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Expect a Smash from Pixar

By William Mack, CFA What lies ahead for the company behind Nemo and Buzz Lightyear? We at Standard & Poor's Equity Research Services think long-term growth prospects are bright for Pixar Animation Studios (PIXR

; recent price, $68). We believe it will continue its successful track record producing popular movies, including The Incredibles, due out in the fall, and Cars, expected to be released in November, 2005.

We also think that the announcement, expected soon, of a new distribution agreement will allow the company to keep a larger share of the profits we expect its movies and their related products will generate beginning in 2006. The stock carries Standard & Poor's highest investment recommendation of 5 STARS, or buy.

Through the feature-film production and the licensing of related products such as toys, soundtracks, interactive games, and apparel, Pixar is a leader in family entertainment. The Pixar digital-animation studio has had notable success with its first five feature films, Toy Story, A Bug's Life, Toy Story 2, Monsters, Inc., and Finding Nemo, which have garnered combined worldwide box-office receipts of approximately $2.6 billion as of March, 2004. The company is a pioneer in digital animation and animated-film production, as shown by the numerous Academy Awards and other honors bestowed on members of its creative and technical teams.

NEMO'S PROFIT RIPPLES. Pixar has had a significant relationship with Walt Disney (DIS

; $23). Its first feature film, Toy Story, was released in 1995 and co-produced with Disney. In 1997, the relationship was extended and formalized, as the two parties entered into an exclusive co-production agreement for five additional original films. Pixar and Disney agreed to co-finance and co-brand the five original animated films, and to share equally in the profits of each film, and in any related or ancillary merchandise, after recovery of all marketing and distribution costs and fees. The first film produced under the agreement was A Bug's Life, and the second, Monsters, Inc. (Toy Story 2, released in 1999, did not count toward the five-film total, as it was considered a derivative of the original Toy Story, but it was produced under the same terms as the five original films.)

In addition to theatrical release of feature films, the agreement calls for Pixar to share equally with Disney in other related revenues, including home VHS and DVD video releases; pay-per-view, cable, and broadcast-television distribution; merchandising of toys and interactive games; and the sale of music soundtracks from films.

With the release of Pixar's next film, The Incredibles, expected in November, we look for most of this year's profits to be generated by products related to Finding Nemo, which was released in May, 2003. Nemo's international box-office revenues have already surpassed its domestic box-office receipts, and should, in our view, translate into a solid overseas performance through the middle of this year on the strength of its home video and other film-related products.

MUSCLE-FLEXING TIME We do not think The Incredibles will match Finding Nemo's box-office success, but we expect its worldwide theatrical receipts to reach $500 million, about the average for each of the company's five earlier films. This is well below Nemo's $850 million. We note that, compared to past releases, which were all G-rated, the PG-rated The Incredibles should appeal to a broader audience (i.e., teens and adults). We think this factor will partly offset the decline in younger viewership that we see.

Though our favorable long-term view of Pixar has mostly to do with the high-quality movies we believe it will make, we also think that a new more favorable distribution agreement could greatly enhance the company's long-term profitability prospects. The company's co-production agreement with Disney ends a year after the expected late-2005 release of Cars, the final film in their five-picture deal. This distribution contract, first signed in 1991 and subsequently rewritten, allows Disney half of all profits as well as joint control of Pixar's films. We believe Disney understands that this agreement's terms may no longer make economic sense for Pixar.

Because we think Disney, with its orientation toward family entertainment, is the best fit for Pixar, we see that company as the leading candidate, from among a handful of distributors competing for Pixar's business. Regardless of which company ultimately distributes its movies, however, we expect Pixar to pay a standard fee for this service, rather than give partial control or even pay a share of any one film's profits to the distributor.

EARNINGS AS EXPECTED. Since Pixar is intent on solely financing movie production under any new agreement, its profit or loss per movie is likely to be both greater and more volatile than is currently the case. Aside from theater receipts, Pixar has multiple revenue streams, including home video (i.e., DVD and VHS), television, film-related merchandise, and software sales. All film-related revenues are identifiable by a specific movie, rather than a specific product, for a period of as many as three years after their box-office release.

Revenues that accrue beyond that time are allocated to Pixar's library, which is an ongoing revenue stream. For example, Toy Story 2, which debuted in theaters in November, 1999 and was released on home video the following October, had revenues from these various sources of about $167 million in 2000 and 2001. Starting in 2002, this film's annual results have been combined with each of Pixar's other films under the general heading "Library."

We think the overall quality of Pixar's earnings is below average, as Standard & Poor's Core Earnings estimates are about 12% below our operating forecasts in each of 2004 and 2005. A material portion of management's past compensation has been paid in stock options, which the company does not expense on its income statement. Our S&P Core Earnings forecasts for 2004 and 2005 include estimated option expense of 29 cents per share for 2004 and 28 cents for 2005 -- around recent historical levels. We note that aside from the expenses related to these relatively predictable incentive-related expenses, the company's operating earnings have corresponded to the S&P Core Earnings figures we compute, and we believe this will continue.

NOT-SO-INCREDIBLE RESPONSE? We believe Pixar is attractively valued, trading at around 13.9 times our 2004 figure at enterprise value (market capitalization plus net debt) to EBITDA estimate. Our valuation analysis is based on a

discounted cash-flow methodology, in which we discount both the free cash flows we forecast to grow by 14% through 2009 and the value for subsequent years at that time by 9%. We then reduce the resulting total value by our forecasted 2004 net cash of $597 million, to arrive at our 12-month target price of $79 -- about 15% above recent levels. Adjusted for the modest risk we see in Pixar, we think the shares will solidly outperform the Standard & Poor's 500-stock index over the next year.

The primary risks to our recommendation and target price, in our view, include weak viewer responses to The Incredibles, and an unfavorable announcement regarding the future distribution of Pixar's films. We anticipate the company will have announced a new distribution partnership around the release date of The Incredibles. (We expect Pixar to accrue most of this movie's projected revenue in 2005.). Moreover, with results dependent on relatively few products, we believe Pixar's quarterly performance can be relatively inconsistent or hard to predict. Analyst Mack follows shares of small-capitalization and consumer-discretionary companies for Standard & Poor's Equity Research Sevices

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