On Thursday, LionsGate Entertainment (LGF) reported mixed 4Q06 results and announced 2007 guidance which was inline with expectations. The shares are responded well initially, rising more than 3%. After almost a year of disappointing financial results, I think the rally in the shares is more a function of relief than the result of any important new positive fundamental trends.
Revenues Far Ahead of Estimates
For 4Q06, revenues came in at $313 million, far ahead of analyst estimates that ranged from $250 million to $300 million. Strength came from higher than expected home video revenues, which were due to good sales of DVD titles from recently released films. Theater revenue and TV revenue came in as expected. The revenue upside did not flow through to operating income as EBITDA only met guidance of $20 million. Expenses were too high once again, which is a problem that recurred throughout FY06 and raises questions about the long-term profitability of LGF’s business model. Despite the lack of operating leverage, free cash flow (FCF) easily beat estimates, coming in at $48 million as working capital items again contributed greatly. The shares are probably responding to the better than expected free cash flow but the continued disconnect between EBITDA and FCF leaves earnings quality issues front and center.
Revenue Guidance for 2007 Tops $900 Million
For FY2007, LGF provided revenue guidance of “greater than $900 million” and free cash flow guidance of around $85 million. Management based the revenue guidance on what it called conservative assumptions for box office receipts along with general commentary for TV, library and home video revenue. FCF guidance of $85 million is less than the $103 million the company reported in 2006. But management noted that 4Q06 included a $20 million working capital benefit, so in reality they are forecasting flat comparisons.
Closing the Gap Between EBITDA and FCF
On the call, management noted that it plans to close the gap between EBITDA and FCF by increasing its operating profits. This will have to be the case as almost all of 2006 FCF came from balance sheet items. Balance sheet items can play an unusually large role for TV and film production companies, but ultimately operating income has to support FCF. Unfortunately, management provided no EBITDA guidance for FY07. Repeated questions by analysts did help to flush out the composition of 2007 FCF but there is still much looseness in the cash flow model for me.
Guidance of Flat Results for 2007 Reflects Mediocre Earnings Quality
I don’t mean to be overly negative in my assessment of the quarter and guidance. I sold the stock partially because I was concerned about earnings quality. But the main reason I soured on LGF was that I did not see growth potential in FCF over the next couple of years that would support what I see as a full valuation for anything short of a takeover. I think guidance for flat results in 2007 supports my thesis.
There are reasons to be optimistic. Investors will respond if 2007 FCF and EBITDA converge. The company continues to build library value in both films and TV. TV especially looks strong with the number of series and pilots the company is producing growing nicely in 2007. Carl Icahn has taken a stake in LGF, complementing a stake built over the past year by a former associate.
LGF Remains a Suitable Takeover Candidate
LGF is a unique asset as the only sizable independent movie and TV studio. The company fits well with many public companies that could easily swallow the financial commitment to acquire LGF. There are significant shareholders with a history of agitation. Stabilizing financial performance, asset value, and takeover speculation will support the shares unless there is another significant setback related to earnings quality. Management has heard the earnings quality complaints and seems to be responding. We’ll probably wake up one day to news that LGF is being taken over. I’ll regret not owning its shares that day but until then I just don’t have the confidence in the company’s growth profile or cash generation consistency to be long.