I think I've found a compelling cash flow story with a decent chance of growth in Carmike Cinemas.  I know Carmike is no stranger to VIC, and its performance to date has disappointed, but maybe the 5th time is the charm...

Executive Summary

Carmike Cinemas is a major U.S. motion picture exhibitor, and the largest targeting small to mid-size non-urban markets.  Increased competition in recent years has forced accelerated portfolio renewal.  This, a lackluster 2010, and high debt levels have weighed heavily upon the stock.  However, going forward, Carmike seems poised to generate at least $15M of free cash flow annually, making the current share price look quite attractive.   

Background/Recent Developments

With 240 theatres in 35 states, Carmike Cinemas is the 4^th largest motion picture exhibitor in the U.S., and Carmike is somewhat unique in that they target small to mid-size, non-urban markets with populations generally under 100,000.  Carmike brands itself as “America’s Hometown Theatre” and targets these locations because management believes such markets offer the benefits of reduced operating costs, fewer alternative forms of entertainment, and, until the past few years, limited competition.

In the mid-last decade, a combination of easy credit and irrational exuberance led competitors to target some of Carmike’s older theaters by opening new, upscale theaters in Carmike’s markets.  While that trend has steadily declined in recent years, it forced Carmike into many write-downs and disposals of underperforming theaters.  Carmike also responded to these competitive threats by accelerating its portfolio renewal and investing in higher maintenance and upgrades of older theaters.  Since 2006, they have closed 78 underperforming theaters and opened 14 state-of-the-art multiplexes.

While newer theaters generally have more screens, the higher number of theater closures has modestly reduced Carmike’s total screen count.  That, coupled with the negative effects from extreme weather and lackluster industry performance in Q2 and Q4 of 2010, has weighed heavily upon the stock.  Nonetheless, Carmike’s cash flow remains fairly robust.  In addition, the coming increase in higher value content and a deal signed in Q4 of 2010 provide reasons to think Carmike’s fundamentals might just improve.

Screenvision Deal (Q4 2010)

In October 2010, Carmike signed a 30 year deal with Screenvision, a national leader in cinema advertising – in 2,500 locations across all 50 states, making Screenvision the exclusive advertiser in all of Carmike’s theaters.  In exchange, Carmike received an upfront cash payment of $30M (reportedly earmarked for prepayment of bank debt) and a 20% interest in Screenvision’s “profits and growth.”

Why CKEC looks cheap to me

Despite turmoil in the larger economy and poachers targeting its legacy theaters, Carmike has been rather resilient in recent years.

* FCF defined as CF0 – (changes in net operating assets) – CapEx

Carmike has been able to increase prices of admissions and concessions as well as offer higher value tickets for films shown in 3D, all with little perceived cost to demand.  This has steadily increased its revenue even as its total number of screens has declined by nearly 10%.  Profitability was also on the rise until 2010 when extreme winter weather in the Southeast damaged some sites and led to closure of over 100 locations for some portion of a weekend.  Later in the year, poor relative performance of some major titles (e.g., “Salt” and “Inception”) in Carmike markets further squeezed revenue and profitability in 2010.  Nonetheless, Carmike was able to generate $15M of FCF and prepay $25B of bank debt through the first three quarters of 2010. 

I’m going to be overly conservative and assume no FCF in the fourth quarter of 2010 due to previously stated higher CapEx, Christmas falling on a weekend, and a disappointing box office turnout (according to Regal Entertainment).  Thus in a year hurt by extreme weather, a relatively poor mix of films, an underperforming holiday quarter, and added costs (refinancing costs, legal fees in association with the Screenvision deal, and higher than maintenance-level CapEx), CKEC generated $15M of FCF, which represents about a 17% FCF yield on its current share price.

What is more, the future actually looks promising for Carmike for the following reasons:

1)   3D content is increasing.  There are 35 3D films slated for 2011 compared to just 21 in 2010.  3D tickets carry an average premium of $3, which boosts both sales and margins.

2)   “BigD” theaters.  These are upscale auditoriums with oversized screens and better sound quality for which Carmike charges an extra $2 per ticket.  This project has just gotten underway in 2010, but the company expects to open one of these in about 25 select locations at a rate of one per month.  They claim BigD is very successful with an ROI over 20%.

3)   20% interest in Screenvision.  I have no clue what this adds to earnings going forward so I have essentially excluded it from my analysis.  So any incremental increase to earnings from the Screenvision stake is just a bonus.

4)   Innovative auditorium arrangements.  For instance, Carmike is piloting a “VIP lounge” concept with leather recliners, waiters and alcohol.  This is something in early concept phase, but could dramatically boost high margin concession sales if they find the right markets and business model.

5)   Alternative content.  Seems like every major exhibitor is pushing this.  The new digital projectors have opened up a great deal of opportunities in alternative content video feeds of anything from live concerts to sporting events.  It seems like the licensing agreements and content distributors are just recently beginning to form, and I think it will take some advertising and “training” to get audiences to consume non-Hollywood content this way, but in the long-term, this could drive major advances in attendance per screen (and sometimes at higher ticket prices).

In summary, if every year were like 2010, CKEC would be a good deal at its current price.  However, there are many reasons to believe that Carmike will perform better in the future.   Furthermore, in comparison to its publicly traded peers, CKEC certainly seems to be trading at a discount: 

Short Sellers:

As of 2/15/2011, CKEC had almost a 10% short interest.  I don’t claim to know all the bear arguments out there, but I found this February 15 post on Seeking Alpha:

“I ran some scans today and came across CKEC, a movie theater operator catering to small, rural markets. Theaters are obviously not the best industry to be in, with the digital commoditization of video media due to the likes of Netflix (NFLX) and such, and sales have gone absolutely nowhere in the last two years. With debt/equity ratios through the roof and an expensive 22x multiple for a stock that has seen four sequential quarters of decreased fund sponsorship, the fundamental story looks ripe for shorting. Moving to the technical side of things, the 200d is approaching a cross back below the 55d, while the stock price approaches an underside test of both moving averages. October and November both saw failures at the 200d and I expect the same here, while a stop on a close over the 200d allows for an attractive risk/reward, considering I think this stock is headed back below $5. I love to short stocks during bull cycles that have underperformed significantly trading sideways/stagnant, after selling off sharply during the previous bear cycle. This is precisely what the chart shows for CKEC”

So, at least according to this anecdotal evidence, the bear case stems from technical analysis with only cursory attention paid to the underlying business.  I would also note that, until movie studios agree to give first run distribution rights to “the likes of Netflix and such,” Netflix is not really a competitor.  I also don’t see the studios changing their revenue milking strategy anytime soon.

Anyway, bottom line:  this trader might well be right in the short term, but in the long run, I’d rather be on the same side as the insiders…

Insider Incentives/Transactions:

Officers and directors currently own approximately 6.5% of CKEC shares.  The previous CEO stills owns ~3.5%, and the current CEO, COO and one of the directors own ~1% each.  The CEO has been buying consistently – but in small amounts – for the past nine months, and one of the directors, a private investor and consultant named Alan Hirschfield, bought 20,000 shares in August 2010 at an average price ~$6.50/share (about $130K total).

As a side note, the company has historically seemed to follow a cash deployment policy with its shareholders in mind.  The company paid a generous dividend until 2008 and has since been aggressively paying down bank debt.

Expected Catalyst(s):

·            Further debt reduction from $30M Screenvision payment and FCF in subsequent quarters will make equity look very cheap.

·            Reversion to mean by Carmike’s theaters after a less-than-stellar 2010

·            Increased revenues from more 3D titles

·            Any positive data emerging about Screenvision interest

Downside Risks:

1) People stop going to the movies – I assign this a low probability.

2) Competitors contest Carmike markets.  This risk has greatly moderated recently due to tighter bank lending and “more rational” behavior by other operators. 

3) Large and prolonged spike in interest rates.  I think this is the biggest danger because, as of the second quarter of 2011, CKEC will have approximately $200M in long term bank debt at LIBOR + 3.5% (maturing in 2016), and current interest rates are very low from a historical perspective.  However, they seemed to do fine under much worse circumstances in 2006-07 with over $300M in bank debt when interest rates were much higher.

4) Competitors close the digital gap.  Carmike is currently ahead of its competition in theater technology having finished its upgrade to digital projection in 2007.  This current “advantage” will wane in the coming years as the rest of the industry completes its transition to digital.  However, I think location is by far the most important competitive discriminator, so I don’t see the current digital “advantage” to be all that significant.

·            Further debt reduction from $30M Screenvision payment and FCF in subsequent quarters will make equity look very cheap.

·            Reversion to mean by Carmike’s theaters after a less-than-stellar 2010

·            Increased revenues from more 3D titles

·            Any positive data emerging about Screenvision interest