DIGITAL DOMAIN MEDIA GRP INC DDMG S
May 28, 2012 - 2:20pm EST by
castor13
2012 2013
Price: 7.39 EPS $0.00 $0.00
Shares Out. (in M): 43 P/E 0.0x 0.0x
Market Cap (in $M): 315 P/FCF 0.0x 0.0x
Net Debt (in $M): 51 EBIT 0 0
TEV ($): 366 TEV/EBIT 0.0x 0.0x
Borrow Cost: NA

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  • Related Party Transactions
  • digital media
  • Stock promotion
  • Poor management
  • Cash Burn

Description

Overview

Digital Domain Media Group, Inc. (“DDMG” or “the Company”) is a short because it loses money, has had questionable related party transactions, a confused corporate strategy that could lead to further shareholder destruction and few sustainable competitive advantages.  DDMG has ~43mn shares outstanding; ~35mn of those shares are under a lock-up agreement that expires next month.  Digital Domain was created in 1993 by James Cameron, Stan Winston and Scott Ross as a digital VFX studio.  In 2006, it was purchased by an investment group led by John Textor (current Chairman and CEO) before becoming majority owned by Digital Domain Media Group, Inc. (DDMG) in 2009.  Several years later, in November 2011, DDMG went public in an IPO that priced well below the bottom of its $10-$12 range. 

I first discovered this stock after seeing a Facebook posting from a friend who attended Coachella this year.  Tupac Shakur appeared on stage in a life-size three-dimensional holographic image to perform “Hail Mary.”  The illusion was constructed by DDMG using an old-fashioned technique called “Pepper’s Ghost.”  Even though the performance generated negligible revenue for the Company, it added $130mn+ to the Company’s market cap in the weeks that followed. 

Questionable Corporate Strategy

DDMG’s core business is providing computer-generated animation and digital FX for movie studios and advertisers.  This includes converting 2D to 3D, mapping human movements onto CG characters, and providing realistic attributes to animated characters.  The Company’s work can be seen in many big-budget motion picture movies, including Thor, TRON:Legacy, Titanic and The Curious Case of Benjamin Button.  

Like Pixar in the 90s, DDMG is attempting to move beyond its role as an outsourced provider of visual effects and upstream along the film value chain.  First, DDMG wants to create its own animated feature films, which will, in the future, require significant payments to artists, directors, writers and producers over long (3-4 year) periods of time, not to mention potentially large marketing expenditures.  Second, DDMG plans to enter into co-production agreements that will give the Company some ownership over created content and revenue share in future royalty streams.  One such avenue of IP monetization is video game publishing, which is another area DDMG has talked about entering.  A third tangentially related strategy includes launching Digital Domain Institute, a for-profit post-secondary school offering a 4-year Bachelor of Fine Arts degree.  Oh yeah, and also, the Company wants to replicate this business vision in China and the Middle East.  All this will, of course, require significant external financing (through both government grants and private lenders/investors) given that the Company is unable to generate material cash flow in its core business.  I suspect that this empire-building is linked to Textor’s personal ambition of being a Hollywood big – note that his amended employment agreement from July of last year grants him producer credits on all films produced by DDMG.

But film is not the only area where DMDG is hoping to vertically integrate.  The Company has historically done VFX for ad clients so naturally, DDMG thinks it should also handle brand management campaign planning across different media platforms (phones, TVs, tablet, etc.), offering an “end-to-end” service for ad clients.  Granted, many of these new initiatives (the new animation studio and for-profit school in Florida and studios in Abu Dhabi and China) will initially be funded with government grants and this minimizes the risk of a major bust.  But, even so, DDMG is committing a significant amount of capital as well and these grants are discrete, conditional payments that should by no means be capitalized.

It gives me pause to see a company expanding aggressively outside its area of core competency, but especially so when it hasn’t proven adept in monetizing its core competency to begin with (from a shareholder’s perspective).  Below is a summary of DDMG’s operating profits over the last several 7 years:

($ millions)              
  2005 2006 2007 2008 2009 2010 2011
Feature films                 62.4           50.6           82.6           75.6
Commercials                 21.5             9.4           19.2           20.1
Animation                   1.2                  -    
License revenue                          -               0.1
               
Operational revenue                 85.1           60.0         101.8           95.7
               
Government grants                      -               6.8             3.3             3.0
               
Total revenue           49.5           67.0           77.8           85.1           66.8         105.1           98.7
               
Total gross profit             5.9           13.1           14.9             4.8           13.0           21.2             4.8
% of revenue  11.9% 19.6% 19.1% 5.6% 19.4% 20.2% 4.9%
               
Depreciation             3.5             4.3             4.1             6.3             6.6             7.3           13.3
               
Cash SG&A (excluding share-based comp)             3.9             9.6           20.3           21.3           15.0           23.6           36.4
Share-based comp                -               0.3             2.1             1.8             1.1             1.9           26.7
               
Amortization of intangibles                  -                  -                  -               2.9             2.9             3.5
               
EBIT           (1.5)           (1.1)         (11.6)         (24.6)         (12.7)         (14.5)         (75.0)
EBIT (ex. share-based comp)           (1.5)           (0.8)           (9.5)         (22.8)         (11.5)         (12.7)         (48.3)

Few Sustainable Competitive Advantages

Few of DDMG’s competitive strengths are sustainable.  With respect to DDMG’s animation initiative, management is quick to mention the deep bench of talent that they’ve recently acquired for DDMG’s animation studio, including marquee names from Disney.  But you can get anybody if you pay them enough.  The key question from a shareholder’s point of view is whether these individuals, when paired with DDMG’s unique assets, can create more value inside DDMG than they could at Disney/Pixar or anywhere else.  If not, then it’s difficult to argue that these human assets are immobile, and thus a source of sustainable competitive advantage.

The Company also points to its “scale and network of production facilities” as a competitive strength in for-hire visual FX.  However, this business is characterized by a highly variable, labor-intensive cost structure – I estimate that about 80% of the cost structure is variable.  Every new studio engagement requires more creative and technical bodies.  There are few economies of scale.  Additionally, the structure of the film production industry makes DDMG’s customer base in VFX inherently unstable.  Unlike most industries where common suppliers and customers engage on a recurring basis to produce a good for which there is reasonably consistent demand, in film production, directors, artists, producers, screenplay writers and any outsourced services come together for a 3-4 year period of time, make something, and then disband.  Because most of DDMG’s revenue comes from VFX services to motion picture studios, it’s not uncommon for work on one project for one studio to constitute nearly half of DDMG’s sales in a given year.  Once the movie is made, the revenue goes away and has to be replaced with sales from another large studio project.   As the Company transitions towards larger, big budget films, we can expect revenue to be much lumpier and lower-margin.

Finally, there are maybe 5 or 6 movie studios that matter and many have in-house visual FX capabilities.  Meanwhile, there are dozens of VFX companies that compete for any outsourced business, leading to little bargaining power, poor economics and meager returns.  Within the advertising vertical, again, the Company faces heavy competition on multiple dimensions – from full-service ad agencies (and clients) like Omnicom, WPP and Interpublic focused on traditional mediums, digital platforms and even VFX studios focused almost exclusively on ads.

On a few occasions, management has referenced Pixar as a model they would like to follow.  However, I see several differences between Digital Domain today and Pixar in the 90s.

First, Pixar offered game-changing animation technology for its day.  Until Pixar came along, animation still involved hundreds of artists working for years to create hand-drawn cels.  In comparison, Pixar’s technology allowed studios to create more intricate characters that were easily editable, produce animated films faster and significantly cut costs.  As Steve Jobs said in 1996, “We have 10 years of proprietary software systems that you cannot buy anything close to in the marketplace.  You have to build them yourself.”[1]  Pixar brought all this technology to bear in 1995 with its precedent-setting Toy Story, the industry’s first feature-length CG animation film.  That Pixar fashioned itself a technological innovator in animation is apparent in its R&D investment during the 90s (I show this through 1996, right around when Pixar’s film library post Toy Story really took off):

($ millions) 1992 1993 1994 1995 1996
Total Company Revenue             4.2             6.8             5.6           12.1           38.2
           
R&D             2.3             1.8             2.3             4.1             7.0
% of revenue 54.7% 25.7% 40.9% 33.6% 18.3%

In contrast, during the last 7 years, DDMG has invested barely anything in R&D.  R&D spending is so small that it isn’t broken out separately from SG&A and the few times when it is disclosed in the footnotes (like for 2007 and 2008), it was less than 3% of revenue. 

We might also get a sense of the value-added proposition differences to studios by comparing Digital Domain’s gross margins with those of Pixar’s Animation Services segment during the 90s:

  1992 1993 1994 1995 1996 1997 1998
Pixar Animation Services gross margin % 4.9% 20.5% 13.4% 24.1% 23.0% 37.5% 77.6%
Average 28.7%            
               
  2005 2006 2007 2008 2009 2010 2011
DDMG gross margin (% rev. ex govt grants) 11.9% 19.6% 19.1% 5.6% 10.3% 17.6% 2.0%
Average 12.3%            

In fairness, however, the difference in economic backdrops does not really make the comparison apples-to-apples. 

The second thing Pixar had going for it was a strong, complementary business partnership with Disney.  Disney’s key asset is its brand, which ensures a consistent, family friendly experience and allows the company to monetize content across multiple channels (television, theme parks, merchandise).  While the Disney/Pixar relationship dates all the way back to the late-80s, it really solidified in 1991 when the two companies agreed to produce three full-length CG animated movies.  Toy Story and A Bug’s Life were created by Pixar but marketed and distributed by Disney, and everything was co-branded.  It’s likely that Pixar’s movies and characters gained greater success as a result of its relationship with Disney relative to what it could have achieved on its own.  The relationship-specific nature of Disney’s co-branding partnership with Pixar finally made an acquisition perfectly logical. 

In summary, Pixar’s success stemmed from leveraging its CG technology to create an entirely new category of full-length animation film that large audiences hadn’t been exposed to before.  Its technology was groundbreaking and its creative talent produced more value with Pixar’s assets than it could arguably produce anywhere else.  Pixar had its roots with animation and improved upon that focus while partnering with the strongest brand in family-friendly entertainment.

Historical Context

 DDMG’s “spaghetti on the wall” strategy sounds familiar.  Before acquiring DDMG, John C. Textor was at toddler and maternity products online retailer, BabyUniverse, Inc.  He was elected Chairman of the company in November 2002 and upon also taking the reins as CEO in April 2005, he took the company public in August of that year in a $19mn IPO.   What followed was an aggressive growth strategy that expanded BabyUniverse into a number of different businesses.  The company went from being a basic e-tailer of toddler and maternity toys, apparel, and accessories; to also selling “artisan-crafted” furniture to rich mothers; to creating an online community site with message boards and content for new moms; to launching a TV channel devoted to parents. 

 While Textor pursued this growth strategy, the Company’s operating losses mounted.  The Company went from being basically breakeven in operating profits in the two years prior to his becoming CEO to generating ~$7.5mn in the two subsequent years.  BabyUniverse also burned nearly $7mn in cash from operations during that time before the company was finally merged with eToys Direct in late 2007.  Textor stayed on as Chairman of the combined company, which filed for Chapter 11 bankruptcy roughly a year later.

Re-defining Profitability

Despite all of the above, DDMG is involved in all sorts of neat, artistic computer-generated VFX in movies and commercials, some of which have earned critical acclaim.  The Company’s work in The Curious Case of Benjamin Button is pretty astounding.  Qualitatively, the Company “feels” like it should be a profitable….and management keeps telling us it’s profitable – it sounds true; but is it true?   

Recently, in press releases and earnings calls, DDMG has started providing its own definition of gross margin.  It is breaking out its cost of revenue into three components: direct cost of revenue (labor that is specifically assigned to current revenue-generating projects); “unutilized” labor (labor that is not assigned to a specific revenue-generating project but might be in the future) and production and other costs (fixed costs).  Then, it is subtracting only the direct cost of revenue to arrive at its own version of “gross margin.”  Of course, it’s obvious why DDMG has started doing this: first, its expansion agenda requires up-front expenses without corresponding revenue and second, it is transitioning its core VFX business to take on larger projects with bigger budgets that require labor to stand idle for long periods of time in between.  But, the latter two are still real, recurring, cash costs and just as relevant as direct costs.  Excluding them from gross margin would be similar to a company excluding unabsorbed overhead from gross margin or equating gross margin with contribution margin %.  In any case, excluding unutilized labor from COGS in 2011 still yields pretty big losses:

($ millions)   PF
  2011 2011
Feature films           75.6           75.6
Commercials           20.1           20.1
Animation    
License revenue             0.1             0.1
     
Operational revenue           95.7           95.7
     
Government grants             3.0             3.0
     
Total revenue           98.7           98.7
     
Total gross profit             4.8           21.5
% of revenue  4.9% 21.8%
     
Depreciation           13.3           13.3
     
Cash SG&A (excluding share-based comp)           36.4           36.4
Share-based comp           26.7           26.7
     
Amortization of intangibles             3.5             3.5
     
EBIT         (75.0)         (58.4)
EBIT (ex. share-based comp)         (48.3)         (31.7)

 Adjusted EBITDA – Management urges investors to focus on “Adjusted EBITDA” which is supposed to represent a measure of recurring profitability associated with business operations.  This measure excludes interest expense, taxes, depreciation/amortization, and stock-based comp.  While none of these adjustments strike me as particularly unusual, the Company includes cash grant receipts from government agencies above and beyond what is already recognized in revenue. This is aggressive considering that these are really one-time payments to fund start-up costs and part of these cash payments must be returned to the state/city if certain milestones aren’t achieved. 

 Furthermore, one of the frequently cited reasons management gives for why its profitability measures are lagging is that they are recognizing the start-up costs associated with DDI and the animation studio up-front while government grant revenue is recognized over a period of time.  Perhaps I am misinterpreting these remarks, but it seems an easy way to test this claim is to simply add back changes in deferred grant revenue from governmental agencies, which is exactly what management does anyways to calculate Adjusted EBITDA:

($ millions)              
  2005 2006 2007 2008 2009 2010 2011
EBITDA (ex. stock comp)             2.0             3.5           (5.4)         (16.6)           (2.0)           (2.4)         (31.6)
               
Increase in deferred government grants                -                  -                  -                  -               3.2             8.2             1.2
Add: write-off of deferred offering expenses                         0.4
Add: acquisition-related non-cash adjustments                     1.1             3.0  
Add: write-off of capitalized film dev. cost                         4.8
               
Adj. EBITDA including cash govt grants              2.0             3.5           (5.4)         (16.6)             2.3             8.8         (25.2)

 These grants are clearly sizeable.  Without these grants Adjusted EBITDA would have been about breakeven or negative in 2010 and 2009. 

 (my Adjusted EBITDA number will differ, sometimes materially, from DDMG’s Adjusted EBITDA figure because, for example, in some years DDMG adds “other expenses” back without explaining what those are.  I choose not to add these back).

 There is something else that I find unusual.  Textor states the following in DDMG’s 4Q11 press release:

 "Again, we would like to highlight the fact that our grant receipts, which were secured to fund the Florida expansion, have substantially outpaced our Adjusted EBITDA losses, which show the upfront expense of this expansion. For example, our Adjusted EBITDA loss for all of 2011 was $22.4 million, while we are still holding deferred grant revenue of $32.7 million. This grant revenue paid for our expansion in Florida and will, we believe, be recognized into income, as pure profit flow-through, over the coming years."

 Management reiterated these remarks on the conference call.  I referenced DDMG’s 4Q11 balance sheet in order to find this $32.7mn number but could find no logical line-items on the liability side that would add up to this amount.  So, I added up the following line items (these line items had the word “grant” in them and in the case of deferred grant revenue, would eventually be recognized as revenue): Deferred grant revenue from governmental agencies (short-term and long-term) + deferred revenue land grant =….$32.8mn.

 If this isn’t coincidence, then management’s remarks are highly misleading.  This is because, as I’ve explained above, DDMG’s reported “Adjusted EBITDA” already adds back changes in deferred grant revenue from governmental agencies.  The $12.5mn of deferred grant revenue on the balance sheet has already been baked into this year’s and prior year’s Adjusted EBITDA metric.  Thus, management has already “pulled-forward” any future “pure profit flow-through.” 

 Other Nits

 1) It can be disconcerting and desperate when the CEO spends significant time on an earnings conference call talking about the stock price rather than the business.  In the 3Q11 call, following an IPO that priced below the lower end of the range, John Textor explained that in the private market, “sophisticated financial investors…..from all parts of the world” valued the stock at $9.63; that these investors had the opportunity to do the deep due diligence that the public did not; that while everything was fully disclosed in the S-1, it was “a difficult document to read.”

 2) John Textor was a founding director of Lydian Trust Co./Lydian Private Bank, a Palm Beach Florida financial concern with a history of irregular accounting that failed in August 2011.  Its top executives are being sued by investors and several government agencies are investigating the bank’s “questionable activities” according to the South Florida Business Journal[2].  I did a few casual Google searches and came across the following remarks in an online comments section of a local online newspaper:

 “Neither Digital Domain, nor Mr. John Textor, has any business relationship to, or ownership interest in, Lydian Trust. Mr. Textor was a founder of Virtual Bank and 1st Virtual Holdings in the year 2000. This company ultimately became Lydian Private Bank / Lydian Trust. Mr. Textor's holding company, Wyndcrest Holdings, was a 9.9% shareholder of Lydian until the successful sale of its interest in 2004, when Mr. Textor also resigned from the board of directors....

 When asked by another commenter, the poster identified itself as the “Public Relations Department at Digital Domain Media Group.”  Granted, there is no way to ascertain this poster’s real identity.  But, there seems to be a lengthy precedent of business relationships between John Textor and this bank since his resignation.  For example, BabyUniverse had a lending agreement with Lydian in 2006/2007, and up through June 2011 Lydian was a lender to Digital Domain, and owned warrants to purchase nearly 14% of Digital Domain common stock.  The above point is not illegal in any way (borrowing from crooks doesn’t make you a crook), it’s just sort of icky. 

 3) In September 2010, the Company undertook a weird transaction with its CEO John Textor that went like this: John Textor transferred 1.7mn shares in Digital Domain and an $8mn loan to DDMG; DDMG paid Textor $500k for this and gave him warrants to purchase ~840k shares of DDMG stock with a 1 cent strike price and in return, Textor agreed to personally guarantee the transferred loan.  Basically, this looks like a way for DDMG to have accumulated share ownership and allowed Textor to avoid recording the warrants as compensation.  It appears that the Company effectively paid Textor ~$9.30/share for his Digital Domain stock; yet, between August 2010 and January 2011, Digital Domain sold 176,775 shares of common stock in private placements to 3rd party investors for just $6.00/share.

 There’s an additional $700k or so of cash payments made to Textor and his affiliated companies in consulting and capital raising transaction fees.  There are a few other suspicious looking payments too: like the $115k that Textor received for providing services to one of the Company’s subsidiaries or the $155k paid to Jon Teaford, the CFO, for providing “educational assistance” or $54k that the former CEO of Digital Domain received for temporary housing assistance.

4) DDMG has a poison pill option and other measures that hinder potential takeovers.

5) DDMG capitalized the deferred financing costs related to its recent IPO.  While I’ve heard of companies doing this for debt issuance where there is a contractually defined maturity period, this seems like aggressive treatment for perpetual capital.  The Company also capitalizes software costs

 Shortcomings of the short thesis:

Grant money from Florida and resource rich countries, often incented by motivations unrelated to risk/reward, greatly mitigates the possibility of a huge near-term liquidity disaster and reliance on outside capital.  For example, while DDMG is also investing its own capital, it has received over $285mn in cash grants, loans, land and facilities from various governments to fund start-up costs.

 John Textor invested $10mn of his own money in the IPO while CFO John Teaford bought $500k, nearly a quarter of the IPO; though, this, coupled with pricing below the range, might also signal that institutional demand was weaker than expected

 This is a hit-driven industry – Ender’s Game (37.5% co-production w/ Oddlot Entertainment) could be huge; so could Legend of Tembo (DDMG’s animated film).  For example, management disclosed estimated payoffs (including post-box office ancillary revenue) from Ender’s Game based on the following domestic box office revenue:

 Box Office           Payoff to DDMG net of $18mn investment

 $60mn                                  -$6.8mn

$80mn                                  -$1.0mn

$115mn                                $9.5mn

$150mn                                $22.5mn

$200mn                                $36mn

$250mn                                $43mn

 HSX.com is currently predicting around $125mn in box office receipts, so let’s just say this is worth $20mn in value to DDMG over several years, or still less than 10% of DDMG’s current market cap.

 

Could be acquired



[1] Alcacer, Juan, David Collis and Mary Furey.  “The Walt Disney Company and Pixar Inc.: To Acquire or Not to Acquire?”  Harvard Business School, 1/15/10.  Print.

[2] South Florida Business Journal; “Government is investigating Lydian Private Bank executives”  http://www.bizjournals.com/southflorida/print-edition/2012/03/30/government-is-investigating-lydian.html?page=all

Catalyst

 
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    Description

    Overview

    Digital Domain Media Group, Inc. (“DDMG” or “the Company”) is a short because it loses money, has had questionable related party transactions, a confused corporate strategy that could lead to further shareholder destruction and few sustainable competitive advantages.  DDMG has ~43mn shares outstanding; ~35mn of those shares are under a lock-up agreement that expires next month.  Digital Domain was created in 1993 by James Cameron, Stan Winston and Scott Ross as a digital VFX studio.  In 2006, it was purchased by an investment group led by John Textor (current Chairman and CEO) before becoming majority owned by Digital Domain Media Group, Inc. (DDMG) in 2009.  Several years later, in November 2011, DDMG went public in an IPO that priced well below the bottom of its $10-$12 range. 

    I first discovered this stock after seeing a Facebook posting from a friend who attended Coachella this year.  Tupac Shakur appeared on stage in a life-size three-dimensional holographic image to perform “Hail Mary.”  The illusion was constructed by DDMG using an old-fashioned technique called “Pepper’s Ghost.”  Even though the performance generated negligible revenue for the Company, it added $130mn+ to the Company’s market cap in the weeks that followed. 

    Questionable Corporate Strategy

    DDMG’s core business is providing computer-generated animation and digital FX for movie studios and advertisers.  This includes converting 2D to 3D, mapping human movements onto CG characters, and providing realistic attributes to animated characters.  The Company’s work can be seen in many big-budget motion picture movies, including Thor, TRON:Legacy, Titanic and The Curious Case of Benjamin Button.  

    Like Pixar in the 90s, DDMG is attempting to move beyond its role as an outsourced provider of visual effects and upstream along the film value chain.  First, DDMG wants to create its own animated feature films, which will, in the future, require significant payments to artists, directors, writers and producers over long (3-4 year) periods of time, not to mention potentially large marketing expenditures.  Second, DDMG plans to enter into co-production agreements that will give the Company some ownership over created content and revenue share in future royalty streams.  One such avenue of IP monetization is video game publishing, which is another area DDMG has talked about entering.  A third tangentially related strategy includes launching Digital Domain Institute, a for-profit post-secondary school offering a 4-year Bachelor of Fine Arts degree.  Oh yeah, and also, the Company wants to replicate this business vision in China and the Middle East.  All this will, of course, require significant external financing (through both government grants and private lenders/investors) given that the Company is unable to generate material cash flow in its core business.  I suspect that this empire-building is linked to Textor’s personal ambition of being a Hollywood big – note that his amended employment agreement from July of last year grants him producer credits on all films produced by DDMG.

    But film is not the only area where DMDG is hoping to vertically integrate.  The Company has historically done VFX for ad clients so naturally, DDMG thinks it should also handle brand management campaign planning across different media platforms (phones, TVs, tablet, etc.), offering an “end-to-end” service for ad clients.  Granted, many of these new initiatives (the new animation studio and for-profit school in Florida and studios in Abu Dhabi and China) will initially be funded with government grants and this minimizes the risk of a major bust.  But, even so, DDMG is committing a significant amount of capital as well and these grants are discrete, conditional payments that should by no means be capitalized.

    It gives me pause to see a company expanding aggressively outside its area of core competency, but especially so when it hasn’t proven adept in monetizing its core competency to begin with (from a shareholder’s perspective).  Below is a summary of DDMG’s operating profits over the last several 7 years:

    ($ millions)              
      2005 2006 2007 2008 2009 2010 2011
    Feature films                 62.4           50.6           82.6           75.6
    Commercials                 21.5             9.4           19.2           20.1
    Animation                   1.2                  -    
    License revenue                          -               0.1
                   
    Operational revenue                 85.1           60.0         101.8           95.7
                   
    Government grants                      -               6.8             3.3             3.0
                   
    Total revenue           49.5           67.0           77.8           85.1           66.8         105.1           98.7
                   
    Total gross profit             5.9           13.1           14.9             4.8           13.0           21.2             4.8
    % of revenue  11.9% 19.6% 19.1% 5.6% 19.4% 20.2% 4.9%
                   
    Depreciation             3.5             4.3             4.1             6.3             6.6             7.3           13.3
                   
    Cash SG&A (excluding share-based comp)             3.9             9.6           20.3           21.3           15.0           23.6           36.4
    Share-based comp                -               0.3             2.1             1.8             1.1             1.9           26.7
                   
    Amortization of intangibles                  -                  -                  -               2.9             2.9             3.5
                   
    EBIT           (1.5)           (1.1)         (11.6)         (24.6)         (12.7)         (14.5)         (75.0)
    EBIT (ex. share-based comp)           (1.5)           (0.8)           (9.5)         (22.8)         (11.5)         (12.7)         (48.3)

    Few Sustainable Competitive Advantages

    Few of DDMG’s competitive strengths are sustainable.  With respect to DDMG’s animation initiative, management is quick to mention the deep bench of talent that they’ve recently acquired for DDMG’s animation studio, including marquee names from Disney.  But you can get anybody if you pay them enough.  The key question from a shareholder’s point of view is whether these individuals, when paired with DDMG’s unique assets, can create more value inside DDMG than they could at Disney/Pixar or anywhere else.  If not, then it’s difficult to argue that these human assets are immobile, and thus a source of sustainable competitive advantage.

    The Company also points to its “scale and network of production facilities” as a competitive strength in for-hire visual FX.  However, this business is characterized by a highly variable, labor-intensive cost structure – I estimate that about 80% of the cost structure is variable.  Every new studio engagement requires more creative and technical bodies.  There are few economies of scale.  Additionally, the structure of the film production industry makes DDMG’s customer base in VFX inherently unstable.  Unlike most industries where common suppliers and customers engage on a recurring basis to produce a good for which there is reasonably consistent demand, in film production, directors, artists, producers, screenplay writers and any outsourced services come together for a 3-4 year period of time, make something, and then disband.  Because most of DDMG’s revenue comes from VFX services to motion picture studios, it’s not uncommon for work on one project for one studio to constitute nearly half of DDMG’s sales in a given year.  Once the movie is made, the revenue goes away and has to be replaced with sales from another large studio project.   As the Company transitions towards larger, big budget films, we can expect revenue to be much lumpier and lower-margin.

    Finally, there are maybe 5 or 6 movie studios that matter and many have in-house visual FX capabilities.  Meanwhile, there are dozens of VFX companies that compete for any outsourced business, leading to little bargaining power, poor economics and meager returns.  Within the advertising vertical, again, the Company faces heavy competition on multiple dimensions – from full-service ad agencies (and clients) like Omnicom, WPP and Interpublic focused on traditional mediums, digital platforms and even VFX studios focused almost exclusively on ads.

    On a few occasions, management has referenced Pixar as a model they would like to follow.  However, I see several differences between Digital Domain today and Pixar in the 90s.

    First, Pixar offered game-changing animation technology for its day.  Until Pixar came along, animation still involved hundreds of artists working for years to create hand-drawn cels.  In comparison, Pixar’s technology allowed studios to create more intricate characters that were easily editable, produce animated films faster and significantly cut costs.  As Steve Jobs said in 1996, “We have 10 years of proprietary software systems that you cannot buy anything close to in the marketplace.  You have to build them yourself.”[1]  Pixar brought all this technology to bear in 1995 with its precedent-setting Toy Story, the industry’s first feature-length CG animation film.  That Pixar fashioned itself a technological innovator in animation is apparent in its R&D investment during the 90s (I show this through 1996, right around when Pixar’s film library post Toy Story really took off):

    ($ millions) 1992 1993 1994 1995 1996
    Total Company Revenue             4.2             6.8             5.6           12.1           38.2
               
    R&D             2.3             1.8             2.3             4.1             7.0
    % of revenue 54.7% 25.7% 40.9% 33.6% 18.3%

    In contrast, during the last 7 years, DDMG has invested barely anything in R&D.  R&D spending is so small that it isn’t broken out separately from SG&A and the few times when it is disclosed in the footnotes (like for 2007 and 2008), it was less than 3% of revenue. 

    We might also get a sense of the value-added proposition differences to studios by comparing Digital Domain’s gross margins with those of Pixar’s Animation Services segment during the 90s:

      1992 1993 1994 1995 1996 1997 1998
    Pixar Animation Services gross margin % 4.9% 20.5% 13.4% 24.1% 23.0% 37.5% 77.6%
    Average 28.7%            
                   
      2005 2006 2007 2008 2009 2010 2011
    DDMG gross margin (% rev. ex govt grants) 11.9% 19.6% 19.1% 5.6% 10.3% 17.6% 2.0%
    Average 12.3%            

    In fairness, however, the difference in economic backdrops does not really make the comparison apples-to-apples. 

    The second thing Pixar had going for it was a strong, complementary business partnership with Disney.  Disney’s key asset is its brand, which ensures a consistent, family friendly experience and allows the company to monetize content across multiple channels (television, theme parks, merchandise).  While the Disney/Pixar relationship dates all the way back to the late-80s, it really solidified in 1991 when the two companies agreed to produce three full-length CG animated movies.  Toy Story and A Bug’s Life were created by Pixar but marketed and distributed by Disney, and everything was co-branded.  It’s likely that Pixar’s movies and characters gained greater success as a result of its relationship with Disney relative to what it could have achieved on its own.  The relationship-specific nature of Disney’s co-branding partnership with Pixar finally made an acquisition perfectly logical. 

    In summary, Pixar’s success stemmed from leveraging its CG technology to create an entirely new category of full-length animation film that large audiences hadn’t been exposed to before.  Its technology was groundbreaking and its creative talent produced more value with Pixar’s assets than it could arguably produce anywhere else.  Pixar had its roots with animation and improved upon that focus while partnering with the strongest brand in family-friendly entertainment.

    Historical Context

     DDMG’s “spaghetti on the wall” strategy sounds familiar.  Before acquiring DDMG, John C. Textor was at toddler and maternity products online retailer, BabyUniverse, Inc.  He was elected Chairman of the company in November 2002 and upon also taking the reins as CEO in April 2005, he took the company public in August of that year in a $19mn IPO.   What followed was an aggressive growth strategy that expanded BabyUniverse into a number of different businesses.  The company went from being a basic e-tailer of toddler and maternity toys, apparel, and accessories; to also selling “artisan-crafted” furniture to rich mothers; to creating an online community site with message boards and content for new moms; to launching a TV channel devoted to parents. 

     While Textor pursued this growth strategy, the Company’s operating losses mounted.  The Company went from being basically breakeven in operating profits in the two years prior to his becoming CEO to generating ~$7.5mn in the two subsequent years.  BabyUniverse also burned nearly $7mn in cash from operations during that time before the company was finally merged with eToys Direct in late 2007.  Textor stayed on as Chairman of the combined company, which filed for Chapter 11 bankruptcy roughly a year later.

    Re-defining Profitability

    Despite all of the above, DDMG is involved in all sorts of neat, artistic computer-generated VFX in movies and commercials, some of which have earned critical acclaim.  The Company’s work in The Curious Case of Benjamin Button is pretty astounding.  Qualitatively, the Company “feels” like it should be a profitable….and management keeps telling us it’s profitable – it sounds true; but is it true?   

    Recently, in press releases and earnings calls, DDMG has started providing its own definition of gross margin.  It is breaking out its cost of revenue into three components: direct cost of revenue (labor that is specifically assigned to current revenue-generating projects); “unutilized” labor (labor that is not assigned to a specific revenue-generating project but might be in the future) and production and other costs (fixed costs).  Then, it is subtracting only the direct cost of revenue to arrive at its own version of “gross margin.”  Of course, it’s obvious why DDMG has started doing this: first, its expansion agenda requires up-front expenses without corresponding revenue and second, it is transitioning its core VFX business to take on larger projects with bigger budgets that require labor to stand idle for long periods of time in between.  But, the latter two are still real, recurring, cash costs and just as relevant as direct costs.  Excluding them from gross margin would be similar to a company excluding unabsorbed overhead from gross margin or equating gross margin with contribution margin %.  In any case, excluding unutilized labor from COGS in 2011 still yields pretty big losses:

    ($ millions)   PF
      2011 2011
    Feature films           75.6           75.6
    Commercials           20.1           20.1
    Animation    
    License revenue             0.1             0.1
         
    Operational revenue           95.7           95.7
         
    Government grants             3.0             3.0
         
    Total revenue           98.7           98.7
         
    Total gross profit             4.8           21.5
    % of revenue  4.9% 21.8%
         
    Depreciation           13.3           13.3
         
    Cash SG&A (excluding share-based comp)           36.4           36.4
    Share-based comp           26.7           26.7
         
    Amortization of intangibles             3.5             3.5
         
    EBIT         (75.0)         (58.4)
    EBIT (ex. share-based comp)         (48.3)         (31.7)

     Adjusted EBITDA – Management urges investors to focus on “Adjusted EBITDA” which is supposed to represent a measure of recurring profitability associated with business operations.  This measure excludes interest expense, taxes, depreciation/amortization, and stock-based comp.  While none of these adjustments strike me as particularly unusual, the Company includes cash grant receipts from government agencies above and beyond what is already recognized in revenue. This is aggressive considering that these are really one-time payments to fund start-up costs and part of these cash payments must be returned to the state/city if certain milestones aren’t achieved. 

     Furthermore, one of the frequently cited reasons management gives for why its profitability measures are lagging is that they are recognizing the start-up costs associated with DDI and the animation studio up-front while government grant revenue is recognized over a period of time.  Perhaps I am misinterpreting these remarks, but it seems an easy way to test this claim is to simply add back changes in deferred grant revenue from governmental agencies, which is exactly what management does anyways to calculate Adjusted EBITDA:

    ($ millions)              
      2005 2006 2007 2008 2009 2010 2011
    EBITDA (ex. stock comp)             2.0             3.5           (5.4)         (16.6)           (2.0)           (2.4)         (31.6)
                   
    Increase in deferred government grants                -                  -                  -                  -               3.2             8.2             1.2
    Add: write-off of deferred offering expenses                         0.4
    Add: acquisition-related non-cash adjustments                     1.1             3.0  
    Add: write-off of capitalized film dev. cost                         4.8
                   
    Adj. EBITDA including cash govt grants              2.0             3.5           (5.4)         (16.6)             2.3             8.8         (25.2)

     These grants are clearly sizeable.  Without these grants Adjusted EBITDA would have been about breakeven or negative in 2010 and 2009. 

     (my Adjusted EBITDA number will differ, sometimes materially, from DDMG’s Adjusted EBITDA figure because, for example, in some years DDMG adds “other expenses” back without explaining what those are.  I choose not to add these back).

     There is something else that I find unusual.  Textor states the following in DDMG’s 4Q11 press release:

     "Again, we would like to highlight the fact that our grant receipts, which were secured to fund the Florida expansion, have substantially outpaced our Adjusted EBITDA losses, which show the upfront expense of this expansion. For example, our Adjusted EBITDA loss for all of 2011 was $22.4 million, while we are still holding deferred grant revenue of $32.7 million. This grant revenue paid for our expansion in Florida and will, we believe, be recognized into income, as pure profit flow-through, over the coming years."

     Management reiterated these remarks on the conference call.  I referenced DDMG’s 4Q11 balance sheet in order to find this $32.7mn number but could find no logical line-items on the liability side that would add up to this amount.  So, I added up the following line items (these line items had the word “grant” in them and in the case of deferred grant revenue, would eventually be recognized as revenue): Deferred grant revenue from governmental agencies (short-term and long-term) + deferred revenue land grant =….$32.8mn.

     If this isn’t coincidence, then management’s remarks are highly misleading.  This is because, as I’ve explained above, DDMG’s reported “Adjusted EBITDA” already adds back changes in deferred grant revenue from governmental agencies.  The $12.5mn of deferred grant revenue on the balance sheet has already been baked into this year’s and prior year’s Adjusted EBITDA metric.  Thus, management has already “pulled-forward” any future “pure profit flow-through.” 

     Other Nits

     1) It can be disconcerting and desperate when the CEO spends significant time on an earnings conference call talking about the stock price rather than the business.  In the 3Q11 call, following an IPO that priced below the lower end of the range, John Textor explained that in the private market, “sophisticated financial investors…..from all parts of the world” valued the stock at $9.63; that these investors had the opportunity to do the deep due diligence that the public did not; that while everything was fully disclosed in the S-1, it was “a difficult document to read.”

     2) John Textor was a founding director of Lydian Trust Co./Lydian Private Bank, a Palm Beach Florida financial concern with a history of irregular accounting that failed in August 2011.  Its top executives are being sued by investors and several government agencies are investigating the bank’s “questionable activities” according to the South Florida Business Journal[2].  I did a few casual Google searches and came across the following remarks in an online comments section of a local online newspaper:

     “Neither Digital Domain, nor Mr. John Textor, has any business relationship to, or ownership interest in, Lydian Trust. Mr. Textor was a founder of Virtual Bank and 1st Virtual Holdings in the year 2000. This company ultimately became Lydian Private Bank / Lydian Trust. Mr. Textor's holding company, Wyndcrest Holdings, was a 9.9% shareholder of Lydian until the successful sale of its interest in 2004, when Mr. Textor also resigned from the board of directors....

     When asked by another commenter, the poster identified itself as the “Public Relations Department at Digital Domain Media Group.”  Granted, there is no way to ascertain this poster’s real identity.  But, there seems to be a lengthy precedent of business relationships between John Textor and this bank since his resignation.  For example, BabyUniverse had a lending agreement with Lydian in 2006/2007, and up through June 2011 Lydian was a lender to Digital Domain, and owned warrants to purchase nearly 14% of Digital Domain common stock.  The above point is not illegal in any way (borrowing from crooks doesn’t make you a crook), it’s just sort of icky. 

     3) In September 2010, the Company undertook a weird transaction with its CEO John Textor that went like this: John Textor transferred 1.7mn shares in Digital Domain and an $8mn loan to DDMG; DDMG paid Textor $500k for this and gave him warrants to purchase ~840k shares of DDMG stock with a 1 cent strike price and in return, Textor agreed to personally guarantee the transferred loan.  Basically, this looks like a way for DDMG to have accumulated share ownership and allowed Textor to avoid recording the warrants as compensation.  It appears that the Company effectively paid Textor ~$9.30/share for his Digital Domain stock; yet, between August 2010 and January 2011, Digital Domain sold 176,775 shares of common stock in private placements to 3rd party investors for just $6.00/share.

     There’s an additional $700k or so of cash payments made to Textor and his affiliated companies in consulting and capital raising transaction fees.  There are a few other suspicious looking payments too: like the $115k that Textor received for providing services to one of the Company’s subsidiaries or the $155k paid to Jon Teaford, the CFO, for providing “educational assistance” or $54k that the former CEO of Digital Domain received for temporary housing assistance.

    4) DDMG has a poison pill option and other measures that hinder potential takeovers.

    5) DDMG capitalized the deferred financing costs related to its recent IPO.  While I’ve heard of companies doing this for debt issuance where there is a contractually defined maturity period, this seems like aggressive treatment for perpetual capital.  The Company also capitalizes software costs

     Shortcomings of the short thesis:

    Grant money from Florida and resource rich countries, often incented by motivations unrelated to risk/reward, greatly mitigates the possibility of a huge near-term liquidity disaster and reliance on outside capital.  For example, while DDMG is also investing its own capital, it has received over $285mn in cash grants, loans, land and facilities from various governments to fund start-up costs.

     John Textor invested $10mn of his own money in the IPO while CFO John Teaford bought $500k, nearly a quarter of the IPO; though, this, coupled with pricing below the range, might also signal that institutional demand was weaker than expected

     This is a hit-driven industry – Ender’s Game (37.5% co-production w/ Oddlot Entertainment) could be huge; so could Legend of Tembo (DDMG’s animated film).  For example, management disclosed estimated payoffs (including post-box office ancillary revenue) from Ender’s Game based on the following domestic box office revenue:

     Box Office           Payoff to DDMG net of $18mn investment

     $60mn                                  -$6.8mn

    $80mn                                  -$1.0mn

    $115mn                                $9.5mn

    $150mn                                $22.5mn

    $200mn                                $36mn

    $250mn                                $43mn

     HSX.com is currently predicting around $125mn in box office receipts, so let’s just say this is worth $20mn in value to DDMG over several years, or still less than 10% of DDMG’s current market cap.

     

    Could be acquired



    [1] Alcacer, Juan, David Collis and Mary Furey.  “The Walt Disney Company and Pixar Inc.: To Acquire or Not to Acquire?”  Harvard Business School, 1/15/10.  Print.

    [2] South Florida Business Journal; “Government is investigating Lydian Private Bank executives”  http://www.bizjournals.com/southflorida/print-edition/2012/03/30/government-is-investigating-lydian.html?page=all

    Catalyst

     
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