Reading International (RDI) - LONG

• RDI is an under-followed microcap (market cap: $96M, EV: $290M) that is both a cinema exhibitor and a real estate owner/developer/operator in the US, Australia and New Zealand. RDI's core strategy is to use the cash generated from the cinema segment to fund its real estate development.
• RDI's stock is worth significantly more than its current price. The Company has been on my radar for some time but the key issue (and the main reason the stock is cheap) has been if and when the value will be unlocked given that the CEO, who is also the largest shareholder, has full control and is not necessarily motivated by the stock price.
• However, a near-term transaction involving the Company's most valuable real estate holding, and a number of other real estate sales/developments should serve as catalysts to narrow the gap between price and value. Moreover, the significant underlying asset value offers downside protection, and a patient investor will be rewarded over time.

• Although RDI trades well below a conservative estimate of intrinsic value, specificity on exact value is not useful with so many moving pieces. In the model summary above I provide an indicative equity value of ~$9.6 per share, more than double the current price. If you do not discount the real estate (as I have done above), the value would be ~$14 per share.

Real estate segment

RDI owns real estate in Australia, New Zealand and the US. RDI's portfolio consists of many land parcels at various stages of development in addition to income generating properties, which are primarily retail centers with an RDI cinema often as a key tenant.

Valuing the portfolio is complex as the properties are in widely varying degrees of development: fully developed and income generating (e.g. Indooroopily office building), income generating yet underutilized (e.g. Union Square Theater), in development but soon to be income generating (e.g. Courtenay Central Phase II) and undeveloped land (e.g. Manakau). Using multiple methodologies including comparables, recent transactions, local real estate expert input and estimates of income on certain properties, I value the real estate at ~$404M. I then discount this value by 25% to arrive at a value of $303M, which is itself greater than the current EV (before even considering the cinema segment). As to the 25% discount, it is somewhat arbitrary but the purpose is to account for the uncertainty of the timing and the proceeds/income RDI will receive from land and underutilized properties. Unfortunately, there is no property-level NOI detail in the filings. Note: The properties and their estimated values are listed as an appendix.

Land in development:

This represents the bulk of RDI's real estate portfolio. It primarily consists of lots in urban locations in Australia and New Zealand. The lots are in various development stages and a number of them are adjacent to existing RDI income-generating properties. The book values are mostly well below a conservative valuation. The value of RDI's undeveloped real estate has achieved unrealized appreciation not only from rising property values over time but from rezoning, government and council approvals, etc. The largest land development parcel is Burwood Square: a 51 acre lot in Melbourne that has been zoned for commercial, retail and residential use. It is currently in a transaction process and I expect an announcement in the next 3-6 months (transaction will likely include a sale of the site's 34-acre residential plot and a development plan). Local property experts confirm Burwood's value at ~$70-80M. Moonee Ponds, another key Melbourne land development parcel valued at ~$30M, could also form part of this transaction. Moreover, a number of the land projects in development (e.g. Newmarket phase II, Courtenay Central phase II and Auburn phase II) will become income generating in the next 1-3 years.

Income-generating real estate:

Even with much of its real estate not generating income, 2010 EBITDA from RDI's real estate segment was ~$15M on $25M revenue. The 2010 EBITDA number is understated given that the opex includes costs associated with land in development. There is also incremental opportunity from redeveloping/expanding/converting some of the underutilized operating assets as RDI did with its conversion of the Sutton Hill Cinema on 57th St in NYC into a luxury condo building known as Place 57. RDI recently announced that it is considering selling its 75% stake of the property that is currently the site of RDI's Cinema 123 (Manhattan, 3rd Ave between 59th & 60th), estimated proceeds to RDI are $25-30M. The Company also announced that it is considering JV partners to develop its underutilized, prime Union Square property. Other redevelopment opportunities include the Minetta Lane Theater in NYC and the Royal George Theater in Chicago.

Cinema/live theater exhibition segment

RDI has 58 cinemas (462 screens) across the US, Australia and New Zealand. The majority of these cinemas are wholly owned and managed by RDI. RDI's cinema/theater portfolio includes:

• US: 25 cinemas (232 screens), including Hawaii's dominant chain (Consolidated Theatres), the Reading chain, the City Cinema chain, and a number of independent/arthouse cinemas (e.g. the Angelika, the Tower); RDI also owns three live off-Broadway theaters in New York, and one in Chicago (Royal George).
• Australia: 22 cinemas (170 screens) - majority under the Reading brand (4th largest cinema exhibitor), and the leading independent/arthouse cinema in Australia
• New Zealand: 11 cinemas (60 screens) - under the Reading and Rialto brands (3rd largest cinema exhibitor)

I would have thought that 'in-home' entertainment systems, DVDs and the internet etc. would be rendering cinemas things of the past. However, to date this is not the case. Results continue to highlight that consumers spend entertainment budget outside-home, and cinemas remain an affordable option. A threat to the key competitive advantage of cinemas is that distributors release films through multiple channels simultaneously. However, industry experts suggest this is unlikely in the near to medium term because box-office success drives 'downstream' viewing demand and value.  Moreover, cinema exhibitors, including RDI, are responding to the risks by switching screens to digital and equipping certain cinemas with 3D capabilities.

Cinemas also proved particularly resilient during the economic downturn and RDI's cinema segment continued to perform strongly in 2010. Cinema segment 2010 EBITDA was ~$30M on ~$211M revenue.

I expect the cinema segment to generate reasonably stable cash flow in the years ahead, although it is unlikely to witness growth. In terms of value, I apply a 6x multiple to RDI EBITDA, yielding a value of ~$180M. Cinema comparables trade at higher multiples but RDI should arguably trade at a small discount because of its relative lack of scale.

Debt: RDI has minimal financial risk

I would usually delve in to more detail about the debt but in this case even though RDI has ~$227M in debt, there is minimal financial risk. RDI has significant unencumbered quality assets (including Burwood which is unencumbered) that, if required, could be encumbered to refinance the current debt or sold to pay down debt. Moreover, the Company will use some proceeds from the Burwood transaction to pay down debt.

Bloated corporate G&A

Corporate G&A of $13.7M in 2010 is too high although substantial legal costs (>$1M per year) in recent years (associated with the Malulani JV and the IRS settlement) are no longer recurring. The Company is also cutting costs by moving its back office to Wellington, NZ. If the Company were split up or sold, much of the G&A would be eliminated although I am not expecting that. Some of this G&A should be allocated across the segments and primarily to real estate as management time and legal costs are spent more on that segment. To incorporate the corporate G&A in my valuation, I apply a multiple of 7x to a normalized level of $12.5M equaling -$87.5M which I remove from the value. I ignore the positive tax effects of these future expenses.

Ownership structure, corporate governance and management

There is hair in this story and it primarily involves the CEO, James Cotter, and the ownership structure. The stock has a dual class structure; class A non-voting stock (21.5M shares) and class B voting stock (1.2M shares). CEO Cotter owns 70% of the class B stock and has full control. The 10K risk section explicitly states that Cotter has the power to "take actions that might be desirable to Mr. Cotter but not to other stockholders." Cotter pays himself well and there have been related-party transactions over the years. His three children, all ex-lawyers, are also on the payroll but they do have legitimate roles at the Company.

I do not like the related-party transactions or the controlling structure, which is an impediment to activism.  I believe Cotter's control coupled with the complexity of the business are the main reasons why the stock trades at $4.21. However, Cotter and his children do own ~25% stock. This ownership stake keeps their long-term interests aligned with shareholders as it is a major family asset. Moreover, I have been reasonably satisfied with Cotter and his team's operating ability as both the cinema and real estate segments have achieved sizeable increases in economic value over the past decade. That said, this will not be very evident in the financials until value is unlocked via asset sales/developments.

Cotter is 73 years old. He is a highly un-promotional CEO; there are no conference calls and zero analyst coverage. While Cotter might not greatly care about the immediate share price, he did imply at the annual meeting that he is frustrated by it and indicated that he will monetize certain assets. His decision to sell Burwood and Cinema 123 and engage in multiple other transactions appears to be a sign of things to come. He also did a small ($250K) buyback in 2010 and additional buybacks are an option once Burwood is sold. Cotter also announced that the Company will present at an investor conference later this year.

Other points

• Sources of additional value:
  • Long-term lease assets: RDI has a number of long-term leaseholds that are more akin to real estate investments than leases and likely worth more than their book value of $18M (includes Village East cinema long-term leasehold in NYC).
  • NOLs: RDI has NOLs for which I ascribe no value. $26.5M US NOLs (expiring 2025-29), $58.5M Australian NOLs (no expiry), $17.5M New Zealand NOLs (no expiry). These NOLs should shield tax payments in the years ahead.
  • Unconsolidated JVs and other assets: RDI has an interest in a number of JVs, including a 33% in the profitable Mt. Gravatt 16-screen cinema in Brisbane, Australia. RDI also owns a few immaterial assets that are on the books at zero but have option value (such as the Reading Viaduct in Philadelphia).
• RDI has no coverage although the CEO indicated that RDI will present at an investor conference this year. It is also worth pointing out that Andrew Shapiro, PM at Lawndale Capital Management, writes about RDI on Seeking Alpha and his posts are insightful.
• Double counting: The cinema segment operating expenses includes rent, which is market-priced even for company-owned properties. When sold or redeveloped, Cinemas 123 would surely cease to be a cinema. As this accounts for <1% of screens, the impact of the income loss from this small cinema would be de minimis.

Risks

• Currency risk: RDI does not hedge currency so the Company is benefiting from the appreciation of the $AUS and $NZ as earnings will be higher in $US terms and also any asset sale will generate higher $US value. A move the other way would have a negative impact. Some of the benefit will be locked in once the Burwood transaction is complete.
• Australian property bubble: Aus real estate generally appears overvalued. I do not expect a major price decline but a correction would reduce the margin of safety. The sale of Burwood (and also Moonee Ponds) would reduce the impact of any correction.
• Cotter risk: There is a risk that Cotter could act against the interests of other shareholders although he has not previously taken advantage of his control position. Given the Cotter family ownership stake, I believe this is not cause for major concern. Cotter could also attempt to take RDI private below fair value, however he has never made such an attempt and a large revolt from other shareholders, including friends and colleagues, make such an event unlikely.
• Time/value trap: One concern is the time it might take to get a return on this investment. I believe that if not Cotter then his children will eventually be motivated by the share price. I am comforted by the fact that, even though this is an asset-driven investment, the NAV will grow over time, especially as more land currently in development generates income. The risk/reward is attractive with uncertainty on timing but limited risk at the current price.

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