The theater industry has been threatened by at-home streaming services like Netflix and Amazon. Because of this competition, the market has moved its interest away from the industry’s biggest players. However, Donald Marchiony believes the time is now to invest in Cinemark Holdings (NYSE:CNK), the holder of America’s third largest theatre chain with 339 locations. An analyst at Westpark Capital, a Dallas fund with $85 million AUM, Marchiony thinks Cinemark is greatly undervalued as its margins are still conducive to great returns. With the theatre industry continually maintaining positive numbers, Cinemark presents an interesting opportunity for any deep value investor.
Sumzero: What about Cinemark initially caught your eye as a value investor?
Donald Marchiony: I initially became familiar with Cinemark as a result of due diligence on a prior investment in Carmike Cinemas, which was recently acquired by AMC. While at the time Carmike was the under-the-radar small cap play, Cinemark has always been the class of the industry. What attracted me to Cinemark specifically was the consistent top-line growth, industry-leading margins, high and increasing returns on equity and the significant free cash flow to firm generation. I also like the fact that the prevailing narrative on the theater industry is generally negative, which resulted in Cinemark trading at a deep discount to intrinsic value.
SumZero: What is the market missing?
Donald Marchiony: The market is hyper-focused on two negative themes: 1) industry-wide attendance has decreased at a CAGR of 0.6% over the past decade and 2) the potential for a drastic change to the theatrical window. While the first point is indisputable, it masks an otherwise fantastic industry. The domestic box office has set a record in four out of the past five years, ticket prices have increased every year since 1993, and attendance has increased sequentially in each of the past two years. The theater industry also stands to benefit from rising inflation expectations. Similar to the hotel industry, exhibitors can reset their ticket prices on a nightly basis. In addition, Cinemark has a proven track record of efficiently deploying capital into high ROI projects. This is a very stable, high-quality business that the market loves to hate.
SumZero: What key metrics should investors be paying attention to as your thesis matures?
Donald Marchiony: There are several metrics that investors need to pay attention to, including attendance, attendance per screen, ticket pricing and growth of concession spend per patron. The goal is to get more people through the door, i.e., increase utilization, and to get each person to spend more on food and drinks. People who aren’t familiar with the theater industry may not be aware, but concessions are where all of the profits are made. In addition, since the gross margin on concession spend is roughly 85%, the incremental margins in this business are very high. Due to the investments that Cinemark has made (and continues to make) over the past few years, as well as the incredibly strong movie slate in 2017 and 2018, the company will be able to significantly increase its FCFF over the next two years.
SumZero: What are the biggest risks associated with the trade in your view?
Donald Marchiony: The biggest risk to Cinemark, and the theater industry, is the potential for a wholesale change relative to the theatrical window. As it currently stands, the theatrical window is roughly 120 days, which has steadily come down over time. While the prevailing narrative is that there is likely to be an introduction of a two-to six-week “premium VOD” window, or that the current window will be taken from ~120 days to ~60 days, I believe this is an unlikely scenario. More likely than not I think you’ll continue to see an extension of the status quo, perhaps a slight decrease, but nothing that would endanger the current model. One of the primary reasons the opportunity in Cinemark exists is due to the fact that there is significant fear in the market relative to this issue.
SumZero: What are Cinemark’s biggest problems right now?
Donald Marchiony: The biggest problem Cinemark and the industry as a whole has right now is that attendance has been steadily declining over the past decade (at a CAGR of 0.6%). Two examples of the heightened competition for consumers’ time are the advent of premium at-home content via Netflix and Amazon and new entertainment options like Top Golf. While the incremental margins are very high in the theater industry, that dynamic holds on the downside, too. Cinemark has been making significant investments into its infrastructure to drive attendance and attendance per screen, and despite some general malaise in the theater industry over the past decade, those investments are paying off.
SumZero: What distinguishes Cinemark from the other industry players?
Donald Marchiony: In an industry that is relatively uniform, Cinemark distinguishes itself with industry leading margins. Some of that delta is structural, e.g. Cinemark over-indexes to cities that generally have lower rent than AMC (Cinemark is not in New York City or Boston), but the margins are a reflection of its quality management team. Cinemark’s management is generally thought of as the class of the industry.
SumZero: What is the average Cinemark ticket price? Have ticket prices increased proportionately to inflation?
Donald Marchiony: As of the most recent quarter Cinemark’s domestic average ticket price was $7.39, compared to $9.57 for AMC and $9.64 for Regal. The growth of ticket prices has actually outpaced inflation since the early 1980’s: 3.2% growth vs. 2.7% (measured by CPI). The recent rise in inflation expectations is one of the reasons why I believe investors will be attracted to Cinemark as the company can reset pricing at a moment’s notice. The industry’s ability to adjust to inflation is actually greater than the hotel industry as there are almost no advanced bookings.
SumZero: Between ticket sales and concession sales, which is more important for generating revenue? Has the decreased seat-count from replacing seats with larger footprint, higher comfort seats affected either of these?
Donald Marchiony: In terms of revenue generation, the company generates more revenue from ticket sales, but the vast majority of operating income is driven by concession spend. The re-seating investments that Cinemark is making are actually improving both ticket sales and concession spend per patron. The gross increase in attendance at re-seated theaters has been as high as 40%. Moreover, concession spend per patron growth at re-seated theaters has been double that of its legacy peers. The primary reason for the increase in concession spend is due to the fact that reserved seating is implemented at re-seated theaters. Therefore, people feel less rushed when they come to the theater, and they spend more time at the concession stand. Cinemark has also had success driving concession spend per patron through initiatives such as cafeteria-style (DIY) concessions and premium food and drink offerings. I believe we’re still in the middle innings of driving concessions per patron growth; it should be a nice tailwind over the next two to three years.
SumZero: Are there any interesting trends in the data on the age demographics of customers attending movie theaters? Is going to the movies an activity that still appeals to a younger generation?
Donald Marchiony: The primary movie-going demographic has always been the 12-39 age bracket, split evenly between male and female. Within that cohort, 25-39 year olds actually frequent the movies most often. In general the trends reflect the same industry-wide reality, which is that attendance has been slowly declining since the mid-2000s. I would argue that teens still want to get away from their parents for a few hours; parents still want to have some time off from the kids. People go to the movie theater for the same reason they go to a restaurant or to a sporting event: it’s a differentiated experience they can’t be replicated at home. Eventually that dynamic could change, but I think it’s beyond the time horizon of this investment.
SumZero: AMC theaters has also been installing luxury seats, as well as serving premium food options and alcohol in some of their theaters. With AMC’s 21% market share (including its added percentage from the Carmike merger) versus Cinemark’s 11%, why not invest in AMC rather than Cinemark?
Donald Marchiony: This is an interesting question. I think you first have to understand why people choose a specific theater to see a movie. The order of priority is as follows: 1) Movie and time, i.e., is the movie I want to see playing at the time I am able to see it? 2) Proximity, and 3) Amenities and features. With that as the backdrop, it is more likely than not people are going to the theater that is closest to them, rather than basing their decision on whether the theater has premium seating. Premium seating drives frequency, it doesn’t necessarily attract a consumer who is outside of a specific theater’s target market. Therefore, it is unlikely AMC or Regal will steal any significant share from Cinemark, or vice versa, due to the upgrade initiatives. Relative to an investment in AMC versus Cinemark, I think AMC has a lot on its plate right now with the acquisition of Carmike in the U.S. and Odeon in Europe. Moreover, some of the margin inefficiencies between AMC/CKEC and CNK are structural, so I don’t foresee the combined company’s margin profile approaching Cinemark’s. If anything I think you have some integration risk with AMC, and I’d rather go with the best-in-breed in this situation.
SumZero: How does Cinemark and other theaters compete with on-demand streaming services? What differentiates traditional theater-released movies from Netflix, HBO, or Amazon original movies?
Donald Marchiony: First and foremost, I absolutely think that premium at-home content via Netflix, Amazon and HBO has been one of the factors that have driven the steady decline in theater attendance. I don’t want to be dismissive of that threat. That said, anyone who says that the theater experience is the same as watching a movie at home hasn’t been to the theaters in a while. My survey indicated that there are a variety of reasons people go to the theater, including the big screen, the premium sound and the ability to get premium food offerings. More important, though, is that people like to get out of their house and they like to be entertained. Parents like the fact that their kids have to put down their iPhones and iPads. People like to go to the movies for a date night. I think it’s something that’s woven into the fabric of our society, and it’s an experience that’s differentiated enough from at-home entertainment that people will still go to the movies for a long time to come.
SumZero: Where else do you see value in the market today?
Donald Marchiony: I don’t see as much value in the market today as I did prior to the election. I’m not pessimistic on the consumer or the U.S. economy, but I do think some stocks have gotten ahead of their fundamentals. Interestingly, I think you could see some disappointing 4Q results with companies pulling back spending around election uncertainties, and that could provide for nice entry points into some companies we’ve been following for a long time. I also think there are a lot of interesting opportunities in the residential construction supply chain. Based on my checks and the publicly available housing data, I think residential construction will likely be strong in 2017 and 2018. There are some companies that still represent good value in that space.
SumZero: How has your approach evolved over the years?
Donald Marchiony: In my relatively limited time being on the buy-side, I think two of the most important things I’ve found are that focus and self-reflection are key. The amount of news flow in today’s market can be a huge distraction, even debilitating in some respects. I try to tune out as much noise as I can. I’ve also come to appreciate that my past mistakes are the best learning experiences and to incorporate those learnings into my investment process.
SumZero: Tell me about your investing background and investing mentors and heroes.
Donald Marchiony: I studied finance and economics in college and was lucky enough to land a role as a buy-side analyst right out of school. In terms of investment heroes, there are so many fantastic investors out there. I really admire David Einhorn and Greenlight Capital. The marrying of top-down macroeconomic themes with bottom-up stock picking is something I’ve tried to learn from. Whether it was the call on the housing meltdown or his thesis on the boom and bust of the iron ore/steel complex, I really admire his process.
SumZero: What advice would you give to someone interested in pursuing investing?
Donald Marchiony: I think the most important advice I could give someone interested in investing is to try to think in a non-consensus manner, and to develop your own personal process. Relying on other people’s work and conviction is unsustainable. You have to perform and believe in your own work and process, otherwise you’ll constantly be chasing your tail. Developing a repeatable process that works for you, and honing that process over time, is paramount to being a successful investor.