April 15, 2011 - 3:03pm EST by
2011 2012
Price: 29.50 EPS -$1.07 -$0.60
Shares Out. (in M): 51 P/E NM 49.3x
Market Cap (in $M): 1,696 P/FCF NM NM
Net Debt (in $M): -33 EBIT -28 10
TEV ($): 1,665 TEV/EBIT NM NM
Borrow Cost: NA

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I recommend a short position in RealD.  RLD is an overpriced story stock that on the surface is still growing robustly, but is beginning to experience some deterioration in underlying fundamentals, suggesting that lofty current expectations will not be met.

RLD is a leading global licensor of 3D technologies, which enable 3D viewing in the theatre, home, and elsewhere.   RLD licenses cinema systems to motion picture exhibitors that show 3D content and provides active and passive eyewear, as well as technology to consumer electronics manufacturers.    Basically all of RLD's revenues to date are from theatre licenses and product sales, which are 3D glasses.  RLD went public in July, 2010.

The business model works as follows: RLD installs its 3D systems free of charge to the exhibitors and then collects royalties from them.  License revenue is accounted for as an operating lease.  Earnings growth will be dependent mainly on the royalty per admission, although some revenue is derived from fixed license fees and per film fees.   Amounts received up front, less estimated allowances, are deferred and recognized over the lease term.   Licensees do not actually report and pay for license revenue until after the admission has occurred, so estimates are used for revenue recognition purposes.   It currently costs RLD $10-12k to install a screen.

As the main revenue driver, admissions are very dependent on the number of 3D screens deployed, the number of 3D movies released, the quality of those movies, and the overall box office receipts, which is based on ticket prices, as well.   There is generally a $3 ticket premium for 3D films, of which RLD receives approximately $1.  The approximate breakdown is $0.43-0.50 royalty per admission and $0.45-0.60 for sale of eyewear.

Eyewear currently has a -19% gross margin, so it is a big drag on earnings, although margins are expected to improve as the installed base gets supplied and recycling improves.  However, there is a significant amount of "breakage" with eyewear, so there will be continual restocking.   Internationally, RLD sells glasses directly to the exhibitors, but domestically eyewear is heavily subsidized by the studios and distributed to exhibitors.  The risk to RLD and the exhibitors is that once there are higher 3D penetration levels that those subsidies could be reduced.

Due to stock options issued to motion picture exhibitors, gross revenue is reduced by the value of the options at the current stock price during each period to arrive at net revenue.  More on that below.

RLD appears to be hitting on all cylinders.  Growth has been off the charts and RealD screen additions have been well above plan.  According to the MPAA, in 2010 there were 39,547 screens in the US and there were 8,459 digital 3D screens, or 21% of total and 51% of all digital screens.    This was a 138% increase in installed 3D screens.   Globally, the numbers are similar with total screens growing to 21,936 from 8,979, up 144%.  Similarly, RLD enabled screens grew 163% yoy in 12/10.   On 3/28/11 RLD press released that it had surpassed 15,000 screens with 8,600 domestically and 6,500 internationally, which is 50% growth qoq. 

Industry projections from an array of sources, including the exhibitors, are for 40-50% of screens to be 3D enabled in approximately the next five years.   Globally, there are about 150,000 screens, but many of those are in regions that will not be adopters of newer technology, so the real addressable market is probably closer to 110,000 screens.  Only about 36,000 of those are digital, which is required to enable for 3D.  Digital screens have more or less doubled in 2009 and 2010 and I expect that growth rate to start to slow, but still stay fairly robust, due to penetration levels.   Another reason for the growth rate to slow is that digital conversion costs $100-150k, which is prohibitive for many theatres, particularly in smaller markets and less wealthy countries.  The DCIP in North America has catalyzed the conversion process by facilitating funding, but internationally there is much less support for exhibitors.  3D is currently enabled in 61% of digital screens, so if the digital conversion rate slows, this will also impact 3D screen growth.

So why would anyone want to short a stock growing this fast?  Well, there's the valuation, the deteriorating per unit economics, potential saturation, weak earnings quality, cash flow, and liquidity position, and insider selling.  Basically, this is a one product company that is in the sweet spot of its adoption, facing an impending slowdown.  

The consensus is optimistic on the stock and its prospects.   There are seven buy recommendations and one sell recommendation.   Including options and warrants, the market cap is $1.696 billion and the enterprise value is $1.665 billion.  On a gross basis, RLD is trading at 5.6x LTM revenue and 36.4x LTM EBITDA.  Net of motion picture exhibitor options, it is 6.9x revenue and EBITDA negative.   Based on consensus estimates RLD is valued at 31.4x F12 (3/12) and 16x F13 (3/13) EBITDA.  Keep in mind that in F12 net and gross revenues should be the same.

In the scenario where everything goes absolutely perfect for RLD, screen growth continues at this pace, and demand is extremely strong, it still seems expensive to fairly priced.   If revenue growth in F12 was 40% (off of F11 gross) and 10% in F13 revenue could grow to $520 million and $570 million.  And if EBITDA margins expanded from around 24% to 29% and then to 33% in F12 and F13, it would generate $115 million and $150 million of EBITDA, which would mean it is trading at 14.5x F12 and 11.1x F13.  I do not think this scenario is realistic though and under any scenario growth starts to slow considerably in F13.

With admissions flagging in recent years, the success of Avatar caused exhibitors to take notice of the potential benefits of 3D.   Exhibitors were able to charge a premium during a time of economic weakness and still maintain good admissions.  This was a powerful incentive for the exhibitors to accelerate the roll out of 3D screens, especially since they were 3D capacity constrained with the popularity of Avatar and a slate of several other very successful 3D movies.  3D box office pretty much matched 3D screen installment growth, so the incentive remained in place for exhibitors as long as metrics like revenue/admission, revenue/screen, and revenue/release were growing.  If exhibitors begin to see diminishing returns from enabling additional theatres, it would make sense for them to add fewer screens.

However, as the proliferation of 3D enabled screens reaches a certain point that constraint for exhibitors eases and box office growth will decouple from screen growth.   At that point, the number of 3D enabled screens will become less important and the quality of content will again become much more important to overall revenues, as will the number of releases.   In F11 there were 34 3D films released, up from 22 in F10, and in F12 there are only 35 planned 3D film releases, so I believe that decoupling is rapidly approaching.  Even if admission growth does remain that robust, the stock seems to be already pricing that in, so one has to really believe that even though 3D screens are pervasive enough in developed economies and that the quantity of 3D films is stabilizing, that the films released next year are going to be so strong that it will continue to drive more and more viewers to theatres to pay premium prices to get upside in the stock.

Although top line growth continues to grow at a brisk pace, the per unit economics are flashing some warning signals, so there is reason to suspect growth will begin to slow.   3D pictures released, screens enabled, and locations with 3D all still look good, but the gross revenue generated from each screen, location, and release has been deteriorating since Avatar.



















Total domestic RealD enabled screens









Total international RealD enabled screens









Total RealD enabled screens










Total domestic locations with RealD enabled screens









Total international locations with RealD enabled screens


















Number of 3D motion pictures released









Average enabled screens









Average locations







































Furthermore, in addition to the 3D release schedule beginning to slow appreciably after this year, the 2011 and 2012 3D theatrical release schedule is questionable in terms of quality and unlikely to replicate the success of some of the 2010 blockbusters.  Releases thus far in 2011 have been somewhat disappointing at the box office also.   Admissions will definitely pick up over the summer months, but the summer releases could end up falling short of expectations for 3D because it's hard to see how people get that excited for another Harry Potter movie, another Pirates of the Caribbean movie, another Marvel comics movie, and some animated features.  Those are the highlights.  Surely, some will be big winners, but it is very unlikely that any will come close to Avatar.  There is a strong possibility that theatres will not see levels of utilization, revenue/admission, revenue/screen, and revenue/release of 2010.  The release of Avatar might very well have been an anomaly that has driven irrational expectations.  And without blockbusters like that it will be difficult to maintain premium pricing, especially in a weak consumer environment.  While RLD's existing contracts provide some level of visibility to revenue, movie releases are inherently volatile and seasonal.  Predicting blockbusters and bombs is not always that easy, so results will probably be lumpy.

Another growth avenue for the company that management touts is its potential in consumer electronics.  However, RLD has virtually no presence in this space currently as consumer 3D as a technology is still in the very early stages, so it is all on the come and the technology will probably go through some dramatic changes before it is ready for mass market adoption.   There is also reason to believe that RLD might not be nearly as successful in this area as it has been in theatres.  An interesting trend to watch is the introduction of gaming consoles that utilize a 3D technology that does not require eyewear, which seems like a much more enjoyable way to view 3D in the home.  Mass market adoption is not expected to begin until 2014 at the earliest.

While RLD's market share is impressive at approximately 80% domestically and 50% internationally as of 12/10, the way it attained such prominence is somewhat controversial in the domestic market.   RLD issued stock options to the three largest film exhibitors in the country, Cinemark, AMC, and Regal.  The 3,668,340 options, representing over 7% of shares outstanding, strike at $0.00667 and have a 10 year life.  They were granted in order to induce the exhibitors to adopt RLD's systems and it appears to have worked.   In exchange for the grant these three agreed to install 4,500 systems.   Which leads to questions about the quality of revenue, strength of demand, quality of technology, and whether domestic  market share might approximate international share without these incentives.   As of last quarter, 3,749 of those screens were installed, so the appetite from the big three exhibitors in US could change in the near future and options could be fully vested by midsummer this year.  The offset to this added dilution is that less and less will be subtracted from gross revenues.  Also of note, is that analysts and management like to look at EBITDA excluding the cost of these options.

Cash flow generation has been very weak.   It is normal for working capital to be a drain on a rapidly growing company, but there is more that needs to be considered here.   Deferred revenue has been declining, while revenue growth has been extremely high, which portends of a coming slowdown.  Inventories have been growing and turns have been slowing, but this could just be a build going into the summer season, but it could also imply a more stable market and lower growth rates in the future.  DSO's have also been growing; not to an alarming level, but enough to warrant keeping an eye on.  Despite the weakness in cash flows, RLD has benefited from an increase in accounts payable and accrued expenses, which could be providing an unsustainable boost to CFFO.   Due to RLD's business model of installing equipment with no upfront cost to exhibitors, so far the model has been very capital intensive and RLD has only been marginally free cash flow positive in two quarters.  RLD has $35.5 million of cash left on the balance sheet and has burned $18.7 million LTM.  RLD also recently increased its credit facility from $15 million to $50 million through 12/11, at which point it falls to $25 million, in order to avert a cash crunch.

To date there has not been much competition, which has also enabled RLD to maintain enviable market share (along with the option grants), but this is changing.  Dolby, XpanD, and MasterImage are all real competitors in theatrical and they could become competitors in consumer electronics, as well.  MasterImage, in particular, has been gaining a lot of share internationally with a lower cost solution.  There is currently about a $3 ticket premium for 3D movies, which is split between the RLD, the studios, and the exhibitors.  Increasing competition with lower cost offerings will likely drive this down and possibly redistribute the split. 

RLD has a dominant position now, which should be unassailable for the next few years.  However, contracts with exhibitors generally last 5-7 years, so just when RLD should be generating meaningful cash flow and earnings, it will face widespread contract renewals.  At that point, switching costs for exhibitors will be minor, having invested nothing in the systems, and RLD might face another significant round of capital spending, and possibly other expensive initiatives, like more option grants, to defend its market share, or at the very least price pressure.  By the time contracts are expiring en masse, technology, competitors, and pricing could be materially different, potentially making it attractive for exhibitors to switch vendors.   It appears that RLD's competitive advantage period is very short and most of the value in sellside DCF's with lofty price targets comes from 2015 and beyond.

There has been large insider selling.  On 12/6/10 RLD's initial private equity investor and management did a secondary, selling 9 million shares at $27.75.  Both the CEO and President sold over 1 million shares each.  Naturally, insiders will want to diversify their holdings after a good gain when they have liquidity, but it is still worth watching.

My contention is not that 3D is a fad.  I do believe that over time there will be a migration so that eventually most films are released in 3D.  However, I do believe that the expectations for RLD are unrealistic and its growth rate will moderate.  And there is a good chance for nearer term disappointments, as admissions/release falls, screen growth slows, and competition intensifies, while in the longer term the format could be very different than the way we currently view 3D. 

Shorting is risky in general, but especially so with a high growth, high market share company.  So even though earnings and cash flow are weak now, eventually it could grow out of the heavy capital spending phase and margins could improve, making it look more like a traditional licensing business, which could at some point translate into better returns on capital and cash flow.  Additionally, growth rates for the industry might turn out better than expected.


Deteriorating unit economics
Slowing growth
Weak cash flow
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