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Hollywood's hits aren't necessarily Wall Street's
Investors need more than 3-D specs to see the whole picture on box-office stocks. Here are 5 guidelines for savvy investing, including when -- and whether -- to buy a blockbuster.
By Michael Brush
Investors who watched smash movie hits such as Die Another Day or The Lord of the Rings: The Two Towers may have left the theater this holiday season wondering about the best way to cash in on some of the box-office excitement.
While movie results definitely can correlate to stock moves, be warned that the stock-picking task better resembles the unpredictable thinking of a sci-fi thriller than it does the simple logic of a romantic comedy.
Here, for example, is one unexpected plot twist: Immediately following a companys highly successful film release, its typically better to avoid -- or even bet against -- the stock; contrary to what your gut might tell you, its actually a better time to sell than buy.
Another convoluted rule of thumb: Companies with the biggest movie market share often make poor movie plays. Thats partly because the biggest studios -- such as Harry Potter backer AOL Time Warner (AOL, news, msgs) -- are in too many other businesses, many of which may not be doing well. That means the impact of a blockbuster movie can be horribly diluted.
To guide you through other twists and turns of the sector, here are some basic rules for anyone venturing into movie stock investing.
Buy the rumor; sell the news
There are usually enough investors in the know (and you can be one of them, if youre willing to play the game and take the risk) to bid up a movie stock ahead of a strong film release. Once the movie fulfills its blockbuster promise, though, though, those same investors tend to take profits and drive the stock back down.
Prime example: Pixar Animation Studios (PIXR, news, msgs), the highly successful studio behind such hits as A Bugs Life, Toy Story and Monsters Inc. In the months leading up to the release of these films, Pixar shares gained anywhere from 8% to 29%, only to lose 15% to 25% thereafter.
Consider 1999s Toy Story 2, the sequel to Pixars debut hit. About three months before the Nov. 24 release, Pixar shares were trading in a valley around the $34 mark. But excitement about the upcoming movie rose quickly -- and so did the shares. Three quick spikes sent the stock up to the $43 range. Then only a couple days before the movie hit U.S. cinemas, Pixar stock reached $50 a share.
Unfortunately for investors who bought into the hype, those shares wouldnt see that level again for years. Pixar stock dropped sharply in the two weeks following the release of "Toy Story 2" -- despite the films cash-cow performance at the box office. Many reviewers said the sequel beat the original, and viewers agreed by the thousands. Nonetheless, six months after "Toy Story 2" came out, Pixar shares had fallen back to $34 apiece.
Just this fall, shares of Metro-Goldwyn-Mayer (MGM, news, msgs) rose to around $15 from $9 ahead of the release of the James Bond film Die Another Day. But as with "Toy Story 2," they retreated afterward. (To be sure, the market followed the same pattern at the time, so the entire run-up in stock price cant be attributed to the movie alone.)
Focus on the purer plays
If you think you are good at spotting movie trends, its best to concentrate on the companies that get the largest portion of their revenue and earnings from films. Pixar, of course, takes top billing here. It rakes in about 90% of its revenue from movies. The rest comes from software licensing.
The company plans to follow up on its four highly successful animation films to date with a release next May called Finding Nemo. Its an underwater tale of a fish separated from its father and their efforts to reunite. Another hit here -- which looks likely if early focus group results are any guide -- is crucial to solidifying Pixars leverage in key negotiations just around the corner for a juicer distribution deal. Pixar movies are distributed by Walt Disney (DIS, news, msgs), meaning the Magic Kingdom itself gets the film reels to cinemas around the nation and promotes the product.
Currently, Pixar gets only 36% of the profits from its movies, under what seems like a fairly onerous distribution contract with Disney (though Disney does foot a big marketing bill for each film). That deal ends in 2005. Pixar, however, can start shopping around for new partners as soon as it delivers "Nemo" in March or April 2003. The recent failure of Disneys Treasure Planet animation film may give Pixar even more leverage in negotiations with Disney.
Indeed, Pixar shares chalked up impressive gains in 2002 in part because of speculation that the company could double its earnings under a richer distribution deal -- taking 75% of the profit generated. Recently trading in the upper $50 range, the stock looks fully valued, even for many sell-side analysts. Insiders may have the same idea. President Ed Catmull and John Lasseter, the studios famed director, sold more than $3.7 million worth of shares in November and December. Look for a 2004 release called The Incredibles, and another film, Cars, the following year by Lasseter, the first release hell direct since Toy Story 2.
Metro-Goldwyn-Mayer (MGM, news, msgs) owner of the MGM Pictures and United Artists labels, has produced recent big hits like "Die Another Day" (potentially the biggest Bond film ever), Legally Blonde and Barbershop.
But it also has been trying to diversify by expanding its television operations. That said, it still gets over 85% of its revenue from film in one way or another, making it a relatively pure play on the business. Look for Legally Blonde 2 and Out of Time, a movie starring Denzel Washington, as potential hits in 2003. The company is also in the early stages of lining up another Rocky (that would be "Rocky VI," in case youve lost count).
Though MGMs fate hangs on each potential big release, a large piece of its movie revenue has little to do with new releases. Rather, it comes from the companys vast film library housing old favorites such as The Pink Panther, the "Rocky" films and Silence of the Lambs. That part of the business should continue to benefit from the surge in DVD sales.
The real asset at MGM is the library and the cash flow that the library throws off, says Andrew Rittenberry, an entertainment sector analyst with Gabelli Asset Management. As long as they continue to build product for the library, the cash flow from the library continues to grow, and that is the most important thing for MGM. Analysts at J.P. Morgan believe MGM is fairly valued at around $14.
Pixar and MGM are relatively small players. Among the large-cap entertainment conglomerates, Fox Entertainment Group (FOX, news, msgs) has the most exposure to the movie business. (Fox is majority owned by Rupert Murdochs News Corp. (NWS, news, msgs) .) Thanks to big hits like Titanic, Planet of the Apes and Ice Age, Fox gets about 35% of its revenue and about 11% of its operating cash flow from films. Look for potential hits in Daredevil due out in February, the first movie based on a Marvel Comics superhero since Spider-Man. X 2, a sequel to X-Men, comes out in May. And Master and Commander: The Far Side of the World -- a potential hit movie franchise based on Patrick OBrians Jack Aubrey novels -- is due out in June.
Dont try to chase market share
AOL, Sony (SNE, news, msgs) and Disney will each have 17% or more market share in 2002 on gross receipts of over $1.5 billion apiece. Compare that with pure play MGM; its expected to wind up with a market share of just 4%.
In most industries, a market share advantage that big would be worth a lot. But not here. The large-cap entertainment conglomerates make for tough picks for the movie buff, because they typically get far less than 10% of their operating cash flow from filmed entertainment.
The outlook for big diversified entertainment companies like AOL, Disney, Viacom (VIA.B, news, msgs) and Vivendi Universal (V, news, msgs) is often linked even more closely with businesses that have little to do with new movie releases. Advertising trends in the television industry, for example, are crucial. So are the dynamics of the cable, theme park and cruise industries.
Sony is the extreme case. The film business is a very small portion of the overall revenue, says Rittenberry. Sony is an electronics company with a movie studio.
Beware the big -- and unpredictable -- flops
Movie companies try to be diversified and share risks. But a single flop can still hurt badly. Most film divisions manage their lists of movies in development like money managers handle investments, says Rittenberry. They have different genres and different sizes, and they try to keep a pretty balanced portfolio, he says.
Film companies also share risk by getting partners involved in the financing of pricey productions. They also often sell off a piece of the take to distributors in foreign markets. To be sure, the big studios dont often do this with the obvious winners. MGM, for example, will clean up by keeping Die Another Day all to itself. Chris McGurk, vice chairman and COO of MGM, expects the film to gross as much as $450 million worldwide, even before it goes into the library. That should translate into $100 million in profit. The last Bond film brought in around $360 million in box office revenue.
Film units are also hedging their risks by producing more low-budget films -- in the $2 million to $20 million range -- with the hopes that a few will turn out to be big hits. That strategy worked at MGM with "Legally Blonde" and "Barbershop, both of which cost less than $20 million but more than tripled their budgets at the box office. By using a fairly aggressive financing strategy, we have been able to reduce the volatility of the film business, says McGurk.
Despite efforts like these, a single miss will still have a big impact on a movie stock. MGM shares slipped from around $15 to about $9 midway through 2002 in part because it took a huge write-down when Wind Talkers -- a high-budget Nicholas Cage war flick -- flopped. Even the big entertainment companies that depend much less on movie revenue can be hit hard. In early December 2002, Disney shares fell 10% in part because it had to take a large write-down on "Treasure Planet," which audiences left stranded at the box office.
Pixar, always the movie company that marches to its own drummer, is the most exposed to potential damage from a flop. Yes, it spreads out distribution costs by assigning them to Disney. But it has a very small portfolio. It releases only one film every 18 months or so, and it works in just one genre: family-oriented animation flicks. So far, the company is batting 1.000 -- with a true hit every time. That may not always be the case.
Watch out for other risks
With the cost of DVD burners down dramatically, film companies may have a hard time avoiding the fate of the music industry. Sanford Bernstein analyst Tom Wolzein thinks illegal DVD copying could cut movie revenue by as much as 25% over the next five years -- thats equivalent to the estimated decline in music sales over the past five years because of piracy. He thinks operating cash flow at Disney and Viacom could get hit the worst among the major entertainment conglomerates.
Finally, as if to underscore the unpredictable fate of movie stocks, consider this tidbit from a successful hedge fund manager who has good contacts inside the Republican party. This manager thinks the next presidential election cycle will bring payback time for Hollywood, which is a big financial backer of the Democratic party. Republicans in positions of power, this manager suggests, may try to tarnish Hollywood as the presidential campaign picks up. That, presumably, would discourage financial contributions to the Democrats.
If hes right, look for investigations into accounting and tax matters that could add up to the kind of drama Hollywood usually tries to invent -- to the detriment of movie studio shareholders.
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