When Kirk Sells, Buyer Beware
By Devin Leonard

(FORTUNE Magazine) – Kirk Kerkorian, the reclusive 87-year-old majority owner of Metro-Goldwyn-Mayer, has crafted some of the most astounding deals in Hollywood. He has sold MGM twice, reaping billions of dollars each time only to buy it back. Now he is poised to do that again, dangling his movie company under the noses of potential buyers such as Sony Corp. of America and Time Warner (parent of FORTUNE's publisher).

Kerkorian's timing couldn't be more perfect. MGM's recent theatrical releases--among them Agent Cody Banks 2 and the remake of Walking Tall, starring The Rock--have been disappointments. But the company's library of more than 4,000 films, including the James Bond, Pink Panther, and Rocky franchises, has never been more valuable, thanks to the DVD boom. MGM doesn't disclose how much money it makes repackaging its old movies in digital form, but David Miller, senior media analyst at Sanders Morris Harris, estimates that its library threw off $265 million last year in Ebitda. He says DVD sales were responsible for more than a third of the library's cash flow.

More power to Kerkorian. But is this the right time for Sony or Time Warner to take MGM off his hands? Sony has offered to purchase MGM for $5 billion--19 times the library's Ebitda. (It's bringing in partners to finance the bid.) Time Warner has reportedly made a preliminary offer worth $4.7 billion. These are clearly top-of-the-market valuations. "The reality is, of the 4,000-odd titles, there are only 200 or 300 that are really marketable," scoffs Porter Bibb, managing partner of Technology Partners, a merchant bank. "The rest of them are absolutely B pictures and dogs." Neither Time Warner nor Sony would comment. But it's no secret that both camps are upset that MGM officials are trying to drive up the price and draw in other bidders by turning the sale into a high-profile auction. MGM also declined to comment.

It's hard to imagine a better way to describe chestnuts from the MGM vault like Blacula, a blaxploitation version of the Bram Stoker chiller. However, any potential buyer of MGM faces a far more significant issue: The cash-flow growth from DVD sales is expected to slow dramatically in the next four years. According to PricewaterhouseCoopers, U.S. DVD sales rose by 44%, to $12 billion, in 2003. It predicts that sales will rise another 24% in 2004, but growth will slow to 7% in 2008. By 2008, 89% of U.S. households are expected to have a DVD player, compared with 3% five years ago. So while consumers will rush out to buy the DVD of Shrek 3, they probably won't haunt the racks at Best Buy as obsessively as they did when they first bought a player. Because of this, some observers in the entertainment world say the true value of MGM is closer to $4 billion.

Hollywood hopes to reignite DVD sales growth by peddling them in places such as China, where household penetration is much lower. That's easier said than done because DVD piracy is so rampant in those markets. The movie industry is also pinning its hopes on high-definition DVDs, which can hold up to ten times as much data as current disks. Sony is pushing a high-definition DVD format called Blu-ray with partners that include Matsushita Electric, Philips, Pioneer, Sharp, and Samsung. Toshiba and NEC have developed a competing format called HD DVD. Ideally, in the eyes of Hollywood, high-definition DVDs will be so compelling that consumers will repurchase all their MGM James Bond titles in the new format.

Any studio head who believes this is going to happen anytime soon would be well advised to seek a new career. Most analysts predict that there will be a knockdown battle between Blu-ray and HD DVD. It will also be years before most people can afford to buy a high-definition DVD player, since early versions are expected to retail for as much as $3,000. Richard Doherty, director of the Envisioneering Group, a digital-media consulting firm, is adamant that there will be no mass adoption of high-definition DVD until 2010 at the earliest. Who knows? By then MGM may be back in Kerkorian's hands. --Devin Leonard