Lions Gate (LGF) is the seventh largest film production company in the United States. All the top six companies are owned by major conglomerates: Sony (SNE) owns Columbia Pictures, Time Warner (TWX) owns Warner Brother Pictures, Walt Disney (DIS) owns Walt Disney Pictures, Comcast (CMCSA) owns Universal Pictures, News Corp (NWS) owns 20th Century Fox, and Viacom (VIA) owns Paramount Pictures. Can Lions Gate stay independent? It is unlikely for the following reasons:
- In this digital multimedia age, content providers have become more important and valuable than ever before. After Netflix (NFLX) obtained the Disney content rights, its stock jumped more than 50%. Media/cable companies, such as Comcast, Viacom, Amazon (AMZN) and Netflix, have to compete extensively on the content they provide to their subscribers. It is thus not surprising that Amazon and Netflix started doing their own productions. The bidding for the content rights has been very costly to Amazon and Netflix. Both Netflix and Amazon's streaming business are losing money at the moment. It is more cost effective to buy a content rich company like Lions Gate than do in-house production or bid other company's content.
- Lions Gate has some of the best content franchises in the industry. Since 2010, Lions Gate has transformed itself from a low budget, money losing company into a major player with strong cash flow. Currently, it has a very popular franchise of "The Hunger Games" (3 more films in next three years), a potential blockbuster "Divergent" and a promising "Ender's Game". Lions Gate has just finished the "Twilight" series and owns the rights to the saga. Its TV series "Anger Management" and "Nashville" are very popular as well. Lions Gate, along with MGM and Paramount Pictures/Viacom, is also a co-owner of Epix, a pay TV movie channel which debuted on October 30, 2009. Epix has thousands of movies and TV series titles and has signed a licensing agreement with Amazon. The content Lions Gate holds has made the company a very attractive target for conglomerates like Amazon, Disney, Fox, Viacom and other big players. Disney recently announced a deal to pay over 4 billion dollars to take over Lucasfilm for the rights to the "Star Wars" series. Comcast just announced a deal to take over the rest of NBC from GE (GE).
- Low cost financing is available for conglomerates. The easy money policy pursued by the Federal Reserve has made financing widely available at very low cost. Recently, Amazon issued bonds worth 3 billion dollars maturing from 3 to 10 years. The rates on average are less than 100 bps over Treasuries. In addition, the stock market has been quite positive to M&A activities. Disney's stock increased about 10% after it announced the takeover of Lucasfilm. Assuming a 25% premium ($25 takeover price) and no cost cutting, an all cash takeover will be accretive to Amazon, Disney, Fox (News Corp), Viacom, Google (GOOG) and other big companies. The average earnings estimate for next year on Lions Gate is $1.39, which will generate a return of 6% on a $25 takeover price. For most large companies, the financing cost is around 3%. An all-stock transaction will be accretive to Amazon and Netflix. (I do not think that Netflix has the capacity to do a cash deal.) If synergies can be found (most likely), it can also be accretive to Fox, Disney and Viacom.
- The nature of the movie business may compel Lions Gate to consider a deal. The movie (and TV shows) business is inherently volatile. It is always either feast or famine for the independent producers. In the current environment, the cost of producing and marketing a film has soared. Financing a new movie is much more costly for independent companies like Lions Gate than for diversified conglomerates. Lions Gate has managed its business prudently through pre-selling international distribution rights, sharing marketing costs with distributors and paying down its debts. At the end of the day, however, the business still largely depends on how many hits it can produce. Lions Gate luckily has "The Hunger Games" franchises and a few hit TV series. It also has some potential blockbusters, but no guarantees. If "Divergent" and "Ender's Game" do not deliver, the company will be in trouble again after 2015. Carl Icahn tried to force Lions Gate into a deal in 2010 but failed. The circumstances were totally different at that time. Lions Gate was losing money and had no major hits. The valuation was at the bottom. In comparison, the company is firing on all cylinders now. The valuation is at an all-time high. Given the history that no large independent movie studio can last long (either being taken over or failed), it is an opportunistic time for Lions Gate to consider a deal.
- The market cap of Lions Gate is relatively small. The market cap of Lions Gate is around 2.75 billion dollars. A takeover premium will push it to about 3.3 billion dollars, which is not a problem for most of the conglomerates in the industry. The valuation itself right now is not cheap. At a forward P/E of 14.6 and a trailing P/E of 60, the stock is fairly valued. Therefore a financial buyer, such as a private equity, is unlikely. On the other hand, strategic buyers will be very interested in this largest independent studio for its content. Among all the potential buyers, it would make the most sense for Amazon to buy Lions Gate. It would instantly increase Amazon's earnings and give it a competitive advantage over its competitors. It will also allow Amazon for the first time to have something unique to offer with high margins.
As the largest independent movie studio, Lions Gate has some of the best content in the industry, from movies to TV series. The potential of three more films in "The Hunger Games" series, the series of "Divergent" and "Ender's Game" has made Lions Gate even more attractive to the streaming companies like Amazon and Netflix. The availability of cheap financing and the relative low market cap of Lions Gate make a takeover likely. The risk nature of the movie business may also compel Lions Gate to seek a deal when everything is going well for it.
Disclosure: I have no positions in any stocks mentioned, but may initiate a long position in LGF over the next 72 hours.