October 09, 2005 - 1:42pm EST by
2005 2006
Price: 10.22 EPS
Shares Out. (in M): 0 P/E
Market Cap (in $M): 407 P/FCF
Net Debt (in $M): 0 EBIT 0 0
Borrow Cost: NA

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I still feel that IMAX is a short as it is a broken business model that has marginal unit economics to its exhibitors and is facing a business breaking competitive entry from a competitor that sells comparable systems for ($70K and falling vs. IMAX's $1.6 million). These risk are not reflected in the high 20s PE multiple at which the stock trades.

Disclosure: I and or my affiliates are short IMAX, and may sell additional shares or cover some or all of our shares, at any time. We have no obligation to inform you of any changes in our views of IMAX.

As I've posted extensively on this name before, I refer you back to my prior posting. I would like to highlight a few key points before addressing where I've been wrong so far on this situation and why I think this remains quite compelling.

- Imax generates the lions share of it's earnings from new theater installations rather than recurring fees. There does not appear to be a replacement cycle of the installed base and the new deals they are cutting appear to have much lower recurring fees. Every year they need to start from zero again. The core of our thesis remains they will eventually hit the wall having exhausted their market and earnings will vanish.

- Of the 6 film slots a year, there are really only 3 good film slots a year, namely early summer, late summer and the thansgiving/christmas holidays. Studios don't release the type of high grossing films needed for the IMAX format during Jan-April and Sept-October. As a result, even if they get a couple of very strong films during the 3 good slots, there is a limit to how much revenue they can run through a screen a year. As a result, the unit economics of the operations just aren't compelling. Maybe a full 3D roster of films can change this, but I'm not convinced it will.

Where I've been wrong so far:

- Polar Express: IMAX launched a 3D version of Polar Express day and date for the holiday season last year. The success they had with this film was well beyond my expectations. I knew this was going to sell well with it being 3D (much differentiated from 35mm), but what I failed to appreciate was that they were going to sell out the majority of the weekday slots with grade school students bused into IMAX theater as school trips. After all it was the Newbury award winning book and IMAX has a vaguely science connotation with schools. Polar did about $40 million in the box office in 3 months. The prior record was around $15 million, so this was off the charts. The stars really aligned perfectly for them. Only every couple of years can you get the type of movie for which busloads of kids will show up. IMAX parlayed the strong box into a wave of new signings.

- The MPX-R: Imax cant sell enough of it's large systems (price tag $5-7 million all in with construction, $2.5-3.5 million to IMAX) now that the institutional market is saturated, so the introduced the MPX which is a less costly system for smaller theaters ($1.5 million to IMAX, between 100K-2 mil extra for construction). The MPX was specifically targeted to the commercial operators rather than the institution space. They started out with the $3.5 million all in price tag which invovled building on the new IMAX screen as a "pod" onto an existing theater...few takers. They they came up with a $2.5 million all in price tag that combined two smaller existing auditoriums and knocked down the wall creating a single larger IMAX screen....not many takers. Finally they came out with the MPX-R which takes once of the two largest theaters, knocks out the front two rows and puts a larger screen up front. At a cost of $1.6 million, they have gotten some very serious traction, however, I've visited an MPX-R and the experience felt like a regular screen not the much touted IMAX experience. Without a real differentiator, like 3D, I don't think I would have noticed any real difference between that and other large modern auditoriums…perhaps the screen was a bit brighter. This lowered price did however bring the unit economics into an passable range, which wasn't anticipated by my original thesis. They are at the limit of where they can go here, having basically cut the construction down to $100K from as high as $2 million. Any further price reduction will come out of their margins.

What's new:

- 3D/digital competition is finally coming: Digital projection had always been a fear to IMAX bulls, as it allows theaters to inexpensively replicate, with a regular (digital) projector, the high quality images that imax's 70mm technology produces, but regular 35mm film can't match. Imax is a cumbersome, proprietary technology that can’t compete with digital. To really hammer this home, you currently need a fork lift to load the many IMAX reel in the projector, with digital this is all electronic. Digital has always been on the horizon, but it's very real today.

Real D: There is a company called Real D that is installing digital 3d projectors in theaters that cost $70K each, declining to $30K in a year. They currently can't project the same size screen as IMAX (roughly 1/2), but that will be on parity in a year as well. On Nov 4th, they will play a 3D version of the animated film Chicken Little on 100 screens domestically. Note that they are starting out in year one with a greater installed base than IMAX and due to massive cost advantages this will only increase. I understand that if this is successful, Real deal plans to roll this technology out to 1000 screens in the next 2 years. I ask a simple question, why would a theater operator pay to install an IMAX screen for $1.6 million, when Real D will pay $70K for it themselves?

IN 3: IMAX and IN 3 are in the midst of litigation back and forth regarding IMAX's new live action 3D plans. IN 3 apparently already has the patents on this process. While I'm not as close as I'd like to be here, I understand that IN 3 has the stronger case. This could block IMAX from launching a live action 3D movie this summer. Furthermore, there's nothing about IMAX, other than its installed base, that makes it the logical partner for IN 3 to monetize its intellectual property.

Digital projection in general: Disney has plans to roll out 1000 digital screens in 2006. Others will follow, potentially leaving IMAX behind.

- Unit Economics/Box Office results. IMAX claims that they need to get to $1 mil in box office to provide exhibitors appropriate returns and are well on track to do so this year. They claim that they already have 700K of this in the bank and get to it as follows, 105K for polar express in January, 162K for Aliens of the Deep (a proprietary IMAX film), 127K for Robots, 190K for Batman, and 116K for Charlie and the Chocolate Factory which hadn't finished it's run. I'll give them another 60K for Charlie/Batman remaining run. 70K for Magnificent Desolation (an Imax proprietary space movie which just launched a poor 9K per week...scheduled to run 10 weeks) and then they'll have 6 remaining weeks of Harry Potter and Polar Express, which I think will be extremely strong call it 250K-300K. All in that add up to roughly $1.1 million, but here's the catch. Aliens of the Deep only ran on 20 some screens (many of which were institutional vs. commercial). In addition, to be able to have that robust box office in January and in Month 3 of a release was somewhat unique to Polar express. All in I don't see them having problems getting to the $1 million range, but north of 1.1 million is hard to see.
So let's take that box office add 200K of concessions to it and see how profitable this is to the operators. What return on $1.6 million will they get? $1.2-1.3 million of revenue at call it a 20% operating margin (operators run about 15% EBIT margins on their regular biz, I'll give them a premium here). After tax, were talking about $1.5 million or roughly a 10% ROE. Nothing to get excited about, particularly when you sacrifice your largest, most profitable theatre to make room for this. To sell the system, IMAX has to rely upon nebulous concepts such as incremental economics and softer factors such as the prestige it will bring your theater to have an IMAX there.

- AMC deal: A major part of my thesis was that they wouldn't sign deals with large domestic chains. They recently did just that with AMC, but once you understand the terms of the deal, it's clearer. Of the $1.6 million cost for a MPX-R, AMX is only paying $100K for the construction. IMAX is contributing the rest.


- The borrow is both expensive and difficult to come by.

- From a ST timing perspective, we are about to enter into the holiday period where they we bring Polar Express back to the box office. I don't expect this to be as big as last time without the national ad campaign from the 35mm release, but I should still be a strong performer. The stock could pop on strong results, but doesn't address the competitive issues.

- They are probably about to give further clarity on their 2006 films and in particular, the # of 3D movies they will be launching. Given their historical relationship with Warner, it wouldn't surprise me to see them put up a strong offering, perhaps Superman in live action 3-D during the early summer. They've already announced Ant Bully a 3D CGI movie for August that should play well and could have another 3D with Warner's Happy Feet which would replace Harry Potter over the holiday season. If I'm wrong on this thesis it will be 3D that makes this model work...regardless valuation is on my side.


Success of competing digital and 3D formats starting with Chicken Little on November 4th.
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