Porn's Future on Wall St.

Tom Johansmeyer
Porn has taken mainstream media by storm.

Stars routinely cross over into small acting roles in TV and film, and the New York Times and Wall Street Journal have tracked developments in the business in surprising depth.

Mainstream coverage, though, differs from mainstream business, and surviving the pressures of public capital markets is essential to the long-term growth of the industry.

Public capital markets are brutal; failure to perform leads to sharp declines in stock price, while near-term wins are rewarded richly. Success simply sets the bar higher for the next quarter, requiring continual victories with ever-rising stakes. A public company thus lives from one quarter to the next, constantly striving to please analysts and meet growth targets.

Few adult entertainment companies are publicly traded, making any analysis of public porn an exercise in speculation. As the more promising companies are private, those listed on public exchanges may not indicate how well the industry could perform as a whole.

Nine adult entertainment companies are publicly traded, representing four countries. The majority are headquartered in the U.S., and one each coming from Germany, Australia and Spain. The public adult companies also represent a variety of market segments. Three are gentlemen's clubs, three produce content, two are involved in retail operations and one processes online payments.

Big Gains at the Clubs
By far, the gentlemen's clubs have posted the strongest performance, with double-digit revenue growth and triple-digit profit gains on average. Retailers show flat sales performance year over year while attaining double-digit profit growth, and content companies, on average, have lagged. Conspicuous by its absence is new media. Despite the proliferation of online content providers, affiliate programs and relationship services (e.g., none of these has reached public capital markets.

Content providers should have the edge over other adult sectors, because they are much larger. The market capitalization for public content companies is $224.47 million, versus $50.97 million for gentlemen's clubs. Bigger is usually better in public markets, as investors perceive size as an indicator of some stability.

Also, larger companies attract the attention of securities analysts, typically leading to more trading activity for a particular stock. For publicly traded adult entertainment companies, size does not deliver the expected advantage, because even the highest market capitalizations in adult entertainment are microscopic by mainstream standards.

Content companies perform exceptionally well when evaluated by price/earnings (P/E) ratio. Every dollar of content company earnings generates an average of $411.21 in value for company shareholders. But, this is a tad misleading. The high average P/E results largely from Playboy, which drives up the market capitalization side of the ratio (i.e. the "P") with a market capitalization of $338 million while reducing the earnings component of the ratio with a loss of $700,000. Private Media Group also has an inflated P/E ratio of more than 1,600 as a result of low earnings relative to shareholder value. While these two cases look like success stories, investors may become disillusioned with the stock if earnings do not grow and ultimately could cause a drop in share prices.

Gentlemen's clubs, conversely, show more modest P/E ratios paired with high revenue and earnings growth. Publicly traded clubs have become extremely profitable, posting annual earnings growth of almost 470 percent. The fact that earnings have grown more than 10 times faster than revenues indicates an operational efficiency that investors are likely to appreciate. The fact that the clubs are small, with average annual revenues of only $14.37 million, only leaves room to grow, and rapid earnings growth only makes it seem more likely.

Retailers show an interesting dynamic in the public company space. Revenues have declined by 1.81 percent, though earnings grew by more than 20 percent. In a stagnant market, retailers are becoming more profitable, likely by improving supply chain efficiency and reducing operating costs. The retailers look the most like mainstream public companies, despite their size. The average P/E ratio of 13.76 is strong but not astronomical. Earnings growth of greater than 20 percent is impressive but not extraordinary. In short, the public retailers seem more mature.

Can porn go public? Or, will public capital be restricted to a few adult entertainment anomalies? Given that most adult entertainment companies are private and closely held, the answer is difficult to ascertain.

According to Francis Koenig, President and CEO of adult industry investment community AdultVest, there is room for porn in public markets, but it will take time. Diversified companies such as LFP and Adam & Eve are most likely to perform well in public venues. Diversification (among content, products, entertainment and licensing) provides multiple revenue streams and avenues for growth. Also, it indicates a level of operational maturity that will equip these businesses to handle the pressures of public capital markets. Koenig is particularly optimistic about gentlemen's clubs as well, as they offer a geographic growth strategy around new club openings in addition to growth on a club-by-club basis.

What's Stopping Adult?
The primary barrier to public offerings among adult entertainment companies remains an issue of size. While this has not stopped some adult entertainment companies from going and staying public, it does limit new entries to the stock exchanges. Going public is neither easy nor inexpensive, and the mechanics of listing on an exchange require the support of attorneys, investment bankers and accountants. It is easy for the price tag to reach millions of dollars, with hundreds of thousands of dollars in annual expenses to comply with stock exchange and Securities and Exchange Commission (SEC) regulations.

But, there is another way.

Smaller businesses can go public via the Over-the-Counter (OTC) system, which has a more manageable regulatory structure and as a result, lower compliance costs. The cost of going public OTC can be as low as $100,000 up front, with recurring annual fees of tens of thousands of dollars.

Payment processing company IBD is traded OTC, attracting capital from public investors without the rigor of formal stock exchanges. IBD is the smallest of the world's publicly traded adult entertainment companies, with $6.9 million in annual revenues and a market capitalization of $2.2 million. Given its size, OTC is the ideal venue, as IBD does not meet the revenue minimums of most stock exchanges.

Risk? What Risk?
Going public OTC is not without risk. The OTC environment attracts fewer investors, making it less liquid than the exchanges. A good quarter will send the stock price soaring, but disfavor with investors can lead to catastrophic declines. Be prepared for a few tough years at first. Over time, maturing operations, comfort with public capital markets and investor awareness are likely to offer a bit more stability.

Entering public capital markets can be exciting, lucrative and unnerving. Wealth is created and rescinded in minutes, and the pressure to perform is extraordinary. For the adult entertainment business, public capital is on the horizon. The ability to grow eventually will be limited by the availability of capital, and public markets are the only viable long-term solution. You may be able to go to the bank for millions, but you have to go to the public for billions.

It will take some time for porn to go public. Consolidation must come first, creating a critical mass that makes the stock exchanges attainable. While OTC is an option, it will not draw the industry as a whole to public investors; the environment is not robust enough. A few big splashes will be necessary to trigger a trend, requiring big companies to go public on exchanges. After a few years of mergers, though, porn will enter the mainstream portfolio; the industry doesn't have a choice.

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