Misunderstanding Marvel

I blew it when I wrote in June that Marvel Entertainment (NYSE: MVL  ) would have to raise its guidance by at least $0.40 per share for 2008; I was off by half. Wall Street's analysts -- who projected at least $1.96 in full-year 2008 profit rather than the $1.55 to $1.75 Marvel now expects -- were off even more.

What we had all hoped is that Marvel's 2006 illustrative film profit model was perfectly accurate and that, with a $300 million megahit in Iron Man, the studio would generate at least $51 million in operating profit this year, rather than the $5.2 million to $14.4 million Marvel is now estimating.

But we should have known better. Marvel Vice Chairman Peter Cuneo warned us all during the first-quarter conference call in May. From the transcript:

We really don't know until we run some of our in-house models, which we have not done yet, exactly what we are going to get paid for when. ... Until [Paramount's costs] are recouped and they get their distribution fee, we will not see -- other than our gross participation fee -- we will not see any cash. If we don't see any cash, then we are not going to book any profit. So the timing still is up in the air, and I would again caution everybody for 2008 to look at this very carefully and make sure that you are fairly safe with your projections. [Emphasis added.]

Translated, this means that we can't know exactly when the massive profits generated by Iron Man and The Incredible Hulk will flow to Marvel; 2009 seems to be the earliest. Yet investors, whose selling torpedoed the stock yesterday, appear to believe the money is gone. (It isn't.) And they blame Marvel for the "miss" -- as if it's the folks in management, and not us starry-eyed analysts, who blew it. (They didn't.)

Get real, people.

With great numbers come great returns ... eventually
Marvel's second-quarter numbers were outstanding. Overall licensing revenue improved by 44.7%, and domestic consumer products licensing nearly doubled. Earnings, meanwhile, blew the Street away -- $0.59 per share versus the $0.45 analysts had been expecting.

Cash also continued to flow:

Components of Adjusted Cash From Operations

Trailing 12 Months*

2007*

2006*

2005*

Reported net income

$155,796

$139,823

$58,704

$102,819

Depreciation and amortization

$3,502

$5,970

$14,322

$4,534

Amortization of film inventory

$21,202

$0

$0

$0

Amortization of financing costs

$4,979

$4,980

$4,980

$1,660

Deferred revenue

($6,416)

($28,956)

$140,087

($6,093)

Film production costs

($185,349)

($251,045)

($15,055)

$0

Borrowings from film facility

$227,026

$255,926

$7,400

$25,800

Capital expenditures

($1,376)

($2,659)

($16,286)

($4,289)

Adjusted operating cash flow

$219,364

$124,039

$194,152

$124,431

Sources: Press releases, SEC filings.
*Numbers in thousands.

Since last June, Marvel has produced $2.79 per share in adjusted cash from operations and $1.98 per share in net income. Divide both numbers by yesterday's close: Marvel trades for 11 times its adjusted cash flow and less than 16 times earnings.

I find that fascinating ... and unreasonably cheap. Peers Walt Disney (NYSE: DIS  ) , Time Warner (NYSE: TWX  ) , and DreamWorks Animation (NYSE: DWA  ) all trade for roughly 14 times earnings. But of these, it's Marvel that produces the most outrageous returns on invested capital:

Return on Invested Capital*

Trailing 12 Months

2007

2006

2005

Earnings before interest and tax

$269.00

$273.03

$110.16

$181.17

Net operating profit after tax (37.5% tax rate)

$168.13

$170.64

$68.85

$113.23

Average invested capital

$457.17

$387.86

$345.75

$466.45

ROIC

36.8%

44%

19.9%

24.3%

Sources: Capital IQ (a division of Standard & Poor's), filings.
*Numbers in millions.

DreamWorks gets the closest, at just 14.5% over the trailing 12 months. Even more impressive: Only 82 of the thousands of companies that trade on U.S. exchanges have produced returns on capital equal to or higher than Marvel over the past year, according to Capital IQ. Microsoft (Nasdaq: MSFT  ) , Altria (NYSE: MO  ) , and Aeropostale (NYSE: ARO  ) are among the names on that elite list.

The only number from Marvel's report that's worth worrying about -- and it may not even be worth that -- is revenue from publishing, down roughly $1 million year over year. But that appears to be due to outstanding numbers in last year's second quarter, when signature hero Captain America fell victim to Marvel's killer writers.

Don't let a small mistake become huge
So, yeah, I blew it in overestimating Marvel's 2008 profit. So be it. I refuse to let a small mistake -- not reading the transcripts carefully enough -- become a huge error. That's what I'd be doing were I to sell my Marvel stake at today's severely discounted price.

Courage, investors. This story has a happy ending -- even if Wall Street doesn't yet see it.

Face front, true believer! More Marvel Foolishness awaits:

Microsoft is a Motley Fool Inside Value recommendation. Marvel Entertainment, DreamWorks Animation SKG, and Walt Disney are Motley Fool Stock Advisor recommendations. Try any of our Foolish newsletter services free for 30 days.

Fool contributor Tim Beyers had positions in Marvel shares and LEAP options at the time of publication. Get a daily dose of his Foolish musings through this feed for your RSS reader. The Motley Fool has a market-beating disclosure policy.


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