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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.

Posted by Steve Birenberg at August 13, 2005 02:26 PM in LGF