Description
If you are interested in: a market leader in a recovering industry with a potentially large growth driver in the future and one with a solid competitive moat, expanding operating margins, no debt, 20-25% ROIC, expanding FCF and currently valued at only about a 14-16% FCF/EV yield and a P/E of under 10x on a x-cash basis with book value providing reasonable downside protection, then read on!
KEY STASTICS
Price: $4.09
52-week Range: $2.25-$4.59
Shares Outstanding: 13.6M
Market Capitalization: $55.7M
Enterprise Value: $44.0M
Cash: $11.8M ($0.87 per share)
Tangible Book Value: $2.09
C04/05 Sales: $48.6M/$51.8M
EV/Revenue: 0.90/0.85
C04/05 GAAP EPS: $0.28/$0.31-$0.36
NTM FCF: $6-7M (14%-16% yield)
A REFOCUSED COMPANY THAT APPEARS TO SPEAK THE LANGUAGE OF VALUE INVESTORS: Ballantyne of Omaha is a leading U.S. supplier of commercial motion picture and specialty projection equipment utilized by major theater chains and location-based entertainment providers. In FY 03 about 83% of sales were from theatre products, 12% from lighting and 5% from restaurant products (since discontinued). Ballantyne is one of the leading vendors of film projectors to the movie industry with an estimated 65% market share in the US and 35% worldwide. The company also manufactures specialty entertainment lighting products used at various arenas, television and motion picture production studios and theme parks. In an effort to focus on its core business during a major industry downturn, the company decided to phase out its restaurant equipment product line during 2003 and its audiovisual segment in 2002. The company has been in business since 1932, mirroring the life of the film industry and has established a number of strong business relationships in the industry. Management has earned its stripes by managing the company relatively well through one of the most severe downturns in the history of the industry in the 2000-2003 time period when capital expenditures from most of its major customers all but completely dried up and many customers and industry participants went out of business. A review of the proxy shows that senior management does not overpay themselves and in our discussions with the management they appear to take shareholders interest very seriously and speak the language of us value investors, including a strong emphasis on staying focused on their core business, increasing margins, generating FCF and growing the company’s cash position. Noteworthy, recently two important events have occurred. First, the company was just granted listing on the American Stock Exchange, which should increase awareness and open the shares open to a broader potential shareholder base. Second, an overhang of about 3.9 million shares (or 31% of the shares) held by a venture firm was recently cleaned up and will also increase the float.
THE INDUSTRY HAS GONE THROUGH A FEAST AND FAMINE CYCLE AND IS NOW BACK ON A SUSTAINABLE GROWTH PATH: The most important growth driver in Ballantyne’s business (and an important variable for the stock price) is screen growth by the major theater exhibitors in the US and international markets tied to their capital expenditure plans.
During the late 1990's the domestic motion picture exhibition industry underwent a period of extraordinary growth in new theatre construction and the upgrade of older theatres. From 1996 to 1999, the number of screens increased at a compound annual growth rate of approximately 8%, which was more than double the industry's screen growth rate of approximately 3.5% from 1965 to 1995. The industry expansion in 1996-1999 was primarily driven by major exhibitors upgrading their asset bases to an attractive megaplex format that typically included 10 or more screens per theatre and adding enhanced features such as stadium seating, improved projection quality and superior sound systems. From 1996 to 1999, the five largest motion picture exhibitors spent in the aggregate over $4.1 billion on capital expenditures to expand and upgrade their theatre circuits. The aggressive building strategies undertaken by exhibitors resulted in intensified competition in once stable markets and rendered many older theatres obsolete more rapidly than anticipated. This effect, together with the fact that many older theatres were under long-term, non-cancelable leases, created an oversupply of screens, which caused both attendance per screen and revenue and operating income per screen to decline. Most major exhibitors used extensive debt financing to fund their expansion efforts and experienced significant financial challenges in 1999 and 2000. In 2000 and 2001, substantially all of the major exhibitors of motion pictures significantly reduced their expansion plans and implemented screen rationalization plans to close under-performing theatres. In addition, many smaller less well financed exhibitors went out of business. During this period, the number of screens declined by approximately 1,800, the first screen decline since 1963. At the end of 2003 there were about 36, 000 screens in the US and about 100,000 worldwide.
However, despite this, the domestic motion picture exhibition industry has historically maintained steady growth in revenues and attendance. Since 1965, total box office revenues have grown at a compound annual growth rate of approximately 6% and annual attendance grew to approximately 1.6 billion attendees in 2003. The industry has been relatively unaffected by downturns in the economic cycle, with total box office revenues and attendance growing in three of the last five recessions. For example, 2003 was a steady year for the film exhibition industry in which total box office revenues of $9.5 billion approximated that of a record 2002, while attendance declined by approximately 4% to 1.6 billion attendees.
Looking forward, the rationalization in the industry has benefited the remaining exhibitors as many patrons of closed theatres have migrated to remaining theatres, thereby increasing industry-wide attendance per screen and operating efficiencies. Thus, many of these remaining screens are in more financially strong hands. In addition, attracted by the favorable cash flow dynamics in the business model, in the last year three of the top five largest exhibitors (AMC, Cinemark & Lowe’s Cineplex) have been purchased by private equity firms, further adding to the health and financial strength of the remaining players. Recently I contacted a number of the top 10 public and private exhibitors, domestic and international representatives of the National Association of Theatre Owners (NATO) as well as various other industry suppliers and other contacts to discuss capital expenditure plans in the industry and expectations for screen growth. In general, capital expenditure programs seem to be back on track and that following a multi-year period of declining screen growth, the expectation is that screen growth should return to the low single digit growth of about 2-3% over the next 12-24 months with ongoing theater modizination programs adding additional opportunities for growth. Noteworthy, privately held Kerasotes Theaters (the 9th largest exhibitor in the US with about 562 screens) is planning on growing its screen count by over 30% over the next two years. While they are clearly the outlier in their growth plans, the direction is undoubtedly for a return to growth in the industry, which will put a little wind at the back of the company during this time period. For its part the management of Ballantyne indicates that given the long lead time cycles associated with theater construction plans by the major exhibitors, it has good visibility and that its order book looks healthy into 2005. In addition, we could be at the cusp of the next major growth driver in the industry; the move to digital cinema (discussed below), which could be BIG.
THE CLOUD OF DIGITAL CINEMA COULD BE REMOVED SHORTY, REVEALING A SILVER LINING: One cloud of uncertainty surrounding the shares is the impact of the industry moving to digital cinema. As in the case of other industries, the move to digital production, distribution and exhibition of films will inevitably occur in the cinema industry, the only question is when it will happen. This transition has been talked about for a number of years but has been slow to develop as there are currently only roughly 200 digital screens worldwide of the 100,000 screens operating. There are a lot of reasons for the low penetration of digital screens, but the main reason at this point is not really technology related, but economically driven. The issue comes down to who will pay the estimated $75-100,000 cost per screen to go digital. On one hand the major studios, who can benefit by an estimated $2-3B in distribution and piracy savings are all for the transition. However, there is very little savings in it for the major exhibitors, who will have to install new high resolution projectors (not to be confused with the low-end kind currently used for pre-movie ads). The current solution proposed by an independent organization is to create a somewhat complicated financial consortium headed by a few major banks. In theory, the studios will contribute to a fund managed by the consortium with a portion of the savings they accrue from reduced distribution and piracy costs. The exhibitors may then draw from this fund to help finance the purchase and installation of these digital projectors. Ballantyne correctly sensing from its customers that the digital transition would be slow to take off, has not invested much in the digital technology and currently does not have a digital projector to market. However, Texas Instruments who provides the DSP technology in the industry (similar to Intel in the PC industry) has licensed its IP to three companies (including Ballantyne’s major competitor), any of which could in turn license it to Ballantyne. On one hand, Ballantyne still has not gotten any feed back from its customers that they are ready to move to this technology. This is confirmed by my extensive research checks with the major theater exhibitors. On the other hand, sensing that having a digital product roadmap is an issue with investors and could be one for customers sometime in the future, we understand from sources in the industry (confirmed by management) that the company will announce a partnership with one of the other two TI licensees in the near future. We believe that management is shopping for the best deal now, especially one that will give them manufacturing rights. Not only will this pending announcement clear up an important concern in the minds of investors, which is likely depressing the valuation of the shares, it will likely focus investor attention on the huge sales opportunity associated with the transition to digital cinema. We believe this is the silver lining of digital cinema for the projector industry and could be a major growth opportunity for Ballantyne beginning in the 2006 time period. As has occurred in other industries (i.e. cameras, cellphones, radiography, etc), the question is not “if” the industry will move to digital cinema, but “when” will it transition. When it does, a majority of the installed base of about 100,000 film projectors will have to be converted to show digital images/movies. Considering a conservative ASP of $50-60,000, this will create a huge multi-year growth opportunity for Ballantyne and the industry. It’s important to understand that this is an industry that has been around since the early 1900’s and one characterized by strong and long lasting business relationships that will be tough for any new competitor to overcome. Historically, there have not been significant shifts in market share that take place among the major vendors, which not only gives the company a strong competitive moat, but moreover bodes well for Ballantyne maintaining share during the transition to digital cinema and benefiting from the associated huge potential sales opportunity.
A SIGNIFICANT IMPROVEMENT IN THE COMPANY’S FINANCIAL POSITION, HIGHLIGHTED BY IMPROVED CASH FLOW: Aided by the improvement in capital expenditures from exhibitors and a return to more normalized screen growth, Ballantyne’s financials have shown notable improvement. Sales have shown solid growth from the depressed levels of the prior years; operating margins have improved notably over the last 12-18 months (but are still below historical levels) and GAAP EPS have improved considerably to an annualized rate of $0.28 in the last quarter. Moreover, for the last few quarters the company has generated healthy FCF at an annualized rate of $3.5-5.0 million. This has resulted in an improving cash position and a capitalization structure that is basically debt free. Looking forward, there are a number of factors that could increase FCF levels even further. Over the next few quarters net income should grow aided by modest revenue growth and an expected further improvement in margins. In addition, management indicates that it has completed a number of minor capital improvement programs and it expects that on-going maintenance related capital expenditures will run less than depreciation over the next few quarters. Also, the current quarter (Q4 ending December) should be a very strong quarter from a sales, EPS and a FCF perspective. Profitability and FCF in the current quarter will benefit from the completion of a major large size projector order in Asia that inflated inventory levels and depressed FCF last quarter. In Q4 alone, FCF could approximate close to $3 million. I believe FCF in 2005 could approximate the $6-7 million range and that Ballantyne could exit next year with cash of $18-19 million (versus $11.8 million, or $0.87 per share last quarter). While it is unclear what management will do with the cash, we suspect that for the time being they will let it build to give them the flexibility to make an acquisition, if necessary, to further position their thrust into the digital cinema market. Thereafter, we believe a share repurchase program is a likelihood.
AN APPEALING VALUE STORY TODAY, A POTENTIAL GROWTH STORY, WITH SIGNIFICANT APPRECIATION POTENTIAL: To me, Ballantyne appears to have most of the characteristics that a true value investor finds appealing in evaluating a potential investment. A solid business franchise with strong FCF potential selling at an attractive value with a strong management that appears to have shareholder interests in mind. In addition, the Ballantyne story also has a silver lining that could be very appealing to growth investors in the future once the move to digital cinema begins to kick in. What is appealing is that given the strong FCF dynamics and yield in the business today, we are also being rewarded quite nicely in the interim while the second leg in the story develops. Given the strength of the fundamental story today, the catalysts and the potential growth story associated with the transition to digital cinema, we believe Ballantyne could sell at a 12.5x cash flow multiple in the next 12 months and possibly higher if it gets discovered by growth investors. On this basis, which many would still not view as expensive, the shares could trade up to close to the $6 range in the next 12-18 months. In addition, Ballantyne could make an appealing acquisition candidate for a larger company who may be interested in trying to capitalize on the major discontinuity technology trend in the transition to digital cinema.
Catalyst
• Strong sales/EPS and FCF dynamics in Q4 (December)
• The announcement of a digital technology agreement
• Expanding FCF, which could fuel a share repurchasing program
• A possible acquisition of the company