Patersons Research, Quickflix Limited, 11 November 2014

QU ICKFLIX LTD

Research Note

THE GAME OF ‘SVOD’ THRONES

Investment Highlights 11 November 2014  Streaming Video on Demand (SVOD) is expectted to be a high 12mth Rating SPEC BUY growth market as digital media consumption evolves. Price A$ 0.006 Quickflix (QFX) has the early mover advantagge in Australian Target Price A$ 0.026 and New Zealand, as it has developed a streeaming platform, 12m Total Retturn % 325.7 built a sizeable movie and TV episode content library, and

possesses an expanding subscriber base. With this solid RIC: QFX.AX BBG: QFX AU product offering, and despite the increasingly competitive Shares o/s m 1520.7 SVOD market landscape, we envisage QFX continuing to grow Free Float % 80.8 its subscriber base. We see the Company as iinexpensive and Market Cap. A$m 9.1 believe QFX is an attractive acquisition or Joint Venture partner candidate for other players such as Internet Service Net Debt (Cash) A$m -2.4 Providers (ISSP’s) and Broadcasters who wish to enter the Net Debt/Equiity % N/a SVOD market. 3m Av. D. T’ovver A$m 0.06  The global SVOD market is said to top $11bn this calendar year and 52wk High/Low A$ 0.02/0.01 is expected to grow at 21% year-on-year whilst gaining market share 2yr adj. beta na from the estabblished Pay-TV and Free-to-Air providders. Given QFX’s current market cap of $9.1m, the Company would be an attractive Valuation: and obvious partner for those who want to enter the SVOD market. Methodology DCF The Nine Entertainment and Fairfax media joint venture, StreamCo, Value per sharre A$ 0.026 has budgeted up to $100m to create a similar offering, which further highlights how cheap a QFX acquisition would actually be. This opens up opportunitty for Free-to-Air broadcasters such as Seven West Analyst: Rob Brierley Media and Ten Network or ISP’s such as Optus, iiNet or TPG to Phone: (+61 8) 9263 1611 acquire, or enter into strategic alliances with, QFX. Email: [email protected]  QFX has developed the 3 core areas needed for a streaming service: The first pillar is the QFX platform, which has the ability to connect to Disclosure: Patersons Securities Ltd acted a vast number of devices in over 77% of Australian and New Zealand as Lead Manager and Underwriter to a households (currently connected to over 480,000 devices). The rights issue and share placement that second pillar is content and QFX has an established back catalogue of raised $5.8m at 1.0c per share for content and rights to new movies and TV series on its Pay-per-View Quickflix Liimited in November 2013. or purchase per episode service, in addition to relationships with Quickflix also partially funded the studios. The third pillar is an established customer base, which has preparation of research on the Company grown at 65% compound annual growth rate (CAGR) over the last 10 by Patersons Securities. Patersons years and is currently around 130,000 subscribers. Securities received fees for these services.  We believe QFX is currently undervalued by the market, with little to no value ascribed to its established and well-functioning streaming platform, its existing DVD and Blu-ray library, and its existing customer network. In comparison to industry leadder, Netflix, on a market cap basis, QFX has a subscriber value of $75.30 per user while Netflix is c.$450 per user (based on its 57 million global 12 Month Share Price Performance members). This shows the potential upside in valuation for QFX and we reiterate our Speculative Buy recommendation.

Performance % 1mth 3mth 12mth Absolute -14.3 -57.1 -64.7 Rel. S&P/ASX 300 -13.8 -51.5 -60.1

RESEARCH NOTE – PATERSONS SECURITIES LIMITED 1

All information and advice is confidential and for the private informaation of the person to whom it is provided and is provided without any responsibility or liability on any account whatsoever on the part of this firm or any member or employee thereof. 11 November 2014 Quickflix Ltd

POSSIBLE CORPORATE ACTIONS

Streaming Video on Demand (SVOD) as a form of media consumption has grown globally, with the market said to top $11bn and grow by 21% year on year eroding traditional pay TV market share. QFX is focussing on the 3 pillars required for a successful SVOD service, namely the platform, the content and the subscriber base. There is also an associated brand value that QFX has built up, having generated c.$100m of revenue from around 500,000 customers over the years.

As new players enter the market in hope of gaining exposure to the significant growth potential on offer, each will either have to create its own platform which can be an expensive and timely exercise (PSL estimate $10-15m over a 12-24 month period), secure movie and TV episode content, and invest on marketing to reach potential customers. Alternatively a new entrant could choose to acquire an established SVOD player and its platform, content and subscribers.

Figure 1: Quickflix’s Three Pillars of its SVOD Service Offering Platform Content Subscribers 77% of households Subscriber base massive 130,000 back catalogue 1.5Mbps Premium PPV content new Growing with new and growing marketing SmartTV, Gaming Established relationships larger than all SVOD (legal) Console, PC with studios in AU and NZ currently

Source: Patersons Securities Limited

Undoubtedly the market in Australia is becoming more competitive. Foxtel launched its Presto on- demand movie streaming service in March 2014; StreamCo commenced its set-up phase in August 2014, hoping to launch in H1CY2015; and Netflix seems destined to officially enter the region sometime in 2015. This emerging competitive landscape has seemingly spooked the market resulting in a sharp decline in QFX’s share price.

QFX offers an established platform capable of reaching 77% of Australian and New Zealand households, with over 480,000 connected devices including SmartTVs, gaming consoles and PCs. QFX also offers an established back catalogue of movies and television series in addition to its premium Pay-per-View or purchase per episode content, as well as long-established relationships with content providers such as movie studios. QFX’s current subscriber base is over 130,000 DVD and streaming subscribers, which is larger than any current SVOD service in Australia or New Zealand.

Given the current market capitalisation of $7.6m, QFX would be an attractive and obvious entry point for those who want to enter the SVOD market. The Nine Entertainment and Fairfax media joint venture, StreamCo, has budgeted $100m to create a similar offering which further highlights how cheap a QFX acquisition would actually be.

A potential sticking point in any acquisition of QFX would be the Preference Shares held by StreamCo (equivalent to 6% of QFX shareholding), which have an associated obligation for redemption at full face value of c$10.9m under the circumstance of a change of control of the entity. However we note there may be grounds for the “Redemption Event” to remain un-triggered if QFX sells or joint ventures a portion of, rather than the entire business. For example, it is open to conjecture whether the sale of Australian and New Zealand streaming business while retaining the currently untapped International segment of the business and/or the well-established DVD and Blu-ray mail service would result in the triggering of the “Redemption Event”.

This opens up opportunity for free to air broadcasters such as Seven West Media and Ten Network or ISP’s such as iiNet or TPG Telecom to acquire these 3 aspects of the business and either rebrand or white label the product.

We also note that even if the acquirer were to redeem the full face value of the Preference Shares, the deal could still be highly value accretive (priced at $20m before premium or $145.8 per current subscriber), albeit one that may strengthen a potential competitor’s coffers.

RESEARCH NOTE – PATERSONS SECURITIES LIMITED 2

All information and advice is confidential and for the private information of the person to whom it is provided and is provided without any responsibility or liability on any account whatsoever on the part of this firm or any member or employee thereof. 11 November 2014 Quickflix Ltd

PLATFORM

The QFX streaming service, first rollled out in 2011, is comparable if nott superior to offerings in the Australian market at present, having benefited from the fine-tuning and evolution of the platform and its device connectivity with the advancement in technology and consumer demands. We note that StreamCo, The Nine Entertainment and Fairfax Media Joint Venture, is looking to develop its own streaming platform and is quoted as having a budget of up to $100m (including content and marketing). We note that if even a 5th of this figure was to go toward tthe development of a brand new streaming platform, it would ovvershadow QFX’s current value by 2 times.

Figure 2: Devices Connected to Quickflix

Source: Quickflix Limited

QFX’s streaming platform is able to connect to most devices with an internet connection, including Smart TVs, game consoles, personal computers (PCs) and tablets. Compatibility with new technology such as Google Chromecast, which converts most televisions into “smaart TVs” that can be directly connected to the internet for streaming or browsing purposes, is evidence of the requirement to keep abreast of current technological advancements, a trait that QFX has dissplayed thus far. A point of differentiation for QFX is the ability to stream 3 movies/TV episodes concurrently and have 6 separate devices registered and connected to the streaming service, per account.

Figure 3: Device Able to Stream Coontent

Source: Quickflix Limited

SVOD services require a minimum internet speed in order for optimum sttreaming. QFX state 1.5Mbps is required for standard streams and 3.5Mbps for HD streams. 83% (7.3 million) of Australian households are connected to the internet, with the majority (77% of households) having a broadband connection. The average Australian internet connection speed is 4.6Mbps.

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The average New Zealand internet connection is 3.3Mbps, with 90% (60% in 2010) of households connected via broadband or better. The connection statistics have increased strongly over the last 5 years and are expected to improve still as New Zealand targets 98% connection and improved speeds by 2019 via the Ultra-Fast Broadband Initiative and the Rural Broadband Initiative, whilst Australia continues with its National Broadband Network (NBN) roll-out.

Figure 4: Australian Household Internet and Broadband Connectivity

Households with internet access Households with Broadband access

100% 90% 80% 70% 60% 50% 40% 30% 20% 10% 0% 2006–07 2007–08 2008–09 2010–11 2012–13

Source: Australian Bureau of Statistics (ABS), Patersons Securities Limited

Technologically QFX is well positioned as it has server capacity to services multiples of its current subscriber base. The streaming platform is expected to be ‘up’ 24/7 all year around with no down time as servers are able to be rotated.

The DVD service platform service is a tried, tested and trusted offering with DVDs being queued on the service and then posted out systematically. This ensures a constant turnover of physical DVDs and Blu-Ray discs. Delivery occurs through Australia Post, where a QFX centre is sub located for increased logistics efficiency, and is delivered in 1-3 days.

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CONTENNT

QFX has a huge back catalogue of movie titles and television series rangging from classics to recently released blockbusters. A majority of the titles are available via the monthly subscription model which gives access to the DVD order system ($12.99/month) and the online streaming service ($9.99/month) or a Combo service ($19.99/month). In addition QFX offers a premium content service which is available to all customers as a $5.99 per movie Pay per View (PPV) or $2.99 per TV episode purchase service.

While streaming services are able to compete on pricing points, the real drawcard to attract customers is via programming and content. QFX competes with rival streaming services when attempting to secure content, with some content being awarded to preferred SVOD providers where established relationships and agreements exist, and others being awardeed via tender processes. QFX has recently attempted to bolster is content acquisition credentials by appointing David Smith as a Non-Executive Director. Mr Smith is a former Vice President of Twenttieth Century Fox Television Distribution and is a senior US fillm and television entertainment executive with over 20 years’ experience in licensing and acquiring content for subscription and transacctional services including for over‐the‐top internet, cable, satellite, broadband and mobile platforms.

The content eco-system remains a minefield with various distribution agreements and licenses in place. For instance the most pirated show of all time, Game of Thrones, is created by HBO with licence agreements given to Foxtel for broadcast in Australia. Streaming content however is awarded to QFX, which is able to stream or offer premium content to its subscribeers after the season is aired on Foxtel. We highlight that QFX was one of the few legitimate services that Game of Thrones Season 4 was available on. We note the price point of Foxtel and QFX separates the market in which they operate and thus, as a secondary tier broadcasting licence, this separates and elevates QFX’s content offerings from its peers.

Figure 5: Piracy Comparison

Source: qz.com, TorrentFreak

Notable content drawcards includes full season sets of highly acclaimed TV series such as The Wire, The Sopranos and Dr Who; all available on the subscription service. Orannge is the New Black, Game of Thrones and Walking Dead are available on the premium PPV service.

Piracy, especially the ease of piracy, remains the biggest thorn in the side of studios and streaming services, QFX included. An estimateed 3.5 million Australians access illeegal pirated content at least once a month. New legislation could see the Government enforcing ISPs to block access to illegal content sites which could funnel these content seeking users to services such as Quickflix.

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SUBSCRIBERS

Subscriber numbers have increased 65% CAGR over the last 10 years, which was boosted by the introduction of the online on-the-top streaming service in 2011. Paying subscriber numbers have been subdued since 2012, as the general Australian public remain late adopters of the technology and relatively high levels of piracy usage has been tolerated.

Paying customers, as at 30 September 2014, stood at 118,204 (a 21% increase on 2013) and trial customers were 12,361 at the end of the period. Customers have registered multiple devices to the Quickflix service, with over 480,000 devices actively connected.

Figure 6: QFX Subscribers and Trialists

Source: Quickflix Limited

Revenue is derived from both the monthly subscription model, with pricing points reduced in May 2014 to improve competitiveness and customer acquisition, and from premium content which is priced depending on the content. The monthly Average Revenue per User (ARPU) has declined to $12.63 as the adoption of these lower pricing points has occurred. Comparatively Netflix has an ARPU closer to $9 and, on the other end of the scale, Pay TV provider Foxtel has an ARPU closer to $100. We anticipate further diversion of ARPU to sub-$10 levels but point to the scalability of SVOD services which suggests that higher rates of market penetration will derive higher operating margins even with declining ARPU’s.

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Figure 7: Market Share of Australian Digital Media

Source: Patersons Securities Limited

SVOD services have penetrated justt 1% of Australian and New Zealand households, yet (according to getpocketbook.com) around half of these households are said to be using Netflix which is yet to officially launch in Australia. With new entrants in the market such as SttreamCo and Presto, further over-the-top penetration is expected to occur as the Australian households become aware of these services.

Figure 8: Market Share of Australian SVOD

Source: getpocketbook.com

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The significant concern for QFX is seen as the potential imminent official entry of Netflix into the Australian market. Whilst this will most likely increase competition in the SVOD market further, we note that it may also act as a catalyst for subscriber growth for QFX, as price points would be similar but content may well be in QFX’s favour (due to international distribution rights).

Historically subscriber churn has been high and conversion from trial customers to paying subscribers has been low. We note however that the number of internet enabled devices has doubled in the last 2 years in Australia and over 7.3m households are currently connected to the internet. As Australian digital consumptions demands and behaviour change, we should see a shift to lower churn rates and higher conversion into paying customers.

The December and March Quarter are the busier periods for QFX and we expect customer numbers to increase over this period.

Figure 9: Market Value per User Netflix Quickflix Market Cap (m) 25,974.24* 9.10 Subscribers (m) 56.55 0.12 Market Value per user $459.29 $75.30

Source: Quickflix Limited, Netflix Limited, Patersons Securities Limited

AUD/USD assumed at 0.88

On 16 October 2014, Netflix’s share price gapped down by nearly 20% after its Q3 earnings announcement as growth in subscribers missed previous guidance. The attributable value per user, post market re-rating, is $459 a user, while Quickflix’s value is only $75.30 per user. This highlights the significant upside in valuation of QFX, once its customer base reaches a point of critical mass of at least c500,000 users.

Figure 10: Customer Valuation Comparison

Netflix Quickflix

$500 $450 $400 $350 $300 $250 $200 $150 $100 $50 $‐ Netflix Quickflix

Source: Patersons Securities Limited

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Recommendation History

Stock recommendations: Investment ratings are a function of Patersons expectation of total retturn (forecast price appreciation plus dividend yield) within the next 12 months. The investmment ratings are Buy (expected total returrn of 10% or more), Hold (-10% to +10% total return) and Sell (> 10% negative total reeturn). In addition we have a Speculative Buy rating covering higher risk stocks that may not be of investment grade due to low market capitalisation, high debt levels, or significant risks in the business model. Investment ratings are determined at the time of initiation of coverage, or a change in target price. At other times the expected total return may fall outside of these ranges because of price movements and/or volatilittyy. Such interim deviations from specified ranges will be permitted but will become subject to review by Research Management. This Document is not to be passed on to any third party without our prior written consent.

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