Analyst: Low-Priced DVDs in Demand, Hit Films Drive Gains

The following is an excerpt from a report compiled by Michael Pachter of Wedbush Securities. 

movie theater

Movie Rental Industry

Key Redbox releases this year (with domestic box office total in millions from www.boxofficemojo.com):

o 7/23: The Incredible Burt Wonderstone ($23)

o 7/30: G.I. Joe: Retaliation ($123)

Key Redbox releases last year (with domestic box office total in millions from www.boxofficemojo.com):

o 7/24: Mirror, Mirror ($64)

o 7/31: Wanderlust ($17)

Over the next two weeks, there are two rental releases that grossed over $50 million in domestic box office compared to two last year. DVD rentals for the upcoming two-week period should outperform the same period last year, as this year’s DVD releases grossed more than last year’s at the box office.

Box office picks up significantly in Q3. Outerwall (NASDAQ:OUTR) estimated Q3 box office up 43 percent y-o-y, with eight titles grossing over $100 million, compared to only three last year. Last year, studios shuffled their release slates to avoid the Summer Olympics, which resulted in an elongated barren patch. We believe that the bull thesis is correct: DVDs are going to be around a long time, and a large percentage of the population will seek to rent at the lowest possible price.

 

Netflix (NASDAQ:NFLX) has seen its DVD business decline from 14 million to 7.5 million subscribers over the past 18 months, and we expect continued declines going forward. Outerwall’s Redbox unit has virtually all of the remaining price-conscious consumers, and we believe that the vast majority of these will prefer to see new movies for $1.20 a day rather than renting them for $4.99 – 5.99 through video on demand. So long as there are DVDs, we think that Outerwall’s business model will remain intact, and we think that the extraordinary studio profit contribution from DVD sales all but ensures that DVDs will be around for years to come.

In June, Wedbush completed a survey composed of the responses of 1,000 domestic Netflix subscribers. The survey included 29 questions, with an emphasis placed on content and pricing. The survey results reinforce our belief that Netflix faces a difficult balance as it attempts to contend with ever-increasing content costs, while satisfying the demands of its customers for everincreasing content. In our view, the company must choose between maintaining low prices and seeking higher profits.

We believe that the company will continue to offer low prices (which drive its subscriber numbers) and generate minimal profit, but should it hope to boost its profitability, it will be required to raise prices. Should it choose to increase prices, however, the survey responses suggest to us that Netflix runs the risk of alienating a significant portion of its subscriber base.

In our view, the survey responses suggest that any price increase will drive high churn, potentially negatively impacting revenue growth (and hence profitability) if fewer subscribers at higher pricing fail to make up for the revenue lost from price-sensitive subscribers quitting the service. The survey makes it clear that low pricing is the key draw for many Netflix subscribers, and not content quality. However, content quantity is clearly important to subscribers, as a large percentage focused on content as a reason for joining or quitting the service.

Exhibitor Industry

We expect Q3 domestic box office to end up 8 percent from a strong release slate and easy comps. Q3:12 experienced year-overyear decreases in the box office each month of the quarter. We believe the larger number of blockbuster releases will drive year over-year gains for the quarter, similar to Q2:13’s performance. Q3 is trending up 6.1 percent through August 4.

We calculated a weighted average growth of approximately 7% in Q2 across Cinemark’s (NYSE:CNK) Latin American markets. We estimate that international admissions revenue will comp lower than the market growth numbers due to increased theaters and higher reporting percentages incorporated into the market growth calculations.

We expect a very active M&A market to continue in 2013 and 2014 as the industry continues to consolidate. The transition to digital, IMAX (NYSE:IMAX), and 3D screens is helping to drive industry consolidation. Approximately 85 percent of screens have been converted to digital, and while most circuits have some portion of screens converted, a significant number (around 6,000, or 15 percent) remain unconverted. According to Carmike (NASDAQ:CKEC) there are approximately 40,000 screens in the U.S., of those, ~ 20,000 are controlled by the top four exhibitors, ~ 4,000 are controlled by the next 15 largest circuits, while the next 36 circuits control ~ 3,600 screens, leaving over 12,000 screens owned by very small operators.

Theaters coming to market fall into two buckets: (i) private equity owners, which are easier to predict due to their time horizon and (ii) family-owned, which are harder to predict and usually come to market during generational transitions. Regal (NYSE:RGC) estimates that there are approximately 2,500 – 3,000 screens which would be attractive to the big four exhibitors at the right price. Attractive screens are modern (built in stadium seating era) and in stable or growing markets.

Michael Pachter is an analyst at Wedbush Securities. 

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