AMC Rises to the Top

A decision to invest in movie-theatre chain AMC should be based on improving industry fundamentals or catalysts that can unlock value. Perhaps surprisingly, it looks like AMC might pass on both scores. The outlook for its industry has improved as expansion into megaplexes slows, which should benefit the existing operators. Operational performance, meanwhile, has improved.

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By Mike Trigg (TMF Tonto)
November 16, 2001

Earlier this week, my brother sent me an email saying he was contemplating buying Kansas City-based movie-theater chain AMC Entertainment (NYSE: AEN) in the wake of Sept. 11. "My sense," he wrote, "is AMC is in one of the entertainment segments that will benefit from the attacks. People are traveling less. They have less disposable income. They will stay closer to home. Movies probably are part of the local entertainment mix."

His argument won my attention, but knowing my brother's penchant for Kansas City-based companies -- which stems from a superfluity of civic pride -- my initial thought was that his analysis was not sufficient to justify an investment. Moreover, the stock had gained 47% since the terrorist attacks, perhaps indicating that any surge in business AMC might collect in the coming months had already been priced into the stock.

Rather than investing based on instinctive guesses about trends, a decision to invest in AMC should be based on the discovery of improving industry fundamentals or catalysts that can unlock value. Surprisingly, it looks like AMC might pass on both scores.

The movie-theatre business is arguably the worst place investors could put their money, with the possible exception of airlines. Building and maintaining theaters is expensive, leading to low margins and free cash flow generation. Capital-expenditure requirements and debt balances run high, and the services movie theatres provide are essentially a commodity, making brand differentiation nearly impossible. 

Hence, it should come as no surprise that the industry has struggled. Chains spent enormous amounts of time and money to build next-generation theaters, taking on significant amounts to debt to subsidize expansion. When older theatres began suffering as the new cinemas grew in popularity, the theater chains posted sizeable losses. Since 1995, according to Lehman Brothers, 12 chains filed for bankruptcy.

With much of the expansion already completed, industry fundamentals have begun to improve. Bankrupt companies have been forced to close underperforming theatres, benefiting existing operators -- such as AMC -- as attendance per screen and admission prices rise. Both should increase revenues over the next several years. The plethora of bankruptcies has also created tempting acquisition opportunities.

The docket for upcoming movies should also benefit the industry. True, there have been several flops this year(such as Mariah Carey's Glitter), but with films like Harry Potter and the Sorcerer's Stone, The Lord of the Rings, and Star Wars, Episode II: Attack of the Clones on the way, the near-term growth picture appears robust. The movie business is also unlikely to be hurt seriously by a recession because it's a relatively cheap form of entertainment.

With 25 of the top 50 grossing theatres, AMC appears well-positioned to benefit from these dynamics. Nearly 75% of its theaters are megaplexes, versus an industry average of 30%. This is significant since new theaters drive more traffic because of their prime locations and comfortable stadium seating. The theatres are also more profitable because having one large facility with centralized ticket and concessions sales helps leverage operating costs.

Following a $250 million equity investment from Apollo Management, which increased the company's outstanding common shares from 42.8 million to 66.2 million, AMC's balance sheet has improved dramatically. The investment reduced AMC's ratio of debt to EBITDA (earnings before interest, taxes, depreciation, and amortization) in the most recent quarter to 3.6, according to Bloomberg, well below its five-year average of 5.6.

As expansion slows, capital expenditures should fall from $121 million last year to $75 million this year and next. The company  expects $25 million in free cash flow next year, which should lead to further debt reduction. These developments suggest that my brother's interest in AMC has merit after all -- but considering the unfavorable financial characteristics of running movie theaters, investors should consider more than the near-term outlook before buying a ticket to this industry. 

Mike Trigg was born and raised in Kansas City and has been a customer of AMC's for some time.  His stock holdings can be viewed online, as can the Fool's disclosure policy.

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