Pixar Story 2: This Movie <I>Still </I>Looks Familiar (Fool on the Hill) January 6, 2000

An Investment Opinion

Pixar Story 2: This Movie Still Looks Familiar

By Bill Barker (TMF Max)
January 6, 2000

Nearly two years ago, back in March of 1998, my younger sister asked me about buying some shares of (Nasdaq: AMZN), a company she liked. Taking the extreme run-up that the stock had been enjoying as evidence of something it perhaps was not, I told her that it was "too late" to buy Amazon. Exercising an independence of thought that could be characterized either as "Foolish" or "well-informed by years of observing the poor decision-making abilities of her older brother," my sister decided to buy the stock anyway, and is up, oh, I don't know about 800% or so in the meantime.

I note that only because some of what I'm going to write today at first blush might seem to smack of a little I-told-you-soism, and I just want to admit that I've got more than my fair share of missed calls to balance out the good ones. But back in October I wrote a column about a recent run-up that shares of Pixar Animation Studios (Nasdaq: PIXR) had just experienced. Pixar is the maker of three films, Toy Story, A Bug's Life, and now Toy Story 2, each of which has been developed in cooperation with Walt Disney Co. (NYSE: DIS).

Going through the history of the price movements of Pixar, and showing the cyclicality of the stock movements (massive run-ups before the release of one of its movies, followed by overselling of the shares afterwards), I mentioned back in October that at $40 a share, Pixar was perhaps about fully valued at the time -- not that that would prevent the market from following the same old pattern of pushing the stock higher right up until the release of the movie, and right back down afterwards.

Pixar did in fact hit a 52-week high of $50 3/8 a share the day before Toy Story 2 was released, and has been selling off ever since, currently making shares of itself available for a mere $34 each. This loss of about a third of its market cap comes in spite of the fact that Toy Story 2 has already booked $211 million at the box office and is now predicted to finish its domestic run with sales of about $250 million, which would put it at about #15 on the list of all-time domestic box office successes (not adjusted for inflation). So anyway, what's up with that?

Perplexed shareholders might be thinking that the wild success of the film should, in a perfectly orderly market, add significantly to the value of the shares. But they would think that only if they had failed to do the math on what the wild success of the movie would translate into. Really, a hit even on the scale of Toy Story 2 will translate, after taxes, into maybe $3 a share in cash to Pixar -- and of course Toy Story 2 is a bigger hit than either of Pixar's previous movies, and a bigger hit than one could reasonably expect to be the norm for the company in the future. Why should a company move $15 or $20 a share up in anticipation of an event that will create only as much as $3 a share for the company and its shareholders? Well, trading and speculating on the share price I suppose, and that pretty much sums it up.

All of which doesn't mean that Pixar isn't a worthy investment at today's price, because I think it probably is now. With about $4 a share of cash and cash equivalents lying around in the vault, Pixar is trading at an enterprise value of $30 a share. Considering that the consensus analyst estimates are for Pixar to earn $1.23 a share this year, the company is currently trading at an enterprise value of less than 25x this year's earnings, a pretty reasonable price for a growing company you might say.

This, though, is misleading in two different ways. First, most analysts don't seem to have upwardly revised their earnings estimates in reaction to the overwhelming success of Toy Story 2 -- yet. So I wouldn't be surprised if the consensus earnings settle in at around $1.50 a share or even higher, meaning that shares of Pixar are possibly going at an enterprise value of less than 20x this year's earnings. On the other hand and more importantly, who cares what the earnings estimates for this year are? Pixar isn't a growth company -- it's a cyclical company, with its earnings entirely dependent on whether it releases a film at all, and how well that film does. Pixar's earnings per share history looks like this:

1994    ($0.06)
1995     $0.04
1996     $0.54
1997     $0.46
1998     $0.15
1999E    $0.92
2000E    $1.23
2001E    $0.72
Since Pixar didn't release a film between the end of 1995 and the end 1998, earnings sagged as the revenues realized from the first Toy Story movie had more or less dried up by 1998. Then, with the release of A Bug's Life in 1998, earnings for 1999 have moved strongly higher, and with this year seeing revenues still coming in from Bug's as well as Toy Story 2, another record year of earnings is pretty much assured. However, after this year, earnings will slide back down, and it isn't until 2004 that Pixar will actually be seeing a year where it is receiving revenues from three movies simultaneously, as no film is to be released this year, and revenues essentially are recognized over a three-year time frame. 2004 will see the company collecting on its 2001, 2002, and 2003 releases.

This makes the company a bit difficult for the market to value -- and history shows that to a large degree the market has solved this dilemma by just punting on rationally valuing the company at all. What the market has done instead is show crazy, mad love for the company in anticipation of the release of each new film, and then ennui bordering on disdain once a film is released and the time frame to the next film release is longer than about nine months. Mr. Market, in short, is a really bad person to ask what the true value of this company is.

All of which gives a patient investor a chance to finally buy shares of the company at a good price today -- in my opinion. By "good" here, I mean a price below the intrinsic value of the company, as determined by running all of the numbers of the company through your standard discounted cash flow model. Doing that is a little bit beyond the scope of today's column (I'd be glad to participate in some work being done on one on the Pixar message board), but here's the super abbreviated version.

If you assume that Pixar's first three movies are the best evidence of what future movies will do, the domestic box office sales for a Pixar movie could average about $200 million. Triangulating from various sources of past history and company-guided analyst projections, domestic box office of that level translates into about $130 million in EBIDTA per picture for Pixar. Since the company has an enterprise value of $1.4 billion, assuming it can produce a movie per year starting in 2001, Pixar is trading at a bit less than 11x EBIDTA at the moment. This assumes that it can maintain its past performance while ramping up to put out a new film every year, which is no given.

Still, no matter how you slice it, Pixar today has a better combination of a developed track record and a sane share price than at any point in the past. That, sooner or later, should make it a pretty attractive offering to some investors.