Jun 2, 2021
[6 min Read]
Cineplex Inc., listed as CGX on the Toronto Stock Exchange, is a Canadian entertainment and media company that operates movie theatres across Canada. It operates through four segments: film entertainment and content, media, amusement, and location-based entertainment. As of December 31st, 2020, the company-owned, leased, or had interests in 1,667 screens in 162 theatres, as well as 8 location-based entertainment venues in four provinces.
Cineplex is a top-tier Canadian brand and is the country's largest film exhibitor. However, the impact of the pandemic on CGX's revenue was substantial. By the middle of March 2020, Canadian provinces introduced a state of emergency and the closure of non-essential businesses meant that CGX also had to close down. Its revenue dropped 75% from 2019 and has been down over 80% in the LTM. However, revenues are projected to sharply rebound by the end of 2021 and continue to grow, more information on this will be explained within the thesis.
From a financial point of view, the company has very low operating leverage, most of its costs are variable, and this has prevented its net income from dipping extremely low. Though its revenue sharply declined, so did its cost of goods sold and SG&A. The primer driver of its negative net income was its interest expense. Given that there was little to no EBIT generated, the firm did not have a great interest coverage ratio over the past 24 months, however its large cash flow balance has allowed investors to retain faith in CGX to remain solvent.
Cash levels were maintained through the sale of PP&E, the issuance of 303mm of long-term debt, and the tightening of dividend policy. Cash levels have remained above 10mm, near the 2019 pre-pandemic levels. In addition to this, CGX also has 259mm of a bank revolver undrawn which provides additional liquidity to the company.
Cineplex has a competitive advantage of being the prime film exhibitor within Canada. Its only Canadian competitor, Landmark Cinemas, tends to operate in smaller towns as CGX dominates with the larger and more population dense cities such as Toronto and Ottawa. CGX is also much larger than Landmark and benefits from economies of scale, specifically the ability to raise capital at a lower cost which is a large survival driver within the current market condition.
CGX is effectively unopposed within the Canadian Industry, which gives them great pricing power and provides stability for investors.
Research expects that the theatre exhibition industry will rapidly grow towards the end of 2021. With a backlog of movies that are still waiting to release and the increasing vaccination rates, the pent-up demand for blockbuster films could propel the industry out of this large trough.
The key success driver in the industry right now is the ability to stay liquid. Sales have significantly dropped which could put companies in liquidity and credit crunches if they are unable to generate cash flow from other sources.
The industry also expects that external competition through online streaming platforms is increasing, it is not entirely a zero-sum game. A Harvard business review study in Korea revealed that most theatergoers remained loyal to the theatre experience even when they had the option of watching the movie at home. Similar trends were seen with hardcover books, whose sales remained steady even after more books became available on tablets and online. John Fithian, the president of the national association of theatre owners was correct when he argued that “theatres provide a beloved immersive, shared experience that cannot be replicated.” The HBR study revealed that the business was not zero-sum and that the propagation of streaming services actually brought in new consumers into the mix, which is good for the industry as a whole.
A great example of the retained demand for the theatre experience is in Europe. During May, the UK and France reopened theatres, and advance sales were extremely strong. This has demonstrated that there is still a clear appetite for the big screen experience across the world and that in-home streaming simply cannot replicate the movie theatre experience.
CGX has been proactively cutting costs and raising capital throughout the pandemic. Its AGM discussed efforts to reduce operations costs through rent and payroll adjustment and new liquidity events to increase cash and handle the annual cash burn.
From a cost control perspective CGX has curtailed capital expenditure, suspended dividends, deferred lease costs, and reduced salaries through layoffs. Payroll costs have been lowered from $5.2 million in the fourth quarter of 2020, which is much lower than the $41.9 million from the same quarter of 2019. This cost-cutting coupled with its already low operating leverage has served to minimize the impact of reduced volume on its bottom line and improves its ability to use existing cash balance to repay interest expenses and prepare for the eventual reopening.
From a liquidity perspective, as mentioned earlier, PP&E sales and debt raises through second lien notes and convertible debentures have provided them with available liquidity of 3,317mm. A sale and leaseback of the head office was conducted so the proceeds could be used to repay outstanding credit debts. In addition, the Scene program has been renewed with Scotiabank and this has allowed the company to secure an additional $60 million. With an estimated monthly cash burn of ~26.9mm, this is more than enough to power CGX through up until operations can begin again.
The margins production companies make from movie sales to theatres are much higher than what is earned through online streaming platforms. This is evidenced by the fact that Hollywood opted to postpone most of its movie releases in theatres, such as Fast and Furious 9, rather than release them on streaming sites. Streaming sites are a very low margin proposition for movie studios and given the high costs associated with the production business, theatre contracts are a large part of how these studios recoup their costs. Though companies like MGM are releasing films simultaneously within theatres and on streaming platforms, the power Cineplex has through the boycotting of specific studios can significantly influence decisions such as these because of CGX being the Canadian market leader.
Canada is unique in that majority of its non-essential businesses have been closed for over a year. As a result of this, there is a lot of pent-up demand not just for CGX's theatre business, but also its entertainment and amusement arms which include Playdium and Rec Room. CGX offers experiences that were unavailable to consumers for the majority of the pandemic so it is clear that as soon as restrictions ease up, a short-term surge in demand will follow. CGX will be able to capitalize on this surge as it is the market leader in the Canadian space. This surge will also serve to bring the share price back up to 2019 levels as the market realizes that it is not the end of this movie exhibition business.
A relative valuation was not pursued for CGX. This is primarily due to the extreme volatility of similar movie theatre businesses in the United States and the lack of publicly traded competitors within Canada. It would be very difficult to compare CGX on a like for like basis with an American Company, in part due to the volatility of specific movie theatre stocks due to short selling and retail investors trading frenzies, but also that fact that the pandemic situations in the geographies are different and the multiples would not entirely match up.
An intrinsic discounted cash flow valuation was taken up instead. Optimistic growth estimates for 2021 and 2022 were estimated due to the surge that would be seen through reopening as well as the backlogged movie slate that would drive sales throughout 2021 and 2022.
Revenue growth estimates were constrained for 2021 given that a quarter without operations has already passed, but revenue growth does grow for almost every segment during 2022. From 2023 onwards the growth levels slowly fall towards stable levels of around 5-3%.
Working capital ratios were the same for the most part other than the day's payables outstanding which were slowly decreased to account for the gradual tightening of credit terms from suppliers who have become more lenient during the pandemic.
From a PP&E perspective, capital expenditure was projected to be very low for the remainder of 2021 but pick back up from 2022 onwards, based on management guidance from the annual general meeting.
Overall, under a WACC of 7.37% and a terminal growth rate of 1.59%, an implied share price of $23.96 was estimated which represents an implied upside of ~55%.