By: Steve Smith
Pairing up these two theater chains present distinct views on the future of movies.
You never know which films might be a hit which makes investing in studios a high risk venture. But there are several very clear trends in the way we consume moving pictures that sets up an interesting investment opportunity.
I’m looking at pairing up a long or bullish position in IMAX (IMAX), the maker of wide and surround theaters, with a short or bearish position in Regal Entertainment (RGL), the owner and operator of traditional movie theater chains.
Paired trades are often viewed as something of a hedged position but this is not entirely accurate. Paired trades typically position two companies in the same industry against each Coke (KO) vs. Pepsi (PEP) or McDonald’s (MCD) v Burger King (BKS) as a means of reducing sector risk they should NOT hedged positions. In fact to take a cynical view they should be considered as two ways to be wrong. For example, if you had been long MCD and short BKS over past year you would have lost 7% in former and been decimated by the 50% gain in the latter as Burger King shares soared on activist restructuring and turnaround initiatives.
But by using options we can reduce and limit any potential losses and increase the probability of profits. Before getting into the specific strategy let’s look at the two companies and what informs my investment thesis.
Generally speaking the movie theater business faces the challenge of flat to even lower attendance as improved home systems, quicker time to streaming or DVD releases and compelling programming from Netflix (NFLX), HBO and even YouTube.
The main things supporting total industry sales figures are blockbusters and higher average ticket prices. These two items play right into IMAX’s strength. People still want to see large-scale “event” movies on big screens and are willing to pay more for the special formats such as surround or 3-D that IMAX specializes in.
The company currently operated 868 IMAX theaters in 59 countries. Most of the theaters are located within multiplexes in which it has revenue sharing deals such as AMC or Cinemark. As it becomes something of the “anchor” tenant for these chains it can command a higher percentage of the profits.
IMAX also has several nice avenues for growth. These include opening 30 new locations in the U.S in 2015. But the real growth opportunities lie overseas where it is expanding aggressively. In the next year it is expected to open 40 theaters in China alone and estimates it has a total backlog of 250 theaters in the works from the Middle East to South Africa.
It is also pushing into theme parks and other tourist destinations such as science and educational facilities and cultural centers such as museums. It is even teaming with companies such as Harmon (HAR) for installing high-end private home theaters.
From a technical standpoint shares of IMAX have been consolidating sideways for the past few months. A recent close above both the 20 and 50 day moving averages on Wednesday suggest it may be ready to break out to the upside.
There was notable bullish option activity this past Tuesday as over 15,000 of the June $33 calls traded. Most of this was done at the $1.30 asking price and nearly all of it translated into new open interest suggesting this was new buying. Someone is betting shares will be above $34 by June; a decent 13% gain over the next five months.
The company reports earnings on February 18th, which might provide the next catalyst for share price gains back above the old highs of $31.50.
By contrast Regal Entertainment (RGC) prospects are much dimmer. The company operates over 7,367 screens in 574 theatres in 42 states. But there is no growth on the horizon. In fact revenue declined by 7.5% to $2.93 billion for fiscal 2014 and are expected to drop another 3% on quarterly basis when it reports earnings on February 12th.
The disappointing performance had company hire investment-banking firms to explore “strategic alternatives” i.e. put itself up for sale which have the stock a pop back in October. Apparently there were no takers as companies withdrew from that process last week causing a commensurate drop in the stock.
It appears the shares will now be hard pressed to regain those old highs above the $22 level.
I want to use the prospect of IMAX share price gains against the limited upside of Regal to create something of a buy-write position using options. I’m buying calls in IMAX and selling calls in Regal. Note; this is not a covered position; each is margined or requires capital separately.
In the IMAX call purchase the capital required and total risk is limited to the purchase price. In the sale of RGC calls one can use a spread to limit the margin and risk.
In IMAX I’m buying the June $33 calls for $1.40 a contract.
In RGC I’m selling the March $22.50/$30 call spread for a $0.75 net credit
This is a $0.65 net debit for the combination.
The IMAX calls will achieve a profit if shares are above $34.40 by the June expiration. Of course profits can be taken sooner.
The RGC bear call spread will expire worthless if shares are below $22.50 at the March expiration allowing one to collect the $75 per spread. Note by selling nearer term RGC calls we are getting the benefit of accelerated time decay. And then have the option of selling the next expiration cycle to collect more premiums.