Digital Domain Media Group: It Takes A Visionary To Speculate

| About: Digital Domain (DDMGQ)

Digital Domain Media Group (DDMG) has been the source of a tense battle between two longstanding camps: speculators and value-seekers.

My advice to value-seekers: It's okay to speculate. It's even good to speculate. Even when a stock has a poor P/E and EPS, it's necessary to think outside the box and predict what will happen a year or two ahead.

Better yet, don't think outside the box. At least connect the dots: Hologram Technology > Revive Dead Musicians > Live Concert > More Live Concerts > Unlimited Live Concerts + CGI Technology + James Cameron and Michael Bay + Self-Produced Films = Future profits.

I really do believe it's as simple as that. Wall Street, however, has been on pins and needles lately, and is nervous to endorse a stock that isn't churning out a profit at this very moment. It refuses to succumb to hype, even when it is warranted.

Warranted speculation about DDMG's bright future is based on an incredible technology that DDMG possesses in conjunction with AV Concepts, with many positing that their hologram technology is the future of the entertainment industry. Number crunching value seekers ignore this speculation, and point to the company's $16 million debt as problematic. As such, its negative EPS is anathema to any quantitative purist.

Since the famed hologram Tupac performance, DDMG jumped from $5 a share to $9 a share, and has now settled closer to $7 a share. This is a clear indicator that the market finds itself in an internal struggle, between wanting to quantify the future potential value of DDMG, yet restrained by the facts of the ground, pertaining to debt and poor EPS.

The problem with Wall Street and even major hedge funds is that they are looking at DDMG in the prism of stocks that succumb to speculation, namely biotechs. Biotechs dominate the "speculation industry" and more often than not, fail to yield results. DDMG, however, is in a completely different category. If the biotech comparison still stands, then view the hologram Tupac performance as stage III approval from the FDA. Any approval from the FDA will send a biotech soaring, just as DDMG's hologram performance was an announcement to the world that its technology is legitimate and has a huge future market. Additionally, look at DDMG's 20 years of Hollywood digital production, and take that as a successful FDA approved drug being licensed out to other companies. The difference between a risky biotech and DDMG is that a biotech will take years to capitalize on FDA approved drugs, whereas DDMG's technology is both ready and already on the market. It just needs time to sort out who their clients will be. More importantly, DDMG is taking its technology into its own hands and has started to self-produce its own films, with the hyped "Ender's Game" due in 2013. Sure, that -$4.63 EPS will give pause to any investor, but only in the traditional sense of any negative EPS. DDMG already has a product that had been under the radar for some time. Now it is above the radar. The hologram technology offers immense future earnings, and is already past the metaphorical phase III testing that the market so greatly values. As is its digital production resume.

I do not believe that I am the only one to look at DDMG as greatly undervalued. I believe that the markets learned a lot when Disney (NYSE:DIS) purchased Pixar for $7 billion - Disney simply waited too long. I think that companies, Disney especially, have learned their lesson: Waiting costs a lot of money. Go and ask Yahoo! (NASDAQ:YHOO) about its handshake Facebook (NASDAQ:FB) deal for $1 billion on which it reneged. Facebook is now worth close to 100x that today.

Interestingly enough, there are some striking parallels between Pixar and DDMG. Both were started by visionaries: Steve Jobs and James Cameron. Jobs started Pixar in 1986 and sold it to Disney 20 years later. Cameron started DDMG in 1993, and 20 years will have elapsed some time next year.

What made Pixar unique and ultimately majorly successful was its use of PhotoRealistic RenderMan, which allowed it to create animated movies but not in the traditional sense. The CGI-infused animation made its animated movies more lifelike. And instead of just producing the technology and then handing it out to the highest bidder, Pixar began creating its own movies, setting off a string of a staggering 26 Oscars. DDMG should have been doing that by now, but with its first major release a year away, it is better late than never.

DDMG, in its own right, has pervaded Hollywood's visual landscape with some incredible innovative visuals that go beyond Pixar's life-like niche.

Its visual production resume is staggering.

While it does not use a specific technology like Pixar, DDMG's skill lies in its digital versatility. It handled effects for "Titanic," "Transformers," and won an Oscar for its work in "The Curious Case of Benjamin Button."

The fact that DDMG is already steeped in Hollywood as a respected visual effects and animation company only adds to the already impressive prospect of live concerts using the hologram technology. It is the sports equivalent to finding out that a team's star running back has a cannon for an arm and can play high-level quarterback. When does that ever happen?

Now that DDMG has burst onto the scene across all spectrums, I believe that it is ripe for a takeover. (The company was sold in 2006 to a team led by director Michael Bay, but figures were not released.) The current market cap is roughly $300 million, but future earnings are extremely hard to predict in this case. The technology and movie business are just starting to take material shape. The question is, how to forecast future profits? This is a rather unique case of a company with two potentially huge sources of future revenue, one of which is a field which has no precursor (hologram concerts). Has it received offers yet? Will there be a bidding war? I would bet that the current ownership would take a $1 billion offer.

I believe that the eventual takeover will be at the hands of a film-centric company, as opposed to live entertainment (which would make use of the hologram technology). This is because studios have more money, films are simply more profitable than concerts, and the most logical takeover/merger option, Live Nation (NYSE:LYV), is not in much of a position to takeover. Though I could see it signing a separate deal with DDMG.

There are two primary companies with both the capital and the drive to take DDMG into their respective folds.

The most obvious contender is Disney. Even though the Pixar purchase was a good one, it was expensive. A $1 billion price tag for DDMG as a younger version of Pixar is reasonable when compared with the $7.4 billion paid for Pixar. The difference between the two companies is that Pixar was already producing its own in-house movies and turning profits, because that's where the money is. Though long overdue, DDMG is finally set to release its first in-house movie, "Ender's Game," in mid to late 2013. If "The Hunger Games" is any indicator, then Ender's Game has a bright outlook. Both originated from books of the same genre, and "The Hunger Games" has grossed $600 million worldwide. Disney can either wait to see if "Ender's Game" will be successful and eventually be priced out of buying DDMG, or can jump the gun and make an offer now, knowing and banking on the fact that DDMG has the entire infrastructure in place to start releasing movies the way Pixar successfully did over 12 years ago.

The second choice is a company that seems to constantly be on the heels of Disney, and might want to jump the gun. Viacom (NYSE:VIA) has a fairly impressive movie history with its Paramount and its acquired DreamWorks division, but when it comes to animation, it is routinely outclassed by Disney/Pixar. Viacom's animation division, Nickelodeon Films, has certainly pushed out a few hits, but at the risk of sounding blasé, has yet to produce a movie that grossed more than $400 million. Disney/Pixar, on the other hand, has 10 movies that have grossed over $400 million, with one ("Toy Story 3") reaching $1 billion. These numbers are not lost on big-thinking executives. The difference between a movie that grosses $400 million versus $1 billion is hard to quantify. It's more than just a $600 million difference. It's a difference of pure ability. Viacom's Nickelodeon Films is simply on a lower playing field than Disney/Pixar. (Interestingly, DreamWorks has a deal with Disney, though this deal has no relation to each one's animation departments).

Viacom certainly has the money. Whether it wants to acquire DDMG to bolster its overall film production in its Paramount and DreamWorks divisions, or strengthen its animation prowess within Nickelodeon Films, or if it simply wants DDMG to keep it away from Disney, then it needs to move quickly. In addition to the Hollywood aspect, Viacom can certainly use its strong cache of music-centered TV channels such as MTV, VH1, and BET to promote the hologram technology and the ensuing live concerts, which will come of it.

I do wonder if a potential buyout would be complicated by the recently disclosed deal with twofour54, a company located in Abu Dhabi, and backed by its government. That financing deal promises $100 million to DDMG over the next 6 years, in return for maintaining personnel of a few hundred employees in Abu Dhabi. Obviously that deal was a boon for DDMG, but might make a merger/buyout a tad more complicated, though certainly nothing to stop a move by either Disney or Viacom.

Regardless of what happens, DDMG can be the next Pixar, but with eons more versatility. The hologram concerts might seem like its bread and butter, but the latent value of DDMG lies in its digital animation prowess and upcoming movie production plans. I am confident that there are a myriad of suits buzzing around in their respective corporate offices, with visions of grandeur. And I think that they are looking at DDMG.

Disclosure: I am long DDMG.