IMAX: The Bull Case Doesn't Add Up

| About: IMAX Corporation (IMAX)

Readers and fellow SA contributors were upset with my recent bearish call on IMAX. I thought it might be a good idea to clarify my position further on the company's and stock's prospects, if for no other reason than to get even more people angry with me.

The gist of the bull case is relatively simple: It's all about recurring revenue via rev-share box office on an ongoing basis. This theory sounds good on the surface, but without a fundamental understanding of Hollywood and how content consumption has been evolving, it can lead one to disaster.

Investors need to split IMAX's future into two periods. The first period is screen expansion, which is going on now. There is a decent likelihood that, in the near term, IMAX will do fairly well. It'll generate revenue from new screen installation and ongoing warranty and service contracts. Obviously, as IMAX increases screen count, that means more theatres will be available for general release films to play in, and therefore increased revenues from shared box office. I won't dispute that. (However, I will dispute that entire feature films will be shot in the IMAX format. The system doesn't lend itself to shooting entire films in that format.)

It's the second period where things get tricky. Screen penetration is finite, and the company itself believes there is room for 1250 screens globally. Once IMAX systems have been maxed out, the company will still have ongoing service contract revenue, but its growth will be allegedly driven by rev-share box office. Except that's where the problem lies. Here's six reasons why the "recurring revenue" argument doesn't hold water.

1. The math doesn't add up

There are 52 weeks in a year, and IMAX needs to fill its theatres with patrons during those weeks to achieve maximum revenue. However, there are limited film genres that will play on an IMAX screen. Nobody will pay to see Bridesmaids in IMAX, even if it’s a good movie. They will pay to see sci-fi, action, animated, and fantasy films. Many of these films are released in the summer and the holidays. IMAX cannot jam Super 8 into a given theatre one week, and then yank it in favor of Cars 2 the next week and achieve max revenue from both of these films. There's too much IMAX-optimal content that isn't spread out enough to achieve 52 weeks of filled IMAX theatres.

Of the content that does get IMAX-released, the company presently has only 6.5% of the total number of domestic screens in a full market release of 3,000 screens from which to draw revenue, and of that, receives 10-15% of the total. So for anyone with images of Avatar's $2.8 billion global box office dancing in his head, IMAX would get $28 million at most from that release -- once all 1,250 screens are in place. As it is, it got less.

And not every film is an Avatar. The rest of the year sees the release of weaker content. In the first three months of this year, we saw The Green Hornet, Sanctum, I Am Number Four, Mars Needs Moms, and Sucker Punch. Combined, they took in $500 million globally. At max screen count, assuming 6.5% IMAX penetration globally, that's $5 million in revenue. And that's 25% of the IMAX releases for 2011. That's not much revenue.

Even if every film did really well, and IMAX was able to run each for three weeks, it could only put 17 films into its theatres over the year. That's making some huge assumptions that just aren't going to come true.

2. The secular trend does not favor movie theatres

The 10-K states:

The company also faces in-home competition from a number of alternative motion picture distribution channels such as home video, pay-per-view, video-on-demand, DVD, Internet and syndicated and broadcast television. The company further competes for the public's leisure time and disposable income with other forms of entertainment, including gaming, sporting events, concerts, live theater and restaurants.

You better believe it. The trend in movie theatre ticket sales has been disastrous this past decade, cratering 17% since 2002. This year's projected total is for a staggering 10% drop YOY. Why? For many reasons. But a primary reason is because content consumers, particularly younger people, do not distinguish among media formats. Film, TV, Internet -- it's all the same in the digital age.

Wherever, whatever, whenever. That's how younger people want their content. The "push" model of content consumption is dying and being replaced by "pull." Even worse, this is the same demographic that presently accounts for 50% of ticket sales. As home entertainment continually improves, as content choice becomes broader, as streaming and VOD become standard, and as theatrical windows get shorter, IMAX will face even greater competition than it already does, and that's before those 1,250 screens are even in place.

Even more to the point, for everyone who says that people will go far out of their way to see an IMAX movie, a Rice University study concluded that if you like what you're watching when streaming content, you're less likely to notice the difference in video quality of the TV show, Internet video or mobile movie clip. Picture quality just doesn't matter that much to the younger demographic.

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

This is yet another reason for the decline in ticket sales. Of the 11 films released in IMAX this year, five are universally proclaimed stinkers and a sixth is of questionable value. At least two of the remaining nine domestic releases are going to be bad. Having spent 20 years in the entertainment industry, the last thing I would do is bet my money on the quality of Hollywood content. The Green Hornet in IMAX does not make it a better movie.

4. Box office cannot be predicted

In the book Hollywood Economics, author Arthur de Vany conducted a scientific study of all films released over a long period of time. His conclusion was that one can predict the box office of any given film, but with a standard deviation of infinity. In other words, box office cannot be predicted with any certainty whatsoever. The only people who can even remotely peg these numbers are internal studio finance people, and that information is never shared with the public. IMAX investors who swoon at the prospect of recurring box office revenue, let me ask you something: Why are you investing in a business where you literally will not be able to even guess what revenues are going to be? How can you take a stab at a valuation? You can't.

5. IMAX is a gimmick

I really love seeing movies in IMAX. The right movie plays exceptionally well in IMAX. But at the end of the day, to the average moviegoer, IMAX is nothing more than a really big screen with really big sound. We've seen this before. It was called CinemaScope. It was invented to compete with TV. It didn't last. Neither various others -- and now, we're seeing the inevitable backlash against 3D. IMAX's day is coming.

6. Consumer behavior does not favor IMAX

The primary reason for the 3D backlash isn't the glasses. It's the premium pricing. IMAX is great, yes. But is it worth the extra expense? There will always be cinephiles who will fork over the extra money for it, but they are not going to sustain IMAX's revenues. No, IMAX needs average Joes and Janes. The thing about IMAX is you must make a special commitment to see it. IMAX theatres are not right down the street in every multiplex. Most people have to drive an extra distance on top of paying the extra money. Thus, IMAX has not one, but two economic stressors to deal with, especially if gas prices remain high.

Add to this the brand dilution that IMAX is engaging in. In trying to solve the location problem, the company has created a fake IMAX experience in which the screen is only 25% the size of a true IMAX screen. Yes, people notice and they don't like it. This will create IMAX backlash.

How is this actionable?

Investors better have a look at the risks IMAX itself discusses in its 10-K. In my last article, I suggested IMAX as a possible short. I didn't say to short today. I gave several criteria to watch for as for when it might make a good short candidate. I reiterate them today.

The keys to watch for:

  • Company estimates on the total possible installed base of systems remaining static.
  • Contract cancellations (two theatre chains make up 17% of their revenue).
  • New gimmicks.
  • Continued drop-off in volume of box office admissions, coupled with increased streaming numbers at companies like Netflix (NFLX).
  • Continuous quarters of cash flow decrease. We just started seeing decreasing cash flow in the trailing 12 months, from $29 MM in Q2 2010 to a $10MM negative cash flow in Q1 of this year.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

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