Lions Gate Entertainment: Arbitraging The Bond Spreads During The Business Separation

seekingalpha06-11

Lions Gate and Lions Studios are separating in two different entities by the end of the year, in order to simplify the corporate structure.The 5.5% bonds due 2029 will be split between the two ...

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JHVEPhoto/iStock Editorial via Getty ImagesThere is an interesting opportunity to profit from an incredibly wide credit spread between two very similar bonds at Lions Gate Entertainment (NYSE:LGF.A) and its newly separated Lionsgate Studios (LION). In May 2024 the company announced it has completed an exchange offer for the 5.5% bonds due 2029, which will now be split in half between the two companies. However, these two notes trade with 30 points of spread given the different credit profiles of the new entities. We think the notes remaining at Lions Gate Entertainment (CUSIP: USU53644AC18) are deeply undervalued and will soon re-rate. Transaction overview: a business separation and debt exchange offer At the beginning of the year, Lionsgate announced its intention to separate the business into two separately traded companies: the studio business will trade as Lionsgate Studios (LIONS) and the STARZ business will continue trading as Lions Gate Entertainment (LGF). We believe the transaction aims at unlocking value from a potential valuation re-rate, as well as benefiting from a simplified corporate structure. Recently the company completed an important milestone, with the reverse acquisition of the studio business in a SPAC deal, which raised $350 million in equity proceeds. However, the parent company still owns 87% of the newly separated entity and is planning to distribute this stake to shareholders by the end of the year. But these transactions often make some investors happier than others. This was definitely the case with bondholders and in particular the owners of the 5.5% notes due 2029. These bonds were guaranteed and issued by a subsidiary of the STARZ group (RemainCo) and were not meant to be transferred to the studio business. However, in a surprising exchange transaction announced in May, the company disclosed that a preferred group of creditors (representing a majority) agreed to new terms to move their holdings to Lionsgate Studios. Apparently $383 million of notional will be transferred to the new company - which has a stronger collateral profile - and the remaining $350 million will stay at STARZ. This news was immediately reflected in the trading prices of the bonds, which have very different YTM and spreads. The transferred notes trade at around 92 cents, with a 7.5% YTM, while the other notes trade at 62 cents with a 17.5% YTM. This high yield represents a 10% spread over similarly-rated bonds (B+) and is usually a signal for a high probability of distress. However, we think this is not the case, and the opposite is, in fact, true. The company is fairly levered on a clear path to deleveraging, and once the market figures this out this spread will close rapidly. Some holders of the RemainCo bonds are not of this opinion, however, as they threatened litigation claiming the transaction breached the bonds documents: For its part, bondholder Sycale Advisors hired legal counsel Selendy Gay to consider potential litigation against Lionsgate ahead of the studio’s separation of its film division from the STARZ streaming service. Other bondholders are also in talks to join the group, one of the sources noted. Pro forma financials reveal a strong credit profile for the STARZ business We believe that the bonds remaining at the direct-to-consumer streaming business are attractive for the following reasons: (1) a significant portion of the debt will move to the studios business which is where the collateral is, (2) the STARZ business is already profitable, cash flow generating, and on a path for higher profitability driven by pricing, and (3) management signaled the intention to deleverage. These aspects together support a potential spread compression from the current 10% to a more moderate level, which would trigger a price recovery for the notes. But let’s dive into the financials of the pro forma entities.   Pro Forma Balance Sheet (10-12B Filing)This is a snapshot of the balance sheet from historical Lionsgate to Pro Forma STARZ business, as taken from the 10-12B filing by Lionsgate Studios. The RemainCo will have only $776 million in liabilities, which are inclusive of the 5.5% notes and the term loan A. With also $60 million in cash, that represents a net debt of just over $700 million.   Revenue and Profit By Segment (10-K)On the other hand, the Media Networks segment, which was the old name of the RemainCo, generated over $236 million of operating profit for the fiscal year ended in March. This means the leverage ratio is around 3.0x using 2024 figures, and slightly above that using the estimated $200 million of EBITDA expected for FY2025. The studio business, on the other hand, has a leverage of 6.8x if we include firm-related obligations, which are loans and borrowings secured by intellectual properties. While benefiting from better collateral coverage, the riskiness profile is very different from a leverage perspective. Management also added some color on how the separation will affect the capital structure: It's not until full separation that they travel with the studio. And in the $325 million, which is relative to STARZ is going to be remaining with STARZ the way we've always said, but it's $325 million instead of the $715 million. We'll backfill that with some term loan A obviously, very financeable. STARZ has a very strong free cash flow. It also confirmed that their plans for STARZ remain to deleverage the business, and not prime bondholders with new, useless, and pricey debt: So let me remind you, $200 million plus of adjusted EBITDA, okay, very little CapEx, no appreciable cash taxes at all. They'll have carryover NOLs. And 5.5% coupons with some term loans, not a lot of interest relative to the size of that business. So they're in a very good position to delever. Risks: priming and cyclicality are the largest concerns There are two major risks for corporate credit investors: (1) creditor-on-creditor violence, and (2) a consistent deterioration of the business. Both can be a source of material losses on the principal as they affect the value that bondholders have access to in case of distress. In this case, we are very far away from an event of default (given the low leverage), but the recently announced exchange offer shows how value can still be destroyed. The bonds that will remain at the STARZ business have weak covenants that do not block priming risk - i.e. the risk of incurring new debt that will become senior to existing indebtedness. While management signaled the intention to scale down leverage, we cannot exclude this risk by default. The other important source of risk comes from cyclicality. While the studio business is in its nature more volatile in terms of topline growth, STARZ is also exposed to periods of subscriber decline and/or rising costs. This can weigh exponentially on the bottom line because of the high operating leverage of the sector. All in all, we believe investors are more than compensated for assuming these risks, which are more or less common for many other bonds that trade at far lower yields. Conclusion  Lions Gate Entertainment's 5.5% bonds due 2029 that will remain at the STARZ business are looking attractive. They trade at a massive 1000 basis points spread over similarly-rated bonds despite leverage being in the low 3.0x, and significant de-risking opportunities. We believe that once the separation is complete, and the market has access to complete information on the capital structure, these bonds will trade significantly higher.","kind":null,"is_publish_news":true,"is_publish_highlight":false,"is_publish_live":false,"is_publish_wemedia":null,"editions":null,"column":"","sentiment":"0","news_tag":"","news_rank":0,"symbols":[],"gpt_button":1},"commentList":[],"isCommentEnd":true,"newsSizeData":{"likeSize":0,"commentSize":0,"repostSize":0,"favoriteSize":0,"likeStatus":false,"favoriteStatus":false},"APP":{"userAgent":"Mozilla/5.0 AppleWebKit/537.36 (KHTML, like Gecko; compatible; ClaudeBot/1.0; +claudebot@anthropic.com)","isDev":false,"isTTM":true,"deviceId":"web-server-community-laohu8-v3","version":"4.28.1","shortVersion":"4.28.1","platform":"web","vendor":"web","appName":"ttm","isIOS":false,"isAndroid":false,"isTiger":false,"isTHS":false,"isWeiXin":false,"isWeiXinMini":false,"isWeiBo":false,"isQQ":false,"isBaiduSwan":false,"isBaiduBox":false,"isDingTalk":false,"isToutiao":false,"isOnePlus":false,"isHuaWei":false,"isXiaomi":false,"isXiaomiWebView":false,"isOppo":false,"isVivo":false,"isSamsung":false,"isMobile":false},"href":"/m/news/2442391255"}