A Cash Flow Marvel

If life imitates art, then Marvel Entertainment (NYSE: MVL  ) investors may just be experiencing more of the same old awful luck that lands Spidey in trouble in the comics. Shares of Marvel are down roughly 8% since the debut of Spider-Man 3.

Blame inflated expectations. Critics wanted a better movie, and analysts, believe it or not, wanted a bigger box office.

I know that sounds loony, especially after Spidey's opening weekend snared a record $151 million. Trouble is, box-office watchers were predicting a 10-day take of $247 million heading into Friday. They got $242 million instead, reports film tracker Box Office Mojo.

Caught in a web of earnings
But Spidey isn't entirely to blame for the malaise. Marvel thrilled few when it reported a sharp decline in free cash flow despite a massive 68% jump in revenue and a 168% improvement in net income during its first quarter.

What happened? When Spider-Man toys and other themed products hit the shelves in Q1, Marvel was finally able to recognize as revenue cash it received last year from Hasbro (NYSE: HAS  ) and a joint venture with Sony (NYSE: SNE  ) .

Furthermore, when management once again told analysts that more than half of the year's earnings would be realized by the end of the June quarter, investors acted as if Marvel had peaked. As if Spidey, like his entertaining-yet-geriatric foe The Vulture from the comics, had finally become long in the tooth.

Cash in on a cash-rich business model
Ahem. These investors need to pay closer attention to the numbers. Specifically, real cash generated from business operations:

Components of Adjusted Cash From Operations

TTM*

2006*

2005*

2004*

Reported net income

$88,037

$58,704

$102,819

$124,877

Depreciation and amortization

$13,869

$14,322

$4,534

$3,783

Amortization of financing costs

$4,980

$4,980

$1,660

$3,446

Deferred revenue

($47,923)

$140,087

($6,093)

($6,063)

Film production costs

($47,609)

($15,055)

$0

$0

Borrowings from film facility

$22,700

$7,400

$25,800

$0

Capital expenditures

($8,775)

($16,286)

($4,289)

($3,586)

TOTAL

$25,279

$194,152

$124,431

$122,457

Sources: Marvel press releases, SEC filings.
*In thousands.

Once you get past the sheer volume of math here (sorry about that), two things should jump out at you:

  • First, Marvel tends to collect more cash than is obvious using run-of-the-mill GAAP accounting.
  • Second, up-front, lump-sum payments -- that's what gets booked on the deferred revenue line -- have become a critical piece of Marvel's business model.

Or, in simpler language, Marvel tends to get paid very quickly for the use of its intellectual property.

Almost anything can trigger a check. Whether it's deals with Activision (Nasdaq: ATVI  ) , Sega, or Take-Two (Nasdaq: TTWO  ) for more video games, or with Lions Gate (NYSE: LGF  ) for a new direct-to-DVD animated feature, or with Hasbro for more superhero toys, Marvel is getting paid more for its costume-clad cast of champions.

What investors need to know is whether management is using that capital to produce growth. History says yes:

Return on Capital

Yield

TTM

40.2%

2006

22.1%

2005

24.9%

2004

23.7%

Source: Capital IQ, a division of Standard & Poor's.

OK, but what about the trailing 12 months?
If there's a nagging problem here, it's with the dramatic decline in adjusted cash from operations over the past 52 weeks. I'd be worried, too, if return on capital had also declined and if Hasbro hadn't made a $70 million payment to Marvel in the current second quarter. But return on capital soared, and Hasbro opened its wallet, which should lead to huge Q2 gains in deferred revenue and, thereby, adjusted cash flow.

What's more, Chief Financial Officer Ken West told analysts during the quarterly conference call that he expected Marvel to end the fiscal year with $132 million in cash on its balance sheet, up $100 million from the end of 2006.

If most, or all, of that comes from operations -- a reasonable assumption, since Marvel just paid off its remaining recourse debt -- then investors should expect to see at least another $121 million -- up from $11 million at the end of Q1 -- in cash production through the end of 2007.

Bulked up, but light on valuation
If I'm right, Marvel is on track to end 2007 with $146 million in adjusted cash from operations. Let's round up to $150 million for the purpose of valuing the stock.

The company had 84.02 million diluted shares at the end of the first quarter. Assuming that total remains constant, which it should -- at best, it may even decline some via share buybacks -- Marvel is on track for $1.78 in full-year cash flow per share.

Now, do the math. At Friday's close of $27.40, the stock trades for 15.4 times my 2007 estimate. History says that's no worse than fair and perhaps even cheap:

Historic Cash Flow Multiples

2006

2005

2004

High

13.3

19.6

22.2

Low

7.1

11.8

11.3

Average

10.2

15.7

16.8

Source: TMF estimates, Value Line.

Remember, too, that we're using Marvel's numbers. Any upside surprise from projects like Fantastic Four: Rise of the Silver Surfer, the June sequel to 2005's Fantastic Four, which brought in more than $300 million for News Corp.'s (NYSE: NWS  ) 20th Century Fox, could further boost cash flow and make the stock more attractive.

Too bad investors don't seem interested in waiting around to find out. With Iron Man, the first of its self-financed films, due for next May, Marvel is in a prime position to earn more for shareholders than it ever has before.

But, hey, what do I know? I'm just your friendly neighborhood Fool.

Marvel, Hasbro, and Activision are Stock Advisor picks. Click here to get 30 days of free access to the entire portfolio, which is beating the market by nearly 37%.

Fool contributor Tim Beyers, who is ranked 6,324 out of more than 28,700 rated players in our Motley Fool CAPS investor-intelligence database, wonders whether you're a Marvel or a DC. He owned more than 2,000 comic books but no shares in any of the companies mentioned in this article at the time of publication. Tim's portfolio holdings can be found at his Fool profile. His thoughts on Foolishness and investing may be found in his blog. The Motley Fool's disclosure policy has the ability to continuously crack jokes while it explains complex financial topics. Bring it on, Spidey.


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