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IMAX Corporation (NYSE:IMAX)

Q4 2007 Earnings Call

March 14, 2008 8:30 am ET

Executives

Bradley J. Wechsler - Co-Chairman and Co-Chief Executive Officer

Richard L. Gelfond - Co-Chairman and Co-Chief Executive Officer

Joseph Sparacio - Chief Financial Officer

Robert D. Lister - General Counsel

Analysts

Eric Wold - Merriman Curhan Ford

Rich Ingrassia - Roth Capital Partners

Operator

Welcome to IMAX Corporations’ Q4 Earnings Conference Call. Please note that today’s conference is being recorded. At this time, I would like to turn the conference over to Bradley Wechsler for opening remarks and introduction. Please go ahead sir.

Bradley J. Wechsler

Thank you very much operator. Good morning everyone. Thank you very much for joining us on today’s Fourth Quarter and Fiscal 2007 Conference Call. Joining me is my partner, Co-Chairman and Co-CEO Richard Gelfond. Also with us are CFO, Joseph Sparacio, and General Counsel Robert Lister. Before we begin let me remind you of the following information regarding forward-looking statements. Our comments and answers to your questions on this call may include statements that are forward-looking in that they pertain to future results or occurrences. Actual future results or occurrences may differ materially from these forward-looking statements. Please refer to our SEC filings for a more detailed discussion of some of the factors that could affect our future results and occurrences. During today’s call, references will be made to certain non-GAAP financial measures as defined by Regulation G of the Securities and Exchange Commission. Discussion of the management’s use of these measures and reconciliations to GAAP measures are contained in the company’s earnings release in our 10-K for fiscal 2007 which will be filed later today. The full text of the earnings release along with reporting financial table is available on our website www.imax.com. Today’s conference call is being webcast in its entirety on our website. Please note that later on in the call we will be referencing slides that are being simultaneously webcast on www.imax.com. To access the presentation, click on ‘Company Info’ and then click ‘Investor Relations.’

2007 was a watershed year in IMAX’s 40-year history. Among other things, we made significant progress in transitioning from film to a digital platform, introduced a new business model, had the best film year in our history, and signed 144 new systems, 110 of which were JVs, all on an existing network of approximately 300 open theaters. Despite our strategic achievements, the year was challenging from a financial perspective as we lived the effects of moving from film to digital and dealt with the impact of financial re-statements and other regulatory issues. We told you last quarter that we believe the business was at an inflection point with regards to emerging from this transition, and indeed several recent positive developments leave us very well positioned as we head into 2008 and the next exciting phase of our growth.

Today, I will begin by briefly re-capping our progress in fiscal 2007 which we believe has laid the foundation for future growth and culminated in exciting recent developments. Then I will turn it over to Richard to take you through our most recent progress in more detail as well as the impact we believe our initiatives will have in 2008 and beyond.

As we entered fiscal 2007, we knew a transition to digital and the development of a more attractive business model could dramatically expand our potential in many ways. I’m pleased to say that our new model is now firmly in place and we closed out the year having developed the digital systems in faster time at a lower cost of goods sold and projected higher gross margins than originally budgeted. We accelerated the delivery date of the first system by about 6 months in spite of the technical complexities associated with developing this product. We also believe we are coming in in about $2 million under budget with respect to R&D cost. We are now at the stage of productizing our Digital prototype, which has been operating for several months near our corporate headquarters in Ontario and we are on track to have systems in the field and operating by the end of June with a larger-scale rollout 2 to 3 months after that.

The IMAX story has moved from one of development to one of execution and implementation. Today, we are more convinced than ever of Digital’s crucial importance to IMAX and our future as a business. First, Digital will help facilitate a more rapid build-out of the IMAX network by removing print cost from the system. Second, because of the print savings, the transition to Digital will enable us to show even more Hollywood films, up to 10 or more a year compared to 6 or 7 now, and also enjoy enhanced programing flexibility including the ability to show live action events. Third, Digital lowers installation cost for exhibitors by about $100,000 which with more films would help drive the returns in our sales and joint venture models. Bear in mind that studios will enjoy a higher return on each picture with no print costs which provides an incentive for studios to release even more of their blockbuster films in IMAX and to do so year-round. Obviously exhibitors will also benefit from Digital. In their case, not just to lower installation costs but for more films which will mean higher revenues and greater per-theater profitability.

As we stated before, while we work to develop and launch our digital product, signing slowed a bit as exhibitors range in their demands pending the introduction of our new digital product. Now, the ability to see our digital system has spurred signing and we are seeing exhibitors embrace IMAX’s digital product with encouraging enthusiasm. This is certainly epitomized by our recent announcement of a 35-theater lease deal with Racimec to install IMAX Digital Projection Systems in South and Central America and the Caribbean. Richard will discuss the details of this agreement momentarily, but in short, we think it is but one example of the overwhelmingly positive reception to our transition to Digital. Importantly, announcements of this magnitude reflect a new level of activity for the company with significant interest being generated at a level unlike any that we have ever seen before. The planned launch of Digital has also played a crucial role in spurring and supporting our joint venture initiatives.

Early in 2007, we signed two JVs with Regal. After recouping their investment after just two films, they came back to us and signed a 5-JV deal in October. Then, as you will all recall, in December AMC signed a 100-theater joint venture deal with us. This deal was key for us not only in that it is the largest and most expansive in IMAX’s history, but also because it transformed the company from both the financial and strategic point of view. It will introduce significantly more recurring margin into our business model and will ultimately double the size of the existing IMAX commercial network in North America and almost triple the number of IMAX theaters in North American multiplexes. Deployment starts in the second half of 2008 and continues through 2009 ending in 2010.

As we have previously indicated, we believe that on a steady-stay basis, our agreement with AMC will generate between $30 and $35 million in incremental EBITDA per year for IMAX. Based on conservative assumptions when we are fully deployed, we should be slightly less than 3 year. We expect payback for a joint venture to be achieved in approximately 2.4 years with an IRR of approximately 37%. This does not include maintenance revenues or DMR which we receive when an IMAX theater exhibits a film that has been converted into the IMAX format. With these, pay-back is expected to be in less than 2 years.

With respect to other significant accomplishments in fiscal 2007, we signed a 4-picture deal with Dreamworks Animation to release the studio’s first three 3D films in IMAX 3D which bolstered our visibility in the industry and further validated our Digital strategy. As a reminder, these releases will include Monsters Vs. Aliens 3D in March 2009, How to Train Your Dragon 3D in March 2010, and Shrek Goes Fourth 3D in May 2010. In addition, we will release Kung Fu Panda in our 2D format on June 6, 2008. We are delighted to have entered into this new and important studio relationship and also note that last year we also began working for the first time with Paramount, the studio that distributes Dreamworks Animation films.

Regarding film performance, as previously reported, in 2007, we generated $145 million from Hollywood releases and for Hollywood releases, which is 56% higher than the $93 million that the IMAX theater network grossed during 2006. This translated into an 81% gain for IMAX’s share of DMR gross box office from 2006 to 2007. On a same-store basis which tracks only those theaters showing DMR films that were open a year ago and therefore strips out the growth of the network, gross box office increased 48% to $1.3 million in revenues per screen. For IMAX this translates into higher film royalties and theater participations, and for studios and exhibitors, it translates into higher profits.

Clearly, 2007 was a very busy year for us, and we are extremely gratified to see our initiatives already begin to bear fruit. We believe that our focus on progress with respect to film performance, joint ventures, and our Digital initiative in signing leaves IMAX extremely well positioned for the future with a compelling operating strategy and business model. 2007 bore the brunt of these initiatives from a financial perspective however. As we mentioned, signings and therefore installations in prior year slowed as exhibitors decided to wait to see the Digital product.

Results were also impacted by development costs related to our Digital initiatives and by high SG&A related to accounting and regulatory issues. Furthermore, during the fourth quarter we recorded a non-cash write-down of film projection related assets totaling approximately $4 million which is reflected in cost of goods sold. This write-down relates to the obsolescence of certain film-based equipment that resulted from the switch to Digital. Due to the combination of these factors, we sustained substantial loss in fiscal 2007. However, we believe the pain experienced in 2007 will turn into better results in Q4 of fiscal 2008 and a profitable year in 2009.

I’m not going to spend a lot of time today reviewing our Q4 results since they are presented in detail in today’s press release, but just to touch on a few key items; total revenues for the fourth quarter came in at $32.3 million compared to $36.5 million last year. We signed 107 deals in Q4 of this year, 100 of which were JVs and seven of which were sale or sale-type lease. This compares to nine sales or sale-type lease signings a year ago. Systems revenue came in at $17 million in Q4 compared to $20.7 million last year. We recognized sales and sale-type lease revenues on five installations compared to nine in the fourth quarter of last year. We installed two joint ventures in the fourth quarter of 2007 whereas the previous year we didn’t install any. These JVs had only a minimal financial impact on the fourth quarter financials, but will provide recurring revenues on an ongoing basis.

Our backlog at the end of the fiscal year consisted of 186 systems with a value of $119 million including 104 joint venture arrangements which carry no backlog value at all. This does not include our recent South American deal which adds approximately $45 million to backlog. This compares with 74 total systems with a value of $118.4 million at the end of fiscal 2006 including one joint venture arrangement. In 2008 we expect to install 25 to 28 joint ventures and recognize revenues on 12 to 14 sale or sale-type leases out of our current backlog. Additionally, we anticipate installing up to three more MPX systems early in the year where we will recognize no revenue until our Digital upgrade obligation is complete most likely in 2009.

Finally, we also anticipate approximately 15 to 20 sign and installs. Those are agreements that we signed in 2008 and will also install in 2008, and we project that roughly half of these sign and installs will be JVs and half sale or sale-type leases. As usual, we should caution you that projected installations are always subject to slippage for reasons generally outside of our control.

Our fourth quarter film revenue was $10 million compared to $10.9 million in 2006. Quarter-over-quarter comparisons are roughly equal when you exclude production revenues related to 3D conversions that were recorded in 2006 under the DMR revenue line. For 2007 our share of DMR gross box office increased 81% to $19.9 million compared to $11 million in 2006 excluding production revenues. Production and DMR revenues were $19.9 million compared to $14.6 million, an increase of 36%. Just to make that clear, the first numbers with the 81% comparison stripped out production revenues; when you include production revenues, the year-over-year increase was 36%. As we discussed in our last call, we were very pleased with the performance of Beowulf in IMAX 3D which generated $24.4 million worldwide and roughly $14.3 million domestically or 17% of the domestic box office on less than 3% of the locations showing the film. We were also happy with the performance of Warner Bros. Pictures’ I Am Legend on December 14th which did about $16.5 million in IMAX.

Turning to the balance sheet, we ended the year with $16.9 million in cash and short-term investments, slightly higher than budgeted. This is only a slight decrease from the $18.2 million we had at the end of the third quarter of 2007. IMAX has no cash or cash equivalents in auction rate notes or any other types of securities where access is likely to be hampered. For the year as a whole, cash expenditures associated with legal, accounting, and professional fees were approximately $10.5 million and R&D related expenditures came in at about $6.9 million. In addition to our cash balances, we have a senior secured facility with Wachovia and this allows us to borrow up to $30 million. I should point out that on December 5, 2007, we amended our credit facility so that our EBITDA requirement was reduced to $12.5 million on a trailing fourth quarter basis before returning to $20 million at the end of the year, so we are comfortable with regards to availability. We have not drawn down anything from our credit facility to date other than for letters of credit which is also specifically allowed for under the senior notes separate from the $30 million. $19.4 million remains available under the facilities borrowing-based calculation after outstanding letters of credit of $10.9 million. With that, I’d like to turn it over to Richard.

Richard L. Gelfond

Thanks Brad. I’d like to begin by discussing recent developments and then I’ll take you through our film slate and discuss what all this means for the business in fiscal 2008. This past Monday we announced the largest lease deal and the second largest theater deal in our 40-year history with RACIMEC International Group. RACIMEC is one of the most prominent entertainment and public gaming companies in the world developing gaming applications such as Lotto and Soccer Lottery for various Latin American countries including Brazil, Chile, Argentina, Venezuela, Columbia, and Paraguay.

Under the terms of our agreement, we will work with RACIMEC to install 35 IMAX Digital projection systems in South and Central America and the Caribbean over the next 5 years. RACIMEC will buy the systems from IMAX under our standard lease arrangement where we receive significant cash upfront and subsequent minimums against the royalty and then RACIMEC will work out arrangements with its partners which include developers, exhibitors, and other entertainment operators per negotiated economic terms. RACIMEC will then work with their clients to identify the best location based on market demographics and cultural trends which will ultimately result in a substantial network of IMAX theaters throughout the region.

This deal will bring capital to these underdeveloped regions while providing IMAX with a contracted cash flow. We are very excited in the hands-up presence in South and Central America so significantly and are pleased to be working with such a well-respected and experienced business innovator who has significant expertise in the region. It is not only this lease deal that is testament to the strong and growing exhibitor interest in IMAX. As Brad indicated, interest in joint ventures gained significant momentum following the announcement of our deal with AMC. We are currently in negotiations with a number of exhibitors for well over 50 joint venture theaters. We can’t predict how many will happen; what we can say is that we expect a significant number of these to be signed perhaps shortly.

Turning now to our film slate; on February 15th released Paramount Pictures, the Spiderwick Chronicles, a fantasy adventure based on the best selling series of books. To date, this film has grossed $4.6 million in IMAX, and while we think this is a very appealing story, we note that February is traditionally a soft time for films. As a result Spiderwick may not have the ledge that would generate significantly stronger results over its run. Following Spiderwick, we are looking forward to releasing the Rolling Stones concert film Shine A Light on April 4th, which is directed by Academy Award-winning director Martin Scorsese. A large portion of the play dates for this film will be in IMAX and it is expected to be the largest North American IMAX release ever. Then as we announced last week, on May 9th, we will be releasing Speed Racer in partnership with Warner Bros. Pictures. This action-packed adventure from the Wachowski Brothers and producer Joel Silver, the creators of the Matrix Trilogy, is based on the hit animated series created by Tatsuo Yoshida, and is a fantastic addition to our 2008 film slate.

As part of the Dreamworks Animation deal mentioned earlier, we are looking forward to releasing Kung Fu Panda in June. We’ve just returned from ShoWest, the Exhibitor and Studio Trade Association Conference where the film was screened and the reaction was extremely positive. Of course, we are extremely enthusiastic about our next film the release of Dark Knight on July 19th which is the next installment of Warner Bros. Pictures’ Batman franchise and again stars Christian Bale as the Caped Crusader. We think the innovative sequences that director Chris Nolan has filmed using IMAX cameras are stunningly immersive and will really create a spectacular IMAX Experience. Our release of Harry Potter and the Half-Blood Prince is scheduled for November, and we expect that as with Harry Potter 5, certain sections of the film such as the finale will be presented in IMAX 3D. We are currently working on adding another film for release in September or October and look forward to announcing this addition to our 2008 slate.

Now I’d like to turn to what Digital and our other initiatives mean to IMAX from a financial perspective. As Brad discussed, the next few quarters will be negatively impacted in part by our Digital transition including increased R&D, installations being delayed by clients wanting to obtain a Digital system rather than a film system, and our inability under the accounting rules to recognize revenue on systems where we provided upgrade later. That said, we believe our rollout of Digital systems in the back half of 2008 will lay the foundation for improved financial performance which should begin to become evident in the fourth quarter. As Brad indicated, we expect that fiscal 2009 will be profitable.

From a cash flow perspective, we believe 2008 will be cash flow break-even before funding requirements for the joint venture rollout and anticipate that we will drawdown approximately $12 million of our available borrowing in 2008. As a reminder, while we expect to spend approximately $2 to $3 million funding the initial JVs, these will begin to generate cash and fund other JVs as the rollout evolves. As we mentioned before, there is a very quick rollout period of less than 2 years including film revenues. Based upon our operating plan, which incorporates assumptions regarding new signings and the timing of joint venture rollouts among other items, our maximum cash drawdown for 2008-2009 under the Wachovia facility is budgeted at less than approximately $18 million.

Before we open up to questions, it is worthwhile to take a moment to review our business model which has clearly been transformed by our initiatives over the past year. We’d like to walk you through some slides, the first two of which we discussed after the AMC deal to show you the earnings potential of the JV strategy and then how it fits into our overall earnings picture. These slides are posted on our website. If you go to the first one that says, “Recent Initiatives – Joint Venture,” what you see for this pro-forma is a gross box office of $760,000 which is about what the AMC joint ventures have done for the trailing 12 months.

You should also realize that in a film world, we release about 6 or 7 films a year and in a Digital world we release 10 to 12 films a year; so we haven’t really accounted for any uptick for the Digital world. If you look at ATP, that is average ticket price – $9.75, which is the actual number from the existing AMC JVs, and it gets you attendance of about 80,000 people. So your gross box office is $760,000 and IMAX’s investment is $500,000. Of that $760, 000, half goes to the studios, which is $380,000 and half stays with the exhibitor. So let’s focus on the exhibitor side for the moment – the $380,000. On top of that $380,000, each of those 80,000 people spends about $3 in gross margin in concessions which gets the exhibitor another $240,000 or net revenues for the exhibitor of $620,000. After that $620,000, our partner, in this case AMC, gets what we call a house nut, which is around $80,000 a year, and IMAX gets around $40,000 in maintenance revenues – that’s for maintaining the system on a regular basis – which is about a 25% gross margin business.

That leaves the venture with approximately $500,000 leftover. If you go back to the slide, IMAX’s share of that $500,000 is what’s listed under JV revenue, and we used the 2% inflation factor on costs and on revenues for purposes of this model. So, using those numbers, you get after 7 years $1,500,000 pay-back on $500,000 investment which is for IMAX a 2-1/2 year pay-back or 37.5% IRR. What is interesting about these numbers is the $760,000 as I said is a number in the film world is even conservative in the film world as Brad said during his comments. During the last year, the average IMAX theater did close to $1.2 million; so there’s a lot of room for upside in this model. The most interesting thing though is that this model does not include the other $380,000 which is the part that went to the studio, and as you know, under our model we get roughly 12.5% from the studio which would translate roughly into another $95,000. So when you add that $95,000 a year to the $1,500,000 we’re getting over the 7 years from the exhibitor, you get a 1.7-year pay-back or a 60% return. On top of that, this model is a 7-year deal and it’s renewable by AMC for up to 10 years. So you can see these are very attractive economics. And again one reason we’re spending the time walking through them again is we believe that in the short run there’ll be some additional joint ventures announced; so we think it’s important that our investors really focus on micro-economics and understand them.

If you go to the next page, the next page just aggregates this page throughout the entire AMC rollout. So if you go to the year 2011 and you look at JV revenue and it is roughly $21 million, that’s just a 100 times the number on the prior page or 200,000. If you look at incremental DMR revenue, that’s just a 100 times the 95,000 a theater in DMR revenue. If you look at incremental maintenance that’s just a 100 times the 40,000 in maintenance revenue; so that gives you revenue of around $35 million. Depreciation – the cost of these theaters is amortized over the 7-year guaranteed life of the contract; so if you have a total investment of $50 million, you divide it by the 7 years, you get $7 million a year in depreciation, and the difference between depreciation and total cost is about $3 million which is our cost of maintaining the system when I said before it was roughly at 35% gross margin. So you see this particular one deal modeled on a very conservative basis brings us roughly $25 million in incremental profit or $30 to $35 million in incremental EBITDA.

The only other point I want to make from this slide is if you look at 2008 and you see we’re installing 26 systems, if you go the bottom where it says CapEx, you see the 26 systems at $500,000 a piece is $13 million; however, we were getting 1.8 million that year in incremental cash flow; so the net cost is $11.1, and that’s why this rollout rather than costing us 50, the maximum drawdown which you see in 2009 is roughly $18 million because theaters are online and you are receiving revenues while you are still financing new theaters. So where does that all bring up? That brings us to the final slide which is entitled ‘Hypothetical Business Model.’ Now we showed this at a few recent conferences. I thought it might be helpful to walk you through it on the call. Again, I really want to underline the word ‘hypothetical.’ This is not a business prediction going forward and obviously as these various deals get announced that happen, we will all have to make adjustments to this, but it’s really a way you can create your model and a way of thinking about the business.

We essentially make money in three buckets. The first bucket is one called ‘new sales,’ which is our traditional leased installation business. The second bucket is from joint ventures, and that is deals like AMC which I just talked about, and a third major bucket is in DMR margin, which is the 12.5% of the box office that we get from the studies. So, now just briefly walking you through this hypothetical model, the recurring margin of about $30 million at the top of the page, that’s the existing network today. If we turn the key off, we got rid of our SG&A, we never had another sale, and we just play DMR films and got maintenance and royalties for our network, that would be $30 million a year.

In new sales, we have a number of 32 theaters a year for the 4 years going forward. Just to remind you, our backlog was around 85 theaters at the end of the year, not including the 35 theaters from South America, so that’s 120 theaters in backlog. We don’t think we are really going to install 32 lease-type sales going forward, even though the numbers would suggest that we have the ability to do that, but what we also blended in here was a number of upgrades, which means people paying us to convert from a film-based system to a digital-based system. So again, these are just kind of directional numbers that you have fill in on you own, and you get roughly another $30 million from the lease business.

Then you go to joint ventures, where we put together 180 joint ventures over the next 4 years. Keep in mind we have today under contract about 110 joint ventures that haven’t been installed, so that’s saying just 70 additional ones in the next 4 years. Again, I think this number has room to change as things are announced or disclosed. The margin from new JVs goes from $6.5 million up to just over $25 million, and then the DMR margin, it just pays 12.5% of the box office of the new incremental theaters open, whether they are new sales or whether they are new JVs, and you get $7 million going roughly to $30 million. So if you look at this, you get margin of around $73 million going to $117 million. You take out SG&A and R&D, and we used the $45 million number which has been our recent run rate – one reason we didn’t inflate that is in the last year, it’s included extraordinary expenses for R&D to develop a digital system, and extra expenses associated with lawyers and accountants to deal with regulatory and reporting issues – so you subtract that out, you get earnings from continuing operations of between $28 going to $72 or EBITDA going up to roughly $100 million.

Again, this is by way of illustration, but I think we’ve heard from a number of our investors that they would like sort of a simple way to a put together a model and put together their own numbers, and that’s what we are trying to accomplish by presenting that. With that, I’d like to thank you for listening, and Brad and I would like to open it up for your questions.

Question-and-Answer Session

Operator

(Operator Instructions) And our first question will come from Eric Wold of Merriman Curhan Ford. Please go ahead.

Eric Wold - Merriman Curhan Ford

Good morning!

Bradley J. Wechsler

Hi Eric

Eric Wold - Merriman Curhan Ford

A couple of questions. I know you probably won’t get too granular on guidance or projections, but in the number of installs for this year, what should we think about? It turns out obviously it’s not going to give you a lot in the first half of the year until digital comes out. What should we think about in terms of mixing first half and second half results?

Bradley J. Wechsler

I don’t think we are going to break that out by quarter, but we try to be reasonably clear about our expectations. In the speech, I don’t know if you heard the whole thing. What we said was in ’08, we expect 25 to 30 joint ventures and 12 to 14 sales or sales type leases out of our current backlog. We also expect to install 3 MPX film systems in the early part of the year; however, we won’t recognize revenue on those until they are upgraded to digital probably in 2009, and then our third category which is sign-and-installs, and I think many of you know, those are systems that we’ll sign in ’08 but also install in ’08, we expect between 15 and 20 sign-and-installs roughly split 50:50 between joint ventures and sales-type leases, so hopefully that gives you a framework to work with.

Richard L. Gelfond

Eric, obviously the digital won’t really be installed until the second half of the year, so that gives you a framework to understand the waiting.

Eric Wold - Merriman Curhan Ford

Right, I understand that. I got all the numbers from the beginning. So is it a safe assumption that really no one wants to install anything until digital is there, so people push the majority of everything into the back half of the year?

Richard L. Gelfond

No, I don’t think it’s an assumption that no one wants to sign anything, Eric. There will be installs in the first and second quarter. Some of them, as Brad said, we won’t be able to recognize because they’ll be subject to upgrades, but others that we’ll be installing will be recognized, so that’s not a reasonable assumption, Eric.

Eric Wold - Merriman Curhan Ford

That makes sense. I know there is almost nothing in the first half of the year anyway, so to confirm that that has to change. That’s what most people are expecting anyway, so that’s fine. Secondly on the box office, it looks like you guys – and hopefully the trend continues – are getting more successful and garnering a greater revenue share percentage. You talked about that 10% to 15% range of box office you get from the studios, can you talk about how you have been moving maybe closer to higher in that range and maybe what the average is right now versus maybe where it was a year or two years ago?

Bradley J. Wechsler

Eric, you are absolutely correct. It gives me an opportunity to say something which I didn’t really emphasize in the speech. I think from our perspective, Richard’s and mine, we delivered a whole much of really interesting good news about what we’re seeing in our business. One number or a series of numbers that huff out at us and it’s an incredible validation of what we’re talking about in terms of building a network is the same-store sales growth of DMR revenues of 48% year over year, the network growth of 56% year over year, and then the number when we really talk granular and really look at our participation of DMR, it was 81% growth year over year, which obviously means that not only are we getting network economics, but it’s the point that you just made that we were over-indexing on that 10% to 15% or that 12.5%, and that is really because of some deals we bet on ourselves and we took the upside because we knew what was going on in the IMAX network and the way it was growing, and we were able to structure deals that ended up yielding us a disproportionate part of DMR benefits.

Eric Wold - Merriman Curhan Ford

Any reason why that shouldn’t continue?

Bradley J. Wechsler

Trees don’t go the sky, but I think from our perspective, you should continue to see really great operating leverage in the film business, particularly as the network grows.

Richard L. Gelfond

In some of the deals we have in the future, Eric, where we cross a certain threshold, we move to a higher level of recruitment, so it’s based on performance. We’ve been able to get that more or so now than a few years ago, I think, because of the function that the films are performing better.

Eric Wold - Merriman Curhan Ford

Lastly, on the number of films obviously going to digital allows you to put out more films, and you talked about 10+ versus where you are now. Talk about how fast you could get to that higher level. Is that a 2010 situation versus ’09, and has the dynamics changed where we are putting out more movies, does that mean that the window of a movie is shorter? Do you start showing more movies on top of each other where theaters have two movies – one being showed during the day and one night?

Bradley J. Wechsler

I think especially initially, Eric, it’s going to be shorter playing times for each of the movies rather than playing two films at the same time. The reason for the fact that it’s 6 or 7 movies now as you know is the high cost of print. It’s $25,000 to $45,000. When that cost virtually goes away, there are virtually no barriers to the studios to releasing a film in IMAX. It’s just a minimal marketing cost. As a result, the studio doesn’t need a 6- or 7-week window. They only need a 3- or 4-week window, so that’s the dynamic which will drive the ability to release more films. Now, when is it going to happen? I think you might see the beginnings of it in ’09. I don’t think it’s like a switch and we’ll go from 6 to 7 to 10 to 12. Maybe ’09 would be 7 or 8, something like that, and then ’10, you’d see a fuller slate kick in, because it’s partly a function of the transition. Film theaters aren’t going to disappear overnight. There will be a few years to work through that changeover, but I would think that by 2010, it’s likely that you’d see much of that underway already. The dynamic from the studios is incredibly helpful because as you know most of the box office is done in the first 3 or 4 weeks of the movie, so we are losing some box office on the films that we would have kept open, but you will be replacing them by the opening weekends of additional blockbusters, and that should have an extremely positive revenue impact on the network.

Eric Wold - Merriman Curhan Ford

Perfect. Thank you guys, appreciate it.

Operator

Once again, ladies and gentlemen, if you do have any question, please press *1 on your touchtone phone at this time. Our next question will now come from Rich Ingrassia from Roth Capital Partners.

Rich Ingrassia - Roth Capital Partners

Thanks. Good morning everybody.

Bradley J. Wechsler

Good morning.

Rich Ingrassia - Roth Capital Partners

I would expect that as your digital footprint grows your exhibitor partners will be able to create pre-show packages and maybe some non-movie content which they haven’t been able to do before. Could you say a little more about that, if it would mean anything directly to your P&L, if you think it would maybe just improve your sales proposition to the exhibitors?

Bradley J. Wechsler

Let me just start on #2 to which I can add. One thing is obviously it’s tough to re-show, but as you go digital, obviously you can do live programming and you have programming flexibility. You can do World Cup Soccer or you can do basketball and you can do the opera, which was attempted already and does very well. Those kinds of things would have impact obviously to our profitability. With respect to packaging of re-shows, I am not exactly clear…

Rich Ingrassia - Roth Capital Partners

Advertising…

Bradley J. Wechsler

Advertising…that’s a more complicated issue, and I don’t know how to answer that. Generally speaking this is some of the shelf space that the exhibitors keep for themselves. On the other hand, historically, we’ve kept advertising out of IMAX boxes, so I don’t have a clear answer on that. Rich, you have anything to add?

Richard L. Gelfond

No.

Rich Ingrassia - Roth Capital Partners

Okay. A couple more questions. I understand obviously that all the new deals are for digital systems, but can you talk a bit about plans for upgrading and replacing still projectors and leases that have been in place for more than a year, and what you expect the economic impact would be for that cycle over the next couple of years.

Bradley J. Wechsler

I think you have to think of three separate boxes, Rich. First think of the deals that we signed years ago and have no digital upgrade language and were installed years ago, which is obviously the bulk of our network. Those are opportunities for us to go back and to sell digital upgrades, and I think internally we are thinking in the area of about $300,000 in margin per sale for selling those digital upgrades, so that’s a large portion of the existing network. That’s the first box.

The second box is people who have contracted for a film-based system but have not yet had it installed, so most of those people if not all will want a digital system instead of a film system, and we’re in the process of starting to negotiate with people in the backlog over that issue. Now the good news for us is that the cost of goods sold in a digital system is less than the cost of goods sold in a film system, so to an extent, if we deliver a digital projector instead of a film projector, we should have a higher margin.

The third pocket is where we’ve contracted to upgrade the digital system and we’ve installed a film system, and at the moment that looks like about 15 theaters, and they range in terms of our duty to upgrade from putting up all the money, to a cap on the money we put up, to sharing the amount of money we put up. If you assume we pay for all of them on those 15 – our cost of goods sold is around $300,000 – do it would be around $4.5 million, and some of the ones that we’re required to upgrade are joint ventures, but at the time of the upgrade, we extended as if it’s a new term, so we get that benefit.

Rich Ingrassia - Roth Capital Partners

Thanks for that detail. The costs there are included in your capital needs that you stated previously in the call?

Bradley J. Wechsler

We’ve modeled in the ones where we have contractual duties, yes.

Rich Ingrassia - Roth Capital Partners

Okay. Two more questions, if that’s alright. If I remember correctly there was a time when you were talking to Sony about becoming your digital projection vendor. Now, I see it’s TI. What happened there and did you find the same issues with reliability and costs that Sony carried that the rest of the industry has been citing?

Richard L. Gelfond

I think you may have answered the question at the end of your question maybe a little more harshly I would have. We wanted to get out there with a digital projection system quickly. Initially we had issues as to whether we could do it with underlying TI technology because of our requirements with light output and resolution. Through extensive testing when we were working both Sony light engines and TI light engines, we came to the conclusion that we can get IMAX quality imagery working with two TI light engines with intervening IMAX IP, and because TI had been out there, they are first to market, and durability had already been tested – I think there are thousands of them out there already – we figured that we should launch with TI, and I was delighted that we were able to officially announce that just a few days ago.

Rich Ingrassia - Roth Capital Partners

That’s what I figured. Last question. Any chance you can squeeze in Lucas’ animated Star Wars feature here in August between Dark Knight and Harry Potter?

Richard L. Gelfond

In terms of, I think I can give you a general answer, I can’t give you a specific answer which is, there is a gap between Dark Knight and Harry Potter and that is a gap that we would like to fill.

Rich Ingrassia - Roth Capital Partners

Okay. Thank you.

Operator

Thank you. And at this time, Mr. Wechsler we have no other questions, so I’d like to turn everything back over to you, sir.

Bradley J. Wechsler

Again, why don’t I say a couple of remarks and then Mr. Gelfond will as well. I think it’s got to be clear from our remarks today that we’re pretty excited about what we are seeing in terms of all the forward indicators and everything that’s going on in our business. Obviously, we paid sort of a financial price in terms of the transition and the financials haven’t looked very good. Our fundamental view is financials in our organization will often may not tend to be backward looking as opposed to forward looking and today I think we spent an awful lot of time talking about the really exciting things that we see going on in the business which aren’t that specularly. A lot of them – we’re talking about backlog projects, we’re talking about signed deals, we’re talking about actual films and film performance, and I think as we look forward we see the world looks very different than it has in the last couple of years. Rich…

Richard L. Gelfond

Now, Brad gave sort of a quantitative, and so I’ll give a little bit more of a qualitative answer which is that we just got back on Wednesday evening from ShoWest which is the industry conference, and all the leading studio heads were there and all the heads of the major exhibition organizations – not just the North America but from around the world – and if you were IMAX 3 or 4 years ago, you would have seen that metaphorically we sat in a corner by ourselves with our megaphones sort of yelling, “hey world, we’re over here,” but again being metaphoric, today, especially with all buzz around the release of 3D films which many have read in the papers, so was a big focus of it; metaphorically, we were sitting right in the middle, and we had meetings with the heads of most of the major North American exhibitors, many many international exhibitors, we spoke at the international lunch, many of the senior studio executives, and there was a difference between being an outsider and a real insider, and I think that’s a different way of saying what Brad is saying from a quantitative point of view. From a qualitative point of view, we’ve really evolved the business; whereas we had to break into the club, now we’re members of the club, and I think that is going to manifest itself very shortly in financial results. And with that, thank you all for joining us and we’ll talk to you shortly on the next quarterly call.

Operator

Thank you. Ladies and gentlemen, this does conclude your conference call. Once again, thank you for participating and at this time we ask that you please disconnect your line. Have yourself a good weekend!

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Source: IMAX Corporation Q4 2007 Earnings Call Transcript
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