Digital Cinema Destinations Has Much More Upside Than Downside

| About: Digital Cinema (DCIN)
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Digital Cinema Destinations (NASDAQ:DCIN) owns and operates movie theaters and has a stated goal to grow its portfolio to at least a total of 1000 screens. It closed Friday at $5.94 and has been steadily acquiring small groups of screens. At the end of the first quarter of 2012 (March 31, 2012), DCIN had 19 screens and less than one million dollars in quarterly revenue. At the close of its last reporting period (September 30, 2013), revenue was up more than tenfold and DCIN had 184 screens; since the close of the quarter, it has announced plans to acquire more screens.

The Dynamics of a Roll Up - DCIN's strategy of acquiring small groups of screens and combining them into a company which would control a large group of screens could be loosely described as a "roll up". A number of large companies - notably Waste Management (NYSE:WM) and Comcast (NASDAQ:CMCSA) - initially grew through this strategy and it has a number of advantages. To understand the basic dynamics, let me use a hypothetical. Suppose Newco raises $125 million in equity (5 million shares at $25 a share) and, over a period of time, acquires 1000 screens for 5 times EBITDA (which is, hypothetically $50 million) for a total cost of $250 million. Because the income stream is relatively stable, as it goes along Newco is able to borrow $125 million at a weighted average interest rate of 8%. Newco is able to bring management expertise to these operations and increases EBITDA by 7% - in addition, the acquisitions occur over a 4-year period of time in which the impact of higher ticket prices and general increase in attendance increase EBITDA by 13%. Thus, at the end of 4 years, EBITDA is $60 million. Depreciation is $12.5 million, interest expense is $10, and, thus, pre-tax earnings are $37.5 million. After tax earnings are $25 million and because the company is growing and, per-screen revenue is relatively stable with steady growth, the company trades at 15 times earnings or a market cap of $375 million. This translates to $75 a share or a very nice profit for original shareholders. Of course, this hypothetical is grossly oversimplified but, essentially, a roll up promises profitability due to a combination of increased efficiency with size, the ability of a public company to command higher multiples than the multiples it must pay when making acquisitions, and the availability of credit at reasonable interest rates to a large, stable entity. As noted, the analysis is oversimplified and all sorts of other factors - transactional costs, periodic public offerings, etc. - will affect the ultimate numbers.

The Limited Downside - Because the roll-up path to growth is through the acquisition of cash producing assets, the roll-up almost immediately acquires positive asset value and is able to achieve positive cash flow at a fairly early stage. This means that delays in the implementation of the growth strategy or even its abandonment do not leave investors with worthless assets. Instead, a viable, cash flow positive entity is quickly assembled and, in the worst case, can be operated for some time in a slow growth mode or can be sold to another industry participant. At any given point, such a transition may diminish the market value of the equity (which embodies expectations of growth) but the downside is limited. Thus, a typical roll up should be much less risky than an investment in a drug which may or may not be approved by the FDA or a technology which may or may not be adopted by the target industry.

DCIN Snapshot Analysis - As of the close of the last quarter, DCIN had achieved phenomenal growth going from 19 screens in March, 2012, to 184 screens on September 30, 2013. It should be noted that this rapid growth was facilitated by a joint venture and debt financing. 99 of the screens are held by a joint venture; DCIN gets 5% of gross revenue for managing the screens and generally holds a 33% interest in the assets of the joint venture. DCIN also has borrowed some $10 million and currently pays roughly 12% interest. DCIN's financials suggest that it has reached the point of being cash flow positive on existing operations. Its expenses include larger G&A than would be normal for its size because it anticipates further expansion. If it were to abandon expansion plans, it would be significantly cash flow positive and could pay down and/or refinance its expensive debt. DCIN had some 6.5 million shares as of September 30, 2013; it issued 1.14 million shares at $5 a share in October and has announced roughly 50 screens in its acquisition pipeline since September 30. Its numbers today are probably substantially different from its September 30 numbers so that we will have to await the next quarterly report. However, it appears that DCIN has clearly reached "escape velocity" and achieved a self-sustaining size.

DCIN's Special Sauce - DCIN is not simply conducting a roll up. In many cases, DCIN has added digital projection technology when it has acquired new screens. This enhances revenue and improves efficiency. Perhaps more importantly, DCIN has brought an innovative strategy to the industry and it is already enhancing cash flow. Movie theaters tend to be very "peaky" in terms of box office volume. Theaters fill up on weekends and they are virtually empty mid-week. I recently saw "Captain Phillips" at a theater in a large mall in our area on a Wednesday afternoon (my car was being serviced nearby); I was the only member of the audience. At any rate, DCIN's strategy is to fill seats during these slack periods with alternate programming in the form of opera, ballet, concerts, movies targeting various ethnic groups (e.g. Bollywood) and other special attractions. The revenue generated this way is really like "finding money in the street" because there is really no offsetting lost revenue at time the theater would otherwise be empty. It is hard to say how much impact this will have but it could raise revenue per screen by at least 5-10%, a great deal of which would fall to the bottom line. DCIN is actually targeting a higher number and it will be important to review quarterly financials to see how DCIN is doing in this regard. DCIN is also participating in the distribution of new films which could be exhibited on this platform through its DigiNext joint venture.

DCIN's Future - DCIN's recent financial reports suggest a number of acquisitions in the pipeline. The industry is still fragmented with a number of screens controlled by very small players. Thus, there a numerous target acquisitions for DCIN to consider. As DCIN grows, G&A will be a smaller percentage of operating revenue and positive cash flow should be enhanced. In addition, an important catalytic event will be the replacement of DCIN's very expensive debt with debt carrying a more reasonable interest rate. As noted above, DCIN's objective is to get to 1000 screen size level. It is roughly 1/5th of the way there after less than two years. The investment thesis is that DCIN achieves its objective by buying screens at its target multiples (between 4.5 and 6 times EBITDA), enhances per screen revenue with efficient management and using its off-peak programming strategy, and ultimately sells (either in the market or in an acquisition transaction) at an attractive multiple. In this regard, investors should be aware that DCIN has two classes of stock with the CEO controlling the class with enhanced voting rights.

Bottom Line - I do not see a great deal of downside here. Even if DCIN discovers that it cannot grow as planned, investors would be left with a small cap stock with a reasonably steady cash flow and slow growth leading to a reduction in or a replacement of the expensive debt. At its current size, DCIN would be a possible takeover target for one of the larger players in the industry. On the other hand, there is no reason to doubt that DCIN's experienced and resourceful management can achieve its objectives. CEO Bud Mayo has a strong track record having grown and sold Clearview Cinemas with very favorable results for investors. With growth generated by acquisitions at attractive multiples, DCIN will produce enhanced cash flow and could ultimately trade in the teens or higher.

Disclosure: I am long DCIN. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.