REAL 3D (RLD)

[chmcnfunds]

Negative article from SA (novice writer):

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RealD Still Has Farther To Fall - Get Out Now (And Short The Shares)

Oct 2 2013, 11:30 | about: RLD BOOKMARK / READ LATER

Editor's notes: Follow The Data takes the other side of the RLD trade, arguing that growth will remain prohibitively expensive and that the company's model has too many vulnerabilities. 30-50% downside.
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Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. (More...)

RealD (Ticker: RLD) shares currently trade around $7 per share, down 50% in just 3 months time. Simply stated -- the company has problems -- and there is still more downside to come. Absent new management or a takeover -- both of which are highly unlikely -- I believe the fair market value for RealD shares is 30% - 50% below the current market price.

In my view, RealD is challenged by five very large problems:

Problem 1: New unit installations since FY2011 have negative profitability (and worse ROI given ~$9,000 cost)- but management continues to press forward with new installations and associated operating expenses (S&M + G&A). Said another way - revenue is flat to declining, and operating expenses keep rising

Problem 2: Management is drastically over-investing in R&D (~$20mm/yr) for a highly uncertain/speculative opportunity (no-glasses 3D on Consumer Electronic devices)

Problem 3: A completely new "jump ball" will occur in 5-10 years - threatening all of RealD's core business revenue. It's uncertain if RLD wins the theaters, and "winning" will require substantial R&D, plus selling costs

Problem 4: Consistent revenue declines are more likely than growth -- theatrical 3D has arguably "peaked," potentially in decline

Problem 5: Management has no control over their revenues - creates volatility & unpredictability

Valuation: Currently $340mm Market Cap - Potential for As Much As 50% Downside (i.e. $3.50 share price). Revenue is more likely to fall than grow, but management continues to invest operating expense dollars in both R&D and non-profitable new installments-eroding shareholder value. This results in a business with a GAAP operating income loss with unlikely reversals; EBITDA is only positive due to Depreciation add-backs (I exclude stock-comp add backs).

"Bull-case" scenarios - believed unlikely - provide only ~10% upside from current price (i.e. $370mm value)
"Bear-case scenario" is that management continues to spend on negative ROI projects, pressuring RLD's valuation and destroying investor confidence - eventually pushing valuation towards $165mm market cap
Best guess is 30%+ downside potential in NTM
More Details

1. New unit installations post-FY11 have negative profitability (and worse ROI)- but management continues to press forward. As detailed in the chart below, the average profit per installed 3D unit has declined from $5200 in FY11 to an estimated ~$2,000 in FY14E. The reality is that management is over-paying for installed unit growth. The operating expense investments necessary to secure these new installments have negative profitability profiles; they destroy value instead of creating it! Sure, new installments in high-growth emerging markets like China, Brazil, and Russia theoretically make sense, but the investments necessary in new offices, hiring new sales teams, sales team commissions, wining and dining potential clients, etc. - those costs exceed the revenue. It's in the data!

(click to enlarge) (click link below for tables/charts)

2. Management is drastically over-investing in R&D for a highly speculative and uncertain opportunity

Management has publicly announced that it invested ~$20 million last year in R&D for no-glasses 3D for Consumer Electronic devices, and plans to continue to invest at least $20m per year moving forward. This is a foolish waste of capital for a number of reasons:

The end market demand is questionable at best:
Device manufacturers are highly hesitant to include new licensing deals for technology into their bill-of-materials. RealD's last partnership with Samsung failed for this reason…
Demand for 3D video on consumer electronics devices hasn't proven itself. 3DTV is the ideal format for 3D video - and demand has been tepid for years
Supply of 3D video is low. Only professional-grade 3D video is typically watched, which means movies. TV shows never materialized, and live-broadcast has failed (ESPN 3D is shuttering its operations due to lack of demand)
The patents RealD has are only valuable if RealD's method of displayed 3D images is adopted by the market. There are more than 10 different technical ways to make 3D video… if your solution isn't adopted, the patents are worthless
Even if RealD does manage to get a customer win or two, it's a long road to making it a worthwhile investment:
$40mm is already spent (or in process) - add in additional R&D and sales & marketing support, and the "bet" management is making is around $75 million
Per-unit royalties for technology like RealD is developing is between $0.25 and $1.00 per unit (reference as a comp Dolby (DLB) and DTS (DTSI) premium audio licensing rates)
To break even, RealD would need to get 75 million to 300 million units with its technology embedded sold the market. That's a HUGE amount of required units for a technology the world continues to show tepid demand for.
3. RealD's core theatrical licensing business is completely "up in the air" in 5-10 years due to new technology.

In 5-10 years, no-glasses 3D for theatrical screens will be technically viable. This will require completely new technology to implement, and RealD's existing installed units will be obsolete. There is no guarantee that RealD will "win" in this new technology cycle, and there will be more competitors to deal with (Dolby, Master Image, Xpand + Project manufacturers like Sony and Christie). Furthermore, RealD has yet to invest as much R&D as it needs to in order to even develop the technology for this…

4. Revenue declines are more likely than growth; 3D movie product has been flat for 3 years, and 3D viewership rates are declining in developed markets.

Simply stated, 3D has had its day, and it's carved out a slice of the market, but there is minimal growth. Demand in developed markets has been in slow decline for the last two to three years, and growth from emerging markets isn't overly powerful (plus it's more costly to pursue, as detailed above). When your revenue is flat or declining, and you don't adjust your spending on operating items (or worse, you continue to increase it like RealD is doing) - it's a very bad thing!

5. RealD has no control over its revenue - which creates volatility and uncertainty

RealD receives a percentage of the box office receipts from 3D movies. They basically "take what they get," and they have minimal control over persuading Hollywood to make more 3D movies or encouraging a higher percentage of users to pay a premium to watch a movie in 3D versus 2D. This "boxed in a corner" setup makes RealD's revenue stream highly volatile, and serves to compress valuation-multiples (investors pay-up for consistency and predictability - which RealD has none of).

Risks to Short Thesis:

Risk 1) RealD may be able to convince a second-tier or third-tier Consumer Electronics manufacturer to try out its no-glasses 3D tech - creating headline risk.

Second- or third-tier consumer electronics manufacturers tend to be more open to "gambles" because they need to find ways to capture market share. Some of these manufacturers may be willing to "gamble" on installing RealD's no-glasses 3D in a tablet or smartphone and "see what happens." This would create headline risk to the upside in the short term (just as the Samsung news did a few years ago), even if the core economics don't make sense (reference point 2 above).

Risk 2) Estimated Value of RealD if the business model was shifted to "bleed for cash flows" is about 5% to 10% higher than the current market value.

As detailed below, I estimated that a "bleed for cash flows" valuation on RealD shares would be around $370 million, or around 10% higher than today's price. Given that return would take perhaps 5+ years to generate, I don't see a private takeout as highly likely at current values. But - it could help reduce the downward pressure on the shares as a "floor value."

(click to enlarge)

Risk 3) Management change or publicly-announced strategy shift.

Institutional investors are largely unhappy with the business strategy RealD is pursuing. Given that, if management was replaced, or if management were to publicly announce plans to significantly rationalize their operating spend-it would likely be viewed favorably by the street.

Valuation Scenarios & Rationale

1) Bull-case Scenario: 5% to 10% GAIN (estimated probability: 10%)

If management shifted their strategy, or if a private equity firm took the company out, it could cause a brief uptick in price. Given management's ownership of the firm, and their "head in the sand" commitment to their existing model - I don't see this as likely
2) Medium-Case Scenario: ~40% downside to ~$180mm Enterprise Value (estimated probability: 60%)

Management spends ~$20mm through FY15, continues with new installs in emerging markets but tries to control S&M and G&A spend a bit better (5% y/y growth)
Valuation: $175mm ( ~$35mm EBITDA @ 6x multiple)
3) Bear-Case Scenario: 50%-plus downside to ~$135mm Enterprise Value (estimated probability: 30%)

Management spends ~$20mm through FY15, continues with new installs in emerging markets and fails to try to trim OpX costs
Valuation: $165mm ( ~$27.5mm EBITDA @ 6x multiple)
Rebuttal to the Recently Published RLD Bull Case. A few thoughts regarding the recently published bull case for RealD:

Bull Argument 1) GAAP earnings are being "artificially" depressed & Valuation. To state the obvious, depreciation is a bizarre cost because sometimes it makes sense, other times it can cloud realities. The logical test for an investor is to decide whether or not the time frame an asset is being depreciated over makes sense relative to the terminal value. In RealD's case, a depreciation horizon of 8 years (with no terminal value) makes perfect sense, because (per point #3 above), the technology will be obsolete in 5-10 years.

As for valuation, the scenarios I detailed above are not impacted, because these scenarios utilize a DCF analysis ("bleed for cash flows") or an EBITDA multiple, which adds back Depreciation. Said another way - my analysis indicates that the fair value of RealD shares is well below the current market value regardless of depreciation cost issues.

I agree that RealD shares have value - my math just indicates that the value is below the current market price.

Bull Argument 2) Growth Drivers. Growth doesn't come free. It requires both substantial capital costs and operating expenses. I certainly concede that some of the new emerging market wins RealD has gotten are going to be OK deals (maybe even a few will be good deals) - but on average, management is spending far too much to grow, and it's eroding shareholder value instead of creating it.

To add value, a company needs to make business investments that provide an ROI greater than their cost of capital (let's say RLD has a cost of capital of around 7%). For RLD, the equation for calculating this on an annual basis is: [(revenue per unit) - (annual expense per unit)] / (unit manufacturing cost).

Since 2011, the incremental units RealD installed have generated revenue per unit below the expense per unit - meaning the numerator in the equation above (i.e. profits) is negative. Said another way, the returns from RealD's "growth" isn't just falling short of 7% cost of capital hurdle… it's generating negative returns.
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