Marvel's New Facility

When Motley Fool Stock Advisor selection Marvel Entertainment (NYSE:MVL) briefed analysts and investors about its film business on Aug. 10, I was skeptical. And I had every right to be. Marvel was swallowing debt to buy back shares when there was every indication that it would need cash later to fund its transformation into a studio.

I've since dug further into some SEC filings and had a chance to speak with management. What I've read and heard leaves me more optimistic than I was last week, though I still harbor a few concerns. Let's review.

Unlocking the facility
By now, you've heard that Marvel will finance new films through a $525 million credit facility. What you might not know is exactly how it works. Frankly, that's understandable. Few details have been released before now, and the available legal documents are as dense as Iron Man's impenetrable armor.

Management's presentation (link downloads a PDF file) helped. Here's the summary: The facility is funded by Merrill Lynch (NYSE:MER) and allows Marvel to access cash for making as many as 10 films. In exchange, Marvel risks the future movie rights to the characters portrayed in the films it produces.

Sounds great, right? Sure it does. But it quickly gets complicated. Investors, after all, have a way of demanding value. They'll get it by way of the debt structure. For instance, according to comments from management during last week's conference call, Marvel will pay an average of roughly 8.25% interest if it uses half of the facility, or $262.5 million.

Funding is conferred in two stages: a $60 million mezzanine round followed by up to $465 million in senior bank debt. The mezzanine financing is drawn upon first and pays the London Interbank Offered Rate, LIBOR, plus 7%. The LIBOR currently stands at 5.5%, and that means on the first $60 million of capital Marvel accesses, it could have to pay its creditors 12.5% at current rates. The mezzanine financing is also the last debt to be paid when the facility is terminated, thereby guaranteeing creditors the highest possible rate of return for the life of the loan.

Here's why that shouldn't concern you too much: Marvel's financing is what's known as a pass-through facility, which means that all costs pass through the facility first, including interest. Film profits are treated the same way. In that sense, the facility is like a mortgage. The balance grows as money is withdrawn and interest accrues. Film profits that "pass through" on their way to Marvel pay off debt. The risk comes only when Marvel produces unprofitable films.

Locked out of the green house
If that sounds like a good deal, rest assured that it is. Just don't expect Marvel to see much in the way of cash from its new films before 2009. According to a document filed with the SEC, Marvel must hold profits from its self-produced films in escrow until the third flick is released, and only then after satisfying financial conditions designed to reassure investors.

Technically, the agreement calls this a "blocked account." And it means that Marvel can't simply get lucky with Iron Man in 2008, draw down the profits, and hope for the best on the next film. Instead, it has to produce consistent winners to generate the cash flow Fools are hoping for.

That adds a degree of risk, to be sure. But no more so than what you'd expect with any growth stock. Perhaps that's why Marvel Entertainment Vice Chairman Peter Cuneo encouraged me in an interview yesterday to think of it as an investment portfolio. "Investors want to see some results before releasing cash," he said. That seems fair, as does the drawdown schedule:

In other words: The more hits Marvel produces, the more cash it's able to withdraw.

Follow the money
The lone exception to this rule is Marvel's producer fee, which equals 5% of all film-related revenue. Internal company estimates peg the producer fee at roughly $25 million for a movie that collects $200 million at the domestic box office.

Plus, Cuneo says Marvel has the right to end the facility and take its profits at any time. Expect that to occur if Marvel's first two independent films become huge enough hits to propel the blocked account to a surplus of, say, $300 million. In that scenario, the comic-book king would likely pay what's owed, collect the rest, and search for a new financing deal.

But that could also be wishful thinking. In the here and now, Marvel's balance sheet has been burdened with debt in a drive to repurchase shares. That's not altogether crazy, though. Marvel produces prodigious cash flow and is more than capable of covering the interest the buybacks will incur.

Foolish investors, however, should remain steadfast in watching the balance sheet. As long as Marvel uses its cash flow to pay down what it owes as the movie business ramps up, all should be well. But if not, it could be the worst kind of cliffhanger for investors betting on an already uncertain future. That's a topic I'll get into more on Monday, when our analysis continues.

Marvel is a Motley Fool Stock Advisor selection. Ask for us an all-access pass, and you'll get a backstage look at all of the stocks that are helping David and Tom Gardner beat the S&P 500 by more than 39% as of this writing. It's free for 30 days. All you have to lose is the prospect of a richer portfolio.

Fool contributor Tim Beyers owns more than 2,000 comics but no shares in any of the companies mentioned in this story at the time of publication. Get the skinny on all of the stocks in his portfolio by checking Tim's Fool profile. The Motley Fool's disclosure policy is invincible.