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May 10, 2005

Lion's Gate Entertainment: Hollywood's New Big Cat

Lions Gate Entertainment (LGF) is the largest independent motion picture studio. The company also produces television shows and owns a library of over 6,200 films and 1,800 television episodes. LGF produces inexpensive movies by Hollywood standards with all-in costs in the neighborhood of just $20 million. The company has had success with horror films and "indie" dramas and comedies (think Miramax, not 20th Century Fox or Walt Disney Studios).

Lions Gate shares trade at a valuation in line with other diversified media companies but should enjoy a faster growth rate. The company's financial performance is poised to accelerate due to recent success at the box office and the completion of the integration of its 2004 acquisition of Artisan Entertainment. Investors have historically paid a premium multiple for niche oriented media companies that enjoy high and stable returns. If the anticipated financial momentum materializes, LGF should enjoy an expansion in its operating cash flow multiple that leads to a 20% or greater gain in the share price over the next year. Valuation is also supported by "scarcity value" as following the acquisition of MGM by Sony, LGF is only sizable studio unaffiliated with the major entertainment conglomerates....

While less than half of LGF's annual revenue of nearly $800 million comes from recently released theatrical films, the perception of the shares is driven by the company's film business. Each year LGF releases 15-20 films with an average production or acquisition cost of $6 million. About 2/3rd's of the films are self-produced while the rest are purchased. Recent successful releases include Saw, Open Water, Diary of A Mad Black Woman, and Crash, which opened this past weekend to solid box office and strong reviews.

A successful film for LGF produces box office of $15-20 million. However, LGF's financial model is built on the assumption that the films average about $10 million at the box office (for the fiscal year ending March 2005 the average film earned $14 million), which the company splits evenly with the theatres. International rights are usually pre-sold to recoup a major portion of the production or acquisition cost, resulting in total revenue directly related to the initial theatrical release of $9 million. In addition to production or acquisition costs of $6 million, LGF spends an average of $5 million to market a film, leading to a loss on each film of about $2-3 million before home video revenue and the sale of television rights to the film.

Home video revenue has emerged as the key driver of Hollywood profitability and LGF is no exception. Home video revenue consists of the sale and rental of DVDs and often exceeds the total domestic box office for a film. This revenue is very profitable as the cost of producing the movie is already sunk and the only remaining costs are production, distribution, and marketing of the DVD titles. These costs account for only 40% of home video revenue on a typical movie. TV rights have also become a significant source of revenue and profits to Hollywood as broadcast and cable television networks compete for viewers. LGF has sold television rights for about 35% of total box office, producing another highly profitable revenue stream.

In summary, a typical LGF film will produce revenue of 2-3 times its domestic box office including home video revenue and international and TV rights. Operating margins should be near 15% after factoring in production costs and the marketing and distribution of the film and DVD. Major studios like Warner Brothers or Paramount earn margins closer to 11% and spend $50-100 million to produce and market a film. Specialty animation studios like Pixar might spend $125 million to produce a film but a successful film produces margins near 70%. A flop of any film that costs $50 million or more leads to significant write-offs. LGF has adopted a middle of the road approach to lower risk of costly flops and produce more stable profits.

Several catalysts exist to boost LGF shares over the next few months. First, Crash looks like it could be very profitable. Opening weekend box office of $9 million exceeded estimates and strong reviews and good word of mouth should lead to a total box office of $25-30 million. According to JP Morgan, LGF acquired Crash for $5 million and will spend $13 million to distribute and advertise the film. EBITDA from Crash could approach $20 million with a margin of over 30%. Second, fiscal fourth quarter earnings are due in June and should reinforce the perception that LGF is emerging as a profitable niche player in the motion picture business. Highlights of the quarter will be DVD sales of Saw ($54 million in domestic box office) and box office revenue from Diary of a Mad Black Woman ($50 million in domestic box office). Most importantly, the quarter should show stabilization of the company's financial model and offer a glimpse of potential upside to financial results over the next several years due to recent box office success.