Digital Domain Media Group Inc. (DDMG) Q2 2012 Earnings Call August 15, 2012 11:00 AM ET
John Textor – Chairman and CEO
Shannon Burns – Head, IR
John Nichols – CFO
Koji Ikeda – ROTH
Tony Wible – Janney
Doug Creutz – Cowen & Co
Good day, ladies and gentlemen, and welcome to the Q2 2012 Digital Domain Media Group, Inc. Earnings Conference Call. My name is Chenée and I’ll be your coordinator for today. At this time, all participants are in listen-only mode. We will be facilitating a question-and-answer session toward the end of today’s conference. (Operator Instructions) As a reminder, this conference is being recorded for replay purposes.
I will now turn the presentation over to your host for today, Mr. John Textor, CEO. Please proceed, sir.
Hi. Thank you very much and thank you, everyone, for being on this morning’s call as we report our second quarter revenues and discuss the achievements and milestones of this last quarter and specific plans going forward. Before I get started this morning, I’m going to turn it over to Shannon Burns, Head of Investor Relations here at Digital Domain, for a reading of the Safe Harbor statement. Shannon?
Thank you. Good morning. Certain statements made during this call will constitute forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. These statements include comments about the company’s plans, prospects, strategies, and future performance. They are made on the basis of our management’s current expectations and beliefs, as well as a number of assumptions regarding the future business performance as of the time the statements are made.
Such forward-looking statements are subject to known and unknown risks, uncertainties, assumptions and other important factors, including those identified in the Safe Harbor statement that is part of today’s earnings press release that is the subject of the conference call and webcast. Many of these are outside of the company’s control. These could cause actual results to differ from results expressed or implied in the forward-looking statements. Such differences may result from actions taken by the company as well as developments beyond the company’s control.
Further information on factors and risks that could affect our business is included in the filings we make with the Securities and Exchange Commission from time to time including under the heading Risk Factors in our Form 10-K filed March 30. These documents are available in our website at www.ddmg.co. This conference call and webcast also contain non-GAAP financial measures. A reconciliation of the non-GAAP measures to GAAP measures is provided in today’s earnings release.
All information provided in this call is as of August 15, 2012, and the company undertakes no obligation to publicly update the information contained in this call or any forward-looking statements to reflect new information, events or circumstances, or to reflect the occurrence of unanticipated events. As a last note, please remember that members of the media present on the call are in listen-only mode.
Now, I’ll turn it back to John.
Great. Thank you, Shannon. I’m going to provide a quick overview of what we’re going to discuss on the call before we get to the numbers with John Nichols. The call is going to be a discussion about revenue growth. We’re pleased to report significant revenue growth in the second quarter continuing through the end of the year as expected with comparable growth in our revenue backlog.
We’re going to talk about our margins, our last six months, and the strengthening margin of our projects going forward. The substantial elimination of unutilized labor as we’ve rationalized our cost, the cash flows; I want to help you better understand what we spent our money on in the first half, I think it’s important to segregate investments we’ve made versus a much smaller number related to cash burn from operations. We want you to fully understand where we’re in cash flow in the last six months and going forward.
We’re going to talk about our capitalization and some nice plans we have to make accretive improvements to our capitalization structure. We’re going to go into detail on our strategic process, why we felt obligated to enter an evaluation process and what we think will come out of it and what the goals would be of that?
As far as the quarter itself, it was an extremely productive quarter. When you write these press releases and you have to sort of lay out what actually happened in the quarter, I think in this particular quarter, we’re really surprised that everything we put into the earnings release actually happened within a short three-month period. So it was highly productive quarter. It included the launch of our Tupac inspired virtual performance business back in April 14 on stage at the Coachella Film Festival that created an all-new business for us, a new set of customers in our visual effects business.
We announced our partnership with Apollo’s Core Media to launch Elvis Presley as the first virtual performer, so that’s not just a meet new concept, but that’s a big opening contract and opportunity, a $100 million grant from Abu Dhabi, which allows us to further broaden our global participation in other film markets while building the highest quality animation footprint with lowest possible cost. $100 million grant from Abu Dhabi occurred this quarter.
Our 3D patent portfolio licensing program saw several sort of major milestones with successful outcomes to litigation, the execution of license agreements connected with litigation and also other partnerships that we stepped into, again, the reduction of unutilized labor, which we’re going to drill down into.
We have substantially eliminated extraordinary unutilized labor, that’s labor related to the training of people and the launch of new facilities. It’s what we told the market we’re going to do to build out these new facilities and opportunities. It’s what we promised to the communities that we would do in training these people as we accepted those grants and the success of that is before those grants run out, if you’ve trained your people and positioned them to work on revenue projects and you’ve done that ahead of schedule and that’s a good thing and that occurred at the end of the second quarter and going into the third quarter, we’ve announced that rationalization of our cost.
The China visual effects partnership and film distribution agreement with Galloping Horse also occurred in the second quarter. The company completed principal photography of its first co-owned, co-produced live-action feature film that is co-produced with OddLot Entertainment and Summit/Lionsgate called Ender’s Game. So now we’ve moved into the, moved away from the investment period in that film, which challenged cash flow and now we’ve moved into visual effects production where the film is paying off as a visual effects vendor and we are moving into delivery of that film into 2013. And we also announced, as I mentioned a moment ago, our pursuit of strategic alternatives and we will lay that out further.
So an extremely busy quarter, strong revenue growth, rationalization of expenses and a whole lot of achievements and milestones during the quarter, which I will drill down on, but first to John Nichols, our Chief Financial Officer, he is going to discuss in more detail the financial result of the quarter.
Thank you for joining us today for our update call to discuss recent events and our second quarter results. Some of you may have already seen the financials we’ve released in the 10-Q and the press release this morning. So I’ll just quickly recap the main results and then discuss a few key metrics.
We reported a net loss attributable to common stockholders of $36 million compared to $71.9 million for the second quarter of 2011. This improvement was primarily attributable to non-cash adjustments related to financing instruments, which improved to an expense of $12.6 million compared to an expense of $52.1 million in the second quarter of 2011. This improvement is reflective of the fact of the conversion to equity of many of our outstanding warrants and other securities at the time of our IPO, which has resulted in our financial results being impacted much less by large non-cash adjustments. This $39.5 million improvement in the non-cash adjustments related to financing instruments was partially offset by an increase in the operating loss of $2.1 million.
Adjusted EBITDA was a loss of $9.3 million for the second quarter of 2012 compared to EBITDA loss of $2.6 million in the second quarter of 2011, but comparable to the EBITDA loss of $9.2 million in the first quarter of 2012. This loss reflects the cost of expanding our new businesses in Florida, which include our original content animation film business and our education business.
Our total revenues in the second quarter of this year were $33 million, an increase from $22.3 million in the comparable quarter of the prior year and from $31.1 million in the first quarter of 2012. Revenues from feature film production increased to $21.6 million from $15.5 million in the second quarter of last year. We recognized revenue on eight projects in the second quarter of this year compared to five projects in the prior year quarter.
Revenue from our television commercials increased to $7.1 million in the second quarter of 2012 from $6 million in the second quarter of last year and $2.6 million in the first quarter of this year. We worked on more projects in the second quarter of 2012 including one large contract.
In the recent quarter, we recognized $3.4 million of licensing and tuition revenues, including a one-time licensing fee of $3.2 million from one customer for our patents related to the conversion of 2D to 3D.
One of the key metrics for our business is our backlog. This consists of projects for which we have begun receiving revenue or have reserved capacity and allocated resources. Our backlog was $90.3 million as of July 17, 2012, an increase of 48% from $61.2 million at the comparable period last year. This growth reflects an increase in the revenue projected for feature film contracts that we are either working on or have been awarded by customers and as an indicator of the type of growth that we expect in our feature film revenue in the current year.
We do not disclose backlog for television commercial work as the business operates with less forward visibility than our feature film business. Historically, our television commercial business has generated approximately $20 million in revenue annually. As we look at the efficiency with which we deliver projects to our customers, we break our cost of revenues into three components, direct cost of revenues, unutilized labor, and production and other expenses.
Direct cost of revenues reflect the cost of our employees that are producing work for our customers. We monitor our direct cost of revenues as a percentage of revenues, the metric that we refer to as our gross margin.
In the second quarter of this year, our direct costs of revenues were $67% of revenues, a decrease from 68% in a comparable quarter of the prior year. If you remove the $3.2 million one-time fee for revenues, cot of revenues for the second quarter of 2012 was 75%. Of this 7% increase, 4% are due to the inclusion of $3.6 million of revenue on which we are operating at basically a breakeven margin during production. We are a significant equity owner in this film. In addition to our equity upside, we are contractually due to receive a payment equal to our traditional gross margin on the visual effects work out of any first available box office proceeds.
The delay in receiving diverse margin on this work affects our overall gross margin in our feature film business. This contributed to the decline in our gross margin rate of our feature film business to 17% in the second quarter of this year from 33% in the second quarter of last year. Also, we completed one feature film project on which we recognized a lower than typical margin. We do not expect this film to represent as larger percentage of our revenues going forward.
Gross margin for our television commercial business improved to 31% in the second quarter of this year from 26% in the second quarter of last year. The improvement was attributable to increased margins across the majority of the projects work during the quarter.
Another metric that deserve some explanation is unutilized labor. As has been the case for several quarters, profitability in the second quarter was particularly impacted by charges for unutilized labor as we continued to develop the workforce at our new studio in Port St. Lucie. As we have discussed before, this is what we promised to do when we applied for significant grants and incentives to build our business in Florida. The grants are intended to train a workforce that was not yet ready to be assigned to high-end revenue projects and that was exactly what we’ve been doing.
The cost of unutilized labor was $4.4 million in the second quarter and $4.7 million in the first quarter of 2012. In the second quarter of last year before our agreement with Reliance MediaWorks, the cost of unutilized labor was $2.1 million. The decrease from the first quarter to the second quarter this year is due to the significant improvement in labor utilization at Digital Domain Productions, while unutilized labor related to our relationship with Reliance MediaWorks in India increased. We anticipate the unutilized labor cost will decrease over the remainder of 2012. We have renegotiated our contract with Reliance MediaWorks to eliminate those charges for unutilized labor and we expect that labor utilization further will improve as more of these employees are assigned to revenue producing contracts.
Historically, the cost of unutilized labor in Florida has been substantially funded by grant revenue and economic incentives. However, the revenue from those programs must be recognized over the time span of the associated grants and access, while the costs are incurred upfront. This timing has had a negative impact on our results for past quarters. But in the future, we will record the grants and incentive payments as revenue and have minimal incremental training costs to offset it.
During the second quarter of this year, we’ve recognized $900,000 of grant revenue. At June 30, 2012, we had in excess of $32 million in grants recorded on our balance sheet as deferred grant revenue. These reflect grants we have received and will record in our statement of operations over the next several years.
To reiterate what we have described previously, the long-term model that we are working on to achieve involves a fully-launched level of revenues such that unutilized labor is close to zero using box office participation to drive our direct cost of sales to near 50% of sales and managing our production and other costs effectively. In this model, we believe that we can achieve total cost of revenues of less than 70% of sales, representing a total gross profit of more than 30% of sales.
In the fourth quarter of 2010, when our unutilized labor was only $300,000, we generated $7 million in adjusted EBITDA. As we grow our sales to support our unutilized labor, we believe we can generate substantial amounts of quarterly adjusted EBITDA during the second half of this year. We believe that our 48% increase in revenue backlog bodes well for improvement in our profitability.
Our SG&A in the second quarter of this year was $16.8 million versus $20.8 million in the same period from last year. Share-based compensation expense declined $5.6 million, which was offset in part by increases in other expenses, including a one-time charge of $4.6 million. A reconciliation of net loss before non-controlling interest to non-GAAP adjusted EBITDA is provided in this morning’s press release.
Again, we would like to highlight the fact that our grant receipts, which were secured to fund the Florida expansion, have substantially outpaced our adjusted EBITDA losses, which reflect upfront expenses of this expansion.
Now, we will turn this over – back over to John Textor, our Chairman and CEO.
Great. Thank you, John. Just a couple of points. Well, to follow the outline that I discussed a moment ago, it was an extremely active quarter. We talked a lot about the virtual performer business. I think what’s important to understand about that business, for those that have been on these calls before and have heard us make presentations, this won’t be a secret. We believe the creativity and the technology of the visual effects business is impressive.
We just think that it at times can certainly be better used beyond the entertainment industry to think that we put such technology and applications into feature films, which in the visual effects side is roughly a $3 billion marketplace. When we see some many other businesses that rely on motion graphics or effectively visual effects that are in much, much bigger industries, we think that’s an opportunity and we think some of that work is important.
When you think about taking visual effects in a military simulation, we’ve talked a lot about that. We think we’re going to have our first contract from the military this year. And once you get your foot in the door with the military, these contracts are very, very big and we’re the only high-end animation company that we’re aware of that has even endeavored to go into that space and we’ve done it by hiring key people with military experience and military stature to help us get there. But the virtual performer business will admit to being a little surprised by the reaction to Tupac.
We are not surprised by how compelling it is as an entertainment vehicle. Imagine now that the same people that do visual effects for feature films, where sometimes we have a good margin on the film, sometimes we have a bad margin on the film. Imagine those same people can now build late celebrities or current important public figures and then not only can we get paid to do the visual effects work, but we can own a piece of the ticket.
Our relationship with virtual Elvis is a perfect example of that, because while Tupac was sort of several hundred thousand dollars in cost and revenue to us, it ended there, really it was a proof point. But when you talk about virtual Elvis performing three shows a night, one day in not only Graceland, but in Atlantic City, Las Vegas, Branson, Missouri, Macau, then the leverage you get with incremental revenues against your services business can really be attractive.
$3.1 billion was the size of the feature film visual effects market in 2011. Coincidentally, that same number of $3.1 billion was quoted by a major magazine recently as the revenues brought in by the top 50 performing artists around the world. And when you think about the expansion that you can see in that number if you add a virtual Elvis, a Michael Jackson, a Jerry Garcia, the Rat Pack, every rumor that you’ve heard about somebody that might come back to the stage has probably contacted us by now. So we’re very excited about that business.
The question that I get the most is when are you going to have the next Tupac out? And I get that question, I think from well intending folks that really are asking the wrong question, because they all remember what happened to the stock when Tupac came out. The right question is not when are we going to see another Tupac, the right question is look if you’re the only guy that can do a virtual human that’s believable in that kind of medium, what are you doing to make sure you tie up the real estate?
What are you doing to make sure that you sign contracts because there is a very small number of late celebrities that are really powerful on a national or global state. So, as long as we’re the only people in the world that can do this work, we should focus more on tying up the real estate, getting the contracts, securing the rights, negotiating with the families, making sure that the likeness rights line up with the music rights and the venue rights and that’s what we should be doing.
I can tell you, we’ve been doing that very actively. Just about every major late celebrity has either contacted us or we can tell they’re trying to contact us. It takes them a while sometimes to figure out that not everybody can do this. There is confusion in the marketplace, because people think that the Peppers Ghost projection technique was the magic of it.
That’s not it at all, that’s just a screen and there’re many ways to do this, there’re many ways to do it with a 4x4 screen, with a 60 foot 80 foot stretch Mylar screen, but the reason Tupac was so special is because it was not film of Tupac performing years ago, this was not Nat King Cole singing along with his daughter off of a video that was taken many years ago. This was a truly from the core modeled, digital human being that can give you an all new performance with all new content and that new content can be modified and changed going forward in perpetuity.
I can promise you, if that was a film of Tupac at Coachella and not a digital human being by Digital Domain, nobody would have been talking about it. So, that’s the key difference and whether the people are talking to us now or they’re announcing holographic projects and then they are finding out they have to talk to us, we have a long list of customers, we have a serious challenge on hand to figure out how we allocate resources from lower margin businesses to high margin ticket price producing virtual performances. And it’s not only in this country, but there are three big names of incredible, late celebrities that happen to be Chinese and I can’t pronounce their names and they are just as important in Macau as Tupac was at Coachella. So, I can tell you that’s where we are in the process.
The question, no, I will answer, when is the next Tupac out? I can actually tell you a couple of things. The next Tupac, which is to say our next head replacement, our next facial animation, our next digital human, it’s already out. I just saw it in the last few days. And I can’t talk about it for a while. And I don’t know that anybody is going to care about it. But, that’s the key to this. When you build these digital humans, you’re building them for a lot of different applications. Sometimes you want the market to know, sometimes you want the market to be surprised, sometimes you want the market to be standing in line for days and days and days waiting to see Elvis again.
But, I can tell you in the last few days, we have put out such a character and in the coming weeks, you’ll see our work in head replacement, facial animation sent, which is exactly the same kind of thing we did for Tupac, yet for a different application, a different customer that had different goals. I can tell you again when is the next Tupac, if that still is the question. We do believe we have another virtual performer, that’s not Elvis, that’s going to be debuting at a major, major venue.
And we are in the awkward position of, well, frankly if we talk about it, it’s not as compelling as an entertainment property, it’s not as much as a surprise. This will disappoint the day traders, but fundamentally people should focus on, are we signing contracts, do we have relationships, do we have a model for this that makes sense and I can assure you we do. We believe that the virtual performer business in revenues is bigger than our existing visual effects business. We believe in profitability. It’s a profoundly different model and it’s part of our story to transition into content ownership, not just from services.
Elvis Presley as a virtual performer, the contract there, the relationship there was the important part. It will take time and there are lot of questions about where does he appear first. We’ve pretty much angled in on which Elvis it should be. We’re thrilled to be in partnership with the folks at Apollo and Core Media. The level of relationships and the quality of relationships that we’re growing into is terrific. And Elvis, I certainly hope that we’ll be announcing his specific performance schedule relatively soon, but we do not have answers to that yet.
The $100 million grant from Abu Dhabi, I want to talk about that a bit, because it sort of went a little unnoticed. As you grow your visual effects services business, you do want to grow into parts of the world where you can reduce cost and labor. However, chasing cheap labor around the globe only to get there and find out you had the same kind of margin pressure that you had to begin with, that’s not a good business model. Fundamentally, your business model is driven by the type of work you do, who wants to see it and what they’ll pay for it.
You can rationalize cost by going to India and China and elsewhere, but margin pressure is only going to catch up to you over time. You’ll make some money when you get there. You’ll make some money for a while. Everybody is going to be proud of how you’re saving money and in the end, only – the only way you change your business model is really changing the nature of the product, the deliverable and what the customer will pay for it.
So, why are we in Abu Dhabi? Well, with a $50 million cash grant and a substantial amount of money, $50 million or more in Abu Dhabi building the studio, that is going to have a profound effect on our profitability over the next couple of years for a few reasons. Number one, you’re bringing India labor up into Abu Dhabi even at two times the cost of that same labor staying in India, that’s still very, very cheap versus the rest of the world.
You’re training new Emirati labor in and you’re bringing western leadership labor in. So, your cost structure is already extremely affordable just by being there. On top of that you have a $50 million grant that gives us 50% of our salaries back at the end of each quarter until that grant is consumed. And at the end of the consumption of that grant, what you want is the thriving, capable, high quality animation studio at low cost that is a significant business in that region forever.
In addition to that 50% credit, they of course are building a building for us, but they’ve also announced to the industry that they are offering a 30% production rebate to any film company that will send production work, camera, or visual effects to us, work to Abu Dhabi. Now, studios go crazy for 30% incentive. They will send a production team to Australia, to England, to Vancouver, to New Mexico anywhere around the globe for a 30% rebate. And those rebates are not really offered in low cost labor markets. They are offered in high cost markets like England and the increasing cost market of Vancouver.
So you haven’t seen a 30% production rebate go into a low cost market and if you assume that a lot of this is India labor that’s already low cost, this is the first production rebate that I find truly compelling to the industry, because it sets in a low cost environment. So, Digital Domain has been chosen by Abu Dhabi, the people at twofour54 the media initiative supported by the government there to be center piece of their feature film, digital production, entertainment industry growth over the next several years. And it’s a huge number for us, especially as compared to the value and the profitability and the revenues of our business, but what is the bigger idea in Abu Dhabi?
Well, if you are not there for low margin and you think that five years from now, 10 years from now, sorry, low cost; sooner or later, that all equalizes out, why are you there? Well, you are there because our business model as we’ve laid out, we figured out, teaching the world to do what we do is more valuable and profitable than doing what we’ve been doing. So whether you’re teaching them visual effects and animation through the education division where that world is 30% EBIT margins and we’re the first to do it, I think properly with academic support. Or whether you’re teaching them by building a digital studio in Abu Dhabi or in China and you’re showing them how to put their dreams on screen, how to take their film industry to a level that we’ve only seen in Hollywood in terms of production value, that’s really the more powerful part of this, teaching the world to do what we do, teaching the world to put their dreams on screen. That is so much more valuable than this core business that we have, that one analyst smartly called our legacy business.
Now, why would you want to do that in Abu Dhabi? Well, there are 1.7 billion Arab diaspora spread around the world and they don’t give a hoop what Hollywood thinks about their content needs or their story sensibility. These are 1.7 billion Arab diaspora around the world that would love to see their dreams carried up on screen with the same high production value that we give our Hollywood films. Their story sensibilities are very, very different and they are not being served, and we’re the first visual effects digital production studio or co-production content creator to ever go into that market with a global view.
Why are we in China? Same thing. We got a partner there that’s giving us $50 million to build a similar facility. We have not promised our education business or our feature animation business to anybody in China, so we expect more financial contributions, potentially grant, as we do that as well. But we’re the first major visual effects company to go into China, not to produce American films at lower cost, certainly we’ll do that, but we’re there because the China film market is exploding, it’s an awakening not only in the Middle East, but in China and their film market is likely in the next two or three years to be considerably larger than the United States.
They too – yeah, they care about Transformers when it showed up, but generally they have their own culture, their own lives, their own country, their own interest, their own stories, sensibilities and going to China to teach China how to put it streams on streams is a powerful thing. So what’s unique about our business is that every time we rollout to another state, another country, another community, we make trade, public-private partnership trades that make a lot of sense that make them want to give us money to expand. We have $285 million in grant packages. The vast majority of that not yet received and not yet spent.
Driving the growth portion of our business, transforming into a different kind of a business with a global view scalable frankly trying to stretch our legs well beyond our relatively limited addressable market to visual effects.
So the $100 million grants sort of gets lumped in with all these other grants, but the power of it I think is – well, I think it’s important that shareholders understand why we are there. And frankly if we can make – his Royal Highness Sheikh Mohammed as proud of us as he is of the Faraya Resort or the Yas Hotel then we’ve also made an incredible partner with incredible resources and here is where the Digital Domain Institute comes in in that grant situation.
I can tell another country that I’m going to bring a digital production studio there and they will give me a little help. But if I say I’m going to bring the Digital Domain Institute, I’m going to train your people and lift up this industry that you’ve said is important to your nation, will you get all the help you need? So, our business model in Abu Dhabi is, yes, to reduce cost and to be extremely profitable in our core business over the next few years. Our business model is, yes, to teach them through education and through the development of the studio how to put their dreams up on screen.
And in the end though look at who our partner is? If we really deliver on that and we make his Royal Highness Sheikh Mohammed as proud of us as he is other major venues in Abu Dhabi making a statement about their future then I think we’ve made a really good partner. We’ve done a really terrific thing. Now, is he proud of us now? Are they proud of us now? Well, they’ve chosen a site out on Yas Island to put us right in the middle of all those massive landmarks. So, they’re looking forward to it. We’re looking forward to it. And it is really a remarkable opportunity, completed, announced in the second quarter of this year.
Our 3D Patent Portfolio. We’ve made some provocative comments in the industry and they are noticed within the industry. They’re probably not as noticed in the financial community. The claim is that substantially all 3D films that you see delivered in the marketplace today are dependent on our technology. The exception would be a 3D film that is filmed entirely with a 3D camera.
And so, the great work in patents of James Cameron and Vince Pace, its Cameron and Pace Company, we are not in any way suggesting that our technology is related to their brilliant work in technology and camera. But, when a two-dimensional image, a conventional image in old film or even a new film like a Transformers 3 is filmed with a single lens or parts of it are and you’ve got to interpret that image and imagine what a second lens might have seen, not just the left eye perspective, but the right eye perspective, every modern process of conversion of two-dimensional imagery into three-dimensional imagery is dependent on our very comprehensive and pervasive patents.
We bought these patents because we were violating them, others challenged these patents and failed and we have now with bookends moved into that space. And when I say bookends, we’ve filed suit against somebody in the image creation conversion process that successfully resulted in an amicable license arrangement and a good working relationship.
So, we validated our patents in court. We also were able to sign a license with Reliance out of India, which was somewhat obvious, it’s our partner, but it’s not that obvious. They were doing 3D conversion work and they needed to respect that with the license and that resulted in revenue in this second quarter. Prior to that, on the other end of the line, we got a $3.5 million payment from Samsung, who didn’t think they could even sell a television set without violating our patent.
So, if you look at the multi-hundred million dollar valuations of companies in the space, you look at the multi-hundred million, multibillion dollar revenues driven by 3D conversion film and you understand that we invented this. We are now very brazenly requiring that we’re a greater financial participant in the markets that we invented and the second quarter was a huge movement in that direction.
One other note which is an announcement on this call because the document was signed as we’re going into this call and we will announce this in more detail later, the strategy that we’ve chosen to pursue is a deal with a third party that monetizes the patents for us, upfront and also allows us to split with the royalty. We – it is at times awkward to be the owner of these patents. We’ve said that our patent licensing process is very customer friendly, which means really studio friendly.
But by and large across the rest of the industry from exhibition, projections, consumer electronics, we need to monetize this. We need to be paid for our invention. And so, we have signed a binding deal as of today, which will go through a due diligence process in a few weeks, but it’s binding on us. And if it goes through successfully, it will result in a significant upfront payment and a significant split to us of future royalty payments in a very, very large industry, but again we believe we had a significant amount to do with this invention.
If for some reason that due-diligence does not result in a transaction and we believe that they know our patents well enough that it will, there were multiple bidders that were at the table at the same time and these patents are extremely valuable and that’s a direction we’ve chosen to go. We don’t want to be in the litigation business, but we do want value for our invention.
Reduction of unutilized labor, continued on with milestones. Well, this actually segues into sort of the more financial sort of aspects of our things, so I’ll push that for a second. Other milestones Ender’s Game, again John talked about it, completed principal photography that means that it’s gone from a period where we were investing a significant amount of cash and now we’re getting revenues on the visual effects albeit with deferred margin.
So, going into the financial sort of highlights to supplement what John talked to you about, we have a story of significant revenue growth. Our 48% revenue growth comes principally from our core visual effects business. We did of course have the $3 million of licensing revenues, which is really a first for us and obviously we look forward to that continuing, not always on the linear basis, but in lumps as we sort of drove this program and certainly the completion of the deal I just talked about would have a positive effect there.
We have launched successfully into these new businesses and in addition to the virtual performer business, we debuted visual effects for special venues in the sports community at a major conference with majorly baseball. You can go to our website and see what that looks like or you can go to Citi Field and watch it along with the New York Mets again taking visual effects into new mediums. And the military, we certainly hope and expect that we’ll have a military engagement by the end of the year, and that again is sort of like cracking open a very, very big door to very big room of opportunity.
In terms of margin improvement, I want to talk about that a little bit, to give you my perspective. The quarter and the first half was really the completion of a very, very large low margin project, which was brought in as a required filler for what we’ve long talked about going back into last year of a film that was canceled by a studio.
We really only had one situation like that in the last several years, but with the cancellation or at least the temporary suspension of Paradise Lost, we had to fill our capacity. We had to fill it quickly. We had a large contract. We bid it aggressively. And we also did that because it was really, really high-end work in the facial animation space and the creature animation space. And so, when you hear this repeating drumbeat from Benjamin Button to TRON, to Tupac to Jack the Giant Killer, understand that we will do work at lower margin if it allows us to keep our technology leadership in ways that are much more lucrative.
So, the second quarter resulted on a percentage of completion basis and the completion of a very, very large lower margin film that gave us much value as a filler for capacity that was necessary after Paradise Lost was cancelled.
The other thing that happened, of course, as John talked about is the beginning of Ender’s Game. Now, we get that deferred margin so quickly in the box office revenues that it’s really like almost equivalent to production capital being returned and we feel very comfortable that it has very low box office numbers for Ender’s Game, which is going to be a highly marketed 10-fold film with a major Harrison Ford, Ben Kingsley cast, we feel very comfortable about the recovery of that margin.
Now, it’s uncomfortable from a cash perspective, but again, this is what we said we were going to do. We were going to transition our services business in the content ownership. And if you look at the investment that we made in Ender’s Games and how quickly it comes back to us at low box office numbers, we can make substantially more money and actual cash flow from that film than we’ve made in any year or even combination of a couple of years in our visual effects business.
So, the margin improvement that you’re really going to see now is moving away from that low margin project into Ender’s Game, where you’ve got a real stake in the property. And then the normalized backlog, we’ve got substantial backlog growth. And that backlog translates very nicely – often very directly into revenue growth. Our backlog is all booked at normal margins.
And we’ve got one large film that we just found out is got a nearly double. Now, why is that good? Well, when you bid a film, you bid it with normal margin and you bid it to cover your production overhead. When a show grows, then everything else is variable. And it’s shot cost and shot revenues that then leverage your production overhead much better, and so that’s when margins really, really grow.
Now we’ve had gross margins on films in the past that have really surprised us like Transformers at 52%, Flags of Our Fathers at 44%, even Meet the Robinsons a few years back at 62%. But generally, the feature film margin business on a normalized basis is sort of low to mid-30%s unless the film really starts to grow, and that’s where you expect to pick up a lot of benefit and that’s what we’re seeing in the backlog that we’ve quoted today that you’ll see carryout through the end of the year and into the first quarter of 2013.
Reduction of unutilized labor, John said it, I’ll say it again. We’re doing what we promised we would do. And I understand analysts, shareholders, everybody see unutilized labor as an eyesore, but communities don’t give you grant, so you can put it in the bank and brag about your profit. Because if you don’t do what you said you’re going to do, and you don’t create jobs and you don’t train people, they come ask for the money back. Now, it was a great trade because look what we’ve done. We have launched a Pixar-like animation studio in Florida and are now producing content that is drawing significant interest from studios, from distribution partners as we’ve proven, and so it’s the unutilized labor that reflects the training of all those people.
Now, we talked about it many, many times and we highlighted again in the printed release, is that even to-date we receive more money and grant revenue than we paid out in Florida salaries, our unutilized labor. So, it was a really good trade. It just has really unfortunate accounting, because we have to show the expenses upfront, in the grant revenues, we have to show over time.
Now that of course drops in the profitability later, but when people or analyst or traders talk about, wow look at that unutilized labor, understand it was paid for, also understand that we made public announcement. We did so again today that we have turned the corner on that.
Everybody in Los Angeles by and large is working on a revenue project, we’re at capacity, Vancouver at capacity, Florida, even a failure team now is fully engaged and the Tembo team is of course working on Tembo. India through Mumbai, London by contract with Reliance, we’ve shifted the responsibility for unutilized labor away from Digital Domain. So, the only unutilized labor you’re going to see going forward, you’ll still see a little bit of extraordinary unutilized labor in the first week of the third quarter, but by contract and by utilization, it’s eliminated as we go forward.
Normalized unutilized labor is less than 2% of revenue; it’s really 1.3% to 1.4%. Our unutilized labor in the second quarter before these changes would have been 15%. So that’s a huge rationalization of our expenses. It is behind us from an operating perspective, and substantially behind us from a reporting perspective. Backlog, $90 million, up 48%.Just as a reference, last quarter we announced backlog of 40%. And what did that result in? It resulted in 48% revenue growth. So, backlog truly does translate into revenue growth. And in this case that backlog is normalized margin or its content owned Ender’s Game. So, we’re thrilled with our revenue growth, we’re thrilled with our backlog.
Now, how is that going to translate in cash flow through the last half of the year? Well, there – it’s important to understand the first six months as you think about what the next six months might hold.
In the first six months, we had $34.3 million of cash burn – negative cash flow, $15 million of that was our investment in Ender’s Game, $7.4 million of that were investments in animated feature films, $9.1 million of that was unutilized labor. So Ender’s Game, we’ve talked about, that investment is made, now the cash flow starts to return back to us across 2012 and when the film gets released.
Animated feature films, you can call that cash burn; you can also call that investment. We are in the film business. We’ve made it clear that animated feature films take a long time to produce. We also made it clear that though we have many production partners that will finance that film and studios that right now are looking very closely at that film and our slated films, we – our plan was to wait till we got through the third cut reel of the film before we brought in significant amounts of studio partnership for production capital. Now the third cut reel is going to be completed in the next few weeks.
We’ve hired the investment banking arm of the Creative Artists Agency and we’ve begun interfacing directly with studios and we feel that we’re very much on plan to have our very attractive creative team of Disney, Pixar and DreamWorks and former Blue Sky folks that are being very well received by the studio and the production finance community, we think we’re very much on track of that. But if you take $15 million of Ender’s and $7.4 of animated feature films, that’s $22.4 million of the $34 million that is capital investment in the films. It is not operating cash burn, the way it would be in a widget business or something else.
In addition to that, we have $9.1 million of unutilized labor. So, now that we’ve got beyond that, if you accept for these items that $34.3 million of cash burn is really $2.8 million of cash burn from operation. One exception to that, you might say well, your rent was $2.7 million, well not really, that was the principal and interest payment that basically pays into capital in our studio that we then own at the end of that series of payment. So, that’s somewhere between rent and principal.
But our operating cash burn is important to understand. Because the Ender’s Game thing is over and the animation feature films, if we remain on track and those are financed by the studios or the distribution partners like Galloping Horse have already proven, they will fund those, then we’re feeling like we’re very good shape there. As we go forward to the next six months with a lot of backlogs, with normalized margin, we are going to have some significant capital items there as well too. But our operating cash burn is looking very, very good, when you look at the core business of services, bringing in revenues and taking the cost to deliver.
Capitalization, it’s sort of the elephant in the room. I get a lot of questions on this. Our capitalization of convertible debt has benefits and consequences. The benefits clearly we needed to refinance the prior loan that we had, because it was bought by a lending group that acquired the notes from a very nice savings in loans and unfortunately wasn’t nice enough as a business and they failed. So, when your bank goes bankrupt, you have problems and these convertible lenders were wonderful to come solve those problems for us.
The consequences, I’ve learned a lot more about converts in time, a lot of our people trading our stock already knew about it. It does create overhang on the stock. I could tell you, the good news is that our lenders in recent weeks have been extremely open-minded to reformation and take out discussions that can reverse this dilution. You can bring in financing that is accretive.
So, we’ve got lenders that are friendly that are working with us, that understand. While it represents good returns for us, it’s not the best structure for the company going forward. And there is definitely a win-win scenario, I think that’s developing. We’ve been very active in identifying sources of capital to deal with that. And we not only feel very good about inbound sources of capital for the company’s operations, we feel very good about the opportunity to reform our capital structure in a profoundly accretive way to eliminate the overhang on our stock. And I think it will be good for those lenders and it will certainly be good for the company.
On the strategic process, simply stated, like every management team, we believe our stock value is far below fair value, maybe little different than a lot of management teams that we complain about this. We can prove it. We really can. And the strategic process was really required as we had inbound interest from large companies that solve the value of our company and wanted to talk about strategic partnership about potential acquisitions.
There are many factors that lead to sort of where we are at the stock, our story is very complex. We’ve got these diverse businesses that all come off with visual effects businesses, but they are very different businesses mixed into one model. And it is true when you’re trying to raise money in the public market or just raise interest in your stock as much as somebody may really believe in your education business, it’s kind of hard to convince them to join the movie business or vice versa.
So what’s – and so one of the ways that we fix this is by aligning capital and strategic partners into specific business segment, where education partners gets to partner with the education business.
Film partners get involved in content. People in India and China that like the idea of the post-production business can invest in and partner there. So, our strategic process isn’t necessarily as it’s been reported the sale of the total company, because we do have a number of parties that have already signed NDAs that have tried to preempt the Wells Fargo process to get into partnership with some of these divisions, because simply stated the sum of the parts rights now is worth much more than the whole. We’ve got components of this business – divisions of this business, so we could sell in my opinion for more than our total market cap.
Now, where does the process go? I mean, the way you really fix this, when your stock value doesn’t reflect, actual value, it represents the traders’ view instead of fundamental value as you do it through communication, you do it through performance, you do it through execution of these relationships with strategic partners that validate those models.
We’re getting no credit for the fact that we just launched the college. Classes started in the bachelor program this week with Florida State. I can tell you there are whole bunch of multi-billion dollar education companies, they would love to be as respected and embraced by the Department of Education as we are. We’re getting no credit for that at all. We have a Pixar cell animation studio producing incredible content down here in Port St. Lucie that is drawing significant interest by people in the film industry. We’re getting no credit for that in our stock value.
We have a visual effects business which is an eight-time Academy Award winning studio with nice growing revenues on its own. It is a profitable business. And the comparables out there that was a business that’s sold for $190 million. It didn’t have a reputation and was about the same level of revenues. That’s more than our market gap. So, the strategic process is to try and bring in partners into these different segments to sort of make the sum of the parts evaluation more the reality of our total valuation.
Now, what happened, you got to open up the process and we opened it up by hiring Wells Fargo. Wells Fargo was not going to come into merely our plan. We’re a public company. We’ve got to consider everything and there is the possibility and there is interest from groups that see a total purchase of the company or purchase of the piece of the companies as being the most attractive.
So, back to my point, simply stated, our stock value is far less than fair value and we think we can prove it. We think we already know a good part of the result that we’re going to have in this strategic process with the people that are already at the table. And then Wells Fargo’s job is to make sure that we maximize any combination of those alternatives for the benefit of the shareholder. So, that’s effectively where we are on the things that we wanted to talk about today. And, we have gone a good bit of time.
I guess, the summary is our revenue growth is very good. Our backlog is very good. Our expense rationalization or elimination of unutilized labor, again this is what we promised communities we would do when we took their grants and we’re well ahead of training those people to a very high level of quality.
And then, they are now really, really engaged on real work and you’ll start to see that materially affect our operating numbers as we go forward. And then, from our capitalization improvements that we hope to bring to the table combined with our strategic process, we’re looking forward to a really terrific second six months on a lot of front.
That said, operator, I would love to pause for questions. And I’ll take the first question, it’s from analyst, Rich Ingrassia from ROTH. Rich, are you on the line?
Koji Ikeda – ROTH
Good morning. This is Koji for Rich. Thank you for taking my question.
Great. How are you?
Koji Ikeda – ROTH
I’m doing great. Thanks. Looking at SG&A for the quarter, it looks like you incurred about $5.5 million in professional fees. Can you give us a bit more color on that and if that’s something that will continue going forward or is that just like a one-time spike?
Are you referring to the litigation reserve?
Koji Ikeda – ROTH
I see professional fees about $5.6 million in the SG&A.
That can be an expansion actually of normalized professional fees, from legal fees and things like that, but also from consulting fees associated with our different projects that we classify those into professional fees and then, they’re actually allocated up into other production into cost of sales.
Yeah. I can tell you, I haven’t seen enough lawyers around to work up that kind of a legal bill. But, yeah, that’s a combination of variety of items. We did have a litigation reserve also in SG&A that we backed out of adjusted EBITDA. We had previously disclosed the lawsuit with a gentleman Carl Stork and the company believes – continues to believe that we’re insured for that claim or any settlement of that claim. And, but in the abundance of caution, you reserve that entire amount as if you’re getting noting from your D&O carrier. But that is a lawsuit that we’re happy to settle.
We believed in our case from the beginning. We had a California jury and after the case, they came out and physically hugged me. So I felt well, gee, they liked us a lot, maybe we shouldn’t have settled, but I think everybody knows that juries are basically compromise juries, and we were able to take that out of the hands of a jury in an amicable settlement with Mr. Stork and we believe that we’re insured for this.
And the amount that he got was very rational. And frankly, it was less than the value of the stock that he was trying to get back and so in that sense, it might have been a benefit. But we were happy to resolve that amicably. We believe we’re insured for it. But we did reserve this as if it’s a full expense in our SG&A.
Koji Ikeda – ROTH
Okay. Thanks for the clarification. Next question is regarding the Digital Domain Institute. On the last call you stated that you’re expecting fewer than about 200 students for the fall. Can you give us a more concrete enrollment number now and the application window for fall 2013, I know it just opened and it’s early, but is there any indication of increasing interest for next year? And finally, is there any discussion about having a spring start for the BFA program?
Well, I’ll answer your last thing first. Yes, there are multiple start points that you can have in the state university system and so you’ll see some increases not just on an annual basis, but through the year. Let me start with the goal, our goal is to have 4,600 students in this program within sort of three to five years. So how do you get there with such a slow start? Well, understand that the slow start is a promised start.
We are – maybe, the first for-profit college, which sort of started by way of the Department of Education and with a major university degree. So, 100% customer satisfaction or student satisfaction is important to us, because we have a lot of scrutiny on us right now. So, the idea was to start very small and make sure you get it right. If you look at Full Sail up in Orlando with 12,000 kids, they’re bringing in 500 a month and more than a couple of hundred of those are going into their animation and visual effects business.
So, in terms of the demand, would you go to Full Sail where you don’t get a full accreditation degree, where you can’t work on real films, where you hope one day you can work with Digital Domain? Or would you go to Florida State and the Digital Domain Institute and while you’re in college actually work on real film?
So, if you look at the demand that you see for these another animation programs, you look at a Full Sail with 12,000 students or Savannah College of Art and Design with several thousand students. We think we’ve got a much better program with direct work on major films and the best degree of any of our competitors. And so, we don’t have any problems thinking we’re going to get to 4,600 students. But you’ve got to start small. The other reason you start it small is that you’re not allowed to advertise your program at all until you’re licensed and the formal license that we got actually came after the application window for the BFA program.
So, what you see is 30 kids in the first FSU program, 35 non-degree, so we’ve got 65 in the sort of opening orientation in a couple of weeks. Some of those kids are up in their first year at Florida State getting their general education out of the way and most of those are sophomore transfers. Now, to your question specifically, we now are allowed to advertise ahead of the application window and we’re doing so quite effectively and we’re seeing substantial sort of increases in interest.
We’re not going to report until we are much more normalized at the university sort of our applications. That can be a bit misleading, because the FSU program is actually tougher to get into than say Full Sail. But we’re very happy with where we are, starting small and we feel very comfortable with where we’ll go.
Koji Ikeda – ROTH
Okay, great. Thanks guys.
Great. Thank you. And next question, a couple of analysts, just taking them in order, Tony Wible from Janney or Janney generally.
Tony Wible – Janney
Tony Wible – Janney
Hey, good morning. I got a few questions around the margin structure in the VFX. First is on this quarter, could you kind of walk us through the build-up of how you went from the 10% loss margin last quarter to this quarter? I know you mentioned a lot of different components, but I was trying to size those.
And then, secondly, can you talk about how you would expect the margin structure to hit an inflection and ramp based on all the components you’ve talked about between military, between taking on Ender’s and the margin dynamics with that and there’s just so many moving parts here. I was hoping you can give us a sense for when you would expect the flip over to profitability and how fast that margin would ramp?
Yes, so I’ll take the virtual performer thing first, because it’s a big – we don’t really know kind of answer. We’re now modeling very actively the virtual performer business. It is so contract-dependent because you can say, as we do, we own 50% of the virtual Elvis, but you don’t know what your venue deal is, what are you going to pay for the venue, and what is really the application.
And I will just admit that we’re learning that one on the fly. We just know it’s a lot better than our core business and so it’s a good education and we are not yet prepared to talk really in metrics about how profitable that will be. But we do expect that the profit on any one project would actually be higher than the production cost of that character. So, it’s really an inversion where your profitability is higher than your services. It’s not an inversion on the P&L, of course, because you would run the ticket participation into revenue on down. For the more quantifiable part of your question, I’ll turn it over to John.
As I mentioned, part of the change from profit to non-profit on the three months year-over-year is associated with Ender’s Game and is associated with this one large project, Jack, in which we have incurred significant cost on the completion of the project in the second quarter. Those were really the two primary large impactors of the swing between profit to loss on feature films in the second quarter.
Tony Wible – Janney
And on Ender’s, wouldn’t that be capitalized? I guess, what expenses are you taking on with Ender’s?
No. We’re actually – the investment in the film is capitalized, the actual equity investment, the $15 million that we spent – well, actually the $15 million for the whole first six months, it was actually $3.6 million in the second quarter. We also have a specific visual effects contract where we’re recognizing revenue, we’re billing them as a customer. We’re only being able to bill them at direct cost plus a small percentage of the fringe of that direct cost; direct cost being primarily direct labor. So that’s actually showing up in revenue and cost of revenue at literally no margin.
Tony Wible – Janney
Right. So if Ender’s is, let’s just say, breakeven margin, I guess, the loss then would have to be the one big project with Jack, is that – am I thinking about that correctly or is there something else I’m missing in that?
You’ve nailed that, and let me give you some color on that. Since I’ve been involved with this business since pre-acquisition late 2005 and then the acquisition of our visual effects business in early 2006, I’ve only seen this happen twice where really on Speed Racer and on Jack the Giant Killer, where the work can be so challenging, you kind of know that going in. You bid for the work aggressively because you want to do the important work and then the challenge maybe is more challenging than you expected and you’ve got – you just got to deliver the film.
Now, this has happened twice at this degree since early 2006. And the reason it happens, which is why I’m disappointed enough, there have been management changes in the visual effects division since Speed Racer and now. But the reason that happened in Speed Racer is the people on the film that led the film, the visual effects supervisors that work for us, we, frankly tried too much. Inventing new technologies in the context of a film can be dangerous, trying to change the way you do things from creature animation to lighting.
We did the same thing on Jack the Giant Killer that we did on Speed Racer and we did it, we hired the Oscar winner from Avatar to lead the film and it was a mistake. Frankly, we’ve learned a lot about how profitable Tier 2 work is and how challenging Tier 1 work is. And I can tell you we’re never again are going to take a project of that size where we’re inventing technology as we go.
The other reason that I think that’s a little forgivable for our team on this particular project is remember we had this big hole in the revenues that we had to fill with Paradise Lost. So, had we not filled it with this low margin project, it would have been much, much worse. So, maybe that’s the silver lining there.
Tony Wible – Janney
So, how fast does, I guess, that cost essentially go away – that net cost go away? I mean, in other words, if you kind of think about the inflection in operating margin you saw quarter-over-quarter it was like a 10% swing, could you see that reverse just as quickly?
Yeah, it’s gone. I mean, that film was based on percentage of completion, John was at 97%, 99% fully booked by the end of the second quarter?
The film is still not fully delivered by multiple visual effects houses to the studio, but out of our 400-some shots, we’re down to tweaks of black smoke thickness on 22 shots or texturing stone walls, or yeah, it’s done – from a financial reporting perspective, it’s done.
Tony Wible – Janney
And with all the other stuff between Abu Dhabi, Military coming on later this year, when do you expect the visual special effects business to flip back over to profitability? Do you have a general sense?
I’d say even with the Ender’s Game drag, the visual effects business will be profitable through the end of the year.
Tony Wible – Janney
By the end of the year it will be profitable or for the year?
We’ll be running – no, not for the year, because of the load on the first half of the year. But now that we – we’ll have a little bit of reported unutilized labor in the beginning of the third quarter, but as we sit here today, I believe that day by day, our visual effects legacy business, as you called it, core business as we’ve called it, is profitable.
Tony Wible – Janney
So you could carve it away today and it is a quickly growing profitable business, very respected and very important, and that’s kind of the point I’ve made when we talk about where we are in fundamental value, that business is very attractive right now.
Now when you get to Abu Dhabi, imagine that you’re taking – we’re at a very high level of employment in California right now. We had to grow to get this film done in California, and we still have had to maintain those levels of employment because of some really neat projects that came on.
But when you get into Abu Dhabi at 2X India labor and you got a 50% reduction even from there on the grants and you have a 30% reduction from the studios that allow you to bring down costs even further, the visual effects business in Abu Dhabi and across our total business will be shockingly profitable by the standards of visual effects. I mean, never – and so, the challenge is, how quickly can we get shopped over to Abu Dhabi?
Tony Wible – Janney
And unfortunately, we’re going to struggle to get $10 million of revenues in Abu Dhabi by really in 2013.
Tony Wible – Janney
Tony Wible – Janney
And a couple of housekeeping questions. How much on Ender’s did you book this quarter as far as revenue? And then on your question on capital raise or questions that you’ve had around that in your comments, what kind of investments do you have coming up for either films or other projects?
Well, we’re taking a breather on live action film investing.
Tony Wible – Janney
And I’d say that we were a little overinvested in Ender’s Game, but think about how it happened, right. We pre-sold the film and then the cast came on, then, gosh, Lionsgate decided to more than double their marketing spend after the success of Hunger Games and the momentum behind our film and our cast and our distribution. And so, we were sitting there with that option to go from the 25% level to 37% level. And it is since you’re in the first tier of recovery, the film would have – you’d have to have a Harrison Ford, Ben Kingsley film do less than $80 million, $90 million or $100 million to not recover that capital.
So I’d say we’re overinvested in Ender’s Game, but it was an opportunity that really accelerated transformation of content ownership. But in the live action space, we got really lucky on Ender’s Game. We had perfect partners. We had a perfect pre-sell. It was the largest pre-sell that we’re aware of in Cannes Film Festival history, $44 million of pre-sell. So, that is bigger than we expect to see.
What we’re starting to see more and more, we’ve got a major author, for example, that has a book that’s bigger than Hunger Games, that has also offered us a deal where we can get material ownership without having to invest a dollar and we’re going to kind of go back to that model and take a breather from heavy capital investing. We are lucky on Ender’s Game based on the way the deal sets up, we hope to get lucky at the box office, but we need to leverage who we are into ownership, not our capital into ownership.
Tony Wible – Janney
And we booked $3.3 million for the beginning...
$3.6 million of revenues in this quarter for Ender’s Game.
Tony Wible – Janney
Great. Thank you.
Thank you, Tony.
And, Doug Creutz, I hope you’ve had the patience to hang from Cowen & Co.
Doug Creutz – Cowen & Co
Yeah. I’m still here. You actually just answered one of my questions, which was about plans for more investment in live action films. But, let me switch over to the animated side. It sounded like you said you should have the third reel done and at that point you’re going to be looking for partners on Tembo and I just wondered how that then impacts your ability to start further animation projects or is it basically you’re going to finish Tembo first and then see how things go from there?
No, we’ve already – first of all, we’ve already started looking for that studio partner and that production capital because it’s – there were some natural relationships that grew out of our creative people here in one case, but we’ve been contacted by three major studios of the six.
There is a fourth that I could say probably just made a strong inquiry this week and so while our plan was to go to the studios after the third cut reel, there are some studios that you probably know pretty well that don’t really have answers in animation or they may have gaps in their own lineup and so we have four studios that have made contact with us. I would say our first choice, our first choice may be a step behind the others, but they’ve been down and they’ve visited and they’ve seen the stories and I think that we’re doing very well there. And I think we’re going to be well ahead of the original idea of wait till the third cut reel.
Now the other option is that you don’t do a studio deal right now because what we’re told by the investment banking arms of our major entertainment agency is that surprisingly, instead of doing a slate deal, where you spread the risk for the investor, surprisingly, single picture financing in feature animation for the family market is one of the more attractive and easy to put together kind of investment opportunities.
So we’re parallel passing that as well, just to make sure that our production investment stays ahead of our production expense. For example, when we brought Galloping Horse in, we sold distribution in China then for $5 million. We did it in a way that we weren’t able to count it as revenues because of some of the strings attached to that deal, but we brought in $5 million against Tembo, as Tembo was at about maybe $6 million in cost.
So, we think we can pre-sell for and we can raise production capital, but the big mother of all deals would be that great partnership with a studio and we’re feeling very good about that. It has been repeated many times by the studios that will look to us is that the level of preparedness we have, the strength of our director and story team combined with our ability to drive those stories into finished animation is far superior to any startup animation studio they’ve seen and that’s the power of the Digital Domain backbone really. Sorry if I over-answered your question, but did I answer your question?
Doug Creutz – Cowen & Co
No, you did. And just separately, obviously, there’s another very major animation player out there who is shopping their distribution deal. Does that sort of have to play out before you guys are going to figure out who your partner is or do you think there is no relationship there?
Well, we are positioned very differently from that other major player. We’re like, we can let them have their fart jokes and their crass humor and their sexual innuendo, and we’re a very clean – we’re sort of like Pixar before Brave. Brave was sort of a new film, more DreamWorks like in terms of content.
So while I love the people at DreamWorks and I love the films at DreamWorks and my kids love the films, we are a different product and what we found is there’s obviously one major studio that was on the other side of that DreamWorks relationship going away and there are three other studios that we believe are talking to us as much as they’re talking to that firm. And we also believe it’s clear that big budget broadly distributed feature animation films do very, very well versus live action counterparts.
So, studios are looking for multiple third-party deals right now. In fact, two of the big studios as it represents one of the parties interested in us as a strategic acquisition, has said quite simply, our existing output is one film a year and we want more. So – no, we haven’t – nobody is waiting on that deal for us. They have been aggressively courting us and our creative people here are the very best.
We’ve actually recruited very successfully against that company that you’re speaking of. We’ve brought in directors from Disney, directors from Pixar. We’re very comfortable with where we stand, just because they were there first. Please don’t let that suggest anything about the quality of our offering as perceived by the studio, it’s really the quality of the people and the story that counts.
Doug Creutz – Cowen & Co
Okay, John. Thank you.
Hey, thank you, Doug.
Okay. Well, operator, thank you so much for keeping the queue open for those gentlemen and with that that’s the end of questions from the analysts, and we’ll close out the call.
Final summary, please dig into our numbers. Being public is about making promises and keeping promises, and some of the ugly aspects of our P&L relate to some really favorable grand packages, which just take a little while to understand in terms of how they are accounted for. It’s a story of significant revenue growth, significant margin improvement, rationalization of expenses, significant backlog for the end of the year, cash flows that are much more manageable on a cash burn from operations than they would appear, challenges, of course to continue to fund the kind of major items for us going forward.
But, a lot of sources of capital, good relationships with our lenders that we think can lead to accretive reformations or takeouts of our existing structure in win-win situations where they do well for helping us and we do well as a company, and then simply stated, a strategic process where we feel very confident we’re going to prove this company is worth far more than today’s trading price. This stock represents a trader’s view, not fundamental value and it’s incumbent upon us to prove that for the benefit of our shareholders. So, thank you so much for being on the call. And we look forward to talking to you again.
Thank you for your participation in today’s conference. This concludes the presentation. You may now disconnect. Have a great day.
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