producers to secure its future in DVD, a format he was convinced would
prove a hit. His prescience paid off: DVDs now make up 46% of Cinram's
revenue, compared with 28% in 2002.
Philosophe also understood that Cinram would have to diversify. That's
why the company decided to expand beyond manufacturing into distributing
DVDs, videos and CDs. The prepackaged media market has been shifting
recently from a central distribution model--where product is shipped
by a third party to a retailer's distribution centre, then sent off
to specific stores--toward a direct-to-retail model, where product leaving
the plant is sent straight to outlets. Cinram's management recognized
it would be easier to win contracts by offering distribution in addition
to manufacturing. The company now handles everything from initial placement
of orders and inventory control to warehousing and final shipping, as
well as billing services and returns processing. While distribution
has traditionally been a loss leader for companies like Cinram, it is
now key to winning and keeping contracts. It has also become crucial
in its own right: Cinram raked in $72.2 million in distribution revenue
in 2002, up from $42 million in 2001.
So what's in store as Cinram enters a new stage in its evolution? Short-term,
Philosophe and Ritchie say they'll concentrate on closing the AOL deal
and integrating the new assets. As well, they want to pay down Cinram's
debt, which analyst Patrick Tomalin of Orion Securities in Toronto expects
could be retired by 2007, given free cash flow he estimates at $248
million in 2004 alone. "I absolutely hate debt," says Philosophe,
who admits, however, that he couldn't resist the "fantastic"
5.3% financing terms he was offered by Citigroup and Merrill Lynch.
There's also been speculation Cinram could come out with another equity
offering, but Philosophe insists that's not in the cards--for now. On
the technology side, Cinram is already anticipating the next wave of
DVD--a high-definition, high-density disc. However, the technology probably
won't have a significant impact on the market for another five years,
and industry watchers say DVD will almost certainly be the predominant
format for most of this decade.
Naysayers point out that video-on-demand and downloading from the Internet--a
big blow to the CD music market--are likely to impact DVD sales in the
next few years, and manufacturers like Cinram are bound to suffer. But
Philosophe and Ritchie counter that people have predicted doom and gloom
for Cinram many times in the past--only to see it come back again and
again. "People think that we're in vogue now, sort of like today's
hula hoop," says Ritchie. "But the reality is that we've been
making something that's been in fashion for decades--it's content, music
and movies. Formats change, but we're still here."
A sign in Philosophe's office makes the same point even more, well,
philosophically. It pictures a cluster of sailboats, with a caption
that reads: "We cannot direct the wind, but we can adjust the sails."
It's an attitude that might well propel Cinram forward as it faces the
next strong headwinds of change.
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