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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.

Posted by Steve Birenberg at June 30, 2005 01:52 PM in LGF