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Coping with the new normal

* Zee Entertainment (Z) may be set to achieve pre-COVID scale in 4QFY21, led by recovery in ad spends, coupled with improved market share. Thereafter, revenue growth should normalize to 11–12%.

* Zee’s OTT – Zee5 is in fierce competition with the big players and requires substantial investment (~10 percentage point operating margin dilution), dragging down profitability.

* The EBITDA margin may be pressured – as inventory for the past three years and working capital investment are expensed – as the company is investing heavily in content.

* While tapering investments in inventory should drive positive FCF, repeated oneoffs/provisioning pose a risk to the balance sheet.

* The stock has seen good returns in the recent past. Going forward, earnings recovery in the near term should support the stock. However, for multiple re-ratings, an improving margin outlook and balance sheet stability would prove key. Maintain Neutral.

Recovery in viewership share bodes well for Z

The TV Ad market has witnessed healthy broad-based recovery with consistent MoM improvement in ad spends to near pre-COVID levels. Simultaneously, Zee’s viewership share has also seen steady improvement across Hindi and regional channels and is gaining strength in south India channels. The benefits of a weekly increase in the number of hours of original content on Hindi GEC primetime further reflects improved viewership share. Additional growth in original content planned, along with new non-fiction and selected replacements of content, should aid in recovering further ground. We expect ad revenue to grow 5% for 2HFY21 as well as in 4QFY21. We factor in FY22 ad revenues at an FY20 base of INR44.4b.

Focus on OTT remains high; profitability may be elongated

Zee5’s original content investment spree has continued over the last three years – it has built a strong library by adding ~20 original shows every quarter consistently over the last 2–3 years. However, usage and monetization are yet to catch up as consumption shifts from telcos to own platforms. Compared with other OTT platforms, Z is still far behind in terms of usage. Given the low usage, revenue continues to be largely contributed by subscriptions – as contribution from ads remains weak. Given the crowded domestic OTT market and fierce competition offering extensive content at low prices to attract subscribers, increased investments could stretch the EBITDA breakeven beyond 3–4 years.

Investments in content to remain high; margin may be capped

Zee’s operating cost should remain elevated due to a) high spends on Zee5 (~10 percentage point margin impact on 3QFY21 annualized) toward fresh content and heavy movie acquisitions, b) ramp-up in TV content to improve viewership share, and c) the expensing of the high inventory buildup in the last four years. This may keep the EBITDA margin under its historical guidance of 30%. We expect an EBITDA margin of 27%/27% in FY22/FY23, building in EBITDA growth of 60%/13% and PAT growth of 72%/14%.

Balance sheet cleanup a work in progress

Sharp increase in Zee’s working capital and repeated write-offs have been key investor concerns. The company has seen cumulative exceptional loss and one-offs of INR12b in the last six quarters – forming ~56% of total EBITDA (1QFY20–2QFY21) toward the write-down/provisioning of investments or working capital adjustments. Current assets and investments, which were 55% in FY16, increased to 78% in 1HFY21, with absolute growth of 19% over this period. Management has now indicated that inventory and current assets are expected to decline. This, along with the liquidation of investments and receivables from DishTV, would be pivotal in reviving investor confidence.

Valuation a function of consistency in earnings growth; concrete steps toward balance sheet cleanup

Improving ad growth, on the back of recovery in ad spends and market share gains, should certainly aid earnings growth and the near-term valuation. However, a) continued pressure on the margin due to investments in OTT/content, b) the expensing of the recent high inventory buildup, and c) the lack of visibility on balance sheet stability could weigh on the valuation. The management has stretched Zee5’s breakeven target to FY24, and any progress on this should drive growth and the valuation. We roll over our valuation to FY23 with TP of INR250. We maintain our Neutral rating, factoring in 14x multiple on FY23 EPS of INR18.

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