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Lions Gate Entertainment (NYSE:LGF), a company in which I've held shares for a while without much movement, had a few interesting pieces of news out yesterday.

The first is that they're finally (after "hinting" about it many months ago in a conference call) going to have their films available on iTunes. So those who want to watch the films from the Saw franchise, which has grossed close to $500 million at the box office in three installments, can now do so in the privacy of their own iPod. It remains to be seen if it's more disgusting on the tiny screen than it is in the multiplex.

And the second is that Lions Gate, perhaps in a related move, raised its forecasts slightly for the year. The earnings for last year, released last week, were slightly disappointing - more or less in line with analyst estimates, which is about all you can hope for from an entertainment company that didn't have any surprise breakout hits last year.
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The shares still aren't particularly cheap, at a trailing PE of about 50 and a forward PE of about 25, but if you look at cash flow instead, the shares are getting more reasonable. Going with their new estimates, the shares now trade at an enterprise value (over $1.5 billion thanks to a fair amount of debt) to free cash flow (projected at $100 million this year) ratio of about 15. That's still above what private equity folks are likely to want to see in their investments, so I'm not arguing that the shares are cheap or primed for a buyout, but they're getting more reasonable.

Investing in Lions Gate continues to be a bet on a few things:

First, their library of filmed entertainment is now one of the strongest in the industry. They've opened up another distribution channel with their iTunes deal that may help them to monetize this library, but any investors in the company, myself included, are now counting on continued deals like this for internet delivery, video on demand, and next generation DVDs to boost value. If you believe that "content is king," Lions Gate should have a great future.

Second, Lions Gate is developing into one of the more important studios in Hollywood - if they can continue developing niche films that are profitable, they should be able to count on a much steadier earnings profile over time. Unlike most studios, they don't plan their year around one or two "tentpole" event films that they hope will become blockbusters and prop up all their unprofitable ventures. Instead, they focus on buying and developing inexpensive films, without massive marketing budgets, that appeal to niche audiences and have a very solid chance of profitability (with a few breakout hits in there, odds willing, to spice things up). Another Oscar win as with Crash, or another hugely profitable franchise like Saw, could be just around the corner (or not).

And third, of course, is the potential for a buyout to rapidly monetize the value of the library. Richard Dorfman had an interesting note last Spring on Carl Icahn's investment in the company, and the potential for the shares. He has a good analysis of why film libraries are valuable, and also notes the earlier sales of MGM and the Dreamworks (NASDAQ:DWA) library as potential indicators of the outsize value locked up in Lions Gate's library. I don't know if Icahn has been working on this at all in recent months, he's clearly been focused on other things, but according to the filings I've seen he still owns about 4% of the company. There are also some big chunks held by institutional investors, including the American Funds folks with about 10%, among others, so it's certainly possible that something could develop fairly quickly along these lines.
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And as a small aside, it's always possible that they'll make some money off of their investment in Image Entertainment (OTC:DISK). They tried and failed to take the company over, including a proxy fight that they lost last fall, but they still own (as of the last filings I've seen) close to 20% of the company. The company has been awful for quite a while, but their DVD distribution business is a good fit with Lions Gate, so we'll see if any value ever comes from that.

This remains an interesting story for me; a company with weak but slowly improving financials, that is widely understood to own significantly undervalued assets. Unfortunately, since these assets are films, and valuing them depends on your guess about future distribution streams for older movies, the valuation is far from definitive and any unlocking of that value will probably depend on an outside buyer, unless you have the patience to wait for the company to grow, through current film and TV production and new distribution streams, into a stronger operating business. That does seem to be happening, but absent a string of surprising hits in the near future it's likely to take a while.

Disclosure: I sold a small portion of my LGF holdings back in August, but continue to hold shares and don't plan to buy or sell in the near future.


LGF 1-yr chart

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Source: Lions Gate Entertains in New Ways