Lionsgate Entertainment: Misunderstood, Too Cheap to Ignore

Jun.10.08 | About: Lions Gate (LGF)

Lionsgate Entertainment (NYSE:LGF) is the most misunderstood media company on the planet and I present here my reasoning and analysis on why I think the shares are particularly cheap and why I believe they will appreciate in value over the next few years, despite remaining in a tight range over the past 3 years. For disclosure, I have been a long time bull on Lionsgate, which has been dead money for the past 3 years. I think LGF is ready to break out of this trend, and that is why I have decided to put my thoughts to words.

For overview purposes, Lionsgate is a producer and distributor of original and purchased content. In the past 5 years, LGF has amassed an enormous library of content to distribute: according to its most recent proxy, as of March 31, 2008, LGF distributes a library of approximately 8,000 motion picture titles and approximately 4,000 television episodes and programs. Lionsgate refreshes this massive library with about 18 to 20 new box office pictures per year, approximately 80 direct-to-dvd movie features, and countless new television episodes, including Showtime’s hit series Weeds, AMC’s new award drama Mad Men, ABC Family favorite Wildfire, USA’s former top show The Deadzone, NBC’s new horror anthology Fear Itself and coming soon to Starz, Lionsgate’s Best Picture winning Crash is being adopted for a new tv series. These titles are just a few of what LGF puts out each year, and will be discussed later on.

Often, investors in Lionsgate believe that one particular movie or show will have a significant effect on the company’s value; but this is no longer and not even close to the case. While the Saw franchise and Tyler Perry movies continue to provide support to LGF’s release slate, the company is more diversified than people realize. By 1) expanding their slate, 2) taking on new and larger financing partners, 3) diversifying their business to include a larger television and international segment, 4) often pre-selling foreign rights, and most importantly 5) budgeting their movies in a cost-effective way to prevent large losses, Lionsgate has dramatically minimized their risks to any one picture or title. It is also true that they have minimized their gains to any particular title as well, keeping in mind that if a success leads to a new franchise, it can still be dramatic.

ionsgate’s management has described this as “swinging for singles and doubles.” Taking their analogy further, by “swinging for singles and doubles” rather than homeruns, LGF doesn’t strike out much. In fact, by taking their conservative approach, even many of their box office flops, eventually become profitable via dvd, television, etc. Some examples of this over the years have been Lord of War, Good Luck Chuck, Larry the Cable Guy (including his Delta Farce) and recently Jet Li and Jason Staham’s War. In fact, LGF’s DVD to Box office ratio, during calendar 2007 was a full 20% above the industry average. Below, I break down the analysis into certain categories that reflect my reasoning:

Valuation

OVERALL: Currently, LGF has an enterprise value of only $1.12 billion. As a result of a large increase in the size of their cash pile in fiscal 2008 (which ended on 3/31/08) and a mediocre performance of its stock price, LGF is trading at an ultimate value close to its lowest range over the past 3 years. In my opinion, this doesn’t reflect the performance of the company. For the past four years, Lionsgate has consistently produced near or above $100 million in Free Cash Flow [FCF]  per year, with its most recent year being at $137 million in FCF. At $137 million, Lionsgate is currently trading at an enterprise value over trailing FCF of close to 8, which is close to 1/3 the value of Marvel, and lower than any other studio I have looked at (understanding the fact that most studios are part of conglomerates, it is hard to identify).

Given LGF’s performance, which I will discuss, and the fact that they are a pure-play, LGF should be trading at a premium, not a discount. Over the past 3 to 4 years, LGF has produced average Revenue gains of over 30%, including a 39% gain over the past year, and CEO John Feltheimer recently said he expects double-digit revenue growth to continue this year. Free Cash flow has increased from $95.5 million in 2005, to $137 million in 2008, or a greater than 40% gain in 3 years, with proven consistency. In addition, LGF ended fiscal 2008 with $371 million in cash on their balance sheet, which is greater than their debt of $328 million, all of which is in the form of convertible bonds with a fixed and blended low interest rate of around 3.1%, and predominately a conversion ration of about $14 per share, decreasing fears of dilution. The Company has also announced a $100 million share repurchase program, of which only $20 million has been used.

Many Wall Street analysts and retail investors do not understand LGF because they simply do not put in the time, and often focus on Lionsgate’s EPS numbers. I cannot hide the fact that the EPS numbers have been bad, in particular this past year, losing 62 cents per share. However, this is the wrong way to focus on Lionsgate as a long term investor. Lionsgate, which earned positive income in 2005, 2006 and 2007, lost money on an income basis in 2008 for 2 main reasons, both of which are related: 1) Lionsgate greatly expanded their film slate and 2) accounting rules that affect how movie’s account for their financing of films.

First, what makes content a unique property is that it maintains value and brings in revenues for YEARS while its costs are almost all incurred upfront. Eventually, for a classic title in LGF’s library, costs simply include residuals and the particular blank DVD and boxing. LGF still sells about 100,000 copies of Dirty Dancing per year. However, due to some GAAP accounting rule, LGF, like other studios, expenses their Print and advertising costs immediately when they recognize motion picture revenue solely from the box office. This means that despite the fact that a film will bring in revenue to Lionsgate over the next 6 to 8 years (often more), LGF must immediately expense one of the largest costs of producing the film (P+A). This skews LGF’s EPS numbers when they decide to increase current distribution, which they have done. For a reference point, 6 out of LGF's 12 highest grossing films were released between August 2007 and April 2008.

In addition, LGF has successfully negotiated 2 very valuable film and television financing funds. Under these funds, LGF is reimbursed for close to half of some of their productions by the fund (if the film doesn’t provide the necessary revenue first), but despite this fact, they must expense the full cost of these pictures themselves. While the fund is a very positive tool for LGF (b/c production and P&A costs along with a distribution fee for LGF is taken out before the fund’s partners get paid and b/c this financing has enabled LGF to produce more films which diversifies their results), it has currently had a negative effect on EPS. Nevertheless, LGF’s CEO has said that last years pictures, b/c many of the costs have already been expensed, will result in a large swing back to positive EBITDA.

For these reasons, most importantly that LGF’s products produce revenue over the course of years and not days or months, Free cash flow should be the appropriate measuring tool, and at about 8 times free cash flow, LGF is super cheap, especially considering its growth prospects.

VALUE OF LIBRARY: Lionsgate’s growing library has consistently produced about $250 million in revenue and about $90 million in free cash flow, last year the numbers were higher at over $260 million in revenue and about $100 million in FCF. Many people considering the jewel of the value of Lionsgate. Many industry followers value libraries at 10 to 12 times cash flow, b/c of their high margins. This would mean that LGF is currently trading at about the valuation its library should be valued at, giving an investor LGF’s future operating business (including some of its franchise hits such as SAW, Tyler Perry and Weeds), as well as its stakes in break.com and fearnet completely free.

Successful Acquisitions and pPojects

Lionsgate has made 2 important and very successful acquisitions over the past 2 years.

The first was the purchase of Debmar-Mercury, which has become a powerhouse in the TV distribution and syndication world, including distributing South Park, Tyler Perry’s House of Pain, Deadzone, and Deadliest Catch. Debmar has also been in the process of securing world-wide syndication deals for a new show based on Hasbro’s Trivial Pursuit.

The second successful purchase was of Mandate Pictures. Mandate was one of the main producers of Juno. Since LGF purchased Mandate before Juno’s release, LGF should see significant contributions from the movie, which the CEO has estimated to be “high teens double-digit millions.” Mandate has also been involved in the Harold and Kumar Franchise, which just put out its second movie, which should be very profitable ($12 budget, did $37 million + box office and should do very well on DVD). Mandate also owns ½ of Ghost House Pictures (the other half run by Sam Raimi), which has been involved in The Grudge I and II, 30 days of the night, and most recently The Strangers. Mandate also has a very successful third-party international sales team that has contributed greatly to LGF. Mandate allows LGF to be involved in 4 to 6 additional pictures per year without incurring the Print and Avertising costs, as Mandate's pictures are actually distributed by others on purpose for this result.

Lionsgate has also purchased an over 40% stake in video-streaming website break.com, and a 40%+ stake in platform-distributor Roadside Pictures, which recently distributed Bella (which has had a very successful box office and dvd run for a platform release). Lionsgate has made these purchases without increasing their debt. Some of the purchases involved issuing additional stock, but for the most part, the stock was trading at higher valuations than it is now when it was issued, and Lionsgate has authorized a $100 million share repurchase plan. During this time, Lionsgate’s cash pile has grown from less than $50 million to $371 million.

Childrens' and Direct-to-DVD Business

While LGF is known for their horror, they have a significant childrens direct-to-dvd business. They currently distribute all of the Bratz movies, old school Teenage Mutant Ninja Turtles, and have a huge chunk of Marvel’s business, distributing the animated and direct to dvd titles such as Iron Man, Ultimate Avengers (1 and 2), Hulk, and many others. As Marvel’s theatrical business has taken off, this will undoubtedly provide LGF with some value on these titles. Lionsgate has recently signed major deals with HIT Entertainment, Leapfrog Enterprises and Nickelodeon, and most recently the Little Tykes brand. LGF distributes famous titles such as Thomas and Friends, Bob the Builder, Barney and Angelina Ballerina, as well as such newly acquired brands as Fifi and the Flowertots, Aardman Animation's "Wallace & Gromit" and the Jim Henson Co.'s "Fraggle Rock." Lionsgate’s latest agreements are supposed to increase their share of this market from 9% to 15% and could account for over $100 million in new revenue this year. For more information, click here: LGF Mixes Horror and Kids

In addition, I would just like to point out LGF’s share of the Fitness Market. Their DVD’s entitled The Biggest Loser 1 and 2, Dancing With the Stars, and Jillian Michaels have at various and continued times been on the top of Amazon’s best seller DVD list over the past few years.

Activist Potential

Mark Rachesky, formerly Icahan’s Chief Investment Officer from 1990 to 1996, who currently runs his own fund, has amassed an approximate 14% share in Lionsgate. In addition, his former boss Carl Icahan, owns about 3.6% of LGF. Icahan has held his stake for a few years now, but has yet to make any comments regarding it, while Rachesky has continued to build his position, as most recently as March.

Next Quarter’s Comparisons

....Will Be Easy to Beat 

Last year, Lionsgate had a poor quarter ending June 31, 2007. That is not the case this quarter, with continued momentum in their DVD sales/rentals and the success of DVD launches of Weeds, Rambo, Why Did I get Married, box office releases of The Bank Job, Meet the Browns and Forbidden Kingdom, and direct-to-dvd releases including Chaos, fitness titles an Wristcutters. Analysts have increased their revenue projections for this quarter to about $294 million, already representing a 48.4% rise in year-over-year revenue. I personally believe LGF will beat this target and have revenue exceed $300 million for the quarter. In addition, last year, the current quarter resulted in an EPS loss of $0.45 per share. This should narrow significantly this year, with a chance of near or break-even potential.

LGF has another ambitious slate coming out this fall and winter, and has recently decided to join MGM and Viacom in the creation of a new joint-venture cable television channel. Both of these factors do provide some risk, but both could help Lionsgate continue to grow even further (for more in depth analysis of the risks of the TV channel see Lionsgate is the Cat’s Meow).

If LGF continues to produce and grow their cash flow, this stock has enormous potential. At a multiple that should be closer to 12 times cash flow, LGF should be trading at $14 per share.

Disclosure: I am Long LGF stock and calls.