The Case for Buying IMAX

Gary Schnierow is portfolio manager of 79th Street Capital and previously spent 10 years at JPMorgan as an analyst and portfolio manager. The below investment thesis was originally posted on SumZero, the leading community for hedge fund and mutual fund investment analysts where professional investors share investment ideas exclusively with one another. Through The Motley Fool, select content from SumZero is now available to individual investors. 

Thesis
IMAX (Nasdaq: IMAX) is a media company providing large-format movie projectors and movies to theaters. 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. There are currently more than 450 IMAX theaters in 47 countries. More than 325 theaters show commercial, Hollywood movies, and 122 show IMAX-created movies in museums and similar institutions. The company has other business lines -- it sells screens to museums, makes its own movies (e.g., Under the Sea, Everest), operates a few theaters, and is developing a 3D TV network with Discovery Communications and Sony. While these provide additional value, I will ignore them for this write-up.

My one-year price target is $24. One year from now, the Street will be looking at one-year forward estimates; on my 2012 estimates (there is no Street estimate), $24 is 20 times fully-taxed EPS of $1.19 (actual tax rate about 2%), 9.5 times EBITDA, and an 8.6% FCF yield, the same multiples as IMAX's current valuation on 2011 consensus estimates (and arguably low multiples for IMAX's financial profile). My 2012 EPS estimate shows 35% growth from my 2011 estimate of $0.88 ($1.22 untaxed, which is at the high end of the Street range $0.79-$1.21. Consensus is $1.02). I also model five-year EPS growth (2010-2015) of 20%.

While 35% earnings growth in any year is difficult, and 20% long-term growth forecasts are generally suspect, IMAX's growth is mostly based on moving screen backlog into service. Backlog alone drives system growth through 2012. Beyond 2012, I forecast some new business in addition to backlog. The combination of screens from backlog plus new signings (70% backlog and 30% new signings) will double screen count by 2015. Consequently, an investment in IMAX is more about growth and whether my forecast is accurate, than valuation multiple.

There are three keys to IMAX as investment (and, of course, other factors -- e.g., SG&A spend -- but I am focused on the key drivers in this write-up):

1. The risk to the company's growth is minimal due to its backlog.
2. Screen growth drives revenue, which will leverage its costs, improving margins and returns.
3. Street estimates are too low for 2011 due to underestimating IMAX's growth.

After years of struggle with industry relevance and profitability, IMAX underwent two transformations in 2007. The company had a significant business evolution -- from high-cost film to low-cost digital movies -- and transitioned its revenue model from exclusively one-time equipment sales by adding a recurring revenue profit-sharing model. The combination of these changes made IMAX much more relevant to its two main constituencies -- movie studios and theater operators -- by making their costs lower. This has resulted in the number of commercial IMAX screens increasing from 178 in 2007 to 303 at the end of the second quarter (plus an additional 187 in backlog), and the number of commercial movies shown per year more than doubling from 6 to 15. The company is now profitable, free-cash-flow positive, and has net cash on its balance sheet.

IMAX transitioned from a turnaround to a value stock and is now a growth company with a visible revenue backlog. While growth can drive great returns, there is often little visibility to the projected growth and many ways that it can be foiled. The risk to growth companies is that growth often does not meet expectations. IMAX is distinguished because, due to its backlog, its growth is extremely visible, yet not fully recognized by Wall Street.

The first key to an investment in IMAX is backlog, which accounts for 100% of my 2011 and 2012 screen estimates. I forecast some new business in 2013 and 2014; backlog accounts for 82% of my 2014 screen estimate. Sell-side analysts have historically underestimated IMAX growth and do not publish detailed models, so there is no comparison for 2012 and beyond.

IMAX generates revenue five ways:

1. System Sales: IMAX sells a projector and screen setup to a theater operator (aka exhibitor).
2. JV: IMAX partners with an exhibitor, contributing the equipment and sharing profits.
3. Maintenance: IMAX receives maintenance revenue on every IMAX screen.
4. DMR: IMAX receives a royalty (a percent of box office) from film studios (e.g. Disney, Universal, Warner) on movies that are shown on IMAX screens (e.g., Avatar, Toy Story 3, Inception, Megamind, Harry Potter, Tron).
5. Other: Distribution, theaters, post-production, new businesses (currently only 20% of revenue and less than 10% of gross margin).

The first four revenue lines are all driven by existing screens and new screens. If you can model the number of screens in a year, you can model the revenue lines. IMAX has given screen guidance for 2010 and 2011 -- based only on backlog (there is no new business in their screen count guidance). Current backlog covers my 2012 estimate as well and takes me part way into 2013.

Screens and revenue by year:

2008: 209 -- $106mm
2009: 288 -- $171mm
2010: 364 -- $223mm
2011: 441 -- $242mm
2012: 516 -- $274mm
2013: 586 -- $300mm
2014: 651 -- $325mm

Management guidance in the second quarter was for 370 commercial screens in 2010 and 430 screens in 2011, compared to my 364 and 441, respectively. Fifty-six screen signings since 2Q should drive management guidance higher, hence my higher-than-guidance estimate for 2011. 2Q10 screens plus backlog equals 490 total screens; adding the 56 signings since 2Q brings the total to 546. If IMAX didn't sign a single piece of new business (though it continues to), in 2013 the company would have 546 screens. I have modeled 586 -- 40 more -- and have modeled 105 new signings in the next three-plus years to reach 651 screens in 2014.

Historical trends and international market penetration suggest IMAX should easily achieve my 2014 screen count forecast. IMAX signed 107 screens in 2007, 90 in 2008, 35 in 2009, and 98 in the first half of 2010. 105 screens in four years is 26 screens/year. The company signed 20 screens in July and 34 in September. IMAX signed up a total of 350 screens in the past 4.5 years (78/year), so my estimate of 105 (26/year) in the next four years is only one-third of the historical trend.

IMAX should hit my 2014 estimate by adding more than 105 screens from international growth alone. Sixty-five percent of blockbuster movie box office is generated internationally. As of 2Q10, only 40% of IMAX's screens are outside the U.S. Assuming 62% of IMAX's current backlog is for international screens (my estimate, but within 10%), brings IMAX's international mix to 50% of total screens. To align IMAX's screens with worldwide box office at 65% international/35% domestic, IMAX would need to sign more than 220 additional international screens on top of the current backlog. This would bring screen count to 871 screens, versus my 651 screen estimate.

My estimate for 651 screens in 2014 not only looks achievable, but likely too low. IMAX's history of signing 78 screens per year compares with my estimate for 26/year going forward and the need for more than 220 international signings to bring the company into geographic balance compares with my estimate for 105 domestic and international signings. Nonetheless, for modeling I use 651 screens.

Once you have annual screen additions and screen count, the below assumptions are used to model revenue and gross margins.

1. System Sales: $1.3mm/system at a 62% GM.
2. JV: $333k/screen (for 2011; 2010 should be $380/screen) with $65k-$70k of COGS/screen. 80% GM
3. Maintenance: $40k maintenance/screen at 50% GM.
4. DMR: = 12%-13% of IMAX box office; total box office is driven by the number of screens, the number of movies shown, and the success of the movies. For 2010, 15 movies at an average $114k/movie/screen (for context: Alice in Wonderland $200k, Iron Man 2 $97k, How to Train Your Dragon $117k, Avatar $714k). COGS is $1.5m/movie. GM = 70%.
5. Other: $40mm revenue. 20% GM.

For 2010-2012, using the above assumptions, I have modeled revenue of $223mm, $242mm, and $274mm; gross margin of 58%, 59%, and 62% (improvement is mostly a mix, with slightly better box-office results helping 2012 DMR margin); EBITDA margin of 44%, 46%, and 52%; and fully-taxed EPS of $0.70, $0.88, and $1.19, respectively. IMAX has a $61mm NOL.

While the long-term for IMAX has greater-than-average long-term visibility, the Street is focused on 2011 and several analysts forecast earnings to be flat to down. The reason is that Avatar, a huge contributor to 1Q10 DMR and earnings (approximately $0.12), will produce a tough comp in 2011. It will. However, it will not cause an earnings decline because 2010 and 2011 screen growth will outweigh a box office/theater decline. Consequently, I believe sell-side consensus ($1.02 untaxed) is too low for 2011.

Analysts, while correct that box office per theater will likely decline, are missing that screen growth will produce an overall box office increase. Due to Avatar, IMAX should average almost $1.6mm of box office/theater for 2010 (3Q and 4Q are still unknown) and I am forecasting $1.3mm of box office/theater for 2011, a 19% decline. I am modeling 21% screen count growth to 441 screens in 2011 (management's guidance at 2Q of 430 plus 11 of the 55 signings since then). Furthermore, 2010 screen count is back-end loaded, making 2011 average screen count growth closer to 25%. A 25% increase in average theaters will offset the 19% box office/theater decline, and lead to a total 8% increase in box office and DMR.

At around $16.44 IMAX trades at 19 times fully-taxed EPS, 8 times EBITDA, and has a 9% FCF yield. IMAX does not have good industry comparisons for valuation. Exhibitors and studios have much different business models and industry dynamics. The one industry comparable is Real D (NYSE: RLD). Real D provides 3D projectors and equipment to theaters and, similar to IMAX, shares in the theater operators' box-office receipts. While both companies benefit from network growth, in a given year, Real D benefits or suffers from 3D movie performance, whereas IMAX is not tied to 3D and benefits or suffers from performance of the 15 blockbuster movies it has on its slate (some of which are 3D). Real D is more expensive than IMAX, yet has lower-quality financial metrics. RLD trades on 2011 estimates at about 30 times fully-taxed EPS and 11 times EBITDA, yet is not FCF positive, has lower margins, less visibility, and has more risk to revenue than IMAX.

Variant View

• The Street does not publish models past 2011, despite great visibility.
• Several analysts expect 2011 EPS to be flat or down from 2010 due to 2010 Avatar box office (addressed above).
• My estimates are at the high-end of the very-wide Street range for 2011. Key differences should be box-office assumption and margins, not theater count, but published analyst models do not breakdown revenue lines.
• One bearish analyst is concerned about nascent competition. Competition did not affect IMAX's 2010 new business wins, as the company has had a record year.
• Some analysts have 3D concerns. IMAX is about a movie slate containing the top blockbusters each year, some of which are 3D. If none are 3D, IMAX is still focused on the top movies each year.

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