If the market’s initial reaction is anything to go by, the deal between Lions Gate (LGF, Financial) and Starz (STRZA, Financial) (STRZB, Financial) is already doomed. Over the past six months, shares in Lions Gate are down by 25%; since the deal was officially announced on June 30 Lions Gate’s stock is down by about 2%.
The $4.4 billion deal was immediately hit with criticism. The chief concerns are that the deal will leave Lions Gate with a chunk of debt it will not be able to service in the long term in a world of rapidly shifting TV viewing habits. What’s more, Lions Gate’s earnings are notoriously lumpy as the company relies on its ability to produce box office hits. And while the combination with Starz should help smooth out earnings, changing viewing habits could derail the whole business long term.
Indeed, the day the deal was announced Moody's Investors Service placed Lions Gate’s credit rating on review for downgrade from Ba3 further into junk territory.
While many of the concerns about the deal are valid, there’s one thing many analysts and market commentators are failing to take into account: the John Malone factor.
John Malone: Value creator
Malone is possibly one of the greatest value creators to have ever lived, and his vision brought Lions Gate and Starz together.
Malone took a 3.4% stake in Lions Gate in February 2015 in a swap that gave Lions Gate 4.5% of Starz, representing 14.5% of total voting power. This is just one of the network of media holdings that Malone has control over.
Over the past four decades, Malone has created an unbelievable amount of value for shareholders. During his tenure at Tele-Communications Inc. (his first company) from 1973 to 1999 (sold to AT&T [T] in 1999) he produced a total return on investment of 93,200% or 30.3% CAGR for shareholders.
In August 2001, Liberty Media (LMCA, Financial) was spun out of AT&T leaving Malone in full charge. It’s estimated that Malone’s assets have returned 238% cumulatively and 9.1% CAGR.
An investment of $100 with Malone in 1973 would be worth $315,337 (CAGR 23%) today compared to only $7,308 for a similar investment in the Standard & Poor's 500 over the same period – that’s according to a research note from Fundstrat Global Advisors published last year.
It’s clear Malone knows how to create value. His pioneering use of spinoffs, tracking stocks, management incentives, leverage and tax efficiency has helped squeeze every last dollar and cent of value from assets, and it is unlikely his corporate tinkering will stop here.
Still, the one criticism of Malone’s way of operating is his dependence on debt, something I quizzed George Gianarikas, managing director and head of Global Sector Strategy at Fundstrat Global Advisors, on in an interview earlier this year:
RH: John Malone is a very accomplished value creator, but his complex corporate structures and use of debt to accelerate returns tends to cause investors to take a cautious stance toward his operations.
GG: Look, leverage goes in and out of favor, and ultimately we are no fans of leverage because it can do really bad things to a business. However, Malone has a four-decade-plus track record of using leverage prudently to improve returns. He tends to put appropriate leverage on companies that have a strong visibility profile. He is not involved in certain cyclical sectors, but if he was, I’m sure he wouldn’t lever them up. He has also been an astute buyer of his stocks, through buybacks and seller, through the issuance of stock when he thinks is the right time to do so based on the long-term strategic posture of the company.
Gianarikas has a valid point; the world of content may be changing, but Malone is one of the most experienced operators in the media space and his stewardship should help the Lions Gate/Starz deal come together.
A sensible deal
if you consider the Malone factor, the Lions Gate-Starz deal makes a lot of sense.
Individually, both companies are facing threats to their very existence as the media landscape changes. Lions Gate is perhaps best known for the “The Hunger Games” franchise, and the company is predominantly a film producer.
The problem with the film industry is that revenues can be lumpy just because Lions Gate has been able to produce a blockbuster franchise with “The Hunger Games” there is no guarantee the company will ever be able to replicate this success ever again. So, to reduce its dependence on lumpy film revenues Lions Gate has branched out into the TV market.
Lions Gate's TV division is one of the studios behind Netflix’s (NFLX, Financial) most-watched original series “Orange is the New Black.” The group has also signed a number of online streaming or over-the-top services as part of its initiative to reduce the dependence on film. Partnerships with comedian Kevin Hart, Tribeca Enterprises and Comic-Con International, along with a number of other online platforms overseas and in North America.
Lions Gate doesn’t have its own branded over-the-top service, but Starz does and this is where the deal really makes sense. Starz launched its own stand-alone streaming platform in April, which features original series such as “Outlander,” “Power” and “Black Sails.” The company also joined with Amazon (AMZN, Financial) last December to provide its network offerings as an add-on to Amazon Prime.
By combining, Lions Gate and Starz will be able to offer viewers more content on their own online platforms and offer partners a better deal as the enlarged group will have more bargaining power. On top of this, synergies from the deal should lower costs ensuring that more income goes to the bottom line for every production that hits the airwaves.
Another factor to consider is the content library that the enlarged Lions Gate/Starz will have available to it. The simplest possible way of describing a content library is to compare it to a railcar. Once the initial investment has been made, railcars are relatively cheap to maintain; however, when leased to a customer they can achieve a return on capital invested of around 10% per annum for 10 to 20 years. The cars cost almost nothing to maintain and are a great cash cow for long-term investors.
Content libraries have the same traits.
The TV shows and films that are owned by the production houses sit in these content libraries and are sold to broadcasters or brought by customers on streaming services for as long as they remain available. As a result, over time these productions can generate far in excess of their original production cost and can continue generating a return for years after the first release. The standout example of how lucrative shows can be over the long term is "Seinfeld," which since its last episode has generated more than $3.1 billion in repeat fees – that works out at around $17 million per episode, excluding the income from DVDs and international sales.
Conclusion
All in all then, while the market may have marked Lions Gate down since the merger with Starz was announced, it’s difficult to see why. The deal will create a content powerhouse run by one of the most successful value creators of all time.
”‹Disclosure:Â I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
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