Mergers and Acquisitions

Tom Johansmeyer
Few companies have meaningful market shares, struggling to maintain sales; brand perception continues to outpace revenue performance; and even the largest companies will become attractive acquisition targets, especially for outsiders who can introduce disciplined business practices, increase efficiency and boost earnings. These factors could create significant acquisition opportunities, benefiting owners of production companies and websites who are ready to sell. Porn is ripe for consolidation.

There is little doubt that the porn industry is fragmented. No one company owns a significant share of the multi-billion market; the industry lacks a clear market leader. With more than $300 million in annual revenue, Playboy is the largest of the adult content companies, more than doubling Larry Flynt Publications (LFP) in the No. 2 spot at $150 million in sales. Vivid and Adam & Eve follow with $100 million and $70 million respectively. After Adam & Eve, there is a sizeable gap, with no content companies between $35 million and $60 million. Private Media Group comes next, with slightly more than $32 million. Still with such large numbers, these companies own little of the market, with shares ranging from 2.82 percent (Playboy) to 0.27 percent (Private Media Group).

Small companies make up the vast majority of the market; porn businesses with less than $30 million in annual revenue hold a combined 94.25 percent market share, and the crowded market dynamic drives content companies to increase production, implicitly forcing marketing expenses higher. Growing production and marketing costs erode earnings and commoditize products. As a result, new ventures see an opportunity to gain a foothold in the adult content business, crowding the market further.

This tactic might work if pursued by only one or a handful of production companies. The market shows, though, that it is used universally. The number of films created in 2006 grew to 13,500 from approximately 11,000 in 2005 — an annual increase of more than 20 percent. But, flooding the market has taken its toll on the porn industry, as annual sales grew at a rate of only 9 percent from 2005 to 2006; increased production creates less value.

The number of films created every year and industry revenue are converging. Assuming unchanging growth rates for production and sales based on 2005 to 2006 rates, the industry may be in trouble. In 2005, the revenue generated per film was approximately $1 million, and it dropped to $889,000 in 2006. If the same trend continues, by 2010, revenue per film will drop to half what it was in 2005, with one film accounting for only $555,000 in revenue.

Every year, it will take more films to create revenue growth in the porn industry, which only serves to depress profitability year-over-year. Industries in decline tend to accelerate from one year to the next. Consider a situation in which revenue growth slows by 0.5 percent from one year to the next, and production grows by an extra 0.5 percent every year.

Pressure From Outside
Mergers and acquisitions (M&A) represent the only viable approach to rapid industry growth, especially in a struggling market. Even rapid sales growth of 20 percent per year would not change market share significantly. A company with $70 million in revenue, for example, would reach only $173 million by sustaining 20 percent annual growth for five years, attaining a market share of only 1.44 percent by 2010.

By pursuing an aggressive M&A agenda, adult content companies could grow while becoming more efficient. Assume that two similar porn companies merge, each with $50 million in annual revenue and profit margins of 20 percent. By merging, they become a $100 million company with $20 million in earnings.

But, cost-cutting, redundant staff members and lower production costs would have a profound impact on earnings. If margins widened to 30 percent, the merged companies would have an extra $10 million to invest in buying other companies, marketing and other strategic initiatives.

The challenge that porn faces, though, is volume. A few small deals every year is not enough to change the industry. To own a mere 5 percent of the market, a $100 million company would have to attain annual sales of $600 million, or growth of 500 percent. Taking five years to gain a 5 percent market share, it would have to grow sales at an impossible CAGR of 145 percent.

Few sizeable M&A targets are available, with most candidates ranging from $1 million to $10 million in annual revenue. It could take 400-500 acquisitions over five years to attain a market share of 5 percent.

Outside money would make this process much easier, with private investors supplying the capital for M&A activity, since adult companies lack the cash or abundance of publicly traded stock necessary to grow exponentially (compared with mainstream companies).

Investors would help content companies to complete deals without disrupting existing operations.

There are early indications that outside money will come into the industry. AdultVest has put together two private equity funds, with the ultimate goal of raising $110 million for acquisitions in this market.

"We plan to bring Wall Street perspective and discipline to a business that needs it," said AdultVest's founder and managing director, Francis Koenig. His goal is to consolidate companies in order to reduce costs through economies of scale, which could lead to a substantial competitive advantage.

This approach to rapid M&A could work for adult entertainment as well, especially as AdultVest — and the others that will materialize — gain experience in closing porn deals quickly. With outside capital, companies could consolidate quickly and easily, with a third party accomplishing transactions that may not be possible among the companies directly. Outside capital could make possible the one situation that has eluded the industry — a sustained, successful presence in public capital markets.

What Comes Next?
The industry's immediate concern should be fiscal strength and consolidation, with public offerings coming much later. Through effective M&A, the industry could consolidate without driving existing companies out of business. Economies of scale would result, making it less expensive to create and distribute content.

But, change will not happen overnight. Given the nature of the industry now, it will take at least five years of large, continued outside investment — and M&A among content companies themselves — for a handful of companies to attain market shares of at least five percent each.

Smaller businesses can take advantage of this trend by getting ready early. Now is the time to make your operation as efficient as possible, to position yourself for a buyout.

Invest heavily in marketing rather than new products to increase sales of existing films. Having one film that earns $10,000 is better than having two films that earn $5,000 each.

The top line is the same, but two films will cost more to produce and market. Consistent growth is ideal, showing a maturity of operation and a reliable strategy.

The imminent wave of M&A will affect everybody. The smaller companies that are not acquired will struggle to compete, but those that are bought will fetch the owners attractive lump sums — and probably the chance to manage the brand under the umbrella of the acquirer.

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