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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.

Posted by Steve Birenberg at July 19, 2005 02:44 PM in LGF