Description
National CineMedia (NCMI) offers a base case of roughly 25% upside in 12 months. I estimate the business will earn over $1.50 in free cash flow in 2009 which I value at 20x, with roughly another $1 coming from interim dividends and cash flows. I believe that given the quality of the business and the outlook for sustained double-digit revenue growth that a 5% free cash flow yield is fair if not conservative. NCMI is an outstanding business that enjoys strong barriers to entry, obscenely high returns on incremental capital, strong pricing power, favorable secular advertising trends and open ended growth prospects. An added bonus is that even with it's bright growth prospects the business actually pays a 2.4% dividend yield.
NCM LLC is a partnership that was recently formed by three movie theater chains (AMC, Regal and Cinemark, collectively the Founding Members) and has contractual rights to sell cinema advertising and related promotions in the Founding Members’ theatres. NCMI is a holding company that owns a 44.8% interest in the LLC. While currently trading at a steep valuation multiple, NCMI’s cash flow should grow rapidly over the next few years as utilization of available advertising slots is increased, the recently-acquired (by AMC) Loews screens are integrated into the NCMI network in June 2008, and pricing power is exercised. The business has tremendous operating leverage and as the substantial “effectiveness-weighted” pricing discount of cinema-based ads (compared to prime time advertising) is narrowed over time, revenues and cash flow should increase at double-digits with virtually no incremental capital expenditures.
Near term concerns
I view NCMI as a “time arbitrage” investment. I believe the market is currently focused on a few near term concerns, none of which will impact the long term growth in intrinsic value of the business. As these pass I expect the bright outlook to drive the shares. I believe the issues are:
- 4Q07 box office attendance
- ability to integrate and sell the Loews inventory
- limited near-term CPM growth
The box office is a classic “what will the quarter look like” concern. There will be ebbs and flows in attendance driven by the quality of films released in a given quarter, and Q4 was shaping up for a tough Q before a late rebound. And the long term trend in movie attendance is unlikely to be up. However the attractiveness of cinema as an advertising medium is in the incredibly high quality impressions, not in the growth of audiences.
The Loews inventory is somewhat tricky, but certainly transitory. NCMI won’t know for sure how much inventory they will have to sell until they get into June 2008 because up until the hand off date Screenvision has the ability to sell deals that last into October. There will also be a surge in NCMI’s advertising inventory, likely pressuring utilization, however management has known about this and prepared for this for over a year. By the time we enter second half of 2008, the uncertainty will be gone and it should be absorbed by the end of the year.
The CPM growth, or lack thereof, is what has kept the stock right about where it was when it first opened for trading. There have been two key drivers of CPMs – NCMI’s desire to entice new advertisers to the medium (and therefore a willingness to give some “introductory” pricing) and Screenvision’s pricing pressure. These two drivers will turn NCMI’s way by the second half of 2008. As utilization moves towards 90% (86% LTM) management has always said they will look to more aggressively push price. And once Screenvision loses its Loews inventory to sell, their ability to attract national advertisers, regardless of price, will take a serious hit.
A potential near term upside that hasn’t really been discussed is that Screenvision is potentially on the trading block. It is a 50/50 JV between Thomson and ITV, and ITV has stated they are exploring options for the business. For what it is worth, NCMI doesn’t believe there would be anti-trust issues in purchasing it. That would be a tremendous home run for NCMI. The alternative though, which is just as attractive, is that NCMI continues to sign up affiliate deals with chains that were former Screenvision customers.
Keys to thesis
NCMI’s business details and the cinema advertising business in general are described in great detail in its prospectus and 10k. Instead I focus on what I believe are the keys to the business and the thesis.
• Substantial runway for revenue growth via CPM/price increases and, to a lesser extent, higher inventory utilization
- NCMI’s CPMs are roughly 1.5x the level of prime-time television CPMs. However studies have shown cinema ads to have 6x higher unaided recall. As a comparison, in Western Europe, where cinema advertising is more mature, cinema CPMs are as much as 7-8x the level of prime-time CPMs.
- With inflationary growth in prime-time CPMs, cinema CPM growth of 15% for 10 years would still leave NCMI CPMs at only 5x prime-time levels.
• Very high incremental margins on revenue growth achieved via price increases
- The contracts with the Founding Members provide for a “theatre access fee”, a fee that shall not be lower than 12% of advertising revenue (expected to reach that level in 2008/2009). This is currently NCMI largest expense item. The theatre access fee varies with attendance and the number of digital screens in the system, thus it is completely “leverage-able” via CPM increases.
- NCMI’s second highest expense item, sales and marketing, does possess a variable component, however with national advertising I estimate it to be only ~5% of national ad revenue.
- After the two largest variable expense items, $0.80+ of every $1 of higher revenue from CPM increases falls to the bottom line.
- Given the higher variable commissions, regional advertising has incremental EBITDA margins of 65%, while Meetings and Events are from 30-40%.
• A duopoly market position on its way to a monopoly given dominant market share in large DMAs following Loews integration
- For all intents and purposes there are two players in the US cinema market, NCMI and Screenvision (a JV between ITV plc and Thomson SA). Each currently covers approximately 14,000 screens, accounting for about 28,000 of the roughly 37,000 screens in the US. However Screenvision is primarily in third and fourth tier markets, and once the contract with Loews runs out in June 2008 (transitioning to NCMI due to AMC’s ownership of Loews) that will be even more pronounced. With Loews in the fold, NCMI screens will constitute 72% of the top 10 DMAs.
- Importantly NCMI has contractual rights to Founding Member theaters for 30 years, and they have also built-out an extensive digital network allowing for rapid and cost efficient distribution of advertisements. Thus the moat is quite wide.
• Attractive business model requires virtually no capex and results in very high cash conversion
- As part of the contractual arrangement with the Founding Members, it is the Members’ responsibility to pay for all capex inside their theaters. Capex for newly signed affiliates is covered by NCMI, however it runs at only $10,000 per theatre and generates a payback in 12-18 months (see discussion of affiliate economics below).
• Untapped growth opportunities present meaningful upside not captured in the above FCF numbers
- Potential upside events not modeled in the above numbers include:
o Signings of large new affiliate agreements
o Founding Member acquisitions, which would increase NCMI’s available inventory
o A broader roll-out of NCM Fathom, a business that broadcasts live or pre-recorded programming such as concerts, Broadway plays, sporting events, etc. into theaters over NCMI’s network
o NCMI could effectively increase national inventory by paring down the length of FirstLook’s “content”, by shrinking regional inventory, or both
o Broader rollout of the Lobby Entertainment Network (LEN), currently in just under 70% of Founding Member theaters
o Utilizing NCMI’s digital network and salesforce to sell out-of-home advertising in non-cinema venues (NCMI is a part-owner of a venture doing this in health clubs)
• Broader advertising industry trends provide macro tailwinds
- With the TiVo age upon us, advertisers appetite to target consumers in an engaged, "un-skippable" medium is well satiated by cinema advertising. This has resulted in cinema advertising growth industry-wide of 20+% over the last five years. At roughly $500mm in industry revenues it is still a small fraction of the overall ad industry.
• The management team appears capable and is building the business for the future
- Management has focused their growth efforts on two stages: improving utilization, and then improving CPMs. Given an anecdotal Screenvision salesperson’s comment that “once you get ‘em, you’ve got ‘em,” this strategy seems sound. NCMI is keen to expand the base of cinema advertisers as wide as possible, even at the detriment of short-term CPMs, in order to ensure maximum demand (and therefore pricing power) in the future.
- Management has also done a good job of conditioning investors and analysts not to expect near term strength in CPMs, allowing themselves maximum flexibility to build the business while minimizing the risk of short-term turbulence in the shares.
• The management team has a solid background and a considerable equity compensation component
- Prior to his current position, CEO Kurt Hall was co-CEO of Regal Entertainment Group, and before that he ran United Artists Theatre Company. He thus has a strong grasp of the movie theater business. Clifford Marks, the President of Sales and Chief Marketing Officer, had run sales and marketing for Regal CineMedia (an NCMI predecessor) for three years prior to NCMI’s formation, and before that he was a senior executive in sales for ESPN.
- For 2006 the CEO’s compensation was roughly 1/3 base salary, 1/3 cash bonus and 1/3 option awards. Given the limited history of the company, overall ownership is light; however the CEO does currently have $4.2mm (gross) worth of stock (including unvested options).
• Regional utilization remains woefully low (rough estimate of 25-30%), presenting an opportunity
- This opportunity can be realized in one of two ways: either regional utilization climbs, regional inventory is shifted to national inventory, or both. In 4Q06, for example, a very strong quarter for NCMI that saw national utilization in excess of 100%, the company substituted some national advertising into regional slots.
- Management has cited recent improved regional utilization in conference calls.
• In spite of the lofty valuation, near term expectations appear to be muted
- Seemingly at the “urging” of management, analysts are calling for limited CPM growth in 2008 (anywhere from 2-3%) and only modest utilization increases. This despite the fact that NCMI has grown utilization strongly in 2007 (from less than 80% in 2006 to 86% LTM), and they are sticking to their guidance of 200-500 bps of increase in 2008 despite a huge bump in inventory from integrating Loews. By the second half of 2008, with the Loews inventory digested and Screenvision losing an ability to compete for national advertisers, CPMs should start to accelerate.
• Affiliate agreement economics are very appealing, even relative to outdoor advertising
- Outside of price increases and utilization increases on existing screens, NCMI has an opportunity to grow the number of theaters in their network via more affiliate agreements. Hence it is instructive to examine returns on invested capital on those deals, and compare them to other similar publicly traded companies (e.g., outdoor advertisers).
- Per conversations with outdoor advertisers, rough economics appear attractive (and are reflected in their valuations). Large bulletins cost approximately $60,000 (for owned structures and leased “location”). With utilization approximating 80%, a two-side billboard can generate about $25,000 in advertising revenue per year. Bulletin-level EBITDA margins approach 60%, generating a cash-on-cash return of roughly 25%.
- With affiliate agreements, the per screen economics are roughly: $10,000 to install the digital network equipment; revenue per screen of roughly $16,000-$20,000; and EBITDA margins of 45%. This leads to extremely compelling cash-on-cash returns of roughly 70-90%.
Risks/concerns
• Results will be driven impacted by movie theater attendance
- While NCMI emphasizes that the scatter market has a larger impact than theater attendance on CPMs, it is a simple fact that if less people attend movies NCMI will have less “inventory” to sell. The challenges of the movie business are well documented.
• Large volume of Loews inventory must be digested in mid-2008
- When Regal and AMC originally brought their networks together a few years ago, the inventory that came online, mostly as a result of AMC’s underutilization, pressured CPMs. Loews is roughly 1/3 the size of AMC, and NCMI has plenty of runway to build demand for the inventory they’ll inherit, but it is a concern.
• “Synthetic” nature of company
- Given the way in which NCMI was “constructed”, it’s less a “real company” and more a collection of contracts amongst the three Founding Members and NCMI. Movie theater companies have stumbled into bankruptcy in the past (and hopefully learned their lessons), so it is conceivable that in the event of that movie playing again contracts relating to NCMI could be rejected.
• Power is concentrated in the hands of the Founding Members
- The three Founding Members collectively own 55% of NCM LLC’s common units, giving them effective control. There actions are limited by adherence to the contracts that have been signed in the formation of NCMI, however it is a risk that must be acknowledged and diligenced further.
• Substantial overhang
- The common units the Founding Members own are convertible into shares of NCMI. The lock-up with respect to their shares expired in August 2007, so they are able to exercise their registration rights. Regal has said they intend to hold onto their 22% stake, however they “may not hold it forever” depending on where the price goes.
Catalyst
Passing of short term overhangs. Pricing power is flexed in 2H08 and 2009. More affiliate deals are announced.