Netflix (NFLX) reportedly has shown interest in buying movie theaters.
It makes perfect sense.
Netflix, or Action Alerts Plus holding Amazon (AMZN) , will buy a national chain of movie theaters, busting the entire tickets, concessions, new movie release paradigm. The theater is not dead, it just has not evolved to today's market, and the only way it can is with M&A from outside. The new model will be an incremental subscription and it will super-powered by data, mobile apps and a combination of owned and leased content. The big screen will turn into an experience again.
Here's a deep dive into the industry.
The Issue with Current Movie Paradigm...
The largest issues with the current theater paradigm are the (1) ticket collection; (2) the lack of broadly appealing content; and (3) the lack of content control for the distributor/theater. These are just the most immediate issues. We would add but not discuss, an overall lack of technology and data analytics which could improve top-line and margins if applied.
Ticket Price and Collection
To be clear, I am not saying ticket prices are too high for movies, only that the collection process and apportioning of that fee is antiquated. The ticket shock creates a negative brand experience for the customer before the curtain is drawn and the lights go down.
Take a family of five to the latest release, throw in a friend or two, and the cost of admission is over $100...and that's pre-concessions. And an additional consequence of at-window ticket sales is that, although the theater sees little of this ticket price as revenue, the theater must play Sheriff of Nottingham and collect sales for the studio. This negative brand nuance also affected video rental chain Blockbuster years ago. Well that, and rewind fees, and late fees and Netflix.
How many times will Hollywood studios dupe distribution before they avoid the trap? Pre-purchasing tickets online and experimental services like MoviePass marginally obfuscate this cycle but, as we will discuss, it could be done so much better through real cooperation or better still, consolidation.Content
The lack of broadly appealing content is obviously a subjective thing, but declining ticket sales for the past several years can speak for themselves. Is it possible that Hollywood has become a bit of an echo chamber and a little removed from mainstream America? This might explain why there have been a few failed experiments with studio/theater partnerships on content.
It certainly explains why Netflix, Amazon, Hulu and others have championed their own content creation. Let's just agree that content appeal is somewhat cyclical, but that the mass theater chains are not really in control of their own destiny when it comes to what they show on their screens and at any given time have, or may as well have, empty screens.
This raises our final issue with the current movie/movie theater paradigm, control.
Sure, there are a handful of theaters and small chains that have made a cottage industry out of hand-picking their content. But there is no room for this on a national scale. Theaters must show what the studios put out and they have little to no bargaining power.
Once upon a time, theater chains believed they would gain some power if they got large enough but unfortunately, studios are too powerful. As an aside, the studios are aided by anti-trust regulation that loves to restrict theater consolidation. Even if the theater owner knows a movie is bad, or simply will not appeal to their geographic audience, they can do little to replace this content. If they do, they may not get to lease the next blockbuster movie.
The result of this current paradigm, let's call it the three "C's" (Collection, Content, and Control), is that theater owners must focus on the only part of the experience they do control - Concessions and Comfort (More C's!).
I believe the large chains have mastered this, and I see little room for improvement. You cannot match theater popcorn and the seats, if clean, are amazing. And while I don't go for drinking or dining in the theater, it is another creative attempt to monetize the experience. Even with superior execution on these later two C's, Concessions and Comfort, chains still struggle to grow profits because the real leverage in the theater model comes with ticket sales of blockbuster movies.
What Disruption Could Look Like...Queue the Hero in Netflix or Amazon
We have outlined the issues with the current movie and theater experience. To oversimplify, there are too many parties trying to achieve scale over their unique cost structures, and there is no quality control, accountability, or feedback loop. This is the next industry to be disrupted, or it will continue to languish. Disruption will require new pricing models, vertical integration and technology. I think it will require an industry outsider (or at least a one-time outsider)
A hypothetical purchase, Netflix buying AMC Entertainment (AMC) , may be the best way to illustrate how the disruption might work and what it would mean for the top line, profit margins and the industry. Were Netflix to buy AMC it could disrupt the entire industry. The consumer and disruptors would benefit. As is the case for most disruptions, the middlemen would go away, and the studios would lose some control.
Netflix's stock is on fire. Watch below.
Collection Under the New Model
At-window ticket sales, at least for the acquired theater chain, would change for the better in many ways. While non-Netflix subscribers could still buy tickets at the counter or pre-pay, Netflix subscribers would pre-reserve a seat and stroll right into their theater and to the concession stand with a pocket full of cash (metaphorically). Perhaps concessions are bundled into the subscription as well.
While third-party or non-Netflix content would be priced and split the same as before (at least before Netflix begins to negotiate with studios), Netflix's own content could be priced very competitively and would be higher margin. Furthermore, this content is only seen at Netflix theaters, creating an advantage in each-and-every market.
How Netflix collects ticket costs for third-party content may vary, but I believe an expanded subscription price and a monthly limit on the number of movies that can be seen under subscription would easily cover the cost of traditional studio films. Unlimited monthly consumption is a false economy for the consumer and a bad model for the provider.
Finally, Netflix/AMC would also own the subscribing movie goer who will no longer visit any other competing theater.
Content Under the New Model
Content is where the synergies really kick in here.
Netflix is generating a ton of original, award-winning content already. It would be great to have another screen on which to air this content, especially in a venue that can up-sell concessions and experience. Again, Netflix is leveraging its existing customer base but continues to cater to the non-subscribers.
Also exciting is how much Netflix knows about their subscribers geographically. They know exactly what original or third-party content will appeal to their subscribers and in which theater they might like to view said content. The promotion and up-sell opportunities are endless when one entity owns consumption information without abusing it. Netflix has always excelled at this form of discrete data mining, as has Amazon Prime to a degree.
The obvious argument on content is that the studios would not allow their content in a Netflix theater. Studios can not afford to restrict content anymore in the theater than they can on streaming services. Sure, studios like Disney (DIS) will be upset, but as long as they get paid the same they will opt for more ticket sales.
Control Under the New Model
Increased content is one thing, but control of the theater would mean there would never be an empty screen. With Netflix creating more and more original content, they would not necessarily negotiate better splits with studios, but they could fill theater seats in between third-party releases.
I envision Netflix content "binge parties" and special advanced screenings of Netflix content for subscribers and prospects. The opportunities are extensive. Again, I don't believe the studios could afford to restrict content to Netflix owned theaters, nor would they want to. Netflix has a long history of dealing with content providers. Early on they had to be very creative and smart on how they bought backlog content. Now, with their audience and reach they are a favored nation. It is for this reason, I believe they will act before anyone else.
Concessions and Comfort Under New Model
Theater operations would stay the same, but perhaps have greater economies of scale. Again, the facilities are there and cost money whether the consumers come or not. I think incremental consumers would come back, or come more often, if it were part of an expanded subscription package with expanded content and services.
In conclusion, with so many industries being disrupted by Internet- and technology-enabled companies, it is only a matter of time before the movies and theater industries are the focus of this disruption.
What Does It Means for Netflix or Amazon?
I imagine most people already own Netflix and Amazon directly or through an ETF, so I am not saying to buy them on this thesis alone. However, the top line impact for the acquirer, Netflix or Amazon, would be enormous. As a reformed sell-side analyst, I am a good guesser. The purchase of a national theater chain could add another $5 to $10 per month per U.S. subscriber (at full penetration). Let's call it a $9 billion market opportunity.
Furthermore, since Netflix and Amazon get awarded a richer multiple on their sales (not saying this is right), simply buying the revenue of a theater chain would, even at a significant premium to the market, would be accretive.
What Does It Mean for the Theater Chains?
I do think it makes sense to buy public theater chains on this thesis, even given the "remote" chance it happens.
Public theater chains are historically cheap, given the dearth of blockbuster movies and some conflation of this with changing millennial behavior. I believe millennials have not forsaken theaters, just bad content. The average dividend yield on public theater companies is also historically high, something I focus on a lot for my clients. I have chosen to buy AMC for my clients because of the yield, the current low historical valuation and for its ownership structure (it is right for a deal).
I feel that if one chain is bought all will benefit because it would start an M&A scramble.
What Does It Mean for the Studios?
Someone must get hurt in disruption...so studios will either lose a little money, a little control or both. No need to sell the studios unless it happens, then act fast.
-Frank Gristina is a portfolio manager at Tell-tale Capital Corp.