Description
OVERVIEW: Initially I began looking at this stock as a long idea given the sizzle tied to the concept of a pure play digital cinema company, a very compelling story spun by a very charismatic CEO and the success in investing in another digital play (SCHK, thanks Miles!). However, while on the surface things seemed exciting, my opinion of the shares has since turned 180 degrees. After I began to research the idea I found that many of the supposed claims that management was making were quite different in reality and fundamentals look at best very shaky. Thus, I am recommending Access Integrated Technologies (AIX) as a short idea due to the combination of:
-- a story whose underlying fundamental story has major cracks and could very well implode,
-- a company who has already missed some major milepost targets and faces some upcoming critical deadlines,
-- a very promotional CEO whose story keeps changing,
-- the forthcoming entry into the market of significant competition from well established participants,
-- a company who is burning cash, will likely need to accelerate the burn rate near term and needs to do another financing that will significantly dilute existing shareholders and,
-- an egregious valuation that puts the company on par with the most successful & highest brand name Internet services companies.
While the shares have already begun to retreat from their recent peak as cracks in the story start to become apparent, I believe there is still significant downside in the share price as these cracks could be the early signs of a complete collapse in the story. I believe that as some catalysts surface over the next 3-6 months that undercut many of the company’s claims (which I will discuss below), the shares will likely at best retreat back to the $3-$5 level that the stock traded at prior to its hype infused rise and could even trade below that if the story completely unravels and/or they cannot raise needed additional funding in the near future. As I find shorting a stock based primarily on valuation a fools game, this write-up will be heavy on qualitative analysis and potential catalysts to drive a lower price with a quantitative analysis of valuation at the end.
THE SIZZLE: (The bull case that management has been hyping is as follows.) In the biggest transition in its history, the motion picture industry is at the cusp of a huge change in how motion pictures are reproduced, distributed and shown in theaters from analog (celluloid) to digital. The move to digital cinema is a win-win proposition for both the major studios and the theater owners. Currently, only about 200 of the worldwide base of about 100,000 screens use this technology. However, the acceptance of this technology is about to skyrocket due to a number of factors. AIX is uniquely positioned as the only company that can put the pieces together to make digital cinema a reality in the industry and the company has no competition. AIX has a multi-tied revenue model. The largest source is from collecting a virtual print fee (VPF) of $1,000 every time a film in played. In addition, the company collects revenues from: movie delivery fees, pre-show trailer delivery, alternate content fees and by licensing its software management product (Hollywood Software). Considering the approximate 36,000 screens in the US alone and that on average 200 major motion pictures are released to about 5,000 screens annually, the potential revenue opportunity is huge.
Quite compelling you must admit, right? Well on the surface I would agree. However, before you go out and buy the stock, you may want to remember the old adage that says: things that appear to be so good seldom are. In addition, you may want to read the following, which highlights my problems with the story. By way of background, I have done a pretty fair amount of research on digital cinema and have had the opportunity to speak with senior executives from some of the: major studios, national theater chains, projector, component, satellite distribution, pre-show advertising, financing entities as well as the major industry standards body and industry trade groups. One important take away from these discussions is that there are few secrets in Hollywood, which I hope means that after speaking with a broad audience of key decision makers, I have a pretty good picture of the current environment.
EXHIBITORS ARE IN NO RUSH TO IMPLEMENT DIGITAL: After doing only a minimal amount of research, one message comes through loud and clear. While the studios for the most part (except for one) are mostly in support of this technology, the major exhibitors are very reluctant and cautious because there is very little benefit in it for them and some risk. Exhibitor concerns including: 1) the high cost of installing digital projectors (about $100,000 vs. $30,000 for an analog projector), 2) results from their own tests that this technology will not drive more people into their theaters, 3) a technology debate over 2k vs. 4k technology, 3) the lack of any beta tests in a major market, and 4) concern that this transition will be tied to some attempt to shift the current balance of power and economics to the studios. Thus, it has generally been accepted that the major studios will in some form finance the cost of the instillation of digital projectors with the saving generated from the cost savings tied to lower replication and distribution costs. However, the devil is in the details and getting all the major players to agree with each other (without acting in collusion) and then in an acceptable form to theater owners will need to be done before a financing plan can move forward. With little progress in the industry on this score, back in June 2005, AIX decided to try to get the ball rolling by announcing its own financing plan, with the establishment of a separate company (Christie/AIX) in cooperation with a major film digital projector company. So one significant take away point is that while I have no doubt that some exhibitors will move forward with some digital instillations in the near future, exhibitors are in no rush and the transition will likely be a lot slower than AIX desires.
WHERE’S THE BEEF, CRACKS IN THE STORY BEGINNING!: The stock of AIX more than doubled on the June 21st news of its financing plan in partnership with projector manufacture Christie to transition the industry to digital cinema. What really got investors excited about the announcement was comments that they had the strong support (despite no details at all) from all the major studios and exhibitors and that suggested that all the final pieces of the story would quickly fall in place. However, what has followed from that day has been a continuous series of delays and adjustments to both the timetable and structure of the original story of its financing plan. I believe this highlights some significant underlying cracks in the fundamental story that could be a prelude to a complete implosion in the future. Noteworthy, are the following points:
-- the original timetable of 60 days for announcing details on studio & exhibitor partners had expired with no signings (2 of the 3 studios have subsequently signed on since but no exhibitor partners have been announced).
-- an original goal of signing 5 or 6 of the seven major studios has now been reduced to three.
-- the goal for installing 200 digital screens this year has been reduced to 100-200 (however the longer term goal was raised from 2,500 to 4,000 in 2 years).
-- in a strange announcement after only 60 days had passed, both parties had to modify the terms of their original agreement, which to me suggests that the Christie/AIX partnership is on very shaky grounds and it would not surprise me to see Christie jump ship and/or partner with another financing partner in the future.
-- management has mentioned the possibility of changing the terms of receiving VPF’s on a per site (vs. per screen) basis, which would seriously impact future revenues.
-- upon announcing the first studio deal with Disney, management stated that this agreement would cover the first 4,000 screens and that the economics may be adjusted (read this as the VPF reduced) thereafter due to competition (to AIX/Christie).
KEY DEADLINES LOOMING: Despite these changes/delays and no announcement of exhibitor partners, management continues to suggest that everything is progressing on plan relative to their timetable. The delays in the timetable are important because in the interim the company continues to burn cash and more importantly, there are certain milestones that AIX has to meet in its Disney deal (and by definition any other studio deal it signs) or else they could be terminated. I understand that AIX needs to install 500 systems by March 2005, 2,500 by March 2007 and 4,000 by September 2007. While the timetable behind the Disney agreement (and other future studio deals) could be extended, this puts a little pressure on management to make things happen fairly quickly and highlights a huge risk in the fundamental story. In addition, AIX management likes to point out that they are already delivered 17 major releases to 282 screens to suggest that the transition is already happening. However, what they fail to say is that just about every one of these deliveries are to screens that the company controls either through existing agreements from their acquisition of Boeing Digital Cinema in 2004 or their February acquisition of Pavilion Theaters. Thus, there have not really been any satellite deliveries of films to outside owned theaters/screens and the numbers of screens has not shown much growth. In comparison, as you will see later, this pales in comparison to one competitor.
THE EVIDENCE BACKS MY BELIEF: I am coming to the conclusion that based on the following evidence that I have recently uncovered, while some exhibitors will begin to transition to digital (and some with AIX), it will be very difficult for AIX to achieve its near tem instillation goals. First it’s important to remember that getting the studios to sign deals is the easy part; the hard part will be convincing the exhibitors. One important piece of evidence that seems to confirm my belief is the resolution from the National Association of Theater Owners (NATO) on digital cinema that they recently highlighted on the home page of its web site (http://www.natoonline.org/). Notable there are a number of elements of the resolution that NATO would like to see/occur before moving forward to roll-out digital cinema that directly conflict with AIX’s plans/goals. These include: 1) the need for a financing plan to have the support of all the studios (AIX has two and hopes to move forward with only three!), 2) the need for a beta test in a major market (I confirmed the time period required is 1 year), 3) exhibitors must be able to select the equipment to be installed (restricted to Christie projectors in the AIX financing program) and 4) the unresolved issue of who will pay for future equipment upgrades. Another piece of confirming evidence is insight from the two sole suppliers of projector lenses that indicate there have not been any orders placed as of yet for the volume that AIX needs. Importantly, the lead time to manufacture these lenses is currently about 16 weeks. Thus, even if a large order was placed today, it could not be delivered until February/March 2006. Finally, a recent press report in the Hollywood Reporter states that Warner Brothers is in the process of a one year test of 4k projectors in Japan and that major theater chains may hold off any purchases of projectors and digital cinema implementation plans until the results of the tests are completed.
MAJOR COMPETITION IS ALREADY HERE: Basic economics suggests that if you have such a huge profit opportunity as described by management, in a highly visible market like the cinema industry, you would have some competition. Right? But no, management continues to say in just about every public forum (as recently as an investor conference in September) that they have no competition. Well the fact of the matter as I see it is that not only is there competition, but it appears competition has very quietly already moved ahead of AIX by some measures. Noteworthy, there are no real entry barriers into the business (especially the financing business) and of those that would hold any significance (i.e. long established industry relationships and reputation), are not held by AIX, but its likely competitors. I would put competition into two camps: existing industry players who will likely announce their own financing plans and existing companies that could easily transition their existing infrastructure to digital delivery of films.
On the first point, I have confirmed with multiple people in the industry that there are 3-4 other companies with well established reputations in various parts of the business that are in various stages of putting all the pieces in place for their own financing plans. One of the most significant competitors is Technicolor; a major movie distributor with well established relationships that dates back to 1915, and who is owned by French industrial giant Thomson. My understanding from multiple people is that Technicolor has been very busy in quietly working behind the scenes to begin to build a solid infrastructure, has signed up a disproportionate number of studios (and may already have one major national theater signed on) and could announce its financing plan as early as next week. In addition, another well regarded industry participant is also finalizing its own plan with a goal of signing most of the major studios and even possibly a number of exhibitors in excess of AIX’s plan. Importantly, if either company has, on announcement day, more studio partners and/or a major exhibitor signed up, that would be a huge blow to AIX and the stock. Moreover, Technicolor already appears to have a leadership role from a market share perspective. Noteworthy, while AIX touted as a major accomplishment the fact that it had delivered a digital copy of the recent Star Wars movie to 20 screens, Technicolor in fact delivered 60 copies. Based on new information on Technicolor’s website the scorecard shows that Technicolor has delivered 100 digital releases while AIX has done 17 and Technicolor has 285,000 screens vs. 282 for AIX! However, the bulls on AIX would counter that Technicolor delivered these movies via a hard disk and not satellite, so it’s not the same. However, I would remind you that satellite delivery of any digital media is a pure commodity and Technicolor has not use it so far because the high upfront costs can’t be justified today until volumes increase. Noteworthy Technicolor recently signed an agreement with a satellite provider for their pre-show advertising and content to theaters and entered into a strategic agreement with an Asian based company to form a digital distribution network in this region of the world.
EVEN MORE COMPETITION ON THE HORIZON: Future competition will likely come in a different direction in the form of the major companies that currently provide pre-show and other digital content to the theater industry via satellite. In my opinion, the most notable of these companies is National CineMedia (NSM), which is a recently spun-off joint venture, owned by Regal Entertainment Group, AMC Entertainment and Cinemark. Thus, it’s important to emphasize that the owners/partners of this company are (considering that AMC is acquiring Lowe’s Cineplex) 4 of the top 5 national theater chains that currently account for about 42% of all screens in the US. Currently NSM has about 13,000 screens converted to accept their digital content. There are a couple of noteworthy points to keep in mind when looking at NSM as a potential threat. While the major theater chains do not appear to be moving fast on transitioning to digital cinema, they are installing these low-end e-cinema projectors (and the other required equipment) fairly rapidly due to the tangible revenues opportunity from showing this content. In doing some research on NSM, I found some comments by the President & CEO in the press a few years ago who indicated then that his company was designed from day one with the notion to deliver digital cinema in the future. My understanding is that they have not moved aggressively in that direction as of yet (but could easily add the infrastructure to do so) simply because its exhibitor partners/owners are not interested in the technology yet. Another point to consider is that AIX has suggested that one of the real opportunities they have with their digital cinema roll-out plan is the ownership of the satellite dishes on the roofs of their theater partners. They believe that owning the digital “pipe” in the theaters is very valuable and that there is a first mover advantage to this. While I don’t disagree with this, I would say don’t you think that the theater owners know this and that given National CineMedia’s ownership of this “pipe” to 13,000 screens already, AIX may already be too late. Noteworthy, while AIX talks about the possibility of driving revenue streams from alternate content VPF’s, last year NSM hosted about 7,000 events (meetings & alternate content) generating $100 million. Furthermore, if these 4 leading theater companies were going to pay anyone for the right to show digital content, who do you think they will choose: AIX, or a company they own a significant equity interest in and share the profits from?
HOW WILL ALL THIS BE FINANCED, HUGE DILUTION COMING: When listening to the claims of AIX management investors should keep asking themselves how will they finance all of this. Keep in mind this is a company that I estimate currently has about $10 million in cash (assuming the impact of a recent PIPE, the burn rate last quarter and the purchase of the first tranche of digital projectors), about $20 million in debt and a negative tangible book value. In addition, last quarter the company burned over $2 million in cash and will likely use more in the near term to finance an increase in cap-spending to purchase projectors and satellite dishes and other equipment if it hopes to hit its instillation goals in the near future. Importantly, any delay in signing on exhibitors and installing the equipment will only prolong the burn rate until they can receive VPF revenues. Note AIX’s highly leveraged balance sheet has not gone unnoticed by the studios, who apparently have suggested to management that they would like to see less debt on their books. As a result, management recently said that it was in the process of trying to restructure its balance sheet to convert debt to equity. Also, management has reversed itself in stating that the funding for the capital associated with its roll-out plans will not come from asset backed debt, but equity. Thus, management recently told investors that it will need to raise $50 million Q4 of this year. That amount coupled with recently completed private equity financing (including warrants) and the moves to restructure its debt will mean huge dilution for shareholders in the next few quarters. By my calculations (and using the current share price), the share count will more than double from 10.4 million last quarter to about 22 million after the equity financing is completed. A side takeaway point is to put yourself in the shoes of a potential studio or exhibitor partner and to ask yourself who you want to partner with for the next 10+ years; Technicolor (who you have partnered with for film distribution for 70+ years and who is backed by Thomson) or 2 year old AIX and its weak balance sheet?
AN EGREGIOUS VALUATION: Valuing the company is very difficult as most of the current revenues come from the hosting business (not an attractive business) with all of the digital cinema revenue on the come, few details from any potential deals with the studios are available, trying to gauge the opportunity from other revenue sources discussed by management are difficult, and management’s talk about possibly changing its revenue formula (i.e. lower VPF’s) after the initial 4,000 screens due to competition. With losses likely to continue through 2006, even by the bullish analysts recommending the stock, we need to move to another metric to value the shares. Considering the equity infusion that management discussed that is necessary, the shares currently have an enterprise value of about $236 million. According to one analyst report (that carries a Buy rating and assumes that management will hit all its instillation goals and receive revenues from other various alternate content), it is expected that overall revenues (including revenues from its hosting business) will hit about $17/$41 million in 2006/2007 respectively and that revenues from digital media will be about $10/$33 million respectively in these same periods. Thus, at current levels, the stock is trading on an EV/sales basis of about 14x 2006 revenues and 6x 2007 revenues. However, as no one is buying the stock for the hosting business, I believe it would be more appropriate to value the stock against the revenues expected from the digital cinema business. On this basis the shares are selling at 24x 2006 revenues and 7x 2007 revenues. By comparison the shares of Google, Yahoo and eBay are respectively priced at 8x, 10x and 9x 2006 revenues and obviously much less on 2007 revenues. As you know each of these companies: has a proven business model, strong competitive barriers, terrific brands, are highly profitable and generate huge amounts of cash. By comparison, AIX has yet to prove its business model and stay off competition, has no brand or competitive barriers, is losing money, burning cash and significantly diluting shareholders. This comparison only further illustrates the absurd valuation that investors have accorded the shares as a result of the hype that management has articulated about its business and prospects. Even if it all worked out like management expects and the bullish analysts have modeled in their forecasts, this is an overpriced stock. I am betting that things will not be as rosy and as some near term catalysts become apparent, the shares will at least give back all, if not more, of the gain they have had following the hype infused rise in the shares that began early this year. The shares have already begun to move off their recent highs as some evidence of some of the issues I raised have begun to become apparent. I am sorry I could not post this earlier, but have only now been able to confirm a lot of what I have written. However, if delays in signings persist, management is not able to reach its instillation goals and/or can’t raise adequate financing to move forward, I believe the viability of the company could be at risk and this could turn into a terminal short. In conclusion, I would say that finding the proper intrinsic value for this company is difficult, but understanding what its not (the current price) is much clearer.
Risks to my short thesis include:
-- The sale of the company to an industry participant.
-- The ability of the company to sign enough regional exhibitors in the interim until the majors are ready.
-- The possibility that some of the company’s studio partners may extend the instillation deadlines.
Catalyst
CATALYSTS:
-- Further delays in signing studio partners and especially exhibitors for digital instillations.
-- The announcement of competitive financing plans (possible as early as a trade show next week).
-- The need to raise significant capital and dilute shareholders in the near future.
-- The company could miss some of its instillation goals.
-- An increased cash burn rate in the near future.
-- The possibility that projector manufacturer Christie may also team up with a competing financing plan.