Boardroom Melodrama: The Reel Story of Icahn, Lionsgate and MGM

by: Diane Mermigas

As melodrama over the fate of MGM, Miramax and Lionsgate feeds the headline grist mill, the real story is the steady devaluation of Hollywood studios and their film libraries by the digital forces that are supposed to provide them with new revenue streams.

Adversarial Lionsgate (NYSE:LGF) shareholder Carl Icahn is one of the few participants willing to call it out.

While Icahn’s board room maneuvers and biting criticism of Lionsgate management get all the attention, the activist billionaire raises valid concerns about the uncertain value of film libraries at MGM and elsewhere, as consumer use of digital technologies alters industry economics. In an open letter to Lionsgate CEO Jon Feltheimer, Icahn argues against spending billions to acquire MGM because “library values are currently in a secular decline, never to return to cash flows seen during the heyday of DVD sales.”

Icahn has the facts on his side.

Record box office ticket prices and attendance have created a healthy market for film studios, but there no longer are clear paths to financing and recouping movie production investments. As long as exhibition windows and mobile Internet access are in flux, altering the profitability and predictability of costly films, studio values will be defined more by need, opportunity and circumstance.

Lionsgate reaped the rewards of creative risk-taking in films and television, but it has drawn the ire of Icahn, a 19 percent shareholder. Icahn was thwarted in his recent efforts to take over the studio, but he managed to dissuade Lionsgate from pursuing its $1.3 billion bid for the debt-laden MGM and to think twice about bidding for Miramax.

Sony (NYSE:SNE) and other MGM investors are trying to recoup their money from a studio plagued for decades by financial problems and ownership turnover. Time Warner reportedly leads with its $1.5 billion bid for MGM. Walt Disney (NYSE:DIS) reportedly is seeking about $700 million for its cutting edge Miramax boutique film studio and library in order to focus resources on its signature tent pole films. The Weinstein Co., which founded Miramax, is among the lead contenders. Lower profile film library deals flying under the radar include Liberty Media’s (LCAPA) Overture Films, Universal’s Focus Features and Summit Entertainment.

Although every film studio and library deal is different, the change agents reshaping their fortunes are the same. Even the biggest, most successful studios are being adversely impacted by declining DVD sales (down about 20 percent each of the past two years), transforming on demand services, the explosive growth of streaming video on mobile devices, and a vital global box office. Although it will be years before nascent blue-ray and 3D technology substantively add to the mix, these are better times for consuming movies than trying to monetize them.

One-time, on demand viewing on portable smart devices is fast replacing the physical movie rental or purchase. The snowball effect will be huge. Wal-Mart (NYSE:WMT) and other retailers providing less shelf space for films drives down the value of film libraries which are studios’ source of steady cash flow. Netflix (NASDAQ:NFLX) is staying a step ahead of rivals like nearly bankrupt Blockbuster (BBI) with online on demand Wi-Fi options, and even Google’s (NASDAQ:GOOG) YouTube is getting into the movie business.

One of Icahn’s chief arguments against Lionsgate’s interest in MGM or Miramax is the rapid deterioration of DVD sales of film library product down around 40 percent the past several years; movies have become even more of a risk for many studios and their investors, offset by the international sales of strong television product.

Lionsgate says it would apply to MGM or Miramax the same disciplined financial models it uses to acquire, produce and release original TV production and at least a dozen films annually, yielding 70 percent profitability over the past decade. Despite their best efforts, the management of Lionsgate and other studios already is responding to economic challenge by reducing their release slates by more than a fourth off their 2006 peak.

Heightened competition from equity-backed, mid-sized players (such as Relativity Media, Media Rights Capital and the Twilight films driven Summit Entertainment), the scarcity of debt capital and private investors, and the overall difficulty of film financing are contributing to lots of behind-the-screen problems for which there are no fast or sure fixes - including the current 3D craze.

This year’s box office returns are 10 percent higher than a year ago and ticket prices are up 26 percent, primarily due to the average $3 per ticket premium for 3D films, according to BTIG analyst Rich Greenfield. The cost for a family of four to see a 3D non-IMAX screening of DreamWoks(NASDAQ:DWA) How to Train Your Dragon can run $63 for tickets before popcorn, candy and beverage, he points out. The animated feature topped the weekend box office with $43.3 million in domestic ticket sales on the way to covering its estimated $180 million related costs.

The scramble to build out 3D screens and produce more 3D films could backfire over time as the technology becomes commonplace, as initial box office runs remain abbreviated, and as the means to recoup costs fall short in home entertainment and other after markets.

In some ways, industry players are their own worst enemies. Traditional exhibition windows choke new digital options such as online streaming and video on demand. The exception may be Disney’s (DIS) recent $4 billion acquisition of Marvel Entertainment and its 4,000 character treasure trove, temporarily foiled by legal issues involving the family of the late superhero creator Jack Kirby.

Given the hit-or-miss nature of the film business and nearly 30 percent decline in film operating income from 2007 to 2009, major media conglomerates - Disney, News Corp. (NASDAQ:NWS), Time Warner (NYSE:TWX), Viacom (VIA.B) - have made sure their film studios collectively account for less than 10 percent of their parent corporations’ valuations, according to Barclay’s Capital analyst Anthony DiClemente.

While theatrics continue around Lionsgate’s poison pill move to block Icahn’s hostile takeover, the industry should be focusing on the new digital math that is the real threat.

Disclosure: None

Original post at BNET.