Decoded: What the PVR-Inox merger means for investors

NEW DELHI: Shares of PVR and Inox Leisure Ltd. surged on Monday after the two announced a merger to create the largest multiplex chain in the country with a network of more than 1,500 screens.
INOX will merge with PVR and its shareholders will receive three shares of PVR for every 10 shares held by them in INOX. The merged entity will be named PVR INOX Ltd with the existing multiplexes called PVR and INOX.New cinemas opened after the merger will be branded as PVR INOX.
Analysts expect their proposed merger to offer a competitive advantage over other multiplex operators, drive bargaining power in terms of newer technologies, rentals and marketing spends. The deal is also expected to boost free cash flow, ensure stranglehold over real estate and bring in cost synergies.
The merger comes at a time the multiplex industry is looking at a turnaround as Covid-19 cases have drastically reduced across the country amid stiff competition from Over The Top platforms.
The consolidated entity will have 1,546 screens, implying a market share of 16-17% in total screens (including single screens) in India and a 44%-50% share within multiplex screens.
" The merger will create a large entity with better negotiating power across the length of business partners and better cost management as well. While management has highlighted that CCI approval will not be required, we believe that the merger will undergo some scrutiny from the regulators, given the dominance of these companies," said Emkay Global in a report.
What the deal means for investors
According to analysts, the swap ratio is favourable to INOX investors by about 12 per cent, due to its zero net debt situation compared with PVR's net debt at Rs 857 crore. This was evident in the stock movement too on Monday when Inox shares surged by 20 percent while PVR shares rose only 10 percent.
“Based on the share-swap arrangement, INOX valuation has been pegged at Rs 6,400 crore (EV per screen of Rs 10 crore) whereas PVR is currently trading at a valuation of Rs 11,000 crore (EV per screen of Rs 12 crore)”, said Elara Capital.
After the merger, INOX promoters will own a 16.7 percent stake, while PVR promoters will have a 10.6 percent stake in the combined entity.
Experts believe this merger will take over six months as it will be subject to approvals from the National Company Law Tribunal (NCLT), Securities and Exchange Board of India (SEBI), Competition Commission of India (CCI), stock exchanges and shareholders.
CCI threat
"The merger between Inox and PVR is a win-win situation for both companies. However, this merger needs to get the final approval from CCI because it will be like a monopoly situation in multiplex industries. PVR is a bigger player and it has diversified geographies that will help Inox to grow further. PVR has a debt issue while Inox leisure is a cash-rich company therefore the combined entity will have a better balance sheet. Stock prices of both companies have already rallied therefore there is a risk of profit booking but the long term outlook is bullish," said Santosh Meena, Head of Research, Swastika Investmart Ltd.
Even brokerage Nirmal Bang agrees that the CCI approval is the biggest risk. In 2016, during a much smaller deal between PVR and DT Cinemas, some screens had to be divested for the deal to be cleared by the CCI.
“We believe PVR INOX may need to shed screens in key metros like Delhi and Mumbai, if this rule is applied again by CCI. We also gather that the deal may benefit from ‘exemptions available to transactions involving small targets from notification to CCI,” the report added.
"CCI approval is perhaps the key aspect of the merger, given the dominance of these companies. The company has highlighted that CCI approval would not be required, possibly since the merged entity has revenue of less than Rs10bn (CCI in 2017 had notified that merged entities with less than Rs10bn revenue would be exempted). There will be many markets where the merged firm can potentially overshoot the stated market share threshold or have a monopoly kind of scenario. In such a case, the merged entity might also let go of low-yielding properties, if CCI becomes a hurdle. The other challenges include organisational cultural differences and significant delays in the approval process," said Emkay Global.
Best real estate locations
Nirmal Bang also believes that the merged entity has tied up a large part of the retail real estate pipeline, since each has over 1,000 screens lined up over the next 5-10 years. This could be the biggest competitive advantage. Add to that, the best real-estate locations in all major urban centres in India. "On the revenue front, we believe the biggest synergy benefit will be in the form of higher pricing power in advertising for INOL, whose advertising revenue per screen was 35 percent below PVR’s in FY20. We now see it narrowing far quickly,” the report said.
Synergies:
The merged company would command a 44% market share in terms of box office revenue. Benefits include ad revenue, convenience fee, F&B sourcing along with vendor consolidation, and savings in corporate overheads.
"We believe that the merged entity might want to use its muscle power to negotiate a lower revenue share with movie distributors, but it could be tricky. In total, we estimate revenue and cost synergies of Rs1.1bn for each, resulting in EBITDA accretion of Rs2.1bn. We have not assumed any savings on rental and film distributor share," said Emkay Global.
While PVR has dominance in the north and south and operates 871 screens across 181 properties in 73 cities, while INOX is more focussed on eastern and western regions. It owns 675 screens across 160 properties in 72 cities, which means that the two can expand faster in their respective markets thanks to the scale, which would offer "substantial bargaining power over the entire ecosystem including customers, real estate developers, content producers, technology service providers, the state exchequer and employees," said JM Financial in a report.
In the last five years, the cinema industry has seen a decline in the number of screens. Around 70 per cent of the market consists of single-screen cinemas, which are facing shutdowns, whereas multiplexes, with 30 per cent share and 2,700 screens, are seeing strong growth, Motilal Oswal said.
“Given the large movie market (over 2,000), healthy box office collections, lower number of screens/cinemas, and a concentrated multiplex market (PVR/Inox command over 40 per cent market share), the multiplex market has healthy room to add new screens. The combined entity plans to deepen their network in Tier II and III markets,” Motilal Oswal said. But the brokerage has a neutral rating on the stock because of rich valuations the stock has commanded historically.
Threat from OTT
Despite the huge opportunity for growth in screen additions, the management did acknowledge the threat posed by OTT platforms to occupancies and screen-level profitability metrics. “The OTT challenge, in our view, is a storm in a tea cup. While we are cognizant of the threat, we think it is exaggerated as the economics of taking a movie directly to OTT for a reasonable budget movie that will find a theatrical release is not compelling,” noted Nirmal Bang.
"OTT platforms pose a risk of shrinking the exclusive period, softening occupancies, and lower screen economics,” said Motilal Oswal.
Defensive move to drive cost efficiencies?
"Multiplex businesses is very tough business with high capex and high fixed opex. Even in a fast-growing market like India, the multiplexes have been struggling to generate free cash flows. The business model in its current form is that of a glorified QSR since more than 80% of the profits come from the sale of high-priced food and beverages. The movie screening business is breakeven at best. Advertising revenues are limited to local area advertisers and some standard government ads. Footfalls are completely dependent on the quality of new releases, and the multiplexes have no control over that. Most importantly, they have been losing out to international OTT behemoths in terms of the release of new content. Therefore, this merger of PVR and INOX should be seen as a last resort defensive step to drive cost efficiencies," said Abhay Agarwal, Founder, and Fund Manager, Piper Serica, SEBI Registered Portfolio Management Service Provider.
But, was the rally a knee-jerk reaction?
Any kind of surprise M&A activity, especially by consumer brands, is typically immediately cheered by the market participants and there is a spike in buying interest. "However, in this case, we believe that the merged entity will have to work hard to repair its balance sheet and convince the lenders that it can generate enough free cash flows to sustain the debt taken during Covid lockdowns. Our expectation is that during the period that the merger takes effect and for a year thereafter the market valuation will stay in a narrow range. Those who believe that the merged entity will create a strong business can buy the shares for the long term. However, the short-term traders looking for a quick upside may be disappointed," added Agarwal.