Description

For those of you living under a rock, IMAX has a 99% market share in the large-format theater systems business. A typical IMAX screen is about 8 stories tall and is about 1/2 the size of a football field. The films displayed in IMAX format are 15-70 instead of the 35mm shown in a conventional theater. The display system, combined with a 12,000 watt digital sound system, gives the audience the "IMAX experience". Historically, IMAX theaters have been in "institutional" settings like museums, aquariums, zoos, theme parks, etc... But as of late, IMAX is gunning for the mainstream commercial exhibition market. They currently have over 230 theater systems installed in more than 34 countries.

Brief History:
IMAX has been slowly building out its institutional theater business and attracting patrons with the distribution of movies like "To Fly" and "Grand Canyon: The Hidden Secrets". Typically these movies have a very long run in distribution and grind out consistent numbers for the theaters and IMAX (who earns a distribution fee). Recently, IMAX has been putting up some impressive attendance numbers with event-type institutional films like "Everest" and "Space Station 3D". IMAX made a move in the 90's with the purchase of DPI to transition to digital display of its films. This was a money loser and the business was sold recently at a loss. Their latest gambit has been a push into the mainstream exhibition markets through IMAX deals with Regal Cinemas and the like. In late 2000, IMAX suffered a drop-off in theater backlog because of the financial troubles of the commercial exhibitors. At the same time, they were dealing with the black eye of the failed DPI purchase. The stock lost institutional coverage after a precipitous fall from 20 to 5.

Lately, the company has seen a rebound in the financial health of its primary market, the commercial exhibitors. The company has also introduced a technology called DMR. This technology digitally remasters 35mm films into IMAX format. The company calls this the Holy Grail for IMAX. The thinking is that eventually Hollywood films will show day-and-date releases of their blockbuster event films in IMAX. This will drive theater builds in the exhibition market (because no one wants to go to a Regal Cinemas megaplex and see a movie about whales), which will further drive DMR blockbuster releases and so on. So you see, IMAX had a bit of a chicken and egg problem. No commercial exhibitor wanted an IMAX because you couldn't show any cool movies, and no studio wanted to release a cool movie in IMAX because their wasn't an IMAX theater in the commercial space. The thinking is that DMR will solve this problem.

The company has recently announced that it signed the third installment of “The Matrix” as its first ever DMR day-and-date release. This has the potential to be enormous for the company if the launch is successful.

Management conducted some exit polls to see what theatergoers would think about paying a higher ticket price to see a film in IMAX. The results were encouraging. IMAX estimates a $3-5 premium in price for an IMAX ticket to a 35mm film. This new 'release window' for Hollywood could potentially add incremental revenue to blockbuster films and add incentives to build an IMAX theater in a multiplex.

IMAX's financial picture:
So how does IMAX make money, you ask? A better question is how it doesn't. A typical IMAX deal is one where the company leases the theater system to a licensee for a 10-year period with another 10-year option to renew. The deal usually involves an exclusivity fee, initial rents, minimum rents, annual maintenance, and an overage for attendance. A simple freedom of information request to a state agency that built an IMAX theater resulted in my discovery of exactly how much revenue IMAX is contractually receiving on an institutional build.

Exclusivity: $705,500
Initial Rent: $1,641,500
Annual Maintenance: $90,000
Minimum Rents: $142,000
Overage: 7% on the 1st 400,000 admissions, 5% thereafter

Folks, that is a pile of cash for simply leasing a projector, sound system, and screen, and oh, by the way, IMAX retains an obscene amount of control over a theater's promotion of the IMAX brand. The company says the theater systems business carries a 60-65% GPM. This is the primary driver of IMAX's profits.

I would expect slightly lower numbers for a commercial build given management's eagerness to get the DMR process rolling. But I think once they have traction in the commercial space, management will be able to raise prices.

The company also makes money in a myriad of other ways; on the distribution of films, rental of IMAX cameras to those wanting to make an IMAX film, and post-production of films. It has the potential to make money on the DMR process once the IMAX theater network is built out in the commercial space (right now it is operating at break even in order to spur demand). Basically, the strength of its brand name and its ownership of key technology and know-how has made it virtually impossible for anyone to gain a foothold in the large-format theater space. I could ask you "who is the #2 player in large format cinema?” and I think we would both understand very clearly what kind of dominance IMAX enjoys.


Valuation:

More art than science for IMAX. An optimistic valuation can be based on a maximum potential theater builds of 800 multiplexes out of a possible 2200. The potential for network effects to kick in will allow IMAX to charge a massive premium for DMR conversions. All of this would put an IMAX valuation at way north of the $20/share it traded at in 2000. A steady state valuation based upon existing theater systems with IMAX simply remaining a niche player in the institutional market would imply a valuation of about $8-9/share (also assuming a refi is possible on the '05 notes - see below). As always, we could get into a lengthy discussion of multiples, discount rates, margins, and the like, but suffice to say that these numbers are based on a 5-yr DCF using about a 10% discount rate to capital and backing out debt to arrive at a value for the common. Keep in mind that a small percentage increase on the top line creates massive changes in the value of the common. This is why understanding the competitive potential is the overriding factor here.

The Problems:

The biggest potential problem is that IMAX's day-and-date release for DMR blockbuster films flops. If that happens, the network effects that IMAX is trying to achieve may not come to fruition. I believe this is a very low probability event given the recent success of the DMR re-releases of The Lion King and Attack of the Clones (grossing an additional $15 and $8 million).

The other potential land mine here is the $200 million in '05 notes coming due. I think that refinancing these shouldn't be a big problem for the company given the strength of their model.

The last potential problem is that Wasserstein has distributed IMAX shares to its LPs. This will eventually eliminate significant overhang in the stock (a good thing), but will cause some serious short-term price pressure (a bad thing) if the LPs decide to liquidate. For all you BSDs on VIC who love my idea and are looking for the negotiated purchase of a block of IMAX shares, management has said that they will attempt to facilitate the orderly purchase of blocks of shares from LPs who wish to liquidate.

Conclusion:

This is not a Graham-Dodd cheapo. This is a competitive story. Hal Varian, Michael Porter, and Warren Buffett would love the competitive moat IMAX has built for itself. I look at it like this. If I fell asleep for 10 years, when I woke up, IMAX should be a much larger and stronger company than it is today, and my proportionate interest in it should be much more valuable. Moreover, IMAX is at an inflection point with the introduction of DMR day-and-date releases.

Catalyst

DMR, DMR, DMR. If it works, you've got yourself a winner.
The Matrix. The third installment of the Matrix will be the first day-and-date release for an IMAX DMR formatted blockbuster. If the studios see this as a successful new 'release window', expect a flurry of DMR deals and subsequent theater system signings.