Seeking Alpha

Can Movie Theaters Unlock Value? Rewards Programs And MoviePass

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Includes: AMC, CNK, HMNY, RGC
by: Mike Berner
Mike Berner
Long only, growth at reasonable price
Summary

Movie theaters and airlines have a lot of structural similarities.

Theater chains should imitate airlines' successful rewards programs.

The goal is to create more value for a business that is capital intensive by adding an asset-light revenue stream.

Cinemas probably should have thought of MoviePass idea earlier, but the upstart can probably coexist peacefully with the theaters.

A theater chain like Cinemark already offers good value, but investors should monitor developments with MoviePass and rewards programs.

Back in April I wrote an article arguing that movie theaters, specifically Cinemark (CNK), represent good value in today’s market. For many years now, pundits have predicted the death of the movie theater, yet ticket sales have remained largely steady since the 1990s. Despite the proliferation of alternative forms of entertainment, theaters offer an experience that cannot be replicated at home on the couch.

The one unattractive feature of the exhibition business is its capital intensiveness. With the exception of the well-managed Cinemark, which consistently achieves high returns on capital, theaters offer a relatively low return on investment. Recent theater renovations, including upgraded seating and new projection technology, require high yearly maintenance capital expenditures.

However, I see a lot of potential for more value creation in the sector. If theaters successfully implemented a rewards program similar to what airlines have developed, then their earnings could easily increase by a factor of one-third. This article discusses what developments investors should look out for and also touches on the impact of MoviePass.

Look to Airlines

In many ways, the theater business closely resembles the airline industry. Both are capital intensive businesses, and there is little differentiation among the major players. Most consumers do not fly Delta (DAL) because of its brand name; rather, they choose their ticket largely based on price, flight time, and location. Likewise, moviegoers choose where to see a film based on time and distance. Both theaters and airlines fell victim to overexpansion during the 1980s and 1990s, resulting in a prolonged slump followed by major consolidation.

In recent years, airlines have benefited from a sharp fall in fuel costs, but there is a lot of evidence that their sky-high profits have more to do with structural rather than cyclical changes. Today, airlines basically operate two distinct business lines: a low margin transportation business, and a high margin credit card business. I wrote about this phenomenon a short time ago, and Stifel analyst Joseph DeNardi has done a lot of excellent analysis on the matter. Although airlines have been mum on the margins, United Airlines (UA) revealed during its bankruptcy proceedings that it earned 45 percent on its frequent flyer program.

Most investors overlook these hidden profits because they are buried in financial filings under categories such as "other revenue." Take Hawaiian Airlines (HA), where that other revenue category amounted to $291 million in 2015, or 12 percent of total operating revenue. Some of that figure consists of baggage fees, onboard meals and other revenue streams-unfortunately there is no breakdown, so no one knows how much profit the frequent flyer program contributes. But since total operating income was $426 million, it is likely that the high margin "other" category is a substantial portion of pre-tax income.

Hidden Value

Another key similarity between airlines and theaters is that they both derive a majority of their revenue from a minority of frequent customers. American Airlines (AAL) stated in 2015 that 13 percent of individual customers made up half of the company’s sales. Likewise, frequent moviegoers—classified as people who attend the cinema once a month or more—account for just 11 percent of the customer base but half of all ticket sales. Airlines have unlocked this value through their lucrative frequent flyer programs, but movie theaters have strangely failed to capitalize on a massive opportunity.

Here is how such a program might function. A movie theater chain partners with a credit card issuer and market a rewards card that is co-branded with a major credit card network like Visa (V), Master Card (MA), or American Express (AXP). The issuing bank then buys up seats or concession vouchers that can be parceled out through the rewards program. Card users accumulate points through purchases that can be redeemed for tickets or concessions at the theater. As with any credit card program, a certain percentage of rewards (higher than you may think) are never redeemed. For the movie theater chains, this would be pure profit.

There is no reason why the theater chains cannot do this—if another upstart does not beat them to it.

MoviePass

Last month, the young subscription service caused a stir when it announced that it would lower the price of its unlimited movie pass to only $9.95 a month. In less than one year, the company has gone from a trivial 20,000 subscribers to over 400,000 today. MoviePass, which is majority-owned by the data analytics firm Helios and Matheson (OTCPK:HMNY), has already been covered by other Seeking Alpha contributors. I recommend Max Verline and Mark Gomes for those who want more background on the company.

Theater chains have not received MoviePass with much enthusiasm. AMC (AMC) has been especially vocal in its opposition, announcing in a statement that it would seek to block the service from its theaters.

MoviePass argues that since it pays theaters full price for seats that would have gone empty, its service is a win-win. That may be true, but cinema operators have good reason to be worried. Back when Netflix (NFLX) started out, it offered a platform for networks to syndicate shows like Breaking Bad that had previously performed poorly in reruns. In the short run, it was basically free money. Over time, however, Netflix’s asset-light business model turned the company into a cash machine that rapidly outgrew the networks. The theater chains probably fear a scenario where a cash-rich player like MoviePass grows too large to control and eventually exerts pricing pressure.

It is sort of unbelievable to me that the theaters did not get out in front of MoviePass earlier, but I think the danger to the theaters is exaggerated. After all, travel portals like Priceline (PCLN) and TripAdvisor (TRIP) have coexisted peacefully alongside airlines and hotels for many years now. Obviously travel operators would prefer not to pay out commissions to third-party sites, but the problem is not an existential concern. If anything, MoviePass is still a risky venture because future profits are speculative and barriers to entry for a rival service are low.

Financial Analysis

The cinema business will be an interesting industry to watch over the next few years, and investors should keep a close eye on rewards programs. Using Cinemark as an example, assuming that a rewards card generates incremental ticket revenue on par with the airline industry (roughly 12 percent), the company could generate an additional $200 million in sales. That does not sound like much since the company took in nearly $1.8 billion in ticket sales last year, but remember that margins on frequent flyer programs are thought to be as high as 50 percent. An extra $100 million would jack up Cinemark’s present earnings by 35 percent.

Assuming very modest 1 percent annual growth in admissions revenue ($1.8 billion in 2016) plus 6 percent annual growth in concessions revenue ($990 million in 2016), earnings could grow to nearly $500 million within ten years at current operating margins. Adding that 6.3 percent growth rate to the current earnings yield gives us about 13 percent, which would mean that the company is pretty fairly valued at the current price. Again, this is a conservative figure, since Cinemark has historically grown revenue at a much greater pace. However, if future earnings were increased by 35 percent due to the implementation of a successful credit card program, then the stock is almost certainly undervalued.

Just to plug Cinemark one more time—the stock is down nearly 20 percent since the spring, even though the company has reported solid earnings. The decline is probably due to a combination of AMC shares’ summer implosion and concerns over MoviePass, both of which do not materially impact Cinemark’s business. Hurricane Harvey may have a small impact on quarterly earnings (the company has ten theaters in the Houston area), but this is, of course, a temporary concern.

For now, I would not be too concerned about MoviePass, and in the short term it may even help theaters unlock value. Of course, it would be better for the theater chains if they did that themselves.

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

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