Funding Nemo

We think of vegetarian men as low-testosterone, peace-loving types. But give Pixar (NASDAQ:PIXR) CEO Steve Jobs a Taser (NASDAQ:TASR) and the chance to ambush Disney (NYSE:DIS) CEO Michael Eisner in a bathtub and you might make an exception.

That the Jobs-Eisner relationship had been unpleasant long before the companies decided not to extend their deal is not news. Neither is the fact that Motley Fool Stock Advisor recommendation Pixar won't seem to have any trouble meeting its goal of finding a distribution partner for its post-2005 movies by this fall. Many also know that Pixar's cash mountain -- currently some $522 million in cash and near-cash investments, plus an incoming receivable of almost $200 million from Disney -- is more than adequate to offset Disney's former 50% sharing of production costs. But what none of us knows for sure is just why Pixar is hoarding so much cash.

I'd say they're up to something, which is a good thing considering the talent and track record of Jobs (the same Steve Jobs from Apple (NASDAQ:AAPL), in case you were wondering) and the Pixar crew. We'd all like to know the future, but the stock appears reasonably priced even without fireworks on the horizon. Think of it this way: If the clerk at 7-Eleven (NYSE:SE) gave you back all your change plus a few lottery tickets, you wouldn't complain, would you?

That was then, this is now.

Pixar was culled from George Lucas' Lucas films in 1986 when George, supposedly in a hurry to get cash for his divorce settlement, sold its computer division to Steve Jobs for a bargain $10 million. By 1991, Pixar had its initial three-film contract with Disney. Pixar would make the films and Disney would own, distribute, and market them. After the first film, Toy Story, did so well, Pixar demanded that Disney fork over half of its 100% ownership in the remaining two films under the deal, and offered three additional films for enticement, meaning five more films altogether. Disney accepted.

In case you're doing the math and shaking your head, as a sequel, Toy Story 2 doesn't count under this second deal, but A Bug's Life and Monsters, Inc. do. Ever the climber, Pixar most recently demanded a third deal giving it full ownership of its films, which would relegate Disney to mere marketer/distributor status, albeit enjoying what Pixar claims would be generous above-market terms.

Eisner, however, had been seeing the contract glass as half-empty, at least according to reports that he not only felt Finding Nemo would be a "reality check" for Pixar, but told his board that such a flop might not be too bad in that it would give Disney bargaining clout over the humbled animation studio. Besides the fact that Finding Nemo was the top-grossing film of 2003, it's not surprising that many are questioning Eisner's judgment, given that the Pixar collaboration -- which supposedly stuffs Mickey's pockets with 12.5% of revenues plus reimbursements -- has been adding almost 10% to Disney's EPS lately.

Not bad considering that Pixar is a lot less replaceable to Disney than Disney is to Pixar. Having now received calls from every major Hollywood studio, Pixar is confident it will have an appreciative marketing and distribution partner come fall, with names like Time Warner (NYSE:TWX), Sony (NYSE:SNE), and Fox (NYSE:FOX) in frequent circulation. Who wants to see their copy of Nemoself-destruct anyway? Just kidding.

Downside? What downside?

Pixar doesn't seem outrageously expensive. But with others now in or scrambling to enter the 3-D animation market, what competitive advantage does Pixar have? According to Disney's own studies, says Steve Jobs, the Pixar name is a bigger box-office draw for adults both with and without children than the Disney name. Why? The novelty of 3-D animation probably plays a role. But what's the ultimate end of such animation? Unbelievably lifelike characters? Don't we have those already, and aren't they called actors?

Not so fast. I'm missing the fantasy element possible with animation, which goes part and parcel with quality creative content, something Pixar will tell you is the real reason for its success. I certainly can't argue, especially considering the success of its films, but worth noting is that the success depends on a handful of really, really talented people. Let's hope they stay creative and stay with Pixar.

A company sporting an 85% gross margin and near-50% profit margin has an awesome business model, right? Absolutely, if you're a robot, or a simple stock screen. Remember that Pixar is making movies, not selling the "widgets" so beloved of finance and economics textbooks. Although its margins reflect an attempt to match costs with proportionate influxes of revenue, the whole point is that its movies have done well enough to make those costs look puny in comparison.

Those margins depend on hordes of little ones demanding to see Nemo (OK, I saw it myself), both in the first place and in lieu of anything else. So, my second big concern, beyond Pixar's retaining its creative ability, simply revolves around what other movies happen to be out there. Through no fault of its own, a Pixar movie could be squeezed if an even better flick is running at the same time.

If you must see some numbers...

If Confucius had an MBA, he might tell us, "There are no real valuations, only estimates." Bad humor? Yes. Bad advice? No. Pixar's long operating cycle and uncertain cash flows make valuation especially tricky, and make me favor a discounted cash flow approach over a multiple method -- Pixar's P/E went from 60 to 30 with minimal price movement after fourth-quarter 2003 earnings were announced, meaning the market might not be hanging on multiples, at least of earnings, either.

For this estimate, I'm piggybacking off consensus analyst revenue expectations for the next two years. Revenues are a big "if," but you've got to start somewhere, and it's probably sensible to assume moderate, but not outlandish, success. In 2006, debtless Pixar goes it alone, and I'm guessing it'll almost double its revenues without Disney's 50% cut.

The hinge of this estimate is that I'm presuming Pixar doesn't do anything more exciting than one film per year, and simply chugs along at 3% across-the-board growth per year after 2006. If stock options were expensed for 2001-2003, profit margin drops from 50% to 40%, which I'm using going forward in anticipation of changes in accounting practice, and, simply, to be conservative. Shares outstanding grow at 5% until after 2006, when they join the 3% bandwagon. Capital expenditures slightly outpace depreciation for the next two years before leveling off. Non-cash increases in working capital are practically impossible to estimate for Pixar, so I'm going with a modest $2 million per year.

For a rate to discount our free cash flows to equity, I'm using the quick-and-dirty "CAPM" formula, which uses a risk-free rate that corresponds to the duration of our investment (I'm using 3%), plus a "Beta" coefficient that reflects the volatility of the asset in relation to the rest of your well-diversified portfolio (you are well-diversified, right?) multiplied by the "risk premium" -- the additional return -- the market must pay to entice you away from sleepy Treasuries. Calculation of Beta and the market risk premium can be contentious and difficult, but I'm using the commonly listed 0.6 Beta for Pixar and a middle-of-the-road 5.5% risk premium. Whew!

So without further ado, and keeping things somewhat simple...

Risk Free Rate 3%
Market Risk Premium 5.5%
Beta 0.6

Discount Rate = 3% + 0.6(5.5%) = 6.3%
2007+ growth rate = 3%
Terminal Value = 2.86/(6.3% - 3%) = $86.58
PV of operating assets = $74.87
(S-T Investments & Disney Rec)/Share = $11.68
$74.87 + 11.68 = $86.55 "value" per share

Notice that present value is that of operating assets, and idle cash is typically added to this. Pixar has $48 million in cash right now. Since it might expect to use some of that for near-term expenses, I conservatively lumped it all as an operating asset (i.e. this cash isn't "cash" in the idle sense). Pixar does have $474 million in cash-like short-term investments, plus another $197 million good-as-cash receivable from Disney (not the same as a typical receivable), which I did compute as $11.68 idle "cash" per share. So, according to this simple model, Pixar, which closed at $67.87 yesterday, might be worth $80-plus per share.

Where do we go from here?
Let's not kid ourselves -- at least not too much. What is 54%-owner Steve Jobs really after, besides the $52 per year Pixar pays him? Of course, having all five of your films among the 11 highest-grossing animated films of all time isn't shabby. But in the last conference call, Jobs -- who, incidentally, has never sold a share of Pixar -- indicated that the company hoped to have up to $1 billion cash stockpiled by 2006. Why? To ride out a string of flops? At $100 million to $150 million per film, that's a lot of flops. Dividends? Maybe, but why not start a little one now?

I'm guessing that at a minimum, Jobs plans to put out more than the current one movie per year, but given that his conference call comments hint at a preference for quality over quantity, it's questionable how far down that line he and Pixar's creative talent are willing to go. And it's not all up to him, either.

Pixar's market, at least as it stands now, might not be willing to absorb more than one or two films per year. In other words, he probably has something up his sleeve. Maybe it's an acquisition; maybe it's a significant expansion of Pixar's offering; maybe it's just a few extra films and a buyback or dividend. Whatever is coming, I'd say this lottery ticket has some decent odds.

Now what?
David Gardner chose Pixar for Motley Fool Stock Advisor last August and still believes in the stock. Find out what else he's been recommending -- since April 2002, his picks have outpaced the S&P 500 by 51.5%.

James Early is a vegetarian and has never used a Taser. He doesn't own shares in any of the companies mentioned in this article. He can be reached via email. The Motley Fool has a disclosure policy .