Design And Animation Industry: Operating Margins Attractive, But Declining

Revenue of pure-play design and animation firms grew at a CAGR of 27% from 2007 to 2011

- Revenue of pure-play design and animation firms grew at a CAGR of 27% from 2007 to 2011
- EBITDA margins are the only silver lining for the industry, while net margins continue to be a concern
- Unattractive returns and low interest coverage are raising questions on investments
- DQ Entertainment tops the ValueNotes Service Provider Evaluation Ranking in 2011

India is known to have one of the largest entertainment industries in the world, second only to Hollywood. The country has the potential of becoming a significant destination for outsourced animation and visual effects services. Operational costs are low compared to the west; telecom infrastructure is robust; and there is a large pool of English-speaking graphic artists who are technologically savvy.

Indian design and animation companies have been growing steadily over the last five years. The revenue of Indian pure-play service providers in the industry grew at a CAGR of 27% from 2007 to 2011, while aggregated revenue increased by 18% year-on-year in 2011, according to a ValueNotes report titled "Design & Animation: Financial Performance Review". The report analyses the key financial ratios of pure-play service providers with operations in India, which specifically cater to the animation and special effects segment. The report found that a lack of prudent financial management has dented the benefits of steady growth. Till 2009, revenue growth in the industry was high, but costs were increasing at a faster pace. As a result, the bottom line was poor and showed no sign of improving.

According to Arjun Bhuwalka, project manager at ValueNotes, "EBITDA margins are attractive but declining, while net margin continues to be a concern. EBITDA margins declined in 2009 and have been flat with a minor improvement to 31% in 2011. On the other hand, net profit margins do not paint a happy picture, as they have hovered around 10%."

Unattractive returns and low interest coverage have been raising questions on investments. The aggregated return on capital employed (ROCE) for the companies, has been in single digits during the last four years and was a meagre 6% in 2011. Moreover, in this period, interest coverage fell to 2.49 in 2011.

Top 5 service providers in the design and animation segment in 2011

The leader, DQ Entertainment, represents the financial performance needed by players in the industry in the current situation. The company topped the Service Provider Evaluation ranking in 2011 and has shown strong financial credentials across parameters, with the highest reported revenue, backed by high margins and good shareholder returns. Other companies that have stood out for their financial performance are Prime Focus, Prasad Corp, Crest Animation, and Digient.

Overall, low returns, weak net margins, poor working capital management, and declining interest coverage ratio make the design and animation industry unattractive from a financial perspective. Performance on these key financial indicators has improved marginally in the last couple of years but the companies have not done enough to indicate any potential for a turnaround. Although revenue growth has decelerated, it is still high - this provides an opportunity for companies to improve their performance. However, this will require quick and significant measures in reducing cost.

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