Good Signs From Lionsgate

Lionsgate reported another confusing quarter. Revenues blew away expectations but so did expenses. EBITDA was a big negative number but the company reported over $21 million in free cash flow. The press release was vague and the simultaneously issued 10-Q did not directly address the absolute figures but instead focused on percentages. All that said the numbers and their implication for the rest of LGF's fiscal year ending March 2008 are positive. Guidance was not formally raised but management said the company is on track to exceed its revenue and free cash flow guidance by 10%. This forecast assumes that three films to be released in the March quarter perform to expectations, a not unreasonable view given the box office targets articulated on the call. Finally, management was able to provide an acceptable explanation for why free cash flow and operating cash flow will converge next year. This is an ongoing point of contention for LGF and will be a comfort to investors....

....For 2Q08, LGF reported an EPS loss of 47 cents vs. consensus of a 32 cents loss in a range of -26 cents to -40 cents. Revenues dramatically exceeded expectations at $343 million vs. consensus of $281 million. Expenses soared as well which is why the EPS number was poor despite the big revenue upside. The issue here seems to be largely timing related. First, LGF had a couple of major movie releases in October (Saw 4 and the latest Tyler Perry film) which incurred some marketing expense in the September quarter. Second, and probably more importantly, LGF had to report 100% of the expenses related to films financed by partners through a film financing vehicle even though it is responsible for just 50% of the expenses. The income statement has no offset for this but the cash flow statement does which helps explain the free cash flow figure.

Leaving aside LGF's confusing accounting, the quarter saw several films meet or beat expectations, several box office flops from earlier this year over index in home video, and the promised acceleration in the TV production business where LGF delivered twice the hours of shows than it did a year ago. These items suggest that the second half surge in free cash flow promised by management is highly likely to occur. This is good news for LGF investors.

However, one lingering issue which came up on the conference call a few times is how the company will grow its free cash flow. The timing differences and confusing accounting will stabilize next fiscal year as LGF will have completed the expansion of its film and TV production. The question I don’t have an answer to and one where I am not willing to accept management commentary is how the free cash flow will grow without another step up in production and the near-term losses it creates. At a run rate of over $100 million in free cash flow LGF shares are reasonably valued. However, barring sale of the company, without growth in free cash flow with easier to understand accounting I do not see the shares moving significantly higher. As a result, I plan to remain on the sidelines even as the performance of LGF's films and TV shows is resolving some of my prior concerns.

Lionsgate: Good Results and Outlook But As Usual Confusion

Lionsgate (LGF) shares are trading down about 4% following the release of the company's 4Q07 results and 2008 guidance. As usual, the accounting is complicated but overall I think the results and guidance are fine and expect the shares to bounce back.

For 4Q07, LGF reported EPS of 19 cents on revenues of $332 million. EPS were a little shot of the 22 cents consensus while revenues were $10 million higher than expected. Given the volatility in LGF's quarterly numbers due to timing issues regarding revenue and expense recognition in film and TV production, I see these results as essentially in line with expectations.

For 2008, LGF expects to produce free cash flow "in excess of $100 million" on revenue growth of 10-15%. However, EBITDA and Net Income will be significantly negative as the company absorbs an incremental $200 million in marketing expenses for an expanded slate of theatrical releases and the associated expenses related to DVD releases on the films. The discrepancy is the result of the new film financing deal LGF announced on Tuesday that will provide $400 million in off balance sheet financing for the company's film slate to be released this fiscal year. LGF has to recognize 100% of the expenses related to these films even though the financing vehicle will pick up 50% of the costs. On the call management explained that the cash flow statement will pull back the difference between free cash flow and EBITDA. The addition of even more complex accounting is not good news of LGF but the explanation makes sense and the numbers seem to balance in the end at close to the levels the street was expecting....

Management used the call to make three other key points. First, the company has diversified itself enough to reduce the impact of current year theatrical releases. International distribution, television production, and a larger library all help to provide a more stable core business. Second, the 2008 movie release slate was outlined and a target for $400 million in domestic box revenue was cited. Third, new distribution channels for content such as VOD and iTunes download are growing rapidly and beginning to contribute materially to corporate growth. On several occasions, it was noted that so far these revenue streams are incremental and not cannibalizing traditional distribution channels.

Overall, I see LGF's results as validating the current price of the stock. The increased theatrical slate and new financing vehicle increase risk if the movies bomb but assuming decent box office performance, the company is building the potential for high margin library revenue beginning next fiscal year. I think investors will be generally satisfied with the results, the guidance, and management commentary. I expect the shares to stabilize and bounce back assuming the market holds together.

Lionsgate Finally Reports A Good, Clean Quarter

Lionsgate (LGF) reported a good quarter. EPs of 19 cents matched estimates, while revenues of $255 million did not fall materially short of the $258 million consensus. Free cash flow of $50 million was very strong. Management opened the conference call by stating it was raising guidance to revenues of $950 million and free cash flow of $100 million. LGF left its pretax income guidance of $30-35 million unchanged but said that non-cash stock compensation charges were the only thing keeping it form going higher.

I think the shares will be well supported by the quarter and could move marginally higher on the basis of the guidance increase and confident talk of the FY08 outlook, which begins on April 1st. However, it still bugs me that such a huge gap exists between operating income and free cash flow. This means that free cash flow is being driven by working capital items. My analysis, which may be wrong, is that the gap exists because LGF consistently ups the portion of its film investment that represents residuals and participations. Eventually, this line item will stabilize year over year thus requiring operating income to drive free cash flow....

Over the next several quarters successful acquisitions of a library company and an international distributor will provide growth if the working capital contribution to free cash flow flattens or reverses. This fact, along with what I believe is growing confidence in management on the part of the analyst community, should be enough to support the shares. In other words, the outlook is strong enough and visible enough for a few quarters that sellers have little to hang their hats on. That should be enough to at least support the shares at current prices, with upside of 5-8% plausible.

The current quarter is likely to be supported by several major DVD releases even though year over year theatrical release revenue may be weak. It is unclear if the big boost LGF received from the sale of movie TV rights in the December quarter will be repeated. International revenues should grow again due to the acquisition of a UK distributor. The TV production business also should continue to grow as LGF has more and more programs on various cable network outlets. These factors balance out to the likelihood of a modest uptick in estimates.

Several other items of interest for LGF investors include discussion of an upcoming film financing deal, continued viewer interest in the FearNet VOD channel launched with Comcast, and a forecast of over $200 million in FY08 TV revenue at 15% margins.

LGF has about 116 million shares outstanding leading to a market cap of $1.3 billion. Net debt is just $80 million and all of the gross debt of $325 million is a convertible bond that has a strike price of $14.28. An enterprise value of $1.4 billion compares favorably to free cash flow of $100 million. I'd just be a lot happier if operating income were a lot closer to that $100 million figure and if growth in FY08 was organic as opposed to acquisition driven.

For the next few quarters, I don’t think my concerns will matter. LGF is performing better after a series of misses and Wall Street wants to believe. I've been wrong with my cautious view. Recent good sentiment toward the shares is likely to continue.

A Halloween Update for Lionsgate

I haven’t written much about Lionsgate (LGF) since my ill-timed sale this spring when the shares were 25% lower. Obviously, I am annoyed at the poor timing of my sale but I still don’t trust (or maybe don’t understand) the numbers that are flowing the company’s income statement, balance sheet, and cash flow statement.

Anyhow, seeing as it is Halloween and LGF's latest horror film, Saw III dominated the weekend box office, it seems like a good time to revisit the stock.

LGF hit their numbers last quarter which built confidence in the stock. Following the June quarter, the key to the stock's performance has been the good box office reception of the company's film slate. LGF shareholders understand that timing issues related to film accounting may cause unusual volatility in the current quarter but the fact that the company's three key releases for summer and fall, Crank, Employee of the Month, and this past weekend's Saw III, all performed at least as well expected suggests that 1H07 results should be good. Each film will flow through the DVD window at that time which should allow LGF to report excellent results....

Saw III opened last weekend and for the third straight year, the franchise scored with moviegoers. The original film in the series opened to $18.3 million and built a reputation as a thinking person's horror film during LGF's well orchestrated DVD campaign. The growing popularity of the franchise led to the second film opening at $31.7 million a year ago. This past weekend, Saw III opened at $34.3 million, 8% ahead of the second film. The second film ended its domestic run at $87 million, a figure likely to be slightly eclipsed by the third film. Opening night for III was 16% ahead of II but the whole weekend was up 8%. This might indicate that the stronger opening is the results of horror fans coming out sooner to the latest installment as opposed to significant growth in the overall franchise. Regardless, Saw is a smash hit for LGF and the 4th films is set for release the final weekend in October 2007.

LGF is a valuable asset as the only large sized independent film and TV production company. If the company were sold, I'd expect a significant premium to the current price, say 30-40%. Asset value probably will support LGF shares at no worse than $8 so the risk of holding of the stock is not that great. I see the stock as fairly valued around $10 with limited upside within a broader $8-$13 range.

Until LGF can show that its operating performance, as opposed to balance sheet changes, can support and expand the current level of free cash flow, I plan to remain on the sidelines.

Amazing! Lionsgate Reports A Routine Quarter

By recent standards, Lionsgate (LGF) reported a very routine quarter. There was little excitement in the numbers, full year guidance for March 07 was affirmed, and analyst questions on the conference call were not hostile. The lack of excitement was not just due to a generally inline quarter. LGF also made progress by releasing its earnings promptly after the close and hosting a conference call following the release instead of the next morning. Additionally, the structure of the call improved with short comments by management followed by Q&A. Previously, management talked way too much before taking questions. All of this is progress for LGF and regardless of action in the stock over the next few days if the company has turned a leaf in terms of its consistency and communications with investors, it is good news for investors.

The quarter, 1Q07 for LGF, was largely in line with expectations with one exception. EBITDA and free cash flow each were a low single digit loss and EPS were negative 3 cents. Each of these figures were within an acceptable range form analyst estimates. Revenues were well short of expectations at $173 million vs. expectations for around $200 million. The entire shortfall was attributed to timing of revenue recognition on TV production and management affirmed prior full year guidance for this segment’s revenue for the full year. LGF has 11 series in production vs. just 5 a year ago. It is not clear to me why the payments appear to be later this year but analysts didn’t seem too concerned. The reason why EBITDA closely matched expectations despite the significant revenue shortfall is that TV production revenue is offset by direct operating expenses at a 90% clip.

LGF’s FY07 is heavily back end loaded due to the timing of major theatrical releases and now the timing of TV production revenue....

This means that the calmer environment surrounding the report this quarter may not last. Management reaffirmed full year guidance targets including the key free cash flow call of $85 million.

I have no real beef with LGF meeting this year’s numbers as the assumptions on theatrical revenue for sequels to proven hits like Hostel, Saw, and the Tyler Perry look conservative. The reason I am no longer bullish is because I have little confidence that the company can grow its free cash flow without the substantial risk of significantly upping its movie production. When this happened in 2005, there was great volatility and confusion in the financial results. This tells me that growth based on more movies is not worth paying for.

So despite a better quarter relative to expectations and much better investor communications, I remain on the sidelines. I still expect to one day wake up to a buyout of LGF when I will regret not being long.

Lionsgate 1Q07 Earnings Preview

Lionsgate (LGF) reports its 1Q07 on Wednesday after the close. With the key theatrical releases coming this fall and winter, LGF is looking at a backend loaded year so investors shouldn’t expect much out the quarter. The company had no box office success in the quarter but results weren’t bad enough to warrant any write-offs. DVD sales should be a strength in the quarter thanks to the successful release of the latest Tyler Perry film Madea’s Family Reunion as well as several stage plays from Perry’s catalog.

LGF’s results are notoriously volatile and the company has provided full year guidance so rather than offer consensus estimates, here are ranges based on my review of several different analysts. Revenues should come in between $195 million and $215 million producing an EBITDA loss of $1 million to $19 million. EPS estimates range from a loss of 4 cents to a loss of 11 cents. Free cash flow, which is management’s preferred metric is expected at around $3 million but there aren’t many estimates....

Assuming no surprises in the quarter and the back end loaded nature of the year, management will likely reiterate FY07 guidance which calls for revenues of $900 million, free cash flow of $85 million, and pretax income of $32 million. Analysts view the company’s guidance as conservative but acceptable given the company has regularly missed estimates and reduced guidance over the past year. Key to the guidance is box office of $250-300 million for the company’s FY07 releases, library revenue of over $200 million, and the production of 9 TV shows vs. just 5 a year ago. The key movies for fall and winter are Saw 3, Hostel 2, and Tyler Perry 3. Also, analysts have high hopes that Employee of the Month could do $25 million. SO far this year, Akeelah and the Bee, See No Evil, and The Descent have all had mediocre box office runs.

Investors will be hoping for an update on the much anticipated but long overdue Horror Channel. LGF is one of the most successful studios for horror and has a large library of movies and TV shows it could exploit. This seems like one of the few niche cable channels that is not presently launched.

I gave up my long on LGF because the company was unable to produce consistent financial results and could not explain inconsistencies I found between my understanding of film accounting and the operating results. I am not saying that the accounting is bad, just that I couldn’t reconcile my own understanding of it with the company’s performance and long-term growth.

Key for LGF shares is meeting free cash flow estimates. I think that the company seems able to do so for FY07. However, I don’t understand how the company can grow its free cash flow off the 2007 base without the added risks of a significant ramp in film and TV production. LGF has a premium valuation, partly attributable to takeover speculation. Given my growth concerns, I am not willing to pay the premium.

Lionsgate Earnings and Guidance Provide No Catalyst

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.

Akeelah Provides Just A Small Boost So Far

My idea to buy Lionsgate (LGF) in anticipation of a ramp in the stock ahead of today's opening of Akeelah and the Bee has provided only a 2% return. Not bad, but less than I expected. I've looked over a couple of predictions for the opening weekend and the numbers are just $9 million. I had been thinking the figure would be closer to $14 million. It still could come in at the level and I'd say anything in the $10-12 million range or better will drive the stock higher on Monday. At this point I'd hold over the weekend as I think downside in the box office limited relative to current expectations and upside is possible. Akeelah will play primarily to African-American audiences this weekend and in the past films in that genre have performed fairly well. I'll take the over on $9 million and that should be enough to at least keep the stock at today's levels when it opens on Monday....

Dave Miller of Sanders Morris Harris took at a shot at the economics of the film in a piece earlier this week. Dave thinks that LGF's negative cost on the film is $5 million and P&A is $15 million. He believes Starbucks (SBUX) is not a gross player on the film. Rather, SBUX receives 20% of LGF's share of the film rentals (about 50% of the total box office) after LGF recoups their costs.

So if the film pulled in $50 million, LGF's rentals would be $25 million. The $5 million left after LGF gets its negative and P&A investment back would be split 80/20 in favor of LGF. Based on this analysis, breakeven for the theatrical run for LGF is a total cume of $40 million. This is before any revenue from the home video, pay TV, and free TV windows are considered. Dave thinks that SBUX is getting 100% of the soundtrack, which is selling well in the coffee shops.

This analysis is oversimplified as it does not consider residuals and participations. However, I think it shows this is a low risk film for LGF, which provides another reason to take the risk and hold over the weekend in hopes of a positive surprise at the box office.

Lionsgate Worth A Trade on Akeelah Opening

There could be some excitement around Lionsgate (LGF) this week ahead of Friday's opening of Akeelah and the Bee. LGF shares received a boost last year when Starbucks (SBUX) announced it had selected the film as its first entry into the movie business via in-store promotion.

I think it is possible that LGF could trade up this week in anticipation of a solid opening for the film. SBUX has been promoting the film in its stores since early April and LGF is supposed to be spending a good-sized advertising budget of around $15 million. The film received sneak previews on over 900 theatres this past Saturday as LGF tries to build buzz. The cast will appear on Oprah this week and so far reviews are excellent.

After moving up from a tax loss selling depressed year end close of $7.68 to $10.29 at the end of March, LGF shares have pulled back steadily this month to $9.40, down almost 9% from the high. I still have serious reservations about LGF that led me to sell the stock well below current prices, but I think the recent pullback leaves room for a nice run this week as the anticipation of Akeelah's opening builds....

Observers think the film could head toward a total U.S. box office run of $40 million. This would suggest an opening weekend of $14 million and several early estimates are in this range. The film is going to open on more than 2,200 theatres, making $14 million work out to a little over $6,000 per screen. The film is going to play heavily to families so possibly the recent >b>Disney release The Wild which did a disappointing $4,000 per theatre on its opening weekend is a good comparison. Other African-American themed films including LGF's own Tyler Perry films, Barbershop, Beauty Shop, Waiting to Exhale, and How Stella Got Her Groove Back earned between $5,000 and $14,000 per screen on their opening weekends in anywhere from 1,250 to 2,650 theatres. For Akeelah, these comps translate to $9 million to $31 million. Given discounted family tickets and lack of kids available to attend afternoon showings on Friday, an opening in the lower half of that range seems like the best bet.

Personally, I'd bet the over on $14 million. I think that is enough to impress and allow the shares to hold any gains it makes this week next Monday, so LGF sets up as a bullish trade this week worth holding over its opening weekend on the potential for a positive box office surprise.

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.

Lionsgate Messes Up Again

I was wrong on Lionsgate (LGF). Big time. The company missed its 3Q06 earnings badly with EBITDA, net income, and free cash flow all falling well short of estimates. The company lowered guidance for each of these items for its full year which ends on March 31. The lowered guidance implies that 4Q06 results should actually be fairly close to current estimates. However, with revenue performing in line to better than expected every quarter this year, it is clear that the business model is under pressure as operating margins are much weaker than expected. This makes it tough to have confidence in the FY07 outlook and will lead to a sharp compression in the multiple that is well deserved. I expect the shares to decline to 15-20% this morning....

The miss is being attributed primarily to home video, especially family and direct to home titles. There is also a hit due to a bankruptcy of a major customer and the expensive, but successful and worthwhile, effort to gain Oscar nominations for Crash. In general, the content side of the house looks like it is performing OK as new theatrical releases and TV shows are performing fairly well. However, the flow through of these businesses to EBITA, net income, and free cash flow continues to lag. In fact, the press release, says that there will be "at least" a one to two quarter lag before the success of recently successful theatrical and DVD releases flows through to the benefit of shareholders. I am troubled by the "at least" qualifier as it could indicate that management is not confident that the deterioration in margins has run its course.

In theory, the shares should have downside protection due to LGF's takeover potential. However, the lowered free cash flow forecast, poor performance of the company during FY06, and the apparent deterioration in the profitability of the company's business model suggest that the takeout price would be significantly lower than I previously expected.

The only hope for the shares in the near-term is that large institutional shareholders, several of which own over 5% of the shares agitate aggressively and pressure management to put the company up for sale. Management will resist and say that now is a bad time to sell but I don’t think shareholders would provide any support for management at this point. It would be quite ironic if another company made a raid on LGF and tried to buy it cheap as this has been a tactic that LGF itself has used on others, most recently Image Entertainment.

I expect the damage to the stock this morning to be severe so I plan to listen to the conference call, which will be going on when the market opens, before deciding whether to dump my remaining shares. Presently, I am leaning heavily in that direction. Very near-term rebound potential seems low and I will be able to make a more rational decision on re-entering the shares if I don’t own the shares.

I'll post more in the earnings summary after the conference call.

Lionsgate Earnings Preview

Lionsgate (LGF) reports after the close on Thursday with a pre-open conference call on Friday. Quarterly results for LGF can be quite volatile due to the vagaries of film accounting and significance that a hit or miss at the box office can have on the numbers. Added volatility can occur relative to expectations as the financials are difficult to model and there are relatively few analysts from which to create consensus estimates. In other words, there can be a wide range of estimates around the consensus estimate. For this reason, LGF shares have tended to be volatile following the release of quarterly earnings with the most recent quarters exhibiting a decline in the shares as the headline figures missed estimates.

Despite some of the issues outlined below, I do not expect this quarter to disappoint investors. I also expect the company to maintain its full year guidance (EBITDA guidance was slashed in December while revenue and free cash flow were left unchanged). If LGF can make it by this quarter, I think the path is clear for rally in the shares to over $10 on the basis of what should be strong March and June quarters and a series of positive news items that began with the recent very successful release of the Lord of War DVD to be followed by the release of the Saw II DVD on February 14th and the theatrical release of Madea's Family Reunion, the sequel to the hit Diary of a Mad Black Woman on the last weekend in February....

LGF does not provide quarterly guidance but has offered annual guidance. Presently, the company is projecting revenues of more than $850 million, EBITDA of $35 million, and free cash flow of more than $100 million ofr its fiscal year that ends this coming March 31. The revenue and FCF guidance has remained very stable but EBITDA guidance has come down sharply. Analysts initially thought the company could produce $90 million in EBITDA this year but in its initial guidance LGF suggested $65 million. This past December, following the movie flop In The Mix, EBITDA guidance was slashed to $35 million. The poor EBITDA performance has weighed on the shares despite management's opinion that FCF is the relevant metric. I believe management has a point but the difference between EBITDA and FCF is not sustainable so there is risk in the company's ability to sustain or grow FCF without an EBITDA pickup.

The reason for the variance in the two figures is that film accounting uses the balance sheet aggressively. One significant impact on free cash flow comes from the difference between LGF's investment in films and amortization of films. In general, LGF has greater amortization, adding to free cash flow, because of ongoing amortization of the acquired Artisan film library at $20 million per year. However, so far this year, the big sources of FCF have been working capital and film obligations. Accounts receivable dropped sharply earlier this year when cash was received on DVD shipments. Film obligations (residuals, minimum guarantees, and production loans) have risen sharply and since they are a liability they have added to FCF. The rise has been caused by two factors: LGF is producing more films and the financing arrangements for the films seem to be more dependent on participation and backend by the talent and production partners. LGF will lose this benefit once the growth of the production slate and the financing arrangements stabilize. Consequently, I remain concerned that little margin for error exists in the upcoming film and TV slate. Anything that serves to negatively impact EBITDA, such as the current performance of a new film or TV series, could lead to a cut in FCF guidance. FCF supports not only the current valuation but also the buyout valuation. As an obvious buyout target, LGF shares are supported by speculation on the downside even when movies flop. Thus, a reduction of FCF generation capabilities not only hurts current valuation but it lowers the floor that supports the shares.

Remembering the wide range of estimates, here is the consensus estimates for the December quarter. Revenues are projected $227 million in a fairly tight range. EBITDA consensus is $23 million but I see a couple of estimates at $30 million. EPS consensus is 16 cents but I see an estimate as high as 24 cents. I only found one analyst with FCF estimate which is $32 million.

Other things to look for in the press release and on the conference call include commentary about the Starbucks deal for promotion of Akeelah The Bee, an update on the formation of a horror channel, whether the library margins are stabilizing in the low 20% range, possible interest in the acquisition of United Artists, and a preview of the FY07 movie slate.

Crash Scores Big In Oscar Nominations

Crash won nominations for Best Picture, Best Director, Best Supporting, Best Screenplay, Best Editing, and Best Song in the Oscar nominations announced this morning. While the investment implications are extremely limited, this a real feather in the cap for Lionsgate (LGF). Just a few months ago, the film was considered a real long shot for nominations but a concerted effort by the company to garner nominations paid off. Crash will shoot up the DVD sale and rental charts, providing a nominal boost to LGF's earnings. More importantly, management's success with the film from the theatrical run through home video and now Awards season establishes the studio as a place where producers, directors, actors, and screenwriters will want to take their best projects. Lionsgate has crashed the Oscar party that used to be hosted by Miramax. In the long run, that can help the stock price by supporting shareholder value through the prospects of a better pipeline of movie and TV projects.

Insider Buying At Lionsgate

A couple of quick follow-ups to my Weekend Box Office Update that support my bullish trading bias on Lionsgate (LGF). First, this weekend's Barron's contained positive commentary on LGF in the Inside Scoop column. The column noted recent insider buying by senior executives along with a big boost in the position of Carl Icahn protégé Mark Rachesky. Rachesky reported a 7.3% position last August but his latest filing shows the stake has been raised by about 2 million shares to 10 million shares, or almost 10% of LGF.

The article quotes Ben Silverman of InsideScore.com as noting that Rachesky has a good track record and LGF represents his second largest holding. I am less impressed by the insider buying by executives as the amounts are rather small. However, last summer, the combination of the initial Rachesky filing and similar-sized buys by executives popped LGF shares. With a series of positive news items in the recent past and coming over the next month, LGF shares could be headed back toward the summer and fall highs in the mid $10 area.

Separately, one message board poster on LGF on Yahoo! (YHOO) noted that the better-than-expected opening for Big Momma's House, with the leading part played by an overweight man posing as as older African-American woman could be good news for LGF's Madea's Family Reunion, which opens the last weekend in February. Madea is a similar character created by Tyler Perry, a rising African-American star.

Lionsgate Story Shaping Up

Lionsgate (LGF – recently renamed from Lions Gate Entertainment) announced the sale of its studio production facilities in Canada for $36.1 million. To be honest, I did not even realize the company owned its own facilities. According to a report I just read, this asset was going to generate less than $5 million in revenue and a little over $1 million in EBITDA. Seems like a good price to me. LGF has about 110 fully diluted shares outstanding so this is not a particularly meaningful transaction but I still like the idea of realizing value from a non-core asset. Several studios have been adding sound-stage capacity in Los Angeles so LGF should not have trouble finding capacity for its production slate of movies and television shows.

A handful of Northlake clients and I remain long a small amount of LGF looking for the end of February release of Madea’s Family Reunion, the sequel to Diary of a Mad Black Woman, as the next major catalyst. Between now and then, LGF has several films in the DVD release window that should sell well. In fact, Lord of War (LOW) was released last week and LGF announced unusually strong initial sales of 2.5 million units. This film was a disappointment at the box office, grossing just $24 million. LGF usually is able to realize 110% of domestic box office for its DVD releases, implying that LOW should have brought in around $30 million. Assuming a wholesale price of $15 per unit, LOW is headed for closer to $40 million. This is very profitable revenue, potentially producing an operating margin north of 40%.....

Still to come on DVD in February is Waiting, a teen comedy, which grossed $16 million, and Saw II, which grossed $87 million. Teen comedies usually do well in the DVD sale and rental windows and I see no reason not to expect at least average results for Waiting. Higher grossing movies produce DVD sales less than 100% of box office so I don’t expect the 110% ratio to necessarily hold for Saw II. Sales will still be strong as the original Saw sold over 4 million copies in its original run against a $50 million domestic office. I’d expect Saw II to sell at least that many, probably more. Additionally, there will box sets of the two films with special features that will milk the original film and get a premium price. LGF has had its share of box office disappointments in the past six months but one thing the company does exceedingly well is take advantage of the home video window.

LGF has preannounced its December quarter which is yet to be reported. Due to the In The Mix flop, the quarter will be lousy. However, beginning with the March quarter, there should be several strong quarters in a row due to the aforementioned DVD sales, the box office success of the horror film Hostel, currently ending its run in theatres, and the upcoming theatrical release of Madea’s Family Reunion. I think the stock can trade back over $10 on this sequence of events with most of the gains coming in the run-up to the Madea release on February 24th. Remember that Diary of a Mad Black Woman shocked the industry when it opened at #1 on the same weekend a year ago. With the awareness for Madea, especially with white audiences, likely to much higher due the success of the film in the home video window, I think the film should gross at least as much as the original and beat the “sequel discount.”

With a target over $10 in a month and ongoing acquisition rumors as support, I think LGF is worth holding onto for the next month but the unusual volatility we have seen in the company's financial results over the past year keeps me from buying more except in trading oriented accounts..

Lionsgate Sells An Asset and More Good News Coming

Lionsgate (LGF-the company recently renamed itself Lionsgate) announced the sale of its studio production facilities in Canada for $36.1 million. To be honest, I did not even realize the company owned its own facilities. According to a report I just read, this asset was going to generate less than $5 million in revenue and a little over $1 million in EBITDA. Seems like a good price to me. LGF has about 110 fully diluted shares outstanding so this is not a particularly meaningful transaction but I still like the idea of realizing value from a non-core asset. Several studios have been adding sound-stage capacity in Los Angeles so LGF should not have trouble finding capacity for its production slate of movies and television shows.

A few Northlake clients remain long LGF as I am looking for the end of February release of Madea’s Family Reunion, the sequel to Diary of a Mad Black Woman, as the next major catalyst. Between now and then, LGF has several films in the DVD release window that should sell well. In fact, Lord of War (LOW) was released last week and LGF announced unusually strong initial sales of 2.5 million units. This film was a disappointment at the box office, grossing just $24 million. LGF usually is able to realize 110% of domestic box office for its DVD releases, implying that LOW should have brought in around $30 million. Assuming a wholesale price of $15 per unit, LOW is headed for closer to $40 million. This is very profitable revenue, potentially producing an operating margin north of 40%....

Still to come on DVD in February is Waiting, a teen comedy, which grossed $16 million, and Saw II, which grossed $87 million. Teen comedies usually do well in the DVD sale and rental windows and I see no reason not to expect at least average results for Waiting. Higher grossing movies produce DVD sales less than 100% of box office so I don’t expect the 110% ratio to necessarily hold for Saw II. Sales will still be strong as the original Saw sold over 4 million copies in its original run against a $50 million domestic office. I’d expect Saw II to sell at least that many, probably more. Additionally, there will box sets of the two films with special features that will milk the original film and get a premium price. LGF has had its share of box office disappointments in the past six months but one thing the company does exceedingly well is take advantage of the home video window.

LGF has preannounced its December quarter which is yet to be reported. Due to the In The Mix flop, the quarter will be lousy. However, beginning with the March quarter, there should be several strong quarters in a row due to the aforementioned DVD sales, the box office success of the horror film Hostel, currently ending its run in theatres, and the upcoming theatrical release of Madea’s Family Reunion. I think the stock can trade back over $10 on this sequence of events with most of the gains coming in the run-up to the Madea release on February 24th. Remember that Diary of a Mad Black Woman shocked the industry when it opened at #1 on the same weekend a year ago. With the awareness for Madea, especially with white audiences, likely to much higher due the success of the film in the home video window, I think the film should gross at least as much as the original and beat the “sequel discount.”

Hostel Provides Support For Lions Gate Entertainment Share Price and Earnings

The last time I posted on Lions Gate Entertainment (LGF) was following their presentation at the UBS Media Conference. At the time, I wrote:

I was dissatisfied with the explanation that Lions Gate Entertainment (LGF) provided at its presentation for the latest quarterly shortfall. I can accept the argument that free cash flow is the more relevant metric, but the unusually large discrepancy between EBITDA and FCF doesn't make sense to me based on what I know now. A look at the December quarter balance sheet figures for film investment and amortization might help. I believe that 2006 FCF numbers (ending March 2007) have no margin for error. I am still long my small position as I believe the stock is getting a little too depressed in the short term, with movies coming up in January and February that should do OK and rebuild confidence.

Well, it looks like I'll get bailed out my losing long position in (LGF). This past weekend, one of movies I was counting on, Hostel, was the #1 movie at the box office grossing $20 million. This was even better than I expected, but most importantly, following the sharp cut in guidance following the In The Mix flop it was critical that Hostel perform well or guidance for the balance of FY06 ending June and estimates of free cash flow for FY06 and FY07 would have been in jeopardy of sharp reductions....

Hostel should have decent legs and head toward $50 million in domestic box office. The next big movie in LGF's slate is Tyler Perry's Madea's Family Reunion, the sequel to Diary of a Mad Black Woman. Diary opened at #1 and grossed $50.6 million following its release on the last weekend of February 2005. I think Madea will match the success of the original. It opens on the same weekend this year and will again appeal to Tyler Perry's large African-American audience and benefit from much greater awareness among white audiences due to the success of the first film in theatres and on DVD.

These two films, along with the Saw II DVD and the expected good performance in LGF's TV business, should produce strong financial results for LGF in the first half of calendar 2006. My primary concern at LGF following the guidance reduction was that the free cash flow guidance of over $100 million in FY06 and FY07 was at huge risk if either the combined box office of Hostel and Madea fell short. Remember that LGF's guidance calls for FCF of over $100 million this fiscal year against EBITDA of only $35 million. With that risk in the rearview mirror for the next few months, I think LGF shares can approach their post Saw II peak in the mid-$10 area. To get past that will require realization of takeover rumors which remain strong and plausible. I plan to hold the remaining positions in Northlake cient accounts and reevaluate if the stock crosses $10 but I don't plan on buying more.

Mixed Quarter For Lions Gate But Results Set To Improve

Lions Gate Entertainment (LGF) reported a mixed quarter with revenue and free cash flow slightly ahead of estimates and EBITDA and EPS at the very low end of the range of analyst estimates. The disparity among theses figures is due to film accounting which often leads to mismatches between cash and non-cash expenses and the timing or revenue and expenses related to recent theatrical releases.

Overall, the results were not good enough to support the stock after the recent run related to the box office success of Saw II. However, the damage is fairly limited as in concluding remarks just prior to Q&A, management raised free cash flow and revenue guidance for the fiscal year ending June 2006.

LGF is a tricky stock. On the one hand, overall success on an increasing number of theatrical releases is creating long-term value for shareholders. On the other hand, the rising number of wide releases increases near-term spending on prints and advertising which pressures results against year-ago results, particularly at the EBITDA line. Ultimately, as the release schedule stabilizes at the higher level and assuming that the overall success rate is maintained, the financial results will catch up and near-term results will be more reflective of the value being created at LGF. There should be some evidence of this in the next two quarters based on the increased free cash flow guidance.

Unfortunately, these conflicting trends make LGF a tough stock to own. You have to have patience to let asset value build through the volatile quarterly results. Since I believe that LGF is a valuable asset not likely to remain independent over the next couple of years, I am sticking around but staying small. A takeout on current free cash flow would probably occur in the range of $13-$17, providing plenty of upside reward. Downside support is around the $8 level if there is a continuation of poor quarterly results.

Other highlights of the quarter and the conference call include:

# Ongoing strength in the TV business with four successful shows on four different networks and five pilots in production.

# Weakness in profitability of library catalogue sales. Management reduced margin expectations from the historical 25% level to 21%. This relates to weakening in the DVD market with pricing pressure particularly evident on family titles without major brand franchises. This costs the company $8 million in operating profits this fiscal year against EBITDA guidance of $63 million.

# Strong management and good results in new release DVD markets. Management ships cautiously and follows up with replenishment orders. This may reduce but potential profits for a hot title but in a weakening overall market the downside protection is much more valuable. DVD sales of Crash, High Tension, Barbie, Devil's Rejects, and the original Saw are all performing well.

# Lord of War, Waiting and Devil's Rejects lost money in the September quarter but will be profitable for the year after DVD releases.

# The Nov. 23 release of the Usher film In The Mix is expected to do $10 million at the box office in its opening weekend. LGF bought out its partner for domestic rights which will result in an extra $9 million of P&A expense in the current quarter. Another Usher film is in production.

# Upcoming releases include Madea's Family Reunion, Hostel, and Akeelah the Bee. Made is the sequel to Diary of A Mad Black Woman. Management is expecting domestic box office of $40 million. Excluding Akeelah the Bee, the other releases are projected to total $90-100 million in domestic box office.

# In response to a question, management would not comment on whether the increase in FY06 free cash flow guidance should be rolled forward to FY07. Management said visibility was not high enough to make that commitment.

Lions Gate Entertainment Update

Lions Gate Entertainment (LGF) rose almost 4% on Monday, enjoying its best day since early September when it popped 10% in four days to $10.60 on the back of reports of insider buying by about a dozen top executives. Since then the shares have pulled back steadily, reaching a closing low of $8.36 last Thursday.

It appears the reason for the pop yesterday was the announcement that Harry Sloan, founder of SBS Broadcasting (SBTV) has been appointed Chairman and Chief Executive of Metro-Goldwyn-Mayer. The SBTV buyout closed on October 18th so Harry was a free agent. The interesting tidbit for aficionados of LGF is that Sloan resigned as Acting Chairman and member of the board of LGF on June 30, 2005....

MGM is now controlled by Sony in partnership with Comcast with the backing of private equity funds that have a history of deals in media. I suspect some folks are speculating that with his insider knowledge of LGF, Sloan might be interested in expanding MGM by acquiring LGF. The fact that an Icahn prot�g� acquired over 7% of LGF this summer helps feed the speculation.

Any discussion of an MGM buyout of LGF is pure speculation. However, from the point of view of Sony and Comcast, the MGM deal was all about controlling premiere content. In that context, adding another significant studio to the mix makes sense strategically.

LGF's guidance calls for $90 million plus in free cash flow this year against an enterprise value of about $1.4 billion. A buyout of LGF would not require immense capital and would start from a solid financial footing. Or at least as solid as one can get in the hit-driven movie production and marketing business.

LGF shares reached their recent lows amid a string of poor to average box office results for key releases upon which the company's guidance is predicated. Additionally, investors are concerned with the bear hug the company is putting on troubled DVD distributor Image Entertainment. Meeting September quarter earnings estimates could prove dicey, especially if any of the recent films require write-offs.

On the positive side, Crash has performed very well in DVD sell-through and rental markets since its release in early September. This is very profitable revenue and could easily carry the quarter. Crash has lots of Best Picture buzz for the Oscars which could add another boost if the nomination is secured. In other news, LGF also appears to have made a smart acquisition of a small UK film distributor.

The bid for Image Entertainment looks to be moving toward conclusion although the outcome is unclear. I suspect the market will be happy if LGF loses out and walks away. However, I continue to think this is a reasonable and likely quite accretive deal for LGF.

Most importantly for the immediate future of LGF shares is the release of Saw II this coming weekend. Saw was a surprise hit that went on to pull in $100 million in domestic and international box office (evenly split). Saw II needs to do greater than $30 million in domestic box office to give comfort to LGF's full year guidance. So far reviews are mixed as can be expected for a horror flick. Worth noting, both Variety and Hollywood Reporter, who split on the critical front, expect a strong box office performance.

For now, I am going to hold the remaining positions in LGF and hope for a good weekend out of Saw II.

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.

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.

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.

Crash Winding Down Very Successful Run For Lions Gate

Crash lost 400 screens for this weekend and is down to about 900 screens. With the film's theatrical run winding down, I thought it would be worthwhile to provide a final review of the very favorable economics and also peak into the future for Lions Gate Entertainment (LGF). LGF shares have performed well on the success of Crash but I think plenty of upside remains. Future catalysts for LGF shares include upcoming quarterly earnings and several more promising film releases. A potential sale of the company is always a possibility....

Lions Gate Entertainment (LGF) shares have moved up recently on the successful box office for Crash. The film now looks like it is headed toward $50 million in domestic box office against my prior assumption of $40 million and initial estimates of $30 million.

LGF seems likely to ultimately receive about $100 million in revenue from Crash, composed of its share of domestic box office ($25 million), DVD sales ($70 million), sale of foreign distribution ($3 million) and television rights ($5 million). The cost to acquire and market the film should be around $20 million. Residuals due to the producer, director, writers, and actors could run towards $15 million, and distribution and marketing costs for the DVD could be around $30 million. Thus, total costs could run $65 million against revenues of at least $100 million, producing a $35 million operating profit for LGF, at the high end of my prior estimate. Analyst estimates for 2005 EBITDA are $90 million-100 million, so Crash is obviously a major success for LGF.

Future Catalysts Include Earnings, New Films

Future catalysts for LGF shares include quarterly earnings at the end of June and several more promising film releases over the summer. The quarterly earnings should be good given prior successful films including Open Water, Saw, and Diary of a Mad Black Woman, which should contribute significant revenue and profits. Investors will also be reminded that the LGF model has been working very well over the past year.

Upcoming releases include horror films High Tension, due this weekend, and The Devil's Rejects due in July and the hip-hop documentary Rize, due at the end of June.

LGF shares remain below the $11.40 they reached prior to the aborted bid for Hit Entertainment. I think plenty of upside remains and a potential sale of the company is always a possibility, given that LGF is the only major publicly traded studio now that MGM has been purchased by Sony (SNE).

Crash A Winner For Lions Gate

While the world focused on the astounding box office numbers for the latest Star Wars film, Lions Gate Entertainment (LGF) had another successful weekend at the box office with Crash. Crash has now grossed over $27 million and has shown the best legs of any film this year, falling just 20% in each of its first two weekends. It now looks like total domestic box office for the film could reach close to $40 million, ahead of the $25 million-$30 million I mentioned in my initial bullish post on LGF....

....One rule of thumb is that a film can produce total revenue of 2.5 to 3 times its domestic box office after adding DVD sales and the sale of international and TV rights. So with Crash headed toward $40 million, total revenue of $100 million or more is not out of the question. From what I have read, LGF paid about $5 million for the film and planned to support it with about $13 million in advertising and other distribution and marketing costs. Given the film's success and legs, it seems likely the ad budget has been increased by a few million dollars. If domestic box office reaches $40 million, LGF's share will be about $20 million (theaters get the other half), so the film could break even based on its domestic theatrical run. Most films lose money based solely on domestic box office.

If DVD sales and the sale of foreign and TV rights total $60 million-$80 million at an operating margin of 60%, earnings before interest, taxes, depreciation and amortization from Crash could range from $25 million-$35 million over the life of the film. Most of that seems likely to hit in LGF's fiscal year ending March 2006 where EBITDA estimates average around $100 million, giving me a lot of confidence in the projections.

LGF shares have not rallied much since Crash was released and remain below the $11.40 level they attained prior to the sharp pullback when the company announced they were considering a bid to acquire a British children's television producer that would have doubled the size of the company. LGF withdrew the bid on May 5. I think the shares are headed at least back to the March highs based on the success of Crash and a strong 1Q05 earnings report due on June 29th.

LGF's next major film release is High Tension due in theaters on June 10. High Tension is a horror film originally released in France and now dubbed and subtitled for U.S. release. The film is quite well thought of by horror film junkies. LGF has done well historically with horror flicks, although the box office of recent horror films from other studios indicates the genre may be cooling off.

Lion's Gate Entertainment: Hollywood's New Big Cat

Lions Gate Entertainment (LGF) is the largest independent motion picture studio. The company also produces television shows and owns a library of over 6,200 films and 1,800 television episodes. LGF produces inexpensive movies by Hollywood standards with all-in costs in the neighborhood of just $20 million. The company has had success with horror films and "indie" dramas and comedies (think Miramax, not 20th Century Fox or Walt Disney Studios).

Lions Gate shares trade at a valuation in line with other diversified media companies but should enjoy a faster growth rate. The company's financial performance is poised to accelerate due to recent success at the box office and the completion of the integration of its 2004 acquisition of Artisan Entertainment. Investors have historically paid a premium multiple for niche oriented media companies that enjoy high and stable returns. If the anticipated financial momentum materializes, LGF should enjoy an expansion in its operating cash flow multiple that leads to a 20% or greater gain in the share price over the next year. Valuation is also supported by "scarcity value" as following the acquisition of MGM by Sony, LGF is only sizable studio unaffiliated with the major entertainment conglomerates....

While less than half of LGF's annual revenue of nearly $800 million comes from recently released theatrical films, the perception of the shares is driven by the company's film business. Each year LGF releases 15-20 films with an average production or acquisition cost of $6 million. About 2/3rd's of the films are self-produced while the rest are purchased. Recent successful releases include Saw, Open Water, Diary of A Mad Black Woman, and Crash, which opened this past weekend to solid box office and strong reviews.

A successful film for LGF produces box office of $15-20 million. However, LGF's financial model is built on the assumption that the films average about $10 million at the box office (for the fiscal year ending March 2005 the average film earned $14 million), which the company splits evenly with the theatres. International rights are usually pre-sold to recoup a major portion of the production or acquisition cost, resulting in total revenue directly related to the initial theatrical release of $9 million. In addition to production or acquisition costs of $6 million, LGF spends an average of $5 million to market a film, leading to a loss on each film of about $2-3 million before home video revenue and the sale of television rights to the film.

Home video revenue has emerged as the key driver of Hollywood profitability and LGF is no exception. Home video revenue consists of the sale and rental of DVDs and often exceeds the total domestic box office for a film. This revenue is very profitable as the cost of producing the movie is already sunk and the only remaining costs are production, distribution, and marketing of the DVD titles. These costs account for only 40% of home video revenue on a typical movie. TV rights have also become a significant source of revenue and profits to Hollywood as broadcast and cable television networks compete for viewers. LGF has sold television rights for about 35% of total box office, producing another highly profitable revenue stream.

In summary, a typical LGF film will produce revenue of 2-3 times its domestic box office including home video revenue and international and TV rights. Operating margins should be near 15% after factoring in production costs and the marketing and distribution of the film and DVD. Major studios like Warner Brothers or Paramount earn margins closer to 11% and spend $50-100 million to produce and market a film. Specialty animation studios like Pixar might spend $125 million to produce a film but a successful film produces margins near 70%. A flop of any film that costs $50 million or more leads to significant write-offs. LGF has adopted a middle of the road approach to lower risk of costly flops and produce more stable profits.

Several catalysts exist to boost LGF shares over the next few months. First, Crash looks like it could be very profitable. Opening weekend box office of $9 million exceeded estimates and strong reviews and good word of mouth should lead to a total box office of $25-30 million. According to JP Morgan, LGF acquired Crash for $5 million and will spend $13 million to distribute and advertise the film. EBITDA from Crash could approach $20 million with a margin of over 30%. Second, fiscal fourth quarter earnings are due in June and should reinforce the perception that LGF is emerging as a profitable niche player in the motion picture business. Highlights of the quarter will be DVD sales of Saw ($54 million in domestic box office) and box office revenue from Diary of a Mad Black Woman ($50 million in domestic box office). Most importantly, the quarter should show stabilization of the company's financial model and offer a glimpse of potential upside to financial results over the next several years due to recent box office success.