Let’s Go to the Movies…

I lean more to the cynic side of life when it comes to investing, but I do come across a variety of interesting businesses.  Not many of which are currently in my valuation wheelhouse, but I think it is always a great time to leisurely study a business and understand if someday you might want to invest.

[Please insert italicized and lengthy disclaimer about this not being investment advice, which in reality, no one is going to read, so it doesn’t really matter what it is about.]

Imagine you ran a hotel company, let’s call it Owner Protected Hotel–I will leave it to the branding people to come up with a better name.  But, this is a special hotel company because the only hotels you operate are located  on properties owned by the U.S. National Forest Service.  As a tourist, if you want to visit Yellowstone National Forest or the Grand Canyon and wanted to spend a few nights there in a hotel on the grounds, you would have to stay in a Owner Protected Hotel.  Would this be a good business?  Well, there is one key wrinkle, the U.S. government owns 51% of your company.  This wrinkle provides two key features: 1) an impossible barrier to entry for any competitors into this market–i.e. the market for lodging at a U.S. National Forest property. The government is not going to allow any competitors to open a hotel on its property when it receives 51% of the profits from your company.  And 2) a monopoly on the market: every forest park controlled by the U.S. will contain your hotel.

This company exists in a slightly different market.  National Cinema Media or NCMI, provides movie theater advertising to the theaters that own about 54% of NCMI.  In other words, the 3 major movie theater groups (Cinemark, Regal and AMC) all own a portion of NCMI, so NCMI has a lock on providing these companies with their pre-show and lobby advertising.  Additionally, and I am writing about this now, because NCMI agreed last Monday to acquire its smaller competitor, Screenvision, which provides movie theater advertising to Carmike (the other large theater group, albeit much smaller) and other regional theater chains.  After the acquisition, it is estimated that NCMI will provide advertising to roughly 85% of all theaters (and I think that number is a low estimate).

This isn’t the perfect business for a variety of reasons, but it is a really good one.

The good aspects include this simple idea that NCMI is the only company that can and will provide in-theater advertising to essentially every movie theater in the U.S.  A large majority of its costs are variable: its customers pay NCMI a fee based on how many people are in the seats and NCMI in turn pays the theaters a fee based on how many people are in the seats.  If attendance declines, it will have lower revenues, but also lower costs.  It has very low operating costs and this bears out in its roughly 40%-45% operating margins over the past decade (that’s operating margins not gross margins).  Additionally, the fixed costs contained in the business are highly “leverage-able.”  To sell an ad to GM for 1,000 theaters or 10,000 theaters costs the same.  Also, its Network Operating Center, the central location from which NCMI streams its content to the individual theaters, can stream to 1,000 for about the same price as it streams to 10,000 theaters.  All of these are great reasons for the merger with Screenvision.

Capital expenditure is very minimal, roughly 2%-3% of revenues per year.  The three core owners are required to maintain their equipment at their own expense and additional theaters from non-core owners will require minimal capital expenditures because almost all theaters are digitally equipped and NCMI’s technology is basically an add-on to these theaters’ installed equipment.  High margin and low capex are a recipe for high free cash flow.

There are, however, some significant downsides to this company.

Simply because you have a monopoly on a certain type of business doesn’t imply a great business.  The last great monopolist buggy-whip manufacturer will confirm this idea.  NCMI has a monopoly on in-theater advertising, however, major brands may feel that this form of advertising is less valuable than other forms.  An advertiser might surmise–Instead of watching the pre-show advertisements on the movie screen, most people are probably staring at their Facebook streams on the phones, so why should we pay for in-theater advertising?

Next, the ownership structure of NCMI grants the core owners additional shares when these movie theaters add theaters/screens.  This equates to continued dilution of public shareholders each time Cinemark adds a new theater to its portfolio.  This should give pause because if advertising revenues do not expand to cover the continued dilution, a shareholder is owning less of the pie each time Cinemark builds another theater.

Finally, although movie theater revenues have been consistently growing over the years, their growth is almost entirely driven by higher ticket prices, not higher attendance.  However, NCMI is paid based on attendance, not ticket price sales.  If movie theaters raise their ticket prices, and less people attend the theater, NCMI’s revenues may shrink.

From a financial perspective, NCMI produces about $120m in average free cash flow over the past 5 years, since becoming a separate company.  This number may certainly rise, but I like to focus on the present and get the future for free.  From this $120m, NCMI only gets about 50% because its core-theaters own the rest of the company.  At $60m in free cash flow, the absolute most I would be willing to pay (think Disney franchise) would be a total of $1.2B, which equates to around 20x free cash flow. Before the acquisition of Screenvision, NCMI was valued at about $900m with an additional $450m in debt attributable to it.  Total valuation, including debt, equates to about $1.35B.  Not only is the above the most I would pay for the a company, but it provides no cushion for being wrong in my estimates.

You will notice there aren’t a lot of graphs or numbers with extensive decimal points.  I like an investment to jump off the pages without having  to create a detailed analysis in an excel spreadsheet.

A couple of things to note from an investment system perspective:

This is a “I have never heard of this company type investment.” (I am looking into getting that phrase trademarked.  I think it could go along way with my business development efforts).  I like these companies because there is usually less competition  from other stock pickers and from competitors.

This is a highly profitable company that isn’t high tech.  It has a tech component (delivering the content to the movie theaters, but even that isn’t all that high-tech any more).  It is essentially an advertising delivery company, akin to billboards. High profitability typically occurs in fields such as a pharma and tech, two areas in which I am probably not going to win any intellectual contests.  However, there are still plenty of solid, highly profitable business out there and NCMI provides a good example.

In closing, this is a good business, with a profitable business model in which incentives for all parties are well-aligned.  I am not investing in this company at the current price because I don’t think it provides a great or even a good price.  There are a lot of business risks (noted above) that would require a large discount to merit an investment.  However, companies like NCMI can provide a good lesson for what to look for in good investments.

The best part about this company is doing the research, attending the pre-showing at multiple different movie theaters.  And since, you have already paid for the ticket, you might as well stay and see the new version of Spider-Man or Captain America.  I guess I will find out if my wife actually reads these postings.










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