Time To Take Profit On Lions Gate

| About: Lions Gate (LGF.A)

On Feb. 20th this year, I published an article titled "Is Lions Gate a Takeover Target?" Since then, the stock has risen about 50% and is traded around $32 today. The earnings reported last quarter were good and investors are being rewarded. At today's price, however, it is unlikely there will be any takeover offer. A 20% premium over today's price will put Lions Gate (LGF) close to $40. It is becoming more difficult to justify the valuation. It is time to take profit for the following reasons:

  1. The movie business is inherently volatile with big hits and misses. For Lions Gate, the potential hits are mostly priced in but the dangers of misses are being ignored. For the next 12 months, there are a few movies that investors have high expectations on. "Catching Fire," the second movie from the popular franchise of "The Hunger Games" will come out in November this year. A promising "Ender's Game" will debut in the coming fall. A potential blockbuster "Divergent" will be on screen next year. Any disappointment over box offices will hurt the stock hard. Over the history of the movie industry, it is either feast or famine for the independent producers. It is a good time to sell when things are looking good.
  2. The valuation is very high. The average earnings estimate for next year on Lions Gate is $1.67. Given the cyclical nature of the industry and high debt level of the company, I would consider a 15 multiple fair. The stock is trading around a 20 multiple. The earnings estimate for next year is closer to a cyclical peak than bottom. It is very difficult to produce blockbuster franchises. When you have a successful franchise, the costs of producing the sequels will increase dramatically because of higher compensation demand by actors/actresses.
  3. The financing cost will increase over time. The Federal Reserve has given a signal that it may start to taper QE soon. The bond market has responded to it by increasing rates. The high-yield market is faring worse than the Treasury market. Given the need to finance new productions and its high level of debt (1.33 billion), a 100 bps increase in financing cost will impact LGF's bottom line materially. It will make lots of sense for the company to issue equities at today's price to replace some of its debt.
  4. Streaming is a short-term boost but long-term negative to content companies. In the short term, the aggressive bid for content from streaming companies has increased the bottom line for the likes of Lions Gate. However, over the long term, the streaming will reduce the need for consumers to keep a copy of the film. DVD sales will come down dramatically. Just look at what the iPad did to the music industry. The aggressive pricing by the streaming companies dictates that over the long run, these companies cannot afford to pay high prices for content.

In summary, at today's price, LGF is unlikely a takeover target. Investors should take profit when things are looking bright. On the other hand, the company should take advantage of the high stock price to issue equities to replace some of its debt.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.