A Marvel-ous Deal

Listen up, Fools. Iron Man, which opens in theaters across the country tonight, isn't as big a deal to Marvel Entertainment (NYSE: MVL) as you think.

Here's why. Without a penny of operating profit from movies, Marvel, over the past year, produced a 44% return on invested capital, or at least double its cost of capital.

Surprised? Don't be. High returns on capital have long been a staple of Marvel's business:

But look at all that debt ...
Numbers like these help to explain why I've committed nearly 18% of my portfolio to Marvel shares. Those who say I'm crazy -- and there are more than a few of you -- point out, rightly, that Marvel has borrowed $289 million as of Dec. 31 to finance its yet-to-see-a-dime-of-profit movie studio.

They wonder whether it's reasonable for a company capitalized at just $2.3 billion to take on hundreds of millions in debt to engage in what has historically proven to be a risky enterprise. (Hence the thinking: "Iron Man had better be a blockbuster!")

Let's tackle their concerns one at a time.

First, the debt. Capital IQ reports that, since 2002, when Sony (NYSE: SNE) introduced Spider-Man to the big screen, Marvel has spent $854.5 million to buy back shares. At least $300 million of that came from debt, which has since been repaid. Here's how:

Should we really be calling this company Marvel? How about Captain Cash Flow? Sheesh.

Here's my point. Debt can be a tool when you're (a) earning more than the cost of capital on your investments and (b) producing more than $100 million a year in cash.

A deal like no other
Now, let's talk about the film financing facility. Here's what you probably already know:

1. Marvel is authorized to borrow up to $525 million from Merrill Lynch (NYSE: MER) and others to fund as many as 10 films via Marvel Studios.
2. Movie rights to several of its lesser-known characters serve as collateral in the event of a default.

Self-funding, Marvel argues, will allow it to collect profits that heretofore have gone to Sony for the Spider-Man franchise, News Corp.'s (NYSE: NWS) Fox for Fantastic Four and the X-Men trilogy, and Lions Gate (NYSE: LGF) for The Punisher. (Who, incidentally, returns to theaters in the fall.)

How much profit is a matter of debate. According to my math, which is based on Marvel's own estimates from its Aug., 2006 presentation, it could've been more than $1 billion. See for yourself:

Maybe Marvel's foray into moviemaking isn't as risky an enterprise as we tend to think?

Perhaps not. Even so, I'd hate to see Marvel default and lose the movie rights to Iron Man, since Robert Downey Jr. seems so well, um, suited for the role. Or, for that matter, the Hulk, since Edward Norton also appears to have put in a good performance.

But what of the cost of all this financing? Debt isn't free. Are shareholders really getting their money's worth to fund films that might be successful?

Absolutely. You already know that management produced a 44% return on average invested capital (IC) in 2007. But you might not know that, of the $388 million in invested capital  carried on Marvel's balance sheet last year, $161 million was film debt, which cost $13.8 million to service. Marvel, therefore, paid 8.5% in interest expense.

Cost of equity was likely higher than that, because of the risk of a total loss in the movie business. But more than 15%? Nope, that's biotech territory. Thus, my opening remark: Marvel is earning at least twice its cost of capital. And it's doing so while investing hundreds of millions in films that, to date, have produced exactly zero in terms of a return.

You know what that means ... 44%, as great as that is, could be just the beginning. Go get 'em, Shellhead.