Marvel Entertainment Q4 2005 Earnings Conference Call Transcript (MVL)

February 23, 2006

Executives

F. Peter Cuneo, Vice Chairman
Avi Arad, Chairman & CEO, Marvel Studios
Kenneth West, EVP and CFO

Analysts

Glen Reid, Bear Stearns
Robert Routh, Jefferies & Company
Mike Savner, Banc of America
Barton Crockett, JP Morgan Securities
Alan Gould, Natexis Bleichroder Inc.
Lowell Singer, SG Cowen Securities Corporation
Gordon Hodge, Thomas Weisel Partners
David Kestenbaum, Morgan Joseph
Tony Chicas, Piper Jaffrey

Presentation

F. Peter Cuneo Vice-Chairman.

Thank you very much operator and good morning everyone. With us today we have from California Avi Arad, our CEO of Marvel studios and of course a member of the Marvel board, with us in NY we have Ken West who is our Chief Financial Officer and John Turitzen who is EVP and our general counsel. We’re going to start today by reading our safe harbor statement. We’ll then have a couple of prepared comments from Ken West and then we’ll immediately go to Q&A.

Some of the statements that the company will make on this conference call, such as statements of the company’s plans, expectations and financial guidance are forward looking. Our forward looking statements reflect the company’s good faith beliefs, they are not guarantees of future performance and involve risks and uncertainties and the company’s actual results could differ materially from those discussed on this phone call. Some of these risks and uncertainties are discussed in today’s press announcement and the company’s filings with the SEC, including the company’s reports on form 8K, 10K and 10Q. Marvel assumes no obligation to publicly update or revise any forward-looking statements.

Thank you very much. Ken West has some comments.

Ken West, EVP and CFO.

Thank you Peter and good morning. I will first focus on brief remarks about our results for Q4 and full year 2005 then close with an update of our financial guidance for 2006.

Our independent auditors are in the process of completing their audit of the company’s 2005 consolidated annual financial statement and their evaluation of the design and effectiveness of the company’s internal controls pursuant to section 404 of the Sarbanes-Oxley act. The independent auditors report will be included in the company’s form 10K which we expect to file within the next 2 weeks.

Now for a review of our Q4 and full year 2005 operating income results, which are in line with the company’s internal budget and reflect the impact of a previously disclosed one time cash charge related to the early termination of our master toy license with ToyBiz worldwide. This one-time pretax charge, the estimated range of which was disclosed on January 9th, amounted to $12.5 million in the 4th quarter or the equivalent of $.07 per diluted share after tax. For the full year 2005, total net sales were $391 million, down from $514 million in 2004 and principally reflect the anticipated shift to more licensing related toy revenue in 2005 from the direct sales of Spider Man action figures and accessories.

Consolidated operating margins were approximately 44% for both 2005 and 2004.

Now for a few divisional highlights for Q4.

Reflecting the $50 million video game extension with ActiVision, licensing segment net sales increased 44% year over year to $81.7 million. The revenue from the ActiVision extension more than offset the year over year decline in contributions from the Spiderman merchandising LP. Full year international sales amounted to $36.5 million, which were actually ahead of our forecast of $35 million for the year.

Licensing division operating margins in dispute for 2005 period, improved to 68% compared to 61% in the prior year period, principally related to the volume of license revenues and the provision for certain legal costs in Q4 2004.

Net sales for the publishing segment increased 6% from the prior year period, primarily due to higher advertising revenue. Operating income for the Q4 2000 period and Q4 2005 period was $8.6 million for an operating margin of 37% compared to an operating margin of 53% in the 2004 fourth quarter, which reflected one time benefits of %2.4 million.

As we have mentioned throughout 2005, the toy segment transition from Marvel-produced and direct-sold action figures and accessories for the Spiderman movie, the lines produced by our master toy licensee, lead to the expected decline in toy segment revenue of 45% to $12 million during Q4. Q4 2005 licensed Fantastic Four toy sales were approximately $2.8 million at wholesale and full year sales for this line were approximately $69 million.

As I noted earlier, toy segment operating results also include the $12.5 million one time charge associated with the early termination of the license agreement with ToyBiz Worldwide as we are taking these toy lines in house for fiscal 2006.

I will now turn to our balance sheet, free cash flow and purchase activity during the fourth quarter and year to date.

Subsequent to Marvel’s recent $250 million share repurchase authorization announced on November 9, 2005 and through year end 2005, Marvel has already repurchased 6.9 million shares of common stock for an aggregate cost of $113 million. Combining these purchases with those associated with the balance of last year’s $250 million share repurchase authorization, total 2005 share repurchases aggregated $304.5 million or 16.2 million shares repurchased.

Giving effect to these purchases, we closed 2005 with cash and short term investments of approximately $48 million. Share repurchases have been funded by available cash and free cash flow. As we have often stated, given the relatively modest capital needs of our licensing-oriented business, Marvel’s board of director viewed the repurchase of common stock using the company’s excess cash, ongoing free cash flow and borrowing capacity, as providing the greatest potential long term benefit to our share holders. The board remains firmly committed to repurchasing shares in the open market, pursuant to our outstanding authorization.

Now for our financial guidance for 2006.

Our updated 2006 guidance for revenue is in the range of $320-$350 million or a $50 million increase from the prior forecast range, reflecting our decision to take the Marvel action figures and accessories line in house this year when we will now record the revenue associated with each product sale. This compares to our prior operation under the master toy license where we would record only the royalty income associated with these toy lines.

ge for 2006 net income remains unchanged at the range of $38-$59 million. Full year guidance for earnings per share, reflecting the benefit of share repurchases to date, but before any benefit from future share repurchases, if any, is now in the range of $.44-$.55, increased from the previous range of $.37-$.52.

Key factors contributing to our 2006 outlook include the following:

The benefit from share repurchase activity to date, net of any interest expense or . However, our guidance does not include any expected benefit from future stock repurchases. Now the contribution anticipated from the S3 feature film slated for release during the year; substantial merchandise license generation will take place in 2006, associated with the Spiderman 3 theatrical release but such revenues will not be recognized into income until 2007. Accordingly, there will be no expected contributions from the Spiderman join venture in 2006, vs. a contribution of approximately $25 million in 2005.

evenues of $10-$13 million are anticipated in ’06, down from $24 million in ’05 as well as up to $5 million in incremental expenses related to the expansion of our Marvel studio operation. Additionally, approximately $16 million or approximately $.11 per share net of tax in interest and other non-cash amortization related to Marvel’s film slate credit facility, vs. charges of $4 million in 2005.

Additionally, non-cash option expense of approximately $5 million required under our new accounting principle and international licensing revenues in excess of $30 million as we anniversary our early agreement and focus more on new larger opportunities that are less predictable, involve longer lead times, and are often in new product categories and new territories plus continuing modest improvement in publishing sales and operating income.

As we have previously indicated, despite the reduced expected revenue in net income in 2006, we do expect a very strong performance with the generation of substantial free cash flow. This performance in a period of reduced revenue and net income is largely the result of expected collection of minimum annual license guarantees from agreements signed 1-2 years earlier as well as from the $100 million non-refundable advance received in the first quarter of 2006, pursuant to our master toy license agreement with Hasbro.

Let me now turn the call back over to Peter, to commence our Q&A period.

F. Peter Cuneo.

Thanks very much Ken. Can we have the first question please operator?

Operator:

The first question comes from Michael Savner, Bank of America.

Michael Savner.

Hi, good morning. A few questions if that’s okay. First, can you give us a little more granularity on the guidance revision? Obviously you’re bringing up revenue guidance, diluting net income. In terms of why the margins are going to be lower in ’06 I assume that has to do with the shift on the toy side and maybe some more clarity would be helpful. Second, a little bit more detail on your share repurchase plans. Kind of the optimal balance. Obviously the cash position’s much lower than it was in the beginning of ’05 and you’re near the end of the authorization; so are you implying that you’d maybe bring on some debt to buy back some shares? And then lastly, SG&A, a relatively large spike in SG&A vs. last year, especially in the 4th quarter. Maybe just talk about what was going on in the SG&A line in ’05. Thanks very much.

F. Peter Cuneo.

Okay. Why don’t we start…Ken will comment on the guidance, particularly with the change in revenue due to the change in how we’re handling toys for 2006, which is a transition period. And Ken can also talk a little bit more about the share repurchase.

Ken West.

Absolutely. With respect to the guidance for 2006; as you know and we just discussed the fact that we’re taking the master toy license which was terminated and all the production related activities and direct sales in-house for the year. And as a result, of course, we have the implied impact of increased revenue, the contribution of which has an offsetting impact. Certainly there’s a higher margin of direct sales and there are also incremental costs associated with advertising and promoting and carrying these inventory levels and all those are mixed together, as a result generating down to approximately the same level of anticipated net income.

As far as our treasury stock activity. As we’re already stated, we have been very active in the market. We have an open, authorized amount to acquire and we will continue to monitor opportunistic buys of the future until this program is complete and that will continue to use available cash resources including the potential of available debt to the extent necessary.

Michael Savner.

With regard to the SG&A in the 4th quarter, can you comment on that as well? The increase in SG&A in the 4th quarter?

Ken West, EVP and CFO.

Yes, one of the elements of the SG&A, in addition to certain legal costs that were accrued into the period relating to ramping up for our Marvel studios operations. That would be principally the most significant component.

Michael Savner.

And the rest of the year increase in SG&A? Because SG&A is growing a lot faster than…well, obviously revenues are down but I mean, throughout the first 9 months of the year, SG&A was up as well, though.

Ken West.

Do you mean, are there new investments…?

F. Peter Cuneo.

SG&A is up also because we’ve been growing the staff. Particularly in California at Marvel Studios and in our international offices, principally in Tokyo and in London. So there is some additional overhead associated with upgrading and adding to those staffs, as our business expands.

Michael Savner.

Great, that’s helpful. Thank you.

Operator:

The next question is from the line of Barton Crocket, JP Morgan.

Barton Crockett.

Hi, actually Barton Crocket and thank you. I wanted to ask you a couple of questions here. First, on the from operations guidance, you guys said on your 3rd quarter earnings call November 9th, $70 million is what you saw for cash from operations in ’06. Since then, you’ve announced Hasbro is going to give you $100 million, so you’ve only raised the guidance on this new version to $100 million. I was wondering if previously you’d included Hasbro but it wasn’t fully articulated or whether the contribution from other things like Hasbro has come down, vs. what you saw before? And secondly, I was wondering if you would just tell us how much is left on the share repurchase authorization as of February 22? And also just given that you’ve spent more in share repurchase in the first quarter through then than you have on the balance sheet Hasbro coming through, what’s the cash balance that we have as of the 22nd? And then I guess a final question, any color on Curious George toy sales and an explanation of why you think came in slightly below your reduced guidance range for the year? Thanks.

>There were a number of questions, let me take a few of those that I can recall and then we’ll address the remainder. As far as what’s remaining to be authorized under our stock buy back, there’s approximately 55 million left to be acquired. Our current available cash is approximating about $60 million and as far as our free cash flow anticipated for 2006, there has been a change in our guidance and that has many components. As you noted, we do have the Hasbro advance, which we disclosed of $100 million, there are cash taxes associated with the collection of that, there’s also script development costs that we’re anticipating to outlay, associated with our studio operations and the toy shift, the actual acquisition of inventories that were not originally anticipated and the costs associated with running the toys.

I’d also like to mention that we are at present debt free with regard to our HSBC line of credit. We do have a small amount of outstanding debt against the credit facility we have for our film slate. But with regard to the HSBC credit facility, we have at this point no balance.

With regard to Curious George, we are very pleased with the start of Curious George. Sales are meeting our expectations. Curious George is a program for us that we think has more activity associated with it in the back half of the year, particularly in line with the launch on public television throughout the United States of the Curious George animated series for children and of course the holiday season, which follows shortly thereafter. So we’re at this point quite pleased with Curious George and we’ll just have to see how it goes.

Ken West.

What was your question on Fantastic Four, Barton?

Barton Crockett.

I was asking for some color on why that came in below your slightly reduced guidance for $70-$75 million this year.

F. Peter Cuneo.

Quite frankly, we had some manufacturing disruption, to be candid, with our old toy licensee, ToyBiz Worldwide. We probably would have made very close to our original forecast, which we gave you over a year ago of $80 million, had that not occurred.

Barton Crockett.

Okay, great. And then just to be clear, have you already collected the Hasbro cash? And what was it that you collected, net of tax?

F. Peter Cuneo.

We actually did collect the advance, it was $100 million, the tax outlay will be required approximately May 15, so has not been disbursed, but we have the full advance that was required pursuant to that contract.

Barton Crockett.

And so the tax advance, some estimate of how much that might be?

F. Peter Cuneo.

Probably in the range of $35-$40 million

Barton Crockett

Okay, great. Thank you.

Operator:

The next question is from the line of Robert Routh, Jeffries.

Robert Routh.

Yeah, good morning guys. Just one quick question regarding the buy back. You’re now at $55 million but you’ve yet to cap any debt in order to continue increasing share repurchases, you did mention on the last call that $125 million could be used off of credit facility. I’m wondering does the board at this point in time have any intention of re-upping that buy back once this one is extinguished, or is this kind of it at this point in time?

F. Peter Cuneo.

Well as Ken indicated earlier, the board is certainly very interested in continuing to buy back our stock. We would do this of course at opportunistic prices. It is not a complete open program and so the board is constantly evaluating where we are on the stock buy back vis-à-vis the prices and the financial condition of the company. So this is always on the board’s priority list and gets constant attention, but I don’t think there’s anything that we can tell you specifically today.

Robert Routh.

Okay, great. And just one follow up. I noticed that you guys got back the rights to the Hulk. I’m wondering if you can comment a little bit about that and what your intentions are related to that and I know it’s quite early to say, but given that you’ve pushed just about everything out into ’07, yet you’ve increased guidance for ’06, I’m wondering if you can give us any sense even rough, general picture, as to how you may see 2007 starting to shape up. Because it seems as though investors at this point should be looking out to ’07 rather than ’06.

F. Peter Cuneo.

Why don’t we start with the Hulk question and Avi Arad will answer that.

Avi Arad.

Good morning. Hulk was, as we all know, was a universal project and has been in development for quite a while. Like all our movies, all our contracts, movies have to meet specific release dates. And if principal photography does not reach a certain date, then we get our properties back. Same thing as with New Line. So as time and development was taking its course, we entered into discussions with Universal. There was a realization that it would be quite difficult to make this principal photography date, and gave Marvel an opportunity to recoup our rights. In return, Universal will be the distributor for Hulk, but we’ll do it on our terms, which will give us all rights, all licensing, all revenues; an advantageous position on one of our prime properties. We are very aggressive in development on Hulk and actually it’s the same situation with Ironman, that we got back to New Line. Again, they couldn’t make the principal photography date and gave us an opportunity to recoup and regroup and this is also in development.

F. Peter Cuneo.

Thanks, Avi. With regard to guidance in ’07, Rob, as you know we don’t typically issue specific guidance until the third quarter of the previous year. So we don’t have anything specific at this point. However, I think you can see that we have 3 major motion pictures coming out next year we have Spiderman 3, and the licensing effort on Spiderman 3 is under way as we speak and seems to be going well. We have Ghost Rider, which was postponed by SONY from this year into early 2007. We have, we think, a very fun toy line along with Ghost Rider and that’s certainly a merchandisable film. And of course Fantastic Four 2 with Fox, which I think bears well; comments on the fact that I think Fox who have was very successful and they’re very quickly proceeding with a very high quality sequel that also would be a toyatic film that’s highly merchandisable. So we have three very big events right now, schedule for 2007. we also have some of our programs starting to mature, like our direct to video program, Avengers 1, was just released a couple of days ago and seems to be going very well. It’s a little early to make a final judgment, but we’re pleased with the start on Avengers 1. And so there is a lot of forward momentum for 2007. As far as the specific numbers are concerned though, it probably won’t be for another 9 months before we’ll give specific guidance.

outh.

Great. Thank you very much.

Operator:

The next question is from the line of Gordon Hodge, Thomas Weisel and Partners.

Gordon Hodge.

Good morning. Just a couple of question. One I was just curious on taking back the toy manufacturing business from ToyBiz, I’m just wondering logistically how that is going in terms of have you got a manufacturer all lined up and is the transition complete? And also in your studio guidance for ’06, I’m curious do you include or anticipate a Spiderman 3 advance of any kind this year, or would that all fall in ’07? And also on the video game side, which I assume is also included in the studio line; do you have to make up the full $50 million in terms of to get to overages; in which case we wouldn’t anticipate some video game revenue in 2006? Thanks.

F. Peter Cuneo.

Gordon, let’s talk about first of all the payments from SONY on Spiderman 3 in ’06, yes we expect an additional $5 million payment which coincides with the start of principal photography. As you know, we get 2 payments from SONY with regard to Spiderman film. The first is $5 million when they pick up their option for a sequel and the second is another $5 million when principal photography starts.

Gordon Hodge.

Okay, great.

F. Peter Cuneo.

Your other question with regard to the $50 million payment on ActiVision…the $50 million payment on ActiVision was actually an extension of a current deal. So it has no impact on overages from that deal. And we do expect overages from ActiVision in 2006 and 2007 and beyond. That particular payment was to extend that agreement out another, I forget, 4-5 years and has nothing to do with our overage payments.

Gordon Hodge.

Okay, so you’ll see overages you won’t have to then…it’s just in a few years you might, the $50 million applies to a couple of years out.

F. Peter Cuneo.

That’s correct.

Gordon Hodge.

And just on the logistics of manufacturing the toys and so forth?

F. Peter Cuneo.

Yes, I think that’s going very smoothly. The company felt that it would be more difficult from a logistical standpoint to make a transition from one master toy licensee to another. This has to do with moving inventory, moving tooling and it became very clear to us that it would be a little simpler, actually, would grease the skins a little bit easier, if you will, if we took over the business for what we think will be roughly 9-12 months. And that’s the reason we made that decision. We certainly are not planning to stay in the toy business in any great way in the future.

Gordon Hodge.

I guess the question is just, who is manufacturing the toys for you? Did you…

F. Peter Cuneo.

We have many traditional toy manufacturers that Marvel has used for many, many years. And we continue to also get quotes from new places. I think that is, it’s a concern but not a major concern.

Gordon Hodge.

Perfect. Thank you.

Operator:

The next question is from the line of Glen Reid, Bear Stearns.

Glen Reid.

Hi, thanks. Three quick questions. On your publishing business, I wonder if you could kind of give us an update on how that’s going relative to your expectations. I guess sales were up 6% in the quarter and after the 7-11 arrangement, I wonder if you could give us an idea of how that’s going. Another question, can you give us an idea, what are the restrictions that are still in place on insider sales relative to the buy back program? And then finally, I know you said it was a little early, but maybe you could give us some sense on your expectations for the direct to DVD initiatives on the Avengers.

F. Peter Cuneo.

Okay, with regard to publishing, we’re very pleased with 2005. Again, we had good growth overall. Our profit margins continue to be very, very good up in to the high 38% last year. And I’ve often said I think we may have the most profitable print publishing business in the world, although I can’t prove it. We had very good growth in just about all areas, but this was certainly led by the growth in mass merchants and in the bulk business, which is our new distribution. 7-11 is going well. We’re very pleased with how that looks to date. We’ll continue to monitor that in 2006. From a product standpoint, the biggest growth area was in what we call graphic novels or trade paperbacks. We think that the growth will continue in double digits, double digit growth for that category in 2006.

We, as you know, have signed a number of very exciting writers and artists and of course we now have an involvement with a number of well-known people in the comic book business and we’re very pleased with how that seems to be going. For 2006, again, we’re expecting overall modest growth but lead by the same categories that lead us in 2005.

With regard to insider restrictions, the only individual that is restricted at this point is Ike Perlmutter. And then finally with regard to the direct to DVD business, we think we’re off to a very good start. I know that yesterday looking at Amazon that Avengers was either #8 or #9 on the top selling list. You look at the top 20 on Amazon, basically all but 2 of the properties are theatrical release DVD’s. The two exceptions are Avengers and of course, the Lost television show. So we’re extremely excited about how well we’ve started. We’ll see how sell-through is. The product is just hitting stores now. We have a very wide estimate that we’ll do somewhere between 600,000 and 1,000,000 units, but again it’s a wide estimate because we’re really just at the start of that program. The reviews have been very good from a quality standpoint and we’re extremely pleased with how it started and we’ll have more information 3 months ...