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Digital Domain Media Group Analysis



September 04, 2012 – Comments (0) | RELATED TICKERS: DDMGQ

Board: Value Hounds

Author: TMFSandman

I took a look at the only publicly-traded visual effects (VFX) company, Digital Domain Media Group (DDMG). While there are other companies that create computer graphics for the entertainment field, they're not pure-play VFX houses, or are not publicly traded, or the VFX portion of the business is a small part of a much larger publicly-traded company:

Industrial Light & Magic
One of several operating segments of Lucasfilm Ltd., which is privately owned, so no public financials are available.

Sony Pictures Imageworks
SPI is a small division of Sony Pictures Entertainment, which is itself one of the smaller operating segments of Sony Corp. (SNE). SPI only gets a single sentence mention in the 20-F (the 20-F is the annual report foreign companies file with the SEC if they have securities registered on a US exchange, such as Sony Corp's ADR's.)

Rhythm and Hues Studios
Standalone work-for-hire VFX house but privately-owned, so no public financials are available.

Dreamworks Animation (DWA)
Dreamworks is a publicly-traded animation studio but DWA funds and owns its own content and characters. It's not a work-for-hire VFX shop

Pixar is now a part of Disney (DIS) so is no longer a standalone entity, but even when it was it was similar to Dreamworks in that it owned its own content and characters

Activision Blizzard (ATVI)
Publicly-traded computer games company that owns its own content. Does not do work-for-hire

Electronic Arts (ERTS)
Publicly-traded computer games company that owns its own content. Does not do work-for-hire

The Business
The visual effects artists at Digital Domain have been behind some of the most impressive visual effects seen in modern film and television. Digital Domain was a chief contributor to the visual effects for Titanic, Apollo 13, Armageddon, Tron:Legacy, and many others. DDMG does about $100 million in sales annually and breaks its business down into three major operating segments: Digital Production, Animation, and Education. The Digital Production segment is the one that houses the Digital Domain VFX business, and that business along with the licensing of technologies derived from Digital Domain's VFX business makes up the lion's share (97%) of revenue, depending largely on the Big Six film production companies for its work. Digital Production gets about 80% of its revenue from feature film work and about 20% from commercials. The Animation and Education segments (both based in Port St. Lucie, FL) are very new, with no appreciable revenue streams yet. The company employs 933 people, which very roughly breaks into thirds geographically, split among Los Angeles CA, Port St. Lucie Florida, and Vancouver British Columbia.

The visual effects industry is a difficult one. There are very few clients for the high end work, with the client list essentially limited to the movie studios most people can rattle off easily by name (Fox, Paramount, Warner Brothers, Columbia, Universal, Disney, aka "the Big Six"). The studios solicit bids from the various VFX shops for sequences in movies, usually awarding work to the lowest bidder. The bidding is cutthroat, and bids are difficult to estimate accurately since the VFX houses are usually bidding something they haven't done before. If you pad the bid much at all you'll probably lose.

Visual effects are highly customized to the film and the bar is constantly being raised. Larger numbers of shots per film are requiring some sort of visual effects help. More and more of that is unique work per shot, limiting the amount you can amortize R&D of an effect. Higher resolutions are being required (ex. IMAX). 3D requires rendering both left and right eye views along with all the requisite complications that go with 3D. Studios can put films on hold or accelerate their release, playing havoc with VFX houses' staffing requirements. All this leads to very thin margins.

Add on top of that the complication of government tax incentives that distort the economics of an already low margin industry. Canada, the UK, Australia, Singapore, and other countries have significant tax incentives to develop film industries in their own countries. For instance, work done in Vancouver ends up costing $0.50 on the dollar once all the tax credits are factored in. Shortly after a new country or US state initiates one of these large tax incentives visual effects houses race each other to set up satellite offices in the new tax haven. The winner enjoys a momentary advantage over the others but this is gradually competed away when others set up shop in the same place or when a new country or state creates a new tax incentive that a competitor was able to take advantage of first.

Business History
Digital Domain was founded in 1993 by James Cameron, Scott Ross, and Stan Winston. That original team has since departed and the company was sold to private holding company Wyndcrest Holdings, LLC in 2006. Wyndcrest tried to take Digital Domain public shortly after in late 2007 but the IPO was withdrawn. The SEC filings for the IPO revealed that the visual effects company hadn't made money since 2004. In 2009 Wyndcrest incorporated Digital Domain Media Group as a parent company that included Digital Domain and then successfully IPO'd DDMG in 2011. John Textor, the current CEO and largest individual shareholder of DDMG, is also the founder of Wyndcrest, currently serving as its President. There is only one DDMG 10-K available to look at for the year 2011, though it contains financial data going back to 2007. The S-1 filed as part of the 2007 IPO attempt has data going back to 2002.

One of the first things I check out is the company's earnings history. How fast is the company growing revenue? Are margins expanding or contracting? How often, if at all, does the company lose money? This gives me my first idea how cyclical the business is and how good the business in general is. A company has to make money at some point to be worth something: the value of a company is the present value of its future cash flows.
If we look at DDMG, the Digital Production segment (where virtually all current revenue has been generated) usually manages a segment-level operating profit but once corporate overhead is added things swing to a loss. In fact, the company has lost money for every year it has released information for in the 2011 10-K, and has lost money 8 years out of the 10 that there is financial data available for:

Accounting Earnings

2007: $20 million loss on $73.7 million in revenue
2008: $15.3 million loss on $85.1 million in revenue
2009: $19.3 million loss on $70.8 million in revenue*
2010: $42 million loss on $105 million in revenue
2011: $141 million loss on $99 million in revenue
trailing twelve months: $80 million loss on $102 million in revenue

*(year DDMG incorporated: 9 months of Digital Domain, LLC data, 3 months of DDMG data)

These are accounting earnings and so they have some non-cash charges in them, the biggest of which is a revaluation of some warrant liabilities. Most of the warrants have an exercise price around $8-$10 so are currently underwater, but many of these warrants have a put feature which allows the owner of the warrant to put the warrant back to DDMG and receive cash in return after a certain date (most are several years out from now, ex. 2016-ish). The amount of cash received is equal to either the common stock price at the time or the price of one of the series of preferred shares, depending on which issue of warrants you look at. Each issue has its own terms.

As DDMG's stock price goes up the company is on the hook for a potentially bigger cash payout. GAAP accounting rules state that warrants with put features like this are required to be treated as liabilities, and those liabilities get revalued every reporting period based on where the underlying stock price is. That revaluation of the warrants affects earnings even though it's a non-cash charge: an increase in the liability reduces accounting earnings, a decrease in the liability boosts accounting earnings. While this sort of non-cash revaluation charge or credit happens at other companies, the difference with DDMG is that with no earnings and a truly vast amount of warrants outstanding (if all the warrants were exercised the 22 million new shares created would swell the existing share count of 44 million by 50%), the warrant revaluation has a very large impact on accounting earnings, at times overpowering the numbers of the actual operating business.

There's also some straightforward non-cash depreciation and amortization charges on buildings, software, patents, etc. Here's what the actual cash operating earnings look like:

Cash from Operating Activities

2007: no data
2008: no data
2009: $19.2 million in cash from operations on $70.8 million in revenue*
2010: $16 million in cash from operations on $105 million in revenue
2011: $42 million loss on $99 million in revenue
trailing twelve months: $60 million loss on $102 million in revenue

*(year DDMG incorporated: 9 months of Digital Domain, LLC data, 3 months of DDMG data)

Better but still not good, and headed in the wrong direction. DDMG doesn't look to be able to grow its way out of its operating losses, at least not yet: the more revenue it makes the more money it loses since its cost of sales goes up correspondingly (it has to hire more artists to do more work). Contrast that with a company like Visa, Mastercard, or Ebay, where significantly more transactions can shoot through essentially the same network at little extra cost. Keep in mind as well that cash generated from operating activities is before any money is spent on capital expenditures, whether to grow the business or just maintain the business the company already has: computer software and hardware ages fast.

Balance Sheet
We looked at the earnings statement and cash flow statement, now let's look at the balance sheet. What are the assets? How much cash does the company have? How much debt does it have? How liquid is the company? If DDMG continued to lose money could it float itself for a while with cash on the balance sheet or would it have to reach for credit? Can it get credit? At what interest rate?

Unfortunately, DDMG's liabilities are greater than its total assets. Losses have eaten away all the equity and now the shareholder equity account shows a deficit. Total assets are about $205 million but total liabilities are $215 million. While there have been occasional quarters that showed positive shareholder equity, this was accomplished through selling more equity, diluting current shareholders, not through building up equity through retained earnings.

Creditors, not shareholders, currently have a claim on the whole business if DDMG were to liquidate. So unlike, say, Bank of America (BAC), which could shut its doors tomorrow, sell off everything it owns, settle all of its debts, and pay out each shareholder about $12.00 a share, DDMG owners would get nothing (and should thank their lucky stars for the limited liability corporation, which means they don't actually owe anything).

Ok, the overall leverage picture looks scary. What about liquidity? Can DDMG cover its short term obligations with cash or earnings? Nope. DDMG doesn't even have enough cash to cover its accounts payable let alone all of its current liabilities, and it doesn't have earnings. Though many excellent companies such as Wal-Mart, Dell, and pretty much any oil and gas company operate with negative working capital (current assets less than current liabilities) the key difference is those companies have significant earnings power to fund that difference.

DDMG is currently managing to span this funding gap by selling more equity (it raised $42 million in the recent IPO), selling more debt, and by pursuing and obtaining government stimulus packages (DDMG received $135 million from the State of Florida alone to set up its Port St. Lucie campus). Terms on recent deals reflect the tenuous finances of the company, with DDMG paying 9-10% on non tax-deductible convertible preferred shares issued in May. Much of this creative financing is what adds so much length and complexity to the financial statements, since DDMG goes through each issue describing the terms of each. DDMG's financials are not for the faint of heart. The 10-K rivals a large money center bank's (i.e. Bank of America, Citigroup) in length and complexity.

The following paragraph from DDMG's latest 10-Q paints a pretty clear picture:

Liquidity and Capital Resources — The Company has a history of losses, including a $52.3 million and $144.2 million net loss before non-controlling interests, respectively, for the six months ended June 30, 2012 and the year ended December 31, 2011, respectively. The Company has a limited operating history, had negative working capital of $42.8 million and a stockholders’ deficit of $9.8 million as of June 30, 2012. For the six months ended June 30, 2012 and the year ended December 31, 2011, the Company used $34.3 million and $44.4 million, respectively, in cash flows from operations. The Company has worked to improve its working capital and its cash flow shortfalls through equity and debt funding. The Company raised gross proceeds of $19.5 million in equity capital in a private placement in February and March 2011, gross proceeds of $26.0 million in another private placement consummated in August 2011, and gross proceeds of $41.8 million in its initial public offering completed in November 2011. Additionally, upon completion of the IPO, convertible debt and warrants representing $94.0 million of debt and warrant liabilities reflected on the Company’s balance sheet were automatically converted or exercised, as applicable, into the Company’s common stock. In June 2012, the Company raised gross proceeds of $10.5 million of equity capital in a private placement.

While the visual effects that DDMG produces are fantastic, the company as an investment is not. I saw enough things I didn't like about DDMG that I cut my research short and didn't run a full valuation. Could DDMG turn its act around and start earning money? Sure. DDMG has a lot of irons in the fire. The animated movie that DDMG is working on in Florida and will own the rights to could turn out to be a success. The digital human replicas of dead celebrities (such as their digital Tupac and Elvis) might be something that DDMG could make money on (assuming that people can still identify with dead versions of celebs and that DDMG can indeed secure income stream rights, and not just do the work for hire). The push into non-VFX/entertainment work like military visualization could work. Digital Domain Institute, the nascent for-profit university that trains aspiring digital artists for a fee could work out (for-profit colleges have much higher margins than VFX shops: look at Apollo Group, Strayer, or DeVry). Currently DDI enrolls less then 200 students but Textor hopes to grow this to around 4,600 students in the next few years. Essentially DDMG is making a push into several different higher margin, higher return on capital businesses (owned content, for-profit education).

Keep in mind that some of the higher margin experiments such as the animated movies are quite expensive and will require significant capital upfront: capital that DDMG doesn't have. The company will have to seek outside investors in these projects and management freely admits that. When you do that you also limit your potential upside since you have to pay those investors their share (if the movie is a success).

These are all uncharted waters: all experiments. Since DDMG is selling at a price substantially above $0.00 when it has negative shareholder equity and no history of earnings, a fair amount of optimism is already baked into the stock price: some of these projects need to succeed to justify the current share price of ~$3.00, let alone push the share price higher.

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