Monday, 12 October 2015

Cineplex, I don't get it

I've heard the arguments (resoundingly). They are the only game in town. They have 80% market share of the Canadian film distribution space.  Management are brilliant.  They are recession proof.  They have pricing power due to audience captivity.  They are a cash flow generating machine (and will undoubtedly remain so).  They are having a tough year this year due to a dearth of box office hits, but wait until xmas, next summer, next xmas.

And for this privilege, investors continue to pay up, and I ask myself, why?

The more I read about attempting to operate with a margin of safety, the more I'm starting to think that conventional logic surrounding Canadian widely accepted dividend favourites is something of a farce.  The most chased after stocks end up becoming bid to the point of silliness on the presumption of an infallible business model, and/or safety.  The sad thing about all of this is, the more over-owned a stock gets, the riskier owning it becomes.

Cineplex used to be an income trust pre-2011 and converted to a corporation on Jan 1, 2011. Since 2010, the stock has compounded at close to 23% annually.  At last check, here are the snapshot valuation metrics:

TTM EPS of $1.21
2015 expected (I hate using this) EPS of $1.59

(The forward estimates get even more ridiculous):

2016, $2.04
2017, $2.46
208, $2.98

Let's assume I'm stupid (fair assumption some of the time), and consensus estimates are accurate.

Here are the forward P/E's:

2015, 30x
2016, 23x
2017, 19x
2018, 16x

And I start thinking about the imputed growth assumptions buried in these estimates.

TTM 2014 eps was $1.21, 2018 E is $2.98.  This puts estimated growth in eps at around 25% compound.

Here's a look-back to actual EPS / unit growth between 2010 and 2015 (including the absorption of the Empire theatre chain):

201020112012201320142015Growth
Actual EPS0.890.861.971.331.211.5912.31%

Ok, so analysts are basically estimating double the actual compound growth in EPS between 2014 and 2018.  I wish I was able to see this far into the future.

The business model is fairly straightforward.  "Build it, and they will come".

In my layperson's opinion, the business model is a function of:
  1. # of locations/screens
  2. # of patrons
  3. elasticity of audience demand to pricing for films and concessions
  4. minimization of film distribution costs (if possible)
  5. # of box office hits 
  6. competition for patrons via other means of large scale media captivity
I examined the actual metrics in growth per Box Office, Concessions, Media, and # of Patrons, since 2010, and here's what I came up with:

201020112012201320142015 (6 months)2015 annualizedGrowth
Box Office5985776386656723426842.74%
Per Patron8.678.748.979.159.139.199.191.17%
# patrons (m's)68.9766.0271.1372.6873.6037.2474.48
2010201120122013201420152015 annualized
Concession2952923293503751993986.19%
Per Patron4.274.414.634.825.095.355.354.61%
# patrons (m's)69.0966.2171.0672.6173.6737.2374.46
2010201120122013201420152015 annualized
Media829184110134641289.32%
Total9759601,0511,1251,1816061,2114.43%
Total revenue1,0069981,0921,1711,2346351,2704.77%
96.93%96.19%96.28%96.04%95.72%95.36%95.36%

Ok, the growth is reasonable, but certainly not worth justifying a premium valuation.

So maybe, I need to look at free cash flow.  After all, investors likely own this moreso for the dividend than for the growth.

2010201120122013201420152015 annualized
Standardized FCF89.20117.60111.08165.8078.40-9.20-18.40
Adjusted FCF128.55114.02126.92154.50145.5068.49136.981.28%
Standardized FCF/Adj69.39%103.14%87.52%107.31%53.88%-13.43%-13.43%
Dividends77.8568.0680.7988.693.247.695.2
Dividends/Standardized FCF87.28%57.87%72.73%53.44%118.89%-517.39%-517.39%
Dividends/Adj FCF60.56%59.69%63.65%57.35%64.05%69.50%69.50%

I don't see much in terms of growth in Adjusted FCF either, about 1.3% compound since 2010.

Quick digression into accounting land (I am an accountant after all).


They use two non-GAAP measures to define free cash flow. 
  1. Standardized FCF, = cash from ops – capx
  2. Adjusted FCF, = standardized FCF + non-cash working capital changes and a bunch of other adjustments. 
 Re: 2. I don’t understand the adjustments for “change in operating assets and liabilities” and for “Growth capital expenditures and other” which they define as follows:

“Growth capital expenditures and other represent expenditures on Board approved projects, exclude maintenance capital expenditures, and are net of proceeds on asset sales.”

Their entire business is predicated on either acquiring or building new theatres or maintaining existing theatres, right? 

I examined the Q2 2015 balance sheet, they have a significant amount of A/R and deferred revenue and I was wondering, why? 

Well, they sell gift cards, and I think they account for them as follows:

Dr. gift card A/R (if sold by a 3rd party, like Shoppers)

Cr. Def’d revenue

And when Shoppers pays:

Dr. Cash

Cr. A/R

Or

Dr. Cash (if sold by Cineplex)

Cr. Def’d revenue

When the gift cards are redeemed, they do the following:

Dr. Def’d revenue

Cr. Revenue

All this said, I still don’t understand why they would reverse the impact of the non-cash change in working capital to figure out adjusted FCF.


I actually think this is a significant piece to understand the business, because it makes the difference between a payout ratio of. 7x vs. 1.67x, and investors own this for the dividend.
  
I came up with the following three possible cases regarding cash flow adjustments in respect of gift cards (if any accountant readers out there want to shed light on this, please feel free to leave a comment, and/or school me)

Case 1)

No external gift card sales - all gift cards sold by CGX. No a/r. They get cash up front. They can't recognize the revenue, so they have to set it up as def'd until the cards are used.‎ Once the cards are used, they reduce the deferred and increase revenue.

On the cash flow statement, there's no income impact (revenue hasn't been earned, so no adjustment to net income).‎ It's a source of cash upfront, so this case wouldn't require an adjustment to the adjusted FCF amount.

Case 2)

100% external gift cards sold by Shoppers. They haven't received the cash. They need to set up an a/r from Shoppers, and a def'd until the cards are used. Once the cards are used, they reduce the deferred and increase revenue.

On the cash flow statement, there's no income impact (revenue hasn't been earned, so no adjustment to net income).‎ But, it's not a source of cash upfront, they haven't collected it yet.

When Shoppers remits cash, they reduce a/r and increase cash.‎ This is a source of cash, so unless they reduced income on the cash flow statement from the increase in a/r (not sure why would they do this though - the act of collecting cash from shoppers wouldn't touch income), there should be no adjustment to adjusted FCF.

This leads me to case 3)

Case 3) patrons redeem cards

They've already collected cash in 1) and 2), so in this case, they recognize deferred revenue as revenue, but there's no cash involved, so in this case, they would reduce net income by the impact of non cash change in deferred revenue.

Standardized FCF was ($9,241) for the first six months of 2015.  Ok, they had lower box office revenues and higher capx (more theatres acquired, maintained or built).

If I were to calculate my own version of FCF, I’d take standardized of -$9,241 +/- any other non-cash adjustments.

I would never in 1m years think about adding back working capital adjustments of $40M or “discretionary” board approved capx of $34M.  It’s like saying, had we not built or acquired the new theaters, or had we not sold gift cards, our FCF would be X, not Y.  But isn’t this what they have to do in order to continue to make $?  Acquire or build new theaters, and sell and redeem gift cards and vouchers?  Isn’t this the whole crux of the business model in order to generate cash flows to continue paying dividends equal to between 60 & 85% of “Adjusted FCF”?  Per their Q2 report:

8. ADJUSTED FREE CASH FLOW AND DIVIDENDS (see Section 17, Non-GAAP measures)

Cineplex’s dividend policy is subject to the discretion of the Board and may vary depending on, among other things, Cineplex’s results of operations, cash requirements, financial condition, contractual restrictions, business opportunities, provisions of applicable law and other factors that the Board may deem relevant. It is anticipated that Cineplex will pay a monthly dividend, subject to the discretion of the Board, at an annualized rate in the range between 60% and 85% of adjusted free cash flow per Share

Using Cineplex adjusted FCF of $68,489

Dividends paid YTD  of $47.6M / adjusted FCF of $68.5M = .7x payout ratio, in line with their range.

If I reverse the working capital adjustment, I get:

Dividends paid YTD  of $47.6M / adjusted FCF of $28.5M = 1.67x payout ratio, 2x their range

And of course, looking at the cash flow statement:

I get, operating cash flow of $38M – capx of $47M = -$9M – dividends of $47M = -$56M in actual real cash used.  So they had to borrow $50M to maintain the dividends.  Now, this is probably just a function of 2015, because both Standardized FCF and Adjusted FCF were > 0 in all years except 2015, but I certainly think there's a disparity between the two measures.

With the exception of 2014 and 2015 though, the payout ratio using Standardized FCF was still within the Adjusted FCF payout range of between 60% and 85%, so I'm probably just on a wild goose chase here.

Back to valuation

I made the following assumptions in order to derive a valuation range:

  • Management expects to add 2-3 new theatres per year (per the most recent 2015 Annual Information Form):
  • On average, each theatre has 10 screens
  • For years 1-5, I estimated 3 new theatres per year
  • For years 6-10, I estimated 2 new theatres per year
  • Years 10+ (terminal), 0 new theatres (probably overly simplistic, but I want to be conservative)
  • Years 1-5, grow free cash flow at G = 4% (approximately equal to compound revenue growth since 2010)
  • Years 6-10, grow free cash flow at G = 2% (1/2 years 1-5 G)
  • In order to model the above, I have to come up with an average FCF margin relative to total revenues (I'll use Adjusted FCF and not Standardized FCF)

2010201120122013201420152015 annualized
Total revenue1,0069981,0921,1711,2346351,2704.77%
Locations1311301341611611621624.34%
Per location7.687.688.157.277.663.927.840.41%
Adjusted FCF as %ge of total rev's12.78%11.42%11.62%13.19%11.79%10.79%10.79%11.77%Average


Terminal
20162017201820192020202120212022202320242025
Locations164167170173176178180182184186186
Total rev per location8.158.488.829.179.549.739.9210.1210.3210.5310.74
Total estimated rev1,3371,4161,4991,5871,6791,7321,7861,8421,9001,9591,998
Avg adjusted FCF margin - 10-15157167176187198204210217224231235
PV @ 9% Re144140136132128122115109103971,104
Sum of PV's2,331
Net Debt530.75
IV1,800
o/s shares63.60
IV / share28.30
PV @ 10% Re1431381331281231151081019589907
Sum of PV's2,078
Net Debt530.75
IV1,547
o/s shares63.60
IV / share24.32
PV @ 12% Re14113312611911210395888174631
Sum of PV's1,701
Net Debt530.75
IV1,171
o/s shares63.60
IV / share18.40
PV @ 12% Re137126116107988879716457387
Sum of PV's1,330
Net Debt530.75
IV799
o/s shares63.60
IV / share12.56


In all cases, I get a FCF valuation at significantly less than current share price.  I then ran the similar base case FCF #'s through my valuation matrix.  Here are the results:


2-Stage DCF
TWO STAGE DCF
Free Cash Flow157.36
SharesOut63.60
Net Debt530.75
IV per share-5.87
IV per share
Sum of DFC'sRe =
G = 8%9%10%12%15%Average, growth, blended Re
0,022.5819.1516.4012.278.1515.71
1,023.9419.4216.6612.528.3816.19
3,1.530.4323.9720.4615.3110.3020.09
4,233.5925.8221.9916.4411.0821.78
5,2.537.0727.8023.6317.6311.9123.61
7,3.545.1832.2527.2720.2413.6827.72
8,449.9234.7529.2921.6714.6430.05
10,561.1040.4033.8124.7916.7035.36
Average, Re, blended growth37.9827.9423.6917.6111.85
Current47.5847.5847.5847.5847.58
Prem/Disc25.29%70.27%100.85%170.21%301.40%


I've highlighted G = 4,2 for a range of discount rates to reflect the historical growth in revenues since 2010, although this is probably a leap of faith as actual Adjusted FCF has compounded at much less than 4% since 2010.

In any case, this is a lot to digest.  The current price only seems to makes sense in terms of supporting FCF valuation if go forward FCF growth falls into the 7,3.5% and above range at much lower Re's than I think are warranted currently.

As I've pointed out in previous posts, I feel much more comfortable operating from the top right hand side of my FCF matrix where current market price is pricing in zero growth at the highest possible Re's, than I am at the bottom left hand side of the matrix.



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