Description

Summary

I post this at the risk of looking stupid after what I expect will be a poor earnings report on Monday, but I believe at current prices RLD has an outstanding risk/reward ratio with multiple potential positive catalysts over the next 12 months. If the stock takes a hit due to poor near-term results, all the better. RLD enjoys a favorable position in the worldwide motion picture exhibition market with significant barriers to entry and high margin recurring royalty revenue. The opportunity to invest in RLD at a favorable valuation exists because RLD’s business exhibits significant volatility driven by the popularity of the film slate for 3D viewing, and the 3D box office currently is in a trough of poor results that will cap off a three-year period where EBITDA declined by more than half. Additionally, the company failed to respond to a $12.00 acquisition offer made by activist investor Starboard Value, leading arbs and event-driven investors to sell against a temporarily weak fundamental backdrop. However, I believe that the activist pressure on RealD will only increase, which combined with an improving film slate and announced cost cuts should lead to rapid growth in FY ‘16 and FY ‘17 EBITDA (RLD has a March fiscal year end). If things play out as I expect the stock has the potential to double or more over the next one to three years.

Business Description

RealD’s primary business enables 3D movie viewing in theaters. The company provides a module (known as a “Cinema System”) that attaches to the theater’s projection equipment to show 3D enabled content. Theater operators tend to avoid capital expenditures, so RealD typically provides the Cinema System and screen free of charge to the theater operator in return for a multi-year agreement to pay RealD royalties on the 3D box office. In a typical U.S. theater, the up-charge for 3D is around $3.00 which is equally split between the movie studio and the theater operator, who in turn pays RealD half of its net 3D upcharge or $0.75 in this example. RealD also provides the 3D glasses, which are subsidized by the movie studios. RealD says that it tries to operate the glasses business at breakeven, and although it has done somewhat better in recent quarters, the engine of economic value is the royalty on the 3D box office. The royalty tends to work out to somewhere between 4.5% to 6.0% of the global box office on RealD-enabled screens (largely depending on the quarterly contribution of China which does not report box office in the total, i.e. China royalties are in the royalty numerator and not the 3D box office denominator). Obviously, the 3D royalties are virtually 100% incremental margin and the company’s performance can move around a lot on a quarterly basis depending on the success of the 3D movie slate.

RealD enjoys a strong competitive position in the 3D market. According to RLD’s 10-K, as of 3/31/2014 it had RealD Cinema Systems on 25,200 screens in 72 countries which it believes is substantially more than any of its competitors. Most of the large U.S. theater chains have multi-year contracts making RLD the exclusive provider of non-Imax 3D. RLD originally granted the large U.S. theater chains stock warrants to standardize on RLD systems.   That said, my research generally indicates that major theater operators are happy with the arrangement and I believe they are likely to renew when their deals are up, mostly between 2016 and 2018. Dolby (DLB) attempted to compete in the 3D cinema systems market but has not made much of an impact. Imax (IMAX) is probably the most important competitor, but Imax’s installations are inherently limited since it gives licensees a zone of exclusivity for an Imax theater whereas RLD frequently installs multiple 3D systems in a single location. Imax is positioned as an ultra-premium experience with higher ticket upcharges and royalties, although some theaters have created their own competitive premium large-screen formats utilizing RLD technology.

While its core business of 3D cinema systems provides virtually 100% of revenue today, RealD views itself as a broader visual technologies provider and in recent years has made substantial investments in other businesses. RealD engineers have been working on an alternative smartphone/tablet LCD panel intelligent backlighting system (http://intelilight.reald.com/) that would supposedly improve battery life and sunlight readability while enabling glasses-free 3D. Intelilight obviously addresses a huge potential market but RealD does not currently participate in the LCD panel supply chain and faces the challenge of convincing panel OEMs and smartphone/tablet makers to adopt its alternative design while presumably paying them a royalty. The company has also researched the use of lasers in theater projection systems in conjunction with new specialized movie screens, but to me at least the business model for commercializing this research is unclear since RealD does not seem well equipped to compete with Sony, NEC, Barco or Christy in theater projectors. The company has also demonstrated a software product by the name of TrueImage that enhances the quality of recorded images in postproduction but in my opinion TrueImage looks like a solution looking for a problem with a possibly tiny potential market. Finally, the company is developing XLGS, a premium large format technology competitive with Imax. These business lines generate de minimus revenue today, and as discussed below are a key point of contention with activist investors involved with RLD.

The Film Slate

The amount of the box office generated by 3D movies is the primary near-term determinant of RealD’s revenue and EBITDA given the nearly 100% incremental margin generated by box office royalties. RLD IPO’d in July of 2010 at $16.00 and the stock hit a high of $34.00 in 2011 on the back of the enormous tailwind for the 3D box office generated by Avatar, the most successful 3D film to date. Gross 3D royalty revenue increased from $18M in FY ‘09 to $137M in FY ‘11 (which contained the bulk of Avatar revenue) and $147M in FY ‘12 as studios released more and more movies in 3D. Since then, consumers (especially American) have become more discerning on what movies they are willing to pay the $3 upcharge for, Imax has taken share and 3D box office royalties have fallen to an estimated $110M for FY ’15 despite a much larger worldwide 3D theater installed base. The royalty declines in FY ‘13 and FY ‘14 were largely driven by lower 3D attach rates and while these have recently stabilized, the estimated FY ‘15 decline is driven by fewer high grossing 3D enabled movies. The calendar fourth quarter of 2014 had a dearth of high quality 3D movies and RLD announced an all-time low global box office of $338M. By way of comparison, the peak box office quarter was nearly $1.2B in September of 2011. The current quarter is not expected to be much better and may be even worse, although I think this issue is well understood by RLD investors.

However, things should improve on this front. Movie industry observers believe that FY ‘16/CY 15 has a densely packed slate of bankable action franchises, which tend to do well in 3D. Key titles include Avengers: Age of Ultron, Jurassic World, The Fantastic Four, The Jungle Book, Star Wars: Episode VII and Batman vs Superman: Dawn of Justice. The Star Wars movie is the first of three Star Wars films directed by master action movie director JJ Abrams and may be the largest movie event since Avatar. Looking farther out, James Cameron is concurrently working on not just one but three sequels to Avatar which are supposedly going to be released during the Christmas windows in three consecutive years starting December 2017. Considering the average worldwide RLD screen generated over $20K annually for RLD during Avatar’s heyday, there is considerable upside to the roughly $3,500 per screen I estimate for FY ‘15.

Putting it all together, while it is difficult to make a forward estimates of ticket sales for unreleased movies, I believe that global RLD box office will trough in FY ‘15 with FY ‘16 bouncing back to near FY ‘14 levels and growing from there as directors increasingly follow the lead of Avatar and Gravity to artfully incorporate 3D in the movie-going experience. By FY ‘18/CY ‘17 (which should include the first Avatar sequel), global RLD box office should surpass the FY ‘12 peak. RLD’s take of global RLD-enabled 3D box office has also increased over time largely due to its growing installed base in China.

Shareholder Activism and Cost Issues

RLD had $28M of GAAP opex in FY ‘09, the last full year before going public, and $43M in FY ‘10. Expenses ballooned from there, growing with revenue to $76M in FY ‘11, increasing further to $86M in FY ‘12 while revenue flatlined, and incredibly growing to over $97M in FY ‘14 on the back of two consecutive years of revenue declines. Since then—and I believe at least partially due to activist pressure—RLD has announced a couple of rounds of cost cuts that should bring GAAP opex to around $88M in FY ‘15 and possibly as low as $78M in FY ‘16. Still, it is hard to figure out what RLD needs to spend $78M per year on given that its core business of cashing 3D royalty checks has no COGS and should not be particularly resource-intensive. The company is installing virtually no new domestic 3D cinema systems and is well-established internationally, raising the question of why the company needs to spend over $20M per year in sales and marketing. Most curious is the G&A spending which was over $50M or 25% of sales in FY ‘14.

The combination of a stagnant but high margin recurring revenue stream coupled with high and rising operating expenses due to investing in non-core initiatives has attracted activist investors. Altai Capital Management first filed a 13D on RLD in February of 2014. Altai has reduced its position since then, but the mantle has been taken up by Starboard Value who filed their initial 13D in April of 2014 and made a public offer to buy the entire company for $12.00 per share on October 1st, 2014. My impression is that the activists believe that RLD should be operated as a high margin royalty business focused only on theater 3D exhibition while CEO Michael Lewis wants to become a broader visual technologies company. Naturally, the main point of contention is the spending on all of the non-core business initiatives mentioned above. I tend to side with the activists on this question as from what I can tell RLD’s other initiatives mostly have small markets and/or will be difficult for RLD to commercialize.

While RLD has not made any changes to its board to date, I believe that activist pressure has resulted in the cost cuts discussed above as Michael Lewis tries to strike a balance between making the investments he wants to become a broader company and maintaining a decent level of EBITDA. The company has thus far refused to seriously engage Starboard pursuant to its acquisition offer or otherwise evaluate strategic alternatives although it is looking closely at non-core R&D expenses according to public statements. While I believe that Starboard would like to own the entire company for $12.00, I do not believe they necessarily expected to succeed with their bid and instead wanted to use it as a jumping-off point to get the company to restructure or consider selling itself. While I have no direct insight, I think it is logical to conclude that a proxy fight for the three out of seven board seats up for election in 2015 is likely. The nomination deadline for this year’s proxy is February 23rd so we will find out soon. RLD has a staggered board and Michael Lewis owns around 11% of shares outstanding so there are some barriers to activism and it would take two proxy cycles to control the board.

Financial Performance and Valuation

RealD’s EBITDA peaked at $105M in FY ‘12 and Wall St. analysts expect EBITDA to trough in the current fiscal year at around $51M. As the company matures EBITDA is a decent proxy for operating cash flow and the D&A from previous Cinema System installations far exceeds current capital expenditures. For example, I expect around $42M of D&A this year versus less than $20M of total capex. Based on announced cost cuts and an expected improvement in royalty revenue Wall St. has RLD modeled to do nearly $80M of EBITDA in FY ‘16 while I believe the company could achieve around $100M of adjusted EBITDA and FCF of $65M. Based on a $11.00 stock price, 50M fully diluted shares outstanding, $50M of cash and $34M of debt, RLD trades around 10.3x current EBITDA and more importantly less than 5x my estimate of next year’s EBITDA. By comparison, IMAX trades at 19x current/14x forward EBITDA and DLB (a potential acquirer) trades at 10x to 11x. Using 10x next year’s much higher EBITDA, I believe the stock has the potential to nearly double simply from the improved film slate and announced cost cuts. EBITDA could grow considerably after FY ‘16 as the Star Wars and Avatar sequels hit the theaters in the same years.

The current dynamics around RLD provide further potential upside. First, if Starboard succeeds installing board members, the company may further cut costs related to its products outside core 3D theatrical distribution as well as G&A. An activist-influenced board may also consider selling the entire business, which I believe could be particularly attractive and accretive to Dolby but also may be interesting to Sony, Imax or private equity. The company could also consider employing leverage for a significant stock buyback. The market seems to attribute no value to the other product lines despite RealD’s eight figure investments, so any revenue from selling or licensing these other products would be upside. While I am not necessarily a believer, if the company convinced major smartphone and tablet manufacturers to license Intelilight the revenue could conceivably be greater than 3D box office royalties.

Conclusion

RealD’s current low stock price and poor near-term performance gives investors with a 12-36 month time horizon an opportunity to purchase a great business with high margin recurring revenue and substantial barriers to entry on the cusp of improved financial performance and activist pressure to deliver for shareholders. I believe the stock price has the potential to double over the next 12 months and potentially do better from there as the 3D film slate improves, new products gain traction and/or the business is sold.

Key Risks
•    RealD’s 3D box office not improving as I and the industry expects
•    A strong dollar is going to lead to lower translation of foreign license revenue
•    Continued wasteful spending on non-core initiatives
•    Starboard losing its potential proxy fight or otherwise failing to gain influence
•    New competition potentially emerging in 3D cinema systems

Disclaimer: I hold shares of RLD and may buy or sell shares at any time without notice.

Catalyst

• Improving film slate with higher 3D box office starting in calendar Q2
• Potential proxy fight
• Further cost cuts or announcements of traction with new initiatives
• Star Wars in Q4