Entertainment Deals Testing Wall St. Trust

One of champion investor Warren Buffett’s best-known principles is that he avoids businesses he can’t understand.

But if everybody followed that advice, who would be left to buy entertainment stocks? Apart perhaps from major league baseball, some Wall Street pros say they’re hard pressed to name an industry with more baffling finances than the entertainment sector.

That image was reinforced last week by Vivendi Universal’s multifaceted deal with USA Networks Inc. Not even the two parties involved could agree on the dollar value of the transaction.

In the aftermath of the bankruptcy of energy trader Enron Corp.--now exposed as a bastion of accounting obscurity for obscurity’s sake--investors are being cautioned to demand straightforward earnings reports and to be highly suspicious of “pro forma” accounting and off-balance-sheet deals.

But such an approach would seem to exclude much of the entertainment industry as an investment option--particularly the cable television realm, which is famous for its murky joint ventures, huge debt loads and utter lack of profits, as traditionally defined.

Cable TV firms pioneered the use of the cash-flow measurement EBITDA--earnings before interest, taxes, depreciation and amortization--as a substitute for old-fashioned net income, or profit.

To be sure, there are good reasons for adopting such a yardstick for an asset-heavy industry that requires a massive initial investment and faces high depreciation costs, which are noncash charges. In that environment, a business can be perfectly healthy without showing a bottom-line profit.

That doesn’t make it easy for investors to understand what they’re getting when they buy the stocks, however.

Likewise, movie accounting in Hollywood has long been a total mystery to many investors in studio stocks. In their 1998 book “Movie Money: Understanding Hollywood’s (Creative) Accounting Practices,” authors Bill Daniels, David Leedy and Steven D. Sills noted that “the distribution of a motion picture’s ‘profits’ is, for most film makers, a murky, labyrinthine domain ruled by studio/distributor accountants and lawyers.”

For sheer complexity, Vivendi’s flurry of deals last week may have set a new standard for Hollywood.

Vivendi, the Franco-Hollywood conglomerate chaired by Jean-Marie Messier, simultaneously agreed to buy the entertainment divisions of Barry Diller’s USA Networks (mainly the USA and Sci Fi cable TV stations, plus a TV production company), struck an alliance with John Malone’s Liberty Media Corp. and took an 11% stake in satellite-TV firm EchoStar Communications Corp.

Vivendi valued the USA deal at $10.3 billion; USA priced it at $11.67 billion. Part of the deal involves Vivendi returning $7 billion of previously acquired USA stock. Meanwhile, Vivendi will give Liberty Media $1.65 billion worth of Vivendi stock, taking back Liberty’s USA stock in exchange.

The executive reporting lines within the new Vivendi Universal Entertainment unit appeared so ambiguous, even after a lengthy news conference, that the parent company felt compelled to issue a news release clarifying who reports to whom. (Hint: Diller is on top.)

Confusing as such deals may be to Wall Street, investors who simply threw up their hands and stayed clear of entertainment stocks in recent years have missed some outstanding performance.

USA Networks shares, for one example, have surged 35% this year (including last week’s gain of 10%, to $26.16 as of Friday on Nasdaq) and have produced an annual average return of 29% over the last five years.

Liberty Media, with its extensive cable programming and systems holdings here and abroad, has returned a yearly average of 36% since 1996. The stock added 1.4% last week to end at $13.15 on the New York Stock Exchange.

Vivendi has been something of a clunker, by contrast: The stock gained nearly 8% last week, to $52.65 on the NYSE, but it’s down 19% this year and produced an average annual return of 6% over the last five years. During most of that span, however, Vivendi’s revenue came mainly from its water-utility business; the firm entered Hollywood just last year with its acquisition of the former Seagram Co.

Another disappointment has been Walt Disney Co., which has been in a funk for much of the time since its much-touted purchase of Capital Cities/ABC Inc. in 1995. Disney shares are down nearly 29% this year and have generated an average annualized return of minus 3% over the last five years.

(Warren Buffett owned a big stake in Capital Cities/ABC and received Disney shares in the merger. But he sold out the bulk of his Disney stock in 1999 and 2000.)

By one broad measure, the entertainment-stock sector has outperformed the blue-chip Standard & Poor’s 500-stock index in recent years: The 52-stock Bloomberg/Hollywood Reporter index has gained 92% since Dec. 31, 1996, while the S&P; index is up 65%.

Even in an era when clarity of financial statements, and real earnings, are supposed to rank high on investors’ list of priorities, Wall Street still cuts Hollywood substantial slack, trusting that entertainment is a high-growth industry.

“On the surface, many entertainment companies appear to trade for fancy [price-to-earnings] multiples, and USA is no exception,” said Robert Gendelman, head of mid-cap value-stock portfolios for money manager Neuberger Berman, which has a stake in USA.

Indeed, analysts have expected no bottom-line profit at USA either this year or in 2002.

Wall Street continues to value such shares based on the perceived worth of the underlying assets--always a moving target--and on the consistency of cash flow, or EBITDA: The more steady and predictable a company’s cash flow, the higher the justifiable price, Gendelman says.

After the sale of USA Networks’ big cable stations and production house, the remaining company--to be called USA Interactive--will be a collection of online-transaction businesses, including Ticketmaster and the Expedia travel service.

Such businesses have less of a track record than cable and thus appear riskier, Gendelman said. But on the other hand, investors in USA Interactive can take comfort that Diller has been “a good buyer and a good seller” over the years, he said.

Andrew Rittenberry, an analyst for Gabelli Asset Management, said that though Vivendi’s finances can be “pretty confusing,” the company has a relatively clean balance sheet and probably will be on the lookout for another large acquisition within the next six months as it tries to bulk up to compete with giants Disney and Viacom Inc.

Still, Rittenberry and other analysts noted that complexity can carry a price: Companies whose financial statements are harder to penetrate often trade at a discount, in terms of price-to-earnings or price-to-cash-flow multiples, to ones whose reporting is more straightforward.

But that wasn’t true of Enron: Its stock P/E ratio was astronomical in the firm’s heyday earlier this year, when investors bought into the line that it represented the new wave of energy companies. Instead, Enron turned out to be a house of cards with little in real assets to underpin the stock.

Vivendi, for one, has tacitly acknowledged that telling a clear story is critical to its goal of becoming what Messier called a “tier-one” entertainment company: The firm recently hired as its chief of investor relations Laura Martin, former cable TV analyst for brokerage Credit Suisse First Boston.

It will be her job to help institutional money managers and her former colleagues in the analyst community make sense of Vivendi’s tangle of assets and joint ventures, assess the company’s true future earnings power and put a “fair” value on the stock.