Volume 32, Number 4 October 2017 SECULAR VS CYCLICAL: WHAT MOVIE THEATER STOCKS ARE SHOWING Turnaround investors analyzing a downtrodden stock often face the following question: is the company s problem cyclical or secular? Cyclical means that the company (or its whole industry) is facing temporary headwinds that are likely to swing back eventually to a more favorable direction. For example, auto makers and airlines tend to do poorly when the overall economy weakens but then rebound when the economy strengthens again. Secular means that the negative forces affecting a company are long-term and often permanent in nature. For instance, many people believe that the changes to the retail sector brought about by Internet shopping are not likely to reverse and therefore should be considered secular. The movie theater industry presents a very timely example of the cyclical versus secular dilemma. The stocks of the theater operators have been among the worst performers this year. While the broad market has gained nearly 13%, many stocks in the theater industry have declined by 20-50%. Are the problems secular or cyclical? The right diagnosis could mean a huge difference in returns. A major secular issue is the rising use of streaming services like Netflix and Amazon Prime that let viewers watch movies anytime and anywhere. These services won t be going away and if anything are likely to increase making this a secular issue. The theater industry is also in a cyclical downturn. Since 2009, the industry has had two cyclical downturns, each lasting a year or two, with ticket volume declines of roughly 7-10%. Attendance this year could be down 10% or more. These downturns have been largely attributed to a spate of weak offerings from the movie producers or a temporary shift in entertainment preferences. If the current weak attendance is mostly cyclical, it will likely reverse and produce impressive gains for investors as theater profits rebound. IN THIS ISSUE Stocks on Sale... 3 R : Buy: Advance Auto Parts... 5 Sell: MGIC Investment Corp. 6 News Notes... 6 Performance... 7 Although we respect the longer-term secular issues, we think much of the recent problem is cyclical, largely driven by ebbs and flows in movie quality. Through the end of the summer, this year s movie line-up has been mostly lackluster. Nevertheless, viewers are still enthusiastic about seeing great movies at the theater. The experience of going out to see a movie has been drawing people to the theaters for more than a century, and we don t see that changing soon. Moreover, theater operators are working hard to enhance the moviegoing experience with luxury recliners, improved food offerings, alcoholic beverages and other amenities.
October 2017 The Turnaround Letter Page 2 Better Showing Ahead for Theater Stocks? COMPANY SYMBOL The slate of movies for the rest of this year looks promising with a new Star Wars film, three superhero movies and a new edition of the successful Planet of the Apes series. Two recent releases support our thesis that people still enjoy going to the movie theater. Stephen King s It has been a surprise success, grossing $270 million worldwide in only three weeks to become the #1 horror movie of all time, and Beauty and the Beast grossed $1.3 billion. Current cinema stock valuations reflect investors low expectations. Most of our selections trade for less than 8x next year s expected EBITDA and provide generous dividend yields. Compare these to competitors Netflix, selling at 46x EBITDA, and Amazon, selling at 18x EBITDA, with neither offering a dividend. From our seat, the theaters look like more entertaining value. AMC Entertainment (AMC) AMC is the world s largest theater company with over 11,000 screens in 15 countries in North America and Europe. It is also the largest IMAX operator in the U.S. with 179 locations. Its shares are down 55% this year and are below its 2013 initial public offering price of 18. Along with the industry-wide issues, investors worry about AMC s progress integrating three major acquisitions totaling $3.3 billion that more than doubled its theater count. They are also concerned about its high debt level and tight cash flow. However, AMC remains highly profitable, and it will likely generate strong returns as it integrates and upgrades its acquired theaters and RECENT PRICE 52 WEEK HIGH LOW MARKET CAP $ BIL 2018 EV/ EBITDA DIV YIELD% AMC Entertainment AMC 15.00 35.65 12.05 2.0 7.4 5.1 Cinemark Holdings CNK 36.34 44.84 32.03 4.2 7.4 3.3 Cineplex CPXGF 32.41 41.15 28.16 1.9 10.5 4.3 IMAX Corpora on IMAX 23.00 35.30 17.57 1.5 9.7 0.0 Marcus Corpora on MCS 28.20 34.90 23.85 0.8 7.4 1.9 Regal Entertainment RGC 16.32 24.79 13.90 2.6 7.4 5.4 initiates its first-ever share repurchase program. At a low 7.4x estimated 2018 EBITDA, along with the generous 5.1% dividend, AMC s shares could provide blockbuster returns. Cinemark (CNK) Cinemark is the #3 cinema company in the United States, with 337 theatres in 41 states. It also has an extensive array of 192 theatres in South America, including 80 in Brazil where it has the top market share. Like its peers, Cinemark s recent results have shown rising average ticket prices and higher concession revenue but weaker attendance, both domestically and internationally. Future growth is likely to come from 1) expansion in South America, 2) the continued roll-out of its luxury recliners and enhanced food/drink concessions, and 3) its loyalty programs. Debt is reasonable and the shares provide a 3.2% yield. Cineplex (ADR - CPXGF) Based in Toronto, Cineplex is Canada s largest theater company with 163 locations including 23 IMAX theaters, and it operates other businesses including digital billboards and sports/entertainment complexes. Its theater business remains strong, with both concession sales and average ticket prices getting boosts from an impressive array of innovations. The Media and Amusement & Leisure businesses are growing. Cineplex shares hadn t moved much in over three years, then fell nearly 20% recently on surprisingly weak second quarter results. Management believes these problems are largely transient. The debt level is relatively modest, and the 4.3% dividend is likely to continue.
October 2017 The Turnaround Letter Page 3 IMAX Corporation (IMAX) Movies from this iconic immersive theater company can be seen in 1,154 IMAX theaters in 75 countries, including 403 in China. The company generates its revenues from selling and leasing IMAX theater systems and from licensing its IMAX films and trademarks. It generally does not own IMAX theaters. Recent results have disappointed due to weak per-screen average revenues, particularly in China, and from struggles with diversification efforts beyond the core IMAX business. However, overall demand for IMAX theaters remains strong with a record 580 theater backlog. Some of the weak demand in China may be due to the newness of the IMAX concept there. Management announced a 14% headcount reduction and a $200 million share repurchase. The shares are down 33% since April, but a turnaround in China and tighter focus on its core business could make IMAX shares a hit again. Marcus Corporation (MCS) Milwaukeebased Marcus Corporation operates two businesses: a theater business with 895 screens in 69 theaters in the Midwestern U.S. and a lodging business with 19 hotels and related properties across 10 states. Marcus remains familyrun, generally produces better growth and margins than its peers and has kept pace with industry innovations across its portfolio. Hidden on its balance sheet is its ownership of 79% of its theaters, compared to the industry average of about 9%. The balance sheet is conservative, and the share valuation is in-line with its peers. Regal Entertainment Group (RGC) Based in Knoxville, Tennessee, Regal is the nation s second-largest theater company with 566 theaters (7,379 screens) across the United States, Guam and other Pacific locations. Its strategy is straightforward increase its theater count through new-builds and acquisitions, upgrade its seating to recliners, expand its food and beverage menu (including alcoholic beverages) and offer value-added services like loyalty programs and internet-ordering. Denver-based Anschutz Company is the controlling shareholder, whose recent selling has added to investor concerns. Debt levels are moderately elevated. However, the company is wellmanaged, and it could get a boost by upgrading the remaining 75% of its classic style seats. Recent acquisitions appear to have been bargains. With the shares down 25% from April, and selling at a modest 7.4x with an industry-high 5.4% yield, Regal looks appealing. STOCKS ON SALE AT DISCOUNTS OF UP TO 70% FROM THEIR HIGHS Some investors won t buy clothes, gear, or cars unless they are at full price. The logic: if it is sold at a discount, it must not be any good. The same is true with stocks. It s comfortable to buy brand-name stocks that have been rising strongly and sell at premium prices. But, as Warren Buffett points out, price is what you pay, value is what you get. With that thought in mind, we sifted through a list of stocks with market caps over $1 billion that are selling at huge discounts to their 52-week highs. Interestingly, there were no stocks with declines of more than 40% among the 386 companies with market caps above $22 billion. As expected, many of the candidate companies are in serious trouble and probably deserve their discounts. However, we found a handful that have real value that the market appears to be missing. Listed below are our top five bargain-bin stocks. ACACIA COMMUNICATIONS (ACIA) Acacia, with revenues of about $420 million, is the market leader in specialized high-speed modules and components for data cloud and other
October 2017 The Turnaround Letter Page 4 Stocks On Sale COMPANY SYMBOL RECENT PRICE % CHANGE FROM 52-WEEK HIGH MARKET CAP $ BIL 2017 EV/EBITDA DIVIDEND YIELD% Acacia Communications ACIA 47.24-59 1.9 12.1 0.0 AmTrust Financial AFSI 13.53-52 2.6 9.0** 5.1 Mattel* MAT 15.01-55 5.3 9.7 4.0 Rite Aid RAD 2.03-77 2.1 12.6 0.0 Veeco Instruments VECO 21.30-38 1.0 10.0 0.0 *Previous TL recommendation **AmTrust EBIT (operating earnings) multiple shown high-performance networks. Its key markets, including China, continue to show impressive growth as communications networks continually increase their speeds. Following several years of healthy revenue growth, Acacia has stumbled recently. Quality problems at a supplier left them short of product, and high customer inventory levels (especially in China) temporarily stalled new orders. These problems appear to be just about resolved, and the company appears well-positioned to benefit from robust market trends. Acacia produces positive cash flow, has $285 million in cash and no debt, and trades at a relatively modest (for a technology company) 12x EBITDA. AMTRUST FINANCIAL (AFSI) AmTrust is a global provider of workers compensation, property and casualty, and warranty insurance. The company is working to integrate several large acquisitions and has had severe difficulties with reserve levels, leading to legitimate concerns over its financial health. However, AmTrust is rebuilding and simplifying its balance sheet, providing more disclosure to investors and improving its overall operating efficiency. Since May, it has raised $300 million in new equity, sold a $212 million stake in an affiliate and purchased up to $400 million of re-insurance coverage to limit its risks. Its underlying markets continue to look healthy. With a modest 9x EBIT valuation and a 5.1% yield, AmTrust s future looks much better than its recent past implies. MATTEL (MAT) Investor sentiment for Mattel, one of the nation s largest toymakers, including the iconic Barbie, Hot Wheels, and Fisher-Price toys, couldn t get much worse. Management s efforts to reverse the company s stagnant bureaucracy and boost its innovation appear to be making progress, but the pace isn t meeting the market s expectations. Investors were also disappointed by the 60% dividend cut (Mattel may eventually eliminate it), and concerned that one of its major customers, Toys R Us, recently declared bankruptcy. Mattel still struggles to monetize the value in its iconic brands, but we have confidence that management will find the answer. RITE AID (RAD) Rite Aid, currently the nation s third largest retail pharmacy company with over 4,500 stores, is in the midst of a major transformation. After its deal to sell the whole company to Walgreens was blocked by antitrust regulators, it will now sell about half of its stores to the larger chain and enter into a 10-year supply agreement with Walgreens. These transactions will allow Rite Aid to cut its debt and improve margins. Recent results have been poor, but as the merger distractions subside and management renews its focus on its more concentrated store base, profits and the stock price should rebound. VEECO INSTRUMENTS (VECO) Veeco, with revenues of about $500 million, builds highperformance equipment used for manufacturing semiconductor wafers, LEDs, and other electronic components. The market leader in advanced thin film process technologies, Veeco recently completed the acquisition of UltraTech for $815 million, adding new capa-
October 2017 The Turnaround Letter Page 5 bilities and markets. Its share price is down sharply following its second quarter results on concerns about weak revenue and market share losses, particularly in China. However, overall industry demand for Veeco s products appears healthy, the company s steady innovation should help it retain customers and management seems up to the task of restoring growth. The balance sheet is conservative. RECOMMENDATIONS Purchase Recommendation: Advance Auto Parts, Inc. A A P, I. 5008 A R R, VA 24012 T. (540) 362 4911 www.advanceautoparts.com C : M C ($7.2 B ) S : AAP E : NYSE B : A P S A R (2016): $9.6 B E (2016): $460 M 9/28/17 P : $99.50 52 W R : $177.83 $82.21 E. D Y : 0.2% M. R P : $140 Background: Advance Auto is one of the nation s largest aftermarket auto and truck parts suppliers, distributing its products through 5,073 company-owned stores and over 1,250 independently-owned Carquest stores across North America. The company s history of growth by acquisition has produced a disorganized and overly complex operation. Its internal distribution network appears to be a jumble, leading to bloated inventories and excessive costs as well as reduced availability of parts in its stores. Difficulties with integrating its $2 billion purchase of General Parts in 2014 have only worsened its problems. These problems, as well as Advance Auto s inefficient storefront and office operations, have driven its EBITDA margins down to less than half the average of its peers. These factors, combined with tepid industry growth over the past year and fears of competition from potential new entrants like Amazon, have caused many investors to be skeptical about Advance Auto s future. Even a complete changeover in leadership including the addition of respected activist Jeff Smith of Starboard Value as chairman, a new CEO, a new CFO, and a new head of supply chain, has done little to stoke investor interest. Advance Auto s shares are down more than 40% so far this year. Analysis: Investors lack of patience reminds us of the chef who gets frustrated that his cake, which requires an hour to properly bake, looks awful after 20 minutes. Advance Auto s problems are deep, and so fixing them will take some time. We look at this impatience as providing an opportunity to buy into the turnaround at an even better price. The new leadership is highly capable and has a
October 2017 The Turnaround Letter Page 6 clear mandate for change. Chairman Smith was instrumental in overseeing impressive operational turnarounds at Darden Restaurants, Office Depot, and other companies. Starboard s 4.3% ownership stake keeps its motivation high. CEO Tom Greco formerly headed Frito-Lay North America, which is renowned for its highly efficient operations. New SVP Leslie Keating ran Frito-Lay s supply chain, which has been widely acclaimed as an industry leader. The new CFO brings both auto industry and tech experience from prior stints at General Motors and Amazon. Despite the market s pessimistic view, the new management is making progress already. Inventories in 2Q17 fell 2.9% from a year ago despite higher revenues. A better organizational structure is in place. Zero-based budgeting is being implemented, and many other changes are underway. Even though EBITDA this year could be down by as much as 25% because the costs of the turnaround won t yet produce many benefits, we think the company s future margins and earning power will be much better. Management has outlined plans for a 5-percentagepoint margin improvement in five years. Better inventory management should improve cash flow, improve customer satisfaction and help ward off competition from Amazon. Meanwhile, the balance sheet is solid with modest debt along with $257 million in cash. Broad industry conditions look favorable, as people are increasingly keeping their cars longer. Moreover, auto parts retailers can be a counter-cyclical investment, because if economic weakness depresses new car sales, there will be more older cars remaining on the road. The turnaround s complexity means that it won t be linear, and investors should expect it to take a few years. But with the strong new management, supportive industry conditions, and an attractive valuation at 7.7x next year s EBITDA, Advance Auto should eventually have an open road ahead. We recommend the PURCHASE of shares of Advance Auto Parts (AAP) up to 140. Sale Recommendation: MGIC Investment Corp. MGIC stock has moved up pretty steadily over the past year as results improved. We view the turnaround as now largely complete, and worry that the company could be vulnerable to any weakness in housing. Therefore we recommend selling MTG shares now. Buy limit changes: Layne Christensen After a protracted struggle, some divestitures and a few CEO changes, the turnaround finally appears to be gaining traction. We are raising our Buy limit to 15. Citicorp Citi continues to improve its business and work off the problems from the financial crisis, and it is increasingly likely to return large amounts of now excess capital to shareholders through share repurchases and a higher dividend. We are NEWS NOTES raising our Buy limit to 80. NII Holdings Its transaction with AINMT limits upside but reduces risks. We also believe the shares have been depressed by a large institutional seller trying to exit their position. We are reducing the Buy limit to 1. Caterpillar The company s stronger outlook will probably drive the shares a bit higher, but the valuation is approaching full, and we are reducing Caterpillar to a Hold.