Digital Domain Media Group: Cool Tech Doesn't Mean Profitable Firm

| About: Digital Domain (DDMGQ)
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One of the biggest misconceptions in the world of investing is that being a "cool idea" firm instantly makes a company profitable and worthy of investment. Any investors who have ever purchased shares in Florida-based Digital Domain Media Group (DDMG) have fallen right into this trap.

Don't get me wrong, Domain Media has a stellar staff that produces some downright magical work, such as the Transformers: Dark of the Moon animation and the recent Tupac Shakur hologram. The company has won numerous awards and worked on some of the most popular films. The truth is: I love its work. I don't think the problem with this company lies in its innovation or lack of work ethic; rather, it is found in the destructive management of its financials.

Now, for some reason I can't really understand, Domain Media thought it would be a good idea to create a for-profit post-secondary educational institution with Florida State University. Although it is a cool idea, once again, I don't think it can turn a financial profit. Just look at all the headwinds in the industry, plus the ballooning student debt burden. Most recently, take a look at Corinthian Colleges (NASDAQ:COCO), which is down big on a major earnings miss. Domain Media should stick with what it's good at: creating visually engaging graphic works of art. When a portfolio manager who works only on U.S. domestic equities decides to go into the mortgage-backed securities market (I know this is an extreme example), we would call it "style drift." Style drift is never a good thing.

Let's begin with sales or, rather, the lack thereof. For fiscal 2011, revenue dropped 35% to $20.3 million from $31.15 million in Q1 of 2011. Cost of goods sold has risen 15% for the year, and yet sales have declined? That doesn't add up. Gross profit in Q1 2011 was $8.27 million and by Q4 2011 it was -$6 million, bringing the company's gross profit margin from 26% in Q1 to -30% in Q4 of 2011. Domain Media ended 2011 with cost of goods sold being 95% of revenues, which is up from the end-of-year 2010 figure of 80%. That doesn't look like an improving trend.

Next on the income statement are sales, general and administration (SG&A) expenses. In all quarters of 2011, with the exception of Q1, SG&A expenses have exceeded 50% of sales at the minimum. In fact, in Q3 of 2011 it was over 100% of sales. Think about that: I'm going to sell you a $100 piece of artwork, which cost me at least $100 to make (using Q4 2011 figures), and to find you and actually sell you the piece of art, I spent another $100. Some basic math says that I just spent $200 to sell you something for $100, leaving me with a loss of $100. Does that seem like a sound business plan to you? Due to the substantial depreciation Domain Media incurs, I figure it would be best to just use the EBITDA figure given below. I'll let you look for yourself before I rant more about how this company is blowing so much money that it won't have any left to lose.

Let's go to the balance sheet now, which is not awful -- yet. Current ratio is improving from 0.39 in Q1 to 0.69 in Q4 2011. The one thing I noticed, however, is that the intangibles for the company make up a significant portion of its total assets. Throughout 2011, intangibles made up a high of almost 30% of total assets to a low of 22% of total assets. My problem with this is that intangibles can be the most subjective asset on the planet. Intangibles are basically "worth" whatever you say they are. Now, I am not saying Domain Media has terrible patents or anything like that; I am just saying that it isn't exactly difficult for it to embellish a little on this figure. Domain Media ended the year with $5.07 per share in total assets (including, in my opinion, its embellished intangibles figures) and $4.32 in total liabilities. Total debt obligations due in the next three years are $56.4 million, with $37.2 million due in fiscal 2012.

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Domain Media has managed to weasel its way into the hearts of Florida politicians, receiving approximately $135 million in cash grants, land grants, low-interest financing, and tax incentives. I think this is merely going to kick Domain Media's can down the road until the road ends at the edge of a cliff … and then the can falls off.

Moral of the story: If you are patient, you can short this stock well into the $4 range. Around $4, I wouldn't be a short seller even if the price collapses further just because the company would only be worth about $175 million, which is basically pennies for any big players to acquire the company for its technology. The way this company is headed, it is a binomial result: eventual bankruptcy or getting acquired at a much lower price by another firm.

Disclosure: I have no positions in any stocks mentioned, but may initiate a short position in DDMG over the next 72 hours.