The ST Report market commentary & investment ideas

Reading Int’l- a Monopolistic Popcorn Stand? (updated)

*I updated this article 20 hours after posting. I made an error in the real estate section, you can see it italicized below. It changed my valuation and comments on valuation; you can see these below italicized as well. The rest of the article is the same. I am very sorry to have committed this error, it was not intentional.

Business Model

My dad used to take me to the movies on a somewhat sporadic fashion, and one thing he always used to say was that movie theaters "make all their money on concessions". At a young age, I took this to mean the movie producers (Dreamworks, Disney, etc.) kept the ticket sales and theaters were simply open to make money selling you overpriced popcorn in a monopoly-like fashion (can't bring in your own food). It wasn't until this week that I actually realized how ridiculous that was; Reading's business is about 30% concessions and 70% box office sales. Oh well, it was interesting to think about a monopolistic popcorn stand as able to support a massive theater every time I went to see a movie... and my dad was simply exaggerating so we wouldn't buy the popcorn, he's not a businessman.

I've done some reading on Reading International in the past few days, getting a sense of how this nations' cinema exhibitionists are managed and the business model. It seems that, with consistent cinema cash flow, management pairs up theater exhibitions with real estate operations to cover the interest on heavy real estate debt (bolded just in case you're skimming the article). RDI is split 50-50 (in assets) between cinema operations and real estate ventures.

The cinema half of RDI is managed as a gardener would tend a small victory garden in his backyard, tending it for the consistent produce of tomatoes, onions, and lettuce. To counterbalance this, the real estate half of RDI is managed as a poorly-weeded, speculative area to grow spicy peppers, african trees, venus flytraps, and all sorts of exotic plants. While it is unclear to the gardener as to when or who will be willing to buy these exotic plants (real estate), he tends to it with more conviction than his cinema operations because there is a greater chance of ending up with a magic beanstalk that Jack (James Cotter, Chairman/CEO) can climb into the sky. Besides, the victory gaden basically tends to itself at this point- the cinema business is mature, although consistent, and facing increased competitive pressures from more instant entertainment sources like Netflix and VOD (video on demand). In any event, I find this balanced business model of excess cash generation paired with constant capital needs very interesting.

Management sees their countries of operation (U.S., Australia, New Zealand) as being over-screened and with little expansion opportunity for additional cinema expansion. They've gone very in-detail in their ann'l report for their future plans, but the main idea is to reinvest nearly all cash flow into real estate at this stage. About 2/3 of their business is abroad in Australia and New Zealand, so this bodes well for a weakening dollar for their reported results. I tend not to comment on macro issues such as our dollar, but it has been perhaps the weakest of almost any developed world currency the past decade, and this will likely continue to develop this way as we monetize our debt (no spending cuts in sight for Washington).

The business operates with negative working capital, seeing as they receive revenue from theaters prior to paying licensing fees to movie producers. As I've written in the past, negative working capital is a great situation whereby the business doesn't need to keep current assets sitting on its balance sheet to operate the business; they're free to reinvest extra capital elsewhere, whether through repurchases, dividends, or real estate acquisitions.

Cinema Operations

RDI's cinema exhibitions throw off cash in pretty sizable amounts; I was very surprised by this. While there are no direct numbers on capital spending at the consolidated level, I've estimated them to be very low (1-2%) based on the Mt. Gravatt joint venture numbers. I've shown it below so you can see for yourself:

This gives a good picture of the broken down income statement for a cinema company. As you can see, the concessions are marked up 350% (probably not a surprise with $7 popcorn or $3.50 candy), cinemas pay about a 40% licensing fee to show the films, and other major things cutting into margins are advertisements, personnel, and occupancy costs. At the bottom, you can see how low maintenance costs are; they're between 1-2% back the past 5 years (go to 10-k's to check them all). Distributions from this J.V. to all it's partners are between $2.5-$3 MM, each year on average, and this leads to a near-50% ROA (assets are $4.8 MM). Not bad at all.

In 2008, RDI purchased 15 leasehold cinemas, bringing up their totals from 31 to 48 wholly owned cinemas. The original purchase price was $70.2 MM, subject to a maximum reduction of $23 MM depending on how competitive situations played out. These played out for RDI, bringing down their purchase price to $46.8 MM. Not bad considering earning power for the cinema operations increased about $10 MM/year as shown below:

 

As you can see, I'm not including depreciation charges because they're non-cash and the theaters are supposedly in good enough shape to generate 10-20% ROA, at least historically. Management claims they're in good shape with modern theater amenities, and I'm apt to believe them considering the financial results. Also, maintenance costs are estimations at 1.75% of revenues per year.

All of this must be taken with a grain of salt of course; Netflix is still on an upward surge with their growth, as well as the video game industry, Redbox, and all other sorts of instant entertainment that have come to slowly replace the theater experience. People are still going to theaters of course, which RDI describes as: "humans are essentially social beings", but this message is becoming increasingly tired and not necessarily as trustworthy as it might have been 5 years ago.

There's been a lot of heated discussion on SeekingAlpha articles about whether this is a dying/dead business model. It has been discussed by movie distributors to shrink or eliminate the "window" between movie release to theaters and distribution to other channels like VOD, Netflix, DVD's, etc... I see this as likely in the next 10 years, which would probably crush the theater business model much in the same way you've seen the neighborhood video store (and soon every bookstore) disappear. While it's nice to have that instant ability to go buy a book or rent a movie, consumers have voted with their wallets to want cheaper access to content a little slower (Amazon online, Netflix in the mail). Same with theaters in the long run- these will cease to be eventually. I hope I'm wrong here, but in general I could see this trend emerging.

It is important to note that the theaters pay more royalties in the first few weeks of movies being released, and substantially less as time goes on, but I'm unsure as to how short the window would have to be before these theaters went cash flow negative. My guess is that the window will be increasingly shortened as time elapses (pushing content to Redbox/Netflix/VOD faster) and this will strain the theaters until they cannot support the real estate operations they're all hitched to. You can see the results already taking a toll on margins; I don't expect margin expansion from this business currently.

That being said, I feel as though RDI's theater exhibitions will continue to generate cash flows the next few years and is unlikely to go bankrupt from it in the short-term. Nice to know there is some limited downside for the next few years.

Real Estate Operations

Reading International has the following real estate portfolio separate from cinema operations, listed at carrying value for real estate in development:

• Burwood in Victoria, Australia- $53 MM
• Moonee Ponds in Victoria, Australia- $14 MM
• Manuakau in Aucklan, New Zealand- $14 MM
• 5 more of which are about 15% of real estate values- $15 MM

In total, RDI's total carrying value of their real estate in development is about $96 MM. In addition to this, they have about $18 MM long-term leasehold properties, which all appear to be cinema properties.

So, how do you evaluate $114 MM stated value of real estate in development? This is a question I've been trying to answer myself for awhile now. After having listened to David Einhorn's recent Value Investing Congress criticism of St. Joe, I figure it's best to wait until an investor has the resources to visit these sites to make large bets on them. Otherwise, you're relying on another person's evaluation of real estate whose personal interest in it is to have as high a valuation on it as possible (to increase value of stock options/personal stake in company). Also, after having listened to Bruce Berkowitz's latest annual conference call with investors, his thoughts toward real estate holdings (Sears, St. Joe) are such that he would buy out the whole property if the business underperformed or went out of business. As an individual investor without a multi-billion mutual fund, I don't have this luxury of a backstop if RDI runs into trouble. Perhaps not as much limited downside as we first thought.

Luckily for us, Reading International has transparent disclosure of Burwood, which constitutes 50% of their real estate holdings, and gives me enough confidence to make a reasonable guess. Unlike St. Joe, with which Einhorn traveled to a number of locations in Florida to take pictures and document it with a 139 slide presentation. Here are a few photos provided by the company:

As you can see, this is not like St. Joe, where the real estate is next to a developing airport and just a bunch of trees in the middle of nowhere. This is smack in the middle of a highly populated, residential area, defined by RDI as a "major activity centre" in 2002. While I'm not sure about a $53 MM valuation, seeing as it looks like rough landscape, they have released the way they got to this figure. A private appraiser came up with AUS$1.7 MM per acre of residential land (31-34 acres) and AUS$11.5 MM for the planned mixed residential/commercial part of it. This leads to a higher valuation than the $53 MM, so I'm fine relying on $53 MM for now.

It requires a major amount of capital to develop, however. They've estimated around $600 MM today, up from $500 MM 3 years ago. This capital simply cannot be contributed by RDI's limited means, so they've gone into a variety of discussions about what to do with the property.

Their latest press release, dated May 24, 2011, gives a summary of all discussions at the annual meeting. They talk about disposing the residential part of the land, while still maintaining ownership over it, and receiving payments as it's released to end users. Of course, this makes no sense. However, it sounds like they want someone else to develop it, sell it to end users, and pay RDI a royalty. Not a bad setup at all if this were to work out, although I'm not sure how you could consider it a sale if you don't give up ownership of the land. Also, as of March 15, 2011, Burwood has become classified as a current asset on the balance sheet, being "held for sale". This is pretty significant, since it is valued at more than all other real estate on its books combined, but I'm not sure it's going to be sold completely or licensed out. The release went further, stating that other major development projects would be on hold until Burwood was sorted out. Clearly, it's their main focus today.

Another press release gave a timeline- they stated that June 28th is the last day to submit an interest in Burwood, and that July 5th is when they'd short-list the candidates. From here, I'd presume we'd have further disclosure on possible prices to be sold at or more information on the deal being discussed. This gives us a short-term catalyst and good visibility into how Burwood is doing over the next few months.

Despite this timeline, the disclosure on property visibility, valuation of the land, etc... Burwood has been the subject of much criticism on SeekingAlpha and elsewhere for not being sold sooner. I find this a little strange considering their first release of it being on sale was in June 2010 annual report release. It has just been about a full year- what a tough crowd! It was still in development during the 2009 10-k filing, so it was likely put up for sale about 18 months ago. Considering today's global recessionary period, not really surprised about this delay. It's not as if they've been trying to sell it for 10 years and failed- they're close to some kind of deal and are being pretty open about it. I also think investors are a little turned off to the dual-class A/B structure whereby James Cotter has complete voting control here. It's tough for me to see him control it completely, and considering some people have made comments that he's not necessarily a partner of choice, it's a little unnerving (apparently he's arrogant and considered a "street fighter"). I'm fine with it because we are in virtually identical boats. He has a large stake (about 25% ) and is unlikely to just throw it away.

The other real estate projects are mostly held for further development and could be considered similarly to an illiquid marketable securities portfolio that won't be sold for awhile. I will assign a 50% valuation to these projects considering it's difficult to assess what they're worth and I don't have Einhorn's resources to go visit each location. These haven't been developed yet; they may require additional capital contributions from RDI, so I figure 50% is reasonable. In addition, they present a realization-of-value problem. You could have you double your money in 10 years but it only ends up as a 7% annual return over that time frame. You need to sell in a shorter period if you want good return and this illiquid portfolio could take years to unload for a profit. As such, I'll take this 50% valuation until further developments prompt me to change my mind.

So, with Burwood likely worth about $53 MM today, perhaps more, I'll stick with their valuation. In addition, the rest of their development holdings are worth, by my simple conservative approximation above, about $22 MM, the development real estate portfolio can be considered to be worth $75 MM or so.

In addition to their development projects, Reading also carries income-producing real estate on their books. In total, this amounts to $265 MM carried on their books, valued by Reading itself. I made a mistake in overlooking this for my initial post, as Andrew Shapiro has pointed out, but I had originally read it as being the real estate behind the theater operations, which I figured I had valued with their earning power (as is my usual style). This was my mistake, and I apologize for the error.

This $265 MM of income-producing real estate only generated $25 MM in revenues, $15 MM in operating income ($14 MM and $13 MM the past two years), and $5 MM of this revenue & earnings can be attributed to intersegment operations, so it really only generates about $10 MM per year in income on $20 MM in revenue. While those aren't bad margins at all, it's hard to call these income-producing when they're, at best, covering the maintenance cost of $265 MM of real estate every year. Perhaps a small amount of it can go towards the large interest payments Reading has to make each year on its overall real estate portfolio.

Because these income-producing real estate holdings really only generate very modest positive cash flows after maintenance, I think it better to consider them in a similar boat to the development projects. While they don't require much upkeep (and likely provide its cash flow for that), the real estate is hardly generating much positive value for shareholders every year. The real value will come in a sale. As I stated before with their development projects, it is difficult to assess the true value of these holdings. Also, the realization-of-value scenario is very similar; if they sit on these holdings and don't ever sell (they've talked about selling some of the projects, not as if they're considering disposing it all soon), the annual returns on this $265 MM real estate portfolio is going to be very small. If they sell some the next few years, it will be a boon to shareholders, but not hugely significant unless they dispose most of these projects. Therefore, because I'm always thinking in terms of annualized returns, I would give this portfolio a value at 60% of where it is today, or $160 MM.

In total, Reading Int'l's real estate portfolio is $160 MM in "income-producing assets" and $75 MM in development projects, leading to a total of $235 MM. This appraisal has discounted the company's own values, but they're the ones I'm comfortable with in analyzing an illiquid portfolio of unrelated real estate assets.

Combined Results

When you combine the real estate and cinema operations, you end up with these financials:

As you can see, the operating income may look appealing, but the debt load of the company has interest payments eating into it significantly. Add in taxes and maintenance expenditures (again, an estimate, although I figure most of their spending on real estate is development and not maintenance). What I define here as "owner earnings" is the value creation able to be spent on new real estate projects, buy back shares, etc.

The company releases their own numbers as to valuation, assuring investors that EBITDA is the best way to assess their earning power. I'm not so sure about that. It's almost as if James Cotter (Chairman/CEO) brought in all the exhausted investors from an intense soccer game out in the heat (i.e. continued low share price, underperformance) and offered them all iced Kool-Aid (i.e. EBITDA) as a measure of valuation. Bankers love the use of EBITDA as it allows their models to over-inflate real earning power, providing higher transaction prices alongside higher fees. Judging by bullish SeekingAlpha articles and elsewhere, it seems everyone is drinking the same Kool Aid. Gotta love the EBITDA valuations- makes the company appear extremely cheap, despite the debt load and illiquid real estate portfolio. Are not interest payments, taxes, and capital expenditures expenses? Find me a company that doesn't pay taxes with their business model and I'll be enthused (it's why I'm considering a month-long research project of AIG, with several years worth of operating loss carry-forwards).

Valuation

So with one-half of the business in the declining stage of business life, and the other half being highly illiquid but in development, what could an investor possibly value this at?

I've already stated I disagree with management's valuation guidelines. EBITDA will only lead a foolish investor down the wrong valuation path. Better to actually think; use some common sense in assessing the business.

As a separate entity, the real estate portfolio may be worth anywhere from my conservative $235 up to $300 MM or so, depending on how well they develop it. Hard to tell. Even harder to tell when they will turn it into cash, leading to sub-par long-term annualized returns if you value the real estate fully today.

As a separate entity, the cinema operations earning about $30 MM/year in free cash would be worth between $120-200 MM (considering being in a declining business, wouldn't get a huge multiple).

So, in combination, the total business should be worth somewhere between $355 MM and $435 MM. I realize this is a very large range of values, but it's difficult to get a good approximation on illiquid real estate and a cinema business with a good chance of margin contraction. This assumption, of course, is what RDI's total assets are worth. It speaks nothing to the capital structure in what you're buying with the equity ownership.

A combination of both- the high debt load in holding the illiquid real estate, coupled with cinema operations to cover the interest payments- makes the consolidated entity worth considerably less. As Buffett wisely has said,

"If you're smart, you don't need debt. If you're dumb, you shouldn't be using it."

I don't want to call out RDI's management for being stupid, but I will say this current capital structure is what's hurting the equity valuation.

So, I figure it's best to come up with an enterprise value here- the first time I've used it for valuation. This is what an entity's true cost is to a private buyer, should he continue to operate it as a going concern.

• Market Cap of equity: $113 MM
• Long-term obligations: $227 MM
• Cash & Equivalents: $31 MM

This gives an enterprise value of approximately $310 MM. As I stated above, the cinema and real estate assets are worth between $355 MM and $435 MM. This is on the lower end of the conservative valuation range, which indicates it has some upside on the real estate portfolio should a good chunk of it be sold in a reasonable amount of time.

So, at what price would I be interested, you might ask. I would say 60 cents on the dollar of what I think the assets are worth, looked at as enterprise value. At a range of what I believe is $355-$435 MM, this implies a 60-cent valuation between $215 MM and $260 MM. After reverse-engineering the enterprise value to subtract out long-term obligations and adding back cash equivalents, it gives RDI an implied "price I'd be interested" between $21 MM and $64 MM for the equity. This is not far off of today's market cap at $115 MM, but my valuation is not quite there for what I'm comfortable with. Shareholders today are unlikely to be hurt, considering my very conservative appraisals of the real estate portfolio (because I'm unable to assess it in the field), but from my standpoint, it's not quite cheap enough.

At today's prices and my reverse engineering of enterprise value, the company is trading somewhere between 71 cents and 87 cents of what I consider to be a crude present value approximation of their total assets. This is a decent discount, with good upside on the conservative real estate properties I've discounted myself, but not a large enough discount for me based on what I think it's worth.

Ben Graham wrote about buying a dollar for 60 cents. You're not getting that with Reading at today's prices. You're getting about a dollar for 80 cents. But hey, you could do worse. Just check out LinkedIn's latest prices. You're fortunate to be getting back 10 cents for every dollar. One could only imagine Graham's reaction to today's market environment.

Summary

I want to make it very clear that I didn't start this post as a discussion for or against Reading. I let it to sort of write itself; I began with cinema and saw the great cash flows, moved to real estate and saw all that debt, and finally came to the realization that enterprise value is most appropriate when valuing this business. I let the current price determine my willingness to pay, plain and simple... I plan on writing an article explaining this new epiphany as to why I used EV; it will help you to better think about investing and valuation, look for it to be posted in the next 24 hours. Also, look for it to not be nearly as long (haha?)

Overall, this is a reasonable investment if you have enough information on their real estate holdings; I'm conservative because that's my nature, but you may believe they can realize these values on their books in the next few years and lead you to good results. I'm not going to argue against that. I just have trouble using EBITDA as a measure of earning power and ignoring the interest rates charged on their large debt load today. To those shareholders who like the company, I wish you luck, but I won't be joining this party. If it comes down 40%, I'd be much more interested. Also, considering the theater business is in decline, that would worry me slightly with this large debt burden that could bring them down. This investment is not without some risk, although not enough to scare me away if it hit the right prices.

As I said above, I plan on writing a subsequent post on enterprise valuation soon after posting this one. It's important to have a good framework to think about company valuation- otherwise you end up drinking the EBITDA Kool Aid that any company chooses to serve you. Drinking the same Kool Aid as everyone else does make you feel good though, especially on a hot summer day... perhaps you could enjoy it while visiting a monopolistic popcorn stand.