A week ago Monday, Icahn Management, the investment vehicle for Carl Icahn, revealed in a Form 13F filing that it had acquired 4.1 million shares of Lions Gate Entertainment at a cost of just under $42 million. As a result, Icahn now owns a nearly 4% stake in the last remaining major independent film and television production and distribution company in the United States. I expect him to add to that stake.

At first glance, one would have to wonder why he made this investment, let alone why he would consider adding to the position. Based on just about every traditional valuation measure, the company seems fully-valued with the stock having little upside potential. Lions Gate’s total enterprise value at the time of Icahn’s investment was roughly $1.3 billion, which translates into a multiple in excess of 75 times EBITDA. As for the P/E, it can’t even be calculated since Lions Gate has been reporting losses. Moreover, management has been lowering its EBITDA and earnings estimates for fiscal year 2006 from the already reduced amounts previously reported. On top of that, the company has a substantial amount of debt relative to cash. Yet its stock price is not all that far off its 52 week high. So why in the world would anyone, let alone Icahn, invest in Lions Gate? In short, for the library.

A high quality film library is a very valuable asset. For starters, since all of the production and distribution as well as most of the major marketing expenses have already been incurred and amortized by the time a movie is released theatrically, there is little in the way of costs associated with films in a library. As such, a good library generates high margin revenue that is in many ways analogous to an annuity. Moreover, the market for films is continually expanding. For example, movies can be released into the fast growing DVD marketplace once they’ve completed their theatrical runs.

The burgeoning DVD marketplace is also an excellent source of revenue for older, sometimes forgotten, films. For example, many “big box” retailers sell DVDs of old movies at deeply discounted prices as a way to lure customers into the store, where it is hoped they will be enticed to buy more expensive fare. It has been reported that hundreds of thousands of copies of the movie Dirty Dancing (one of Lions Gate’s titles) have been sold in this manner. Yet while the retail price may be deeply discounted, the profits are still significant since, as noted above, virtually all of the major costs had been expensed long before the DVD release.

But the DVD marketplace, while large and growing, represents just one opportunity for monetizing a library’s assets. Films can also be licensed to pay-per-view operators, premium cable channels, basic cable channels and the broadcast networks. And that’s just domestically. There is also a large global market for quality older films. Moreover, there will likely be further opportunities to sell films in the future to new markets created by new technologies, as an important new audio/visual technology has been invented and commercialized in virtually every decade since 1950. As Kirk Kerkorian is reported to have once said, “movies just don’t go down in value…something new comes along that you can use them again.”

Good films can be sold and/or licensed again and again because they are true “evergreen” assets. That is one reason why I believe it is difficult to value them using a traditional discounted cash flow analysis. For example, a typical DCF analysis might include a “decay” rate to estimate the expected diminution in value that will take place over time. However, such a decay rate does not adequately capture the fact that there are always new markets opening as a result of new technological inventions. Another problem is that a DCF analysis will likely use a 15 – 25 year time horizon. But is such a time horizon, long as it may be, really accurate? Certainly not in the case of a classic. I believe one could make a reasonable argument that films like Gone with the Wind and The Wizard of Oz, to name just two, have useful lives in excess of 100 years. Both are already approaching 70 years since being released theatrically with no sign of an impending drop off in appeal. Obviously, not all films are classics but this example further illustrates the difficulties of using a standard DCF analysis to capture the true value of a quality library.

With titles like Basic Instinct, Dirty Dancing, High Noon, On Golden Pond, the Rambo franchise, Reservoir Dogs, Terminator 2: Judgment Day and Total Recall, to name a few, Lions Gate’s library is nothing if not high quality. Moreover, with 6,200 movie titles and 1,800 television episodes (e.g., Saturday Night Live, Twin Peaks, Will & Grace), it is one of the largest libraries in the world, generating approximately $200 million in revenue annually. Furthermore, it is a library that is constantly expanding as a result of Lions Gate’s production and acquisition activities. According to the company, 15 to 18 new theatrical releases are added to the library each year, along with more than 80 direct-to-DVD/video releases and many hours of television programming.

Being a production company helps Lions Gate extract value from the library in other ways. First, it enables the company to bundle older titles with its newer, more in-demand releases, thereby squeezing incrementally more revenue from those older films. In addition, the company can repackage titles in order to produce special box sets of DVDs, generating demand for older titles in the DVD marketplace where there might have been little or none before. This tactic can be employed when a new theatrical release is somehow or other related to one or more titles in the library. By way of example, Lions Gate could produce a new box set of the Rambo films to coincide with an upcoming theatrical release of a Sylvestor Stallone movie, irrespective of whether or not Lions Gate actually produced the new film. These two methods for extracting value from older films show yet again why a traditional DCF analysis cannot adequately capture the true value of a great film library.

So, what is Lions Gate worth? In a nutshell, it’s hard to say for sure other than that it’s going to be worth what the highest bidder is willing to pay for it in an arms length transaction. However, we can start to get some idea of its value based on a couple of related transactions, one of which occurred very recently. As has been widely reported in the press, a fund controlled by George Soros, like Carl Icahn one of the savviest investors in the world, just acquired the DreamWorks library from Paramount for $900 million. With films like Gladiator and American Beauty, the DreamWorks library certainly contains high quality titles, but so does the Lions Gate library. Furthermore, with just 59 titles, it in no way comes close to having the breadth or depth of the 8,000 titles in Lions Gate’s vault.

The sale of MGM in 2004 for $4.8 billion sheds further light on the value of a great library. I believe it is fair to say that Sony and its partners acquired MGM for its 4,000 title library, not for its production capabilities. In fact, press reports at the time indicated that Sony intended to wind down the production side of the business.

Basically, a sale of Lions Gate would have to involve an auction to extract maximum value. This should be possible since there are likely to be plenty of potential bidders, including studios, cable operators and private equity players, all of whom could bid alone or, as in the case of MGM, as part of a consortium. I suspect cable operators in particular will be eager to participate in the bidding since the Lions Gate library is well positioned to serve as the foundation for one or more new cable channels. (Management has already discussed starting a “horror” channel, given all of the titles in the library in that genre.)

In summary, I believe Carl Icahn recognizes the value inherent in the Lions Gate library and plans to unlock that value by advocating for the sale of the company. Based on the DreamWorks and MGM transactions noted above, it is hard to imagine that the value is not significantly above the current market capitalization. Personally, I would not be surprised to see Lions Gate bring $2 billion or more in a sale, which would translate into a stock price potentially in excess of $16 per share. For reasons already noted, this conclusion is not based on any rigorous financial analysis. Instead, it reflects a common sense approach that takes into consideration the history and dynamics of recent transactions as well as the current state of the motion picture industry.

My conclusions are not meant in any way as a knock on current management. It’s just that in today’s environment, the value to shareholders from an outright sale of the company will likely be substantially in excess of that which can be realized from continuing operations. Something I suspect Carl Icahn knows only too well.

R.A. Dorfman
May 23, 2006

For purposes of full disclosure, neither Richard Dorfman nor Richard Alan Incorporated owns any shares or other securities of Lions Gate Entertainment.

Update: On July 27, 2006, R.A. Dorfman purchased shares of Lions Gate Entertainment for his personal account. He may add to that position from time to time.