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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.

Posted by Steve Birenberg at February 10, 2006 01:02 PM in LGF