Every long-term investor dreams of finding companies with a proven track record of growth and operating performance, stable and predictable margins, a simple and transparent business model, reasonable balance sheet leverage, strong cash flows, and sensible management. Cinemark Holdings (CNK) exhibits all of these attributes, and its shares are currently undervalued. Below, we discuss our favorable outlook for the industry and explain why we think CNK represents the best investment opportunity in the space right now.
Some doubt the future for movie theaters on account of the expanding presence of Netflix (NFLX) and the ubiquity of on-demand movies from cable and satellite providers. Competitive concerns are undoubtedly the reason theater operator stocks are cheap relative their cash generation and growth history.
We are confident that these concerns are misguided. Netflix and on-demand video are formidable competitive forces, but those who think that they will meaningfully reduce theater attendance misunderstand why people go to the movies in the first place. People go to theaters because they offer cheap and reliable out-of-the-home entertainment. Netflix and on-demand video are not the main competitors for theaters. Live sporting events, concerts and the like are the more direct competitors, and theaters have offered and will continue to offer a cheap alternative to these.
To illustrate this point, let's consider a few different scenarios under which people would attend a theater. Teenagers go to movies because it is something they can do out of their homes to get away from their parents. Watching Netflix DVDs or on-demand videos at home does not satisfy a teenager's desire for autonomy. What about a couple? Watching videos at home does not qualify as a date…for those men reading this, we would not recommend asking a lady "out" by suggesting that she come over to your house or apartment to watch some on-demand movies. Our guess is that invitation won't be received well. The thesis here is simple. For a long time, movie theaters have offered people out-of-the-home entertainment, and new forms of in-home entertainment do not threaten this trend.
The stability and predictability of margins and expenses add to the attractiveness of theater operator stocks. There are several different arrangements between theaters and film studios for calculating rental payments for new releases, but all calculate studio payments as a percentage of box office receipts. Never do theaters have to make large, upfront payments for rentals. The rental fees are typically calculated as a film's theater run is nearing its close. This means that the theaters bear little risk from box office flops. It also means that the theaters have minimal working capital requirements. They collect cash from ticket sales before they make rental payments to the studios. Additionally, concession margins are sky-high and stable, running in the mid-80s for most operators.
Though operating leases and debt burdens represent substantial fixed costs, the industry's history of stable growth gives us confidence that these costs are manageable. According to Cinemark, aggregate U.S. box office revenues have grown at a 5.3% CAGR over the last 40 years. A chart of this growth shows no meaningful peaks and valleys, and industry revenues have remained mostly stable or have grown through recessions. This history of and favorable outlook for stable growth give us confidence that this industry can handle a fair degree of leverage.
There is some concern that the "theatrical release window" (the time between a film's release in theaters and its availability on Netflix, DVD, on-demand, etc) will shrink. True, if this does materialize, theater operators would be materially harmed. However, we do not view this as a substantial concern because film studios have no financial incentive to shrink the window. Pricing in these secondary distribution channels is a direct function of a film's box office performance. Cutting short the theatrical release window would diminish box office revenues and would weigh on secondary channel pricing. Unless secondary channel operators offer huge payments to incent the studios to shrink the window, they will not do so. Finally, companies like Netflix and Time Warner (TWX) do not have any incentive to offer these payments as their customers will be more motivated to watch movies if they have won box office success.
Which Company is the Strongest?
Let's consider the companies in this space. There are only a few large theater operators with publicly traded stocks. Regal Entertainment Group (RGC) is the biggest, and Cinemark is the second. Though we examined the other publicly traded companies, we narrowed our focus on CNK and RGC because they have broad scope and scale. There are certainly pros and cons to both of these. Regal is the larger of the two and currently offers a higher dividend yield. Furthermore, RGC has a history of making large special dividend payments to shareholders (in fact, they recently announced plans to return $1.40 in cash to stockholders). All of Regal's theaters are in the US, whereas Cinemark has a presence in Central and South America. Regal's average ticket prices tend to be higher because RGC has more theaters located in higher-priced suburbs and cities.
Despite these bullish tailwinds for RGC, Cinemark is undoubtedly the better investment. Its theaters tend to be located in smaller communities with less competition. Its presence in Central and South America give it an avenue for growth that RGC lacks. Though CNK does have considerable debt, its burden is far more manageable than RGC's. RGC's term loan has much more restrictive covenants than does CNK's. Furthermore, though RGC does have some room for error before it trips covenants, its comps will get much tougher early in 2011, as it loses the benefits of Avatar. Since its TTM performance will likely decline early next year, its risk of having covenant problems will increase. We are not predicting that it will trip covenants, but this is a risk for RGC not shared by CNK. Finally, since RGC just paid a large special dividend, CNK's cash cushion is far higher than its larger competitor.
Though we are bullish on CNK, our analysis did leave us with some concerns. One such concern centers on Digital Cinema Implementation Partners (DCIP), a joint venture owned in part by Cinemark, Regal, and AMC Entertainment (private). This is basically a vehicle through which theater operators will finance new projector equipment. DCIP will collect fees from film studios that want theaters to have 3D-ready equipment. It will also collect lease payments from theaters that rent their projectors. So far, this vehicle has received equity contributions in cash and equipment from its JV partners, and it has secured substantial debt financing. We gather that DCIP will be run to be breakeven, and RGC and CNK managements assure that future contributions to DCIP will not be substantial. However, we have been unable to get our hands on DCIP financials, so we have yet to evaluate these claims for ourselves. Conceptually, the DCIP model makes sense, and DCIP's debt is not recourse to its JV partners. Still, this structure does pose risk, and we are cautious on account of being unable to ascertain the exact scope of said risk.
At around 13.5x TTM diluted EPS, Cinemark seems reasonably priced. However, reported EPS does not accurately convey the company's cash generating ability. Accounting rules for depreciation make CNK's results seem less impressive than they actually are. For years, Cinemark's depreciation charges have exceeded its maintenance capital spending by a significant margin. This discrepancy can result from one of two things. Either the depreciation charges do not accurately reflect economic depreciation, or the company is not adequately investing to maintain its asset base. We conclude that the former is at work here.
Though movie theaters might not be the cleanest, most pleasant places on Earth, most are not crumbling to the ground. If CNK had a persistent policy of underinvestment, its theaters would show it. Furthermore, other companies in the industry also have this depreciation-cap ex discrepancy, and their theaters are not, by and large, crumbling either. This divergence is rooted in accounting rules. When Cinemark (or any other theater operator) leases a theater, it must depreciate any assets related to that lease over the shorter of estimated life or the term of the lease. This is the case even if the operator extends its lease. Therefore, CNK depreciates a substantial portion of its assets more quickly than it would if it were depreciating them solely on the basis of useful life. For this reason, Cinemark and its competitors generate more cash than they report in earnings, even after we account for maintenance capital spending.
Additionally, Cinemark earns a reasonable return on money it reinvests in its business. It's difficult to ascertain exactly what return CNK earns on new theater constructions, but we have estimated the return to be, on average, in the low double digits on an unlevered basis. This is a decent figure, and given that we think the business can accommodate leverage, the company's return on equity is likely to be higher than this in the future.
We mentioned before that U.S. box office revenues have grown at a 5.3% CAGR over the past 40 years. A closer look at this figure gives us added confidence that CNK can grow earnings at a reasonable cost. Of this 5.3% annual increase, about 80% is the result of ticket price increases. The remaining 20% is due to rising attendance. We believe that CNK can continue to slowly and steadily raise prices in the future because its offerings represent a cheap alternative to other forms of out-of-the-home entertainment. Since the company can generate decent earnings growth from price increases and has a favorable outlook for new theater construction, Cinemark's profits are likely to rise at least as much as the industry trend in the future.
Based on CNK's current earnings (adjusted for the depreciation-cap ex issue discussed above) and a conservative growth assumption, we easily arrive at a valuation in the mid-to-upper 20s. If the company's growth exceeds our slightly conservative expectations, its valuation could be higher still. At current levels, the shares offer us a significant margin of safety. Though we never profess to know anything about the near-term movement in a stock's price, we view Cinemark's business as having very little downside risk. We added the shares below $17 and will gladly buy more if the stock declines below that level. Finally, the dividend yield is close to 5%, so we will get paid while we wait for share price appreciation.