Imax: The Bear Case Just Doesn't Add Up

| About: IMAX Corporation (IMAX)

It is important to read analysis that is contrary to your opinion when doing stock research. So many people have already made up their mind before they begin their research. I see this mistake so often with retail investors. They google a ticker symbol and read the articles that "confirm" their point of view and pat themselves on the back for getting it right without putting in the work. It is a difficult thing to be critical of your own ideas. You don't often hear, "Man, I have this really terrible idea I just have to tell you about." That is why it is so important to seek out the contrary perspective especially when everyone else seems to agree with you.

This was exactly the case of my bullish stance on IMAX Corp (IMAX). While I was doing my stock research I found article after article that treated a bullish stance on IMAX to be obvious, so much so that the articles rarely included much substance or analysis. I was guilty of this myself. It wasn't until I was blasted in the comment section of another one of my articles that I realized it. I decided it was time to step up my game. I decided that the way to do that was to re-write my first article and take on the biggest IMAX bear I could find. I had read a couple of Larry Meyers' articles that bashed IMAX but I shrugged it off. I really didn't give his arguments the amount of attention and critical thought that they deserve. Agree with Mr. Meyers or not, he put forth a reasonably strong case (read through the comments as well).

That is what led me to write this article. This is my comprehensive analysis of the bear case for IMAX as put forth by Mr. Meyers. I won't be the first to rebut Mr. Meyers' article but I intend to be the most complete. That is not a knock on the previous rebuttal authors, just a personal aspiration. Before we get there, let me summarize the bull case for IMAX.

The Bull Case

Ever since the incredible success of 20th Century FOX's (owned by News Corporation: NWS) Avatar, released in December of 2009, IMAX Corp has experience a boom in every facet of their business.

Theater Network Expansion

IMAX went from 226 commercial screens at the end of 2009 to 550 commercial screens (includes back log) by the end of 2012 resulting in an increase in revenue from $56 million annually to $81 million.

Service and Maintenance Contracts related to Theater Network Expansion resulted in an increase from $18 million in 2009 to $24 million in 2011.

Half of all new commercial screens were Joint Ventures which provide an additional 20% stake in the box office resulting in an increase in JV revenue from $21 million in 2009 to $30 million in 2011, $45 million in 2010 due to the runaway success of Avatar.

More than half of all new commercial screens are outside of the US and Canada with the largest zones being China (202 screens by the end of 2012) and Russia (74 screens by the end of 2012).

Greater Film Slate

IMAX film slate has gone from 12 titles in 2009 to 26 titles per year including the top 3 films in the Global Box Office in 2011, all of which grossed over $1 billion dollars, 6 of the top 10 (All grossed over $500 million).

Increased quantity of films shot with IMAX cameras, digitally re-mastered (DMR) to IMAX format and distributed by IMAX resulted in a revenue increase from $156 million in 2009 to $224 million in 2011, $228 million in 2010.

IMAX has inserted itself into nearly the entire life cycle of a film and found a way to tap it for revenue. They lease/sell the camera's to shoot the film in 3D or their proprietary format, digitally re-master films into 3D or IMAX format or both, sell/lease the premium theaters systems that exhibit the films, sell the maintenance of the premium theaters systems and through the Joint Ventures get an additional stake in the box office and in some agreements concessions.

Over the next 5-10 years IMAX will continue to build out its Theater Network which will result in rapidly growing revenue in the premium theater sale/lease and service and maintenance business segments. IMAX CEO Richard L. Gelfond has a current target of 1700 commercial screens worldwide with only about one-third of those in the US and Canada. Half of all new commercial screens are expected to be Joint Ventures. As the number of screens increases so should the revenue from Joint Ventures (20% of the box office for that screen) and DMR (12.5% of the box office for that screen).

At some point the number of new premium theater systems will slow or perhaps stop. The long term plan is for IMAX's share of the box office for each screen to supplement sales of IMAX theater systems upgrades, maintenance agreements lease/sale of camera equipment and lease of theater equipment.

IMAX is a technology company and spends approximately $10 million on research and development each year. Perhaps the current IMAX Experience becomes the standard and IMAX launches the next generation of IMAX Experience. Who knows what the future holds from a technological perspective. Apple did not stop at the IPod and IMAX is not likely to stop innovating as evidenced by their recent acquisition of numerous Eastman Kodak (EK) laser projection patents.

So, the bull case is that IMAX is a company in a rather substantial growth cycle that has a plan for when they reach maturity. I would liken Avatar's release in December of 2009 to Apple's (AAPL) unveiling of the IPod. It was an awakening for a company that seemed to be drifting towards its inevitable collapse. That was a pronounced inflection point in Apple's story. That moment forever changed how we look at that company. The release of Avatar, I believe will be the same kind of moment for IMAX Corp.

The Bear Case

First, I would like to concede that Mr. Meyers was right about IMAX Corp when it was priced at $38 a share. While I do believe that mark or higher will eventually be the fair value for the company, expectations simply went too far, too fast. I myself shorted the company at that point. My disagreement with Mr. Meyers starts and ends with his assessment of the long term potential for IMAX Corp. Mr. Meyers broke his argument into 6 sections. I will do the same for the sake of symmetry and attempt to succinctly summarize Mr. Meyers' points in each section for reader convenience. (Mr. Meyers, please feel free to correct me if I miscommunicate your intent. Please understand I am trying to do this in good faith)

Section 1: The math doesn't add up?

For this section Mr. Meyers points are as follows;

1. IMAX screens only represent 6.5% of the total number of domestic screens and IMAX only gets 10-15% of the box office for each screen.

2. IMAX optimized movies are too clumped together for IMAX to reach max revenue potential on each film.

3. Fewer number of releases in IMAX makes box office bombs hurt more

Unfortunately, your figures are just wrong or at a minimum incomplete. By the end of 2012 IMAX will have over 300 screens in the US and Canada. That represents approximately 8% of the total number of screens in the US (approximately 3500 for a major release). This however does not represent 8% of the domestic box office because of the premium added to the IMAX tickets, not to mention 3D. If the average ticket price is $7.93 and the average IMAX premium is $3 (37% higher than average) then IMAX ticket sales should represent nearly 11% (8%*1.37=10.96) of the box office. Of that 11%, IMAX's share is 12.5% for all films converted to their proprietary format and an additional 20% for all Joint Venture screens.

Let's go through the math with my numbers for Global Box Office take for The Green Hornet, Sanctum, I Am Number Four, Mars Needs Moms, and Sucker Punch ($500 million) using the same assumptions you did regarding penetration.

$500,000,000 * 11% = $55,000,000 (11% penetration)

$55,000,000 * 22.5% =$12,375,000 (22.5% represents half of all theaters providing a 12.5% cut for DMR and half providing 32.5% for DMR plus Joint Venture)

These figures do not include 3D and already the effect of correcting your figures is significant and these films were bombs, no doubt. They were disappointing but still a worthwhile venture for IMAX. The only potential significance of these films failure to attract a crowd is to IMAX as a brand. No one wants to pay a premium for crap. I will concede that point and consider that to be IMAX's largest risk.

However, IMAX also had 6 of the top 10 highest grossing films in 2011.

  1. Harry Potter and the Deathly Hallows II ($1.328 billion)
  2. Transformers: Dark of the Moon ($1.123 billion)
  3. Pirates of the Caribbean: On Stranger Tide ($1.043 billion)
  4. Ghost Protocol ($ 694 million)
  5. Fast Five ($626 million)
  6. Cars 2 ($560 million)

Your observation regarding the scheduling conflicts of film releases is a good one. I agree and apparently so does Richard L. Gelfond. To combat the seasonality of "blockbuster" film releases IMAX has started re-releasing films that are known quantities. They have a deal with Disney (DIS) to digitally re-master and release a film every 6 months. So far they have done this with Lion King ($97 million domestic) and Beauty and the Beast ($47 million domestic) with fairly good results. Films from Pixar's catalogue are expected to be a part of this deal as well. It is not a far stretch to see films in the Marvel catalogue in the near future. The fact that blockbusters tend to release clumped together is a challenge, and one that IMAX seems to have figured out.

Section 2: The secular trend does not favor movie theatres

Mr. Meyers states "The trend in movie theatre ticket sales has been disastrous this past decade, cratering 17% since 2002." He believes that people care more about convenience than quality.

The problem with this argument is that it cites a domestic problem and assumes the rest of the world is following suit. Nothing could be further from the truth. The US represented about 31% of the Global Box Office in 2011 and that number is shrinking. Yes, our domestic ticket sales are slumping but international ticket sales are surging. That is exactly why IMAX has pushed so hard to expand outside of the US and Canada. From 2009 to 2011 domestic ticket sales have gone from 74% of IMAX GBO (Global Box Office) to 47%. The Global Box Office has been steadily growing. The idea that the secular trend is away from movie theaters is just plain wrong at best, willfully misleading at worst.

Section 3: The quality of Hollywood content is bad, and getting worse

Honestly Mr. Meyers, there really isn't any substance to dispute. It is just your rather cynical view of the quality of films being made today. I happen to agree that there are a lot of bad movies being made but there are also quite a few good ones. The truth is there is more content being created and distributed than ever before due to digital publishing. An author can publish a book and sell it in Amazon (AMZN) Kindle format if they agree to give Amazon a cut. Independent films can be published through Netflix (NFLX) and distributed through their video streaming service. Anyone can have a blog and write whatever they want and occasionally that turns into a lucrative book and movie deal a la Shades of Gray.

In another article you asserted that IMAX has no ability to control the quality of their product (you meant the films, not the hardware). I disagree. It is not as if IMAX has to take whatever Hollywood chooses to give them. Doesn't Apple choose the apps that are sold in its Appstore? What stops IMAX from doing the same?

Section 4: Box office cannot be predicted

Mr. Meyers believes that box office revenue cannot be predicted therefore earnings cannot be predicted.

This may be true for individual films (though I believe this to be disputable) but trend analysis can provide reasonable valuations for a portion of the global box office (GBO) based on the portfolio of films released. The swings in the GBO are not so wild as to make them random as Mr. Meyers suggests.

IMAX screens averaged about $250,000 in the box office in the first quarter of 2012. The first quarter is historically the weakest for the GBO but to remain conservative we will extend that value to all four quarters. This results in an annual average of $1 million per screen which would result in $325,000 of revenue for IMAX under the typical terms of a Joint Venture screen (12.5% for DMR, 20% for JV). At 1700 screens worldwide, the current IMAX goal, that would be just over half a billion dollars annually.

Section 5: IMAX is a gimmick

Mr. Meyers thinks IMAX is cool but other ridiculous gimmicks didn't work so it won't either. This isn't an argument, it's an opinion and not one I will spend words refuting.

Section 6: Consumer behavior does not favor IMAX

1. People don't want to pay more for IMAX

2. People don't want to drive out of their way to go to IMAX theaters

3. The smaller "IMAX" screens tick people off

People have the option of seeing films in either IMAX format or standard and yet choose to see them in IMAX. IMAX is expanding their network so people won't have to drive out of their way to go to an IMAX theater.

I will concede your third point as a risk to the brand but a manageable one. IMAX Corp is marketing themselves and the IMAX Experience as an "Affordable Luxury" like a latte from Starbucks (SBUX) or a pair of Nike's (NKE). I'm on board and at least for now it would seem like I have quite a bit of company.

How is this actionable?

Accumulate shares anywhere near $22 and wait out the growing pains. IMAX stock has a high beta and produces many opportunities to accumulate shares so stick to your target prices. Based on the resistance I have seen around $25-26 I feel comfortable taking some profits but don't cash out entirely without good reason. IMAX has a solid 5 year plan. I am willing to stick with them and see where it takes me and the stock price.

Disclosure: I am long IMAX, AMZN, DIS, NFLX.