Description

I have previously written up both Lionsgate (LGF) and STARZ (STRZ). LGF acquired STARZ in June 2016. The current price does not reflect the increased value of the businesses, as either stand-alone businesses, or as a combined company. I believe the combined company is worth 50% or more above where it trades.

            LGF is a movie and television studio that finances, produces, creates, and distributes movies and television shows. LGF is responsible for several motion pictures franchises, including The Hunger Games, Twilight, John Wick, Now You See Me and Step-Up. The television production business has produced several of the most critically-acclaimed scripted series of the last fifteen years, including Mad Men, Orange is the New Black, Nurse Jackie and Weeds. The film and television business is supported by a library of 16,000 movie and television titles that LGF licenses to a variety of distributors around the world. The library provides roughly $300mm per year in revenue. The library provides visible revenue and cash flow, as well as a well of IP for future development. The LGF library is one of the largest remaining content libraries; it is difficult for a new film or television production company to scale and sustain itself without a large library.

            LGF’s film business has had an uneven performance at the box office since its marquee property, the Hunger Games, ended in late 2015. Several original films that the studio hoped would turn into franchises (e.g. The Last Witch Hunter; G-ds of Egypt) were domestic box office failures. The Power Rangers, another franchise candidate, which opened in the U.S. on March 24, probably is not going to turn in a domestic box office performance that will rationalize an investment in a sequel. On the other hand, the studio found surprising success with several other movies (Boo; La La Land; John Wick). La La Land morphed into a box office hit, with over $400mm in global box office and several awards. La La Land is likely to be turned into a musical or stage show that could provide recurring income to the studio for many years. John Wick looks like an action franchise with legs; the sequel did better than the original.

            What matters more than the success or failure of any one movie is that LGF has structured the film business to mitigate some of the risk inherent in the film business. LGF pre-licenses foreign theatrical rights to its movies to distributors around the world. These license fees net down LGF’s invested capital per picture to an average of $15mm, before variable marketing expense. Several of these licensing arrangements are structured as output deals, where the distributor agrees to license a slate of films, providing LGF with more visibility. With these deals, LGF gives up the upside from international box office that could come from a hit (the studio does negotiate for overages on films that outperform). But the deals also protect the downside. To my knowledge, LGF is the only major movie studio that employs pre-sales in this manner.

            LGF is small enough that it does need to hit home runs to profitability grow its library and build value in the studio. Over the long-term, the studio has a great track record of delivering a profitable movie slate through a focus on targeted niches. Publicly traded movie studios are often (correctly) perceived as volatile, unpredictable, and low-return on capital businesses. LGF probably suffers from some of this. But the business model is much lower risk than a traditional movie production company because LGF controls its distribution, has a large library, rarely takes huge swings, has output deals in pay-television in the U.S., and pre-licenses international theatrical rights to reduce production capital at risk. I view the movie business in LGF as a vehicle for profitability adding IP to the library, expanding relationships with talent, and creating IP that can be monetized through ancillary businesses, such as television, location-based entertainment and video games. LGF does have the capability to introduce new and old franchises (Hunger Games; Twilight; Saw; John Wick), which provides optionality. But this investment should not succeed or fail based on the movie studio performance, with the caveat that in the short-term, movie studio performance will have an impact on earnings and sentiment.   

            LGF’s television production business is probably the best asset in the Company. Around the world, television is starting to look more like big-budget movies. Digital distribution has made access content to ubiquitous, creating economic models that support a larger investment per hour in television programing. Competition from Netflix and Amazon is spurring new and old media companies around the world to invest more in high-production television programming in order to differentiate their brands and appeal to younger consumers who have different expectations of quality.

            LGF’s television business positions the Company well for the continued growth of television. LGF was early in building scale in premium scripted content. The studio is responsible for many of the network defining scripted series of the last decade (Weeds/Showtime; Orange is the New Black/Netflix; Mad Men/AMC). Not only have these series created long-term assets in the LGF television library that should generate high-margin licensing income for years, they have also attracted great talent and made LGF a desirable partner for many other distributors. In the next year, LGF will have a new scripted shows on Showtime (White Famous) and Netflix (Dear White People), and a new game show on CBS based on the Candy Crush IP. LGF is developing or producing content for several other networks, including Discovery, which is making a push into scripted content (Discovery is a shareholder/CEO David Zaslav is on the LGF board).

            LGF’s television business has compounded revenue at ~20% for the last decade. In FY 2018, television production should earn ~$1B in revenue, making it one of the largest independent television production businesses. Television production is a capital intensive business, particularly in the early years of a new series, where there are high variable costs of production and the series is only in the first cycle of distribution. As LGF continues to scale the business, the margins are likely to be in the low-mid teens. But these investments should create meaningful business value over time because they will grow LGF’s content library, build relationships with talent, and increase the value of LGF as a strategic asset to a large distributor. Historically, great independent television production businesses with scale, good leadership, and a strong programming slate have been acquired by larger companies. ( e.g. Lorimar; King World; Talpa).  LGF’s television business is also well positioned to acquire smaller independent producers that it can scale through its distribution capabilities, adding to its library and building more relationships with content creators. The TV business has recently been acquiring independent producers in the UK.

            STARZ is familiar to many on VIC. I would refer anyone interested to one of the previous write-ups for a description of the business.

            STARZ should experience multiple expansion over the next few years. It is a predictable, scale subscription business with 24.5mm U.S subscribers, a growing slate of quality original content, no advertising exposure, and high EBITDA to free cash flow conversion.

            STARZ is well-positioned to grow its subscriber base as new virtual MVPDs and other distributors enter the market and seek to sell premium channels at the bottom of the stack, rather than on top of the basic cable bundle, which made the premium channels prohibitively expensive for many. STARZ has a collection of rights, and nice OTT product, that collectively make it a great product for distributors to bundle with high-speed data plans and new skinny bundles.   

            STARZ generate very little revenue internationally, which is an opportunity. HBO has nearly 90mm subscribers outside the United States; Netflix has 50mm; Showtime has been growing its international revenue through licensing and output deals. As STARZ build its rights portfolio, it can grow its international business. LGF should be able to help accelerate this effort.

            The combination of STARZ/LGF should create strategic advantages for Starz. LGF’s television production business currently has three projects in fast-track development with STARZ. LGF has a strong incentive to develop content for STARZ. With more big shows on its slate, STARZ can improve its negotiating leverage with distributors, increase its affiliate fees, and add incremental high-margin licensing revenue through syndication. 

            In FY 2019, LGF can earn between $300-$400mm in EBITDA. I believe it would be valued at a minimum of 15x in a takeover, for a value of $4.5B-$6B. LGF is one of the two remaining studios that would provide scale and a foothold in Hollywood at a time when access to, and ownership of, high-quality video content is increasingly valuable. LGF’s library, development slate, owned IP, and relationships with talent cannot be recreated. Dreamworks sold to Comcast for about 17x EBITDA; MGM trades OTC at around12x EBITDA and would likely command a premium to that in a sale to a strategic buyer.

            If FY 2019, STARZ can earn ~$600mm in EBITDA and get a valuation of 11-13x, for a value 6.6-$7.8B. AT&T paid 13.4.x EBITDA for TWX; I believe the implied multiple for HBO is higher because T likely valued HBO higher than Turner. CBS currently trades at ~11.2x 2017 EBITDA—I would argue that Showtime’s multiple is higher than the broadcast business. I do not think it is unreasonable for STARZ to be valued at a minimum of 11x EBITDA, particularly as the new virtual MVPDS seek to package more premiums channels in the new bundles, which should be a tailwind for STARZ’s subscriber growth. Part of this thesis is that the multiples on subscription-supported networks with a growing line-up of original programming, a growing digital distribution footprint, and high-margin international growth opportunities, will expand. 

            Combined, the company is worth between $11-$13.8B. On April 5, LGF sold its 31.2% stake in EPIX for proceeds of ~$400mm, which should be used to pay down debt (LGF should be able to use tax-loss assets to avoid paying taxes on the EPIX proceeds). LGF has another $200mm in non-core assets that are contributing little to no EBITDA that could be monetized between now and FY 2019. The business should also generate between ~$1B in FCF between now and FY 2019. The LGF S-4 for the STARZ merger forecasts $591mm in FCF in 2018, and $643mm in 2019.

            LGF currently has ~$4.1B in corporate debt, including a $798mm appraisal liability from 22.5mm holders of STARZ Class A stock demanding appraisal rights. Assuming that liability is extinguished and there is no corresponding share dilution, LGF can end 2019 with $2.5B in debt ($4.1B less ($1B in FCF + $400mm EPIX + $200mm non-core asset monetization)). With 215mm DSO (assuming minimal dilution), LGF would be worth between $39-$52/share. 

            I should note that I think there are scenarios that could unfold where Lionsgate alone could potentially be valued between 7-$8B, which is close to the entire current enterprise value. One scenario is if a strategic buyer acquires MGM at a large premium to its ~$5B value. That type of deal would positively change perception about the value of IP and libraries, increase LGF’s scarcity value, and motivate LGF’s ownership group to monetize the value in the studio if LGF was trading at a large discount to an MGM deal multiple.

             Another scenario (these scenarios are not mutually exclusive) is that LGF announces plans for a new slate of Hunger Games films. The Hunger Games is one of the biggest box office franchises in history, with total global box office of ~$3b across the four films. The story has broad worldwide awareness. Almost every film franchise that has reached this level of global box office is eventually remade, or a new version of the story is developed.  LGF has hinted at prequels and sequels, but so far, nothing has materialized. If the studio is able to develop a new Hunger Games storyline, it should be a positive for the studio earnings power. The new films need to be good—but if there is solid execution, it can meaningfully increase studio profits, earnings visibility, and library value over the multi-year run of the films. LGF is currently expanding the Hunger Games IP through location-based entertainment attractions around the world; there will be an incentive to keep the story alive in order to build awareness and interest in the expanding the value of those attractions. If an acquiror were interested in LGF, the studio would likely seek to discount the value from any new Hunger Games films in the valuation.

            Lastly, LGF could announce a new slate financing deal with a Chinese partner that puts a favorable valuation on the film slate.  LGF currently has a movie slate financing deal with a Chinese company, Hunan/TIK for 25% of the equity in its film slate, excluding certain titles (Hunger Games; Twilight). Hunan puts up 25% of the production budget on a film in exchange for equity and other rights. That deal will be up in 2018. LGF should be well positioned to enter a new slate financing deal on terms that are at least as attractive as the Hunan deal. LGF’s recent film Now You See Me 2 was a blockbuster in China, grossing over $100mm; a third film in the franchise is being developed specifically for the Chinese market. LGF also has added new two new franchise titles to its library in John Wick and La La Land since the original Hunan deal was signed. The studio had a great performance at the 2017 Academy Awards. All of the above should have bolstered the studio’s reputation as a high-value content creator and increased library value. The Chinese box office should compound at low-mid teens rate over the next several years, creating a strong incentive for Chinese media companies to form long-term strategic partnerships with U.S. studio to guarantee access to product. Recently, there has been a pullback of Chinese investment in U.S. studios due to the Chinese government’s desire to stem capital flight. While this may pose a risk to LGF, I think they can get a new slate financing deal done on terms at least as attractive as the original, even if they need to find a non-Chinese partner.

Catalyst

deleveraging; new content with global appeal; M&A