Taking another look at Village Roadshow

The fortunes of Village Roadshow (VRL) shareholders have been transformed in recent years. Improved corporate governance, business sales, reduced debt, a simplified capital structure and the return of excess cash to shareholders have helped the shares triple over the past five years.

We joined the ride in December 2012 and members who followed our recommendations would have doubled their money before selling in June last year. That's not bad for a collection of mostly ordinary businesses which are slow-growing and capital intensive.

Since then, however, Village Roadshow's shares have fallen 19% and, with the company announcing some interesting developments recently, we've decided to take another look. Essentially a conglomerate of separate but related businesses, the best way to value the company is still through a sum-of-the-parts valuation. So let's update ours for the changes over the past 30 months.

Theme parks

Bad weather in the peak summer months continues to impact the results of Village's Gold Coast theme parks (including Sea World and Warner Bros Movie World) and, more recently, its Wet'n'Wild water park in Sydney.

We'd expect the impact of the weather to even out over the longer term. Of greater concern is the potential for consumer spending to weaken if Australia enters recession as it struggles to transition from the mining boom – although this too should even out over the years and ultimately show gentle growth. There may also be a boost from increased tourism – from within Australia as well as from overseas – following the fall in the Australian dollar.

In estimating sustainable earnings before interest and tax (EBIT) of $70m for this division, we're assuming that Village is able to keep its parks popular by continuing to add new attractions. We're also assuming that competitor Ardent Leisure, which owns Dreamworld and Whitewater World on the Gold Coast, doesn't engage in any irrational price competition.

Assuming EBIT will grow in line with the economy over the long term, we've applied a multiple of 8 to value this division at around $560m.

Asian expansion

As well as generating management and potentially performance fees from managing Guangzhou Properties' $550m Hainan Island Marine Park and Water Park in China once it opens in 2017, Village recently entered into a funds management joint venture with CITIC, a state-owned Chinese investment company.

Village and CITIC will establish a US$500m (A$670m) fund later this year which will invest in theme parks and 'associated commercial real estate opportunities' in Asia. Each company will invest US$25m in the first fund and they plan to establish additional funds in coming years.

While a number of potential opportunities have been identified, details are scant, making it difficult to estimate their cost and hence how big a business this may eventually be. With Wet'n'Wild Sydney costing around $130m and the Hainan Island development costing $550m, a wide variety of estimates are possible. So we've conservatively assumed just one additional US$500m fund is raised.

Village will own half the fund manager and at least 60% of the entity responsible for the design, construction and operation of the theme parks constructed by the fund. Funds management businesses have large fixed costs, so their margins and profitability increase more rapidly than funds under management. With no details of the potential management fees available, we've assumed a 1% management fee and a 20% EBIT margin based on comparable businesses in Australia and our assumption of $1.9bn in funds under management (including Hainan Island).

Applying an EBIT multiple of 10 (due to the greater potential for growth) gives an estimated value of around $100m for this business. Note that we haven't included any value for other opportunities that Village is pursuing in Asia, such as potential marine parks in partnership with US-listed SeaWorld.

Cinema exhibition

Village and its partners (including Amalgamated in Australia) now operate over 700 cinemas at 75 sites in Australia, Singapore and the United States. The company continues to improve its cinemas via the roll-out of its premium Gold Class luxury cinemas and vMax big screen venues while also seeking additional cinema sites in Australia in targeted 'growth corridors' and expanding its US business.

According to Screen Australia, the percentage of Australians that attend the cinema at least once a year remains similar to its level in 2000. The average number of visits per person, however, has fallen to 6.8 (in 2014), down from 8.4 in 2000. And, in an ominous sign for the future, the average number of visits shows its greatest falls among young people.

No doubt younger people's preferences have been influenced by the increased availability of digital downloading and the continued rise of larger, higher quality TV screens and we'd expect this trend to continue.

Even so, ABS figures suggest going to the cinema remains an entrenched social activity that's unlikely to significantly decline in popularity soon. Continued population growth should also provide a gentle tailwind.

With price competition among cinema operators virtually non-existent, Village should be able to continue to steadily increase prices as it has in the past while continuing to increase earnings through new sites and its 'average spend' per customer via its Gold Class and vMax venues.

All in all, we think this division will continue to grow slowly. After taking into account the annual $3m losses incurred on its Belfast property – which Village is trying to sell – we estimate annual EBIT of $45m which, going back to our 'slow growth' multiple of 8, gives a value of $360m.

Content distribution

The Content distribution business's profitability has fallen recently due to poorly performing movies and TV content, but we expect this to be a short-term hiccup, which should resolve itself as more popular content is provided by suppliers. Of greater concern is that technological changes might make Village's roll in distributing third-party content obsolete and Warner Bros – its most important supplier of films – cancelling its agreement or severely curtailing its profitability when it comes up for renewal in 2017.

Village has recently entered into a further deal with Warner Bros to licence all its home entertainment content in Australia and New Zealand, including film, TV and Home Box Office (although no digital rights for the latter). This, as well as the Film Production arrangements with Warner discussed below, suggest its relationship with Warner Bros is still on good terms. The company has also recently struck licensing details with Stan and Netflix covering its film library along with future film releases.

While it is possible that Warner Bros will turn the screws in a couple of years, the two companies' longstanding close relationship suggests this is unlikely. Even so, given the risks, we're knocking down our estimate of sustainable EBIT to $40m and continuing to use an EBIT multiple of 6, resulting in an estimated value of $240m.

Film production

Having exited the music business after selling Concord Music Group in early 2013, this division is now solely focused on film production via its 47% ownership in Village Roadshow Entertainment Group (VREG). Village also owns US$136m in non-voting redeemable shares which pay a 5% cash dividend and 9% payment in kind.

VREG extended its co-production and co-finance agreement with Warner Brothers late in 2014 while also entering into a similar agreement with Sony, with both agreements expiring at the end of 2019. As a result, VREG has increased the number of films it hopes to release each year from 6–8 to 8–12. This will reduce the impact on VREG's results from one or two films doing badly.

Village's interest in VREG is equity-accounted and the details are scarce, making it difficult to value. However, the business's main asset is its library of over 82 films, and some indication as to its value was revealed in its 2014 accounts after VREG sold a one-sixth interest in the future cash flows from its then library of 74 films, generating a $137m accounting gain.

VREG sold a further one-third interest in October 2014, using the proceeds to reduce debt. Assuming the US$300m reduction in VREG's bank debt in the six months to 31 Dec 14 was primarily due to the proceeds, the remaining film library may be worth around US$450m, or $600m at current exchange rates.

Adjusting VREG's latest publicly available balance sheet (as at 30 Jun 14) based on this assumption significantly reduces its negative equity position. With recent blockbusters such as American Sniper, Mad Max: Fury Road and San Andreas making up for bombs like Jupiter Ascending, VREG's performance appears to be improving. We'll receive further details when Village releases its 2015 full-year results but at this stage we think it's reasonable to value Village's non-voting redeemable shares at 100 cents in the dollar, or $180m at current exchange rates.

Any further value that Village may gain from its ordinary shares in VREG will be a bonus. With an IPO still a 'medium-term option', the company's stake in VREG could be worth much more or – if VREG releases a string of bombs – much less.

Upgrading to Hold

Adding it all up and taking into account corporate costs and debt gives an estimated value of around $4.90 per share (see Table 1), about 24% below Village's current share price.

This is a rough estimate, though, and depends on a number of assumptions. These could change materially when additional information on the company's film production business is released or due to further developments in its nascent Asian theme park expansion and funds management business.

Until they do, we don't see a margin of safety at current prices but are comfortable returning the stock to HOLD.