Content-rich MGM ready to roar

Jul 9, 2001  •  Post A Comment

MGM recently joined an unprecedented number of public companies issuing lower second-quarter and full-year earnings estimates and warnings. But don’t be fooled.
MGM, whose anticipated second-quarter shortfall is due to underperformance at the box office, is one of the few bright spots on the entertainment horizon and is poised for continued growth and a major deal.
That deal, which eventually will be a merger or an acquisition, will have to wait until MGM’s stock price improves and the studio can use it as deal currency or until someone is willing to pay a premium for the last remaining independent major film studio. That’s assuming its 82 percent owner, Kirk Kerkorian, wants to sell.
Much has been made about the intentions of Mr. Kerkorian, who has owned the studio three different times and on this most recent occasion put his longtime friend and accountant, Alex Yemenidjian, in charge. He may like the movies as much as the next guy, but Mr. Kerkorian is an investor first and foremost. He has built his estimated $8 billion fortune placing and growing good bets that deliver a stellar return on his investment.
He sold MGM’s assets in 1986 and again in 1990 for large premiums over their then trading value, and he may do it again, according to Laura Martin, analyst for Credit Suisse First Boston. General Electric’s NBC, Cablevision Systems, Barry Diller’s USA Networks, Vivendi Universal, DreamWorks SKG and Paxson Communications are among the most frequently mentioned suitors for the scarce pure-content play.
Return of the deal
While mergers and acquisitions are at a new three-year low-down by 55 percent worldwide the first half of 2001-most experts expect deal-makers to be back in full swing a year from now on improved cash flow performance and lending conditions.
Having changed hands seven times since its inception, MGM still has working for it strong brands, creative people, a potent film and television library and (for now) good management.
After 11 years of bleeding red ink, MGM has enjoyed six consecutive profitable quarters and posted its highest profits from filmed entertainment in its 76-year history since Mr. Yemenidjian took control in April 1999. It boasts the lowest overhead structure in the business, according to Chief Operating Officer Chris McGurk, a veteran of The Walt Disney Co. and Universal Pictures.
Management has strengthened MGM’s balance sheet with a $1.4 billion rights offering to shareholders and three private placements to reduce debt, fund acquisitions and reduce overhead.
But MGM’s vulnerability is clearly defined by its need for scale and for domestic distribution ownership, its exposure to poor film economics and its limited access to new revenue streams. Although it has made some strides, it continues to fall short of some of the critical strategic goals in place under previous regimes-namely increasing branded theme channels and other aggressive means of exploiting its $5 billion library of 4,100 film titles and 10,000 TV episodes.
Taking back what’s theirs
In fairness, MGM only recently began regaining control of many of its choice films following the expiration or buyout of restricting, long-term licensing agreements made in the 1990s under the misguided ownership of Italian businessman Giancarlo Parretti. Ted Turner built his Turner Classic Movies channel on the 2,200 MGM feature films he acquired in 1986.
In fact, sources say MGM continues active discussions with at least one major broadcast television network and one major cable network about creating an MGM-branded multiplex of domestic premium movie channels.
JPMorgan analyst Vinton Vickers estimates that MGM could generate $140 million in revenue and $40 million in earnings before interest, taxes, depreciation and amortization by 2004 if it launched three domestic MGM-branded channels, each with 4 million to 5 million subscribers. The studio could launch an additional two multiplex movie channels in the future when it recaptures the rights to some 600 films it holds jointly with Turner Broadcasting.
The enterprise value of such endeavors could be as much as $900 million, or $5 per share, applying a cash flow multiple of about 16 and assuming MGM forfeits 50 percent of the equity in these new multiplexed channels to gain distribution, Mr. Vickers estimates.
But the absence of branded domestic MGM channels remains the weak link in the studio’s strategy, although the rapid expansion of digital spectrum and the demand for branded content could change all that.
MGM is rolling out new branded movie channels in Mexico, New Zealand and parts of Europe and has stakes in 14 international cable channels, including MGM Latin America and MGM Brazil, and a host of nonbranded international movie services, from STAR Channel Japan to Movie Network Channels Australia. Collectively, they should grow to $100 million in earnings over the next five years, according to Jeffrey Logsdon, analyst at Gerard Klauer Mattison & Co.
MGM has set its sights on $40 million in annual cost savings and a revamped risk-reward film production process while embarking on an ambitious release schedule of 19 films.
The company is divided into two separate studios-United Artists Films and MGM Pictures. UA focuses on seven to 10 specialized and independent films annually, each costing less than $10 million, and MGM Pictures produces and distributes up to 15 major feature films annually,
each budgeted between $25 million and $45 million. Overall, analysts say three- to five-year revenue growth should be about 18 percent.
Setting the bar
In an effort to ensure profitability, MGM management has established a financial goal of $1.25 in revenue generated for every $1 invested in filmmaking.
Perhaps more than other studios, MGM has created a portfolio approach to developing, financing and producing films with partners-many of whom, such as Miramax and Universal, are direct competitors. It has tightened its film approval process, scheduled openings during less congested periods, leveraged its libraries for remakes and sequels (including “James Bond,” “The Pink Panther” and “Rollerball”), and sliced the compensation expectations of high-priced talent. The bottom line: MGM will have spent at most $425 million producing 19 feature films this year at an average cost of $27 million each, well below the industry average of $55 million.
That is why the downward revision of its second-quarter and full-year targets was a blow to MGM management. The company recently said revenues for the second quarter ended June 30 should come in at between $265 million and $270 million, compared with $290 million a year earlier. Second-quarter cash flow adversely impacted by new accounting rules will result in a loss of between $30 million and $35 million, compared with $24.5 million in earnings in the same period of 2000.
Although management had expected about a 10 percent decline to about $110 million in overall earnings for 2001 even before the
accounting rule changes, it now expects full-year earnings to drop as low as $85 million, or 27 cents per share, even though MGM’s
home video and television distribution operations are generating stronger-than-expected revenues and cash flow.
Still, most analysts are sticking by their estimates that by 2005, MGM will be generating $217 million in earnings on $2.7 billion in annual revenues.
MGM management has applied the same prudent financial strategies to its TV production, which is valued by analysts at about $450 million. It has reduced significant deficit financing that undermines most producers of weekly comedy and drama series by concentrating on first-run syndication for network and non-network broadcasters and developing co-production and distribution partnerships.
It developed its two new fall series-“Jeremiah” and “Leap Years,” both for Showtime-from its library in much the same way it developed the series “Poltergeist,” “The Outer Limits” and “Stargate.” MGM has NBC as a production partner in a remake of “The Thomas Crown Affair,” and has 18 TV shows in deve
lopment. About three-quarters of its television-related operating results are generated by science-fiction fare, even though its film library is heavy on drama and action-adventures.
Mr. Vickers expects MGM’s TV production unit to post $23 million in cash flow on about $162 million in revenues this year. Spending about $100 million annually on television production, MGM’s self-mandated financial target is a $1.35 revenue ratio per every $1 spent on TV production, analysts say.
Diversifying the business
With revenues growing at a rate of about 12 percent over the next three to five years, television production represents a small but profitable business that generates about 7 percent of the company’s overall revenues, compared with 40 percent from its library and about half from film production. Management expects those percentages to dramatically change over the next five years as MGM diversifies its businesses.
Mirroring its film partnerships is MGM’s recently announced 15-year international distribution agreement with NBC through which MGM is handling the distribution of all NBC-produced product (except for sports and news) over the next four years in exchange for what analysts estimate will be as much as a 25 percent distribution fee.
Mr. Logsdon estimates the arrangement will enhance MGM revenues by more than $10 million annually, will bulk up its international sales on the back of NBC’s program investments and “sets the stage for further alliance with NBC-the only major network without ownership of a major studio,” he said.
MGM is discussing similar fee-based distribution deals with other networks and studios, having cut by half its distribution costs since withdrawing from an international distribution partnership with Paramount and Universal in early 2000.
MGM also recently announced a partnership with the United Paramount Network (UPN) to broadcast 57 MGM feature films in a Saturday-afternoon block beginning next month on UPN-affiliated stations reaching 86 percent of U.S. TV homes. MGM will manage and share the national advertising sales.
But in its ultimate vertical integration move to date, MGM this year took a 20 percent stake for $825 million (but no management control) in Rainbow Media’s four national cable networks: AMC, Bravo, Independent Film Channel and Women’s Entertainment.
MGM has increased placement of its own product on Rainbow outlets such as AMC and Bravo but has no guarantee that it eventually will leverage its existing film inventory in the launch of new branded services domestically as it needs to do. MGM has had preliminary talks with Cablevision Systems Corp. and John Malone’s Liberty Media Group about launching at least one new movie service using MGM’s film library, not only for cable but also for satellite distribution.
Still, MGM says it hopes to engage in other alliances with NBC and Cablevision and to eventually acquire outright their interests in Rainbow. Such strategies may come into play if MGM surfaces as a solo or partnered bidder for Fox Family Channel, sources say.
MGM management also has had preliminary conversations with AT&T Corp. about acquiring its 23 percent stake in Cablevision, sources say.
Even if its aggressive push to own more domestic distribution doesn’t come easily or at all, rapidly increasing digital spectrum and demand for branded content (for such new technology as video on demand and digital video discs) will boost MGM’s value far beyond its current $5 billion market capitalization. Its nearly $23 a share stock price is well above its $14.87 one-year low but still lagging below its 52-week high of $26.87 and Wall Street’s $27 target price for the company.
Holding the line on costs
But at a time of declining or questionable entertainment values, other upbeat signs make MGM look like a pretty good deal at a time when pressure is mounting for the lone independent studio to make a major alliance with a major distributor.
MGM’s nearly $5 billion market capitalization (which just reflects the estimated value of its underutilized film library) is a fraction of that of most other Hollywood studio companies, which range from about $16 billion for Fox to $209 billion for AOL Time Warner. MGM trades at a premium of 13 times cash flow-well below AOL Time Warner’s 20 times cash flow but well above Fox’s 7.8 times cash flow.
MGM also has a box office market share of about 10 percent (up more than 600 percent from a year ago), tying Fox and exceeding Disney’s Buena Vista and Miramax, but about one third behind Sony and Paramount. MGM has been winning the battle against escalating production and talent costs. Management does not allow itself much in the way of perks but is building a fancy new Century City headquarters that will be ready by spring 2003.
By then, most industry experts are betting, MGM will be part of a bigger entertainment entity, although Mr. Yemenidjian appears to be sticking by a declaration he made to me a year ago: “For us to be looking to sell out at a time when I think my company is going to double or triple in value doesn’t seem to me to be very smart business. Once I get to $15 billion (in market cap) and more diversified sources of subscription and advertising revenues, then I have a choice,” he said.