Guest Pitch: IMAX China (1970: HK)

Expected privatization: 30-50% upside

This idea was shared by DanX. It is an interesting play on the expected privatization of IMAX Chinese subsidiary, which is listed on the Honk Kong stock exchange.

IMAX China is a Hong Kong-listed subsidiary of IMAX Corp (IMAX). IMAX designs and manufactures premium projection and sound systems for movie theaters around the world. IMAX China, as you may have guessed, licenses this technology and provides it in China. The parent company owns 71% of the Chinese entity, which has been perpetually undervalued compared to IMAX US despite better margins and a larger growth runway. Last year, the management tried to opportunistically take its Chinese subsidiary private. Unsurprisingly, the offer of HKD$10/share was rejected by the minority shareholders.  With the lock-up period for the new bid expiring in 2 months, I believe IMAX is preparing for another privatization attempt. The stock trades at HKD$8/share today.

The stated reasons for the last year’s privatization offer centered around the simplification of the corporate structure, savings on public listing costs, and lower bureaucratic burden associated with the listing in Hong Kong. The parent further justified the transaction by saying that IMAX China had significant cash on its books ($78m at the time) that could help IMAX grow. Finally, IMAX wanted to capture the full profitability and dividends of the Chinese subsidiary instead of giving 30% of it to minority shareholders:

And this is before realizing approximately $2 million of annual public company cost savings as well as potential tax efficiencies resulting from the China go-private transaction. It would also allow us greater flexibility in the usage of IMAX China’s cash, which was approximately $78 million at the end of Q1.

There is also cash leakage because we paid a dividend out of China and obviously close to 30% of that went outside the IMAX [ Corp. paring ]. So after this transaction, we’ll have the ability to keep that cash as well.

IMAX offer came at a 50% premium to pre-announcement levels and valued the company at about 6.5x pre-COVID adjusted EBITDA, compared to a historical multiple of more than 10x. The deal was best and final, so upon rejection, they could not have increased the bid and could only come back after 12 months. The transaction was contingent on the approval of 75% of disinterested shareholders and rejection by less than 10% of disinterested parties. Essentially, just 3% of the shareholders could block the privatization.

Soon after the offer was announced, one of the largest minority shareholders, Letko Brosseau with a 1.7% stake, opposed the privatization, stating that the bid was opportunistic and significantly below fair value of IMAX China. He stated:

The offer price was 60% below pre-COVID levels and did not reflect IMAX China’s historical level of profitability and its potential for strong earnings growth.

Unsurprisingly, given that the management could not increase the bid, the offer was rejected with 18% of disinterested shareholders voting against. Ever since the rejection, the stock has basically traded sideways at a round the current levels.

We are currently two months away from the expiration of the lock-up period, after which a new privatization offer could be submitted. A slightly improved bid should be enough to persuade minority shareholders. Last year’s offer was approved by 70% of disinterested shareholders just below the 75% acceptance threshold. IMAX would only need to convince part of the previously opposing shareholders to get the deal through. It should not be too hard, as IMAX China stock has done nothing over the last couple of years and is unlikely to move towards a fair valuation given the low liquidity of the stock and the general turbulence in the Chinese stock market.

I think IMAX still has the same incentives to acquire the full ownership of the Chinese subsidiary, so the revised offer in two months seems very likely.

It makes sense for IMAX to buy out their high-quality subsidiary instead of continued buybacks of its own shares. This strategy would allow them to consolidate a large cash balance of the subsidiary and use it for further growth. Moreover, the buyout thesis is further supported by the comments from management, as well as the recent management turnover in the Chinese subsidiary.

On April 30, the CFO/COO of IMAX China resigned from her position, and the company decided to eliminate the roles of CFO and COO altogether. This seems to be a clear signal that the company is preparing for full consolidation.

On the latest Q1’24 call, management was asked about privatization and whether they plan to revisit it this year. While the possibility was somewhat downplayed, management said that any decision on the privatization would depend on the company’s performance in China. Well, the situation in China has been pretty good in 2023 with some visibility towards continued growth acceleration. Despite this, IMAX China stock remains undervalued, trading 5.8x 2023 EBITDA vs IMAX US at 8x. I believe this year would be a great opportunity for IMAX to snatch the Chinese sub before it has fully recovered and continued on its growth path (more on business prospects in the section below).

Analyst Question
I’ll be quick. You tried to consolidate the China sub as a way to save money. Maybe detail for us if that didn’t happen, where you can pull cost out of that operation without sacrificing opportunities?

CEO’s Response
Well, good question, Steven. In fact, we’ve been doing that. So we just moved our office in Shanghai, our headquarters into half the space at half the rent. And it’s one of our strategic goals is to manage costs there. We broaden our IR effort there and save some cost in the financial area, kind of across the board, we’ve been looking at what opportunities that presents.

And you didn’t ask this, but I’ll address it, because we’ve gotten the question, are we going to try and privatize it? Again, and we can’t go back until much later this year. But we haven’t made a decision yet what to do. I think it will depend on China’s financial performance, what IMAX’s liquidity looks like and then how the Chinese shareholders feel about. I’ll make the decision just reminding everyone that wasn’t had to do. That was — it would be nice if we could do it. But even though we didn’t get it done in the way we want it, we’ve realized some of those savings along the way by being strategic about how we manage our costs there.

 

Business overview

IMAX China’s business is not markedly different from its parent – the Chinese subsidiary provides installation of IMAX systems and maintenance services.

The key difference between IMAX and IMAX China is that the latter does not manufacture the equipment nor reformat the content (from mainstream aspect ration into IMAX appropriate format). The subsidiary has a license to sell these products/services in China, and in turn, pays a portion of the fee to the parent company for the equipment and remastering. This makes the Chinese operation significantly more asset-light and profitable. EBITDA margins of IMAX China have consistently been 20% higher than those of IMAX parent (55%-60% vs 35%-40%, except for covid years, when margins on both  sides were lower).

Broadly, the top line can be subdivided into three categories: box-office, network maintenance, and upfront installation revenues. IMAX usually gets a cut from the box-office sales, about 9.5% for local language movies and 12.5% for Hollywood movies. The second recurring source of revenues are maintenance services for its entire network based on long-term contracts. The equipment sales, in turn, are carried out either through direct sales or through some sort of revenue share model, but the majority of these are in the form of upfront revenues.

Since the launch IMAX China revenue mix was dominated by new system installations. The company currently has about 800 systems installed in China, up from less than 300 at the time of the IPO in 2015. IMAX China still has a substantial backlog of 200 contracted system installations and the opportunity for a further 400 locations across China.

Installation revenues declined sharply during COVID and the associated construction slowdown. However, management has stated on numerous occasions that, in the long run, they expect to come back close to pre-COVID levels of installation sales as China market still remains relatively undepenetrated for IMAX screens relative to US.

Importantly, despite the slowdown of the installation growth the quality of the revenue has improved. The previously installed systems now generating recurring revenues – these now represent about 71% of the total.

Below is an excerpt from Q4’22 earnings call:

Question
So I got 2 questions regarding your theater install. First is that I understand near term is hard to predict. But what’s your longer-term outlook? Could we potentially see a rebound on installation pace back to the pre-COVID levels? And I’m keen to know what are the key drivers and the hurdles underpinning your outlook?

And secondly, could you please provide more insight on how expansion pays and your plan differ in high-tier cities and low-tier cities?

IMAX CEO – Richard L. Gelfond
Okay. So your first question about longer term how we see installs. So China had a longer and later reopening than other markets in the IMAX business. And what we’ve seen was that in the year following the reopening, there’s been a lower level of installs. So if you ask me to take a guess, I would say it’s unlikely that the total installs in China would return to prepandemic levels in 2023. However, we’re seeing now, again, keeping in mind, we’re about 6 months to a year ahead of China in coming back, installs are starting to approach more normal levels. So I think looking out longer term in China, I do think, over time, they will approach prepandemic levels.

And remember, we have a fairly sizable backlog in China. And Jim, you could correct me, but a little bit more than 200 theaters. And I think those are contractual obligations. So I think we’ll start to see those come online as well as new signing installs as we move forward. So I would think over time, we will approach the historic levels of installs. And Jim, maybe you want to talk about the second question about the performance in different tier cities.

The story about the box office trends is a bit more complicated. The decline has been caused by both the COVID-19 pandemic and stricter regulation of Hollywood films in China. As of the end of 2023, both of these issues have largely or partially been resolved. Currently, the box office sales of IMAX movies are at 80% of 2019 levels and are likely to trend towards full recovery in 2024.

Quote from Q4’23 IMAX earnings call:

Analyst Question
Rich, if you can explain a little bit — I know you talked about China, you guys expect a very strong summer in China. We saw recovery last year versus 2022 when things were shut down. What inning is the recovery in China? And how do you feel about the opportunity there to grow in ’24 and into ’25? Maybe just give us like a state of the union address on how you feel about the China prospects going forward.

IMAX CEO – Richard L. Gelfond
Yes. Sure. Sure, Omar. Happy to do that. So it will be a surprise to many people, but the movie industry in China, in general, did pretty well in ’23. And our box office was around $300 million, which is up significantly than any time during the pandemic. And as you said, it really didn’t open until January, and it wasn’t fully open throughout the year.

So have a pretty positive outlook over the next couple of years. The macro trends appear good, and movies are still an economically affordable luxury. And IMAX particularly is even at a premium price point, has done very well. Our indexing is very strong.

So I think with China, the question is just how quickly does it continue to approach normal and what does the backlog slate look like, both for domestic films and for Hollywood imported films and other imported films.

It’s part of my nature, Omar. And I believe, and Natasha could jump in, but I believe we budgeted China this year to be better than it was in 2023. So looking into the future, we feel pretty good about it, but there are still a few variables that have to sort themselves out

A bit more background on the regulatory issues around Hollywood films in China. PRC and the US had a bilateral agreement on the number of films that can enter China every year. The deal included a quota of about 34 films as of 2012, which was set to be renegotiated at the end of 2017. However, due to a reorganization within the Chinese Film Bureau and the escalation of the trade war between the countries, China imposed a soft ban on US films in mid-2019. Imports of IMAX-formatted Hollywood films have decreased from 30 in 2019 to 10 by the end of 2022. This obviously had a significant impact on the company’s box office receipts, considering that pre-COVID, more than 70% of the box office for IMAX China was coming from US films. In 2023, the situation seems to have signficantly improved, with 20 releases being allowed into China. This was very much in line with management’s expectations at the start of the year. If the trend continues, we may see further easing of restrictions and possibly a return to more normal times.

Below is an excerpt from Q4’22 earnings call:

First, you asked about the split between international films and local films. Again, I think it’s hard to say because, obviously, the international films have to go through an import process. But I would expect it to be similar to what it was prepandemic, we’ll see. We’ve been very encouraged by — on the number of films that have gotten in so far. Ant-Man, Wakanda, Shazam, Dungeons & Dragons, a number of other films. So — and we think that the film bureau is kind of returning to a more normal policy. So I think the split would be consistent with what we’ve seen before.

Also, management has realized its over-dependence on Hollywood and is now refocusing on Chinese language movies. This shift in strategy was not just caused by recent regulatory hurdles but also by a change in the preferences of Chinese viewers, who are now more inclined towards local language content. In 2012, 7 out of the 10 highest-grossing films came from Hollywood. Meanwhile, in 2023, none of the Hollywood releases were among China’s top ten highest-grossing blockbusters.

All these trends may seem negative, however, more and more movies in China are being released in the IMAX format. Given the recent strategy change in the company, this could be an opportunity for more growth. As you can see in the chart below, IMAX movies were significantly weighted towards Hollywood, while the general box office in China was largely dominated by local language. This has been changing recently, and management is clearly planning to capitalize on it.

I believe that the combination of all these factors, the post-COVID recovery and general long-term growth prospects, continues to make IMAX China an attractive privatization target for the parent company, especially since the stock price still does not reflect these positives.