Imax: short thesis

The main reasons to short Imax (in my opinion):

  1. Overvalued.  The P/E ratio is roughly 50 (higher if you ignore profits from tax-related reasons).
  2. They are close to saturating their markets and therefore Imax’s profits will start dropping in the future.
  3. Historically, the company has not made money and still has negative retained earnings.  The economics of its niche is not good.
  4. Slightly aggressive accounting that inflates profits.

I don’t think that I am the only person with this idea as Google Finance shows that Imax has 65.89M shares outstanding and the short interest has shot up to 12.2M shares short (see NASDAQ site).  That’s roughly 18.5% of outstanding shares short.  The borrow is very cheap.

The technology/product landscape

Imax is in the business of the highest-quality exhibition experience.  Currently, Imax has a mixture of film and digital projection systems.  There are some advantages to the film systems over the current digital systems (and vice versa).  However, the film systems have not been a profitable market in the past and it is highly likely that they will be replaced with some type of digital solution.

Currently, the digital projection market is dominated by Christie’s 2K projector.  Sony’s 4K projector has a smaller market share.  In theory, you could argue that Sony’s 4K projector is better as it has more resolution.  However, not that many films are mastered at 4K resolution (see Sony’s list) and Sony’s projector has lower contrast than the Christie.  Lower contrast can create the impression of lower perceived sharpness.  Overall, I would say that the difference between the two projectors are mostly irrelevant and there is little marketing being done to make a distinction between Christie and Sony projectors.

Imax’s digital projection system consists of 2 Christie projectors that stack their images on top of each other.  The end result is a picture that is twice as bright.  The images are also offset by half a pixel, so that the effective resolution is somewhere between 2K and 4K.  I do not believe that these technical advantages give Imax a significant edge in image quality.

Screen Size

Screen size is probably much more important to audiences than subtle differences in resolution, image brightness, and contrast.  Imax (“lieMAX”) has some critics (e.g. Aziz Ansari) as the newer digital screens tend to be much smaller than the film-based Imax screens.

Laser projection

In the future, projector manufacturers will likely move towards using lasers as the light source instead of a xenon bulb.  The presentations at the Laser Illumination Projector Association’s website has information on the advantages and disadvantages of lasers.  The main advantage is that even brighter projectors can be created.  This should be the catalyst for Imax converting its remaining film-based systems to digital as the digital systems aren’t bright enough for the massive screens.

Brighter projectors enable two things:

  1. Larger screens.
  2. Better 3-D.  The problem with current 3-D is that the polarizing glasses make the image very dim.
    In the future,

The disadvantage to using laser as a light source is laser speckle (see this Kodak presentation on Youtube).  Kodak has developed technology to reduce this problem.  How noticeable the remaining laser speckle is remains to be seen, though I believe it will be minimal and barely noticeable.  Imax will pay fees and royalties to Kodak to license its patent portfolio.  Imax has partnered with Barco to build laser projectors.  Laser projectors will be much more expensive than traditional projectors as the various methods used to reduce laser speckle add significant cost to the projector (as the presenter in the Kodak presentation admits).  However, I believe that these projectors make sense for Imax as it will be able to convert its largest screens to the digital format.  Imax can save money on the costs associated with producing film prints.

In the long run, Imax may be able to capitalize on its technology by convincing exhibitors to build more theatres with very large screens.  I would note that historically this has been Imax’s business model in the past and it did not make money.  While it didn’t work when Imax was these large screens only exhibited films designed for an institutional market (e.g. documentaries), the business model could in theory work for showing commercial blockbuster films.

I do not believe that Imax has an economic moat as other companies may develop a superior laser projector.  If you look at the roster of the LIPA, you can see that there are several manufacturers in the field.  Given that Imax likely will not have a sustainable competitive advantage, I am not sure if Imax deserves such a high P/E or P/B multiple.  As well, some exhibitors are realizing that they can slap a premium onto the best screen in their theatre and thus offer a “premium” viewing experience (*there may be minor improvements such as slightly better sound, better seating, reserved seating, etc.).  The end result is not that different from Imax’s current digital offering.

3-D

Imax’s 3-D is arguably inferior to RealD’s 3-D system.  RealD (NYSE:RLD) uses circular polarization while Imax uses linear polarization.  Moviegoers watching a 3-D film with Imax technology cannot tilt their head too much or the 3-D effect will be reduced.  RealD has some ghostbusting technology to reduce the amount of ‘ghosting’ in 3-D (where the image for one eye can be seen faintly in the other eye).  RealD is the current market leader when it comes to 3-D projection.

The bull case

Basically, the bull case for Imax hinges on Imax being able to grow earnings and sustain them for years and years on end.  Here is one excellent writeup on Imax.

The bear case…

Imax’s operating earnings

I believe that stripping out the effect of accounting gains/losses on deferred income taxes gives truer picture of Imax’s profitability.  (Because Imax has lost so much money in the past, it has tax losses that it can use against future income.  In the past, these tax assets were written down because it didn’t seem likely that Imax would generate tax profits to use against them.  Now that it does seem likely that Imax can use these tax assets, they are coming back onto Imax’s books and a corresponding accounting profit is being reported.)

GAAP net income (thousands)
YE2011:  $15,543
YE2010: $100,779
YE2009: $5,021

Change in deferred income taxes
YE2011: -$8,089
YE2010: $54,275
YE2009: $8

Net income adjusted to remove the effect of (provision for) recovery in income taxes
YE2011:  $23,632
YE2010: $46,504
YE2009: $5,029

The average net income over those 3 years work out to be $25.055M/yr.  A market cap of $1.39B divided by $25M/yr profit gives a P/E ratio of around 55.  You’ll get slightly different results if you use Imax’s last 4 quarters.  But no matter how you cut it, Imax’s P/E ratio is very high if you consider profits from its operating business.

Market saturation

The Q2 2012 10-Q states:  “The Company believes that over time its commercial multiplex theater network could grow to approximately 1,700 commercial multiplex IMAX theaters worldwide from 529 commercial multiplex IMAX theaters as of June 30, 2012.”

After Imax manages to saturate its market, what will it do?  The market cap is roughly $1.39B.  Divided by 1700 theatres, Imax would somehow have to have made $817k per screen to justify its market cap.  Its margins on theatre sales just aren’t that high.  New installations have a revenue of around $1.3M each so Imax would have to make a 63% after tax profit margin on each sale.  That doesn’t seem likely.

Accounting Issues

On the plus side, Imax does have some ‘hidden’ assets.  Its film cameras have a book value of almost zero yet they are still being used and generate revenue.

Everywhere else, Imax’s accounting leans towards the aggressive side.

Amortization of technology

It is amortizing its technology acquisitions (e.g. Kodak license) in a curious way.  According to its financials:

“The net book value of these other intangible assets was $22.9 million as at December 31, 2011, as the acquired assets will be amortized over the expected consumption pattern of the benefits from the assets, and the Company has yet to begin the exploitation of the acquired assets.”

I find that it is a little unusual and aggressive that it is deferring the amortization of its acquired technology/intangible assets.

As far as its exhibition equipment goes, Imax depreciates its “theatre system components” on a straight-line basis.

Equipment and components allocated to be used in future joint revenue sharing arrangements, as well as direct labor costs and an allocation of direct production costs, are included in assets under construction until such equipment is installed and in working condition, at which time the equipment is depreciated on a straight-line basis over the lesser of the term of the joint revenue sharing arrangement and the equipment’s anticipated useful life.

Economically, I would expect that the value of the equipment to go down the most in the first year (much like computer equipment).  Items like digital projectors become obsolete very quickly, e.g. Imax’s 2K Christie projectors have been made obsolete by Barco’s 4K projectors (which Imax will begin using in its digital Imax installations).  By using a straight-line basis (instead of declining balance), depreciation is significantly understated at the beginning and overstated at the end of the depreciation period (7-10 years for Imax’s joint ventures).  As Imax is in its expansion phase, we are in a period where Imax’s depreciation would be understated.  Note that whenever Imax amends its joint ventures from 7 years to 10 years, depreciation will go down to reflect the longer term.

Credit Quality

Imax’s use of leases in selling its equipment is an area of possible concern.  Between 2011 and 2010 there seems to be a sharp drop in customer credit.  Imax has three tiers of credit quality: “In good standing”, “Pre-approved transactions”, and “Transactions suspended”.  The latter two categories went from $9,138M in YE2010 to $17,289 in YE2011.  As a percentage, the two categories went from 11.6% to 19.5% of all financed sales receivables.

Cash flow

When I short stocks, one of the top things I look for is negative cash flow.  The reason is that common methods of inflating profits (and book value) do not affect cash flow.  One method is to improperly capitalize expenses.  On the statement of cash flows, this will cause capital expenditures (e.g. purchase of property, plant and equipment) to be inflated.  If you adjust net income by adding D&A (depreciation and amortization) and subtracting capex (capital expenditures), you would get a truer picture of a company’s profitability if it is playing accounting games.

With Imax, looking at cash flow can be misleading.  Its use of joint ventures and sales-type leases means that it makes sense for Imax’s capex to exceed D&A.  Sometimes companies can abuse such strategies to allow them to book profits that evaporate later.  If you provide leases that make it easy for the other party to walk away, the other party may be essentially renting your product with the intention of walking away from the lease before it ends.  It would result in inflated profits in the short term while in the long term some of those profits would be reversed.

But, this may not necessarily be the case with Imax.  Exhibitors may have too much skin in the game as they have to make architectural changes to their theatres to move the screen closer and to reduce seating.  Also, there is a legitimate business reason for Imax’s customers to prefer the sales-type leases and joint ventures.  There is a risk that Imax will not be able to put out decent content to feed the Imax screens.  Imax has to negotiate with content holders to make an Imax version and has to spend money on running their content through the DMR process.  So not that many commercial movies can be shown on Imax screens.  The alternative financing solutions help ensure that Imax is doing a good job as Imax takes a greater share of its risks.

Of course, if I am right about Imax booking profits that will not materialize, then it is a good thing for the short thesis.

Insider compensation

Insider compensation runs rather high.  If it was lower then the operating profitability of Imax would be significantly higher (which would be bad for the shorts).  However, I don’t expect the level of insider compensation to change much.

3net

3net is a joint venture between Imax, Sony, and Discovery for 3D television programming.  Its carrying value could conceivably be slightly inflated:

Investments in new business ventures are accounted for using ASC 323 as described in note 2(a). The Company currently accounts for its 10.1% investment in 3net, a 3D television channel operated by a limited liability corporation owned by the Company, using the equity method of accounting. The Company accounts for in-kind contributions to its equity investment in accordance with ASC 845 Non-Monetary Transactions (“ASC 845”) whereby if the fair value of the asset or assets contributed is greater than the carrying value a partial gain shall be recognized.

If Imax assigned a value to its in-kind contribution that is too high, then it will recognize a partial gain on its 3net investment that is higher than it should be.  In the end, even if there is aggressive accounting here I don’t believe that it is really meaningful.

Closing remarks

All in all, my opinion is that Imax is a pretty good short.  It is overvalued and it does not seem like it will have crazy earnings momentum or price momentum.  I believe that the risk of shorting it early only to see it rise several times (like GMCR) is low.  (But then again, look at what happened with Volkswagen… it wasn’t supposed to skyrocket because it was a large cap stock, but it did.)

I suppose the biggest risk with Imax is that its laser projection really takes off and gives Imax a strong value proposition to moviegoers.  I wouldn’t be surprised if what Imax says in its Q2 2012 10-Q will become reality: “The Company believes that these arrangements with Kodak and Barco N.V. will enable IMAX projectors to present greater brightness and clarity, a wider color gamut and deeper blacks, and consume less power and last longer than existing digital technology. The Company believes that a laser projection solution, which it plans to introduce in the second half of 2013, will allow IMAX’s network to show the highest quality digital content available.”  The question is economics.  To justify a $1.39B market cap, Imax has somehow generate massive profits in a world that may only support 1700 screens.

*Disclosure: Currently short Imax and GMCR common stock.  I never shorted Volkswagen… I’m probably lucky for not researching that stock.

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2 thoughts on “Imax: short thesis

  1. Pingback: Film/TV production/technology stocks « Glenn Chan's Random Notes on Investing

  2. Thanks for the article. You divided 1.39 billion by 1700 theaters to get 817k per theater. If IMAX made that much per theater per year, they would make their entire market cap every year and have a PE of 1. That’s a pretty low PE.

    Your calculation indicates that if IMAX can make 81.7k per theater, they could have a PE of around 10. That seems achievable.

    At the time of writing, IMAX has just crossed 30 dollars per share with 750+ theaters and more than 250 in backlog. The stock isn’t cheap and their market cap is more like 2 billion now. Still, the new laser projection system may eventually allow theaters to get rid of their relatively small “liemax” screens and we may someday see 1000 or more real IMAX screens showing bright, high-contrast movies.

    I can understand not buying IMAX since the best case scenario may well not happen. However, shorting the company seems very risky to me. A LOT of people short IMAX (30% of the float as of today). The company is profitable and expanding and has a manageable debt. Even the pretty crappy liemax screens make good money (more than 1 million per year) compared to ordinary screens and the laser projection may actually roll out on schedule next year and permit more larger screens.

    I do agree that IMAX will not be making a profit of 1.39 billion dollars in a single year any time soon.

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