Description

Pixar Animation Studios (Nasdaq: PIXR) is a short because even with its remarkable (and probably unsustainable) ratio of hits/movies made, it is a low-return business with poor cash flow characteristics. PIXR is one bad movie away from negative cash flow and at an EV of $3.71B, Pixar trades at 21x 2002 EBIT (53x P/E 2004). Exorbitantly priced, lacking barriers to entry and facing a slew of new competitors, PIXR is an interesting short.

Company Background

CEO Steve Jobs founded Pixar in 1986 by purchasing the computer graphics division of Lucas Films, and Pixar spent its first five years focused on producing animated short features and commercials. After signing an initial three-film distribution deal with Disney – under which Disney agreed to co-finance, market, and distribute feature films produced by Pixar in exchange for a distribution fee and an equal split of each film’s profits – the company released its first computer-animated feature film, Toy Story, in November 1995. Toy Story’s $362m box-office bonanza quickly established Pixar as an animation leader, and the company has produced subsequent box office successes.
Pixar has created and produced five of the top ten animated films of all time in terms of box office revenue – Toy Story ($362m), A Bug’s Life ($363m), Toy Story 2 ($485m), Monsters, Inc. ($524m), and most recently Finding Nemo ($719m) – and the DVD of Monsters, Inc. set a record as the fastest-selling DVD of all time.

Industry Landscape

Several of the major studios have entered PIXR’s space. Fox acted first, releasing Anastasia in November of 1997. DreamWorks and Warner Brothers followed. By 2002, eight major studios were active in the animation movie space. This successful market entry underlines the lack of barriers in the industry. Pixar has had an unusual track record (five for five in CGI films with Disney), but historical data in the movie business suggests this is unsustainable.

Pixar vs. Industry Averages

Pixar has not yet had films that flop – its “hit rate” has been extraordinarily high. I do not believe that this is at all sustainable based on common sense and a comparison to other studios’ rates of success.

2003 Studio Profitability
2003 Industry Snapshot*

$m Revenues EBIT EBIT Margin
Pixar $ 194 $ 141 73%
Warner $ 10,040 $ 1,153 11%
Disney $ 7,364 $ 620 8%
Universal $ 6,270 $ 816 13%
Fox $ 4,048 $ 485 12%
Sony $ 5,902 $ 290 5%
Paramount $ 3,647 $ 334 9%
Dreamworks $ 1,813 na na
MGM/UA $ 1,416 $(40) 8%**
Average 10%
*Reported numbers are for most recently completed fiscal year
**Three-year average

Pixar Financial Analysis

Pixar ($, mm)
1997 1998 1999 2000 2001 2002 Avg
Revenues 35 10 115 163 63 194
% yoy growth -70% 1018% 42% -61% 206%
EBIT 23 1 75 120 42 141
% yoy growth -94% nm 62% -66% 239%
% margin 66% 13% 65% 74% 66% 73% 59%
NI 22 8 49 78 36 90
% yoy growth -65% 529% 60% -54% 148%
% margin 64% 76% 43% 48% 57% 46% 56%

Income Statement Analysis

Pixar has phenomenal margins that are fairly consistent. This reflects the obvious – that successful movies deliver an excellent return on sales. The financial question for Pixar is – how much capital was deployed to create the asset base necessary to produce its films. As the table below demonstrates, while net margins are so high for Pixar, it turns assets slowly on a large – although largely unlevered – asset base relative to its sales volume.

Dupont Analysis 1997 1998 1999 2000 2001 2002 Avg
Asset Turnover 0.1x 0.0x 0.3x 0.3x 0.1x 0.3x 20%
Leverage 1.1x 1.1x 1.1x 1.1x 1.0x 1.0x 106%
Net Margin 64% 76% 43% 48% 57% 46% 56%
ROE 10% 3% 14% 18% 7% 13% 11%
ROA 10% 3% 13% 16% 7% 12% 10%
ROIC 6% 0% 13% 17% 5% 12% 9%
ROIIC 229% 26% -52% 85%

Returns Analysis

Over the past six years, Pixar has averaged an 11% Return on Equity, indicating that it does not have a franchise. A Dupont analysis helps clarify why this is the case. Pixar turns assets more slowly than a nuclear power plant. In essence, the volume of sales generated is too low for its very expensive asset base. Pixar also does not employ leverage. This is probably a good thing based on the potential for a bad movie, or for their hit rate to go down (which it must).
On the other hand, there are really only two ways for Pixar to increase ROE: either a) increase leverage or b) produce more movies per assets. Is this possible? Is it sustainable?
Balance Sheet & Cash Flow Analysis

1997 1998 1999 2000 2001 2002
Assets 231 251 375 480 523 732
Debt 2 3 0 0 0 0
Cash 176 149 195 203 278 339
Net Debt -174 -146 -195 -203 -278 -339
Sh. Eq. 217 235 344 436 506 713
Inv. Cap. 219 238 344 436 506 713
Incremental IC 19 106 91 70 207
NOPAT 14 1 45 72 25 84
Incr. NOPAT -13 44 28 -47 59
CFO 44 17 109 56 60 -4
Capex 18 17 38 55 9 14
FCF 26 1 71 1 51 -18

The striking thing about Pixar’s balance sheet is its sheer size relative to sales. The qualitative question is – what is the replacement rate (or economic depreciation rate) for its asset base. If this technology can quickly be made obsolete, and Pixar has to pump more cash into capital expenditures, there is not much room for positive cash flow. I would guess that current capital expenditures understate the real “maintenance capex” required to sustain Pixar’s technology edge.

Summary Financial Analysis

In summary, Pixar is not a high-return franchise business. It’s amazing ratio of hits to movies produced does not seem sustainable given historic success rates for other studies. Even a slight change in Pixar’s near perfect record would make it a losing business from an EVA perspective. High margins are great, but if you spend $730m to build the technology, you have to use it more efficiently (i.e. make more movies) in order to generate good returns for shareholders. The pressure will be on Pixar to increase the efficiency of its assets, make more movies and this – probabilistically – should lower their hit rate. All in all, it looks like a good short at 52x forward earnings.

Catalyst

· Reversion to operating statistics closer to average for the industry
· A single box office flop
· Increased competition