Following a disappointing Q3 RealD has revealed that it has appointed investment banker Moelis & Co. to “explore a full range of strategic alternatives available to the Company”, which as Bloomberg notes is “language that typically means a company is seeking a buyer.” So why is RealD for sale (or is it really?), who would want to buy it and what would be the reason for wanting to acquire it?
The ‘For Sale’ sign was so prominent in the earnings conference call (transcript by Seeking Alpha) that it was effectively posted before the figures for the quarter were even mentioned:
We will be looking at the full spectrum of options available to us, including but not limited to mergers, divestitures, return of capital alternatives and a potential sale of the Company. Our previously announced review of R&D initiatives will be a part of this broader strategic review.
Cynics would say that RealD had every reason to draw attention away from the poor figures of the most recent quarter.
Revenue in Q3 dropped to USD $32.6 million compared to USD $55.4 million for the same period a year before, a decline of almost 41%. At the same time losses increased to USD $11.3 million compared to a loss of just USD $271,000 for Q3 a year earlier. Despite this the share price jumped over 10% and one analyst upgraded the stock to “Outperform”.
In the previous quarterly earnings call (transcript by Seeking Alpha), CEO Michael Lewis had already outlined previous steps to “enhance shareholder value”:
Moving beyond our quarterly performance. Over the past year, we have evaluated all aspects of our business and are taking additional steps designed to enhance shareholder value. In consultation with our outside advisors, we’re actively evaluating alternatives for restructuring our R&D efforts, Consumer; Laser; Screen and TrueImage. In doing so we have three primary goals, to minimize future capital outlays and expenses associated with our R&D efforts with an expectation of significantly reducing OpEx and CapEx in fiscal year ‘16; to partner with outside third parties to speed the path to commercialization; and to maximize our future economic participation.
It seems that these efforts of “streamlining” the company and finding “additional efficiencies” have not succeeded or been enough. So what is behind the drop and what would be the rational for a sale?
Part of the decrease is purely film-slate related. The same quarter in 2013 was strong with “Frozen”, “Gravity” and “Thor 2”, while this year’s “Hobbit 3” was not strong enough and “Interstellar” was only released in 2D. But there were deeper underlying problems, as hinted at by CFO Drew Skarupe:
Product and other revenues decreased 41% from the prior-year quarter and represented approximately 36% of total revenues. The decrease was primarily related to decreased purchases from international exhibitors and the overall decrease in our box office performance over the prior-year period. Domestic product revenues represented 55% of total product revenues, and international product revenues represented 45% of total product revenues. Licensing gross profit was $9.5 million or 45% gross margin versus 68% gross margin reported in the prior-year quarter.
So is RealD merely ‘pulling a Regal’? Last year Regal stated that it was looking at possible buyers, after two quarters of disappointing figures. In the end the largest exhibitor in the US decided that it was not for sale and took themselves off the market. But whether it was serious or not in the first place, the company’s announcement gave several media outlets (us included) something other to talk about than the soft box office.
However, there are several reasons to believe that RealD is serious about selling itself. Unfortunately, those reasons are also factors as to why RealD would not necessarily make an attractive acquisition target.
Acquisitions, Lasers and Large Format
The first is that it already had a potential buyer – to whom it was reluctant to sell itself. Last November RealD declined an acquisition offer by activist hedge fund Starboard Value LP at USD $12 per share, a 29% premium on the then-value of that shares of USD $9.27. The company’s share price today is USD $11.80, which is up on its six-month low of just USD $9, though below its 52-week high of USD $13.80.
Starboard, which has previously targeted Yahoo, felt that given a disappointing slate of 3D films RealD would be better off as a shielded private entity. In hindsight this is probably true and the fact that the share price is still close to the offer of USD $12 means that some think that Starboard might renew the offer.
There is even a case to be made that 2015 will be a good year for RealD, given the strong slate of 3D films, which will now also include the last installment of the “Hunger Games” franchise, in addition to “Avengers: Age of Ultron” and several other blockbusters. This in itself was enough for one Seeking Alpha analyst to declare “RealD: Little Known Movie Company Poised To Rise In 2015.”
Though written before the quarterly figures were released, it anticipated weak numbers but felt the future was bright for the company:
RealD will likely disappoint on February 9 when the company reports earnings, but the future is bright. While expectations are low going into its earnings call, it’s never reassuring for investors when revenue shows a significant year-over-year decline. However, on Wall Street it’s all about where a company is going rather than where the company has been. If the company can demonstrate strong growth in market share and significant cost savings, the stock could avoid a post-earnings decline. Due to the strong lineup of 3D movies being released through 2017, I will be a buyer on any dips. I believe the stock is at a decent long-term entry point around $10.50-$11 per share, but I’m wary of a disappointing quarter.
Yet there are factors further into the future than “Star Wars: Episode VII – The Force Awakens” that will determine the fate of RealD and the indicators are not favourable to the company.
With RealD having failed to carve out a niche in the home for stereoscopic 3D, given wide-spread consumer apathy to the format, the company pinned its hopes on its own-brand premium large format (PLF) Luxe brand to compete with Imax. In the earnings conference call RealD gave an update that in the third quarter the Luxe format was launched in China with Broadway Theatre on three screens, the first of which will open in May. The company also has seven Luxe screens in Russia and 18 additional under contract.
Yet even a total of 22 screens between China and Russia is too little to be considered a serious rival to Imax. Significantly, a more serious rival has arrived on the PLF scene with the opening of the first Dolby Cinema. While the number of Dolby Cinemas are currently only in the single figures, they promise to offer something qualitatively different and have a stronger cinema brand recognition than RealD. At the core of Dolby Cinema is also the most significant long term threat to RealD: laser projection.
RealD’s most significant achievement in recent years has been the XL “light doubler“, which improved the lumen light output of notoriously dark 3D systems. But laser projection promises to more than double the current measly light output of 2-3ftL of most 3D systems by a factor of five or more to 14-15ftL. Laser light projection removes one of the key unique selling propositions of RealD and while the cinema industry will not convert to laser projection overnight, my colleague Peter Knight recently made a strong case for why laser will be a major part of the next digital cinema upgrade cycle.
Your Contract Is Up
Yet the most unique thing about RealD was never its technology – circular polarization for stereoscopic 3D has been around for a while – but rather its business model. Faced with steep upgrade costs from analogue to digital projection, even with VPF financing, many exhibitors (particularly in the US) welcomed a business proposal that cut the capex cost for 3D equipment in return for a small cut of the incremental 3D ticket price. Heck, RealD even threw in the 3D glasses “for free” (usually with the help of the Hollywood studios).
In the time of “Avatar”, when 3D admissions were on the rise, very few people grumbled about the “3D tax” that RealD was imposing. However, with competitors coming up with cheaper 3D solutions and attendance for films shown in 3D peaking (again, mainly in the US) in the last few years, the RealD business model has fallen out of favour. It is only Imax that charges an even higher premium, but with is a format that is still being sought out, that gets away with this type of cinema business model currently.
What is potentially most fatal for RealD in the long term is when its original agreements with exhibitors come up for renewal and the exhibitors tell RealD to pack up their equipment and swap it out for non-branded solutions from competitors that do not charge a per-ticket fee for its use. This is what has happened with Vue in the UK last September and is likely to happen with other exhibitors.
Vue did not put out a press release announcing an end to its partnership with RealD, but Sony put one out that Vue was adopting its 3D solution. This sent a clear signal to the exhibition industry. RealD now faces a choice of seeing current exhibitors under contract switch to competitors, or re-negotiate an extension with RealD on less favourable terms than in the first round. The fact that 2015 promises to a blockbuster year for 3D films will if anything persuade many cinemas that they want to keep more of the 3D bounty than share it with a third-party vendor. Either way this has the potential to hurt RealD’s income in the long term.
No Obvious Buyers
So if Starboard does not renew its offer, who would conceivably want to buy RealD? There are few if any obvious candidates.
RealD began its roll-out in partnership with Dolby for Disney’s “Chicken Little”, but Dolby now has its own 3D, PLF and laser solution. A projector company could conceivably be interested in bundling its offerings, but Christie has partnered Dolby and Barco is in the proverbial bed with Imax while NEC focuses on low-cost lasers. Meanwhile, third-party integrators like Ymagis want to offer the widest variety of solutions, rather than try to sell their client base on one particular technology and business model.
No Chinese buyer is also likely to be waiting in the wings, given that they are more interested in exhibitors, Hollywood studios or sporting companies. This means that only private equity is an obvious buyer – but the most obvious one has not renewed its offer.
RealD is already doing all it can to focus on emerging markets, so expect the company to double down on its efforts in territories like China (as with last year’s doubling of Wanda’s screens), while continuing to push its Luxe format. It would not be a surprise for RealD to make an announcement in the laser projection space, possibly with NEC, to remind the world that even laser projectors need some 3D solutions integrated. The company will also trumpet the next exhibitor who decides to renew their contract with RealD (such as this one in Australia) – though financial terms (read: discounts) will not be disclosed.
The only other revenue potential open for RealD is the rout of the so-called patent assertion entities (PAE, aka ‘patent trolls‘). So far RealD has naturally been vigorous about defending what it sees as its technological innovations in the cinema (particularly the XL light doubler) against competitors, but this has primarily been defensive and for its core North American market. Not least as the “light doubler’ allegedly does not enjoy the same patent protection in other territories.
This has been enough to hold competitors like MasterImage and Volfoni to a stalemate, but no outright patent victory has been achieved by either side (despite an occasional flurry of press releases). This has not been enough to stop numerous copy-cat 3D companies in China from flooding the market there and promoting their wares in other emerging markets in Asia, Latin America and elsewhere.
To really extract value, RealD would have to go after more fundamental 3D uses and users in areas other than cinemas where it is currently not active but has patents, something it clearly has the right to do. Disney lost a case two years ago preventing RealD from acquiring the patents that once belonged to InThree from Digital Domain. At the time Disney’s lawyers stated:
“debtors appear to contend that the proposed sale of the In Three Patents can cut off or impair the Disney Entities’ rights to distribute, modify, and otherwise exploit their own films, including among others Tron Legacy and Alice in Wonderland, just because those Works incorporate 3D VFX that were created using the In Three Patents — VFX work that was previously commissioned and paid for by the Disney Entities.”
So far RealD has not used these patents to extract payments from, say Prime Focus, for VFX solutions for converting 2D to 3D. RealD’s Bob Mason even went so far on a panel at the Berlin Film Festival a few years back as to state that RealD bought the patents to prevent them from falling into the wrong hands of so-called ‘patent trolls’.
Yet if revenue on the cinema side becomes a real issue for the company, it is conceivable that RealD could consider selling these and other patents to less scrupulous entities, if they decide not to license them directly.
Anyone looking at RealD as an acquisition target should keep the latter in mind, since technology companies such as IBM and Qualcomm earn north of USD $500 million per year licensing their patents. This is not to say RealD has as extensive a patent portfolio as these multi-billion dollar businesses, but to point out the company’s earning potential is as multi-dimensional as the product upon which its name was made.