Lionsgate F2Q07 (Qtr End 9/30/06) Earnings Call Transcript

Lionsgate Entertainment Corp. (LGF)
F2Q07 (Qtr End 9/30/06) Earnings Call
November 10, 2006 9:00 am ET

Executives

Peter D. Wilkes - Senior Vice President, Investor Relations
Jon Feltheimer - Co-Chairman of the Board, Chief Executive Officer
James Keegan - Chief Financial Officer, Principal Accounting Officer, Chief Administrative Officer
Steven Beeks - President; President of Lions Gate Entertainment Inc
Michael Burns - Vice Chairman

Analysts

Lowell Singer - Cowen and Company
Michael Savner - Banc of America Securities
Thomas W. Eagan - Oppenheimer & Co.
Jolanta Masojada - Credit Suisse
Gordon Hodge - Thomas Weisel Partners
Barton Crockett - JP Morgan
David Miller - Sanders Morris Harris
Alan Gould - Natexis Bleichroeder Inc.
Eric Handler - Lehman Brothers
Andy Nasr - Raymond James
David Bank - RBC Capital Markets
Matthew Harrigan - Janco Partners
Michael Kelman - Susquehanna Financial Group
David Joyce - Miller Tabak

Presentation

Operator

Good day, ladies and gentlemen, and welcome to the Lionsgate second quarter fiscal 2007 earnings conference call.

(Operator Instructions)

As a reminder, this conference is being recorded.

I would now like to turn the conference over to your host, Peter Wilkes, Senior Vice President of Investor Relations. Please go ahead.

Peter D. Wilkes

Thank you for joining us this morning. Jon Feltheimer, our CEO will begin with opening remarks. We will then open the call to questions from our analysts.

The matters discussed in this call include forward-looking statements. Such statements are subject to a number of risks and uncertainties. Actual results in the future could differ materially and adversely from those described in the forward-looking statements as a result of various important factors, including risk factors set forth in Lionsgate's Form 10-K filed with the SEC on June 14, 2006.

The company undertakes no obligation to publicly release the result of any revisions to these forward-looking statements that may be made to reflect any future events or circumstances.

Jon.

Jon Feltheimer

Good morning, everyone. Thank you for joining us for our Q2 earnings call. I have with me our usual Lionsgate cast today: Michael Burns, our Vice Chairman; Steve Beeks, our President; Jim Keegan, our Chief Financial Officer; and Rick Prell, our Chief Accounting Officer.

What we are going to talk about today is the performance and quite frankly, over-performance of our core businesses, and several exciting new developments.

This past quarter was one of continued growth for Lionsgate, and it reflects three of our most important goals -- investing in our product and business for the future, maintaining a healthy balance sheet, and continuing to draw a substantial, sustainable free cash flow as we continue to invest in growth.

I will touch on our balance sheet first, and then talk about our ongoing investments and how we see them paying off down the road financially and strategically.

On October 15th, we called a $60 million 4-7/8% convert, which will save us $2.9 million in interest expense annually, and will reduce our sub debt from $385 million to $325 million, which will have a fixed blended coupon rate of 3.31%.

Therefore, at the close of the quarter, with $200 million in cash on hand and no corporate bank debt, we are generating interest income from our available cash which is about equal to the interest expense we are paying on our debt.

We believe that our balance sheet is in the best shape it has ever been. Our challenge, of course, is to maintain a balance sheet of this quality at the same time that we continue to invest substantially in the growth and expansion of our business. I am confident we can continue to meet this challenge.

Part of meeting the challenge is continued generation of strong free cash flow. In this quarter, we threw up $24 million in positive free cash flow. As you know, our free cash flow swings substantially from quarter to quarter, but this certainly puts us within the range of our annualized free cash flow running rate.

Let’s look at some of the drivers of that free cash flow.

The very strong box office performance of Saw 3 kept a run of four straight wide releases that have outperformed our internal expectations, and will each generate a substantial return on investment.

We are looking to keep that level of success going with the next three wide releases that will round out our fiscal year:

• Our first family entertainment theatrical release, Happily Never After, on January 5th;
• The next film in our highly successful franchise, Tyler Perry’s Daddy’s Little Girls, on Valentine’s Day; and
• The inspirational drama Pride, starring Academy Award nominee Terence Howard and Bernie Mack, on March 23rd.

As you know, we are not trying to hit the ball out of the park with our films. We continue to look for exactly the kind of releases that we have been doing recently -- films like Crank, Employee of the Month, and The Descent, which will each do $25 million to $35 million at the North American box office.

As we showed in our slides at the Merrill Lynch conference recently illustrating the business model for Crank, these types of films can generate very significant profits and over a 50% return on investment at those box office levels.

While our profitable film model does not demand being number one at the box office, when we do get a number one $33 million opening weekend with a film like Saw 3, we will obviously take it.

It is particularly significant in the context of our growth into new markets that Saw 3 was number one and grossed $8 million in its first week at the U.K. box office, distributed through Lionsgate U.K.

In addition to the U.K., Saw 3 opened at number one this past week in Brazil, Argentina, Romania and other territories, including Australia, a territory that we are exploring for self-distribution at this moment.

To be more specific, Simon Franks, the architect of the Red Bus growth strategy, is moving to Australia to create our Australian self-distribution plans, with further announcements to be forthcoming.

One year after our investment in the acquisition of Red Bus, the U.K. film and video distribution company and its full integration into our operations at Lionsgate U.K. is proving to be a very successful growth business for us. We expect that Saw 3 alone will generate approximately $2 million more in ultimate value through our self-distribution in the U.K.

However, the flip side is that as we measure long-term value creation against short-term profitability, releasing our slate in the U.K. will, as it does with our domestic slate, generate a short-term loss as we expense our P&A. An example of this would be Employee of the Month, where we will experience a $2 million to $3 million negative swing in this fiscal year from its U.K. release. However, we are creating value in the long run.

In terms of investing in growth, next year’s slate has more self-produced films, more wide releases, and more star-driven vehicles. It also has some incrementally higher production budgets, but we are balancing all of this and mitigating risk by taking equity partners and creating production subsidies and various financial structures.

As a result, we believe that we are going to be able to grow our slate in a disciplined manner and still maintain and even grow our margins.

Our slate coming together for fiscal 2008 reflects this approach with:

• The action film Rogue, starring Jet Li and Jason Statham;
• Our next big team comedy, Good Luck, Chuck, starring Dane Cook and Jessica Alba;
• Hostel 2, which just finished shooting in Iceland and will be wrapping production in Prague;
• 3:10 to Yuma, from Relativity, the remake of a classic western starring Russell Crowe and Christian Bale, directed by James Mangold and currently shooting in New Mexico;
• A remake of the Japanese hit horror film, The Eye, from Cruise/Wagner;
• The next film in our Larry the Cable Guy franchise, Delta Farce;
• The Condemned, starring Stone Cold Steve Austin from our WWE partners;
• Bug, a psychological horror film from director Billy Friedkin, starring Ashley Judd;
• Two big family entertainment films -- the live action Bratz, a franchise which we just announced and I will be discussing more in a moment, and Food Fight; and
• The next film in our Saw franchise, Saw 4, from our partners Mark Burg and Oren Koules, as well as the fourth film in our Tyler Perry franchise, in addition to several prestige films, such as Trade and Away From Her.

Our line-up really has the look of a major studio slate except for the budget, and it is exactly the franchise driven portfolio approach that Michael and I have been planning for the past six-and-a-half years.

In fact, in addition to our three big franchises, Saw, Tyler Perry, and Hostel, we are in discussions to more forward now on Punisher 2 as well.

We have two or three significant events to talk about in television. As you know, we have invested in our largest slate of new programming ever, with 12 primetime television series. This slate is significantly back-loaded, and although the numbers are clearly evident in our record filmed entertainment backlog, you will see the majority of our television revenue coming in during the back-half of the fiscal year.

We just received the fourth season renewal of Wildfire from ABC Family, a remarkably early renewal for a series whose third season does not even start until January, giving us enough episodes now for syndication and a back-end.

We are finalizing the third season pick-up of Weeds, and when you look at DVD sales and iPod downloads, we think there is significant second cycle potential for Weeds, making it our first television series with real hit value on the back-end.

Speaking of syndication, perhaps the most significant news coming out of our television business is our investment in the acquisition of Debmar-Mercury in July. Within a month of that acquisition, we announced Tyler Perry’s House of Pain television series for first-run syndication and this one series alone could generate between $100 million and $200 million in syndication revenues over the next few years, helping to drive the continued growth of our television business, which already contributes one-fourth of our positive free cash flow.

In addition, Debmar-Mercury has just concluded a deal to syndicate Family Feud with Freemantle Entertainment, giving Debmar with Tyler Perry, South Park, Dead Zone, Farscape, the Revolution film packages and now Family Feud, one of the great portfolios of distribution rights in the syndication business.

As we projected, our home entertainment business continues to be strong, and our library is on track to again generate in excess of $200 million in annual revenue, with improving P&L contribution margins due to better in-house product mix and our sharpened focus on re-promotions of key library titles.

We just announced that we will release the third of our successful Marvel direct-to-video titles, Iron Man, in January, 2007, following on the footsteps of the strong performances of Ultimate Avengers 1 and 2.

But the big news for our family home entertainment business today is our announcement that we are creating a new home for Bratz in filmed entertainment. We are partnering with a leading consumer product entertainment company, MGA entertainment, to release three animated direct-to-DVD features in North America, with the first title in the series, Bratz Fashion Pixies, slated for release in Spring, 2007.

We are partnering with producers Avi Arad, Stephen Paul, and MGA entertainment to also launch the first live action feature film based on the Bratz characters, which will begin shooting in February, 2007, and which we will distribute in the U.S. next summer.

Our Bratz deal reflects our continuing investment in brands that bring long-term value. While we continue to distribute the existing Barbie library titles, we have been looking for a brand to replace the new releases, and in Bratz, not only have we found a growing, exciting and popular new brand, but we anticipate significantly higher margins on our Bratz titles than we generated on Barbie.

Another significant area in which we are investing this year is FEARNet, our branded horror channel with partners Comcast and Sony. We just signed our contracts, and FEARNet may be officially released in the media as early as today, although most of you are already aware of its Halloween launch.

Since that launch, the results are even better than we expected. FEARNet has become the third most-watched VOD site on Comcast. It achieved 2.3 million views in its first six days, surpassing our goals for the first month. FEARNet.com has immediately become the number one horror destination, again surpassing our monthly goals in uniques and page views in one week, with 1 million plus page views and 400,000 video views.

In terms of how FEARNet fits into the financial plan for fiscal 2007, as you know we have been in lengthy conversations with Comcast and Sony about FEARNet, and we obviously did not know when and whether the deal was going to close. We are thrilled that it has, as well as with our early results, as I just mentioned.

We believe this initiative will drive very high returns over time. We are one-third equity participant in the deal, which means we will be incurring one-third of the expenses associated with the launch over the next two to three years.

While it is too early to put precise numbers on it for this year, we do believe that we will be expensing in the low- to mid-single-digit million dollar range this year. We expect that when we report next quarter, we will have better clarity on the specific FEARNet number, including revenue we will be receiving from our Comcast licensing agreement that will offset a portion of this loss.

What we can tell you now is that if not for FEARNet and some non-cash items, mainly stock option expenses tied to long-term contract renewals, we would likely be raising our guidance for all of our metrics at this time.

As I stated at the beginning of my remarks, our challenge is to balance our investment in new businesses that will create long-term value, generate long-term profits, and establish the foundation for long-term growth and consistent, sustainable free cash flow year in and year out, against quarter-to-quarter results in the short-term.

We will refine our guidance on the next call when our picture slate should be set for the year, and we will have more information on two potential slate financings that should have a positive impact on our free cash flow numbers for this year.

I am now pleased to open the call to your questions.

Question-and-Answer Session

Operator

(Operator Instructions)

Our first question is from Lowell Singer. Please go ahead.

Lowell Singer - Cowen and Company

Thank you. Good morning. I have a couple of questions for you. First, the EBITDA or earnings number was below the consensus estimate for the quarter, and I am sensing there were some timing issues there. Could you talk a little about what that might have been?

Second, on FEARNet, could you give us an update? I know you have launched the VOD channel. Where are you in your discussions with cable and satellite operators about potentially launching it as a vertical channel? You sort of mentioned attractive long-term returns. Could you be more specific on what you think this venture could add over time? Thank you.

Jon Feltheimer

Why don’t I start with FEARNet. We certainly are working right now on a plan that could create a linear component with our partners, but what is exciting about this and where the business is going is the business certainly has changed. If you look at the performance of Sprout on VOD in terms of Comcast, very, very successful right now, particularly in terms of the advertising, so we built a model really with VOD, as far as we are concerned, is linear programming that is just time-shifted, and creating opportunity for consumers that they did not have before digital.

We believe we can make a very successful business out of it without a linear component. As a matter of fact, what is currently in the plan with a 10 times residual value after the tenth year, I believe it is a 28% return on investment is what we are looking at, but we do continue to look at the possibility of a linear plan for both satellite, cable, as well as telco potential partners.

Jim, would you drill down a little on the numbers?

James Keegan

Sure. In this quarter, we actually incurred approximately $17 million of print and advertising costs associated with Employee of the Month and Saw 3, that were incurred prior to the [last release], so that created a straight-to-the-bottom-line net income expense.

Jon Feltheimer

As you know, Lowell, timing is one of the reasons that we do not go quarter to quarter in terms of guidance.

Lowell Singer - Cowen and Company

Could I just -- two quick follow-ups. First, the FEARNet business plan, does that assume just a VOD channel?

Jon Feltheimer

The current business plan that we have assumes VOD and Internet.

Lowell Singer - Cowen and Company

Okay, and just one other quick question. You talked about Happily Never After. I think that is a CG film. Obviously that space has become more competitive over the last couple of years. What is your exposure to that film and what sort of outlook do you have internally for that film in the marketplace?

Jon Feltheimer

We have said numerous times when we launch our family films that we are going to do it with the Lionsgate's model, not a typical studio model. We think there is great opportunity in between these huge blockbuster animated movies to do pictures that are much smaller budgeted, that we have much less exposure.

Happily Never After is a film that we have virtually no exposure going in. We did not pay for the production. We put a small amount of finishing funds into, as well as possibly a small amount of the P&A, but most of the P&A and almost all of the production has been paid for by somebody else.

We would be delighted with Hoodwinked level of performance, but honestly, anything in the $15 million to $20 million total box office range for that picture will be extremely profitable for us.

Lowell Singer - Cowen and Company

Thanks a lot.

Operator

Thank you. Our next question is from Michael Savner. Please go ahead.

Michael Savner - Banc of America Securities

Good morning, thanks. I actually just want to follow-up on Lowell’s question for just a second on the P&A spending in the quarter. As we look into the end of the year and the movies coming out in January, I think Hostel and Happily Never After are coming out, but would you assume though that a lot of that benefit from Employee of the Month and Saw are then going to flow through to this quarter? You seem comfortable with the guidance that is out there, so that would seem to imply there is going to be a pretty big pre-tax income and EBITDA boost in the third and fourth quarter to get you to that guidance. So conceptually, I guess that makes sense, but I just want to make sure we are thinking about it correctly.

Then just one quick follow-up. I think one of your last prepared comments about FEARNet and some spending that was not going to be offset, I’m sorry, I missed part of that. Could you just tell us what spending, that couple million dollars you were talking about? I would appreciate it. Thank you.

Jon Feltheimer

First of all, Hostel is not in the fiscal year. Hostel may have been earlier in the year, but I am not really sure. It is moved out. We actually moved Tyler Perry into the fiscal year, interestingly enough. That will probably be about a $9 million hit in the year, but again, we are over-performing in all of our other divisions and all of our other motion pictures, so that will be made up.

You are exactly right. The performance for the rest of the year in terms of motion pictures should be very strong and be able to make up the pre-expensing, if you will, of that P&A.

I did not quite get your question about FEARNet. I did not get what you missed.

Michael Savner - Banc of America Securities

Actually, I want to clarify, because I was not talking about the fiscal year. I was talking about the fiscal third quarter, so those January releases. I am just saying, are we going to see a pick-up in EBITDA in the fiscal third quarter benefiting from the expensing of some of the P&A on Employee of the Month and Saw? We should see a big recovery in EBITDA in the fiscal third quarter. I was not talking about the year.

The last one, again, it was your prepared comments at the very end. You said there were a couple of million dollars I thought you said associated with FEARNet, but we could go offline if I mis-heard.

Jon Feltheimer

The answer is yes, there will be a pick-up or benefit from that in the third quarter. What I believe I said is we are expecting low- to mid-single-digit expensing from FEARNet, but we have to refine that number, as well. Frankly, part of our deal is licensing both for their VOD as well as for the channel itself, and there is a question of timing when that will come in as an offset. That is where the refining guidance for next quarter will come from.

Michael Savner - Banc of America Securities

Got it. Thanks very much.

Operator

Thank you. Our next question is from Tom Eagan. Please go ahead.

Thomas W. Eagan - Oppenheimer & Co.

Thank you. If you already mentioned this, I apologize, but on Saw 3, will the home video revenue, will that all come in in Q4, or will some of that come in Q1 of ’08?

Secondly, when might we see some of the TV syndication revenue. Might we see that in Q4 of this year?

Steven Beeks

On the Saw 3 revenue, yes, the home entertainment revenue will come in in Q4. A portion of it will be in Q4 and a portion of it will be in Q1, and then some of it will dribble out into Q2 of the next fiscal year.

Jon Feltheimer

In terms of TV, TV syndication for shows like Dead Zone, that will be fiscal ’08. All of the Tyler Perry revenues that I talked about, and frankly, most of the Debmar revenues and profitability will begin next year. Debmar will probably do over $50 million of revenue in fiscal 2008, taking what we expect TV revenues to be, over $200 million. But almost all of that this year actually we will probably take a small integration charge on Debmar-Mercury, but going forward, it looks to be very profitable and, as I say, lots of revenue coming in starting in ’08.

Thomas W. Eagan - Oppenheimer & Co.

Thanks.

Operator

Thank you, and our next question is from Jolanta Masojada. Please go ahead.

Jolanta Masojada - Credit Suisse

Thank you. Could you talk about the expectations for the investment in film and TV programs for the remainder of the year? You had a reasonable increase during the quarter. Secondly, could you talk about how the longevity of the Saw franchise is working out? Do you think there will be a change in the cost structure of future sequels?

Jon Feltheimer

I will answer Saw, and then I will turn it over to Jim to drill down on the investment in film.

Obviously this is an unusual franchise. Typically, you might budget 20% off each franchise until it becomes direct-to-video. Instead, the producers, Mark Berg and Oren Koules, working with us hear at Lionsgate, particularly Peter Block, our head of co-productions and acquisitions, and Jason Constantine, have done really an amazing job. We are still hoping that Saw 3 will hit the Saw 2 numbers, which were up some 20-odd percent from Saw 1.

I think unlike many franchises, this one is really appealing to the audience. We keep growing it. We keep improving the production, but in terms of part B of your question, other than the royalties and participation paid to our participants, the actual overall production from Saw 2 to Saw 3 went up very slight, and we do not expect really any further acceleration of that.

I think part of what is going on here is not only is the quality of Saw continuing and production values improving with great directors like Darren Bousman, but I think we have become a staple on Halloween, and that is very unusual. So we have two brands going, one is Saw and the other is Saw on Halloween, and that is where we are going to be again next year, which again, very difficult for these producers and our team to get these ready and have the quality that they have, but we will be there again next Halloween.

Jim, do you want to drill down on the investment in film and television?

James Keegan

Sure, you indicated on investment in film and television for the first six months of both years, about 157 last year, 164 this year, so we are still tracking similarly. But what I would anticipate for the end of the year, on net cash out, where last year was actually net cash out of approximately 285 increase investment in film. We also had some liabilities where we had not paid the cash. $200 million went out last year. I would anticipate this year on that same methodology of approximately $200 million this year.

Jolanta Masojada - Credit Suisse

Thank you.

Operator

Thank you. Our next question is from Gordon Hodge. Please go ahead.

Gordon Hodge - Thomas Weisel Partners

Good morning. Just wondering, Steve, if you could give us a sense of what the library sales were in the quarter, and then pricing trends. That would be great. Then, I think you mentioned that the, if I heard correctly, the Dead Zone syndication revenue is not likely to fall this year, but next. I just want to confirm that.

Then, I’m also curious on the -- it did not look like you shipped any Dead Zone episodes this quarter. Just curious if we should expect that in the future. Thank you.

Steve Beeks

Gordon, without giving you the actual number, our library sales year to year are up the first-half of the year. That is obviously a good sign.

In terms of wholesale prices, our overall wholesale average prices have increased. As a matter of fact, on new theatrical releases, we recently increased our wholesale price by just about $0.50, which is a testament to the strength of our product in the marketplace. Even in terms of the deep catalog, while there had been a trend downward in our average wholesale price, it has stabilized over the last few quarters.

Jon Feltheimer

Dead Zone, there will definitely be more episodes, but they will hit next fiscal year.

Gordon Hodge - Thomas Weisel Partners

Got it. Thanks.

Operator

Thank you. Our next question is from Barton Crockett. Please go ahead.

Barton Crockett - JP Morgan

Great, thank you very much. Let me see, a couple of questions, if I could. One is on the backlog, which went up. I was wondering if you could give us a bit of a breakdown, so we could understand better the margin implications of this between some of the lower margin stuff like the TV series production and some of the higher margin stuff like TV syndication or TV rights or international pre-sales. That is one question.

The other thing is, if you could just again take us through an explanation of the variance between the EBITDA loss of $12 million and the free cash flow profit of $24 million, what drove that disparity? Thank you.

Jon Feltheimer

Okay, Jim.

James Keegan

Sure. First of all, on the backlog, approximately $80 million of our $247 million of backlog is from the TV product. The rest is from the motion picture division. That will give you some sort of idea as to the blend between the margins that will come off of that.

Secondarily, looking at the difference between free cash flow and EBITDA, I guess I would like to point out that our profit from the motion picture division is up this year. It was actually for the first six months, negative $15 million for motion pictures last year. We are now positive $11 million this year. Our divisions were performing.

Jon Feltheimer

Does that answer your question, or do you want Jim to drill down more on the free cash flow?

Barton Crockett - JP Morgan

It does not really get at it. If you could drill down on it more, either here or offline, that would be great.

James Keegan

Let’s go. Then, if you look at my loss of $14 million and adjust that for the non-cash amortization items, primarily that is investment in film, you will come down to a $38 million positive number as you add back the amortization. We invested this quarter in films approximately $66 million. Money going into Crank, Saw 3, Daddy’s Little Girl, we lost to invest actual cash-outs. It cost me $66 million.

The flip-side, then you have the changes of the working capital contributed about $55 million, primarily coming from increases in accounts payable, with comp associated with titles, unreleased titles and AP for Employee of the Month and Saw 3, increases in deferred revenue of about $13.9 million coming from Wildfire, Crank, and a decrease in AR of about $6.8 million, which generated more free cash flow.

Those are actually the components that will drive the free cash flow numbers.

Barton Crockett - JP Morgan

Okay, great, that is helpful. Thank you.

Operator

Thank you. Our next question is from David Miller. Please go ahead.

David Miller - Sanders Morris Harris

Hi, a couple of questions. Steve Beeks, if you are on the call, you did not mention the library-oriented revenue number, but can you talk about how library-oriented free cash flow margins came in in the quarter? Are you pleased with the improvement there year over year?

Then, in the television business, in this year’s fiscal Q2, what percentage of the 11 new series began airing episodes in the quarter? Then I have a follow-up. Thank you.

Steven Beeks

David, our library revenue in the first-half of the year, revenue contribution, P&L margin and the free cash flow generated by the library, are all up compared year to year in the first six months. So yes, we are satisfied with the results in the first-half of the year. As Jon mentioned before, we are on track to hit $200 million and generate and hit our projection of $70 million plus in free cash flow for the full year, coming out of the library.

Jon Feltheimer

In terms of airing, David, I would have to go back and look at the list. As you know, most of the new series we talked about are all back-loaded into third and fourth quarter. The issue when we deliver, it is not when we air it that when we report, it is when we deliver. I would have to go back over the -- the new show we are doing with Mr. T hit this past month. I am not even sure that is in the quarter -- the deliveries would have been in the quarter. Again, you asked about airing.

David Miller - Sanders Morris Harris

You could do delivery, if you have the deliver number, that would be great too. Do you happen to have the delivery number, in terms of what percentage --

Jon Feltheimer

The episodes delivered?

David Miller - Sanders Morris Harris

Yes.

Jon Feltheimer

You know, we will have to do that offline with you.

David Miller - Sanders Morris Harris

That’s fine, that’s fine. Just a quick follow-up, I just want to make sure I heard you correctly, you are reiterating all guidance benchmarks for the year but you are reserving the right to guide up next quarter when you just have a better sense of the economic contribution from FEARNet? I just want to make sure I heard you correctly.

Jon Feltheimer

I don’t think I said it that way. What I laid out is that we will be, given that we closed the deal now, that we will most likely be taking a loss in the fiscal year that is unbudgeted. For FEARNet, what we are still trying to figure out is what that is and how much mitigation we have against the licensing money and when that will come in. Overall, I would say the commitments that we have to FEARNet is around, over the next three years, is around $13 million or so. That is our commitment to fund over the next two or three years.

In terms of an overall licensing deal with Comcast, we will come to probably a number larger than that. There may be some opportunity costs attached to that, but again, a tremendous amount of that investment will be mitigated by incremental licensing.

So what I said is that we are definitely over-performing in our core business and our plan is to try to make up any non-cash, non-recurring or unbudgeted, mostly FEARNet losses, through that over-performance but it is just too early to forecast.

David Miller - Sanders Morris Harris

Okay, great. Thanks very much.

Operator

(Operator Instructions)

Our next question is from Alan Gould.

Alan Gould - Natexis Bleichroeder Inc.

Good morning. Thank you. I have two questions. First, following up on FEARNet, when you are talking licensing, I assume you are talking about licensing your movies on to the channel. Do you expect it to be dollars per movie or a piece of the VOD advertising stream or Internet advertising stream that those movies are generating now that that’s trackable?

Second question is with respect to TV, Jon, could you give us any preliminary thoughts what the off-network syndication revenues per episode could be for a Weeds, for a Wildfire, for a Dead Zone, or any of your other promising series?

Jon Feltheimer

In terms of FEARNet, actually there are two components to what we are doing with Comcast. One is a licensing agreement for the channel, and that is not on a speculative basis. There is a firm number per year for five years for that, so it is not based upon advertising. Then there is a second component which we are still working out with them, licensing for their other VOD platforms, so those are two components, but there will be firm numbers attached, not speculative based upon ratings or advertising or views.

The second is the numbers are a very wide disparity. Cable to cable syndication for something that is just a moderate performer could be as low as $50,000 to $100,000, and I honestly believe if Weeds continues the way it is going and it is the kind of hit that Sopranos or Sex in the City are, you could easily be talking about well over $0.5 million an episode.

Alan Gould - Natexis Bleichroeder Inc.

Thank you.

Operator

Our next question is from Eric Handler. Please go ahead.

Eric Handler - Lehman Brothers

Thank you. Two questions. One, can you give us a sense of what your digital revenue was for the quarter? Meaning digital downloads from any of the platforms across the Internet, and how that compares to let’s say the prior two quarters?

Also, Steve, could you give us a sense of your G&A going forward? Are you returning to a normalized let’s say $15 million level, or should we look for $20 million plus over the next couple of quarters?

Steven Beeks

In terms of your digital question, Eric, at last count, we are in various stages of discussion, active negotiation. We are actually in business with 29 entities that are either now or will be engaged in digital delivery of some sort. As we mentioned before, we are in deals now with Cinema Now, Movielink, and Amazon, and there are probably two or three new deals announced in the next few weeks.

The revenues on our titles from all the retailers currently in the business are up quarter to quarter. On iTunes, for example, revenue on Weeds downloads is up 35% from the prior quarter, and part of that is of course fueled somewhat by the second season is on there.

The revenue from Cinema Now is up over 100%. A significant amount of that growth is coming from their download-to-burn capability. We are now providing them with select titles for download-to-burn on a day-on-date basis with the release of the film on DVD. I think that is going to spur their business on. The first film for which we allowed day-on-date delivery was An American Haunting, which we released two weeks ago.

We have mentioned in the past we project digital delivery, including electronic sell-through of VOD and download-to-burn, to account for approximately 10% to 15% or more of the home entertainment market by the year 2010. Virtually all of this business will not only be accretive but will also result in overall growth in the home entertainment pie, and will also be at much higher margins, when you compare it to packaged media due to the lower cost of the supply chain.

James Keegan

I will take the overhead question. You have seen the overhead number go up. We have had a couple of increases obviously with the bringing on of LG U.K. and Debmar. That will cause a slight increase.

But the real increase you will see is coming from our stock appreciation rights, stock option expense and stock expense. Those items are now flowing through at a fairly high level, so you might see a slight up-tick from those non-cash stock appreciation option expenses.

Eric Handler - Lehman Brothers

Great. Thank you.

Operator

Thank you. Our next question is from Andy Nasr. Please go ahead.

Andy Nasr - Raymond James

Good morning. What kind of numbers do you need to see at FEARNet before you contemplate a linear offering? I was wondering if you could tell us how many upcoming wide releases are included in the MG productions obligations portion of film obligations and how you see that number changing over time.

My last question is, is it safe to say that TV margins will kick up in fiscal 2008 due to the Debmar contribution and syndication revenues?

Jon Feltheimer

Jim, why don’t you go first?

James Keegan

What I envision happening in the MG portion of the film obligations, that the net cash out for the year will be the same, but it is possible -- okay, I do not anticipate the participation obligation vary much year to year. I see that as fairly constant. I see the MG and other portions, it actually could go up within the year, but the offset to that is the increase in investment and film, so it is probably cash neutral as I put a liability on the books there. Until the film is delivered, I do not pay for it.

I put it on the books, the investment in film. MG’s may go up, but actual cash out for the year will remain constant.

Jon Feltheimer

In terms of FEARNet, we already have been working on a linear plan, and that plan going forward is not really contingent upon numbers, if when you said numbers you mean sort of the success on VOD or in broadband. It is more contingent upon a business model that we all feel, the three partners feel makes sense and that really will be all about whether DirecTV and Echostar and the telcos and mostly Time Warner all believe and agree that this is an exciting venture for linear, not just VOD.

Again, our deal with Comcast mirrors a typical linear channel in the sense of subscriber fees after a short free period. So we believe we have a very, very successful economic model without a linear channel.

In terms of TV margins, I think two things are happening. One is obviously as we move to with Wildfire, with Weeds, with Dead Zone, a syndicate-able number of episodes, our margins are going to improve as we increase the ultimate or even add an ultimate where we do not have one for the back-end.

The second thing is if TV has been typically around 10% margin business, Debmar’s numbers probably will look closer to 20%, so if we add 50% plus revenue, I can pretty much assure you that our overall TV margins will be going up.

Andy Nasr - Raymond James

Great. Thank you.

Operator

Thank you. Our next question is from David Bank. Please go ahead.

David Bank - RBC Capital Markets

Thanks. Good morning. A little follow-up on the free cash flow reconciliation. If you could drill down, what we have for the quarter is the sort of net combined impact of payables, receivables and deferred revenues of $55 million. Jim, I know you gave us a little bit of color on it, but particularly the payables number is contributing about $34 million of free cash in the quarter, where total free cash is $24 million. Could you tell us how the payable number is sort of likely -- are we going to see that kind of decline in the next quarter? Could you give us a little bit of sense on payables and deferred revenue for the next quarter or two?

The second question is for us, we were a little light on the theatrical, the TV contribution in theatrical. Part of what you guys said in the press release was the strength in Lord of War and in the mix in particular, aside from Saw 2 and Waiting. I thought that those movies were not particularly sort of blow away box office movies. What was it that -- why were they such big drivers on the TV theatrical side?

James Keegan

First I will address your accounts payable question. If you go back to the same quarter comparable last year, because we do not do a comparative balance sheet, AP in September ’05 was 151.3. We are up to 159.4. AP in December went up to 187 of last year. I might anticipate a similar flow of AP this year to last year, so I would actually anticipate probably a growth on the AP and then it held constant at that level. March ’06 was 188.8. I could see AP continuing to grow, and that is really due to the timing of the releases and the P&A expense.

Second, please take note of the large backlog number we have. We will have lots of cash coming in generated from that backlog. The backlog, as I indicated before, was like $80 million TV, the balance was obviously coming from motion picture. The motion picture backlog is primarily from the Showtime revenues. That will come in in large lump sum cash sums.

David Bank - RBC Capital Markets

Okay, so you are saying that AP could conceivably continue to contribute similar levels to the cash flow statement, but the backlog starts to generate additional cash?

James Keegan

I am actually saying we were -- I am saying AP year to year will probably end up about the same place at March 31 ’06 to March 31 ’07.

David Bank - RBC Capital Markets

Okay.

Jon Feltheimer

In answer to the other question, and Jim, correct me if I am wrong, but as we have said numerous times before, it is interesting that in the short run, losses, failed pictures, or what we call NRVs, hurt us much more than the success actually helped us in the short run.

With the pictures you talked about, in terms of in the mix, we wrote off in the mix previously so then as we get revenue in down the road, obviously it becomes very profitable revenue for us. Actually, Lord of War, again, people focused so much on the box office. Lord of War is a very, very profitable picture for us, a very high return on investment and a very profitable picture because it has performed so significantly in terms of home video.

David Bank - RBC Capital Markets

Yes, but that is during a profit line, but I thought you guys got paid as a function of a multiple of the box office. That is why -- you said strong theatrical titles. Was there some sort of revenue out-performance versus what you would have expected, given the box office?

Jon Feltheimer

Yes, that is actually right. Our conversion right, it is something we talk about a lot. Our overall conversion rate right now is about 1.19 compared to studios at about 1.05. If you continue to see the mix of product that we have, we are very focused on that over-conversion because, as I said before, we are not trying to win the box office race every single weekend. Steve, what is the final conversion rate on Lord of War?

Steven Beeks

Lord of War converted approximately 180%, 182% when you compare DVD revenue to box office, so a very high performance. Actually, Waiting, the other picture that you mentioned, will approach the same number. A huge over-performance on both of those pictures.

Jon Feltheimer

Yes, I remember when Jim Kramer was excoriating us for changing our business model by doing Lord of War because we paid a little bit more, and it was true. We did pay a little bit more for the MG, the minimum guarantee, than we had typically paid before, but again, there was a method to our madness.

We knew, we had examined the record of Nic Cage at video and his conversion rate is extremely high, so this was not unanticipated of us. This was an expectation of ours. We performed slightly lower at the box office than we expected, but really pretty much the way we expected in terms of the conversion rate in video.

David Bank - RBC Capital Markets

Okay. Thanks for the explanation, guys.

Operator

Thank you. Our next question is from Matthew Harrigan. Please go ahead.

Matthew Harrigan - Janco Partners

Could you talk a little bit about the prospective equity partners you may be taking on some of the in-house production? I assume you are retaining complete autonomy on the marketing decisions and such, because your template for the business is different than other peoples, and I assume it is probably more -- I do not want to say hedge funds, but people other than other studios.

Secondly, I know it is harder to move the numbers now that you are a much larger company, but I assume that some of that is implicit commentary that the festival business is just really tough now, so many people competing for films. You are looking for a little bit more kick internally?

Jon Feltheimer

The word in the entertainment business, complete autonomy, that does not sway.

Matthew Harrigan - Janco Partners

De facto autonomy, let’s say.

Jon Feltheimer

Well, we treat our producers and all of our creative partners as partners in the marketing, but yes, I do not believe we have any deals where we just stand by and let the money dictate what we do in terms of marketing.

We have a deal, for example, that was recently announced with Sam Nazarian, who is delivering a number of pictures, including Pride, for us, and the deals all vary. Some pay for part of the equity, all of the equity. Some pay for part of the P&A and some pay for actually all of the P&A.

Each deal is different, but essentially we do maintain the control of the marketing. There are, we have mentioned at the end of my remarks that we have been exploring some very interesting slate financing deals which include both equity and P&A, and I hope to be able to discuss very shortly some of those with you.

In terms of the festivals, I will let Michael answer that.

Michael Burns

With all the influx of money, whether it be hedge funds or slate financing or private equity coming in, that is the good news for us. It is important to note when we go to a festival, and it was not this way about six or seven years ago, we are invited into every negotiation for every picture. Remember, when you look at a festival like Sundance, with over 6,000 or 7,000 pictures submitted for consideration, and where they maybe pick 80 pictures, and then 10 of those pictures you will hear of, five of those will go on to actually do box office.

What I will tell you is that it is the usual suspects that are invited into bid for those pictures, and we have had great success, frankly because of our track record and our reputation for not over-spending and actually having back-ends for the profit participants. That has turned out to be a great competitive advantage for us.

Matthew Harrigan - Janco Partners

Well, I am already a FEARNet user, so congratulations on that.

Jon Feltheimer

Thank you.

Operator

Thank you. Our next question is from Michael Kelman. Please go ahead.

Michael Kelman - Susquehanna Financial Group

Thanks. Could you talk a little bit about your intentions with the Image Entertainment stake now that the board beating has been completed? Also, on a similar front, clearly you have demonstrated an appetite for doing these small, tuck-in acquisitions like Red Bus and also Debmar-Mercury. Could you talk about other areas you may have interest in that could help round our your portfolio of assets?

Michael Burns

I will take the Image stake. We did not win the proxy battle, although I thought that as far as the unaffiliated voters, that we were pleased with the percentage that we received. We still have our Image stake. We are consistently evaluating what to do with that. All I can say in a very specific answer is to stay tuned there.

Jon Feltheimer

In terms of other investments or areas that we are looking at, as I said today, one thing that we are going to most likely do is self-distribute in Australia. It was always part of the plan. English speaking makes a lot of sense to us. We are sending a great entrepreneur over there, Simon Franks, to work on it. We are already well ahead with our plans there and I think that is going to be an exciting new expanse into another market for us.

We are looking at some interesting TV assets. Again, one of the things that we did over the last three years was build a diversification of our free cash flow of our revenues from television to business. I know pretty well -- don’t be surprised if you see us playing in that area as well.

And numerous other things, including of course we are always looking for great library and we are always looking for great partnerships.

Michael Kelman - Susquehanna Financial Group

Thank you.

Operator

Thank you. We have time for one more question, and we will go to the line of David Joyce. Please go ahead.

David Joyce - Miller Tabak

Thank you. Could you just help us think about the home video drivers for the next quarter and through the rest of the year, in terms of the timing of some of the bigger pictures that would feed into that? Some other notable direct-to-DVD?

Steven Beeks

Over the next couple of quarters, the films that Jon mentioned before will be coming to DVD. The Descent will be released on December 26th, and then in the final quarter in Q4, we will be releasing Crank, Employee of the Month, and Saw 3.

Probably the biggest direct-to-video, direct-to-DVD release in the fourth quarter will be Iron Man, which is the third in the Marvel franchise. The first two have been successful beyond our expectations and we expect the same kind of success with Iron Man.

Those are the bigger releases coming out in the next few months.

David Joyce - Miller Tabak

Thank you.

Jon Feltheimer

Thank you, everybody. We will see you next quarter.

Operator

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