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A Deeper Look into Sphere’s Unit Economics and Valuation

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The entertainment industry has been abuzz with the latest spectacle in Sin City: Sphere Las Vegas. This $2.3 billion superstructure, which launched on September 29th, 2023, has been described as a “game changer” in the live entertainment venue space. As an avid Las Vegas visitor myself, I can’t help but be intrigued by this grand spectacle and the potential valuation puzzle surrounding its parent company, Sphere Entertainment Co.

Why Should You Pay Attention to Sphere Entertainment Co. (NYSE: SPHR)?

Before we dive into the analysis, let’s quickly review why Sphere Entertainment Co. is worth a closer look and why the stock might be mispriced:

  1. First of its kind: Sphere’s technological build-out and unique business model make it difficult to compare to other companies in terms of margins and multiples.
  2. Limited guidance: Sphere has provided little to no guidance on expected revenues, operating costs, or its content pipeline, leaving investors to do their own due diligence.
  3. Disperse Wall Street estimates: Sell-side analysts’ forecasts for Sphere vary widely, resulting in a volatile stock price. Research reports often contain fundamental inaccuracies and inconsistencies.
  4. Messy financial history: As a recent spinoff, Sphere’s historical financials are incomplete and messy, making it challenging for quants and algorithms to accurately price the security.
  5. High operational leverage: Sphere’s business model is highly sensitive to changes in revenue, resulting in significant changes in free cash flow once fixed costs are covered.
  6. Catalyst-driven business turnaround: Sphere’s current investor base is exhausted from past cost overruns, making it difficult for them to see the business’s potential in a new light.

Considering these factors, there is an opportunity for analysts and investors who conduct careful research to gain an edge over the market consensus. Sphere has the potential to be worth a lot or a little, depending on how its operations shape up in the coming year. In this article, we will dive deep into the company’s operations and build a reasonable forecast for its future.

Valuation of Sphere’s Business Segments

Sphere’s business can be broken down into two distinct segments: MSG Networks and Sphere Las Vegas.

The market currently values Sphere Las Vegas, the giant 20,000-person theater located on the Las Vegas strip, at approximately $870 million. However, this valuation is likely underestimated due to the uniqueness of Sphere’s ownership structure. Sphere owns over 90% of its content, allowing the company to keep the majority of its box office, concession sales, and advertising revenues, unlike traditional venues that pay a significant portion of these revenues to independent teams or performers.

Based on my analysis, I believe that Sphere Las Vegas has the potential to generate over $200 million of adjusted operating income in fiscal year 2025. Applying a 15x multiple to this figure, Sphere Las Vegas alone could be valued at nearly $3 billion, compared to its current market-implied value of $870 million. When combined with Sphere’s other segments, I estimate a potential share price of approximately $90.00, compared to the current price of $35.00.

The Operations of Sphere Las Vegas

Sphere Las Vegas operates two main locations: The Sphere in Las Vegas and Sphere Studios in Burbank, CA. The former is a 20,000-person theater located on the Las Vegas strip, while the latter is a development facility where R&D, testing, and content development take place.

Historically, Sphere Las Vegas has been incurring significant losses, with adjusted operating losses of $231 million and $292 million in the last two years. However, with the opening of the theater, we can now forecast its future performance.

Forecasting Revenues

Given that Sphere Las Vegas only opened recently, forecasting its revenues is challenging. However, by analyzing early audience data and reviews from the opening shows, such as U2 and Postcard from Earth, we can make reasonable extrapolations.

Sphere Las Vegas generates revenues from five different sources: Live Artist Residencies, Immersive Experiences (custom films), Corporate Takeovers, Executive Suite Sales, and Exterior Advertising & Signage. Here are my revenue forecasts for each source:

Live Artist Residencies

Stadiums are typically rented out to performers for a set price, and the performers then take on the economic risk of the event. For example, U2, which is currently performing at Sphere Las Vegas, will receive 90% of ticket revenues, while Sphere will receive the remaining 10% plus service fees. I expect Sphere to negotiate better terms with subsequent artists, given the uniqueness of the venue and its ownership structure.

Based on U2’s 25 nights of performances in the last quarter of 2023 and an additional 15 nights in the subsequent two quarters, I forecast 55 residency nights for fiscal year 2024. With Sphere’s full occupancy of 20,000 and an estimated average ticket price of $330, this represents a significant revenue opportunity. Additionally, I anticipate signing at least one new artist residency for the second half of 2024, bringing the total nights to approximately 70. The average capacity for these residencies is estimated at 18,000, with an average ticket price of $300. I project an average concession/merchandise spend of $35-$40 per person at these events.

Immersive Experiences (Postcard from Earth)

Sphere currently operates its first immersive experience, “Postcard from Earth,” directed by Darren Aronofsky. Based on initial ticket sales and consistent demand, I expect this offering to generate steady revenues. With ticket prices ranging from $49 to $249 and around 65% seat utilization, “Postcard from Earth” is expected to be a high-margin business for Sphere. This revenue stream is poised for future growth as Sphere refreshes its content with new experiences alongside “Postcard from Earth.”

Corporate Takeovers

Sphere offers its facilities to corporations for special events. Already, Formula 1, Superbowl week, and CES have booked dates at Sphere Las Vegas. With high-profile corporate events throughout the year, I anticipate these bookings to increase, further boosting revenues.

Executive Suite Sales

Sphere has 23 suites, each with 32 seats, available for lease to corporations or individuals. Similar to suites at stadiums, these leased suites are a revenue driver for Sphere. Based on conservative estimates, I forecast $1 million per year per suite, generating substantial revenue for the company.

Marketing Ad Sales

The exterior of Sphere Las Vegas, known as Exosphere, is rented out as advertising space. With reported rates of approximately $450,000 per day or $600,000 per week, this revenue stream has great potential to contribute to Sphere’s overall earnings.

Total Sphere Las Vegas Revenues

By combining the revenue forecasts for each segment, Sphere Las Vegas is poised to generate significant operating income. I estimate its revenue to reach new heights in fiscal year 2025.

Profitability and Costs

When analyzing Sphere Las Vegas’ profitability, it’s essential to consider gross margin assumptions and operating expenses. While the street’s estimates and my assumptions differ significantly, my forecast is based on a bottom-up approach, taking into account the company’s unique ownership structure and anticipated costs.

Gross Margin Assumptions

Despite my assumption of an 80% gross margin, which may seem ambitious, the uniqueness of Sphere Las Vegas and its high growth potential support this forecast. Unlike MSG Entertainment’s venues, Sphere keeps the majority of its content revenues, resulting in the potential for higher gross margins. Although the market consensus currently expects lower margins, I stand by my projection and believe that Sphere’s realized gross margins will be substantially higher than those anticipated by the market.

SG&A and Direct Operating Expenses

SG&A costs can be expected to decrease in fiscal year 2024 as one-time expenses related to building Sphere Las Vegas dissipate. Although the company has not explicitly stated its future SG&A plans, I believe these costs will decline throughout the year. Direct operating expenses, including staffing, utilities, maintenance, and food/beverage costs, will be necessary to support daily operations.

Valuation and Discrepancies

Broadly speaking, the discrepancy between my forecasted valuation and that of Wall Street analysts can be attributed to differing gross margin assumptions. Analysts have incorrectly used MSG Entertainment’s cost structure to estimate Sphere Las Vegas’ direct operating costs, leading to underestimated gross margins. Macquarie, for example, valued Sphere Las Vegas at just $333.6 million, which seems unreasonably low, especially given the success of U2’s ticket sales.

While the margin assumptions may differ, my valuation of Sphere Las Vegas at $2.8 billion aligns with the company’s $2.3 billion investment in building the asset. Additionally, my projections for Sphere’s profitability and future growth support a higher valuation compared to the current market consensus.

Sensitivity Analysis and Catalysts to Watch

Several factors can influence Sphere’s valuation and share price. For instance, a higher equity value for MSG Networks, the sale of naming rights to Sphere, changes in food and beverage sales, seat occupancies, or gross margin assumptions can all impact the company’s valuation. Monitoring upcoming catalysts, such as residency extensions, the announcement of new residencies and naming rights, and the release of quarterly earnings reports, will provide valuable insights into Sphere’s future performance.

In conclusion, Sphere Entertainment Co. and its unique asset, Sphere Las Vegas, have the potential for significant growth and profitability. By carefully analyzing the company’s operations, revenue streams, and costs, it becomes evident that Sphere’s valuation is currently underestimated. As the business continues to evolve and prove its potential, investors who conduct thorough research may find themselves in a favorable position to benefit from Sphere’s success.

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