Thus far June has been unkind to the markets with the S&P down 4.3% and the Russell 2000 down 6.4%. Film exhibitors have seen even larger declines. Since May 31st Cinemark Holdings (CNK) is down 10.3%, Regal Entertainment (RGC) is down 11.7%, and Carmike Cinemas (CKEC) is down 8.3%.
Further, both Regal and Carmike have significant short interest. According to Bloomberg data Regal has 27% of its shares sold short, while Carmike is at 17.5% and Cinemark is at 3.8%.
The first quarter of 2011 was difficult on the film exhibition industry. Box Office Mojo data shows that domestic box office revenue was down approximately 22% in the first quarter versus 2010.
However, the tide has changed in the second quarter. As of June 9, 10 weeks into the second quarter, the box office is only down 8.3% year to date, cutting the year-over-year shortfall in half. Second quarter box office revenue is up almost 11% versus the second quarter of 2009. Further, the movie slate for the rest of the summer and remainder of the year looks strong. Despite this data the short interest remains.
The short case regarding movie exhibitors includes the following arguments:
- 3-D is a fad that will pass as evidenced by the lower percentage of 3-D versus 2-D attendance for Pirates of the Carribean and Kung Fu Panda 2
- 2-D films exhibited in theatres with 3-D equipment result in poor quality limiting the flexibility of movie exhibitors to switch auditoriums between the two mediums to meet specific film demand
- The cinematic window is under pressure from video-on-demand (VOD)
- Large flat-screen televisions in the home combined with streaming options such as Netflix (NLFX) will result in fewer consumers attending movies in theatres
While there are elements of truth in some of these arguments the question is how they will impact of the business of the movie exhibitors. Let's examine each one in turn.
3-D is a fad that will pass
It is dangerous to draw broad conclusions based on the results of two films. Clearly some films were rushed to convert to 3-D in an attempt to capture additional revenue. In these instances audiences viewing the 3-D version may not have felt that the 3-D experience was worth the premium paid. In reality, there will always be movies that audiences do not like, irrespective of the medium in which they are viewed. Audiences leaving a bad 2-D movie may feel that the ticket price was not worth the experience. This is true of almost any entertainment experience. Not every baseball game is won in the bottom of the ninth inning with a walk-off home run. The quality of the movie product irrespective of medium is vital to putting bodies in the seats. The jury is still out on whether or not the quality of upcoming 3-D movies will justify the premium. The success of the upcoming Transformers and Harry Potter movies will be interesting. Further, investors who don't believe in 3-D can make more targeted trades by shorting companies such as Real D (RLD) or Imax (IMAX) versus film exhibitors that still generate tremendous cash flow from successful 2-D films.
2-D films exhibited in theatres with 3-D equipment results in bad quality.
Clearly management at Carmike took exception to this critique and published a rebuttal on June 7, 2011 in which they make it clear that any movie shown at a Carmike theatre, be it 2-D or 3-D, will be "perfectly calibrated and set to deliver an incredibly brilliant picture." In direct response to the criticism around showing 2-D films on 3-D projection systems Carmike responded: "If you have read about diminished, dimmed picture quality at digital theatres caused by projection systems that are left in 3D mode when showing 2D pictures, you won't find this at Carmike. You'll see eye-popping images in every one of our theatres using the Christie LampLOC/LiteLOC technology which doesn't require the cumbersome adjustments of other manufacturers systems."
Full press release here.
Cinematic window is under pressure from VOD.
The movie studios are looking for ways to increase revenue as they have seen their take from DVD sales decline largely due to streaming services such as Netflix. As a result they are experimenting with shortening the cinematic window and offering video on demand content earlier at higher price points. There is no question that this is a risk to the exhibitors, however the movie studios also know that the exhibitors are of vital importance to their overall economics. The best marketing is movie trailers seen by a captive audience in the theatre. Many of the tent pole, blockbuster films have special effects and sound that is designed to be experienced in an auditorium with an audience. In fact, several notable film directors including James Cameron and Peter Jackson, wrote a letter to the film studios on this topic .
Finally, people like to go to the movies. It is an entertainment options that can be spontaneous versus a sporting event or concert that generally requires purchasing tickets well in advance. Further, the price of a movie remains materially below these alternative forms of entertainment.
Large flat-screen televisions in the home combined with streaming options such as Netflix will result in less consumers going to see movies in theatres.
There is no doubt that the viewing experience in the home is better than ever. However, I believe people still like to get out of the house. Going to the movies is still an event and despite the argument that movie tickets and concession prices are too expensive, a trip to the movies is still materially cheaper than going to a sporting event or concert. Further, as mentioned above, the decision to go to a movie can be spontaneous, which is much more difficult to do cost effectively for other forms of out-of-home entertainment.
Given the strength of the second quarter box office combined with the movie slate for the balance of the year I believe that the movie exhibitors offer an excellent risk/reward profile at their current valuations. These are companies that generate significant cash flow and are focused on returning excess capital to shareholders through dividends.
Regal, trading at 7.5x 2011E EBITDA, provides a 7% dividend yield. Cinemark, at 6.8x projected 2011 EBITDA trades at a discount to Regal, has a 4.3% dividend yield and offers exposure to Latin American. Finally, Carmike trades at 5.8x 2011E EBITDA but does not offer a dividend as it is focused on using excess cash flow to pay down debt.
In addition to his commentary on the quality of the viewing experience at Carmike's theatres the Carmike CEO put "his money where is mouth is" and recently bought additional shares in the company.