When The Hunger Games opened in theaters last March, Lions Gate Entertainment (LGF) was trading at less than $15 a share; today, it trades at $35. Essentially, The Hunger Games has added $2.74 billion to LGF's market capitalization since its release. Realizing this dramatic rise in value, I began to question how much of a boost LGF deserves from this franchise and what its fair value actually is.
First, we need to determine what we should pay for film franchise profits: a 15x multiple, more, or less? In fact, why do investors pay a multiple on earnings anyway? Simply put, stocks reflect the present value of future earnings. The market is willing to pay 12x what Apple makes on its iPhone because the company in a year will release another model, generating more profits. The iPhone brand will deliver recurring profits, and thus investors will pay more than this year's profitability. Conversely, what would happen if Apple announced it would never release another iPhone? The stock would only be worth this year's earnings.
Films are unique in that they are sold for a limited period of times (theatrical runs are typically less than 120 days with DVD sales quickly dissipating). To combat this, major studios have attempted to build franchises where they can release installments every few years to generate a recurring revenue stream. Perhaps, there is no stronger example than the James Bond franchise, which is still immensely popular 50 years after inception. Skyfall's profits are worth more to investors than that of a stand-alone movie like Argo because it will lead to enhanced profits in future installments. Consistently rolling film profits into new stand-alone projects is highly risky because so many films bomb due to poor timing, word of mouth, economic conditions, and intangible interest.
To their credit, Lions Gate has focused on the creation of franchises to build a stronger, more consistent studio over the long term. Unfortunately, The Hunger Games has a definitive end-date; it's a trilogy broken into four film installments. After 2015, these films will have very small earnings power. As such, I think it is improper to give this franchise a multiple on earnings. Instead, I am giving Lionsgate credit for their nominal returns. They basically function like positive one-time items. To estimate, the franchise's value I made several assumptions. I gave the second film a 10% boost domestically with a mild drop off to the third and a boost for the final one, similar to how other series have performed. Reflecting its growing international popularity, its overseas box office revenue grows dramatically with each film. The second film's budget is confirmed at roughly $160 million; I assume the next two will be mildly more costly along with a somewhat larger advertising budget. Home media revenue maintains its rough relationship with theatrical grosses. Last, the studio retains 55% of domestic grosses, 45% of international, and 30% of home media, consistent with current contractual outlays. I also assume that long term DVD and media sales have a present value of $150 million once the franchise ends. If anything that is overly optimistic. I find that The Hunger Games is worth $1.045 billion:
With The Hunger Games worth $1.045, where do we get the additional $1.7 billion in market cap gains over the past 18 month? Its television business has been performing better, earnings $54 million last year up from $36 million in 2011. With strong ratings and popular shows like Anger Management, I believe that this division will continue to generate strong results. Lions Gate TV should be able to move earnings above $65 million this year. With popular shows having long shelf lives of multiple seasons and syndication runs, I am willing to value this business more like an annuity business by giving it a market multiple of 15x, resulting in total value of $975 million,.
As a studio, Lions Gate does have core competencies of opening horror films, and its Tyler Perry relationship provides a modest yet consistent franchise that generate between $45 and $60 million in revenue annually. Between horror and Tyler Perry, this unit of Lions Gate has roughly $50 million in annual earnings power, giving that a market multiple thanks to its stability, we have another $750 million in value. The company also possesses a 15,000 title collection that is fairly valued at $720 million thanks to its $90 million in free cash flow generation.
Our combined total value for Lions Gate is thus 1.045+975+750+720 or $3.5 billion. That suggests a $25 share price, representing 27% downside. Why is Lions Gate trading at $35 then? I believe the market is overstating the value of The Hunger Games by assigning a multiple to those earnings. That would be appropriate only if you believe Lions Gate has a core competency in developing billion dollar franchises. Considering they have only picked one while acquiring a second (Twilight) that seems like an overstatement of their capabilities. In fact, both Ender's Game and Divergent have failed to connect with audiences thus far in their marketing efforts. In 2013, there have been several attempts to build franchises aimed at young adults like The Hunger Games and Twilight: Beautiful Creatures, The Host, and Mortal Instruments. Each one has bombed because young audiences are amazingly fickle and unpredictable, resulting in large losses. Unless one of these two films in the LGF pipeline turn into The Hunger Games, its stock is overvalued by $10. Frankly, I think the company will be fortunate to break even on the two efforts.
The market is overhyping Lions Gate stock by giving it too much credit for The Hunger Games' earning power. LGF should not get a multiple on these profits because the franchise has a definitive end-date, and its replacement attempts do not look promising. When adding the nominal value of these profits to its growing TV unit, the consistent part of its studio, and its library, LGF is worth $25. There is $10 of premium associated with its hit-or-miss franchise fare. One needs to turn into The Hunger Games to merit that premium. Given the poor performance of similar endeavors so far in 2013, I believe these films are more likely to miss. With so much premium embedded in the stock, I do not believe LGF has a favorable risk/reward profile and would take profits, looking to re-enter in the $25 range. LGF is a great company, but its stock is overheated.