Lionsgate Entertainment: In Line with the Times

Watching the movie that is described as the best western since Unforgiven, 3:10 to Yuma reminded me of the British movie Lock, Stock and Two Smoking Barrels, despite the vastly different genres these movies come from. The first half of 3:10 to Yuma was slow; taking its time to establish characters but then brilliantly executes in the second half. Investors who follow the stock of Lionsgate Films (LGF) will recall that the theatrical release of 3:10 to Yuma last fall helped Lionsgate's stock register a nearly 15% jump in share price from $9.34 to almost $11. The stock has since settled down lower partly because of market conditions, partly because their aging Saw horror movie franchise (part 5 is due out in October 2008) has lost the punch of the first two parts and partly because the Hollywood writer's strike was affecting all movie studios.

Getting visibility into the drug pipeline of a large biotech like Amgen (AMGN) can be difficult, but the same cannot be said of movie studios like Lionsgate. Looking into the movies Lionsgate is slated to release in the next couple of years, it appears that The Bank Job and Harold and Kumar 2 could ring up high box office returns while Rambo (or Rambo 4 as it is known in India and Singapore) might register good DVD sales. Harold and Kumar 2 is a movie produced by Mandate Pictures, which was acquired by Lionsgate in August 2007. It will also be interesting to see how Ayn Rand's book Atlas Shrugged translates to the big screen, especially with Angelina Jolie playing the role of Dagny Taggart.

Sales of the 3:10 To Yuma DVD have been strong and more than two years after its release, Lionsgate's brilliant Academy Award winning movie Crash remains at the top of Blockbuster Online's list of most rented movies. In true Lionsgate fashion, the company has decided to gain maximum mileage from Crash by teaming up with Starz Encore to release a 13 episode TV series based on the movie. The Crash mini-series will join two other critically acclaimed Lionsgate series "Weeds" and the recent Golden Globe winning "Mad Men".

However, the value in Lionsgate lies not in the next high grossing movie it might release or the next Oscar winner like Crash, but on account of The Long Tail of movies through its rather large library of movies. Every new digital delivery service could mean potential revenue for Lionsgate and while Apple's (AAPL) entry into movie downloads may not bode well for Netflix (NFLX) or Blockbuster (BBI), it will help studios like Lionsgate. In fact Lionsgate expects revenue from digital delivery to increase from less than 1% right now to almost 15% by 2010. The company also expects to benefit from the decision of most movie studios to back the high definition Blu-ray format, after Toshiba (TOSBF.PK) accepted defeat in the Blu-ray vs. HD DVD war. High definition DVD sales are expected to triple to $1 billion in 2008 from $300 million in 2007.

The Numbers:

I think a big concern for investors like me was how Lionsgate will hold up next quarter when its results are compared to the quarter ending March 2007, which included a big jump in DVD sales after Crash won three Oscars last year. I expressed this concern when I wrote the blog entry Stocks That Almost Made The Cut: March 2007 last year and have been periodically checking in on the stock since then. It looks like investors who were worried about the fourth quarter results (Lionsgate's fiscal year runs from April through March), were reassured when Lionsgate announced that it expects to report more than $400 million in fourth quarter revenue, well above analyst estimates of $344.3 million. The company also revised upwards its full year revenue estimate to over $1.2 billion, giving the company a Price/Sales (P/S) ratio of just 0.92. The month of January was very kind to DVD sales of Lionsgate movies with the company capturing 4 out of the top 8 DVD titles in North America.

However, the news was not all positive. The company reported an 88% plunge in third quarter profits as it increased its marketing and film making budget. Despite the $110 million in free cash flow Lionsgate expects to post in full fiscal year 2008, the company will still report negative earnings for 2008. Things are expected to get much better in fiscal 2009 (ending March 2009) as the company expects to report earnings before interest, taxes and amortization [EBITA] of $64.3 million. Assuming no taxes on account of the fiscal 2008 loss and interest plus amortization of roughly $20 million (interest in Q3 2008 was $4.09 million), we get earnings of approximately $44.3 million and a forward P/E of 25.06, which is a little lower than the forward P/E of 28.53 reported on Yahoo Finance. Please note that these are rough calculations based on assumptions and a lot can change in terms of earnings or the debt on Lionsgate's balance sheet.

A forward P/E of 25.06 may appear a little on the expensive side especially in this market until you consider that the company expects revenue growth of 25% in fiscal 2008, generates strong cash flow from operating activities and has maintained a 30% annual growth rate since 2000. Lionsgate also sells for a much lower Price/Sales and Price/Free Cash Flow ratio when compared to competitors Dreamworks Animation (DWA) and Marvel Entertainment (MVL).

Interest in Lionsgate has been building recently with a few institutional funds acquiring shares. The stock actually posted a 2.17% gain last Friday when almost everything was getting butchered and the Dow dropped 315.79 points. The company's earnings are volatile and the stock is equally volatile but exhibits a lot of support at the $9 level.

The Good:

• Various business units at Lionsgate films ranging from movies and home entertainment to stage plays such as Dirty Dancing appear to be executing well.
  
  
• The Long Tail of entertainment is clearly working in Lionsgate's favor. The company's growing library of films and TV serials such as Weeds and Mad Men is expected to generate $90 million in free cash flow on $250 million in revenue in fiscal 2008.
  
  
• Movies such as 3:10 to Yuma, War, Good Luck Chuck and Saw IV helped Lionsgate capture 4 out of the top 8 DVDs sold spots in January.
  
  
• The Saw and Tyler Perry franchises have proved highly successful for Lionsgate with the Saw franchise alone bringing in over half a billion dollars in revenue worldwide. Lionsgate expects to capitalize on the success of Crash by launching a 13 episode mini-series in partnership with Starz.
  
  
• The company expects to increase its cash and cash equivalents to $350 million by the end of fiscal 2008 and is attractively valued with a forward P/S of 0.92 and Price/Free Cash Flow of 10.

The Bad:

• Lionsgate's earnings are volatile and the company expects to report a net loss for fiscal 2008 ending March 2008.
  
  
• The aging Saw franchise may not deliver the kind of returns the first four parts delivered.
  
  
• Increasing digital delivery of content and piracy will cannibalize DVD sales.
  
  
• Lionsgate's balance sheet may not appears very strong on first glace with nearly $600 million in long-term debt. However, almost $269.37 million of that is film obligations and the rest is convertible bonds at a cost of capital of just 3.31%. The company expects interest from its cash position to cover the interest payments on the debt and with closer inspection, the debt does not seem so bad.

Disclosure: I currently hold a small position in Lionsgate and will add to my position after this newsletter goes out to subscribers.