February 10, 2006
Sold Lionsgate
Lionsgate (LGF) shares are holding up much better than I expected following the company's disappointing 3Q06 performance and reduction in FY06 guidance. Therefore, I am selling the shares I own for my clients and in my personal accounts. As I stated in my pre-conference call post, I want some distance as I re-analyze the situation and decide if I want to be involved in the LGF story.
The shares are holding up because management did a decent job of explaining its financials and justifying why $100 million in sustainable free cash flow is possible in 2007 and beyond. They provided a better explanation of their financial model and the shifts in balance sheet items that have a significant impact on free cash flow.
The company claims that if its 18 film releases each year can produce $300 million in domestic box office, the film division will produce $600 million in revenue as the films move through the home video and TV rights windows. Management assumes that the operating margin on this business is 19%. TV production can add $10-15 million in profits, direct-to-home DVDs can produce $5-10 million in profits, and the library can produce $40 million assuming a 20% margin on $200 million in sales. After deducting corporate overhead and net interest expense, there is $100 million leftover as free cash flow....
While this is a plausible base case, I am not totally comfortable with it. The 19% margin on theatrical is above what the big studios earn. In theory, as an independent studio producing smaller pictures, LGF could be more profitable than its big brothers. TV seems like a steady business for the company that has performed consistently well. I think it is hard to make any assumption on the library and direct-to-home businesses given the intense pressure on those businesses at the moment, both of which are still declining for LGF and the industry.
I think what happened in FY06 is that LGF transitioned to a much larger theatrical production slate while the home video business, particularly in catalogue and direct-to-home titles faltered. The transition to more film titles and more wide releases put pressure on expenses and the unanticipated weakness in the other business led to major shortfalls. Free cash flow held up because the expanded slate resulted in much higher backend payments to talent and production partners resulting in a much larger liability. Payables also grew sharply in FY06.
I can accept this explanation and the view that FY06 was a transition year. However, now that LGF has arrived at a steady state, the operating performance is critical to maintaining free cash flow. The benefits from expanding liabilities won't repeat in FY07. Thus, EBITDA will have to drive free cash flow, as it should. For FY07, EBITDA should do well as the company's successful films in the past year move through the high margin home video window. However, there is no margin for error now. Operating results must drive EBITDA, net income, and free cash flow.
With the stock holding up so well, I don’t think it provides enough margin for error relative to the risks that future films disappoint and/or the library and direct-to-home video businesses deteriorate further. Thus, I have sold all client and personal positions in LGF.
Lionsgate Messes Up Again
I was wrong on Lionsgate (LGF). Big time. The company missed its 3Q06 earnings badly with EBITDA, net income, and free cash flow all falling well short of estimates. The company lowered guidance for each of these items for its full year which ends on March 31. The lowered guidance implies that 4Q06 results should actually be fairly close to current estimates. However, with revenue performing in line to better than expected every quarter this year, it is clear that the business model is under pressure as operating margins are much weaker than expected. This makes it tough to have confidence in the FY07 outlook and will lead to a sharp compression in the multiple that is well deserved. I expect the shares to decline to 15-20% this morning....
The miss is being attributed primarily to home video, especially family and direct to home titles. There is also a hit due to a bankruptcy of a major customer and the expensive, but successful and worthwhile, effort to gain Oscar nominations for Crash. In general, the content side of the house looks like it is performing OK as new theatrical releases and TV shows are performing fairly well. However, the flow through of these businesses to EBITA, net income, and free cash flow continues to lag. In fact, the press release, says that there will be "at least" a one to two quarter lag before the success of recently successful theatrical and DVD releases flows through to the benefit of shareholders. I am troubled by the "at least" qualifier as it could indicate that management is not confident that the deterioration in margins has run its course.
In theory, the shares should have downside protection due to LGF's takeover potential. However, the lowered free cash flow forecast, poor performance of the company during FY06, and the apparent deterioration in the profitability of the company's business model suggest that the takeout price would be significantly lower than I previously expected.
The only hope for the shares in the near-term is that large institutional shareholders, several of which own over 5% of the shares agitate aggressively and pressure management to put the company up for sale. Management will resist and say that now is a bad time to sell but I don’t think shareholders would provide any support for management at this point. It would be quite ironic if another company made a raid on LGF and tried to buy it cheap as this has been a tactic that LGF itself has used on others, most recently Image Entertainment.
I expect the damage to the stock this morning to be severe so I plan to listen to the conference call, which will be going on when the market opens, before deciding whether to dump my remaining shares. Presently, I am leaning heavily in that direction. Very near-term rebound potential seems low and I will be able to make a more rational decision on re-entering the shares if I don’t own the shares.
I'll post more in the earnings summary after the conference call.
February 09, 2006
Lionsgate Earnings Preview
Lionsgate (LGF) reports after the close on Thursday with a pre-open conference call on Friday. Quarterly results for LGF can be quite volatile due to the vagaries of film accounting and significance that a hit or miss at the box office can have on the numbers. Added volatility can occur relative to expectations as the financials are difficult to model and there are relatively few analysts from which to create consensus estimates. In other words, there can be a wide range of estimates around the consensus estimate. For this reason, LGF shares have tended to be volatile following the release of quarterly earnings with the most recent quarters exhibiting a decline in the shares as the headline figures missed estimates.
Despite some of the issues outlined below, I do not expect this quarter to disappoint investors. I also expect the company to maintain its full year guidance (EBITDA guidance was slashed in December while revenue and free cash flow were left unchanged). If LGF can make it by this quarter, I think the path is clear for rally in the shares to over $10 on the basis of what should be strong March and June quarters and a series of positive news items that began with the recent very successful release of the Lord of War DVD to be followed by the release of the Saw II DVD on February 14th and the theatrical release of Madea's Family Reunion, the sequel to the hit Diary of a Mad Black Woman on the last weekend in February....
LGF does not provide quarterly guidance but has offered annual guidance. Presently, the company is projecting revenues of more than $850 million, EBITDA of $35 million, and free cash flow of more than $100 million ofr its fiscal year that ends this coming March 31. The revenue and FCF guidance has remained very stable but EBITDA guidance has come down sharply. Analysts initially thought the company could produce $90 million in EBITDA this year but in its initial guidance LGF suggested $65 million. This past December, following the movie flop In The Mix, EBITDA guidance was slashed to $35 million. The poor EBITDA performance has weighed on the shares despite management's opinion that FCF is the relevant metric. I believe management has a point but the difference between EBITDA and FCF is not sustainable so there is risk in the company's ability to sustain or grow FCF without an EBITDA pickup.
The reason for the variance in the two figures is that film accounting uses the balance sheet aggressively. One significant impact on free cash flow comes from the difference between LGF's investment in films and amortization of films. In general, LGF has greater amortization, adding to free cash flow, because of ongoing amortization of the acquired Artisan film library at $20 million per year. However, so far this year, the big sources of FCF have been working capital and film obligations. Accounts receivable dropped sharply earlier this year when cash was received on DVD shipments. Film obligations (residuals, minimum guarantees, and production loans) have risen sharply and since they are a liability they have added to FCF. The rise has been caused by two factors: LGF is producing more films and the financing arrangements for the films seem to be more dependent on participation and backend by the talent and production partners. LGF will lose this benefit once the growth of the production slate and the financing arrangements stabilize. Consequently, I remain concerned that little margin for error exists in the upcoming film and TV slate. Anything that serves to negatively impact EBITDA, such as the current performance of a new film or TV series, could lead to a cut in FCF guidance. FCF supports not only the current valuation but also the buyout valuation. As an obvious buyout target, LGF shares are supported by speculation on the downside even when movies flop. Thus, a reduction of FCF generation capabilities not only hurts current valuation but it lowers the floor that supports the shares.
Remembering the wide range of estimates, here is the consensus estimates for the December quarter. Revenues are projected $227 million in a fairly tight range. EBITDA consensus is $23 million but I see a couple of estimates at $30 million. EPS consensus is 16 cents but I see an estimate as high as 24 cents. I only found one analyst with FCF estimate which is $32 million.
Other things to look for in the press release and on the conference call include commentary about the Starbucks deal for promotion of Akeelah The Bee, an update on the formation of a horror channel, whether the library margins are stabilizing in the low 20% range, possible interest in the acquisition of United Artists, and a preview of the FY07 movie slate.
January 31, 2006
Crash Scores Big In Oscar Nominations
Crash won nominations for Best Picture, Best Director, Best Supporting, Best Screenplay, Best Editing, and Best Song in the Oscar nominations announced this morning. While the investment implications are extremely limited, this a real feather in the cap for Lionsgate (LGF). Just a few months ago, the film was considered a real long shot for nominations but a concerted effort by the company to garner nominations paid off. Crash will shoot up the DVD sale and rental charts, providing a nominal boost to LGF's earnings. More importantly, management's success with the film from the theatrical run through home video and now Awards season establishes the studio as a place where producers, directors, actors, and screenwriters will want to take their best projects. Lionsgate has crashed the Oscar party that used to be hosted by Miramax. In the long run, that can help the stock price by supporting shareholder value through the prospects of a better pipeline of movie and TV projects.
Insider Buying At Lionsgate
A couple of quick follow-ups to my Weekend Box Office Update that support my bullish trading bias on Lionsgate (LGF). First, this weekend's Barron's contained positive commentary on LGF in the Inside Scoop column. The column noted recent insider buying by senior executives along with a big boost in the position of Carl Icahn protégé Mark Rachesky. Rachesky reported a 7.3% position last August but his latest filing shows the stake has been raised by about 2 million shares to 10 million shares, or almost 10% of LGF.
The article quotes Ben Silverman of InsideScore.com as noting that Rachesky has a good track record and LGF represents his second largest holding. I am less impressed by the insider buying by executives as the amounts are rather small. However, last summer, the combination of the initial Rachesky filing and similar-sized buys by executives popped LGF shares. With a series of positive news items in the recent past and coming over the next month, LGF shares could be headed back toward the summer and fall highs in the mid $10 area.
Separately, one message board poster on LGF on Yahoo! (YHOO) noted that the better-than-expected opening for Big Momma's House, with the leading part played by an overweight man posing as as older African-American woman could be good news for LGF's Madea's Family Reunion, which opens the last weekend in February. Madea is a similar character created by Tyler Perry, a rising African-American star.
January 30, 2006
Lionsgate Story Shaping Up
Lionsgate (LGF – recently renamed from Lions Gate Entertainment) announced the sale of its studio production facilities in Canada for $36.1 million. To be honest, I did not even realize the company owned its own facilities. According to a report I just read, this asset was going to generate less than $5 million in revenue and a little over $1 million in EBITDA. Seems like a good price to me. LGF has about 110 fully diluted shares outstanding so this is not a particularly meaningful transaction but I still like the idea of realizing value from a non-core asset. Several studios have been adding sound-stage capacity in Los Angeles so LGF should not have trouble finding capacity for its production slate of movies and television shows.
A handful of Northlake clients and I remain long a small amount of LGF looking for the end of February release of Madea’s Family Reunion, the sequel to Diary of a Mad Black Woman, as the next major catalyst. Between now and then, LGF has several films in the DVD release window that should sell well. In fact, Lord of War (LOW) was released last week and LGF announced unusually strong initial sales of 2.5 million units. This film was a disappointment at the box office, grossing just $24 million. LGF usually is able to realize 110% of domestic box office for its DVD releases, implying that LOW should have brought in around $30 million. Assuming a wholesale price of $15 per unit, LOW is headed for closer to $40 million. This is very profitable revenue, potentially producing an operating margin north of 40%.....
Still to come on DVD in February is Waiting, a teen comedy, which grossed $16 million, and Saw II, which grossed $87 million. Teen comedies usually do well in the DVD sale and rental windows and I see no reason not to expect at least average results for Waiting. Higher grossing movies produce DVD sales less than 100% of box office so I don’t expect the 110% ratio to necessarily hold for Saw II. Sales will still be strong as the original Saw sold over 4 million copies in its original run against a $50 million domestic office. I’d expect Saw II to sell at least that many, probably more. Additionally, there will box sets of the two films with special features that will milk the original film and get a premium price. LGF has had its share of box office disappointments in the past six months but one thing the company does exceedingly well is take advantage of the home video window.
LGF has preannounced its December quarter which is yet to be reported. Due to the In The Mix flop, the quarter will be lousy. However, beginning with the March quarter, there should be several strong quarters in a row due to the aforementioned DVD sales, the box office success of the horror film Hostel, currently ending its run in theatres, and the upcoming theatrical release of Madea’s Family Reunion. I think the stock can trade back over $10 on this sequence of events with most of the gains coming in the run-up to the Madea release on February 24th. Remember that Diary of a Mad Black Woman shocked the industry when it opened at #1 on the same weekend a year ago. With the awareness for Madea, especially with white audiences, likely to much higher due the success of the film in the home video window, I think the film should gross at least as much as the original and beat the “sequel discount.”
With a target over $10 in a month and ongoing acquisition rumors as support, I think LGF is worth holding onto for the next month but the unusual volatility we have seen in the company's financial results over the past year keeps me from buying more except in trading oriented accounts..
January 26, 2006
Lionsgate Sells An Asset and More Good News Coming
Lionsgate (LGF-the company recently renamed itself Lionsgate) announced the sale of its studio production facilities in Canada for $36.1 million. To be honest, I did not even realize the company owned its own facilities. According to a report I just read, this asset was going to generate less than $5 million in revenue and a little over $1 million in EBITDA. Seems like a good price to me. LGF has about 110 fully diluted shares outstanding so this is not a particularly meaningful transaction but I still like the idea of realizing value from a non-core asset. Several studios have been adding sound-stage capacity in Los Angeles so LGF should not have trouble finding capacity for its production slate of movies and television shows.
A few Northlake clients remain long LGF as I am looking for the end of February release of Madea’s Family Reunion, the sequel to Diary of a Mad Black Woman, as the next major catalyst. Between now and then, LGF has several films in the DVD release window that should sell well. In fact, Lord of War (LOW) was released last week and LGF announced unusually strong initial sales of 2.5 million units. This film was a disappointment at the box office, grossing just $24 million. LGF usually is able to realize 110% of domestic box office for its DVD releases, implying that LOW should have brought in around $30 million. Assuming a wholesale price of $15 per unit, LOW is headed for closer to $40 million. This is very profitable revenue, potentially producing an operating margin north of 40%....
Still to come on DVD in February is Waiting, a teen comedy, which grossed $16 million, and Saw II, which grossed $87 million. Teen comedies usually do well in the DVD sale and rental windows and I see no reason not to expect at least average results for Waiting. Higher grossing movies produce DVD sales less than 100% of box office so I don’t expect the 110% ratio to necessarily hold for Saw II. Sales will still be strong as the original Saw sold over 4 million copies in its original run against a $50 million domestic office. I’d expect Saw II to sell at least that many, probably more. Additionally, there will box sets of the two films with special features that will milk the original film and get a premium price. LGF has had its share of box office disappointments in the past six months but one thing the company does exceedingly well is take advantage of the home video window.
LGF has preannounced its December quarter which is yet to be reported. Due to the In The Mix flop, the quarter will be lousy. However, beginning with the March quarter, there should be several strong quarters in a row due to the aforementioned DVD sales, the box office success of the horror film Hostel, currently ending its run in theatres, and the upcoming theatrical release of Madea’s Family Reunion. I think the stock can trade back over $10 on this sequence of events with most of the gains coming in the run-up to the Madea release on February 24th. Remember that Diary of a Mad Black Woman shocked the industry when it opened at #1 on the same weekend a year ago. With the awareness for Madea, especially with white audiences, likely to much higher due the success of the film in the home video window, I think the film should gross at least as much as the original and beat the “sequel discount.”
January 11, 2006
Hostel Provides Support For Lions Gate Entertainment Share Price and Earnings
The last time I posted on Lions Gate Entertainment (LGF) was following their presentation at the UBS Media Conference. At the time, I wrote:
I was dissatisfied with the explanation that Lions Gate Entertainment (LGF) provided at its presentation for the latest quarterly shortfall. I can accept the argument that free cash flow is the more relevant metric, but the unusually large discrepancy between EBITDA and FCF doesn't make sense to me based on what I know now. A look at the December quarter balance sheet figures for film investment and amortization might help. I believe that 2006 FCF numbers (ending March 2007) have no margin for error. I am still long my small position as I believe the stock is getting a little too depressed in the short term, with movies coming up in January and February that should do OK and rebuild confidence.
Well, it looks like I'll get bailed out my losing long position in (LGF). This past weekend, one of movies I was counting on, Hostel, was the #1 movie at the box office grossing $20 million. This was even better than I expected, but most importantly, following the sharp cut in guidance following the In The Mix flop it was critical that Hostel perform well or guidance for the balance of FY06 ending June and estimates of free cash flow for FY06 and FY07 would have been in jeopardy of sharp reductions....
Hostel should have decent legs and head toward $50 million in domestic box office. The next big movie in LGF's slate is Tyler Perry's Madea's Family Reunion, the sequel to Diary of a Mad Black Woman. Diary opened at #1 and grossed $50.6 million following its release on the last weekend of February 2005. I think Madea will match the success of the original. It opens on the same weekend this year and will again appeal to Tyler Perry's large African-American audience and benefit from much greater awareness among white audiences due to the success of the first film in theatres and on DVD.
These two films, along with the Saw II DVD and the expected good performance in LGF's TV business, should produce strong financial results for LGF in the first half of calendar 2006. My primary concern at LGF following the guidance reduction was that the free cash flow guidance of over $100 million in FY06 and FY07 was at huge risk if either the combined box office of Hostel and Madea fell short. Remember that LGF's guidance calls for FCF of over $100 million this fiscal year against EBITDA of only $35 million. With that risk in the rearview mirror for the next few months, I think LGF shares can approach their post Saw II peak in the mid-$10 area. To get past that will require realization of takeover rumors which remain strong and plausible. I plan to hold the remaining positions in Northlake cient accounts and reevaluate if the stock crosses $10 but I don't plan on buying more.
October 26, 2005
Lions Gate Entertainment Update
Lions Gate Entertainment (LGF) rose almost 4% on Monday, enjoying its best day since early September when it popped 10% in four days to $10.60 on the back of reports of insider buying by about a dozen top executives. Since then the shares have pulled back steadily, reaching a closing low of $8.36 last Thursday.
It appears the reason for the pop yesterday was the announcement that Harry Sloan, founder of SBS Broadcasting (SBTV) has been appointed Chairman and Chief Executive of Metro-Goldwyn-Mayer. The SBTV buyout closed on October 18th so Harry was a free agent. The interesting tidbit for aficionados of LGF is that Sloan resigned as Acting Chairman and member of the board of LGF on June 30, 2005....
MGM is now controlled by Sony in partnership with Comcast with the backing of private equity funds that have a history of deals in media. I suspect some folks are speculating that with his insider knowledge of LGF, Sloan might be interested in expanding MGM by acquiring LGF. The fact that an Icahn protg acquired over 7% of LGF this summer helps feed the speculation.
Any discussion of an MGM buyout of LGF is pure speculation. However, from the point of view of Sony and Comcast, the MGM deal was all about controlling premiere content. In that context, adding another significant studio to the mix makes sense strategically.
LGF's guidance calls for $90 million plus in free cash flow this year against an enterprise value of about $1.4 billion. A buyout of LGF would not require immense capital and would start from a solid financial footing. Or at least as solid as one can get in the hit-driven movie production and marketing business.
LGF shares reached their recent lows amid a string of poor to average box office results for key releases upon which the company's guidance is predicated. Additionally, investors are concerned with the bear hug the company is putting on troubled DVD distributor Image Entertainment. Meeting September quarter earnings estimates could prove dicey, especially if any of the recent films require write-offs.
On the positive side, Crash has performed very well in DVD sell-through and rental markets since its release in early September. This is very profitable revenue and could easily carry the quarter. Crash has lots of Best Picture buzz for the Oscars which could add another boost if the nomination is secured. In other news, LGF also appears to have made a smart acquisition of a small UK film distributor.
The bid for Image Entertainment looks to be moving toward conclusion although the outcome is unclear. I suspect the market will be happy if LGF loses out and walks away. However, I continue to think this is a reasonable and likely quite accretive deal for LGF.
Most importantly for the immediate future of LGF shares is the release of Saw II this coming weekend. Saw was a surprise hit that went on to pull in $100 million in domestic and international box office (evenly split). Saw II needs to do greater than $30 million in domestic box office to give comfort to LGF's full year guidance. So far reviews are mixed as can be expected for a horror flick. Worth noting, both Variety/i> and Hollywood Reporter, who split on the critical front, expect a strong box office performance.
For now, I am going to hold the remaining positions in LGF and hope for a good weekend out of Saw II.
August 13, 2005
Lions Gate Reports Mixed Quarterly Earnings
Lions Gate Entertainment (LGF) shares traded down about 7% on heavy volume after the company reported 1Q06 earnings last Wednesday. EPS and EBITDA (operating cash flow) missed estimates by a wide margin but revenues were in line and free cash flow was better than expected. On the conference call, management reaffirmed guidance for FY06 assuming the company's upcoming theatrical releases meet what they believe is conservative box office budgets. Specifically, the company has assumed that sequels to Saw and Diary of a Mad Black Woman earn 30% less at the box office than their predecessors.
I think the LGF story may play out over a longer period than I initially expected but the asset value remains and continues to build. Further, if guidance is hit, there will be a big acceleration in financial performance over the next three quarters which could serve as a catalyst. Consequently, despite the miss in 1Q06, I am holding the shares owned by Northlake clients and would look to buy more if the shares weaken further....
....This quarter shows the vagaries of the film business and why investors should not invest in film and TV production companies on the basis of quarterly earnings. On the one hand, the company missed EPS and EBITDA because it took a write-off on the flop High Tension and two other smaller films that underperformed. These write-offs totaled over $20 million yet future quarters are likely to show about $10 million in EBITDA as these films earn some revenue in the home video and pay TV windows. On the other hand, free cash flow exceeded estimates as the Saw DVD sales that were made in the March quarter turned form receivables to cash in the June quarter. These are two good examples of how the accounting treatments for TV and film production cause unusual volatility in quarterly results. LGF should be entering several quarters where the revenue that flows through the income statement is high margin. Therefore, assuming the company meets its box office targets, financial results should be quite good.
Interestingly, on the call, management noted that it had not seen much negative impact form the slowdown in DVD sales that has been evident at major studios. I suppose this could be the source for a negative surprise in the future but I think it might suggest that my belief that the DVD business is far different at a small, niche studio than at a Pixar or Disney. For example, LGF is very pleased that Saw and Diary are selling 4 or 5 million units while Pixar and Disney have problems because The Incredibles is selling only 30 million units. So far, it appears that LGF's strategy to ship conservatively is allowing it to weather the storm in the DVD market.
The bottom line is that LGF's asset value remains in the low to mid-teens but the last couple of quarters have shown erratic financial performance leaving no catalyst to close the gap. I am assuming guidance for FY06 will be met implying a sharp improvement in quarterly performance over the next nine months. Therefore, I am staying long and plan to add to client positions if the shares weaken further.
July 19, 2005
Positive Comments on DVDs from Fox is Good News for Lions Gate
Lions Gate Entertainment (LGF) rebounded nicely on Friday, up almost 5%, and gained further on Tuesday. Since June 30, the shares have suffered a one-two punch from weaker-than-expected EBITDA guidance for 2H05 and issues in the DVD market raised by shortfalls at Pixar (PIXR) and DreamWorks Animation (DWA).
The rebound that began Friday may be due to some commentary from UBS analyst Aryeh Bourkoff on recent meetings he held with senior operating management of News Corporation (NWS). Among the meetings was a session with Tom Rothman, co-chairman of Fox Filmed Entertainment. As noted by Aryeh, Rothman believes that the DVD shortfalls at Pixar and Dreamworks are "isolated incidents, not indicative of secular trends." Rothman acknowledged slowing growth given the greatly enlarged base of home video business but according to Aryeh, Rothman drew a distinction between "slowing growth and slow growth." Rothman also noted that for Fox Filmed Entertainment, home video growth is "thriving" and remains very strong....
....I have been reluctant to read too much into the shortfalls at Pixar and Dreamworks because both problems were the result of just one movie for companies that are completely reliant on sales of a single title. Both companies misjudged demand while shipping 40 million or more units (actually in the case of Pixar, Disney (DIS) misjudged the demand). This is a far different model than used at Fox, Lions Gate, Paramount, Disney or Warner Brothers. For example, LGF announced last week that it had shipped 2.4 million units of Diary of a Mad Black Woman and was taking reorders.
Providing some further comfort to my LGF long position is this excerpt from Aryeh's report:
Regarding concerns related to DVDs, [Fox] management has taken seriously recent company and press reports pertaining to DVD demand shortfalls. Nonetheless, the company remains confident that the issues are isolated, not indicative of secular trends. Further, the company has not experienced a notable change in DVD pricing for new theatrical releases relative to year-ago trends, which helps to further support the positive momentum and maintenance of high levels of profitability for this segment of the theatrical release cycle.
I think LGF can handle a slowing DVD market given the company's library depth and recent string of successful theatrical releases. There is a risk that the industry has to undergo an inventory correction as growth slows from the unusually high pace of recent years to single digit growth in the next year or two. This could catch LGF but I think 2H05 guidance is overly conservative and as time passes the company's unique model as an independent studio producing lower budget films and TV shows will result in an expanded valuation and a better appreciation for the asset value that exists at LGF.
With free cash flow over $90 million this year and growing in 2006, I am willing to wait another quarter with the shares trading at a reasonable 14 multiple free cash flow. Hopefully, I will be correct that guidance is conservative and the shares will be back on track for the return toward my original target of $14. I have the shares on a shorter leash now than I did before, however.
June 30, 2005
Lions Gate Reports Strong Quarterly Earnings
LGF reported earnings for its fourth fiscal quarter of 2005 ending March 31, 2005 last night and conducted a conference call this morning. Overall, I found the results to be excellent, easily supporting the current valuation on the shares. Revenues were very strong reflecting the success the company had at the box office in the year ending March 31st. This success translated to better than expected DVD sales, particularly for the films Saw and Open Water. The current fiscal year is likely to experience a similar bump for revenues from Diary of a Mad Black Woman, Crash, and Saw II (to be released at Halloween)....
The shares are trading lower for two related reasons. It is no surprise that LGF is producing strong financial performance. Consequently, there was a lot of fast money in the stock looking for the shares to rise off the earnings report and especially the guidance for FY 2006 earnings (year ending March 31, 2006). Unfortunately, the fast money found the company's guidance to be insufficient. If I were a short-term investor I'd agree. The company called for flat revenues and slightly higher operating cash flow and free cash flow for 2006. These figures were below analyst estimates and my own expectations.
However, on its call and as is its past practice, management noted that it issues conservative guidance and then beats it. When management went on to describe the assumptions behind the guidance it was clear that it is extremely conservative. Management is budgeting for a $20 million loss on this year's 18-20 theatrical releases. Normally, I'd consider that appropriate because the economics of movie-making are for the losses on the box office more than offset by profits on sales of DVDs, foreign film rights, and television rights. Given the success of Crash and the almost certain success of Saw II, I think this is a conservative assumption given the low cost model upon which LGF produces movies.
Management also noted that it incurred $3 million in marketing costs related to films that had not yet been released. Accounting rules require this expense to be realized ahead of the associated revenues. LGF also recognized $17 million in expenses related to distribution of DVDs where there is a revenue share that will be realized in the current and coming quarters. Sarbanes Oxley compliance spending for accounting was $3 million and is unlikely to repeat at the same level. There were also $2 million in one-time charges. Thus, it appears that management recognized an incremental $25 million in expenses with no attached revenue. In fact, there will be revenue realized in the upcoming quarters.
Given the conservative accounting and guidance and a pipeline of successful films over the past twelve months that are still working their way through the theatre to DVD to TV revenue stream, I think that LGF is almost certain to easily exceed the newly established targets.
LGF's recent success is building long-term shareholder value because it is attracting better talent for TV and film production and creating a library of titles that can be mined for years to come. This is not a stock to be analyzed on quarter to quarter results. Focus must be on free cash flow over multi-year time periods. I think FY05 and the FY06/07 guidance supports the asset value. If LGF were valued at the same multiple that peer studio MGM was acquired for last year, the shares would be trading near $18. The asset value exists and management actions are continuing to build potential wealth. Keep LGF low on your radar screen from day-to-day but don't be surprised in a year or two if you have made 50% or more on the shares.
June 10, 2005
Crash Winding Down Very Successful Run For Lions Gate
Crash lost 400 screens for this weekend and is down to about 900 screens. With the film's theatrical run winding down, I thought it would be worthwhile to provide a final review of the very favorable economics and also peak into the future for Lions Gate Entertainment (LGF). LGF shares have performed well on the success of Crash but I think plenty of upside remains. Future catalysts for LGF shares include upcoming quarterly earnings and several more promising film releases. A potential sale of the company is always a possibility....
Lions Gate Entertainment (LGF) shares have moved up recently on the successful box office for Crash. The film now looks like it is headed toward $50 million in domestic box office against my prior assumption of $40 million and initial estimates of $30 million.
LGF seems likely to ultimately receive about $100 million in revenue from Crash, composed of its share of domestic box office ($25 million), DVD sales ($70 million), sale of foreign distribution ($3 million) and television rights ($5 million). The cost to acquire and market the film should be around $20 million. Residuals due to the producer, director, writers, and actors could run towards $15 million, and distribution and marketing costs for the DVD could be around $30 million. Thus, total costs could run $65 million against revenues of at least $100 million, producing a $35 million operating profit for LGF, at the high end of my prior estimate. Analyst estimates for 2005 EBITDA are $90 million-100 million, so Crash is obviously a major success for LGF.
Future Catalysts Include Earnings, New Films
Future catalysts for LGF shares include quarterly earnings at the end of June and several more promising film releases over the summer. The quarterly earnings should be good given prior successful films including Open Water, Saw, and Diary of a Mad Black Woman, which should contribute significant revenue and profits. Investors will also be reminded that the LGF model has been working very well over the past year.
Upcoming releases include horror films High Tension, due this weekend, and The Devil's Rejects due in July and the hip-hop documentary Rize, due at the end of June.
LGF shares remain below the $11.40 they reached prior to the aborted bid for Hit Entertainment. I think plenty of upside remains and a potential sale of the company is always a possibility, given that LGF is the only major publicly traded studio now that MGM has been purchased by Sony (SNE).
May 23, 2005
Crash A Winner For Lions Gate
While the world focused on the astounding box office numbers for the latest Star Wars film, Lions Gate Entertainment (LGF) had another successful weekend at the box office with Crash. Crash has now grossed over $27 million and has shown the best legs of any film this year, falling just 20% in each of its first two weekends. It now looks like total domestic box office for the film could reach close to $40 million, ahead of the $25 million-$30 million I mentioned in my initial bullish post on LGF....
....One rule of thumb is that a film can produce total revenue of 2.5 to 3 times its domestic box office after adding DVD sales and the sale of international and TV rights. So with Crash headed toward $40 million, total revenue of $100 million or more is not out of the question. From what I have read, LGF paid about $5 million for the film and planned to support it with about $13 million in advertising and other distribution and marketing costs. Given the film's success and legs, it seems likely the ad budget has been increased by a few million dollars. If domestic box office reaches $40 million, LGF's share will be about $20 million (theaters get the other half), so the film could break even based on its domestic theatrical run. Most films lose money based solely on domestic box office.
If DVD sales and the sale of foreign and TV rights total $60 million-$80 million at an operating margin of 60%, earnings before interest, taxes, depreciation and amortization from Crash could range from $25 million-$35 million over the life of the film. Most of that seems likely to hit in LGF's fiscal year ending March 2006 where EBITDA estimates average around $100 million, giving me a lot of confidence in the projections.
LGF shares have not rallied much since Crash was released and remain below the $11.40 level they attained prior to the sharp pullback when the company announced they were considering a bid to acquire a British children's television producer that would have doubled the size of the company. LGF withdrew the bid on May 5. I think the shares are headed at least back to the March highs based on the success of Crash and a strong 1Q05 earnings report due on June 29th.
LGF's next major film release is High Tension due in theaters on June 10. High Tension is a horror film originally released in France and now dubbed and subtitled for U.S. release. The film is quite well thought of by horror film junkies. LGF has done well historically with horror flicks, although the box office of recent horror films from other studios indicates the genre may be cooling off.
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.
