CKEC : A Conviction Buy

Once in a blue moon, I come across a stock which is so severely undervalued that it makes my heart race. CKEC is one such stock. While the stock is a microcap and is relatively illiquid, I believe that if one takes the time to slowly accumulate a significant position, the rewards will be well worth the wait.

Carmike Cinemas (CKEC) is the 3rd largest cinema chain in the US, with 240 theatres and 2241 screens, although you’ve probably never heard of them. This is because Carmike focuses on small to mid size cities, where they are often the only theatre in town, and has no presence in major metropolitan cities. The cinema industry went on a building boom and took on too much debt in the 1990s, and 12 operators went bankrupt in 2000, including Carmike. It emerged from bankruptcy in 2002 with 327 theatres, and since then has been in deleveraging mode, closing marginal theatres and paying down debt. After the boom, the industry as a whole has largely rationalized, with a net elimination of theatres, and a wave of mergers. A notable consolidation is the 2005 merger of Loews Cinemas with AMC, creating the second largest cinema chain in the US, second to Regal Cinemas. Carmike itself acquired GKC Theatres in 2005, which owned 30 theatres, for $61.6M. As a result, over-capacity has largely been eliminated. Since Carmike’s emergence from bankruptcy in 2002, despite closing nearly 30% of its theatres, Carmike’s revenue has actually increased, ranging from a low of $469M in 2005 to a high of $514M in 2009. Ticket price per patron has risen from $5.35 in 2005 to $6.78 in 2010, and concession sales per patron has risen from $2.52 in 2005 to $3.44 in 2010, handily outpacing inflation. And most investors are aware that the cinema and movie industries are recession-resistant. In times of economic stress, people flock to communal activities like the movies. Therefore, despite some secular challenges that are routinely trotted out (high definition large screen TVs, Netflix, internet streaming, a shrinking DVD window period, direct-to-DVD movies etc.), I believe that CKEC will probably do okay in both an inflationary environment as well as a double dip recession. In effect, CKEC is a quasi-monopoly. If a small town can support only a single cinema, then a competing cinema chain would know that setting up another cinema would cause both itself and Carmike to lose money, and would not do so. CKEC’s revenues are limited only by the size of the town, its customers’ disposable income, and competition from other entertainment.

However, short interest in both RGC and CVEC have been rising recently, which I believe are driven by the lackluster box office earnings in 2011 thus far, coming in below box office earnings in 2010/2009. While cinema revenues in general are heavily influenced by box office numbers, the short thesis has several holes. Firstly, box office takings are unpredictable even to Hollywood veterans, and although YTD box office takings are trailing 2010 and 2009 numbers, a couple of blockbuster hits later in the year can easily make up lost ground. Secondly, Carmike’s customer demographic differs from the larger RGC and AMC-Loews cinemas, and skews towards action/adventure/comedy movies and away from dramas. And finally, while per-ticket sales are lower with Carmike than with bigger competitors, ticket volumes tend to be more steady with Carmike, a reflection of the more limited entertainment options available in smaller cities and towns. Therefore, Carmike is less susceptible to poor box office numbers.

Before I go into a valuation for Carmike, I am going to first point out several features from the financials. Firstly, Carmike generates more cash than is reflected by its net income. Its cap-ex is limited to a maximum of $22M per year due to a loan covenant, which is substantially below the $30M-$40M of depreciation reported, therefore free cash flow should be boosted by $10-$15M annually. In addition, nearly all of Carmike’s theatres have already been converted to digital distribution and projection, and 80% of the theatres have 3D screens, so the bulk of the big ticket cap-ex items are behind it. The company operates on a negative working capital basis, because its revenues are received in cash, while its suppliers are paid later, therefore it essentially runs its business off other people’s money. Debt consists of $233M in a term loan due in 2016, at an interest rate of LIBOR plus 3.5%. About half the loan is hedged with interest rate swaps to not exceed 9.5% in interest, and the average interest rate in the quarter ending Sep 2010 was 5.50%. Some leased land and buildings are also accounted for as capitalized leases totaling $116M, and the rent is accounted for as interest, approximately $20M to 25M annually.

I will now estimate a conservative valuation based on the lowest revenue for CKEC in the past 8 years, which was around $470M in 2005. Gross margin for Carmike is approximately 20%, which gives $94M in operating earnings. I assume the following expenses : $17M for SG&A, $22M for cap-ex, $14M for interest (6% interest on 233M LTD), $25M for rent on capitalized leases, $6M for taxes, which would give a free cash flow of $10M. I assume a PE multiplier of 12 for Carmike’s recession resistant business with favorable economic characteristics, which would give a total valuation of $120M, approximately 30% above its current market cap of $93M.

And finally, I’ve saved the kicker for last, for the patient reader which has made it thus far. In October 2010, Carmike signed an agreement with Screenvision giving it 30 year exclusive right to show pre-movie advertising in Carmike’s cinemas. In return, Carmike will receive a $30M check in January 2011, plus 20% ownership of Screenvision. Screenvision is a private company and its value is not easily estimated, but Shamrock Capital has recently purchased a 50% stake in the company for $160M, which would value Screenvision at $320M. After the transaction, Shamrock has a 61.2% stake in Screenvision, Technicolor holds a 18.8% stake, and Carmike holds a 20% stake. Incredibly, the market seems to have completely missed the value of this deal to Carmike. Even assuming a 100% control premium to Shamrock’s transaction, it would give a $30M value to Carmike’s stake in Screenvision, and together with the $30M check, should boost Carmike’s valuation by $60M. Therefore, I’m comfortable giving CKEC a valuation of $180M, or a $14 per share value, nearly double current prices. And note that this is based on a conservative estimate of box office earning, which may spike higher if a blockbuster movie suddenly appear. And I anticipate that CKEC will surge higher once the $30M check and 20% stake actually appears on the balance sheet. Based on the astounding undervaluation coupled with superb business characteristics, I’ve designated CKEC a conviction buy, and have made it the largest position in my portfolio.

Disclosure : I own shares in CKEC.