National CineMedia Inc. (NASDAQ:NCMI) recently announced the acquisition of Screenvision, the #2 player in the cinema advertising sector. When the deal closes in 3-6 months, it will drive $30-40mm of cost synergies and meaningful revenue synergies, making the deal ~20% accretive to FCF per share. NCMI's unique structure means that this increase in FCF will translate to dividend increases for years to come. Further, NCMI trades very cheap in its historical valuation range, as the market is fundamentally misunderstanding recent transient weakness in NCMI's topline. As I explain in more detail below, NCMI's steady FCF growth and unique structure will drive the stock to $25/share (+60%) over the next 12-18 months.
NCMI operates the largest in-theater media network in North America, through which it sells advertising to national, regional, and local advertisers. Its FirstLook pre-show plays before every movie in theaters across the country. The pre-show has advertising slots, which NCMI sells to some of the largest Fortune 500 auto, technology, food, media, and other companies. Cinema advertising is very appealing to these companies for its sight-sound-and-motion characteristics, while boasting a captive audience that cannot skip ads (unlike TV). The big-screen format of cinema advertising promotes very high recall by theater patrons, and its 3D and mobile capabilities make it a unique and creative ad medium. As a result, cinema advertising is taking share from traditional ad mediums (TV/radio/print), and has a secular tailwind at its back, as TV ratings continue to decline and advertisers look for other sight-sound-and-motion mediums with scale and reach over which to advertise.
NCMI was founded through a partnership of the three largest cinema circuits: AMC (NYSE:AMC), Regal (NYSE:RGC), and Cinemark (NYSE:CNK). These 'Founding Members' remain some of NCMI's largest shareholders and strongest advocates. Pursuant to the long-term agreement with the Founding Members when NCMI was formed, any acquisition by Founding Members of another theater circuit automatically comes into the NCMI cinema advertising network. In addition, the fees paid to the Founding Members for use of their Theaters are fixed at a low rate, which currently approximates only 20% of NCMI's advertising revenue. As a result of this fixed-fee structure, NCMI can meaningfully expand its margins as it grows its revenue. NCMI also historically operated a non-core business called Fathom, but this was recently divested.
Results for the first quarter of 2014 (traditionally NCMI's slowest quarter) and guidance for the second quarter suggested weakness in topline revenue growth trends, which caused the stock to fall ~20% YTD. Investors were concerned that something had structurally changed within the advertising market, which was hurting cinema. However, the market is fundamentally misunderstanding this weakness, as proven by the below chart. As you can see, when adding NCMI's historical revenue to Screenvision's historical revenue (together comprising the entire cinema advertising market), it is clear that cinema advertising is growing at a double-digit % rate. This proves that recent weakness in NCMI's topline was only the result of temporary share-losses to Screenvision, which are no longer relevant going forward given the merger of Screenvision into NCMI.
Source: NCMI Investor Presentation
NCMI should quickly grow its FCF to $1.30 per share. Management guided to $222-232mm of EBITDA in 2014. When adding Screenvision EBITDA of $32mm, and cost synergies of $30-40mm, we get pro forma EBITDA of ~$295mm. NCMI should leverage high single-digit topline growth to grow PF EBITDA by a double-digit % rate, reaching at least $350mm of EBITDA by 2016. After incorporating below-the-line CF items (integration payments, Fathom loan receivable, capex, interest, and taxes) and subtracting out the Founding Member's share, we get to FCF to NCMI of ~$90mm, which translates into ~$1.30 per share.
NCMI's unique structure, which resulted from its original formation at its IPO, means that NCMI must dividend out essentially all of its FCF to shareholders. This is exemplified through its history of distributing 90-100% of its FCF in the form recurring dividends and its recent special dividend. Assuming NCMI pays out 95% of its $1.30 FCF per share that would be a dividend of $1.25 per share, an increase of over 40% from its current recurring dividend.
It is also important to recognize that NCMI's dividend is exceptionally stable and safe. NCMI maintains cash at its holding company sufficient to pay multiple quarters of dividends, even assuming zero cash flow generated by the business going forward. So there is meaningful cushion to protect the dividend even in the most dire and unlikely of scenarios.
At a recent conference in response to an analyst's question about risk to the dividend, CEO Kurt Hall said: "...we wouldn't have done the special dividend if we thought there was really any concern about that... I mean, our structure is very unique. Once the cash gets to the parent company, literally nothing we can do with it other than dividend it out or pay taxes, right. Those are the only two big things. And so we're always trying to manage to make sure that not so much cash gets built up there that it creates an influence up on the stock, because having $2 or $2.5, I think is what we got to of cash sitting on your balance sheet, it's just very unproductive. The returns on that is very low, and I'd rather put it in the hands of the shareholders. So we did a lot of downside analysis about, okay, take whatever draconian projection you want about the future and run it out, and how many years could we sustain the existing dividend, and it was 6 years to 10 years. And so I'm not all that concerned."
NCMI has historically traded at a dividend yield of between 5-6% on average, but has often traded at even higher valuations sub-4%, such as in the second half of 2013. A yield lower than 5% is justified if NCMI can grow its topline at a high single-digit rate. Conservatively assuming a 5% dividend yield, NCMI is worth $25/share (+60%).
Disclosure: I am long NCMI. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: The author, his family, and funds the author manages and/or is associated with may or may not have a position in any of the securities mentioned in this write-up. Any of the aforementioned may trade in and out and around any of the securities mentioned without notifying you. Do your own diligence. Also note this write-up does not constitute any investment advice.