INVESTMENT SUMMMARY:

With IMAX’s stock trading at 18x 2013 Street EBITDA, and 43X EPS, the bulls are buying into management’s international growth ambitions, but ignoring the actual growth trajectory and the questionable economics of the business model.   We believe there’s a 50% downside to the current price given the little FCF generation by the business despite years of investment in screen growth, declining revenues from China, and correcting the company reported EBITDA to account for the costs of converting films to play on IMAX screens.

(1)    Watching movies on IMAX is awesome! We don’t dispute that.  What we do take issue with is the lack of improvement in the economics of the business after years of investment in the bulls’ international expansion thesis.  Since 2010 IMAX has tripled its network size thanks to hundreds of screen signings and installations.  Despite this solid upward trend in IMAX’s network, IMAX’s FCF (excluding investments in Joint Revenue Sharing Agreements) hasn’t shown a similar trend to its network growth. In fact, based on management’s definition of FCF, IMAX has generated a cumulative FCF of just $39M since 2010.  With no real upward trend, momentum in FCF inflecting after all these years of investment, we believe that the company is negatively comping on same-store-sales basis for a significant portion of screens.

(2)    Interestingly, the China screen growth story, which has also been another source of the bulls’ excitement, shows contrary results as well.  As we dug through the latest 10-Q, we noted that the YTD revenues from China have declined y/y despite a doubling of JRSA screen growth in the region, and a 21% y/y growth of total global box office.  

(3)    Finally, we point out that the company’s reported EBITDA inflates the real cash EBITDA by 12-24% given that the company adds back film asset amortization.   The film asset amortization is a product of capitalizing cash costs associated with digitally remastering a movie to play on IMAX screens.  We show that this amortization lines up closely with the annual cash expense and should be considered an operating expense.  The film asset investment is a real annual cash expense needed to generate DMR revenues, and by stripping it’s amortization out of EBITDA, the company’s reported EBITDA calculation has been falsely inflated. 

INVESTMENT HIGHLIGHTS:

(1)    Signings and installations both continue to march downward despite the large backlog

IMAX grants exclusivity zones for each exhibitor that installs an IMAX screen.   In other words, if an exhibitor wants to put an IMAX screen on 42^nd Street in Manhattan, another exhibitor within a certain radius of that IMAX screen can’t install one.  Given this model, exhibitors are encouraged to sign up as quickly as possible in order to lock in that “zone”, otherwise someone else might beat them to it.   This signing takes place regardless of whether the exhibitor has built a theater in that zone yet or not.  Exhibitors can sign this agreement with IMAX with the promise of installing the screen in the future.  To date IMAX has 284 systems in backlog (157 under Sales/STL and 127 under JRSA). 

The problem here is that it’s unclear what happens if the exhibitor backs out of the agreement, or never really gets around to building the theater in that zone.  How firm are these written handshakes?  We took a look at the screen signings vs. installed screens from 2011 through 2Q13 in order to determine the health of the network growth.  According to Exhibit 1, both signings and installations have been trending downward since the beginning of 2011, while the backlog has grown to 284 (157 STL and 127 JRSA).  This begs the question then, with signings slowing, why hasn’t IMAX been chipping away at the screens in backlog?  One would assume that as signings slow, the installation trend should at best be flat to up as the backlog is worked down. 

EXHIBIT 1: Annual Installations vs. Signings

Source:  Company filings

Since 2010, the network has grown 3X, but free cash flow has only zigzagged around

The crux of the bull thesis rests upon the fact that the higher network growth should grow free cash flow.  As we showed earlier, the network growth has been slowing.  However, what’s interesting is that despite this 3X growth in the network, free cash flow hasn’t amounted to much anyways.  Exhibit 2 shows the JRSA screen growth from the end of 2009 through 2Q13.  As the chart shows, the company has grown its network by 222 JRSA screens, an eye-popping 290% growth. 

EXHIBIT 2: JRSA Screen growth

Source: Company filings

Despite the robust upward trend in JRSA screen growth, free cash flow (excluding JRSA investments) hasn’t seen anything close to a similar trend.  EXHIBIT 3 below plots the annual free cash flow over the same time period along with the JRSA investments made by IMAX.  As the chart shows, JRSA investments have been fairly steady, while IMAX’s free cash flow has been anything but steady.  Surprisingly, FCF has not shown a real upward inflection trend even though the network has grown 3X.

EXHIBIT 3: Free Cash Flow and JRSA Investments

Source: Company filings

Moreover, the table below shows flattish 1H JRSA revenues over the past 4 years, which we reasonably conclude that the company is experiencing negative comps on a same-store-sales basis.  A new install generally does not have a revenue ramp up period, but rather a tent pole grand opening.  This suggests that older screens may be seeing revenue declines, but being offset by new grand openings, and why revenues have remained flattish. 

Source: Company filings

(2)    Despite a 2X in China screen installs, revenues from China declined

China has been a source of excitement for the bulls as the Chinese have shown a great interest in watching Western films on the giant screen.  Undoubtedly, this was the case over the past few years and we don’t dispute that.  However, we are starting to question whether this Chinese excitement continues to have legs from here.  As the table below shows, since 2010 the 1H revenues from China had been essentially doubled y/y until 1H13.  This is a very troubling sign that’s been missed by the bulls and one that has been flying under the radar by the street.  With JRSA screens doubling from 1H12 to 1H13, why did revenues from China decline 7.2% y/y?  We can’t point to the box office as a reason since total JRSA global box office grew 21.5% y/y in 1H13.  Perhaps the excitement over seeing 3D IMAX is naturally slowing in that region given solid growth since 2010. 

Source: Company filings

(3)    Company reported EBITDA inflates true earnings power.

The company’s reported EBITDA masks the true earnings power of the business by adding back the film asset amortization.   The company is required to follow GAAP accounting’s individual-film-forecast method, which on a high-level basis requires the costs incurred to producing a film to be capitalized, and then amortized during that film’s revenue generation period.  For example, the costs associated with digitally remastering a movie to play on IMAX screens is capitalized under this method, and then amortized as the company recognizes DMR revenues.   So this is exactly the conundrum: the DMR revenues are included in EBITDA, but the amortization costs, which are real cash costs to generate the DMR revenues are excluded from EBITDA.  Essentially, the company is showing free DMR revenue in the EBITDA line.

We dug through the 10K to see what the difference is between the cash costs versus the film asset amortization expense.  Interestingly, we were able to get the film assets cash costs under its own line item in the operating activities section of the cash flow statement, which shows that this is a real operating expense.   The table below shows the cash versus amortization difference for film assets over the past 3 years.  Clearly the difference is minimal between the two as they line up very closely, and therefore this amortization should not be excluded from EBITDA. 

Source: Company filings

The table below adjusts the company reported EBITDA to include the film asset amortization.  As the table shows, the company’s reported EBITDA has been overstated versus the true cash EBITDA by as much as 24%.

Source: Company filings

VALUATION

IMAX is predominately becoming a theater network given all the JRSA installations.  However, we do not believe this company is a growth story given our analysis above on screen installations, FCF, and China/international expansion.  Therefore we value IMAX based on the 2013 EBITDA multiple for 3 comparable theater network operators.  Our IMAX 2013 EBITDA forecast is derived by taking the consensus EBITDA and adjusting it for the film asset amortization which we forecast at $16M, similar to 2012 which had the same number of DMR films.

The 3 operators below are a pretty good representation of the diversity in the business models and capital structures.  Regal and Cinemark are the largest U.S. based movie theater operators with levered balance sheets, but Regal is more domestically focused while Cinemark has footprints outside of the U.S. Meanwhile, Cineplex is a Canadian based movie theater network with a lightly levered balance sheet, and with very little to no international exposure.  We believe IMAX sits somewhere in between the US and Canadian operators given that IMAX is in a net cash position, but with significant exposure internationally (which on a side note will ultimately subject the company to repatriation taxes).  IMAX’s international exposure also carries somewhat of a larger degree of risk as the company conducts business in nations that may not have similar standard of laws governing businesses and contracts (i.e. China).  We therefore generously apply a 11.4x multiple, which is 1 turn below Cineplex’s multiple to adjust for these risks and arrive at our price target. 

Company Background:

IMAX, together with its wholly-owned subsidiaries is one of the world’s leading entertainment technology companies, specializing in motion picture technologies and presentations.  Its theater systems are based on proprietary and patented technology developed over the course of the company’s 45-year history.

The company’s customers who purchase, lease or otherwise acquire the IMAX theater systems are theater exhibitors that operate commercial theaters (particularly multiplexes), museums, science centers, or destination entertainment sites. The company generally does not own IMAX theaters, but licenses the use of its trademarks to exhibitors along with the sale, lease or contribution of its equipment.

As a result of the immersiveness and superior image and sound quality of The IMAX Experience, the company’s exhibitor customers typically charge a premium for IMAX films over films exhibited in their other auditoriums. The premium pricing, combined with the higher attendance levels associated with IMAX, generates incremental box office for the company’s exhibitor customers and for the movie studios releasing their films to the IMAX network.

The company predominately generates revenues from the theater exhibitors by either:

1.)    Selling or entering into a sales type-leases (STL) for the theatre systems, and then receiving a small ongoing revenue every year thereafter for maintenance purposes.

Or

2.)    Entering into a joint revenue sharing  agreement (JRSA) with the theater exhibitor for a period of 5-10 years.  This is where IMAX typically installs the equipment at very little to no cost to the theater exhibitor, but then IMAX receives a certain percentage of the box office (typically 18-20%). 

The company also generates revenues from the movie studios as well called DMR revenues.  In order for the films to play on IMAX screens they must be digitally converted into IMAX’s large-format at a current cost of roughly $800 thousand per film. This proprietary system, known as IMAX DMR, has opened up the IMAX theater network to film releases from Hollywood’s broad library of films. In a typical IMAX DMR film arrangement, the company will receive a percentage, which generally ranges from 10-15%, of net box-office receipts of a film from the film studio in exchange for the conversion of the film to the IMAX DMR format and for access to IMAX’s premium distribution and marketing platform.  In 2012, the company converted 35 films, up from 25 films in 2011, and is expected to convert another 35 films in 2013.

The Company believes that over time its commercial multiplex theater network could grow to approximately 1,700 IMAX theaters worldwide from 634 commercial multiplex IMAX theaters operating as of June 30, 2013. While the Company continues to grow in the United States and Canada, it believes that the majority of its future growth will come from underpenetrated, international markets. As of June 30, 2013, approximately 47.3% of IMAX systems in operation were located within international markets (defined as all countries other than the United States and Canada), up from 42.2% as at June 30, 2012.

Catalysts:  3Q earnings, market realization of poor economics in the business model