Frazer Harrison
Another quarterly report for Lions Gate Entertainment (NYSE:LGF.A) (NYSE:LGF.B) is in the books. The company is still publicly traded, but it is searching for a buyer. CEO Jon Feltheimer – well, you have to feel at least some empathy for the guy, considering how long that search has been taking (him, and investors too, of course). And through it all, he continues to work with Starz to make it more attractive to a buyer, hoping that once the company separates its library/studio from streaming, it will be an easy task to interest another buyer in the company’s catalog.
Lions Gate’s Q2 earnings took a GAAP hit related to Starz restructuring activities and impairment, beating expectations in the process. Even so, it still was a loss on the bottom line of $0.12 per diluted share, coming in ahead of projections by three pennies. Adjusted free cash flow was over $120 million, but that included production loan/tax-credit activity in addition to capital spending; actual cash from operations before any of that was negative at just under $140 million. In the previous year, adjusted free cash was $195 million.
We all know what the bullet points are: Starz and studio are separating, there’s going to be a spin-off (most likely), the library is the big attractant, and Feltheimer just needs to hold the fort down as long as he can until some financial entity enters the picture, one that is brave enough in the face of current market conditions. Let’s look at where Lions Gate is today, and why the stock, in my eyes, continues to be a speculative buy (for the patient investor) based on consolidation and/or spin-off transaction.
Lions Gate Needs A Deal
The conference calls are becoming more interesting in some sense than the actual earnings report; it’s really all the comments about strategy and such (prepared to be less than impressed on that count, as we will see) that will eventually tell a story to the bankers on Wall Street that the small studio is an asset some larger entity will want to own as the next stage of the streaming wars commences. And yes, there is another stage coming, as Disney’s (DIS) D+ and Netflix (NFLX) both enter the advertising-supported arena.
Before we get to comments from the call, let me review a few highlights from the quarter. As has been the trend, the company is in a waiting period until big franchise films such as the next John Wick/Hunger Games entries make their way into the multiplex next year; therefore, television production is taking the lead. While the pandemic is still a concern, recent blockbusters have demonstrated that people are willing to come out for the right product at the right time; at the moment, Lions Gate simply can’t generate a lot of revenue from theaters, as the motion-picture top line indicates: it declined to $224 million from $330 million in the year-ago frame. Segment profit was roughly $55 million versus $100 million, a precipitous drop. Recent projects such as Clerks III and Prey for the Devil couldn’t scare up much box-office bucks, with the latter not being able to take advantage of the Halloween frame as much as it could have; at the time of this writing, it has grossed $20 million worldwide.
Television revenue increased to $430 million versus roughly $330 million, but income for episodic unfortunately decreased to $13 million from $28 million. That was because of a hit from a series that was cancelled, so without that timing issue, things might have been better. No matter, because episodic is where Lions Gate is strong at the moment as it has seen a lot of pickups in that business as the earnings call mentions.
The biggest element Feltheimer enjoys touting – and for good reason, considering all the goodwill Amazon (AMZN) gave for Metro-Goldwyn-Mayer – is the company’s library. For the trailing twelve months, it generated just under $750 million in revenue. It basically stays around that number every quarter. I would like to see more impact from the library, perhaps a more aggressive approach toward monetizing it and growing that statistic, but it still helps to offset variable weakness in other segments. Libraries can be complicated to sell and exploit as there are many rights issues, but they still are valuable in the streaming age, and you can bet it will be one of the reasons why the company eventually sells.
The first topic Feltheimer covered during the call was Starz and its international restructuring. The company reduced its streaming footprint by leaving several markets, and the remaining Starzplay products are now known as Lionsgate+. Perhaps the rebranding will help to hook more subscribers, although beyond a name change, high-quality branded content will obviously be in more need. But the CEO is doing what he can to focus the division on growth so a spin-off or sale can work in the marketplace. One of the advantages of taking some territories off the table is, as was mentioned, reducing exposure to unattractive average-revenue-per-user metrics, which was deemed an inefficient way to monetize content via subscribers.
The concept of Lions Gate as content-supplier “arms dealer” in concert with a sometimes-exclusive streaming platform (although clearly the company has signaled it is no longer interested in producing exclusive content for a streamer as a major part of its business model) was put forth yet again, which represents a bit of cognitive dissonance as my parenthetical implies. Lions Gate at this point basically wants to offload Starz and retain an economic relationship with it via content deals. The CEO stated:
Our licensing and windowing activities also extend to STARZ in terms of how they stream, license and bifurcate the rights to their shows. Having a bespoke partner at STARZ has allowed us to scale to over 100 shows across our scripted and unscripted business, while our content partnerships with 3 Arts Entertainment, Debmar-Mercury, Pilgrim Media, BBC Studios in the UK, Bell Media in Canada, Stan in Australia and talent management and production company 42 in the UK have allowed us to build a truly global content creation capability.”
He went on to mention the value of the overall content ecosystem to incubate commercial episodic product, not just at Starz, but for any and all platforms. One example included Ghosts for broadcast.
It’s interesting to me that it has been such a laborious process to find a buyer for the entire ecosystem, both studio/streamer, since a new owner could actually reconfigure the mandates in place and start investing in exclusivity to perhaps ramp up the Starz subscriber count at a faster pace. The base of total subscribers globally has steadily expanded, but it still sports a 30-handle; currently the stat is at 37.8 million, but back on September 30, 2021, the base stood at 30 million users. Linear remains weak while over-the-top continues to offset. And obviously subscriber numbers will be affected by the restructuring going forward, so there will have to be a pro-forma approach in the analysis later on.
A buyer would most likely want to take the streamer in new directions with content and output deals, and would certainly keep Lions Gate shows around for a while to create a transitionary period; after that, if the studio is still on its own, it will simply continue on with its arms-dealer approach.
As Lions Gate continues on with its separation of Starz and figures out the optimal way to transfer leverage there, I want to go back to the movie approach and try to get inside the mind of management concerning that part of the business.
The CEO mentioned that investors essentially need to remain patient for the next set of tentpole product (Wick, etc.) while also relishing the diversity of the film model:
But our film business is about more than tentpoles. With Prey for the Devil, our most recent wide release and Fall, a smaller opportunistic release, we show that we can create successful business models for every kind of film.”
What Feltheimer presumably means by opportunistic here is a lower-budget (read: lower-risk) film in the popular horror genre that can be launched in theaters and risk-mitigated by foreign sales and potential digital/streaming transactions. Fair enough. But he continues:
Upcoming releases like the Gerard Butler, thriller, Plane, prestige films like Are You There God? It’s Me Margaret, the action thriller Shadow Force, and Alice Darling starring Anna Kendrick round out one of our most balanced slates in years, a slate that speaks to our optionality and ability to play in every part of the movie ecosystem.”
On optionality, I read that to mean a studio that has no choice but to de-focus, if you will, on sole commercial, franchise product. I’ve certainly said this before, but Lions Gate, because of its depressed stock price, needs to only consider the most commercial material out there, and to perhaps look more toward sure bets than anything else. Many of us agree the stock is undervalued, but that undervaluation can remain for a long time unless aggressive changes are made. While the Prey film didn’t turn into a Smile-like blockbuster, I’d rather see more horror films given the greenlight to complement the next batch of tentpole stuff. Let me put it another way: Lions Gate isn’t like Disney in that it doesn’t think material first, talent second – it’s the other way around, and because of that, the company is limited in the exact manner in which it can pursue a slate construction. Instead, it is left with ROI analysis/risk-mitigation only as opposed to a top-down approach that starts with genre. Disney can say to its corporate self, let’s make more superhero projects. Lions Gate, in a bid to attract the biggest talent it can at the most profitable price, doesn’t have such luxury, and Feltheimer knows this…thus, the optionality euphemism.
For Starz, the quarter was a tough one in terms of accounting as CFO Jimmy Barge highlighted the impairment charge against it:
…we took two large charges this quarter that impacted our unadjusted operating results. First in the quarter, we took a non-cash goodwill impairment charge of $1.475 billion related to our 2016 STARZ acquisition. This write-down reflects changes in the market valuations for streaming assets and related factors stemming from increased competition and a slowing global economy.”
The second charge, around $230 million, reflected the aforementioned restructuring. Barge said the forecast is for increased profitability in international over time, and the breakeven point should be reached perhaps near the conclusion of 2024. Barge also highlighted the advantage of the upcoming separation as a way of reducing intercompany eliminations, the accounting offset included from sales by the studio to the streamer.
Yet, on the separation/spin-off…you could forgive investors for being disappointed that more news isn’t out there on the process; Feltheimer just didn’t offer up a lot of perspective, and analysts didn’t seem to press the point perhaps as vigorously as they should have. The trades have certainly noticed, and impatience is obviously growing.
Simply put, market conditions must be dictating the timing of Lions Gate’s intentions. At the time of this writing, both share classes of the stock have hit 52-week lows with 6-handles to the price. Feltheimer’s dream of finally achieving the proper valuation for his company has yet to manifest itself, and with debt and lack of scale a drag, that plan has no choice but to be pushed.
This places the company in a very distracted position. While searching for a proper valuation by necessity in this case dictates a structural transaction, whether it be spin-off or sale, management must, unfortunately, take its eye off the core, normal business model for a little while as it navigates the strategic alternative. The destiny of Starz was to have already been decided by the end of summer – remember that self-imposed deadline? – but it continues to remain with LGF; nevertheless, this is the source of an eventual catalyst that, on spec, will cause a sharp rise in the shares.
Final Musings
I added to my LGF position when it hit recent 52-week lows. My thinking is this: yes, I’ll have to wait longer, but buying now sets me up for later when one (or more) of the following occurs:
- The company spins Starz off, or sells it outright (or seeks stakes from outside investors to get a new valuation).
- The company is sold as a whole.
- The company spins off the studio, or sells it outright.
- The film slate switches over to the high-profile product such as Summit Entertainment’s Wick.
- Restructuring of the Starz division begins to reap benefits.
- Market conditions improve as the bearish stance matures.
Lions Gate is considered a risky and expensive stock at the moment by SA’s quote system. I get it.
But there are catalysts on the horizon in my opinion that will reward improvement of cost basis. Hollywood and private equity still favor consolidation trends…it’s unfortunate shareholders have to hold through the current bear market. I will be holding through the down times.
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