Everybody knows what's wrong with the movie theatre business. Hollywood has lost touch with what audiences want to see. Home theatre systems make a trip to the multiplex seem a lot less appealing these days. Cinema advertising annoys people. Ticket prices are too high. And films are coming out on DVD faster than ever before. Given those widely held beliefs, some may question why Ellis Jacob, president and CEO of Toronto-based Cineplex Galaxy LP, would shell out $500 million for the Famous Players theatre chain. After all, why buy a bigger chunk of such a troubled industry, whose grosses in Canada as of Aug. 18 are down 12.7% from a year ago? Well, the situation in the cinema business might not be as dire as some observers make it out to be. What's more, a closer look at the Famous Players deal suggests it just might be worth its ticket price.
Cineplex's road to becoming the country's dominant movie theatre company, with roughly a 60% share of box office revenues, began a year ago when Jacob and his team sat down with representatives from New York-based Viacom. During that meeting, the U.S. media giant confirmed a rumour that it was selling its Famous Players cinemas. Recalls Jacob: “They're focus to us was, 'Look guys, we think you're the best buyer, but we don't think you can get this deal done because of the competition issues.' “
When Viacom opened up the first round of bidding for Famous Players in January, Cineplex was still working with the Competition Bureau to get its approval. Jacob and his team, however, managed to make it into the second round. Then in May, a breakthrough: the bureau gave Cineplex the go-ahead for the deal, as long as the company sold off 34 of its theatres. In June, Cineplex announced it had reached an agreement with Viacom to buy Famous Players for $500 million, including approximately $36 million in capital lease obligations. Just 42 days after that piece of news, the company completed the transaction by, among other things, raising all of the financing for the deal. “Viacom was actually shocked when we told them we wanted to close,” says Jacob. “They couldn't believe we were already done.”
But just how good was the deal Cineplex brokered? Ben Mogil, an analyst at Toronto-based Westwind Partners Inc., sees it as “hugely accretive.” In other words, he believes the Famous Players acquisition will boost the distributable income per unit of the Cineplex Galaxy Income Fund (TSX: CGX.UN). First, says Mogil, Cineplex should be able to cut at least $20 million in costs from the combination of the two companies by eliminating the duplication of things like head offices, accounting firms and purchasing departments. Second, Cineplex took advantage of the strong market value of its units when it issued additional ones to help finance the deal.
Aside from taking on $36 million in capital leases, Cineplex financed the Famous Players purchase with $110 million in equity, $105 million in convertible debentures, a $67-million real estate sale and the remainder with debt, at the time the deal closed. Recently, the company paid down debt with the $83-million sale of 27 theatres to New Glasgow, N.S.-based Empire Theatres (a large part of the 34 theatres Cineplex must sell to meet the Competition Bureau's requirements).
Assuming Cineplex can get $33 million for the remaining theatres it must sell, Joel Sutherland, analyst at National Bank Financial, estimates the Famous Players deal will increase the company's issued equity by an estimated $109 million and debt by an estimated $172 million. Increasing debt generally adds risk to a company, but in this case, Sutherland doesn't see this as a problem for Cineplex. “Offsetting that factor is Cineplex's overwhelming leading position,” he says. “If you asked me to weigh its risk profile, it's now improved after the deal.”
As good as the Famous Players deal looks on paper, it can't be of much value if the industry is in decline. But that's not really the case, argues Howard Lichtman, president of Toronto-based marketing consulting firm the Lightning Group and an expert on the cinema business. Lichtman says he's certain that bad movies–and bad movies only–are to blame for the drop at the box office. As support, Lichtman challenges Canadian Business readers to open up a newspaper from today, a month ago, two months ago or three, and tell him what movie they actually want to see. “As unscientific as that might be,” he says, “it shows that Hollywood has missed the mark on what people are interested in.”
Nevertheless, Lichtman has faith the film studios will break out of their creative slump. The marketing consultant holds up history as proof. The North American box office, he points out, declined in 1987 and 1991. But in each case, Lichtman adds, the cinema industry broke box-office records just two years later.
On the subject of home theatres, technology is improving and costs on items such as big-screen TVs are coming down. But Reinier Evers, founder of Amsterdam-based Trendwatching.com, which operates an international network of 6,000 “trend spotters” in countries from Canada to Japan, isn't convinced box-office sales will suffer as a result. “People still want to leave the house,” he explains, “so theatres, which sell a night out more than anything else, will do just fine.”
But what about the rising cost of going to the multiplex? According to the Motion Picture Theatre Associations of Canada, average ticket prices have gone from $5.45 in the 1998-99 period to $7.45 in the 2003-04 period. Lichtman's recent analysis of out-of-home entertainment options, however, reveals that the cost of tickets to professional sporting events and concerts has risen faster than for movies, and that catching a flick is still one of the cheapest nights on the town.
As for DVD sales cutting into the box office, Lichtman points out that 2004 was a good year for the theatre industry and a record year for DVDs. “So there's no correlation between DVD sales doing well and the box office doing poorly,” he says. The marketing consultant adds that while this year's box-office grosses are down, at the same time DVD growth rates have slowed significantly.
If the movie theatre industry isn't actually in decline, Cineplex could conceivably grow. One of the ways Jacob plans to pull this off is with the company's digital pre-show, an advertising product with full-motion visual and audio capabilities, launched in 21 Toronto area theatres in April. A 20-minute segment shown before the lights go down in the theatre, it mixes ads with advertiser-sponsored vignettes ranging from behind-the-scenes looks at upcoming films to trivia questions on actors, where the Hollywood stars themselves give the answers. The Famous Players acquisition plays to this strategy, since Cineplex can now roll out the service to 132 locations rather than just 86. “We recently did some exit interviews on the pre-show,” says Jacob, “and we got excellent feedback.”
Scott Stewart, a director at Toronto-based media buying company Genesis Media Inc., likes the idea that Cineplex's digital pre-show lets advertisers place their messages within the entertainment content. That helps to hold the audience's interest, he says. Unlike other types of media, Stewart adds, people watching theatre advertising can't flip to another channel, tune to a different station or turn the page. On whether moviegoers are becoming irritated by ads, he says, “I don't think they are. I think they accept it.”
Westwind Partners' Ben Mogil sees huge potential for Cineplex's digital pre-show. He points out that Cineplex acts as the advertising sales agent for Landmark Cinemas, AMC and Empire Theatres. So with the addition of the Famous Players theatre chain, Cineplex, the analyst estimates, will one day be able to deliver around 85% of the box-office audience to advertisers. He estimates cinema advertising accounts for only 0.5% of total advertising spending in Canada, while in Europe that figure is around 3%. “We don't think it's going to 3%,” he explains, “but we don't see why it can't go to 1% over time.”
All told, Jacob looks more like a hero than a fool. And observers predicting a slow death to the movie theatre industry just might see an unexpected twist.