When we profiled Cineplex Inc. (TSX: CGX, OTC: CPXGF) last June, we wrote that there was much to like, including an attractive yield and growing dividend, but that the stock was very expensive. Consequently, we only added a small pilot position to the Dividend Champions Portfolio at that time.

Fast-forward nine months and the share price is essentially at the same level, which means the stock has gotten left behind in a rising market.

Cineplex recently reported its full-year results, so now is an opportune time to review the merits of this investment.

What We Like

With a 78% market share, Cineplex holds an absolutely commanding position among Canadian movie theater chains. The firm’s 1,683 screens attract a total of 77 million annual visits. That implies every Canadian visits a Cineplex theater an average of twice a year.

The company’s market dominance gives it scale and access to a large number of customers from whom more revenue can be extracted.

Cineplex’s strategy to increase revenue per visit is primarily focused on upgrading the cinematic experience by adding VIP Cinemas, IMAX theaters, motion seats, and 3D systems—all of which are priced at a premium.

Beyond that, Cineplex also continues to upgrade and improve the food and drinks available at its venues.

This strategy has been reasonably successful. Box-office revenue per patron visit has climbed 3% annually since 2007, while food service sales have risen 6% annually over the same period. 

Altogether, patrons spent an average of C$15.20 per visit in 2016. This compares quite favorably to competing forms of entertainment, including live sports, music events, and restaurant dining.

Although attendance in 2016 dropped from the record levels achieved the previous year, Cineplex remains very profitable. Return on equity averaged 13.4% over the past five years, which is considerably higher than the firm’s cost of equity.

The balance sheet is in good condition, with a debt-to-capital ratio of 26%. And cash-flow generation remains sound, with an average cash-conversion ratio of 15% over the past three years.

The company’s dividend policy targets a payout ratio of 60% to 85% of adjusted free cash flow, which has allowed for steady dividend growth of 5% annually over the past five years. The current payout ratio is 65%, which is toward the lower end of the firm’s targeted range, suggesting that there’s ample room for future dividend growth.

What We Don’t Like

Despite its leading position, Cineplex operates in a slow-growing market, which has created challenges.

Over the past five years, Canadian box-office sales have stagnated at around C$1 billion per year. Aided by small acquisitions, Cineplex has managed to grow its box-office revenue by 12% over the same period, while attendance has risen 5%. Nevertheless, it’s hard to grow in a mature market.

Box office and food contribute almost 80% of total revenue, and they will remain the core of the business for the foreseeable future.

Cinema attendance is linked to the popularity of the films on show, which not only drives box-office sales, but also food revenue. This can result in considerable earnings volatility, since there won’t be blockbusters every quarter.

However, Cineplex has created new growth avenues, particularly with the introduction of amusement gaming. The company has developed facilities for recreational gaming and also organizes live online-gaming tournaments. Gaming tournaments are becoming big business around the world, and early signs suggest this initiative could be very positive for Cineplex.

Even so, we’re concerned about the company’s recent acquisitions in the arcade and amusement park areas, as well as its capital-intensive development of several large entertainment centers. We consider these to be risky propositions, at best.

But overall, the company’s ultra-premium valuation is still our main concern.

We like the simplicity of this business, as well as management’s strategies to capture additional profits from a large and growing clientele.

And we think there is reasonable growth ahead as Cineplex continues to boost patron spending by further enhancing premium cinematic experiences and value-added food services. Indeed, these moves could help produce a nice bounce in profits this year from a somewhat depressed 2016 base.

However, Cineplex’s stretched valuation already accounts for good future growth—and then some. The stock trades at a 12-month forward price-to-earnings ratio of 28 times and an enterprise value to EBITDA (earnings before interest, taxation, depreciation, and amortization) ratio of 12 times.

Fortunately, the dividend is safe, and it’s expected to grow at 5% per year. The stock currently yields an attractive 3.1%.

Perhaps owing to valuation concerns, the share price has gone nowhere over the past two years. We would consider adding to our existing holdings if Cineplex trades below C$48, or US$36.