Image Entertainment Heads Back to the Auction Block

Includes: DISK, LGF.A
by: Thomas Kirchner

The collapse of Image Entertainment’s (OTC:DISK) buyout by David Bergstein sent its stock down 43% to a 5-year low on Friday. It now trades at less than half the $4 that Lions Gate Entertainment (LGF) was willing to pay before being outbid by Bergstein. The exact cause for the collapse of the transaction is a mystery to us, because financing, the usual culprit in the current M&A market, was much more solid than in most private-equity backed deals that have failed recently.

At the current level, Image Entertainment trades at a fraction of the price that Lions Gate was willing to pay, and we believe that it remains an attractive acquisition target for a consolidator, in particular in light of its rapidly growing Egami digital distribution platform.

David Bergstein’s BTP topped Lions Gate’s offer with a $4.40 proposal, subsequently increased to $4.68 plus shares representing 6% of Image Entertainment, which would have continued to be listed. The transaction would have provided Bergstein with warrants for another 8.5 million shares and the ability to acquire preferred shares. This would have allowed him over time to squeeze out the remaining 6% held by the public.

The financing for the $125 million price tag was provided by hedge fund D. B. Zwirn ($60 million debt) and Bergstein (balance in equity). After shareholders approved the merger in October, the closing was postponed repeatedly without the company giving shareholders any specific reason. However, Bergstein has made deposits totaling $3 million with the last two extensions of the closing deadline.

Bergstein does most of his current deals in partnership with construction magnate Ron Tutor. In what looks like a classic rollup strategy, the pair acquired music holding firm Sheridan Square Entertainment as well as movie distributors ThinkFilm and Capitol Films in the UK. ThinkFilm allegedly cost $25 million, the price tag of the other two is not known to us. Bergstein also owns a sizable film financing business, Capco, and holds 38% of Image Entertainment’s stock.

Bergstein is in trouble over ThinkFilm’s Canadian operation because of its distribution of Canadian films in Canada. Canadian law prohibits foreign control of culturally sensitive assets, and Bergstein will have to divest this activity of ThinkFilm at some point, and some Canadian producers have instigated litigation against Bergstein’s firm because Canadian tax credits may have to be repaid due to the change in ownership. Image Entertainment would have been a nice strategic fit to his small media empire.

Rather than working on the prompt closing of the Image Entertainment acquisition, Bergstein spent the last few months wheeling and dealing left and right. In early January, he shelled out $11.5 million (including the cost of warrants) to acquire a 57% stake in troubled Munich-based production firm IM Internationalmedia. Canadian newspapers report that he is close to selling the domestic Canadian operations of ThinkFilm.

Bergstein will have to pay $4.2 million as a “business interruption fee” now that he has terminated the merger agreement - effectively a reverse breakup fee. However, he accused Image Entertainment in his latest 13D filing of violating the terms of the merger. He claims the company was obliged to:

obtain necessary approvals from its existing lender to permit the incurrence of $60 million of indebtedness to fund the cash consideration payable upon consummation of the Merger.

We were unable to find such a provision in the merger agreement. A person at Image Entertainment involved with the merger agreed with our suspicion that Bergstein simply made up the lender approval requirement as a lame excuse to get out of the $4.2 million breakup fee. Bergstein’s office did not respond to a request for comment.

Even more puzzling is this reason in the light of the proxy statement, which makes it clear that the $125 million financing consists of the Zwirn debt plus equity funding. Last time we checked, lenders didn’t provide equity. Maybe Bergstein should have thought of this problem before signing the agreement.

That leaves open the question why Bergstein wanted out. After all, Image Entertainment would be a good fit to his other businesses. His 38% stake has just taken a big hit. Cynics would argue that he may try to acquire shares in the open market at a lower price, which we think would only add to his legal troubles.

Image Entertainment remains an attractive acquisition target in light of its library of titles and its rapidly growing digital distribution platform. The Egami division grew last quarter by 193%, and at that rate should make a meaningful contribution to earnings in a couple of years. Until then, Image Entertainment will have to raise some funding or sell itself.

Due to the high probability of receiving the $4.2 million breakup fee, we recommend that management consider litigation fund as an option. It would be less dilutive than any other option. The company could receive additional damages from Bergstein’s baseless termination of lucrative distribution agreements, valued at $30 million. On February 1st, the merger agreement expires officially, and then Image Entertainment will be back on the auction block. The eventual sale should come at a steep premium to the current price.

Disclosure: Thomas Kirchner manages the Pennsylvania Avenue Event-Driven Fund [PAEDX], which holds shares of Image Entertainment.