Since the last mention about PAE on this site (we have talked about it some more on the blog) PAE's CEO has left the company. The Chairman, Jeff Sagansky, is interim CEO and PAE is looking to acquire ContentFilm, a UK-based film company with a large library and distribution business. PAE's vision has changed and we think this acquisition is more like a merger, given that ContentFilm is larger than PAE.

We also think that Sagansky has no reason to stay on as CEO and that a CFL executive will likely take that position. I would also like to note that Sagansky has sold one of his companies to CFL in the past and has a large ownership stake. It is not clear whether PAE wanted to merge with CFL all along but Howsam (former CEO and regarded by most as the founder) did not want to.

From here, I have not written PAE off but have sold my shares pending a valuation analysis of CFL. I am also unclear on the future direction of the company because CFL is larger than PAE so I must familiarize myself with CFL and see how it may affect the combined company's strategy going forward. For instance, CFL has intentionally avoided the production business, but PAE recently expanded its production operations with an acquisition in mid-2007.

Peace Arch Entertainment (PAE) has made three substantial business transactions over the past few weeks. We have been behind the fast-growing vertically integrated Canadian film company since it was trading at $1.00 (it is now at $2.58), and below is our take on the latest transactions.

Trinity Home Entertainment Acquisition (announced May 9) – PAE will buy the California DVD distributor Trinity Home Entertainment for $10 million, extending PAE’s distribution network into the United States. With earnings of $2.5 million in 2006 on sales of $19 million, we think this acquisition is a great move. We expect Trinity to contribute more than $2.5 million to PAE's bottom line next year, when PAE pushes its newly acquired film libraries through Trinity’s distribution network. PAE continues to buy private companies at attractive valuations, no doubt because there are few competitors in this niche market. For more information please see the press release.

Dufferin Gate Productions Acquisition (announced May 18) – PAE is acquiring Dufferin Gate Productions, which produced the well-received The Tudors TV series for Showtime. The company is paying $6 million for Dufferin Gate, which had EBITDA of $1 million last year. We speculate that the price is higher on a relative basis than PAE’s previous acquisitions because the Dufferin Gate deal includes a 72,000 square foot production facility located in downtown Toronto. The assets used to produce The Tudors were also likely acquired, so PAE stands to benefit from the higher margins they will realize when future seasons of the show are produced. In short, we think the acquisition was strategic and that the future contribution of Dufferin Gate to PAE's bottom line will be significantly above the $1 million EBITDA that was reported. For more information please see the press release.

Private Placement to Raise $33 million (announced May 9) – To raise money for the Trinity and Dufferin Gate acquisitions, PAE is carrying out a private placement. The private placement will dilute ownership by about 35% at current prices (US $2.58) . However, we believe this is a much better alternative to debt, which doesn’t fit with PAE’s risk-management strategy. The placement also indicates that institutional investors want to invest in PAE, and we’ll be looking for lock-up provisions to affirm our hypothesis that those investors will be in it for the long-term (as was the case with last year’s private placement). For more information please see the press release.

Conclusion
PAE continues to effectively manage risk while embarking on ambitious growth initiatives. It is also important to note that a small portion of both the Trinity and the Dufferin Gate transactions will be funded by stock ($500,000 for Trinity and $600,000 for Dufferin Gate). This aspect of the transactions is meaningful because it demonstrates the willingness of the acquired companies’ owners to partake in the growth of PAE – it indicates that they are in for the long haul. The two companies’ existing management teams will stay in place as well.

We believe that PAE will earn returns that significantly exceed its cost of capital (last year's acquisition of Canadian DVD distributor ka-BOOM! Entertainment was hugely successful), which is the principal reason we are sticking with PAE throughout this private placement process. We think management has what it takes to develop a leading North American integrated film company.

Since our last update on Peace Arch Entertainment (AMEX:PAE, TSX:PAE), the share price has appreciated substantially. It has risen from $1 when we first mentioned it last October all the way up to $2.89 a few days ago. We believe the stock has risen for all of the reasons we previously outlined: PAE has been emulating the successful practices of Lions Gate Entertainment (NASDAQ: LGF, TSX:LGF), which entails creating a vertically integrated business model. They accomplished this by acquiring a home entertainment distributor, and by being an owner and producer of high-quality film and television products.

Over the last couple of years the company has moved towards brand and sales management, which requires content to sell. The company solved this problem by acquiring more than 20 films for distribution in theaters and on DVD this year, in addition to the 500-title library they acquired at the start of the year. To help them monetize all
these assets the company added a number of key salespeople in their film and television divisions.

As President John Flock has consistently stated, television is a growth area for the company. This is evident from the robust revenues and profits the company produced in the most recent quarter, mostly attributed to their successful mini-series The Tudors.

We stated previously that we knew this company was undertaking activities that would lead to profitability and growth in earnings, we just weren’t sure when that profit would appear; it appeared last quarter, and the results are stunning. PAE had revenues increase 450% and earned $2.2 million in the most recent quarter.

Peace Arch Entertainment is broken down into 3 divisions: film, television and home entertainment

Film

The film division acquired numerous high-profile pictures including Chapter 21, Delirious and Watching the Detectives, all of which premiered at prestigious film festivals this year.
Management expects all of these films to be distributed to theaters later in the year, and while these films have provided a reputation for Peace Arch, they are not integral to the success of the company. Said another way, Peace Arch can be successful without them.

As well as acquiring the high-profile films listed above, the company acquired and/or produced more than 20 B movies, which each contain at least one name star. The strategy is a low-risk strategy in which the same film crew is continually shooting films around Canada. The company also reduces risk by using Canadian film tax credits, by pre-selling foreign distribution rights, and by using a type of financing called ”gap financing.”

It should be noted that all financing of these films is non-recourse and Peace Arch is not responsible if the films fail, as debt is backed solely by the films. The success of any one of the productions is unsure, but Peace Arch produces enough to diversify the revenue streams so that the division is profitable. All of these films are straight-to-DVD, and many are shown on pay-TV channels such as The Movie Network (TMN) in Canada. Occasionally, they have a hit film that grosses above-average revenues, and the company is able to quickly capitalize on the film by making a sequel, as they did with Animal and Animal 2.

Television

This division is demonstrating that Peace Arch can be a major player in the entertainment industry. In April 2006 they released a mini-series on Showtime called The Tudors. The Tudors is a $38-million production co-produced with Showtime that played to a record audience and scored the highest rating for the network in three years.

Peace Arch has also been involved in a small number of other television productions such as a few movies-of-the-week (MOWs) and a few reality-focused television shows for different cable outlets.

Home Entertainment

This division continues to be a huge success for Peace Arch. They acquired kaBOOM! Entertainment, which is now named Peace Arch Home Entertainment, at a purchase price of 4x earnings. kaBOOM! began as a home entertainment distributor dedicated to family entertainment, but has now branched out to non-family third-party productions, and is growing its revenues and profits at a fast clip. It is quickly emerging as one of Canada’s fastest-growing DVD distribution businesses.

Late last year the company acquired a 500-title film library. This is an important milestone, because as this unit distributes more content to retailers, it can demand higher fees and force retailers such Wal*Mart, Best Buy and Future Shop to carry more Peace Arch-related titles. It should also be noted that this division provides stable
revenue streams, compared to the lumpy revenue the other two divisions produce.

In the past couple of years the film industry has undergone significant change. The major studios have focused more on high-budget films and franchises. This summer alone is filled with many franchise-oriented films like Shrek the Third, Spider-Man 3 and Pirates of the Caribbean: At World’s End. This change has allowed smaller independent film companies like Peace Arch and Lions Gate to pick up the slack.

For reasons listed above, Peace Arch has been able to grow all divisions at a very fast clip. There has also been considerable talk about the company turning their home entertainment straight-to-DVD business into a bigger operation that would include a theatrical distribution arm in Canada. It remains to be seen, but there is a possibility that they will become a bigger distribution company in the near future.

Catalysts

• The past year has been met with significant changes in the company, including a significant increase in revenue and profits. One year ago the company was worth $30 million, and now the company is on target for earnings of around $5-10-million in profits.
• The company had a very successful first series of The Tudors, and the show has been renewed for another season. Peace Arch has four seasons planned, and each season becomes more and more lucrative as costs are reduced and the license fees the company can extract grow larger.
• The first batch of high-profile films have been to film festivals and have attracted distributor attention, and should be released later this year. Peace Arch recently acquired the high-profile film Winged Creatures that will be screening at the Cannes Film Festival in two weeks. These films have not earned any money for Peace Arch yet, but will provide meaningful revenue later this year.
• The home entertainment division is set to release a record number of films, and there is a chance that a couple of them will catch on with audiences. This would allow for more profitable sequels, very much like the profits Animal 2 provided for the division.
• The company hired a number of talented sales executives from companies like CHUM Limited to head their film and television divisions.
  This is an important milestone, as the company has a growing body of content, including the 500-title library recently acquired. The team should be able to extract more revenue from the current and future productions as they use their expertise and experience to grow sales.

Final Thoughts

I have never been a person who uses technical analysis as a decision for buying a stock. Instead I am very much the opposite: a fundamental analyst. However, I do believe most of the gain a company makes is in the early years. It should be noted that Peace Arch is now appearing on the radars of bigger investors and traders as it approaches the $5 target. This fact should allow each dollar of earnings to garner a
higher multiple. Concurrent with this, there are now two analysts covering the stock, and both have targets higher than the current price.

I feel lucky to have made an investment thesis when the stock was at a much lower price, and now that my thesis is proving to be correct I am reaping the gain of this solid investment. The Peace Arch story is not over, and the company is now just crossing an important mark: the transition from start-up to growth company. We at Think Intrinsic believe this company will continue to be a very successful investment over the coming year.

Peace Arch Entertainment (PAE) is a Canadian film producer and distributor. PAE profits by purchasing film libraries then selling distribution rights. Also, PAE produces their own movies. These will generate future revenues which are not currently reflected in the financial statements. We consider PAE a small Lions Gate Films with tremendous upside. Industry veterans took control of PAE about a year ago and have significant insider ownership. Now, onto the update:

Peace Arch Entertainment (PAE) announced results for the quarter and year ending 2006 at the end of November. As expected, revenue increased at a large clip over the last year. The company showed a loss as a result of the ramp up in their business by hiring more people and producing more films. As expected, the Canadian DVD distribution arm kaBoom! Entertainment continues its growth in revenues and profit.

What does this mean?

The income statement doesn’t look good, and the traditional value investor would high-tail it out of this company, however we are no traditional value investor. It gets worse; the loss this year equals more than 10% of their market cap. What is not shown in the financials are the finished films sitting collecting dust. Most films gain added recognition when they enter theatres, and Peace Arch not being a theatrical distributor must rely on film festivals to showcase the uniqueness of their films. Peace Arch has many high profile productions waiting to be distributed, including award winning film Delirious and John Lennon-themed production Chapter 27, both of which are being showcased at the Sundance Film Festival. Peace Arch has also produced a high profile mini-series about King Henry VIII that is being shown on Showtime in the near future. All of these impressive assets are sitting on the balance sheet at cost, and not represented in the income statement; yet.

Their Strategy

Top priorities going forward are to build brand name awareness by creating high-profile films and expanding their film library. Building brand awareness will allow the company to be on the shortlist of production companies that filmmakers will want to work with; this allows Peace Arch to produce better productions. Expanding film libraries will allow the company to demand higher prices from retailers in Canada through their distribution arm, kaBoom! Entertainment and will provide long-term recurring revenue.

How'd they do?

Two of their films are opening the Sundance Film Festival and they acquired a 500 film library; they performed to expectations. They also signed many alliances with companies like Sony, Showtime and Genius Productions, as well as acquired more than 20 low-budget films, which should bolster next years revenue.

Expected Results

We expect Peace Arch to continue to develop their properties, grow their revenue and reputation. We cannot be sure when the company will be profitable, but looking at the impressive productions that will be producing revenue this year, we can be sure it will be a banner year for the company, in terms of revenues and reputation.

Additional Information

More information about the management and the company is available on PAE's investor site.

The Globe and Mail article on the new Peace Arch

Become a member and you can subscribe to updates about the companies we cover.

Disclosure: Author is long PAE.

Overview
Peace Arch Entertainment is a vertically integrated entertainment company based in Canada. Their main operating activities are to finance, package and distribute content, which include films and television shows, that they acquire or produce. At no time in history have consumers had more choice over the content they watch and where they choose to watch it. Therefore, it is our opinion that the future of this business will belong to content owners with broad distribution networks and relationships. Peace Arch is in the process of building a library of content under a number of different brands, which is reminiscent of fellow Canadian film company, Lions Gate Entertainment. Lions Gate has proven that this business model works and PAE is a way in which an individual investor can profit from the experience of a talented management team as they grow PAE.

Why We Like Peace Arch Entertainment (PAE)

The senior managers come from prominent jobs in the entertainment industry from such companies as HBO Films and Chum Media. Except, they now have very significant equity interests.

The business model is risk-reduced in the following ways:

1. They buy film and television libraries cheap, and use their distribution and contact network to resell and relicense the properties at favorable prices.
2. Buy independant films that have "buzz" and the potential to win awards, repackage them, and license them at a premium.
3. Finance films in the thriller, horror and action genres; finance them with tax-credits, bank loans, and equity interests, which allows the company to finance numerous lower budget movies with little to no risk.

PAE owns one of the largest DVD distributors in Canada - kaBOOM! Entertainment. PAE purchased kaBOOM! for $8.5 million in January 2006; they are on target to earn around $2 million in fiscal 2006.

Highlights
Summarized from a post on the Yahoo! message boards by glmmrtwnfn:

1. Lucy Liu to star in "Watching The Detectives," which began shooting on July 10th in New York City.
2. kaBOOM! To distribute 100 episodes of THE BIG COMFY COUCH, The first DVDs will be released in November 2006
3. kaBOOM! Entertainment Inc., announced today that it has signed an agreement for the Canadian distribution rights to the golf reunion comedy "The Foursome,"
4. Received an order to produce and distribute 13 episodes of "Makeover Wish," a new series for HGTV Canada that was successfully piloted in the winter.
5. Purchase of over 500 motion pictures from the film library of Dream/CHP, one of the largest independent film libraries in the world.
6. Agreement with Showtime for the distribution of a new dramatic series based on the life of King Henry VIII called The Tudors.
7. Award-nominated films under the Peace Arch banner: Chapter 27, Delirious, and Guantanamero.

Peace Arch should offer significant shareholder value by reselling and relicensing existing properties at large premiums. This is a major advantage of a vertically integrated corporate structure. They can purchase a library, repackage the property, distribute it through kaBOOM! in Canada, and use their contact network to distribute it worldwide.

Case Study
Contentfilm, an integrated packaging and selling media company based in London, England recently purchased the complete library of American content company Allumination for $7 million. JP Morgan subsequently valued the film and television library at $45 million. This is an example of entertainment assets in more capable hands.

Conclusion
Peace Arch Entertainment is still in the first inning of its history, and in the past 18 months has shown tremendous growth. The growth should continue as the company focuses on: building their library of films by acquiring and producing award nominated and winning films under their Peace Arch banner, financing their genre pictures, expand kaBOOM!'s operation, and attract more talented managers to the company.

Additional Resources
Conference calls, transcripts, brochures, and much more