Lions Gate Loves Libraries: On Entertainment One And Q1 (LGF.A)

Lions Gate Entertainment (NYSE:LGF.A) (NYSE:LGF.B) has been the recipient of many headlines over the last few months… some good, some not so, and, perhaps, some puzzling.

We’ll get to that. Let’s pull forward my current opinion on the stock: I continue to hold the stock with a bias toward adding opportunistically.

The stock is not for those investors who are faint of heart; it is speculative, with the speculation based mostly on a thesis of a buyout in my view. I’ll lay out all the risks later.

I’ll talk about the valuation, but with this case, I tend to look at the 52-week range more closely than some other metrics, given the buyout possibility. The share price has existed within a low of a 5-handle to a high of a 12-handle; right now, at the time of composition, we’re looking at a current 7-handle price. Closer to the low, which I like, with a little sideways-trading distance from it, which I like even better. Seeking Alpha Quant currently rates the overall valuation as an A, and I’ll point out a few positive metrics there.

As the company is primarily a buyout thesis in my opinion, there are only a few fundamental bullet points upon which to focus:

• Library revenue.
• Movie revenue.
• Cash flow.

Beyond those bullet points, there is one very notable event that took place since the last time I wrote about Lions Gate, and this I find much more significant than all of those topics (in a broad sense): the purchase of Entertainment One from Hasbro (HAS).

First, let me take up the library.

The Q1 report from August 9 said the library of filmed-entertainment assets nearly reached $900 million in sales over the past twelve-month period, which was a record. I can attest to this, as I was getting sick of seeing a 7-handle on library revenue for a long time. No doubt CEO Jon Feltheimer has made this a priority during and coming out of the SARS-CoV-2 crisis, not only because of theatrical limitations during the shutdowns, but because, as time went on, the importance of Starz the streaming service (not to mention Starz the linear channel) radically lessened in stature.

The library is also a cool asset to own considering the current strikes by the Writers Guild of America and the Screen Actors Guild-American Federation of Television and Radio Artists. The company has a lot of product it can license out to third parties that are in need of additional content (I’d even consider re-releasing some product to theaters that have the capability of resonating with a mass audience/marketing campaign).

Movie revenue jumped over 40% to $406 million while income increased over 30% to $69 million. The John Wick IP helped here, but the library results for the quarter were also a driver.

Unfortunately, the next quarter might not see as robust a performance (depending, of course, on how the library and other products pan out) considering that what was hoped to be a breakout hit turned out not to be: Joy Ride, a comedy from Seth Rogen’s and Evan Goldberg’s Point Grey outfit, did not live up to expectations, grossing only $14 million at global auditoriums.

Don’t give up hope yet. Lions Gate has three potential hits lined up for August and beyond: the next iterations of Expendables, Saw, and Hunger Games. The latter obviously has the most pull, but given that the other two are still notable brands, for Lions Gate’s scale, they could indeed make a difference.

Adjusted free cash flow was over $30 million this quarter versus a use of cash of over $60 million the previous year. Lions Gate throws in a lot of adjustments, including the effects of production loans and tax credits and derivative investments, so I like to look at the cash generated from operations and consider that in isolation: just under $30 million against a negative reading last year. A good improvement, certainly, although shareholders would be forgiven for wanting a lot more, even considering the company’s aforementioned scale.

As we all know, the company is separating Starz out from the rest of its business (although that may be delayed because of Entertainment One), and it intends on keeping up a deleveraging bias. That should help Feltheimer and the buyout thesis, but it is worth noting that the company can still look at this asset as a potential marketplace for content; indeed, the implication here from the conference call is that content deals will be made to continue the relationship. In this sense it is almost like what Hulu was originally intended to be: a marketplace for movies and episodes that could compete with Netflix (NFLX) and reduce the latter from being the single major buyer of content; once it was up and running, the consortium of industry players would simply transfer the risk of subscriber expansion to someone else. Obviously Hulu is now in the hands of Disney (DIS), with the Mouse on the hook for billions of dollars to buy out Comcast’s (CMCSA) stake next year, but that original model is instructive here: Lions Gate can spin out the asset and hopefully continue to do business under its content arms-dealer model. As for Starz itself, it continues to be stuck at around 30 million total global subscribers; with bundling and new approaches (advertising-support, perhaps, at some point?), different owners could find a paradigm that fits the brand.

Perhaps the most surprising development is the Entertainment One purchase.

Or is it so surprising?

There may be two ways of looking at this event.

When I first read about the purchase, I was skeptical; after all, why would Feltheimer want to bulk up his studio when he’s looking to sell out, not only for himself and his own payday, but also for all his shareholders? It would seem that this would be a step backward, to take on debt prior to the streamer separation. It also could be argued that acquisitions at this point only serve as potential distractions.

This question was broached in the conference call. And the answer from Feltheimer is certainly an acceptable one:

“…[I]t was a really attractive multiple, particularly in our hands, frankly. This is something, again, we do really well. We built the company with a lot of library acquisition. And there’s a lot of operating assets there. And frankly, in our hands, I think this is, as I said, in my remarks, super accretive.”

The other reason he brought up was existential – simply put, this is when the asset was on sale to another buyer.

Hasbro, the previous owner, like AT&T (T), found out that dealing with Hollywood isn’t always a walk in the park. The town is constantly on the lookout for other people’s money, and unless you are willing to stand tough and really invest both the capital and the time in a filmed-entertainment model, you will do what the toymaker ended up doing – exit the business save for keeping only those brands with which you can work (Hasbro kept Peppa Pig and stuff like that). Hasbro, in my opinion, sold out too soon, and didn’t do what it should have done – namely, go beyond fictional porcine characters and make low-budget films of all genres, as well as tentpole features that establish fresh intellectual properties.

Lions Gate is definitely the better owner, and at $375 million cash plus debt assumption (total: about $500 million), it isn’t that bad a price (recall that Hasbro shelled out $4 billion for the company, after which it sold off some assets it felt were non-relevant).

Well, not a bad price generally speaking, but… it’s actually a lot of money for Lions Gate. Here’s what it might mean.

I believe Feltheimer is doing his best to navigate a tough marketplace; check short-term T-bill rates and you’ll get the picture. Hasbro was a motivated seller. Whether half-a-billion is a lot or not, I think Feltheimer recognized an opportunity to hedge against a near-term future where Lions Gate is still trading on the public markets, even with a Starz separation. He also is cognizant of the guild strikes – even if they were settled by the time this is published, you’ve got delays built in. Everyone in town is scrambling (cue headlines about unscripted showrunners being called on red phones to save the day). Libraries are valuable during such macro nightmares. In the end, I think he couldn’t resist buying eOne and its 6500 pieces of filmed entertainment.

And another issue perhaps needing a hedge would be the challenge with 3 Arts (in which the company is a majority owner) during a strike, which was mentioned in the call: you’ve got to feel for Feltheimer who has to manage not only a disruption in slate development, but also a hit to that talent-management asset. It always struck me as strange that a studio would count a management outfit in its portfolio, as it would seem to be something of an interest-conflict; in the end, there was an interest-conflict, as in owning it didn’t really provide any hedge of its own against content development. Now Lions Gate has to wait for business to come back in Hollywood, and even then, the studios around town will probably be conservative on talent quotes, which would cause further impact (not to mention the whole contraction in streaming programming as that industry undergoes a revaluation). Buying 3 Arts was in part driven by a need to incubate talent that would otherwise find working at other studios more attractive; perhaps that was the case, but today, a solid library of shows might be slightly preferable to a solid portfolio of showrunners. (Lions Gate also increased its exposure to talent assets with its deal for overseas management/production concern 42, as detailed here).

Yes, it would be my preference to simply retain the cash, spin Starz, and start searching for a PE-firm consortium looking to invest in some Tinseltown risk. Again – everything is complicated, there are nuances in any story, the geometry of any deal comes with many angles to evaluate, and that makes me of two minds to this transaction.

Ultimately, I will go along with Feltheimer on the library because the company has amply demonstrated it knows how to monetize catalogue content… but we have to take a step back as well to think about the ultimate takeaway.

I found it puzzling when I read the headline, because a partial meaning to the move arguably could be sourced to the concept that Lions Gate is going to need more time to find a buyer. The spin will happen, even if it is delayed; but after the exchanges have been made, presumably the thing on everyone’s mind will be: when does the company finally cash us all out? That question may have been answered by eOne: unfortunately, a little later rather than a little sooner.

However, as scary as current conditions are right now, at the end of the day we all know that each passing trading session gets us closer to a true bull market; as conditions improve, and the streaming/content wars continue to change media dynamics, buyers in the media space, whether PE or SPAC or tech conglomerate, will be looking for consolidation deals to get to the next stage of the cord-cutting linear apocalypse. As the rubble of the latter continues to pile up, those looking to rebuild will be looking to Lions Gate and its libraries and its studio system to provide a valuable competitive edge in taking a step-up in scale in my view. This is why I continue to hold the stock and remain in a permabull position.

Risks and Valuation

Let’s consider now some risks and valuation aspects. I’ll begin with the latter.

Seeking Alpha Quant, as I said at the top, gives the stock an A overall rating, which is an improvement over a previous grade. The adjusted-PE metric (15.74 as of this writing) on a forward basis is in-line with the sector median but below the stock’s five-year average (17.32). Price/sales and enterprise-value/sales are both very attractive on forward estimates but EV/EBITDA forward is expensive. From a hypothetical acquirer’s perspective, that premium might be of little concern given the overall context of what a company like Lions Gate could do for a media portfolio, but from an institutional stock trader’s perspective, granted, it might keep the stock cheap until the writers’ strike ends and the movie slate gets cooking again. Such is the game of value investing.

I’ll also reiterate my point at the beginning about the 52-week range. The A shares have gone roughly from $5 to $12 over the past twelve months, with the B shares basically in-line to that. Both classes are approximately in the $7 area right now as far as price goes. The market is pretty rough at the moment, so the macro situation most likely will take the stock down further. If the stock retreats, then given the SA rating, it may indeed be very inexpensive and worthy of a look.

Now, for the risks:

• The buyout may be delayed or never come: Very difficult to believe the latter, but in terms of a delay – sure, given market conditions, that is a significant risk. Nevertheless, a lack of an offer is something everyone must consider before investing here.
• The company’s content model fails: Every studio gets into a slump. Disney has at times seen weakness in its tentpole productions, and in fact, now is one of those times, as the new Indiana Jones film underperformed. Lions Gate needs more hits in addition to the recent Wick entry. It will get them, but there is no guarantee that any particular box-office season will be kind to the company. I’ll also point out that Feltheimer may want to tighten up his film strategy and not just look at his studio’s distributional ecosystem – i.e., the company’s contacts not only with multiplex chains but with digital platforms, including hybrid theatrical/digital – as a way of justifying releasing any and all types of films; concentrate on the most commercial ideas for the multiplex, leave the rest for television.
• The company gets taken out with a low premium attached: I see this as a low risk because Feltheimer seems to have a certain price in mind to which he wants to stick. He’s had talks/opportunities in the past, and yet here we are, still waiting for consolidation to reach this studio.
• Wall Street sours on the stock and continues to keep it in value territory: Yes, anything can be a value trap. Something to definitely keep at the forefront of an analysis.
• The strikes go on even longer than anyone imagines: I would have to assume there is some urgency to settling this matter, but then again, studios need to be cautious in their negotiations considering they need to get their streaming units to profitability as of yesterday, if you know what I mean; this issue could certainly complicate matters.

In conclusion: I’m waiting for what I believe the final act will be for this stock: an eventual buyout. I’m a permabull from that perspective. I also am counting on Lions Gate improving its theatrical slate, which will act as a catalyst as it will attract Wall Street investors. This has always been an interesting stock/company to me; see what your own due diligence comes up with.