THESIS

With its core US market approaching saturation, China growth declining and little evidence of FCF generation despite years of investment and a tripling of its screen network – IMAX trades near all-time highs on ~18x EBITDA. 

I believe IMAX is a decelerating growth story with questionable scale economics and priced for perfection. Combined with a weak 2014 movie slate, I believe IMAX has ~18-43% downside or more from current levels as the stock re-rates to a ‘hits-driven’ multiple (10-13x Forward EBITDA). 

INVESTMENT HIGHLIGHTS

• Growing Backlog/Decelerating Installs: Despite record backlog and theater signings, IMAX has had flat/declining installations for the past couple of years. Management took down 2013 install guidance last quarter, and guided for flat installations for 2014.
• US/Canada Market Saturation: IMAX installed 29 theater systems in US/Canada in the twelve months ending 12/31/13, bringing the total commercial US/Canada screens to 353, with 55 screens remaining in backlog. Over that time, revenue declined ~$9.4mm from ~$145.7mm to ~$136.2mm, or down 6.5%. Though I expect some new signings as they expand into Tier 2/3 markets – IMAX will have to rely on int’l markets for screen growth.
• Global Growth Ambitions/Declining Marginal Economics: Continued global screen growth relies on IMAX expanding to emerging markets such as India, SE Asia and Latin America, where box office receipts are far lower - making marginal economics vastly inferior.
• Questionable Scale Economics: Despite tripling the size of its screen network since 2010, IMAX has minimal and inconsistent FCF to show for its growth or its investments. Also, IMAX has already announced its deals with the largest exhibitors – Regal, AMC and Wanda – so there’s little risk of additional sizeable deal announcements.
• Increasing Customer Competition: IMAX’s largest customers (AMC, Regal, Cinemark) are also becoming competitors, and are rolling out their own premium large-format theater experience in markets where they cannot bring IMAX due to zoning exclusivity and/or to keep more of the economics of the higher ticket prices.
• Weak 2014 Movie Slate/Difficult Comparisons: While Gravity was a ‘must-see’ movie in IMAX 3D in Q4 2013 and has already grossed over $100mm in IMAX alone – it creates a difficult Q4 comparison in an already weak 2014 movie slate that includes fewer 3D movies (28 vs. 34 in 2013). IMAX also faces difficult comps in Q2 2014 (Iron Man 3, Star Trek, Man Of Steel in Q2 2013).
• Slowing China Growth: Over the past year, IMAX China screen growth has increased from 108 to 150 screens, or +39% growth. Despite the dramatic increase in screen growth, LTM revenues (ending 12/31/13) grew ~25%. China seems to be slowing, though 239 China theaters remain in backlog.

DESCRIPTION

IMAX designs, manufactures and markets premium digital theater systems for large-screen, enhanced-viewing movie theaters. IMAX customers that purchase or lease the IMAX theater systems include commercial theater exhibitors, museums, science centers or destination entertainment sites.

• IMAX digitally re-masters conventional motion pictures into the large-format image and enhanced-sound quality of The IMAX Experience, which are then shown at IMAX-branded theaters that have IMAX equipment.
• IMAX-branded theaters offer a more immersive experience for filmgoers relative to conventional cinemas, with higher resolution and fidelity sound.
• There are currently more than 785 IMAX theaters in 55 countries, with more than 653 in commercial multiplexes, 19 in commercial theaters and 113 that show IMAX-created movies in museums and similar institutions.
• IMAX-branded theaters generate an industry-leading per-screen average (PSA) of more than $1mm as its brand and perceived quality advantage have enabled theaters to gain traffic and charge premium pricing.
• IMAX also produces original films (Under the Sea, Everest), operates a few theaters and is developing a home theater system for consumers.

BACKGROUND

IMAX was a largely unprofitable niche theater standard for several decades, until advances in digital film during the early to mid-2000s dramatically lowered the cost of distribution and enabled the company to distribute its large-screen format technology to a wider audience. During this time, IMAX also has shifted its strategy to focus on selling systems to theaters on a joint revenue-sharing basis. The combination of these changes made IMAX much more relevant to its two main constituencies – movie studios and theater operators – by driving their respective costs lower. Though some consumers complained IMAX Digital (aka ‘LIE-MAX’) was inferior to the traditional analog format, the standard quickly gained traction and gained the support of the major movie studios – which promoted and adopted IMAX for their blockbuster films.

• As a result, the number of commercial IMAX screens increased from 178 in 2007 in just the US, to 720 globally at the end of 2013, plus an additional 407 in backlog.
• In that time, the number of commercial movies shown per year has increased from 6 in 2007 to over ~40 globally at the end of 2013.

Business Model

The superior image and sound quality of The IMAX Experience allows exhibitor to charge customers a premium for IMAX films relative to other films they may be playing. The premium pricing, and typically higher attendance levels associated with IMAX films – generates incremental box office for the exhibitors and for the studios releasing their films onto IMAX screens.

IMAX generates revenue several ways, though the management readily admits there is no ‘standard’ deal – differing by geography, studio or even specific movies.

• Sales-Type Lease (STL): IMAX sells or leases a theater system to a theater exhibitor, and then receives a small ongoing fee for maintenance.
• Joint-Revenue Sharing Agreement (JRSA): IMAX partners with an exhibitor for a period of 5-10 years, contributing the theater system (~$500k) at little to no cost to exhibitor. IMAX receives a percentage of the box office (typically 18-20%), as well as a small ongoing fee for maintenance.
• Digital Media Remastering (DMR): In order for films to play on IMAX screens they must be digitally converted into IMAX’s large-format at a current cost of ~$800k/film. In a typical IMAX DMR arrangement, IMAX receives a percentage (typically 10-15%) of a studio’s box office receipts in exchange for converting the film to the IMAX format and access to IMAX’s distribution and marketing platform. IMAX typically converts 35-40 films a year.
• Other: Distribution, theaters, post-production and new businesses (~20% of revenue and less than 10% of gross margin).

Management
CEO Richard Gelfond and Chairman Bradley Wechsler have been with the company since 1994. While the stock has been range-bound for the past three years (down ~2.5%), Gelfond was responsible for shifting the company’s business model from equipment sales to joint revenue-sharing, and has a good job of creating shareholder value over the past five years (up ~400%).

• Per the last proxy statement, Gelfond and Wechsler held 2.4% and ~1.0% of shares outstanding, respectively. All other members of senior management hold less than 1.0% of shares outstanding.
• Neither Gelfond nor Wechsler have made outright purchases of IMAX stock over the past three years, but have made significant sales.
• Gelfond received $3.6mm in cash comp in 2012, and just re-upped his employment at year-end 2013:
  • Increased base salary to $1.1mm, +46% from the $750k base salary he made previously.
  • Cash bonus of up to 2x base salary, with a target bonus of 1x salary.
  • Three annual stock option grants valued at $3.9mm per year.
  • If terminated w/o cause or resigns, unvested stock options.
  • Bottom Line: Overall CEO compensation is comparable to other media/entertainment companies according to Mercer (as stated in the proxy), though the new CEO employment agreement seems high given the stock has been flat for the last three years. Overall, management seems to be selling stock as soon as the options vest, there is minimal insider ownership (6.2%) and there have been no outright purchases of stock. 

INVESTMENT HIGHLIGHTS

Growing Backlog, But Decelerating Signings/Installations

Installations have been trending lower since 2011, while backlog and signings are at record levels. It is unclear to me what backlog means exactly as some exhibitors may never get around to build a new theater and/or secured an exclusive IMAX zone for defensive/competitive reasons. On the last earnings call, management took down install guidance for 2013 to be at the lower end of 110-125 screens and added that 2014 would be similar at 110-125 annual installs.

Installations vs. Signings 

Source:  IMAX 10-K for 12/31/13; *Management has guided to 110-125 installs for 2014

US/Canada Market Saturation

As of 2013, IMAX has installed 345 of the 400 contracted IMAX installations in the US and Canada, leaving 55 domestic screens in backlog.  Based on company-defined zones, IMAX has ~70% penetration in US/Canada. Although IMAX will likely grow that incrementally, domestic screen growth is no longer a driver for the company. Management believes the key to the North American business is ‘over-indexing’ on specific films – that is, get a disproportionate amount of the box-office dollar share on the IMAX network. Management believes this can reach the mid-teens in the face of a weaker slate of movies and increasing competition in the premium large-format niche. Historically, across the slate – this has averaged ~10% of the box-office receipts on 2-3% on the screens.

Global Growth Ambitions/Decreasing Marginal Economics

Domestic theaters represented almost half of IMAX's global theater base in 2013, but management believes that the global market can support 1,700 IMAX theaters and expects that the vast majority of future expansion will be driven by international markets. Based on company-defined zones, IMAX has ~26% penetration internationally as of Q3 2013.

• While the global IMAX target market seems reasonable, I believe it is highly unlikely IMAX can maintain its industry-leading PSAs of over $1mm as it expands into less developed markets, and customers/competitors launch their own premium large-format theater alternatives.
• While the IMAX brand has been around for decades, screening Hollywood blockbusters on the IMAX network is still a relatively new concept and has generated unpredictable PSAs from volatile movie results.
  • There’s no science in predicting box-office results, making normalized profitability projections difficult as IMAX matures.
  • IMAX international PSA ($1.4mm average in 2012) has historically exceeded the domestic take ($1.0mm), but this will not be the case as IMAX expands in less wealthier, smaller markets.
  • Key new markets for IMAX include: Indonesia, Malaysia, India and Brazil – all economies with a growing middle class, but where per-capita income is far lower than developed markets.

Questionable Scale Economics

While network growth has been slowing, even more surprising is the lack of revenue growth and ultimately FCF generation from the larger network. Since 2009, JRSA network growth has grown 300%, while revenues have bounced around – but clearly not scaled.

Moreover, IMAX has shown flattish 1H JRSA revenues over the past 4 years, which I reasonably conclude that the company is experiencing negative comps on a same-store-sales basis.  A new install generally does not have a revenue ramp up period, but rather a tent pole grand opening.  This suggests that older screens may be seeing revenue declines, but being offset by new grand openings, and why revenues have remained flattish. 

IMAX Customers Becoming Competitors

IMAX offers an incredible customer experience, yet each of IMAX largest US customers are rolling out their own premium large-format alternatives. While part of this is simple economics (uplift in ticket pricing, but with no IMAX rev-share), most theater exhibitors would prefer to have incremental IMAX screens if they could (with the possible exception of Cinemark). Despite the strength of the IMAX brand and the IMAX Experience, I believe the increase in premium large-format competition will begin to impact over the near/medium-term.

• IMAX grants exclusivity zones for each exhibitor that installs an IMAX screen.  If one exhibitor has an IMAX screen in a certain area, another exhibitor cannot install another IMAX within a certain radius. As a result, the exhibitors have an incentive to lock-in zones as a defensive measure and/or preserve optionality.
• While the IMAX DMR conversion process is proprietary, technology cost deflation is enabling other processes to be cost-effective. As a result, theater owners can now play any movie on their large-format screens and keep the uplift in pricing for themselves.
  • Regal Premium Experience (RPX): Aggressively rolling out RPX, and already has more RPX screens in its network than IMAX (140 RPX vs. 82 IMAX at YE13). Expects to add another 20-25 RPX screens in 2014 (vs. 5 expected IMAX installs), with only 7 IMAX installs remaining on its original agreement.
  • Cinemark Extreme Digital (XD): 150 XD screens at YE13, with plans to launch another 50+ in 2014. Believes XD experience to be comparable to that of IMAX.  Currently, 8 IMAX screens in its network.
  • AMC Enhance Theater Experience (ETX): 17 ETX theaters at YE13, with plans to launch another 17 ETX over the few years. AMC is the largest IMAX exhibitor with ~143 screens at YE13, with another 7 screens to install in the US on its original agreement.
  • International: China Film Group recently rolled out a competing premium large-format theater in China, and has been locked in a dispute with IMAX for months (See NYT Article in Appendix). The situation is tricky as China Film Group also is a government-owned entity that also controls the import of films to China. As IMAX is claiming the system is based on stolen trade secret, but they may find out that the lack of intellectual property controls is a cost of doing business in China.

Slowing China Growth

One of the reasons IMAX was a great long was the ‘China growth story’ for IMAX and China’s insatiable demand for Hollywood content. However, China revenues declined H1 2013 vs. H1 2012, before rebounding slightly in Q3 2013. As you will note in the table, H1 2013 vs. H1 2013 marked the first time China revenues declined Y/Y, despite screen installs doubling and IMAX box office grew over 20% in H1 2013. A strong Q4 2013 China box office reversed this trend.

• IMAX has 73 JRSA screens installed currently, with another 132 in backlog as of the 10-Q dated 9/30/13.
• Last July, Wanda Film Group and IMAX revised an existing JV, stipulating that Wanda would build at least 40 and as many as 120 new theaters over the next 12 years – increasing their commitment to 120, of which a good portion will pivot to the laser projection system.
• Wanda already runs 82 IMAX theaters in high-end malls typically located in major cities across China.
• China Film Group: A recent NYT article (see Appendix) highlighted that China Film Group is rolling out a competing large-format theater alternative. Since China Film Group also controls the import of Hollywood imports, the situation is tricky.

China ‘Growth’ Story 

Source:  IMAX Filings.

Other Ways to Win:

• ‘WOW’ Factor Fades: IMAX has only recently gained mass-market appeal, so it is possible consumers are less willing to pay for the immersive experience as the concept matures. Film franchises based on comic book characters may be peaking (‘Ant-Man in 2015?), resultin consumer interest in ‘fan-boy’ characters diminishing and box-office per film declining. Spider-Man 2 in 2014 is a re-boot of a re-boot – and will be a good test of this premise – further making 2014 film slate vulnerable (See chart below).

Spider-Man Peaking? 

• Economic Downturn: The movie business has historically been relatively immune and even counter-cyclical to the economic cycle (considered affordable entertainment when cutting back on other expenses), but attendance has remained essentially flat to slightly down over the past 25 years. IMAX has only recently played Hollywood feature-length films, while its network has tripled over the past few years. The higher IMAX ticket price makes it more vulnerable to a prolonged economic downturn.
• Int’l Growth Issues: IMAX generated ~56% of its gross box-office revenues from international in Q3 2013, and expects to get a majority of its growth from international going forward. Undoubtedly, this growth will come from places that will not possess similar laws governing businesses and contracts.
  • As IMAX may find out in China, international regulations are not standardized and may impede or stunt its growth outside developed markets.
  • IMAX may be subject to repatriation taxes as profits from international scale.
  • Though little/no competition today, IMAX may see competitors emerge in markets where its brand is less well known.
  • Niche Next-Gen Upgrade Market: Part of the bull argument is the theater upgrade-cycle to IMAX’s next-generation laser-projection systems in late 2014/early 2015. While pricing hasn’t yet been announced, it will be likely be more expensive than current-gen, come with its own issues (laser speckling) and ultimately limited to the institutional segment, some China contractual theaters and the remaining large film-based IMAX theaters.

BULL CASE

• IMAX’s brand and technology have enabled it to become the dominant proprietary standard in the large-screen cinema market.
• After the film is converted, it is relatively inexpensive to distribute IMAX digital-format films to new theaters, so a growing theater base provides IMAX substantial scale advantages over smaller theater networks.
• As IMAX's theater base grows, operating margins will improve and achieve a normalized return on invested capital (management quotes 30%).
• As the IMAX theatre network grows, the company takes in a larger share of global box office on IMAX screens, directly impacting box office related (JRS and DMR) revenue streams
• Some movie studios have supported the IMAX brand by actively incorporating IMAX into the marketing programs of their highest-profile blockbuster films, since consumers have been willing to pay higher ticket prices for the IMAX experience.
• Additionally, a growing number of popular directors, including James Cameron and Christopher Nolan, are choosing to shoot a portion of their films with IMAX's proprietary 65mm cameras – further differentiating IMAX from its peers and increasing its network effect.

Value Proposition: Exhibitors

• Exhibitors can offer the immersive, premium experience that customers desire and can’t be replicated in the home.
• IMAX allows exhibitors to charge a premium for this experience, roughly 30-35% on average.
• IMAX brand is strong and indicates a ‘high-quality’ theater to potential customers, improving ticket sales across IMAX and non-IMAX screen.
• Increased traffic drives high-margin concession sales (90% gross margins). 

Value Proposition: Studios

• Re-mastering a film in IMAX signals this is just a movie, but a must-see event.
• Almost every IMAX film has opened up at #1 for the box-office weekend.
• IMAX movies command a premium and have a higher per-screening utilization (more Butts-In-Seats, or BIS).
• Success at the box office translates into higher rentals, merchandise sales and increases the likelihood of sequels.

Comparables

IMAX is essentially a brand and technology licensing company, but I consider it more of a retailer with ‘box economics.’ While the exhibitors are rolling out competing large-format initiatives, they have different business models and industry dynamics – and different top-line growth profiles, have leverage, pay dividends and trade at lower valuations. RealD has a similar business model and partially shares in exhibitors’ box-office receipts.

• Exhibitors: AMC Entertainment (AMC), Regal Entertainment (RGC), Carmike Cinemas (CKEC), Cinemark Holdings (CNK) and Cineplex (TSE: CGX). Exhibitors as a group have traded between 6.0x-8.5x forward EBITDA multiples.
• RealD (RLD): Provides 3D projectors and equipment to exhibitors, but is even more ‘hits-driven’ than IMAX as it is completely levered to 3D movie performances (vs. IMAX ‘blockbuster’ movie slate). RLD also has lower quality of quality margins, has less visibility, is not FCF positive and – after its recent run – more expensive than IMAX on EV/EBITDA basis (Note: I almost wrote RLD up as a short, and would likely include it in my ‘Short Book’ if putting fresh money to work/liquidity). RLD has historically traded in the 12-16x EBITDA since IPO, and currently trades at 11.0x 2013 EBITDA and 9.3x 2014 EBITDA.

Guidance (Q3 2013 Call)/Stifel Conference (2/10/14)

• Lowered SG&A guidance, but not R&D guidance.
• Guided towards the lower end of installation range for 2013 (110-125), noting late-year deliveries pushed into 2014.
  • Expects 2014 installations to be similar to 2013: 110-125 installations (back-end loaded).
  • 95 of 2014 installations out of backlog.
  • Backlog: 356 theaters (333 new theaters; 23 upgrades w/ 18 laser systems) – 83% of backlog in int’l
    • 333 new theaters – to be rolled over several years
    • 84% are contracted for installations within new builds
    • Record high backlog with 356 theater at the end of Q3
    • Robust H2 2013 theater signings.
    • "Gravity" must-see in IMAX with very high PSA rates of $1mm in some venues.
    • Concerned about difficult Q2 and Q4 comps, as well as World Cup in Q2.
    • Laser projection system rollout by YE14 on-track – geared to film-based and institutional.
    • Several film-based theaters outfitted with interim Xenon solution (expect very strong Q4 revenues).

Analyst Ratings: 7 Buys / 4 Holds / 1 Sell; Avg. PT = $32

CATALYSTS

• Earnings Release: 2014 installation guidance; bulls want to see top-line growth and operating leverage.
• 2015 slate announcements/delays.
• China Film Group – continued disregard of IP or IMAX lost their case.
• Additional theater signings.
• Individual movie underperformance.

Upside Risks

• Underestimating global IMAX box office run-rate.
• IMAX may install more systems than expected which could drive upside to revenues and earnings estimates.
• IMAX international opportunity may prove to be larger than expected - the number of screens and IMAX penetration of screens may be higher anticipated.

Downside Risks

• IMAX films may flop on its format and/or underperform expectations.
• Growth in IMAX screens may be slower than expected which would impact the revenue growth trajectory.
• IMAX's growth strategy is now leveraged to international and emerging markets which may possess relatively weak regulatory/legal environments.
• Historical IMAX EBITDA multiples likely will not hold as growth slows.

VALUATION

Given all the JRSA installations, one can argue IMAX is simply becoming another theater network – as the growth slows, IMAX’s multiple should be in-line with slower-growing exhibitor peers which trade at 6.0-8.5x EBITDA (and RLD at 11.0x) – though I think a slowdown of this magnitude may be years away.

At 11-13x 2014E EBITDA, I arrive at a value of $16.26-23.09/share, or ~18-43% downside.

CONCLUSION

• IMAX transitioned from a company in turnaround, to a value stock, to a growth company with a visible revenue backlog to now: a decelerating growth story with questionable scale economics.
• While growth can drive great returns, there is often little visibility to the projected growth and many ways that it can be foiled.
• IMAX is trading at a healthy premium to the exhibitors and its own historical multiples, but does warrant a growth multiple.
• For many years, IMAX had a extremely visible growth thanks to its backlog, a strong movie slate and interest in 3D from both consumers and studios alike (ever since the success of Avatar). 

• Earnings Release: 2014 installation guidance; bulls want to see top-line growth and operating leverage.
• 2015 slate announcements/delays.
• China Film Group – continued disregard of IP or IMAX lost their case.
• Additional theater signings.
• Individual movie underperformance.