POST OF THE DAY
Marvel Enterprises
Crossing Over to the "Dark Side"

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By kyougoh
March 5, 2004

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I shall wear a very unfamiliar hat today (a Goth version of the jester's hat maybe?). This won't be a Marvel-bashing post per se, but I would like to bring up some concerns, so that we don't just have a one-sided picture of MVL. I'm looking forward to rebuttals to my arguments. I'm long Marvel and I would love for my points to be proven wrong.

I'd like to address MVL's possible obstacles. I think MVL is now at a point where it will face new problems:

1) Growing pains
2) Over reliance on movies

Marvel is no longer seen as a struggling company fresh out of bankruptcy. In fact, many analysts and investors have extremely high expectations of Marvel. This was most recently seen in the huge run-up (and subsequent sell-off) to the 4Q 2003 earnings call.

It is also notable that this earnings call was the first one in a while where Marvel did not raise guidance before it. I think that this will become the norm, rather than the exception from now on. The conference call addressed the issue of overages, earned royalties in excess of a licensee's minimum guarantee. Since recent agreements have been more favorable to Marvel, overages are likely to go down significantly. I feel the days of positive guidance revisions giving the stock price a nice little push are over.

The high expectations are also as a result of excellent movie performances. Spiderman holds the box office record of best three-day domestic debut ever. Many anticipate a similar performance from the sequel. These expectations will be included in Marvel guidance and analyst forecasts, and are also somewhat priced into the stock as is. With such sky-high expectations, every successful movie, while a good thing, continuously sets more elevated heights for Marvel to fall from.

Growing pains also result from the losing of a tax shield. Although revenues are projected to increase from 2003, the 41% tax rate Marvel will start to pay would cause net income to drop by about 50 million. Marvel continues to generate a lot of cash, but the 50 million a year will reduce its growth rate significantly. Marvel is maturing, and will no longer be able to emulate the tremendous gains its stock has shown in the past.

An important point I don't recall anyone mentioning is that of market saturation. There are only that many movie studios, and of them only a handful that can finance big budget blockbusters. Even if MVL succeeds on all fronts and successfully sets up the 10 franchises they've targeted, that would mean 3-4 big releases a year (to have a sequel every 3 years). Once the auxiliary releases like Man-Thing, etc are included, that's about 5-6 movies a year. There's 5 slated for 2005 as is. How long can MVL and the studios sustain this? There'll come a critical point when MVL movies are competing with each other for movie budgets, or go head-to-head in the box office.

This applies to toys as well. Junior may well want toys from every single Marvel franchise there is, but the parents are the ones with the wallet. Just because there are 10 lines of toys doesn't mean parents will buy all of them. There will come a time where Marvel has exhausted its current fanbase and will stop growing until it finds new markets.

Marvel management is not blind to this. They have foreseen this and are looking at moving out of the action movie niche and expanding their target demographic, both for movies and toys. In the conference call, Avi mentioned Elektra and Black Widow as attempts to capture the female demographic, and Power Pack as a movie that could emulate "Spy Kids". Also mentioned was the genre of comedy, although no concrete ideas of characters were given. These are new frontiers for the company and while steps have been taken in the right direction, there is a lot of uncertainty whether Marvel can win over more of the demographic, and also make a more successful push into the international market.

Marvel must constantly develop new markets to sustain its growth and justify the high expectations we have placed in it. Until it has successfully proven its ability to do so, the possibility of it becoming a niche entertainment company should be a legitimate and important concern.

I also feel that many of Marvel's numbers and projections, and in fact, almost the entire bottom line, is over reliant on the success of their movies. This is worrying because the quality of a movie is not something 100% under their control. Although they do exert a huge influence in the direction the movies take, ultimately if the studio does not execute a film well, the stack of cards MVL has placed on top of that movie will collapse. DVDs, toys, and video games will all suffer with a film that tanks. It isn't wise to rely on consumers as fickle-minded as the movie-going audience.

Obviously, no one sets out to make a bad movie. But there've been enough flops in comic-based movies to serve as warnings. One of DC's flagship characters, Batman, is an example. Marvel will have to work very hard to avoid sequelitis, as they rely so much on movies being drivers for revenue. Overexposure would also be a problem to consider. X-men 6 may be plausible, but The Punisher 3? Daredevil 4? Once the existing (and excellent) storylines have been mined, Marvel will find itself having to create new material. Today's movies are mostly using tried and tested comic book material, and thus Marvel knows the plot is enticing. When they have to go back to creating new material again, it might not be as easy.

With multiple movies out a year, Marvel is somewhat shielded from any one movie tanking. But Marvel has yet to release a movie that completely flopped (Hulk did not perform to expectations but was by no means a disaster). We have no idea what a precedent like that would cause. Maybe the reason Marvel is so heavily shorted is that shorts see Marvel as a company that hinges solely on box office results. One misstep, one can open a Pandora's box and cause institutional investors to re-evaluate their investment in the company. With ~70% institutional investment, any mistakes may result in a mass exit, making the stock price plummet.

This post turned out to be a lot longer than I expected it to. I hope my crossing over to the dark side has been helpful to some of you. If not, I'm sure the rebuttals to my arguments will be.


Best,


Tim.


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