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Adding a Game Breaker

No deal is good news for this entertainment company, and we're adding it to the portfolio.
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We are initiating a 300-share position in independent film production company Lions Gate Entertainment (LGF) with the stock recently trading at $10.31. We believe shares have 50% upside from current levels as the company rolls out new movie releases and investors who fled the stock on speculation the company would acquire European firm HIT come back to this attractive growth story.

To fund this purchase, we are closing out our 1,200-share position in Applied Micro Circuits (AMCC) ; its shares were recently trading at $2.64. Despite break-even quarterly results, its first since the telecom collapse in 2001, we can't justify holding this stock in a volatile market, and we no longer expect shares to trade meaningfully higher during the next 12 months. The telecom equipment sector is filled with too much capacity and not enough demand, as can be witnessed by the dismal operating results from Nortel (NT) and Lucent (LU) of late.

We owned Lions Gate back in September as a Stealth Stock and booked some 40%-plus gains when we sold out of the position in November. We are classifying Lions Gate as a Game Breaker this time around, given its potential to dominate the independent film production landscape with a spate of coming movie releases.

Lions Gate is the last remaining company in the independent movie production space and assumed this role when its largest competitor, Metro-Goldwyn-Mayer, was acquired by Sony (SNE:NYSE ADR) and Comcast (CMCSA) in late 2004. At the time of the MGM deal, Lions Gate shares were trading closer to $8 a share, but the stock rallied to a high of $12.04 after we initiated a position. Much of the excitement was generated on speculation that the company would be the next to be taken over and on high expectations for the release of Michael Moore's film "Fahrenheit 9/11."

Shares have come under pressure of late -- falling some 10% in the past month -- based on speculation that Lions Gate would make a bid for European children's entertainment company, HIT Entertainment. The decline in share price put the stock back on our radar, but after looking at the potential costs and benefits of a deal with HIT -- which owns the rights to "Barney the Dinosaur" and "Thomas The Tank Engine" -- we decided this deal would cloud the future financial performance of Lions Gate and opted to remain on the sideline because it would have diluted the company's value as an independent production company.

On Thursday, Lions Gate announced its management team is walking away from the deal. With the HIT deal off the table, management can now focus on upcoming film releases including "Crash," which opens in theaters today, and on the upcoming DVD release of the surprise box office hit, "Diary of a Mad Black Woman."

As with most of Lions Gate's low-budget films, the break-even point for "Crash" is $12 million in box office receipts, which should be easily attainable. Online movie site Hollywood Stock Exchange is expecting "Crash" to bring in $21.56 million in ticket sales during its first four weeks, and the movie should give Lions Gate some nice gains this quarter. In addition to "Crash," the list of potential summer hits -- which includes "High Tension" and "Undead" -- provides additional catalysts that should drive shares higher in the coming three-to-12 month period.

There are risks to Lions Gate's future performance. Chief among them is the potential for a string of box office failures. In addition, a slowdown in gross domestic product could curb consumer spending, limiting the earning potential of new releases this year. Finally, shares trade at a P/E multiple of 32, which is about twice that of the S&P 500, implying lofty expectations that could come crashing down should the company disappoint investors. That said, Lions Gate's strong operating history should negate these fears.

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