Description

 Image Entertainment saw its price demolished in the past two trading days as its acquisition deal with David Bergstein's BTP, LLC appears to have completely broken down.

The current market price represents a significant discount to the true value of the company under all but the most pessimistic set of assumptions about the business. In addition, there remains a significant probability that the acquisition will go through, or Image will derive value from the break-up of the acqusition that increases its business value.

An investment at these prices offers a good chance of doubling or even tripling in value in the short term. At the same time, Image's business and asset values are strong enough to offer a reasonable margin of safety.

Background

Image produces and distributes DVDs in the United States. The company owns 3000 DVD titles, and it has distribution deals with other content owners to reproduce and sell their content. More information on the company's product offerings can be found at their website: http://www.image-entertainment.com

Acquisition Deals

Two different companies have attempted to purchase Image in the past 3 years. I believe the presence of two independent offers provides some clarity on the value of the company's underlying assets and ongoing business franchise.

1. In 2005, film studio Lion's Gate spent over a year trying to buy out the company at $4 per share in cash. They went so far as to purchase about 20% of the company on the open market and to carry out a full proxy battle, which they lost by just a few percentage points. Management argued the deal was too little money, though I think it's reasonable to conclude that they were also interested in keeping their jobs.

2. After the Lion's Gate proxy battle failed in 2006, BTP, LLC, began to pursue the company. In March of 2007, they signed a merger agreement which ultimately called for a $4.40 cash payment per share, with shareholders to retain 6 percent of the company after the deal. This deal was not only more lucrative but made more sense for management, as it would keep them in place and permit them to continue to benefit from a publicly traded stock.

For reasons which are still not clear, the BTP deal dragged on for months, and ultimately BTP agreed to do two things to secure extensions of the deal through Feb 1, 2008:

• Put $3M into a trust account to count toward the acquisition price, and

• Cause affiliate CT1 Holdings LLC to sign a distribution agreement with Image. CT1 is the parent company of ThinkFilm and Capitol Films.

My experience with troubled mergers—and the state of the economy—suggest to me that BTP was having difficulty coming up with the merger consideration, though this remains unclear.

The BTP deal has a $4.2M “business interruption” fee, to be paid by BTP to Image if BTP terminates the agreement without due cause (as defined in the contract).

Recent Deal Breakup

I strongly suggest readers take a look at the most recent Edgar filings by Image and BTP and evaluate the situation for themselves. Each side is blaming the other for the deal falling apart, and there is some probability that either side's characterization of the situation is accurate.

My belief is that Image's description of events is far more plausible than that put forward by Bergstein. There are a couple of key points here:

• Image's Chairman has stated publicly that he believes the value of the distribution agreement with CT1 is $30M. He also has stated, while quoting from the contract, that the contract remains in force regardless of the status of the merger.

• Image has stated their clear intention to pursue the $4.2M fee.

Bergstein disputes pretty much everything Image says, but in my opinion his story doesn't really hang together:

• Bergstein claims the reason the deal is not done yet is because Image's main creditor won't permit it. I have never encountered this as an issue in a cash merger, primarily because the buyer generally brings the financing. Also, the merger agreement does not even contemplate this as an “out.”

• Bergstein claims he can cancel the distribution agreement because Image has initiated a lawsuit to enforce it. This is absurd on its face. What does a contract even mean if you can't enforce it? Image has cleared this up by pointing out that there is an (irrelevant) provision in the distribution agreement which allows CT1 to cancel it should Image litigate the totally separate merger agreement.

• It has been my general experience that the entity bringing the money to a merger is usually the one which tries to get out of the deal.

There are several possible outcomes from the current situation. In my opinion, most of the likely scenarios benefit Image shareholders. Should the deal ultimately close, shareholders will receive the full merger consideration. Should Image hang on to the distribution agreement, shareholders will derive significant value from that. Should Image get the $4.2M fee, that too represents significant value. Should the parties renegotiate the deal, shareholders will also likely receive far more than the current share price.

Probably the worst case scenario here is a protracted and expensive litigation, with Image ultimately losing. I do not believe this scenario is very likely, but should it happen it would undoubtedly make Image a terrible investment.

Core Business Value

Image competes in a difficult segment of the economy. In recent years, management has done a mediocre job of identifying successful DVD releases. The company has also only recently begun a serious effort to shift sales away from the declining DVD segment to the higher-margin and growing Internet channel. Accordingly, revenues have declined somewhat across the past three years. 2007 revenues came in at around $100M, and revenues for the first half of fiscal 2008 are down another 5% from 2007.

The company has also generated losses in the past two years. There are reasons for some optimism on this front:

• Results for 2007 contain merger/proxy-related costs of around $1M per quarter.

• Management has taken steps to stem losses by lowering headcount by 38% across 2006 and 2007. The company also closed a European office that cost $500k per year to maintain. Most of the savings from these changes have yet to be realized, as the company faced severance costs.

• 2007 suffered from an unusually poor showing for Image in the marketplace due to product mix issues.

• In 2007, Image shut down its costly DVD-duplication operation, choosing instead to outsource it to vendor Sonopress.

• On its most recent conference call, management provided guidance of 2008 revenues in the $100-110M range, and that the company should turn a profit.

• Image's nascent, higher-margin online business is rapidly accelerating. For the quarter ended 9/30/07, digital revenues were $598k, nearly triple the same period the previous year.

Across the past 10 years, Image's net profit margin has ranged from -12% to 8%, with a median in the 1-2% range. In recent periods, the company's depreciation has exceeded capital expenditures by a significant margin—$6M in 2007 and 2006, and $3M in 2005. On a $100M revenue rate, this boosts the company's potential FCF yield to the high single digits.

Ownership

Management's stock ownership has provided them a reasonably strong incentive to generate near-term shareholder value. CEO Martin Greenwald owns about 6% of the company. Billionaire John Kluge's Image Investors Co owns more than 25%, and other executives own between 1 and 2% of the company.

Clearly, the current collapse in the stock price is not something management or Kluge want to see continue. I also believe their willingness to sell the company to BTP demonstrates their desire to liquify Image's assets. Regardless of how the BTP situation turns out, I believe it's likely management will seek an exit strategy, most likely at a price far above the current market.

Valuation

Image has 21.7M shares outstanding, for a current equity valuation of $25M. Debt stands at $27M, though (Current Assets – All Liabilities) is a more moderate $12M, meaning that if the company's revenue base continues to decline, it should be able to pay down debt from freed-up working capital. So, enterprise value lies somewhere between $37M and $52M

I have identified several sources of value for Image:

1. FCF from operations. Even at a very conservative 3% FCF yield, the company can generate $3-4M per year in FCF. This value source alone provides an EV/FCF multiple in the 9 to 17 range, for this conservative FCF yield assumption.
   

2. The potential $4.2M “business interruption” fee from BTP. This cash would be worth $0.19 per share.

3. The CT1 distribution contract. Should the company realize value here, the company should see value somewhere within range of the CEO's $30M estimate. Even placing a more conservative valuation on this contract dramatically increases' the company's value.

4. Clearly outside buyers have shown strong interest in the company's catalog, offering $4 and $4.40 per share in cash for it. Should these valuations be anywhere near fair, this is an immense source of value.

5. Optionality associated with the possibility of the BTP deal yet closing. Image management has said they continue to want to close the merger. Were it to close on the current terms, buyers would quadruple their money in a matter of weeks.

Catalyst

Resolution of issues surrounding the BTP merger;
Realization of cost savings due to layoffs;
Realization of projected revenue improvements;
The emergence of another buyer for the catalog (or the reemergence of Lions Gate); Management and John Kluge's desire to see full value for their shares