Published: August 11, 2010

I've been investigating fad stocks lately, and thought one article might be enough, until I came across such a perfect example, I thought investors absolutely had to know about it. [See: 3 "Fad" Stocks That Collapsed. . . and the Next One To Fall]

We often learn more about investing from our mistakes than our winners, and this stock has already made fools out of a lot of investors. And it's setting up to do so again.

The movie business is, by and large, a terrible place to invest your money, unless you're dealing with a diversified media company like Walt Disney (NYSE: DIS) or a company with a proven track record like Dreamworks Animation (NYSE: DWA). [See: This Movie Stock is Following the Playbook to Massive Returns]

In fact, the movie business defies a rule I generally invest by, which is to put money into the stocks of companies that provide industry leaders with goods and services.

Panavision, for example, was one of the leading movie camera companies for Hollywood when it went public, but it eventually tanked. Movie theatres have historically been too burdened with debt for their stocks to ever perform well, either.

To this list I'm adding IMAX Corporation (Nasdaq: IMAX). The company provides cameras that shoot in its proprietary large-screen format and, of course, digital projectors and screens for showing the movies in theaters.

IMAX doesn't make its money from the cameras, however. Hollywood does not shoot entire films in IMAX format. Instead, IMAX makes most of its money by leasing its systems to theatres and with maintenance and rev-share contracts for re-mastering and distributing Hollywood releases in its special format.

The problem is there are only so many movie theatres that can convert into IMAX theatres. The company currently has about 430 systems in its network, but says it may top-out at 1,250 screens. Currently, 85% of the company's revenue backlog is generated by these orders. So what happens when the world is saturated with IMAX screens? No more leasing deals. That could be a huge problem, because about 30% of IMAX's $225 million in revenue comes from the sales/leases, and that 30% comprises a full 100% the company's net income.

But once all those screens get installed, won't IMAX's revenues soar from ongoing rev-share deals from re-mastering and distributing films in its format?

Not likely. This is the fad aspect of IMAX. To compensate for poor content, studios and exhibitors have raised prices and relied on gimmicks like 3-D and IMAX to offset the past decade's trend of flat-to-lower admissions. IMAX just happens to be benefiting from Hollywood's desperation. And when this gimmick runs its course, IMAX will be left at the altar like a jilted lover.

Make no mistake, IMAX is just a gimmick. A re-mastered IMAX image is nothing special -- it's just bigger, and it gives an excuse to charge higher ticket prices. Next time you're at a movie theatre, ask random patrons if they would pay extra money to see a run-of-the-mill movie in IMAX -- even in a good economy. I bet nine out of 10 will say "no."

Another sign of a gimmick is when fake versions show up... And in IMAX's case, they have.

The company's dirty little secret is that some installations aren't true IMAX. The AMC theatre near my home, for example, simply stretched its screen to fit the auditorium, and re-mastered it in IMAX. The trick, though, is that screen is 25% the size of a true seven-story IMAX screen. It's fake IMAX, and moviegoers are beginning to realize it.

How many of these 1,250 screens the company expects to have will be true IMAX? Because those fake screens will not pull in the same kind of audience. Sooner rather than later, IMAX revenues from re-mastering and distributing Hollywood films will drop off. People don't like paying extra for to see a movie that isn't true IMAX, and they don't like paying extra for something once the novelty wears off, either.

Hollywood will find a new gimmick. Other companies that already have expertise in converting TV and DVD signals into new 3-D equipped televisions will be the next big wave. I don't see a big home market for IMAX. It isn't like Dolby (NYSE: DLB) -- which has become a necessity in the production of film sound production and exhibition.

From an investing perspective, we've seen this before with IMAX. In the late 1990s, the company produced spectacular documentaries that you would mostly find in museums. When it seemed like this format was really going to catch on and more locations installed IMAX screens, the stock took off. Eventually, people realized that the commercial prospects for IMAX films weren't compelling. The stock fell from a high near $30 to just $1 in 13 months, back in 2000-2001.
 

Investors had been fooled.

Since 2009, the stock has moved from $3 to almost $20. The problem, as I've pointed out, is that there's no fundamental reason for the stock rise. IMAX is an accidental beneficiary of Hollywood's desperation.

The company showed increasing net losses from 2006-2008. Now they're making money, but it won't last. The stock will collapse again.

Don't get fooled again.

Action to Take --> Stay away from IMAX. In fact, short it. (The shares took a -6% beating in Wednesday trading alone.)

Great companies solve a problem that people have. IMAX doesn't. Great companies take markets over. IMAX can't because the very nature of its product prevents that from happening. Soon the IMAX wave will pass and revenue will begin to fall again.

-- Frederick Steier
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