Description

Investment Overview
Carmike Cinemas is a compelling free cash flow story in a sector in which investors have turned overly bearish due to real, yet overblown, secular concerns. Management at CKEC has finally recognized the need to dial back the capex, which should cause free cash flow to approach $3.20 in 2006 after being breakeven in 2005, and grow to $3.70 in 2007 on further rationalization of capital expenditures. At a 10% free cash flow yield, CKEC could trade between the low to high $30s, representing upside of 26% to 46% from current levels. In a takeover, the upside would be even greater. While the movie exhibition business is certainly challenged by secular issues as well as cyclical issues, a 10% free cash flow yield implies a rather conservative valuation, since no technological advance is likely to completely circumvent people’s desire to experience at least some entertainment outside the home in a communal setting. In addition, if weak 2005 domestic box office performance turns out to be as much cyclically driven as secularly driven, then further upside could exist as the stock could fairly trade at 12-14x free cash flow in a more benign industry environment. It is worth noting that our free cash flow estimates assume 5% sequential annual attendance decreases, only partially offset by pricing that grows at 2.5%.

Company Description/History
Carmike is the fourth largest movie theater chain in the US and focuses on small- to mid-sized markets with populations under 100,000. Carmike entered bankruptcy in 2000 and emerged in 2002. It was one of several theater operators to end up in financial distress after a period of overexpansion in the late 1990s that left Carmike, and many of its peers, over levered and overloaded with underperforming theaters as a result of industry overcapacity and cannibalization. Rather than rehash ancient history here, I will refer curious readers to a VIC write-up from 12/11/01 that walks through the bankruptcy emergence process. (There is also a write-up on CKEC from 11/25/02 for those that are interested.)

Carmike fell from a high of around $39 last December to a low of $21.65 in September, mainly as a result of general industry pessimism. Domestic box office revenues are down 5% YTD in 2005. Industry bears will cite a number of secular challenges facing the industry, most of which relate to increasing competition from improving home theater options. Over the last year or so, flat panel TVs have come down in price and the quality of the at-home viewing experience has improved considerably. Adding insult to injury, the “DVD window” or the amount of time that elapses between a motion picture’s release on the big screen and its emergence for rent at Blockbuster or for sale at Best Buy has declined to just over 4 months on average (2005 at 129 days versus 144 days in 2004 and 171 days in 2000). With movie tickets and concessions costing north of $8 per patron at CKEC (more like $15 in NYC!) in contrast to home viewing 3 months later at a fixed cost of $5 (rent) to $20 (buy) for as many people as can fit in a room, the elasticity of demand becomes an issue. Additionally, there are increasingly popular entertainment options fighting for the attention of the target moviegoer (teenage boys in particular) including video games and internet surfing. Combine industry woes with poor cost management at CKEC during the first half of the year and it is clear why the stock was down.

The Investment Opportunity (Why the Sky Isn’t Falling)
There are two reasons I would recommend a purchase of CKEC now. One is quantitative – improving free cash flow. The other is qualitative – a belief that industry concerns have been overdone.

What has changed with the free cash flow? Excluding acquisition spending, CKEC will probably breakeven on a cash flow basis in 2005, perhaps burn a little cash. Including acquisition spending, it will burn almost $5 per share (however, the acquisition does look to be accretive and well-priced). Putting acquisition spending aside for the moment, consider that CKEC will spend $55 million in capex in 2005 but will only spend $25 million on capex in 2006. This $30 million capex cut represents about $2.36 per share. The $25 million in 2006 capex is made up of $8 million in maintenance capex and $17 million in project capex (versus $47 million in 2005) which is earmarked for 100 stadium seating conversions (at $100K each) and only 5 new theaters (on a base of 311 current theaters). In 2007, project capex is expected to ramp down an additional $7 million, or 55 cents per share, as new theater building will grind to a halt and the only non-maintenance capex will be for another 100 stadium seating conversions. It is a wise move for management to ratchet back the capex as the company can get a better return on its cash acquiring existing theaters (which also prevents potential overbuilding/overcapacity issues) or buying its own stock. CKEC’s last acquisition (of GKC) was at 5.5x EBITDA (CKEC trades around 9x) and at $250K/screen (CKEC trades around $290K/screen), which made the acquisition accretive. If anything, the direction of valuations on smaller private market transactions is likely to trend down, as small mom and pop theater owners may be eager to get out at lower prices than in the past given recent industry woes. Clearly acquisition spending would cut into the $3.20 2005 free cash flow and $3.70 2006 free cash flow that we are looking for, but management doesn’t seem particularly acquisition-oriented at the moment, and discipline in past transactions would lead one to speculate they will not overpay for assets in the future. For the reasons discussed below, we don’t think movie theaters are a buggy whip business, although the business is admittedly very mature. Assuming the business should trade at free cash flow yield between 8% and 10%, you get a valuation range of $32-$46 depending on whether you use 2006 or 2007 free cash flow (2007 should be reflective of sustainable long-term cash flow). While one occasionally sees companies trading at 15% free cash flow, these are typically businesses that will ultimately go the way of the dinosaur – think paging or telephone landlines (the latter being up for debate of course). The movie theater business has far greater staying power than these businesses that trade like they are going out of business. The largest public comp to CKEC is RGC, which trades at an 8% free cash flow yield and 10x trailing EBITDA. RGC has higher margin assets albeit in potentially more competitive urban markets and is generally thought to have excellent management.

Despite the abysmal performance of the US box office in 2005, the market has probably gotten too pessimistic about the prospects for movie theaters going forward. Many industry observers point to the weak performance of the box office this year and point to a weak slate of films that missed the mark as much as the increasing competitiveness of alternative forms of entertainment, be they digital, at-home or both. Culprits include a number of bloated big studio pictures that cost over $100 million to make but barely generated $20 million at the box office (anyone see “Kingdom of Heaven” this summer? I didn’t think so). Many experts believe that film quality is cyclical as established formulas that have been successful in the past get overexploited by studios suffering from group think, who only start thinking creatively and taking chances again once they have a string of flops on their books. Public company Marcus (MCS) has a slide in their 2006 Annual Meeting Presentation (available on their website www.marcuscorp.com , page 46) that shows that cinema attendance has for many years experienced peaks and valleys. One notable valley occurred around 1987, when VCR household penetration really took off. According to Marcus, people never thought the box office would recover then either, but it did, and is in fact 50% higher than it was at that trough almost 20 years ago. There are two main reasons that we think people have not permanently lost their interest in going to the movies. First, there is the subjective observation that for centuries people have enjoyed sharing entertainment in communal settings. Evidence of this basic human interest in shared entertainment experiences dates back to the Greek amphitheaters and has morphed into uniquely modern phenomenon such as massive videogame playing conventions that take what is by nature a rather introverted activity and make it social. Additionally, teenagers make up a big part of the movie-going core, and no matter how great the TV is in their living room or basement, unless things have really changed since we were kids, they don’t want to stay home and hang out with their parents. Second, there has been evidence, even in this dismal year, that when the product was right, people will come. Time Warner has proudly proclaimed on several occasions that this is the first year that they have had four movies gross over $200 million each at the domestic box office (Batman Begins, Charlie and the Chocolate Factory, Wedding Crashers, and Harry Potter). People, yet again, stood outside all night this summer to be among the first to see the latest (and final) installment of the Star Wars series. Finally, in recent weeks as the holiday movie crop has been unleashed, there have been multiple examples of old-fashioned blow-out box office hits (e.g., Harry Potter and Narnia) as well as better than expected box office for more modestly budgeted adult fare that was just well-made (e.g., Walk the Line). These movies have finally led to some positive year-over-year comps for the domestic box office in recent weeks. If one can make the leap that people will show up for good product, and that some movies (e.g., Star Wars, King Kong, Harry Potter, etc.) are infinitely better on a big screen with Dolby sound, then 2006 could prove to be a very reassuring year as the year-over-year comparisons will be easy and the movie slate looks strong, including sequels to successful franchises (Pirates of the Caribbean 2, Mission Impossible 3, XMen 3, Ice Age 2, Superman Returns), new animated films from Pixar (Cars) and DreamWorks Animation (Over the Hedge), and the adaptation of one of the most successful novels in recent memory (The Da Vinci Code).

For those that are still worried about cannibalization of the movie-going audience by DVD window compression, Video on Demand, and other home theater options, there can be some comfort taken in CKEC’s rural positioning. While CKEC’s average ticket is already lower than that at the top 3 chains that operate in more affluent markets, CKEC theaters tend to be the only one in town so are less susceptible to price competition if things get progressively bleak on the attendance front. Also, given the lower income of the CKEC customer in its rural markets, their customer may be a little later to get a full-blown home theater system with a huge screen and superior sound quality.

Another positive for an investment in CKEC is the consolidation that has been occurring in the industry. Two of the three larger chains are controlled by private equity funds whose coffers are full of cash after large fund raises. While we don’t expect CKEC to be acquired in the near future, the money is there if one of the larger chains decides they want to do it.

Also adding to the bull case are a 2.75% dividend yield and about $75m in net operating loss carry forwards, which will shield CKEC from paying full cash taxes until at least 2009. Finally CKEC is poorly covered on Wall Street, with just 5 analysts following it, only 2 of which rate it a Buy (so there’s room for upgrades).

It is worth noting that at some point in the not too distant future, probably 2-3 years, movie theaters will begin the transition to digital projectors in earnest. This is a risk for all movie theater chains because capex could ratchet up and eat up free cash flow unexpectedly for a multi-year period. It seems unlikely, however, that this transition will happen without partial, if not total, subsidization by the studios. Studios have already in fact begun to acknowledge that they need to subsidize this process to get it going, since the cost/benefit of going digital accrues to them as they avoid the cost of printing film negatives ($1000 per print for 2000-4000 screens on a typical wide release costs the studio $2-4 million; digital projectors cost approximately $100k per screen and eliminate the need for prints). While everyone is focusing on the risk presented by the transition to digital, for the rural guys, a move to digital may in fact present a revenue opportunity. Moving to digital projection will allow regional operators like CKEC to experiment with offering a broader array of pictures. Consider as an example that the current Academy Award frontrunner Brokeback Mountain – aka the “gay cowboy” movie - may never make it to a CKEC cinema. This is because it’s a risky financial bet for studios to spend an additional $100-$300K on prints of a non-mainstream indie film (within the context of a budget that could only be $5-$20 million total for production and marketing) in order to show them in rural locations like CKEC’s where the revenue opportunity is a wildcard. With digital projection however the marginal cost goes to zero for testing films like Brokeback Mountain or Pride and Prejudice in small markets. Who knows? Maybe they will play in Peoria!!!

Current Valuation

Share Price: $25.33
Shares: 12.7 mm
Market Cap: $321.7 mm
Net Debt $391.5 mm
Enterprise Value: $713.2 mm

2005E EBITDA: 82 mm
EV/2005 EBITDA = 8.7x
2006E EBITDA: 95 mm
EV/2006 EBITDA = 7.5x

2005E EPS: $0.44
P/E – 2005 = 57x
2006E EPS $1.46
P/E – 2006 = 17x

2005E FCF per share (ex acquisitions): $0
2005E FCF multiple: NA
2006E FCF per share: (ex acq.) $3.20
2006E FCF multiple: 7.9x (12.6% yield)
2007E FCF per share (ex acq.): $3.70
2007E FCF multiple: 6.8x (14.6% yield)

2007 should be a fairly “normalized” year for both EPS and FCF.

CKEC EV/Screen: $289K
CKEC EV/Screen at trough: $235K (fall 2002)
RGC EV/Screen: $750K


Fair Valuation

Based on a 10% free cash flow yield on 2006 FCF of $3.20 per share, the low-end price target would be $32 (+26%). Based on an 8% free cash flow yield on 2007 “normalized” FCF of $3.70 per share, the high end price target would be $46.25 (+83%).

Alternatively, one could look at CKEC in terms of private market value or takeout valuation using EV/Screen. Looking at 10 transactions between early 2003 and fall 2005, the lowest transaction was at $250K per screen (CKEC’s purchase of GKC) and the highest transaction was at almost $700K per screen (Loews purchase by private equity holders). The average transaction was at $500K per screen. Using $500K per screen on CKEC’s 2,471 screens would yield a price of $66.46 (+162%). Using the median transaction for valuation would yield an even higher price. Using the Loews multiple of $700K per screen would be inappropriate because those are higher revenue and higher margin screens in more populated areas.

In trying to assess the downside, looking at EV/Screen could be helpful as well. At the lowest transaction price of $250K/screen, CKEC would be worth $17.80 (-30%). At this price, CKEC would trade at an 18% free cash flow yield on 2006 numbers.

In summary, CKEC is probably worth about $39 (average of $32 and $46) without a takeover or a return to secular growth in the movie theater business. This represents 54% upside to current levels. In a takeover, the return would likely be over 100%. This type of upside seems to mitigate the downside risk of 30% if EV/Screen multiples on CKEC contract again.

Catalyst

Catalysts
1. Rapidly increasing free cash flow which can be applied to de-levering (Debt/EBITDA = 4.9x), dividend raises, or stock buybacks once they get the debt down to a level that would allow them to buy back stock
2. Continued accretive tuck-in acquisitions at low multiples that enhance bottom line growth
3. Better industry film attendance in 2006 driven by easy comps and a good slate of films which helps restore confidence in the movie exhibition industry
4. Takeout by private equity or a competitor
5. Migration to digital projectors in 2-3 years could be a revenue enhancement opportunity for rural players such as CKEC
6. End of tax loss selling – this stock is down 30% this year

Risks
1. Box office slump continues
2. DVD window compresses further
3. Conversion to digital projectors leads to unanticipated capex spending starting in 2-3 years.

Disclosure Statement:
This is not a recommendation to buy or sell the stock. We own shares of the company, and we may buy more shares or sell shares at any time.