Description

Mitc beat us to it but TBRD was the next stock we were going to write up for the VIC in a few weeks. We decided to go ahead anyways because I think we have enough additional info to warrant a separate submission as opposed to just flooding the comments. Please see his write-up for additional detail and background. We will focus only what is incremental to his memo.

How Atomic Cartoons Competes

Animation is a highly competitive industry, so how do they compete? Atomic wins business primarily based on their reputation of dependably delivering quality content on time and servicing the customer well. This is proven out through a growing list of hit shows.

The studio is also building an edge in acquiring the best IP. This edge comes from:

1. Being a smaller, independent studio which allows Atomic to be nimble, have quick turnaround during negotiations and get deals done fast

2. Having relationships with all the major broadcasters like Amazon, Netflix, HBO, Disney, etc

3. Access to financing to gap finance projects

It is rare to have a studio with all three of these attributes. Usually the big guys have the relationships and the financing but are slow moving and bureaucratic when it comes to negotiating and turn times on contracts. Atomic can get a term sheet done in 24 hours and have revisions turned around same day. Other small studios may be quick but lack the relationships with the majors or have limited access to financing.

Atomic's Chief Creative Officer, Matthew Berkowitz, originally joined the studio in 2016 as the VP of Originals and was tasked with increasing the company’s original content output to 50%—up from the 20%. Since then, Berkowitz has developed 5 original shows including Last Kids on Earth, Princesses Wear Pants and Eerie Elementary. 

One anecdote of Berkowitz - when Atomic wanted to buy the rights to Last Kids on earth, a children's book that has sold > 2 million copies, the agent for the author Max Brallier wouldn't even allow Atomic to get on the phone with Brallier because he was already in discussions with 7 other studios. Berkowitz circumvented the agent, reached out to Max directly, ended up flying out to meet and won the deal because of this hustle and quick pacing. The studio's relationship with Brallier has only grown and Atomic just started production on Eerie Elementary in August, another series written by Brallier (under a different pen name).

The success of Last Kids (multiple seasons on NFLX) and the way they worked with Brallier now has Atomic receiving 100s of submissions per year from content creators. From this funnel Atomic is looking to sign around 10-12 options/deals per year.  Another edge Atomic has is there willingness to take less ownership of IP in order to get a deal done. When negotiating terms for IP the larger studios like Dreamworks or Nickelodeon typically want to own 98%+ of the rights on the back end. Atomic however will take as low as 80%, thus sharing much more of the upside with the author which is a major selling point in getting deals done. This is in fact may have been part of why Atomic was able to land Princesses Wear Pants which Dreamworks reportedly really wanted.

IP Licensing and Royalties

When the company creates a hit show from owned IP it can also earn significant high margin revenue from licensing and royalty opportunities.

Last Kids is a prime example of the power of owned IP but very little of the economic benefits have hit the financials yet. Last Kids "Season 1" was released in September 2019 but was simply one episode to introduce the series. Season 2 was 9 episodes and aired on Netflix in April 2020 so will be included in Q2 earnings when those are released next month. Season 3 will be out in October.

There is now a Last Kids on Earth toy line available which was also released in Q2 of this year, and a video game in the works that is set to release in mid-2021.

“After reading the books, and getting a preview of the Netflix series, we jumped at the chance to work with Atomic Cartoons and Cyber Group Studios to develop a video game based on The Last Kids on Earth. It has all the hallmarks of a successful franchise – comedy, adventure, friendship, fun – and we look forward to gamers around the world coming along for the ride when we launch in 2021.” - Terry Malham, CEO of Outright Games (https://www.fastcompany.com/90421287/the-last-kids-on-earth-leaps-from-books-to-netflix-to-toys-next-stop-billion-dollar-franchise)

If the Last Kids video game hits the higher end of their internal targets the company will receive mid-to-high single digit millions in royalties from this one video game alone. If you read the Last Kids books, you will see that it is almost as if it was written to be a video game, most of it is about game-ifying zombie attacks and collecting monster artifacts so it shouldn't be a clunky transition to a game format.  Lego Star Wars and Lego Indiana Jones are comparable video games to what Last Kids on Earth will be like in terms of difficulty/controls, etc. Apparently the game is testing very well with kids so far while in development. In addition to the royalties on the video game sales, the game will also offer the potenially very lucrative in-game micro transactions that Thunderbird will also receive a very high royalty on ( > 40%). 

All this from IP that Thunderbird paid only ~$7,500 for the option for.

On Last Kids specifically, the company does not receive any book royalties and lets the author keeps all that. They negotiated separate royalty buckets for merchandise, toys, and video games. They have a pre-established waterfall with a set amount they receive per toy sold, per video game sold, etc. This royalties are tiered and scales up as they hit certain revenue/unit milestones. 

Atomic is also working to maximize these high margin royalty streams even further. Up until recently the studio had been using licensing agents to go out and negotiate the toy deals, video game deals, etc. They have now cut out these agents and are bringing this in-house. This initiative required hiring two people and along with setting up legal and other infrastructure cost Atomic about $1 million to do. While a meaningful investment for a small company, the ROI on this investment should high because doing this in-house will accrue an additional 30% or more of the royalty stream for Thunderbird. For example, if they were getting a 40% royalty on each toy sold, 12% or more was going to the agent (30% agent cut * 40% royalty on retail sale = 12%). Going forward Atomic will retain the full 40%.

Unfortunately, they didn't cut out agents before inking the Last Kids licensing deals for the video game with Outright Game and toyline with JAKKS Pacific, but from here on out they will reap all of the benefits from the licensing of other promising owned IP such as Princesses Wear Pants. 

On the “Partnerships” side of the studio there is also upside from royalties, just more limited. For example, on Hello Ninja they will retain ~20% of the royalties related to all merchandise sales.

Example of Last Kids toy: https://www.target.com/p/the-last-kids-on-earth-slicer-bat-25-34-soft-foam-bat-with-5-battle-stages/-/A-76857431#lnk=sametab

Low Risk Development Model

As MITC alludes to, TBRD has a low-risk approach to developing new shows. They pay a nominal amount for the option to an author (less than five figures). They never spend more than six figures on a show's pilot/trailer before getting it sold, even including their forthcoming feature film being produced with the writers of The Simpsons. Often they will just need to make a one minute trailer or show a sample of the look and feel that cost almost nothing to get a show pre-sold to someone like a Netflix. Then the network or buyer puts up the lion’s share of the budget to get the show going (80%+). This is much different than a lot of the movie studios that might invest heavily in a movie that flops, leading to lumpier cash flow.

Recently opening another animation studio in LA was also seemingly low risk as they went in knowing that they already have a three year backlog of work for Netflix from day one.

Service Side

The company had a severe decline in Service revenues from 2018 to 2019 as the company made the strategic decision to not renew its agreements to continue producing Man in the High Castle as well as another large budget series for ABC. While this was a hit show that generated a lot of revenue it came at low margin. While this may cause the company to screen poorly, we see it as a positive that they are not chasing unprofitable growth. From 2019 MD&A:

Thunderbird aims for 20% - 30% gross margins per show on the Service side with revenue recognized using a percentage of completion method like it would be with a construction company.

Miscellaneous

The split of of animation type the studio is currently doing is 60% CGI  and 40% 2D animation. CGI is more expensive to make, but they claim they make a higher gross margin on it so that mix shift towards CGI will boost gross margins overall.

Long lived assets are the goal. They are looking to build franchises that will have a long tail of revenue and spin-offs. For example with Last Kids for NFLX, they have a 2-year hold-back period where the show is exclusively on NFLX and then after the two years elapses they get the rights back and can go and sell that same existing content (for which all the money is already spent) to multiple networks around the world. So really a lot of the revenue and value from Last Kids will come in 2022 and beyond. They will negotiate these deals territory by territory and not give any single broadcaster exclusivity in order to maximize monetization. Alvin and the Chipmunks is a good example of this--it is on four different networks concurrently just in the UK.

Another example of a successful, fully owned show  that will have a long shelf life is Highway Thru Hell on CBC in Canada. It has broken all kinds of viewership records and has subsequently generated several successful spin-offs (Mud Mountain and Heavy Rescue 401) that will be monetized over and over again in the future. (https://mediaincanada.com/2017/01/12/highway-thru-hell-spin-off-hits-ratings-record-for-discovery/#)

Thunderbird also has a tremendous ability to flex expenses with lot of their animators and production employees are on short term contracts. They work for them on a particular process or show and when that show is done they are no longer an employee so there is no “downtime” and labor expense mismatch. They usually roll them to another project immediately but if demand ever waned expenses can come down immediately. 

A major growth driver going forward will be adult animation content (think BoJack Horseman or Archer). During the covid lockdowns when live action production ground to a screeching halt (and has not really ramped back up yet), many writers in the industry turned their attention to animated content ideas. They are targeting this category to make up about 20% of their content overall. They have a show coming to FX in collaboration with Marshawn Lynch and Conan O’Brien around the Beast Mode brand, and another show working in conjunction with Japanese lifestyle brand Tokidoki (show with the characters Mermicorno, unicorn+Mermaid).

An additional source of content the company is getting into is turning graphic novels into shows. They have some projects in the works on this including one with a comic book that was a recent Eisner award winner. 

Transaction comps

A relevant transaction comp that shows the value of one extremely successful franchise is Hasbro bought Entertainment One, the owner of Peppa the Pig, for $3.4 billion, valuing it at 2.8x NTM sales estimates and 13.6x forward EBITDA.

Another is Leftfield Entertainment, the creator of Pawn Stars, selling 80% of of the company in 2014 for $360M, multiples of TBRD’s EV.

Chairman of TBRD in March 2020: 

"I would point to EOne being acquired last year by Hasbro for about 15x EBITDA (LTM).. Keep in mind we're trading at 4x trailing EBITDA. E1 was a much bigger business than ours, about 3 - 5 years ahead of us, our ambition is in line with where EOne took their business. Incredible business, had Peppa the Pig as a real amazing piece of IP an they were taken out for $3 billion. Another great example of being acquired, and again you'll see this theme of owned IP, was Pixar being acquired by Disney. Pixar was really based on 5 - 6 franchises, Toy Story, Finding Nemo, Cars.. It didn't take many. It was a genius business and a very focused business. They decided to get acquired because they felt Disney had more leverage and mediums to be able to leverage the amazing IP that Pixar was really only leveraging at the time through movies/cinemas. Disney was able to extract that value across their parks and toys, now Disney+, just many more ways to monetize. I have experience in starting a business and selling it which I started in 2015 and sold for 2018 for $265 million. And so while we'll look at any and all opportunities.. we think we're so under the radar and under valued right now that we wouldn't even look at that right now. We want to get out our story out these and be the acquirer of oppotunities first because we're just getting started."

Another interesting dynamic you see play out sometimes is where a major studio will outsource the production of a movie to a smaller animation studio and then ultimately acquire the studio if the movie is successful. You saw this happen with Universal who acquired Paris-based animation studio Mac Guff who animated Despicable Me. Mac Guff was paired with Illumination Entertainment who together have gone on to produce a steady string of animated box office hits. The table below shows just how profitable hit animated movies can be. Illumination Mac Guff films have averaged $75 million budgets and $723 million box offices. 

Atomic is moving into the animated feature film space doing Service work for a Curious George movie for Hulu/NBC and a to be announced title for Lucasfilm/Disney.

Risks

Management is pretty clear about their intent to acquire something in the near term to expand globally. This is worrisome because it would appear they already have a full plate now with so many projects in the works and should focus on executing and growing organically.

Certain Board members, namely Brian Paes-Braga, comes across as potentially sketchy and hypey. He has a very strange promotional personal website.  He overly emphasizes ESG values such as saving the world from the unspeakable evils of fossil fuels but drives a Ferrari and flies private.  This self promotion, hype and overly eager virtue signaling rubs me the wrong way (I'm sure most love it), but then again who isn’t a hypocrite in some way? All this said, he is obviously capital markets savvy and very involved/proactive. 

Overall we have been very impressed with the management team. They have thoughtful answers for every question and are methodical in their approach to every aspect of the business. They speak in terms of 3+ year plans. It seems  clear that if the stock doesn't get traction in the public market they will ultimately look to sell the company or break up the two divisions (Atomic/Great Pacific Media) and sell them separately. 

Additional links of interest: 

Interview of founder Tim Gamble:

https://www.youtube.com/watch?v=soZOkfQpRFg

CEO McCarron talking about new slate, 9/23/20:

https://www.youtube.com/watch?v=UTpZConSb1U

Interview with Chief Creative Officer, Matt Berkowitz:

https://www.youtube.com/watch?v=ShCAErZegws

Chairman Brian Paes-Braga promotional overview video of Thunderbird investment opportunity:

https://www.youtube.com/watch?v=oR0BKuv4WnE

CEO McCarron interview May 2020:

https://www.youtube.com/watch?v=bJAqjJ0UQM8

Longer interview with CEO from August: 

https://www.youtube.com/watch?v=HTLPo6DvhwQ

Catalyst

-Continued high growth and multiple expansion

-Sale of the company