My Hollywood Thoughts

Alright I will answer all the questions brought up on the theaters & specific issues with RGC / CNK.
First, on Q2 -6% NA industry Box Office attendance decline.
Detail on the weakness: May & June as May Box Office was up 20% y/y for the month. April was EXTREMELY weak due to horrible product as Blades of Glory was the only movie that made any money in the month ($120m) as Disturbia topped the charts each week & only made $80m total & unfortunately topped the BO for each of the final three weeks of April vs. a Q206 april that had 4 different movies top the week chart (Ice Age 2, Scary Movie 4, Silent Hill, & RV) in addition to the extremely strong performance of Ice Age 2, which grossed $200m at the Box, & Scary Movie 4 ($120m). In total, april was down 23% vs. Q206 (-$120m short vs. Q206).
In May the three tentpoles drew huge crowds into the theaters, but the problem was that the movies were all released so close to each other that they definitely resulted in material cannibalization that wouldn't have been present if they would have been released in a more spread out fashion. Regardless, May was up 20% vs. Q206 and attendance was up 12%. Then came June, which really only had one disappointing movie - Evan Almighty (btw...the producer behind EA is a complete idiot....what dumb fuck spends $200m on a comedy? EA was most expensive comedy ever for reference) but the weakness was truly driven by the fact that the 3rd installments of the 3 May tentpoles all really were bad movies & thus had unprecedented drop offs after huge opening weekends as bad reviews / lack of originality didn't drive repeat viewings or the marginal movie goer to the theaters in June. As a result, June ended up comping down by -6% (-$70m) mainly due to lack of legs on the 3 tentpoles & the EA disappointment.

Q3 is up 17% QTD and may end up over 20% as the rest of comps are very easy. So, if you look at the entire summer its actually up 13% & is going to finish as the strongest summer ever meaning that all the hub bub about the Q2 shortfall is simply noise & due to timing issues on release dates. In addition, YTD the Box is up 8% on 5% to 6% price and 2% attendance growth on top of last years 3.5% attendance 3% price growth. So to me I think people need to stop worrying about isolated period y/y comparisons & realize the industry is in the second year of its traditional cyclical upturn, which btw is almost entirely always driven by the quality of product produced in LA.

Regarding your Q4 outlook, I think the slate looks solid as Vince Vaugn's Fred Clause will be big, Seinfeld's first movie - Bee Movie - will do very well, Alvin and the Chipmunks will surprise to the upside as it will likely drum up some old nostaglia the way Transformers did, which I believe will end up being the biggest movie of the year. In addition, National Treasure 2 & the Golden Compass will do well. Finally, the biggest source of upside may actually come from the 3-D releases of Beowulf & U23D as the media will provide enormous buzz around the brand new digital 3-D & spark interest in the incremental moviegoer. Mark my word, digital 3-D is the biggest thing to happen to movies since color. People still have very negative thoughts associated with 3-D due to memories of the poor quality analog 3-D & the red and blue glasses. I will post more on 3-D another time, but the main takeaway of this paragraph is that Q4 should be flat at worst but could surprise strongly to the upside as current expectations are extremely low despite the fact that the last two Q4's were very weak. Also, remember that the 3-D movies require 25% less atttendance than other movies / screen as they carry $2 to $3 price premiums. Michael Lewis, the founder of Real D who btw invited me to the premier of the U23D movie & promised to introduce me to Bono, has told me that he thinks that there will be 1000 3-D screens by the end of Q3. If we assume the movies have the same attendance as they would in 2-D, which is not in line with precedent as 3-d movies released to date have produced 2x the attendance per screen as the 2-D version, they comined take in a conservative $100m it would imply $100k per screen & 7.5k to 8.0k attendees per screen ($12.50 to $13 ticket price) vs. a required 10k attendees per screen under the 2-D $10 price scenario. Thus, the 2-D movie would require 10m attendees at current price levels which is 2m to 2.5m more people than the 7.5m to 8m attendees required to produce $100m in admissions revenue in the 3-D scenario, which means that there could be considerable upside to CKEC & RGC's Q4 earnings vs. current street & price implied expectations.


In regard to el cid's question on RGC's ability to maintain its dividend, you need to understand that its ~$320 to $350m in CFO is largely made up (2/3) of its $200m+ D&A non cash addition as depreciation expense is almost 2x annual capex of $125m due to the fact that RGC depreciates its PP&E over the term of its lease on its theaters (15yrs) vs. actual useful life avg. of close to 25 yrs. In addition, RGC's annual maintenance capex is only $40m meaning that $85m of annual capex is discretionary project capex that can easily be cut any year and not really effect results much in the ST (1yr to 3yrs) as RGC is not actually growing screens but rather closing low ebitda / screen theaters that usually are old flat floor theaters & replacing them with brand new 18 screen multiplexes that carry much higher ebitda per screen. Finally, the whole industry went through an enormous capex cycle in the mid to late 90s when they converted their theaters into stadium seating theaters vs. flat floor and grew screens at 6.5% vs. slightly less than 1% now. Thus, the industry has rationalized supply growth & has very little capex needs as the majority of the major circuits are not interested in growing screen counts. Also, the conversion to digital projectors will decrease the theater co.'s capex needs as well as they will no longer have to spend capital on replacing / purchasing new 35mm projectors b/c the hollywood studios are paying for the new digital projectors & have agreed to at least one replacement cycle as well. So, capex is a lever that can be pulled to increase dividend coverage as well.

However, forgetting about all of that accounting / P&L stuff for a minute, RGC has two years of dividends in cash on the balance sheet, an underleveraged balance sheet at 3x leverage vs. target level of 3.5x to 4x, which equates to roughly $300m to $600m of capital capacity on its current capital structure that could easily be used to support the dividend & offset a down year at the box office, and most importantly a new secular growth cash stream from its NCMI dividend that will be roughly $20m this year and I am estimating that it will grow to $60m by 2010, which provides RGC with almost 600bps of downside box office cushion on the downside as each 1% of box office growth = $10m in ebitda . Also,

For refence, the movie theater industry has grown at a 5% annual CAGR for the last decade as well as for the last 30 years. The growth is definitely cyclical but is based off of movie product from LA not economic conditions in the US. El Cid you are mistaken to think that the theater industry doesn't outperform in recessions / downturns as historical record has shown that the industry has exhibited the largest pricing increases / box office growth in economic downturns. The reason for this is because going to the theater is a value entertainment option as its by far the cheapest form of out of home entertainment. Yes, a $10 movie ticket price is looking steeper these days but relative to a $50+ seat at a Red Sox game (NBA & NFL games are even more) a $100+ concert ticket, and a $150+ theater ticket it looks like an old fashioned Warren Buffet value option. I mean look people aren't going to just stop living b/c there is a recession, they still are going to get out of their homes & seek entertainment as its human nature but the difference is that if you are curtailing spending, especially if your taking your family as the huge price disparity is multiplied by the # of attendees, then the movie theater looks like a very attractive form of entertainment on an economic basis. Concessions argument is flawed b/c every out of home entertainment option has ridiculous concession prices making it a wash. Finally, 50% of theater attendance comes from kids 12 to 24yrs old - people who are not economically sensitive and will always be more resistant to spending downturns as parents cut their own spending before their kids - a phenomenon that has historical precedent & makes logical sense.

Finally, understand that this industry is in the 1st inning of the biggest secular change in its history as it converts its 35mm projectors to digital projectors, which will materially improve the theater experience & theater profits via labor savings, drastically more efficient and flexible operating systems, more inventory that should drive incremental attendance, & MOST IMPORTANT the arrival of 3-D movies, which should materially improve RGC's revenues, profits, FCF, & ROIC due to the $2 to possible $5 price premium that 3-D movies provide theaters with and more importantly a likely increase in incremental attendance as these companies now can once again offer a differentiated product from home video. One note, 3-D movies will likely only be made for the top 10 to top 15 movies of the year as there is an incremental $5 to $15m in production costs & truly is not right for all movies. However, the top 10 movies represent about 35% to 50% of annual box office or about $4 billion to $5 billion of gross admission revenue. If you conservatively assume no incremental attendance & just a 25% ($2.50) ticket premium it would represent roughly $1bn to $1.25bn in incremental revenues and $300m to $400 in incremental ebitda as the price increase would drop right to the bottom & increase margins, of which RGC would likely capture $100 to $150 m (20% to 30% incremental growth) of as it has slightly over a 20% market share. Just to highlight the upside scenario, as I believe no incremental attendance is a very consersative assumption, assume the incremental attendance of 1.5x per screen to 2x per screen that the movies released in 3-D thus far have produced and the incremental ebitda becomes extremely large b/c it not only adds 10% to 20% in attendance growth to the ticket price growth discussed above, but it drives likely 15% to 25% volume growth in concession sales (3-D type movies will be the kind that are very concession friendly as many of them will be CG movies & others will be major blockbuster movies like Pirates or Transformers) on top of annual concession price growth of 4% to 5%. Remember concessions provide huge incremental ebitda due to the fact that they carry 85% gross margins on the associated sales. So my bull case scenario that assumes RGC has 3 to 4 3-D screens per theater, hollywood produces 10 3-D films, RGC charges $3 premium (btw the CFO has told me she fully intends on moving the premium up to $5 eventually) and that attendance per screen goes from 1.5x for the first film down to 1.1x for the 10th 3-D film, I arrive at incremental EBITDA of roughly $250m for RGC (50% incremental HIGH ROIC ebitda growth that will MOST definitely also drive multiple expansion as ROIC will materially increase along with profit and revenue growth) which I estimate equates to $20 per share in value per RGC share on current share count if I give this incremental profit stream a 12x multiple due to the fact that 1 3-D movie pays off the $17k per screen annual license fee that RGC will have to pay Real D for the technology (based on 1.5x attendance per screen vs. 2-D) meaning that all the rest of the incremental revenues from additional 3-D movies drive this revenue stream's ROIC above 100% to roughly 700% if there is 10 3-D films & RGC has 1500 3-D screens (~25% of its total screen count which is consistent with what the CEO has told me on numerous occasions and his target 3 to 4 3-D screens per theater & RGC has an avg. of 12 screens per theater).

So long story short, well i guess this post is by no means short, digital is going to add a second material secular growth driver to RGCs 23% stake in NCMI, which actually it gets paid twice on as NCMI growth will likely lead to stock price apprecation (my Dec. 2008 Target Price is $42 (80% higher than today's $23 price) and it will receive 23% of NCMI's FCF each year - I forecast NCMI LFCF will grow at a 20% CAGR through 2010 - as NCMI is structured basically in the same manner as a REIT in that it pays out like 90% + of its FCF.

BOTTOM LINE: Regal's dividend is not in any danger of being cut, i am highly confident that it will likely grow as it has historically as RGC has grown its dividend at a 4yr CAGR of 24% & has paid $17 of dividends since its 2002 IPO that priced at $22. If it makes you feel better about the 0% downside scenario, RGC never really even got below $19 in 2005 - the worst year in the theater industry since 1985 - on -9% attendance decline. 2005 was the year that incremental gross DVD HH growth peaked & 1985 is the year that gross incremental VCR HH growth peaked coincidentally, which I view as supportive of the thesis that disruptive technological breakthroughs in home video drive initial attendance shocks to the downside (2005 was largest attendance decline in industry since 1985 which was last year the industry saw double digit attendance decline. Even more supportive of the 0% downside case than the fact that a 9% industry attendance decline didn't drive the stock below $19 is the fact that the investor outlook on the industry was extremely negative as most thought the industry was on secular decline. Unfortunately for the bears, 2005 represent the cycle trough year as the industry saw a recovery in 2006 of 6% growth on 3% attendance / 3% price growth. As mentioned above, YTD the box office is up 8% & can easily be argued that it will finish up low double digits for the year as the remainder of Q3 has very easy comps & I believe Q4 will surprise investors to the upside meaning that the industry is still cyclical. Not only is the industry still cyclical in my view, but, unlike in 2005 when the stock failed to breach $19, it now has a secular bull story as the 2 new secular growth drivers mentioned above in the 20% plus growth in cinema advertising & loads of upside from the digital conversion should drive a move towards a secular growth period in the industry like it saw in the 1990s during the screen building period and will put off a cyclical downturn to at least 2011 or beyond.


Matt Weight / Doug: On the incremental financing from Wall St. for movies.

This is an interesting topic as I have befriended a former studio exec. whom I always have lunch / beers with when I am in LA to listen to whats incrementally new in the industry, that told me he thinks the financing from wall street will likely slow within 12 to 18 months - might be accelerated due to recent events in the market. Conversely, I have read in Variety recently that numerous new movie packages have once again been put together by banks like Merrill Lynch & Hedge Funds like Stark Investments, who found out that movie financing needs to be approached like a portfolio as some movies will work that you finance (300 this year) and some will disappoint (Poseidon last year). In addition, Hollywood film production offers an investment that is completely non-correlated to the general market movements - something very rate in bear markets like ours today that tend to drive all correlations to 1. Finally, I agree with MW in that many of these guys have a big rush from being part of hollywood & completely are driven by the sex appeal of movie production (even though its a high failure investment).

I do want highlight though that the finance community's movie investing has provided enormous incremental capital available to make movies & is definitely the reason why the number of wide release films has from ~400 in 2002 to 600 in 2006. Thus, there is a definite risk that the theaters will be hurt if this capital is no longer available, but it is something that won't be felt until the next decade. The reason for this is due to the sharp acceleration in movie production going on right now to build up a strategic inventory supply in anticipation for the coming labor strike that is expected to take place in 2008. THIS IS THE TRUE BEAR STORY. I am currently not worried about it as my contact at CAA tells me that the actors guilds will act tough early on but will definitely cave within 4 months, which is in contrast the to consensus opinion that the strike could last for a long time as the current guild president was elected on the premise that he will BE TOUGH in the upcoming labor dispute with the studios. Which side is true is tough to tell, but the problem is that the actors want a compensation solution for the upcoming digital convergence and the studios have yet to really adopt a standard economic model for the coming digital media revolution. Thus, if one side is asking for something the other can't provide, especially if the one side is full of uneducated clients which actors are, it could increase the probability of the downside scenario & increase the probability that there is a higher % of poor quality movies that have been greenlighted due to labor concerns.


So, I hope I answered all your questions, but if anyone has anymore feel free to post & I will respond.