1 Major Risk -- and Opportunity -- for Lions Gate Entertainment Investors

Source: Lions Gate.

Lions Gate Entertainment (NYSE: LGF  ) is quite a singular case among movie studios.

The company is substantially smaller and more concentrated than most competitors, and this can be a major source of risk for investors when things don't work out as expected. On the other hand, necessity can be the mother of invention: Lions Gate has proved its ability to be particularly selective and cost-efficient to overcome its disadvantages in areas such as financial resources. Besides, blockbusters such as The Hunger Games can be enormously profitable for investors in a relatively small movie studio such as Lions Gate.

Small size, big challenge
It's not easy to compete in the movie business when most of your industry peers are bigger and more powerful, and Lions Gate acknowledges that reality quite clearly. From the company's annual report:

We are smaller and less diversified than many of our competitors. Unlike us, an independent distributor and producer, most of the major U.S. studios are part of large diversified corporate groups with a variety of other operations, including television networks and cable channels that can provide both the means of distributing their products and stable sources of earnings that may allow them to better offset fluctuations in the financial performance of their motion picture and television operations. In addition, the major studios have more resources with which to compete for ideas, storylines and scripts created by third parties as well as for actors, directors and other personnel required for production. The resources of the major studios may also give them an advantage in acquiring other businesses or assets, including film libraries, that we might also be interested in acquiring.

It takes a lot of time and money to launch a new movie, and results are always hard to predict. Investors in DreamWorks Animation (NASDAQ: DWA  ) were reminded of that lesson in a painful way, as its stock dropped by nearly 11% on Monday because of a disappointing box office performance from the highly anticipated release of How to Train Your Dragon 2.

That movie generated an estimated $50 million during the weekend, coming second only to 22 Jump Street, which produced $60 million over the weekend. With those kinds of numbers, How to Train Your Dragon 2 can hardly be considered a flop. However, Wall Street analysts were expecting a better performance, since the original movie was a big success and reviews for the sequel were widely positive.

Lions Gate Entertainment needs to compete against an industry juggernaut such as Disney (NYSE: DIS  ) , which has access to enormously valuable intellectual properties and unparalleled financial resources. To put things in perspective, Disney has a market capitalization of nearly $144 billion, versus approximately $3.8 billion for Lions Gate.

Disney has made a series of big and valuable acquisitions over the past several years, including the purchase of Pixar for $7.4 billion in 2006, Marvel for $4.24 billion in 2009, and Lucasfilm and the Star Wars franchise for $4.05 billion in 2012. Disney has shown that a big wallet can be a key strategic asset when competing for content in the industry, and the company certainly has huge financial advantage over Lions Gate.

Creating strength from weakness
On the other hand, a smaller size can also be a considerable plus for investors in Lions Gate. As opposed to bigger and more powerful competitors, Lions Gate is deeply focused on keeping production expenses under control and carefully examining the commercial viability of new projects before committing its capital.

Lions Gate usually films in locations offering tax incentives and other subsidies to reduce costs, and the company frequently enters co-production agreements to mitigate its financial exposure to a single project. In addition, Lions Gate often signs agreements with actors that offer them participation in a movie's financial success in exchange for reducing up-front payments.

This approach means Lions Gate doesn't need every new film to be a huge success for the company to be profitable, and a single unsuccessful movie is unlikely to produce unacceptable financial damage. On the other hand, when it hits a home run like The Hunger Games, profitability can be enormous, since the impact on revenue can be especially important for a relatively small studio.

Lions Gate has a promising pipeline scheduled for its fiscal 2015, including a new Hunger Games movie expected to be launched this November. Divergent produced more than $250 million in global box office receipts, and this bodes well for Lions Gate as the company builds that franchise for the years ahead.

Source: Lions Gate.

If revenues from these launches are higher than currently anticipated, this could have big financial implications for Lions Gate, so investors may want to watch these movies closely -- not only at movie theaters, but also at the box office.

Foolish takeaway
Being smaller than the competition is a considerable risk for Lions Gate, and hence its investors. However, the company has developed solid strategies to overcome its challenges. Besides, a small revenue base means that investors stand to profit substantially when Lions Gate hits a home run as it did with The Hunger Games. This small movie studio offers both above-average risks and superior opportunities for gains in comparison with its peers.

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Andrés Cardenal

Andres Cardenal, CFA is a tenacious researcher of the best investment opportunities around the world. Andres is an economist and CFA Charterholder living in Buenos Aires, Argentina. Naturally flavored. Follow me on Twitter for more investment ideas:

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