Critics, cinephiles and gamblers will be closely following this weekend's Academy Awards. So will quite a few investors: the UK is home to an ensemble cast of companies that play leading roles in the film industry, ranging from production and distribution to special effects and cinemas. There's no Oscar for 'Best Supporting Shareholder', but backing the industry's stars can be rewarding nonetheless.
It's tempting to think that the rise of Netflix (US:NFLX) and other video-streaming sites - which offer monthly access to thousands of film and TV titles at the cost of a single cinema ticket - could herald the end of cinemas, if not the film industry. But the success of new media is actually fuelling the sector's growth: worldwide video-streaming revenues are set to grow by more than a third annually between 2013 and 2018, according to PwC, driving 4.5 per cent yearly growth in film industry spending to over £110bn. British filmmaking is especially strong: spending on domestic film production rose more than a third to a record £1.47bn in 2014, says the British Film Institute, driven by a 40 per cent surge in foreign investment.
A key attraction continues to be film tax relief, which allows UK film producers to reclaim up to a quarter of their expenditure; it's now about 38 per cent cheaper to shoot a film here than in the US. No wonder the national trophy cabinet is filling up: UK-produced space drama Gravity landed seven Oscars last year, while The Theory of Everything and The Imitation Game are among this year's frontrunners with over a dozen nominations between them.
The impact of a strengthening UK economy on cinemas isn't as black and white: people may have spare cash to splurge on movie night, but films also provide an inexpensive escape from the drudgery of a recession. The more salient factor seems to be the quality of films on offer: analysts blame a mediocre release slate for the 2 per cent dip in UK box office revenues and 5 per cent slide in cinema admissions last year. However, judging a film's quality and its box office prospects is no mean feat. Oscar-winning screenwriter William Goldman sums it up thus: "Nobody, nobody - not now, not ever - knows the least goddamn thing about what is or isn't going to work at the box office."
The film industry's unpredictability often means a handful of releases take the lion's share of box office revenues; only one in three films recoup their production, marketing and distribution costs. That's a concern for investors, as it begets volatile performances and razor-thin margins. For instance, Sony expects its pictures division - which produced controversy-hit The Interview and the last five Spider-Man films - to eke out a full-year operating margin of just 6.6 per cent. Accordingly, studios increasingly hedge their bets by releasing a dozen new films each year and branching out into television, live shows and even theme parks - not unlike an investor diversifying a portfolio. For the same reasons, Hollywood tends to favour 'safe' franchises with an established audience, prioritising sequels, remakes and adaptations. That trend is evident in this year's release slate, which includes the 24th James Bond film, the seventh instalments of Star Wars and Fast & Furious, and sequels to Jurassic Park, The Avengers and The Hunger Games.
The outcome has been several years of big-budget blockbusters with simple plots and plenty of explosions, providing myriad opportunities for marketing, merchandising and product placement. They also price out the competition, tend to drive strong DVD and streaming sales and won't be lost in translation in lucrative foreign markets. However, these trends risk starving creativity and sacrificing originality; acclaimed directors George Lucas and Steven Spielberg fear an endless parade of blockbusters will saturate and numb audiences - somewhat ironic, given their own CVs. It's also harder to get less flashy films into cinemas; Oscar-winner Lincoln was nearly relegated to US pay-TV network HBO.
What do these industry shifts mean for investors? They suggest the best course of action is funding large, diversified film studios. Pinewood Shepperton (PWS) counts entertainment titan Disney (US:DSY) among its clients: the upcoming Star Wars, Avengers and Alice in Wonderland films were all shot at Pinewood's South Bucks studio. Healthy demand for studio space and services such as set building and editing sent first-half sales up 15 per cent; Pinewood is now expanding to bolster its capacity, and recently took full control of Middlesex-based Shepperton Studios. It is also hosting more TV shows such as The Voice and National Lottery Live. The upshot is that broker N+1 Singer expects its pre-tax profits to increase by half to £5m next year. But at 463p, Pinewood's shares trade at a lofty 34 times next year's forecast EPS of 13.6p.
An alternative choice might be film and TV distributor Entertainment One (ETO), which acquires the rights to movies such as Nightcrawler and The Theory of Everything then exploits them internationally. True, the group bombed at the box office last year: receipts were a third lower in the nine months to end-December, driving a 14 per cent slump in film revenues. But TV sales surged 37 per cent as it sold more programming to broadcasters and digital platforms Netflix and Amazon (US:AMZN) Instant Video. Moreover, its popular Peppa Pig franchise is expected to surpass $1bn in retail sales this year, while product deals with US retail giants Walmart and Target should drive further growth. The group also took a majority stake in Grey's Anatomy producer MGC, strengthening its ties to Hollywood and foothold in the enormous US market.
Entertainment One spreads its risk by releasing around 200 films a year, says finance chief Giles Willits. "Don't overexpose yourself to any one movie," he warns investors. "It's quicker to flush the money down the drain." More movie releases and a global box office recovery promises to rejuvenate the group's film business this year. Together with bumper TV sales, that underpins broker Investec's forecast full-year pre-tax profit growth of 13 per cent. Entertainment One's shares have soared sevenfold since our buy tip (39p, 20 Nov 2009), but still trade at an irresistible 12 times forecast EPS for 2016.
Cautious investors may balk at the 'hit or miss' production business. Cinema companies may present a safer option as they choose which films to show, for how long and on how many screens. However, they rely on studios to release appealing films, while the ubiquity of high-definition TVs and speaker systems has narrowed the difference in quality between home viewing and cinemas. Their response has been to invest in better sound and picture quality, spruce up their seating and facilities, sweeten their food and drink offerings, branch off into broadcasting live sporting and music events, pack more screens into fewer cinemas and charge higher prices.
Take Cineworld (CINE), which weathered falling domestic admissions and box-office sales last year with a 4 per cent hike to its average ticket price. The cinema group is also expanding internationally: its purchase of Cinema City has allowed it to tap into underserved audiences in Israel and continental Europe, where full-year admissions rose 4 per cent. It now controls around 1,900 cinema screens across more than 200 sites, and plans to open about 50 cinemas in the next three years.
Cineworld's exposure to studio release schedules may be more of a blessing than a curse; Investec thinks the upcoming Avatar and James Bond sequels could attract new audiences and drive substantial earnings growth. This year alone, it expects cash profits to rise 22 per cent to £150m. Cineworld's shares are up 6 per cent on our latest buy tip (401p, 14 Jan 2015), but still trade at 16 times full-year forecast EPS, leaving room for further gains.
Investors with more refined tastes might prefer independent cinema chain Everyman Media (EMAN), whose Bohemian offerings have struck a chord with film aficionados. It offers film-goers a glass of red wine, a slice of freshly-made pizza and a mix of mainstream, art house and classic films. Everyman operates 10 high-end movie theatres in the UK and plans to open a further five over the next 18 months, underpinning Cenkos analysts' forecast 22 per cent rise in full-year cash profits. But like its films, Everyman's shares won't suit everyone: at 77p, they trade at a pricey 59 times forecast earnings.
Everyman harks back to the golden age of cinema; imaging specialist OMG (OMG) is firmly focused on the future. Special effects first burst on to the big screen in Star Wars in 1977, and play a crucial role in many of today's top films. OMG's camera rigs were used to capture the movements of both Hulk in The Avengers and the eponymous bear in Paddington, and it counts performance-capture studio The Imaginarium - co-founded by Lord of the Rings actor Andy Serkis - among its clients. It also provides specialist imaging and surveillance technology to the engineering and defence industries. And it's growing quickly: analysts at N+1 Singer expect pre-tax profits to triple this year then rise by more than half in 2016. Yet at 35p, OMG's shares trade at an enticing 14 times forecast full-year EPS of 2.5p, and offer a small yield of 1.7 per cent.
IC VIEW: The film industry faces the same structural and technological challenges as the radio, publishing and home entertainment sectors. We're bullish on companies that embrace the new paradigms of digital technology and distribution but remain diversified. For instance, Entertainment One works with Netflix and Amazon, but also boasts promising TV and production businesses, while OMG is spearheading imaging technology in multiple industries. We also think Pinewood Shepperton's close ties to Disney and growing exposure to television bode well. And although Cineworld and Everyman are vulnerable to the vagaries of the box office and consumers' whims, both target underserved audiences. In spite of the challenges, we don't expect the credits to roll on the film industry any time soon. Investors should buy their tickets.
