The company embraced the switch to digital video, which has allowed Imax to digitally remaster blockbuster films into its proprietary large-screen format at much quicker pace and allow for day and date releases. The 2008 switchover at Imax has driven a rapid expansion of Imax commercial theaters from 210 in 2008 to over 1,150 today.
The company leveraged the digital switchover along with its assets to become the dominant player in the premium large-format cinema marketplace, with over 50% market share, and we believe it has carved out a narrow economic moat. On the demand side of the equation, audiences have flocked to see Imax movies; the company’s box office revenue increased from $272.8 million in 2009 to over $960 million in 2016.
Despite the rapid expansion and widespread audience acceptance, Imax shares have slid 20% year to date over concerns about the recent weak box office performance in the United States, franchise film fatigue, and the threat of shifting consumer preferences to watching movies at home via services like Netflix . While the recent summer season was considerably weaker than previous years, we believe the decline was due to the weak slate of films and does not indicate the beginning of a rapid decline in movie attendance. Additionally, we do not think that the disappointing summer box office necessarily signifies overall franchise or comic book film fatigue but rather reflects specific films. While Netflix continues to gain mind share, we note that the overall U.S. box office was up in both 2015 and 2016 and that fragmentation is a constant feature of the media landscape.
Despite recent box office woes, we still believe that Imax is well positioned to take advantage of continued audience appreciation for blockbusters via its current installed base and theater backlog. Even after a recent rebound, the shares are still trading in 4-star territory and may offer an attractive entry point to investors.
Three Sources Combine for Narrow Moat Rating
Our narrow moat rating for Imax is based on three of the five moat sources Morningstar has identified: intangible assets, customer switching costs, and network effects.
First, we believe Imax benefits from an intangible assets moat source in two ways--on its eponymous format standards and technologies, including its projection systems and digital film conversion process, and the intimate relationships that Imax has developed with movie studios that trust the company with prereleases of their most valuable content.
On the technology side, Imax has over 50 years of expertise with large-screen formats and a knowledge base that startups can’t match right away. Further, we see several technological hurdles that provide high barriers of entry for those that want to enter the large-screen movie format space and compete on quality with Imax.
Imax created its format in the late 1960s with first Imax film shown in 1970 in Tokyo. Before 2000, Imax films were primarily shot with cameras designed for the 70-millimeter film format and were generally documentaries. Imax theaters during this time were primarily either stand-alone or attached to a museum. Because of the weight, heft, and expense of shooting with Imax cameras, no major Hollywood films were exhibited in Imax theaters before 2000. The first Hollywood film to be exhibited in Imax cinemas was Disney’s Fantasia 2000
, an animated film created specifically to take advantage of the Imax screen, projectors, and sound systems. Disney soon released The Lion King
and Beauty and the Beast
in the Imax format as a result of the critical acclaim for Fantasia 2000
After the rereleased Disney film experiments, Imax began remastering Hollywood films with the release of Apollo 13
in September 2002 (five years after its original release) and Star Wars: Episode II–Attack of the Clones
in November 2002 (six months after its theatrical release). These two films were the first to undergo the Imax Digital Media Remastering process, which upconverts standard 35 mm film or digital video to the Imax format (70 mm film or Imax Digital). The DMR process and the switch to digital projection in 2008 helped to lower the cost of delivering a movie to roughly $100 per movie per system, versus $30,000 per 2-D analog print or $60,000 per 3-D analog print. Imax DMR not only provides the company and its screens with access to a large number of films on annual basis, but it also offers a competitive advantage versus exhibitor-branded premium large-format cinemas. Since Imax upconverts the film as part of the DMR process, the resulting product generally has higher video quality than exhibitor-branded large-format services, which generally use a better digital projector and larger screen than a standard theater to blow up the original version of the film.
We also believe Imax has strong, intimate relationships with movie studios that no startup can match right away. While a studio pays a percentage of the gross box office to Imax for converting a film, the studio also receives the right to use the Imax logo in advertising for the movie. This cobranding reinforces Imax with consumers who have shown a willingness to pay higher ticket prices for the Imax experience. The increased use of the DMR process over the past 15 years also demonstrates the level of trust that studios have in Imax, particularly since the vast majority of Imax releases are day and date. This means that the studios must entrust Imax with a copy of the film before release and be confident that the film won’t be leaked onto the piracy scene. Given recent leaks at movie and television studios, including Game of Thrones
at HBO and Orange Is the New Black
at Netflix, handing over a finished cut of a film before release implies a very high level of trust, considering the large potential loss in revenue from piracy. We believe that gaining this level of trust will be hard for new entrants.
Second, we believe that Imax benefits from a rare three-sided platform network effect, where studios, theater owners, and consumers have embraced the company’s technology. With network effects, companies often face the chicken-and-egg problem. In the case of Imax, the company took on two roles--content creator and exhibitor--by helping fund the documentaries that would be shown in its own theaters, alleviating the problem by creating both the chicken and the egg. While audiences took a while to follow, the company also benefited from unique positioning in that many of its first theaters were attached to educational institutions such as museums and it could run its movies for years instead of months.
However, the expansion to screening feature films added another chicken-and-egg problem to the creation of the current network effects moat source. While the first day and date DMR conversion occurred in 2003 with the November release of The Matrix Revolutions
, the number of Imax DMR feature films grew slowly at first. However, the DMR conversion process along with the switch to digital screens in 2008 helped to create a three-sided network effects moat source. The first DMR films helped to increase attendance and revenue. This growth in attendance and revenue attracted exhibitors who installed more Imax theaters. The additional movie theaters drew in the studios, which paid to convert more DMR films, restarting the cycle. We note that Imax generates revenue from each side of this network effect. Studios pay a fee of 10%-15% (depending on geography) of the gross box office to convert films via DMR. Theater owners can either buy or lease the Imax hardware outright or enter into a revenue-sharing agreement that offers Imax a percentage of the theater’s gross revenue.
We recognize that network effects can often unravel for companies. A potential risk for Imax would be audience fatigue around blockbusters, leading to lowering attendance and box office revenue, in turn discouraging studios from converting their films to DMR, creating a negative flywheel effect. However, we don’t see this network unraveling anytime soon, as the company has taken several steps to navigate these risks. The first one is that, even if the network were to weaken, exhibitors would probably not convert Imax theaters back to standard very quickly, given the capital cost and the lease terms. Beyond that, Imax has increased the number of film genres, has limited the number of 3-D conversions, and is implementing shorter movie windows, all of which should mitigate some of the downside risk.
Third, we believe Imax benefits from customer switching costs associated with theater equipment, the JRSA lease length, and the buy-in from directors for the cameras. The DMR film release slate is one part of the Imax Digital offering that exhibitors can either purchase or lease from Imax. Another key part is Imax’s own proprietary digital projector system, which started with digital light processing projectors and is transitioning to laser projectors. Imax also has its own 11.1 surround-sound system, which uses an enhanced soundtrack from the DMR process. Before converting a standard theater to an Imax one, the company first inspects the space to ensure it meet its minimum specifications for size, soundproofing, and other dimensions. After approving the theater for conversion to an Imax Digital screen, the company consults with the theater owner on the process and must sign off on the final product. Under the sales model, the conversion process can cost a theater owner around $1.3 million per screen with a much lower capital cost under the leasing or revenue-sharing models. However, the leasing and revenue-sharing models both have a 10-year noncancelable term with multiyear renewal terms. We believe the cost of converting a theater, whether in terms of capital spent or length of the leasing agreements, indicates that Imax benefits from a customer switching cost moat source.
While the DMR process converts standard film to the Imax format, Imax continues to build cameras to shoot movies directly in its format. While the original 70 mm cameras were bulky, the company has worked with suppliers like Arri to create digital cameras that film directly in the Imax format. The first Hollywood film to feature scenes shot directly with an Imax camera was The Dark Knight in 2008, which had roughly 28 minutes of Imax footage. While there have been a number of other feature films with Imax-filmed scenes, the first movies to be filmed entirely with Imax cameras are expected to be released in 2018: Avengers: Infinity War
and Mission: Impossible 6
. We believe this interest provides some of measure of lock-in to the Imax format and encourages studios to convert films via DMR. Similarly, this lock-in around Imax’s proprietary cameras provides the company with a barrier to entry in keeping other upstarts out of the space.
Business Model Shifts Drive Increase in Box Office Exposure
Imax has expanded its installed theater base tremendously since 2008 due partly to the explosion of DMR films and the lower cost of converting theaters with the switch to digital projection that year. During this expansion, the company started to increase the percentage of its screens under revenue-sharing agreements. As a result, Imax has become increasingly exposed to the box office, particularly in the U.S. and China. While this added exposure swaps revenue volatility from installations for box office volatility, we believe the trade-off is worthwhile since the additional exposure to the box office will provide a longer revenue tail for the company. The JRSA model also allows the company to more rapidly expand its network versus the traditional sales model.
Three Choices for Theater Owners
Imax effectively offers three business models to theater owners: sales, traditional joint revenue sharing, or hybrid joint revenue sharing. Under the sales model, Imax sells or leases the equipment for the Imax theater for either a fixed up-front price or fixed annual payments for the lease term. The lease agreements generally have a 10-year term with 5- to 10-year renewal options held by theater owners. Under the sales model, Imax generally also receives annual ongoing maintenance and warranty fees. If the theater owner buys the equipment, it gains title to equipment, but Imax retains the title under a lease model. While there is a service component to the sales model in terms of the initial setup and ongoing maintenance, Imax functions in a similar manner to a technology hardware company under this model.
The other two models allow the company to benefit from the increasing popularity of the Imax format by providing the company with a percentage of revenue from ticket sales. Under the traditional joint revenue-sharing arrangement, Imax forgoes the large up-front fee for a minimal initial fee and a large percentage of box office receipts (typically 15%-18%). The traditional JRSA starts with an initial 10-year term with 3- to 5-year renewal options held by the theater owners. Some theaters owners like the traditional JRSA, as it allows them to add or convert to Imax theaters with a much lower capital expense. Imax has signed traditional JRSAs with more than 40 partners with over 550 screens worldwide and another 269 screens in the backlog. Due to the minimal up-front payment, Imax typically signs JRSAs with theater owners with stronger balance sheets and in geographies with lower political risk. However, this risk assessment model did not preclude the company from entering into traditional JRSAs in greater China (China, Hong Kong, and Taiwan), where there are 215 screens under this model. Until 2016, Imax only offered traditional JRSAs in China to Wanda Cinema on an exclusive basis. However, only 71 of 553 traditional JRSA theaters worldwide are located in markets other than the U.S. or greater China.
Imax’s third business model combines the sales and traditional JRSA models to create the hybrid JRSA. In this model, Imax receives a larger up-front fee than in the traditional model; thus the take of the box receipts is lower, typically around 10%-12%. The deal length is comparable to the traditional model with an initial 10-year term and 3- to 5-year renewal options held by the theater owners. While the hybrid model still provides the theater owner with the benefit of a lower capital expense than a sales or lease model, Imax still participates in the upside from a strong box office for Imax films. The hybrid model has largely been used outside the U.S., as it offsets some of the risk in the traditional JRSA from eschewing an up-front payment. We expect that Imax will continue to use this model particularly with newer customers in countries outside the U.S. or greater China, but we believe the traditional model will remain a more popular choice when Imax offers its clients a choice between the two, as the traditional model has little to no up-front capital cost for theater owners.
The shift toward the joint revenue-sharing agreement provides Imax with a longer revenue tail versus the traditional sales model. This shift also should help increase revenue in higher-penetration areas such as the U.S., where the growth from new installations has declined and will continue to do so. This switch toward box office exposure was a conscious decision on the part of management, as demonstrated by the change in segment reporting at the beginning of 2017 and projections provided at the analyst day in May.
The new segment reporting splits the company into four revenue units: network business, theater business, new business, and other. The network business segment contains the box office-derived revenue from the DMR films and the joint revenue-sharing agreements. Theater business reflects the revenue from the sale and installation of Imax systems in theaters, the associated maintenance contracts, and the up-front installation costs from the joint revenue-sharing arrangements. New business includes the virtual reality centers, Imax Home, original content, and other start-up businesses. Other incorporates the theaters owned by the company, camera rentals, and other miscellaneous items. Management expects EBITDA growth over the next 10 years will be driven by the network business segment and, by extension, the exposure to the Imax box office.
Despite the potential to expand growth, increased exposure to the box office does come with some downsides. As we outlined in our discussion of the three-sided network effect, Imax is now further exposed to a downturn in the box office for blockbusters. While the company is attempting to mitigate its exposure to blockbusters, as discussed in the next section, we don’t think these changes will completely insulate it if the slowdown of this summer lingers over the next few years (a scenario we don’t see occurring, given the strong slate of movies expected to be shown on Imax screens over the next year). Also, a decline in audience acceptance of blockbusters would hinder the sales model for Imax, as exhibitors would be less likely to convert more theaters or renew leases.
Another downside to the joint revenue-sharing agreements is that Imax bears a larger portion of the up-front costs as the theater owner generally bears a much lower percentage of the initial install costs. Because a new greenfield Imax theater may take two to three years to fully ramp up, the number of newly installed joint revenue-sharing screens will negatively affect margins, particularly in years with a larger number of new installations. While this impact will smooth out over time for installed theaters, Imax will feel the impact over the first few years. The magnitude of this impact will be diluted as the installation base continues to grow and the relative size of the new installations declines.
Diversifying Box Office Exposure
As the number of screens under the JRSA models continues to increase as a percentage of overall screens, Imax’s revenue will become increasingly driven by the box office for Imax films. This should benefit the company as the total number of films converted to the Imax format continues to increase. However, many of the largest box office films for Imax tend to concentrate in the blockbuster franchises in genres such as action/adventure, comic book, sci-fi, and fantasy, which have larger production budgets (generally above $80 million). While management continues to expand Imax into other genres including family, animation, and even low-budget horror, the continued growth of the box office will still depend on audiences continuing to attend blockbuster films in the U.S. and internationally.
While we foresee audiences continuing to flock to blockbuster films, there appears to be a glut of these films in the recent past and on the horizon. Over the past two years, a number of large budget films have posted disappointing box office results, including Transformers: The Last Knight
, King Arthur: Legend of the Sword
, and The Divergent Series: Allegiant
. Historically, Imax’s box office would suffer from an underperforming film as the film would still book for at least two to three weeks and most blockbuster films posted their strongest results during the opening weekend. Because of the struggles of some recent films and the large number of films scheduled to be released over the next few years, Imax recently announced that it would start signing some films to one-week runs and dayparting theaters (for example, running a family film during the day and a comic book film at night). The company is also working with studios to limit the number of 2-D to 3-D conversions as audiences appear to have tired of the gimmick, particularly for films that were neither laid out nor filmed with the 3-D aspect in mind.
Another diversification effort by Imax is the continued initiative to increase the number of Imax conversions of local productions, particularly in China and India. While audiences in both countries have embraced Western blockbusters, filmgoers continue to flock to films produced by the vibrant film production scenes in their respective countries. In China, Imax China will need to continue to supplement its slate with local productions because of regulatory restrictions and the increasing popularity of Chinese productions. The Chinese government restricts the number of U.S.-produced films to 34 releases per year under its revenue-sharing model while also unofficially forbidding the release of new foreign films during blackout periods such as a six-week period during the summer of 2017. Since not every one of the foreign films will necessarily be appropriate for conversion to Imax and release dates may clash, Imax China has recently begun to ramp up its conversion of local films. Also, Chinese audiences have increased their appetite for not only local productions but Chinese productions in Imax’s traditional genres. The success of Wolf Warriors 2
, Monster Hunt
, and Journey to the West: The Demons Strike Back
in Imax proves that the format can be very successful outside of American blockbusters. This growth in audience interest and production budgets should help Imax China expand the number of converted local films over the next few years from the projected nine in 2017. While we expect foreign films to remain popular with Chinese audiences, Imax must continue to embrace local productions, particularly as Imax China expands beyond the major cities to where audiences may have less of an appetite for American films.
The Summer Slump: Beginning of the End or a Blip?
The summer of 2017 (generally defined as the first Friday in May through Labor Day weekend) was a disaster at the box office in the U.S.; the season was the worst since 2006. The summer ended on a sour note as the last weekend in August was the worst in 16 years and Labor Day weekend hit its lowest level since 2000. While there are some reasons for the disappointing summer season, including a weak slate, we don’t believe the downturn portends the end of the movie theater. Both 2016 (up 2.2%) and 2015 (up 7.4%) saw overall box office growth after a very weak 2014 (down 5.2%), and the slate for 2018 appears strong.
One of the potential reasons for the disappointing season was audience fatigue around comic book movies and sequels as Hollywood attempts to generate new franchises and milk older ones. A number of widely released movies, such as Pirates of the Caribbean: Dead Men Tell No Tales
, War for the Planet of the Apes
, and The Mummy
, did underperform in the U.S. However, a number of franchise films, such as Wonder Woman
, Guardians of the Galaxy Vol. 2
, and Spider-Man: Homecoming
, outpaced expectations in the U.S. This dichotomy may simply be due to the freshness of certain franchises or the quality of the most recent installments. It also may signal that audiences may have a finite number of films that they are willing to pay for as the average ticket price continues to increase in U.S.
Another potential reason for the weak box office performance is the impact from the continued growth of Netflix and other providers of subscription video on demand. One train of thought is that viewing habits have shifted to in-home viewing and binge-watching, making movie attending a costly hassle. The addition of original movies to Netflix will only exacerbate this trend, threatening to put movie attendance into a permanent decline. While we agree that Netflix and the other SVOD companies have accelerated the fragmentation of media consumption, we see no evidence or reasoning for why this impact should be so pronounced in 2017. Total U.S. box office grew in 2015 and 2016, years in which Netflix was already a major presence in the American media landscape.
The movie industry is constantly in crisis, particularly during a down year or whenever a new method for consuming media arises. Filmed content consumption has shifted several times over the past century, beginning with the transition from out-of-home appointment viewing at movie theaters to at-home appointment viewing via the television to physical-media-based on-demand viewing via the VCR and DVDs. The Internet and broadband access have made the dream of massive content availability a reality, with the advent of online video-on-demand providers such as YouTube paving the way for a new kind of online platform: subscription video on demand, led by Netflix and Hulu in the U.S. During each one of these transitions, the movie theater was expected to fade away or decline in relevance in a corresponding manner to the changes in communications, in which the telegram was replaced by the landline phone, which was usurped by the mobile phone. Unlike communications, transformations in the media landscape have generally led to increased overall consumption, fragmentation, and adaptation. Most recently, the widespread adoption of large-screen high-definition televisions combined with the popularity of DVDs, premium pay television, prestige television, and SVOD services led to a polarization of production budgets. Most U.S. films are now produced for less than $40 million or more than $80 million. Much of the talent that would have written, directed, and acted in the $40 million-$80 million production budget films shifted to create prestige television shows for premium cable at first, then for basic cable, and now for SVOD platforms like Netflix and Hulu. The film industry has adapted by funding franchise films in genres of animation, superheroes, and sci-fi/fantasy on the high end and horror film and genre comedies at the lower end.
While the summer of 2017 was a disappointment in the U.S., the Chinese box office continues to boost Hollywood films even as the pace of growth slows. During the first nine months of 2017, at least eight Hollywood films (including some of the most disappointing ones like The Mummy
) boosted their worldwide box office by grossing more or the same amount of money in China. While China is widely recognized as the second-largest and second-most important movie market, the U.S. media still judge the success of movies on the box office take in the U.S. For the top 20 Western movies in China in 2017, movies that once would have been judged as flops or simply break-even are now successes largely because of the impact of Chinese audiences.
We believe that the summer of 2017 is an anomaly and we don’t expect the overall box office in the U.S. to continue to decline in 2018 and beyond. One recent release buttressing that belief is the performance of It
during the typical postsummer doldrums. The movie posted numerous records during its $123 million opening weekend, including the largest September open, largest fall open, and largest horror film open despite middling reviews and audience scores. The film also performed well for Imax. Examining the last three months of 2017, there are reasons for optimism for a strong end to a down year for the overall and Imax box office, including Thor: Ragnarok
and Justice League
in November and Star Wars: Episode VIII
in December. Looking into 2018, we see a strong slate headlined by multiple Marvel Cinematic Universe films, two X-men films, Solo: A Star Wars Story
, Deadpool 2
, and Incredibles 2
, all of which we expect to be shown in Imax.
Overreaction Provides Opportunity
The recent box office woes have taken their toll on Imax’s share price over the past year as the shares fell from a high of $35.30 in November 2016 to low of $17.35 in August. We still believe that Imax is well positioned to take advantage of continued audience appreciation for blockbusters via its current installed base and theater backlog. Despite a recent rebound, the shares are still trading 18% below our $30 fair estimate and may offer an attractive entry point to investors.
Similar to management’s projections, we expect that the company’s growth will be driven by the network business segment and by its exposure to the box office for Imax films. The company’s revenue is increasingly tied to a percentage of box office for Imax films, as the DMR business and the joint revenue-sharing models generate the majority of their revenue through this method. As we look at box office revenue for Imax, there are three potential drivers. The first is the number of Imax films converted and shown per year. The second is the box office per screen average, or PSA, for Imax theaters. The final driver is the number of JRSA screens.
The number of DMR films exploded from 8 in 2008 to 50 in 2016. However, we believe that while the number of local-production DMR films will continue to increase, they will simply take the place of Hollywood films in those markets. So, while the overall number of DMR films will increase, the impact on overall box office will be muted. The company’s genre diversification efforts will also help increase the number of DMR films, as will dayparting theaters. Despite these efforts, we believe the relative increase in the number of DMR films will be small and the impact on driving box office growth will be limited.
The second factor of PSA for Imax screens is one of the differentiation factors for the company versus other premium large-format theaters. The company’s average PSA of $946,000 over the past five years in the U.S.is well above the estimated PSA of $600,000 for exhibitor-branded premium large format. While the PSA for 2016 and the first half of 2017 is down, it has remained relatively steady over the past seven years. At the investor day in May, management predicted the global PSA for the company would expand slightly over the next 10 years to $1 million from $964,000 in 2016. On the other hand, we expect the global PSA to fall sharply this year but rebound toward the 2016 level over the next five years. In either case, PSA is not driving box office growth for the company.
We believe that the third factor, the number of JRSA screens, will drive Imax box office revenue growth and, correspondingly, Imax revenue growth. JRSA screens make up over 50% of the installed base and are almost 70% of the backlog. A significant number of these screens (193) are less than two years old and may not have ramped up completely, particularly the 145 screens in China. While the company installed 164 total screens in 2016 (111 JRSAs), we don’t believe this level of installation is sustainable and expect it to decline over the next five years toward management’s long-term projection of 60 per year with a bias toward JRSAs. We project that the large number of recently installed JRSAs screens and future JRSA installations will drive annual revenue growth of 8% for the network business.
The growth in box office revenue should also provide a slight lift to gross margins for the network business segment. Since the segment does not take on the installation cost, it already boasts strong gross margins with a projected margin of 68.2% for 2017. We expect that revenue ramp at the recent JRSA installations will help expand gross margins to 69.0% by 2021.
The majority of the revenue (60%) for the theater business in 2016 was derived from the sale and installation of Imax systems, with 23% from maintenance contracts and 17% from other revenue, including any up-front revenue from the hybrid JRSAs. Since we believe that over time, the number of installations per year will decrease and the sales model will be a lower percentage of future installations, we project that the theater business will generate a larger percentage of its revenue from maintenance contracts. This shift will have a negative impact on gross margins, which we expect will fall to 46.6% in 2021 from a projected 50.6% in 2017.
We expect overall revenue to grow 5.3% annually driven by the network business, which will offset the slight decline at the theater business segment. Our model doesn’t include any significant revenue impact from new business over the next five years, as we don’t expect the VR business to expand significantly over the next few years, and we view Imax Home as more of a branding exercise than an avenue for growth. We project overall gross margins to expand to 55.5% from 53.7% as the improvement at the network business offsets the decline at the theater business. We expect overall operating margins will also expand to 23.3% in 2021 from 15.5% in 2016 as the company gains leverage on selling, general, and administrative as well as research and development expenses.