After "La La Land," Can Lions Gate Keep Dancing in 2017?

By Billy Duberstein Markets Fool.com

Lions Gate Entertainment (NYSE: LGF-A) (NYSE: LGF-B) reported results for its third fiscal quarter back in February, posting a GAAP loss of $0.31 per share, but a gain of $0.21 per share after adjusting for severance and acquisition costs in the quarter. Film revenue was down 13% year over year despite the success of Boo! A Madea Halloween, Hacksaw Ridge, and others, as the quarter was up against previous-year big winner The Hunger Games: Mockingjay Part 2. TV production was up strongly, however, with 39% revenue growth and 55% segment profit growth as the company continues to expand the better-performing television segment.

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These results were OK, but it should also be noted that Best Picture winner --- wait, wait a sec -- sorry...correction, Best Picture runner-upLa La Land, which had a worldwide box-office gross of $405 million through its first three months in theaters,did not get a wide release until after the quarter ended.

Moreover, this was perhaps the last quarterly report from Lions Gate "as we knew it," as the company closed on its acquisition of Starz in December. Lions Gate announced the $4.4 billion Starz acquisition in June, laying out a deal of about 60% cash and 40% stock. The two companies were relatively the same size, so it can really be thought of as a merger of equals. Starz is going to be crucial for Lions Gate going forward, so assessing the studio's prospects entails a hard look at the rationale for the deal. Let's dive in.

Image source: Lions Gate.

Recurring subscription cash flow

Post-merger, Lions Gate is a highly levered company, with an estimated 5.0 to 5.5 times debt-to-adjusted-EBITDA ratio (assuming full-year 2016 run rates for the combined companies' EBITDA), which is quite high...unless your name is John Malone. Cable legend Malone is a shareholder in both companies and really, really, loves to use debt to roll up subscription-based companies. In this case, Starz is the subscription-based entity. The company has strong recurring cash flow that is much more dependable than the ups and downs of a content creation company like Lions Gate.

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This is illustrated in the recent earnings report, where the company broke its results into three categories: motion pictures, television production, and media networks. Media networks is basically the Starz networks. When looking at the last nine months' pro forma results of each segment (as if the deal had closed April 1, 2016), the numbers are startling:

Metric

Motion Picture Production

Television Production

Media Networks

Revenue

$1,386

$601

$1,088

Segment profit

$79

$48

$323

Segment margin

5.7%

8%

29.7%

Dollar figures in millions. Data source: Lions Gate. Data for nine months ended Dec. 31, 2016.

Media networks may not post as much growth as production over time, but the steady, profitable cash flow is a necessity for Lions Gate to pay down its debt.

Size matters

The media industry has been on a consolidation tear over the past few years, which provides both offensive and defensive benefits to those involved.

Offensively, there are cost synergies that consolidated companies enjoy, and the Lions Gate-Starz deal will be no different. Lions Gate forecasts a reduction in operating costs, staff reductions, and other efficiencies going forward. Also of note, Lions Gate is domiciled in Vancouver, Canada, so Starz will now be combined under a much lower tax rate than the U.S. offers. The company projects around $200 million in combined operating and tax synergies, which is nothing to sneeze at, especially for a $4 billion company.

Defensively, the combined entity will get numerous advantages. For one, Starz must consistently renegotiate contracts with its distributors, including cable companies and entertainment distributors such as Amazon.com (NASDAQ: AMZN) and Netflix (NASDAQ: NFLX). Cable companies, as we all know, have been consolidating recently, and a little company like Starz might not always get a fair shake in negotiations. The relationships with cable companies were further complicated by the launch of Starz's over-the-top streaming app, released roughly a year ago. Having Lions Gate's resources to help back Starz up will help the companies in negotiations with distributors going forward.

Moreover, Starz can potentially own more of its content itself, which had been an expensive proposition prior to the merger. For instance, Starz doesn't own Outlander, which is one of its biggest shows, but rather licenses it from Sony Pictures. In the future, when Starz finds a project that it is truly sweet on, but might be somewhat expensive, it might now possess the capability to own the rights outright, which would make it more money.

Starz brings a lot

Finally, the Starz asset in and of itself may have been underrated at the time of purchase. The company is often an after-thought in the mainstream media, which focuses on Netflix, HBO, and Showtime. Still, Starz is going after premium shows for under-served audiences, such as the African-American community and female audiences. As the company has steadily increased its rate of originals over the past few years, subscribers have followed. Starz added 700,000 new subscribers year over year, bringing its total subscriber count to 24.3 million . In January, Bernstein analyst Todd Juenger noted a surprisingly loyal audience for the channel. He was quoted as writing: "Our hypothesis was that most Starz subs never asked for the service in the first place and wouldn't miss it if it were gone ... The results [of our survey] give strong evidence our hypothesis was wrong."

Under the direction of CEO Chris Albrecht (the former HBO executive who greenlighted some hits you may have heard of, such as The Sopranos and Sex and the City), Starz has landed some niche hits, such as Outlander, Power, and Ash vs. Evil Dead. This spring, the company will launch an adaptation of Neil Gaiman's American Gods starring Ian McShane and Gillian Anderson. Like Outlander and Evil Dead, the show has a built-in audience and great cast, so it could make for another under-the-radar success. Investors hope that the addition of Albrecht will boost the creative machine of the entire company.

Going forward, investors in Lions Gate should enjoy the success of La La Land and the rest of the film slate. Still, one could argue that Starz may be more important to the combined company than the namesake production segment, so investors should keep tabs on the success of Starz as it competes in the crowded premium TV space.

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Billy Duberstein owns shares of Amazon. The Motley Fool owns shares of and recommends Amazon, Lions Gate Entertainment Class A, Lions Gate Entertainment Class B, and Netflix. The Motley Fool has a disclosure policy.