In the past three years, the fund delivered a sweet 26% annualized return to investors. The fund seems to be quite diversified, with the largest position accounting for only 2.5% of its total portfolio. Its top two positions are Lions Gate Entertainment Corp. (USA) (NYSE:LGF) and Bally Technologies Inc. (NYSE:BYI).
A profitable movie franchise
Lions Gate Entertainment Corp. (USA) (NYSE:LGF) is the global entertainment company with a leading position in motion picture production and TV programming and home entertainment. As such, it operates in two main business segments: Motion pictures and television production.
About $2.3 billion, or 86.3%, of total revenue was generated from the motion- pictures segment while the TV-production segment contributed only $379 million in sales. The motion-pictures segment was also the biggest profit contributor, with $396.6 million in operating income while the operating profit of the TV-production segment came in at only $24 million.
What is interesting about Lions Gate Entertainment Corp. (USA) (NYSE:LGF) is its film franchise business model. Recently, the company has been quite successful with the highly profitable Twilight franchise. In the middle of June, Moody’s also raised the company’s debt rating from B1 to Ba3, thanks to the expected impressive performance of the next three “Hunger Games.” Moody’s mentioned that the firm had “highly visible and significant free cash flows of well over $150 million per year through fiscal 2016.” Moody’s thought highly of the company’s strategic acquisition of Summit Entertainment, which brought significant strategic and cost synergies to Lions Gate Entertainment Corp. (USA) (NYSE:LGF).
Lions Gate was recently trading at $31.80 per share, with a total market cap of $4.3 billion. The market values Lions Gate Entertainment Corp. (USA) (NYSE:LGF) quite expensively at 20.1 times its trailing EBITDA (earnings before interest, taxes, depreciation and amortization). In the future, Lions Gate has a high probability to grow rapidly with its movie franchise business model. However, I don’t think investors should allocate a lot of their investment capital into Lions Gate Entertainment Corp. (USA) (NYSE:LGF) due to its high valuation.
A global leading company in gaming systems
Bally Technologies Inc. (NYSE:BYI) is a diversified gaming business, selling gaming devices and technology solutions, operating in three main products: Gaming equipment, gaming operations and systems. Some $375.4 million, or 41% of the total revenue, was generated from gaming operations while gaming equipment ranked second with $310.7 million in 2012 sales.
Recently, Bally Technologies Inc. (NYSE:BYI) announced that it agreed to acquire SHFL entertainment Inc (NASDAQ:SHFL) at around $23.25 per share in cash. The total transaction value is $1.3 billion, including $8 million of debt and $41 million in cash of SHFL entertainment Inc (NASDAQ:SHFL) as of April. The deal is expected to close by June 2014.
Bally Technologies Inc. (NYSE:BYI) main operation is in the U.S., accounting for around 84% of the company’s revenue while the international region represents as much as 53% of SHFL entertainment Inc (NASDAQ:SHFL)’s sales. The acquisition of SHFL will increase the revenue percentage share of the international market to 24%. Moreover, SHFL will bring to Bally’s a more diversified revenue stream including utility, proprietary table games and electronic table systems. Bally Technologies Inc. (NYSE:BYI) expects to create around $30 million in annual synergies, thanks to economies of scale, a more efficient supply chain, regulatory licensing and other marketing and trade-show costs.
At a recent price of $70.10 per share, Bally is worth around $2.9 billion. The market values Bally at 10.4 times its trailing EBITDA. I personally do not think Bally is paying an expensive price for SHFL entertainment Inc (NASDAQ:SHFL)’s buyout. At $23.25 per share, SHFL entertainment Inc (NASDAQ:SHFL) is valued at around 11.2 times its trailing adjusted EBITDA, including the synergies of $30 million.
This seems to be a good deal for Bally, as it would create “one of the world’s largest end-to-end gaming technology innovators.” according to Bally’s CEO Ramesh Srinivasan. However, what I worry about is the fact that Bally is financing the deal with debt. Including expected synergies, the pro-forma leverage level is quite high, at 4.6 times total debt/adjusted EBITDA. At closing, Bally estimated that the leverage ratio would be around 4, and the company would de-lever at a rapid rate after the deal.
My Foolish take
With their market leading positions, Lions Gate Entertainment Corp. (USA) (NYSE:LGF) and Bally are expected to deliver decent long-term results to patient investors. However, because of Lions Gate’s high valuation and Bally Technologies Inc. (NYSE:BYI) post-acquisition high leverage level, investors should not put a high percentage of their capital into those two stocks.
The article The Top 2 High-Return, Small-Cap Stocks originally appeared on Fool.com and is written by Anh Hoang.
Anh HOANG has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. Anh is a member of The Motley Fool Blog Network — entries represent the personal opinion of the blogger and are not formally edited.
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