Description

National CineMedia (“NCMI”) is the largest cinema advertising company in North America. The pre-roll of advertisements that plays before a movie starts is there because of NCMI. The business is low-growth but recession-resistant and highly cash-generative. NCMI has 47% EBITDA margins and 90%+ conversion to unlevered FCF. If it weren’t about to pause its dividends, it would have a 27% dividend yield. 

There’s only one gating factor here. NCMI has $900MM in debt, and like most companies, it has a partially fixed cost structure. There’s financial leverage and some operational leverage. Leverage, in any form, introduces path dependency into an asset. The question is whether, due to coronavirus, the path NCMI takes over the next year results in bankruptcy or survival. We think it results in survival. We also think that once you net out the loss that NCMI will face from a likely 9-month national shutdown of movie theaters, the shares are worth at least $6.05, 126% above their current price. 

The Business

According to Nielsen, NCMI’s advertisements reach over 700 million moviegoers each year, which equates to 63% market share. NCMI has such broad reach because it has agreements in place with AMC, Cinemark and Cineworld, the big three exhibitors. NCMI’s contracts with the big three don’t expire for another 18 years. And in fact NCMI has a complicated ownership structure that highlights how intertwined these four firms are. 

NCMI is just a holdco. The actually operating company is NCMI LLC, of which NCMI owns 47.8%. The remaining 52.2% is owned by Cinemark and Cineworld. It was also formerly owned in part by AMC. 

Note: the 48.6% ownership interest is no longer current. Now the figure is 47.8%. 

AMC, Cinemark and Cineworld (Regal) do the dirty work. They rent the space. They staff the theaters and provide concessions. NCMI LLC freerides off all of this to show a pre-roll of advertisements to you while you wait for the movie to begin. This requires a fraction of the cost structure. NCMI, as a result, has incredible 46%+ EBITDA margins with at least 90% of this converting into unlevered FCF. Capex is only 3% of sales. Because the business is capital-light, all the FCF is dividended out. 

NCMI is basically a low-growth, high-certainty perpetuity. The economics here are substantial. The only question is whether it’s us, the current shareholders, who enjoy them or the creditors who would be moving into our home once it goes into foreclosure.

The Situation

The coronavirus pandemic has closed US movie theaters indefinitely. NCMI can weather, even thrive, in downturns, but a pandemic happens to be the precise threat that could kill this business—a threat that prevents people from being near one another. 

Coronavirus is extremely communicable. Allegedly 84% of transmissions are from people who are asymptomatic. Meanwhile sick people can remain asymptomatic for up to two weeks. Combining both factors, the virus is almost perfect in its ability to infect. As a result, it is either nowhere, or it is everywhere. And if it is everywhere, it will become a part of everyday life. Authorities in several countries now have basically admitted as much, writing that strict quarantines merely slow its infection rate so that the healthcare system isn’t overwhelmed and the gravely ill can get adequate care. 

But think about the upshot of this. Health authorities are saying the whole thing is 50/50. 50% chance we nip COVID in the bud. 50% chance at least half the population gets it. And this in turn leads to the final upshot. In nine months, either way, whether everyone’s exposed or no one is, none of us are still likely to be in quarantine. Restaurants, movie theaters and other public places are probably going to be open for business. Life will go on. It’s unlikely a vaccine will be developed and made widely available in this time frame. But it is possible an effective anti-viral would be made available in under a year. Gilead, for example, currently has in a clinical trial scheduled to conclude in April. 

So what does a shutdown look like? We have to assume NCMI shutters for 9 months, as that suggests that the current lax social distancing practices fail and that there are not one but several more outbreaks between now and the end of the year. To figure out what NCMI’s loss is during a 9-month hibernation, we start with their contractual cash obligations listed in their 10-K. 

As you can see, they have $71MM in contractual cash obligations in 2020. Obviously this is just a bare bones figure and doesn’t reflect what’s really required to keep the company intact and do right—or at least somewhat right—by the people involved. So to this $70MM, we add $50MM in various administrative costs, bringing the total to $120MM. 

NCMI has $213MM in liquidity ($81MM in cash + securities and $132MM in revolver capacity). They can cover a nine-month loss of $90MM or even a full-year loss of the whole $120MM. But this isn’t the only issue. Here’s the company’s financial picture. 

The company has $900MM in debt, virtually none of which is due before 2025. However, the company’s debt covenants cap the company’s debt to EBITDA, among other things. These covenants won’t be tripped at the end of Q1. Oddly because the covenants look at the trailing four quarters and because NCMI earns half its EBITDA in Q4, NCMI may only barely trip its maintenance covenants at the end of Q2. Regardless, it will definitely trip them by Q3. If the shutdown reaches that point, and we have to assume it will, then we’ll have an event of default, and the loans will accelerate. 

It is our opinion, however, that the creditors will not tip the company into bankruptcy and in fact have a huge incentive to play fair with NCMI. There are several reasons for this. One, we now officially live in a zero interest rate world. They’re going to be looking for yield. Two, the term loan and the revolver both have floating interest rates, which means less interest will be paid than before. On top of this, the Trump Administration is likely to introduce incentives to banks to finance companies through this difficult time. Banks are better capitalized than they have been in years. As Kyle Bass pointed out on CNBC recently, instead of being part of the problem, as they were in 2008, they’re poised to be part of the solution. Many industries are in desperate need of temporary financing, and banks with proper incentives from government are in a position to save them and make great returns in the process. 

In NCMI’s case, we think the creditors will follow trend and continue financing the company. And if they don’t, if they want to accelerate their loans, then it’s not far-fetched at all that someone else would be eager to step in and finance this company at something within the ballpark of the 6.3% interest rate the company currently pays on average. 

There’s also another equally important consideration. NCMI is a captive of the three major exhibitors (two of them really). Attempting to strategically wipe out the equity of business partners on whom on your business depends is a short-sighted act of war, particularly when what we have here is very issue Chapter 11 was designed for—an issue of temporary liquidity, not permanent insolvency.

NCMI is far more likely than not to survive this crisis intact and go back to being the cash machine that it once was.

Movie-going isn’t dead

Since NCMI is in the cinema business, many won’t want to own it at any price. Attendance declines are well-known. The theatrical window has shortened. Movies have also lost the cultural cache that they once had. 

We don’t think movie theaters are closing anytime soon, however, and here’s why. Despite the popular narrative that movie-going is dead, attendance at NCMI theaters was the exact same in 2019 as it was in 2009. Yes, in non-NCMI theaters, attendance has declined a little less than 1% a year for a long time, but this is offset by price increases. The fact that there’s any pricing power in movie theaters at all speaks to how much the movie-going experience means to the public. Something else that speaks to the stickiness of movies is that the fact that movie attendance tends to go up during recessions, as it did in 2001, 2002 and 2009. In other words, going to the movies means enough to enough people that they’ll spend the same amount to attend, even though it’s a greater percentage of their income.

Another factor is at play, and this one isn’t quantifiable. There’s just something about seeing a movie in a theater. A great TV show provides a wonderful in-home experience. But a movie is an actual event. I can remember taking my kid sister to Lord of the Rings with shocking clarity. I remember the look on her face. I remember that buzz running through the theater as everyone waited for the movie to begin. By contrast, the circumstances surrounding even a single viewing of Breaking Bad are shrouded in fog to me. Of course, series make more money. They always have. The only reason the entertainment industry can pay the mortgage and keep the lights on is because of television (now series). The movie business is a low-return enterprise with a pitiful amount of repeatability. It barely even satisfies the definition of a business. TV shows are mild-mannered accountants who show up to work each day. Movies are manic-depressive girlfriends who fascinate, right up until they file the first false police report. But there’s a reason why movie-going has persisted for over a hundred years, despite the rise of television, the VCR, the internet and so on. When a movie is working—really working—it reaches heights of spectacle and drama that 99.9% of series can only dream of. There’s something about the form—and the form requires the movie-going experience to elevate it—that’s special. Movie-going has endured for over a century. Things only last because they deserve to last.

With all that said, while movies are capable of being wonderful, the movie business itself is a different animal. There is only so much profit to go around. And if you can find some corner of the business that’s an actual business, like theaters, like NCMI, the entry point is everything.

NCMI’s entry point is very appealing, despite the obvious risks. The company paid dividends of $.88 a share from 2012 to 2017, a 33% dividend yield at today’s price. However, since 2017, it has lowered the dividend to $.68 a share, 25% yield at today’s price. We think that once the Wuhan virus threat is gone and things normalize, NCMI has the ability to pay $.72 in dividends, a 27% dividend yield. 

Valuation

Due to the pandemic, we have a unique situation. NCMI is poised to put up $.72 share in FCF annually and will dividend all of it out. This FCF stream is highly stable but unlikely to grow much. Therefore we assign a 10x multiple to it, giving us an equity worth $7.20 a share. However, to keep this company, we’ll have to weather a $90MM loss, which is $1.14 per share. We, therefore, take $7.20 a share and subtract $1.14 for a company worth $6.05 a share. This equates to 126% upside.  

For those who think in terms of yield, not multiples, the shares currently trade at $2.70, which gives us a 27% dividend yield. However, to cover the $90MM loss, let’s assume the company shuts off all dividend payments until the loss has been paid for. This will take a year and a half. The present value of a 27%-yielding perpetuity that we have to wait 1.5 years to get is 23%. That is what NCMI shareholders are likely to earn over the long-run at current prices. 

What invalidates the thesis? One thing really. A far longer shutdown than anticipated. Nonetheless we think the pandemic has given long-term investors a rare opportunity to own an unusually stable income stream at a once-a-decade price. 

One final note: as everyone knows, the number of coronavirus cases in the US is set to explode. What I don’t think many people are prepared for is how the virus’s geometric rise will play out with actual numbers. Going from 200 to 5000 cases is scary. Going from 5000 to 125,000 is panic-inducing. In 2-3 weeks, if CV spreads as many think it will, reality is going to sink in. People won’t just worry about the bankruptcy of stocks like NCMI. They will become utterly convinced of it. There’s a very good chance this stock falls another 50% in the next month. We think that’s a buying opportunity. More importantly, if CV is as serious as it seems, hopefully it’s also an opportunity for the government and the broader public to step up efforts to keep at-risk people safe. 

This is not a recommendation to buy or sell securities. Please conduct your own research and reach your own conclusion. We may buy or sell securities at any time. 

Catalyst

Containment of CV.