Description

National Cinemedia (NCMI) is the largest cinema advertising company in the US.  Originally formed through a joint venture amongst the ‘Big 3’ exhibitors (RGC/CNK/AMC), NCMI’s sole business is the marketing of advertising spots that show in movie theaters before the previews begin.  Structurally, NCMI is unique in its setup as a ‘yield vehicle’.  Every quarter, the Opco’s cash flow is sent up to the Holdco and Founding Members, respectively, and then the Holdco uses that cash flow to pay its recurring dividend to public NCMI shareholders. 

However, there’s a problem with this structure: cash flow per share isn’t growing (in fact, it’s declining) and is inadequate to cover the dividend today.  While the Holdco has a cash cushion to continue paying the dividend for some time, it cannot go on forever – especially if FCF/sh continues to deteriorate.  And furthermore, the lack of dividend coverage is only one of the significant headwinds facing the stock…

While the stock has moved lower during the drafting of this write-up, I still see significant downside perhaps as soon as the 4Q report...        

Thesis

The growth story around NCMI’s cinema advertising business has proven false, and flaws in its structuring threaten to weigh heavily on the stock over the next 12-24 months. 

Valuation and Dividend Coverage: NCMI trades at 12.6x EBITDA, a premium multiple resulting from its ‘yield vehicle’ structure.  Its dividend yield is 6.2% and its FCF yield is 5.7% - so its dividend coverage is ~90% currently.  BBERG misrepresents NCMI’s EV calculation, as they account for the Founding Members’ 56% stake in the company as $246mm of minority interest, rather than the $1.1bn of market cap it actually represents.  This results in BBERG showing an 8.7x multiple versus its actual 12.6x.  Even though the Founding Members' stake are LLC interests, these are convertible into NCMI stock and should be included when calculating NCMI’s equity market cap.  This all sets a poor backdrop for the more impactful points of the short thesis that follow.. 

AMC Secondaries: AMC is one on NCMI’s Founding Members and owns ~24mm shares (17.4%) of NCMI.  Its recent acquisition of Carmike Cinemas (CKEC), the #4 player in the US market, will result in two very significant negative consequences for NCMI’s stock.  First, per NCMI’s LLC agreement, AMC will be entitled to receive an additional ~19mm NCMI shares (AMC’s PF stake will be ~27% total), as a result of AMC’s network growth from acquired CKEC locations (see calculation in table below).  Second, the DOJ has required AMC to divest its stake in NCMI to below 5% in order to complete its acquisition of CKEC.  That means that AMC is going to be selling at least 17mm shares, and possibly as many as 35mm shares, into a market that only trades ~300k shares per day.  It is possible that NCMI’s Board could come to an agreement with AMC that would waive the incremental share issuance, but no such waiver has yet been suggested publicly by mgmt.  Even if they do waive the incremental issuance, 17mm shares is still a lot of stock to be sold, and this will be an overhang on NCMI’s share price.  Furthermore, AMC’s theater buying spree (most recently Nordic announced last month) increases its need for cash to de-lever, potentially expediting the timing under which AMC plans to dump NCMI shares.  At the very least, AMC must adhere to the divestiture schedule set out by the DOJ, which requires: <15% ownership within 12 months, <7.5% ownership within 24 months, and <5% ownership by June 2019.  Bottom Line: AMC is a forced seller, and I think that stock is coming sooner and with less price sensitivity than the market expects.  Just imagine if one of the other Founding Members decides it too wants to monetize its stake alongside AMC, or if business trends deteriorate further.  This could all be a very poor backdrop for AMC to be selling so much stock.    

Street’s Estimates: Street is too high on 2017 numbers, and guidance will disappoint.  Over its history, late-year guide-downs have plagued the stock (as recently as the 2Q report in Aug 2016).  Cinema advertising is not the core of any ad budget, so it only receives the marginal ad dollar that it can pull away from TV and other traditional mediums.  This has made the business difficult to forecast, a problem exacerbated by lackluster growth in cinema advertising.  Simply, the thesis that money would move away from TV to benefit cinema has failed to play out.  Even in the context of national ad dollars moving away from TV in 2012-15, NCMI’s revenue was flat.  Over the last year, national ad buyers have changed their tune about digital, and the movement of spend from TV to digital has halted and in some cases reversed.  Concerns about ROI and fraud have halted the tailwind that NCMI has for years claimed it was befitting from – now this reversal is a headwind.  On NCMI’s 3Q call, CEO Andy England stated: “The 2016 and 2017 upfront market has been unusual and that the large broadcast companies have reportedly seen low double-digit CPM increases, despite TV ratings weaknesses, leading into the negotiating period. It's widely speculated that this is as a result of tight inventory driving very high scatter prices in the first half of the year, leading advertisers to determine that committing greater dollars to the upfront was a more prudent strategy. This in turn has taken substantial dollars out of the overall marketplace.”  Cinema advertising is also facing a very tough compare in 4Q’16 and 1Q’17, as the Star Wars reboot generated extraordinary excitement and buzz around the medium.  This dynamic of a single movie impacting advertiser demand for cinema is very unusual, and not likely to repeat (even for subsequent Star Wars installments).  Against this backdrop, and given NCMI’s revenue and EBITDA have been essential flat for several years, how is the Street forecasting revenue and EBITDA growth of 8% and 9% respectively for 2017?  It’s not going to happen, and knowing this, mgmt is most likely going to guide flat to LSD% growth.  I would lastly note that NCMI’s LLC agreement mandates a per-attendee fee be paid to the Founding Members for every patron that buys a movie ticket.  This fee is fixed for five years, but 2017 is a step-up year.  So this expense growth will be a headwind to margins.

Mgmt Turnover: Over the past year, NCMI’s mgmt team (since the IPO) has voluntarily left the company.  Former CEO Kurt Hall had been the biggest champion of cinema advertising since NCMI’s founding, but after a failed merger with Screenvision and stagnant growth in the business, Kurt departed late last year and (as far as I can tell) has sold all of his NCMI stock.  The former VP IR and Interim CFO also left recently.  I see this mgmt turnover as increasing the risk that the new mgmt team might compel the BOD to cut the dividend if fundamentals deteriorate further.  They have inherited an underwater dividend, and they may want to lower the bar now rather than wait until their hand is forced.       

Rising Rates: As NCMI has tended to trade on its dividend yield, we should see multiple compression if rates continue to rise.

Business

NCMI sells national (~75% of revenue) and local (~25%) advertising during pre-shows in Regal, AMC, Cinemark (the “Founding Members”) and other affiliate theaters.  NCMI was originally formed when the Founding Members merged their in-house cinema advertising businesses to achieve greater scale.  As a result of its partnership with the Founding Members, which are the three largest domestic exhibitors, NCMI owns ~2/3 of the cinema advertising market.  Any theaters developed or acquired by the founding members are required to be added to NCMI’s network.  If acquired theaters are under contract with NCMI’s sole competitor, Screenvision, “integration payments” are made by the Founding Member to NCMI until that contract expires.  This prevents any timing mismatch between when NCMI issues the Founding Member shares (which are required as compensation to the Founding member, pursuant to its LLC agreement) and when NCMI begins to benefit from the economics of those acquired theaters.

In 2014, NCMI agreed to acquire Screenvision, but that deal was subsequently struck down by the DOJ.  Screenvision is owned by PE sponsor Shamrock, and CKEC owns a minority stake.  As such, much of AMC’s agreement with the DOJ regarding its acquisition of CKEC revolved around its business with NCMI.  In other words, after blocking the NCMI/Screenvision deal, the DOJ didn’t want there to be any backdoor way to do that deal through AMC’s acquisition of CKEC.  Furthermore, given AMC would own significant minority stakes in both NCMI and Screenvision (but more NCMI than Screenvision), the DOJ didn’t want AMC to be biased as to which of the two served as its vendor.      

Financials and Capitalization

Some things to take note of here..

Cash taxes are difficult to discern from the SEC filing because of a tax sharing arrangement that allocates to the Founding Members almost all of a tax shield created at the company’s initial structuring (in 2006).  As a result, Holdco is a full cash tax payer (~35%).

NCMI’s share in Opco is always shrinking, because of dilution from shares issued to Founding Members when they acquire additional theaters.  Since NCMI has failed to grow the business sufficiently to absorb the incremental saleable impressions at these additional theaters, FCF per share has been declining and dividend coverage has fallen well below 100%. 

The Fathom business was a melting ice cube with minimal EBITDA contribution, so they traded it away to the Founding Members in 2013.

Risks to Thesis

Screenvision merger: Perhaps under a new administration, Shamrock is eventually willing to try again with the NCMI merger.  However, this would be extremely risky for two reasons: (i) the DOJ has already set a clear precedent for its perspective on this combination, and (ii) the business of Screenvision, a sales driven organization, was absolutely decimated in the year following the announced merger – and it took a while before the business was back on its feet.  For these reasons, the termination fee imposed upon NCMI would likely be prohibitively costly.

AMC finds a single buyer for its NCMI stock: I see this risk as low given the size of AMC’s holdings, illiquidity of the stock, and lackluster business performance. 

AMC maxes out the allowable window to sell NCMI stock: This is certainly possible, but risky for AMC.  The stock could move lower and/or the capital markets could move against them.  In any case, this impending supply will remain an overhang for NCMI’s stock.  Also, AMC needs liquidity to de-lever after its buying spree, so I believe there is some sense of urgency on their part to monetize its NCMI stock.  

Conclusion

NCMI is facing fundamental headwinds and technical pressures that will weigh on the stock for the foreseeable future.  Continued deterioration in FCF will eat into Holdco’s cash cushion, raising the risk of a dividend cut.  Against the backdrop of lackluster business performance and rising rates, there is unlikely to be robust demand for AMC’s secondary offerings.  This supply/demand imbalance for the shares will be a lasting overhang and exert downward pressure on the stock.  

Catalyst

4Q'16 earnings and FY'17 guidance

Secondaries in NCMI stock by AMC (and other Founding Members?)