Shares of Lions Gate Entertainment (NYSE:LGF.A) plummeted over 30% on Feb. 5 in response to its weak third quarter earnings report. The studio's revenue fell 10.8% annually to $670.5 million during the quarter, missing estimates by $96.5 million.
Much of that miss was attributed to the softer-than-expected performance of The Hunger Games: Mockingjay Part 2. Motion picture revenue fell 14.3% to $505.8 million, international motion picture revenue dipped 1.4% to $140.1 million, and TV production revenue grew just 2.1% to $164.7 million. On the bottom line, adjusted net income plunged 39.3% to $66.8 million, or $0.45 per share, missing expectations by two cents.
However, the stock's precipitous plunge also bumped its forward dividend yield to 1.9% -- the highest level since it started paying a dividend in 2013. Should investors consider this yield a reason to hold the stock, or is it in danger of being reduced to previous levels?
Payout ratios and free cash flow
To understand how sustainable a company's dividend is, we should check its payout ratios. On an EPS basis, Lions Gate paid out 84% of its earnings over the past year as dividends. By comparison, its larger peers Time Warner (NYSE: TWX) and Fox (NASDAQ: FOX) only paid out 31% and 25% of their earnings respectively. Lions Gate's higher payout ratio might make it look more "generous" than Time Warner or Fox, but it also means that it has less room to raise its dividend. Lions Gate has raised its dividend twice in the past.
But on a free cash flow basis, Lions Gate's dividend looks more sustainable. Over the past 12 months, Lions Gate paid out just 34% of its FCF as dividends. Time Warner paid out 34% during the same period, while Fox paid out 31%. Lions Gate's FCF also improved last quarter, rising from negative $4.6 million in the prior year quarter to $73.9 million. A portion of that boost was attributed to favorable tax rates and the studio's strategic investment in Pilgrim Studios last November.
Dividends or buybacks?
Lions Gate management didn't discuss the dividend at all during the conference call. Instead, it discussed the possibility of increasing its buyback authorization to as much as $250 million. Over the past 12 months, Lions Gate only spent $15 million, or 12% of its FCF, on buybacks -- which turned out to be a bad move based on the stock's 42% decline over the past 12 months.
Lions Gate's management noted that they couldn't buy back any stock as long as the company was in merger talks with Starz (NASDAQ: STRZA) or other potential suitors. But with interest rates still low, and its stock trading at just 12 times forward earnings, it might be prudent to buy back stock if a deal doesn't pan out. Either way, Lions Gate still has enough free cash flow growth to fund both dividends and buybacks.
But what about bottom line growth?
However, Lions Gate's dividend and buybacks won't mean much if the studio can't launch new blockbuster film franchises and increase the weight of its more stable TV production division, which produces series like Orange is the New Black and Nashville.
Lions Gate is much smaller than major film studios like Fox and Time Warner, so it sells the international distribution rights to its films in advance. For example, it covered most of Divergent's production costs by selling the international rights for $70 million. While this allows Lions Gate to spend very little cash to make a movie, it also puts a cap on its overseas revenue. Moreover, the strategy also only works when the film has a guaranteed audience -- that's why the studio keeps adapting young adult (YA) books like Twilight, The Hunger Games, and Divergent into movies. Lions Gate's non-YA films, like The Last Witch Hunter and American Ultra, generally haven't fared as well.
The next Divergent film, Allegiant, will be the company's main tentpole film for the current quarter. But based on the 14% decline in domestic box office sales between Divergent and Insurgent, Allegiant's ticket sales might disappoint analysts.
Looking further ahead, Lions Gate hopes that its adaptation of Chaos Walking, another YA dystopian series, will appeal to fans of The Hunger Games and Divergent. Its upcoming Power Rangers reboot could also evolve into a new multi-year franchise. Lastly, the studio is also mulling the development of a prequel series for The Hunger Games.
The dividend is safe, but does it matter?
For now, Lions Gate's dividend remains safe, since its free cash flow remains robust. The studio might even raise its dividend later this year. But in my opinion, other media companies (like Time Warner) pay higher dividends than Lions Gate, so its yield isn't really a compelling reason to own the stock. Instead, investors should focus on its merger talks with Starz, and whether or not other suitors will make a bid for Lions Gate's top-heavy business.