As Of                Filer                Filing    For·On·As Docs:Size              Issuer               Agent

 3/01/07  Marvel Entertainment, Inc.        10-K       12/31/06   11:2.4M                                   Paul Hastings LLP/FA

Document/Exhibit                   Description                      Pages   Size 

 1: 10-K        December 31, 2006                                   HTML   1.16M 
 2: EX-10       Ex. 10.1: 1998 Stock Incentive Plan                 HTML    124K 
 3: EX-10       Ex. 10.2: 2005 Stock Incentive Plan                 HTML    119K 
 5: EX-10       Ex. 10.26: Amd 2 to Transaction Documents           HTML     43K 
 4: EX-10       Ex. 10.7: 2005 Cash Incentive Plan                  HTML     68K 
 6: EX-21       Ex. 21: Subsidiaries                                HTML     10K 
 7: EX-23       Ex. 23.1: Consent of Pricewaterhousecoopers LLP     HTML      8K 
 8: EX-23       Ex. 23.2: Consent of Ernst & Young LLP              HTML      9K 
 9: EX-31       Ex. 31.1: 302 Cert of CEO                           HTML     15K 
10: EX-31       Ex. 31.2: 302 Cert of CFO                           HTML     14K 
11: EX-32       Ex. 32: 906 Cert of CEO & CFO                       HTML      9K 

 

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549

 

FORM 10-K

(Mark One)

ý  ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

 

For the fiscal year ended December 31, 2006

 

OR

 

¨  TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

 

For the transition period from ________ to _________

 

 

Commission File No. 1-13638

 

MARVEL ENTERTAINMENT, INC.

 

(Exact name of Registrant as specified in its charter)

 

 

417 Fifth Avenue

New York, New York 10016

(Address of principal executive offices, including zip code)

 

(212) 576-4000

(Registrant's telephone number, including area code)

Securities registered pursuant to Section 12(b) of the Act:

 

 

Securities registered pursuant to Section 12(g) of the Act: None.

Indicate by check mark whether the Registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act.  Yes ý   No ¨

 

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Indicate by check mark whether the Registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act.   Yes ¨   No ý

Indicate by check mark whether the Registrant: (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the Registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.  Yes ý   No ¨

Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of Registrant's knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K.  Yes ý

Indicate by check mark whether the Registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer. See definition of “accelerated filer and large accelerated filer” in Rule 12b-2 of the Exchange Act. (Check one):

Indicate by check mark whether the Registrant is a shell company (as defined in Rule 12b-2 of the Act).  Yes ¨   No ý

The approximate aggregate market value of the voting and non-voting common equity held by non-affiliates of the Registrant as of June 30, 2006, the last business day of the Registrant’s most recently completed second fiscal quarter, was $1,090.5 million based on a price of $20.00 per share, the closing sales price for the Registrant's common stock as reported in the New York Stock Exchange Composite Transaction Tape on that date. As of February 26, 2007, there were 85,750,101 outstanding shares of the Registrant's common stock, including 2,521,524 shares of restricted stock.

 

DOCUMENTS INCORPORATED BY REFERENCE

The information required by Part III (Items 10, 11, 12, 13 and 14) is incorporated by reference from the Registrant’s definitive proxy statement, which the Registrant intends to file with the Commission not later than 120 days after the end of the fiscal year covered by this Report.

 

 

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TABLE OF CONTENTS

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Unless the context otherwise requires, the term “we,” “us,” “our,” “Marvel” or “the Company” each refer to Marvel Entertainment, Inc., a Delaware corporation, and its subsidiaries. Some of the characters and properties referred to in this report are subject to copyright and/or trademark protection.

General

Marvel is one of the world's most prominent character-based entertainment companies, with a proprietary library of over 5,000 characters. We operate in the licensing, publishing, toy and film production businesses in both domestic and international markets. Our library of characters includes Spider-Man, Iron Man, The Incredible Hulk, Captain America, Thor, Ghost Rider, The Fantastic Four, X-Men, Blade, Daredevil, The Punisher, Namor, Nick Fury, The Avengers, Silver Surfer and Ant-Man, and is one of the oldest and most recognizable collections of characters in the entertainment industry.

Our growth strategy has been to increase exposure of our characters by licensing them to third parties for development as movies and television shows. The increased exposure can then create revenue opportunities for us through increased sales of toys and other licensed merchandise. Our self-produced movies, the first two of which (Iron Man and The Incredible Hulk) are scheduled for release in 2008, represent an expansion of that strategy that increases our level of control in developing and launching character brands.

Our business is divided into four integrated and complementary operating segments: Licensing, Publishing, Toys and Film Production.

The expansion of our studio operations to include feature films that we produce ourselves began in late 2005 with our entering into a $525 million film facility to fund the production of our films. This expansion has resulted in the creation of a new segment, the Film Production segment. During 2006, we substantially completed the ramp-up of our movie production business, including the addition of key personnel, to support the development and production of our self-produced films. Consequently, we have presented the Film Production segment separately as of December 31, 2006. Previously, Marvel Studios’ operations related to the licensing of our characters to third-party motion picture and television producers. Those licensing activities were included, and are still included, in the Licensing segment. However, the operations of developing and producing our own theatrical releases are reported in our newly created Film Production segment, as these operations are inherently different than that of licensing our characters. The film facility is described below.

Marvel and Sony Pictures Entertainment Inc. have entered into a joint venture for the purpose of pursuing licensing opportunities relating to characters based upon movies or television shows featuring Spider-Man and produced by Sony Pictures. The joint venture is named Spider-Man Merchandising L.P., but in this report we refer to it simply as the “Joint Venture.” Effective April 2004, the operations of the Joint Venture, previously recorded under the equity method, have been consolidated in our accompanying financial statements as a result of our then assuming control of all significant decisions relating to the ordinary course of business of the Joint Venture and receiving the majority of the financial interest of the Joint Venture. The operations of the Joint Venture are included in our Licensing segment.

Licensing

Our Licensing segment licenses our characters for use in a wide variety of products and media, the most significant of which are described below.

Consumer Products

We license our characters for use in a wide variety of consumer products, including toys (other than toys licensed to Hasbro, Inc.), apparel, video games, electronics, homewares, stationery, gifts and novelties, footwear, food and beverages and collectibles. While revenues from these activities are classified in our Licensing segment,

 

 

 

 

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we classify revenues from our past toy license with Toy Biz Worldwide Ltd. and our current toy license with Hasbro in our Toy segment.

Studio Media Licensing

Feature Films. We have licensed various Marvel characters to major motion picture studios for use in motion pictures. For example, we currently have licenses with Twentieth Century Fox to produce motion pictures featuring characters, including The Fantastic Four and X-Men. We also have outstanding licenses with studios for a number of our other characters, including Spider-Man, Deathlok, Namor and The Punisher. Under these licenses, we retain control over merchandising rights and retain more than 50% of merchandising-based royalty revenue.

Video Games. We have licensed some of our characters to top-tier publishers such as Activision, Electronic Arts, Microsoft, Sega, and others to produce current and next-generation video games on multiple platforms including Xbox 360, Playstation 3, Nintendo Wii, Playstation 2, Nintendo DS, PSP and PC.

Television Programs. We have licensed some of our characters for use in television programs, which fuel additional brand awareness. Several live-action and animated television shows based on our characters are currently in development including live-action television programming based on Moon Knight and animated programming based on The Fantastic Four, Iron Man and the X-Men.

Made-for-DVD Animated Feature Films. We have licensed some of our characters to an entity controlled by Lions Gate Entertainment Corp. to produce up to ten feature-length animated films for distribution directly to the home video market. The first two animated features, Ultimate Avengers and Ultimate Avengers 2, were released in 2006. The animated feature The Invincible Iron Man was released in early 2007 and has had strong sales to date. Doctor Strange is scheduled for release in August 2007.

Destination-Based Entertainment

We license our characters for use at theme parks, shopping malls and special events. For example, we have licensed some of our characters for use at Marvel Super Hero Island, part of the Islands of Adventure theme park at Universal Orlando in Orlando, Florida. We have also licensed some of our characters for use in a Spider-Man attraction at the Universal Studios theme park in Osaka, Japan.

Promotions

We also license our characters for short-term tie-in promotions that appear as advertisements, premium programs, sweepstakes and contests to consumers and/or the companies’ trade markets.

Publications

Our Licensing segment licenses our characters to publishers located outside the United States for use in foreign-language comic books and trade paperbacks and to publishers worldwide for novelizations and a range of activity books.

Publishing

Our Publishing segment has been publishing comic books since 1939. Our titles feature, among other characters, classic Marvel Super Heroes. Our characters have been developed through a long history of comic book plots and storylines that give each of them their own personality, context and depth.

The Publishing segment's approach to our characters is to present a contemporary drama suggestive of real people with real problems. This enables the characters to evolve, remain fresh, and, therefore, attract new and retain old readers in each succeeding generation. Our characters exist in the “Marvel Universe,” a fictitious universe that provides a unifying historical and contextual background for the characters and storylines. The “Marvel Universe” concept permits us to use the popularity of our characters to more fully develop existing but lesser-known characters. In this manner, formerly lesser-known characters such as Ghost Rider, Black Panther and Wolverine have been developed and are now popular characters in their own right and are featured in their own comic books.

 

 

 

 

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The “Marvel Universe” concept also allows us to use our more popular characters to make “guest appearances” in the comic books of lesser-known characters to attempt to increase the circulation of a particular issue or issues.

Customers, Marketing and Distribution

In 2006, the Publishing segment continued to be the comic industry leader, with 45% of the dollar share and 46% of the unit share of the industry. The Publishing segment's primary target market for comic books has been male teenagers and young adults in the 13 to 23 year old age group. Established readership of our comic books also extends to readers in their mid-thirties.

Our comic book publications are distributed through three channels: (i) to comic book specialty stores on a non-returnable basis (the “direct market”), (ii) to traditional retail outlets, including bookstores and newsstands, on a returnable basis (the “mass market”) and (iii) on a subscription sales basis.

For each of the years ended December 31, 2006, 2005 and 2004, approximately 70% of the Publishing segment's net revenues were derived from sales to the direct market. We distribute our publications to the direct market through an unaffiliated entity (Diamond Comic Distributors, Inc.). We print periodicals to order for the direct market, thus minimizing the cost of printing and marketing excess inventory.

For the years ended December 31, 2006, 2005 and 2004, approximately 15%, 13% and 13%, respectively, of the Publishing segment’s net revenues were derived from sales to the mass market. Our sales to the mass market also include trade paperbacks, which are compilations of previously printed periodicals collected to tell a “complete” story.

In addition to revenues from the sale of comic books to the direct market and the mass market, the Publishing segment derives revenues from sales of advertising and subscriptions and from other publishing activities, such as custom comics. For the years ended December 31, 2006, 2005 and 2004, approximately 15%, 17% and 17%, respectively, of the Publishing segment's net revenues were derived from these sources. In most of our comic publications, ten pages (three glossy cover pages and seven inside pages) are allocated for advertising. We permit advertisers to advertise in a broad range of our comic book publications or to advertise in specific groups of titles whose readership’s age is suited to the advertiser.

Our Marvel Online business has had a small but growing impact on Publishing segment revenues, mostly through online advertising and comic subscription sales. Our website www.marvel.com has also proven to be an effective means to market various Marvel products and events. We expect strong growth and diversification in Marvel Online revenues as we continue to increase our online presence.

Toys

Our Toy segment is in a period of transition driven by the signing in January 2006 of our agreement with Hasbro and the December 2005 early termination of our agreement with our then exclusive toy licensee, Toy Biz Worldwide Ltd. (“TBW”). The Toy segment was run differently in 2006 than in 2005 and has changed again for 2007, now that products are produced and sold by Hasbro.

Toys in 2005 and in Prior Years

During 2005, our Toy segment created, designed, developed, marketed and distributed a limited line of toys to the worldwide marketplace. Our toy products were based upon Spider-Man movies and upon characters that we licensed in, such as characters from the movie trilogy The Lord of the Rings, the television shows for Total Nonstop Action (“TNA”) wrestling and the movie and television shows based on the character Curious George.

We had an agreement with TBW since 2001, under which we licensed to TBW the right to use the Marvel characters (other than characters based on the Spider-Man movies) in producing and selling action figures and accessories, and certain other toys. The license also permitted TBW to use our “Toy Biz” brand name. Under a separate agency agreement, we provided product development, marketing and sales services for TBW in exchange for a service fee. We received royalties and service fees from TBW based on TBW’s sales of Marvel-designed toys

 

 

 

 

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produced and sold by TBW. On December 23, 2005, we terminated both the license and agency agreements with TBW effective January 1, 2006, one year ahead of their scheduled expiration date.

Royalty and service fee income recognized from the license with TBW aggregated $51.8 million in 2005 and $15.2 million in 2004. All royalties received from the sales of toys licensed to parties other than TBW during 2005 and earlier were recorded as royalties in our Licensing segment, as we did no product development, marketing, sales or other services for these licensees.

Toys in 2006

Most Marvel character-based toys previously produced for retail by TBW were produced and sold by us in 2006. We also continued to produce toys based on Spider-Man movies and based on licensed-in characters such as Curious George and characters from Code Lyoko and TNA wrestling.

In 2006, TBW acted as one of our sourcing agents and, in that capacity, helped us to locate suitable factories in China for the manufacture of our toys. We use a leading independent quality-inspection firm to monitor quality control of our Toy segment’s products.

In January 2006, we entered into a license agreement with Hasbro under which Hasbro has the exclusive right to make action figures, plush toys and certain role-play toys, and the non-exclusive right to make several other types of toys, featuring our characters. The license gives Hasbro the right to sell those toys at retail from January 1, 2007 through December 31, 2011. In some cases, however, Hasbro was permitted to sell toys at retail during 2006. The license is subject to extension in the event that entertainment productions featuring our characters are not released according to an agreed-upon schedule. We also entered into a services agreement with Hasbro under which we have agreed to provide brand expertise, marketing support and other services in connection with the licensed toys. In 2006, royalty and service fee income recognized from Hasbro aggregated $5.2 million. Most of the Toy segment’s 2006 sales, however, came from toys that we produced and sold ourselves.

Toys in 2007

In 2007, most of the Toy segment’s sales will come in the form of royalties and service fees from Hasbro. The Toy segment will also continue to generate revenue from sales of licensed-in properties such as Curious George.

Customers, Marketing and Distribution

Toy sales to customers in the United States accounted for approximately 70%, 65% and 65% of the Toy segment’s net toy sales in 2006, 2005 and 2004, respectively. The Toy segment’s products are aimed primarily at boys aged 4-12 and collectors.

Outlets for our toys in the United States include specialty toy retailers, mass merchandisers, mail-order companies and variety stores, as well as independent distributors who purchase products directly from us and ship them to retail outlets. Our customer base for toys is concentrated. The Toy segment's three largest customers, currently Wal-Mart Stores, Inc., Toys 'R' Us, Inc. and Target, accounted in the aggregate for approximately 57%, 48% and 56% of the Toy segment’s net toy sales in 2006, 2005 and 2004, respectively.

In 2006 and 2005, no product line accounted for over 10% of our consolidated net revenue. In 2004, the only line of products to account for more than 10% of the our consolidated net revenue was the line of toys based upon the movie Spider-Man 2.

The Toy segment produces its products for foreign customers and for most of its domestic customers to order, and sells them “FOB” East Asia. When we sell products FOB East Asia, title to the products, along with risk of loss, passes to the customer in Asia, where the Toy segment’s products are manufactured. The Toy segment does not sell on either a guaranteed-sale (returnable) basis or a consignment basis. Pursuant to the terms of the termination of TBW’s license agreement, we purchased TBW’s domestic inventory of finished goods as of January 1, 2006 for approximately $6 million. The Toy segment had inventory of $0.8 million at December 31, 2006.

 

 

 

 

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Film Production

Our Film Production segment develops, produces and distributes films that are financed with our $525 million film facility. The first two films produced by the Film Production segment, Iron Man and The Incredible Hulk, are scheduled for release in 2008.

The cast of Iron Man will include Robert Downey, Jr. as Tony Stark (a.k.a. Iron Man), Gwyneth Paltrow as Virginia “Pepper” Potts, Terrence Howard as Jim “Rhodey” Rhodes and Jeff Bridges. All four actors have received or been nominated for Academy Awards for their past work. Jon Favreau will direct. The Incredible Hulk, which has not yet been cast, will be directed by Louis Leterrier.

We have engaged Avi Arad to be the independent producer of both Iron Man and The Incredible Hulk. Mr. Arad was a director and executive officer of Marvel, and the head of Marvel Studios, for many years until mid-2006.

The film facility enables us to independently finance the development and production of up to ten feature films, including films that may feature the following Marvel characters, whose theatrical film rights are pledged as collateral to secure the film facility:

 

Iron Man and The Incredible Hulk, included in the above list, were added to the film facility during the quarter ended September 30, 2006. Also included as collateral for the film facility are the theatrical film rights to many of the supporting characters that would be most closely associated with the featured characters and character families. For example, the theatrical film rights to Captain America’s sidekick, Bucky Barnes, and his nemesis, Red Skull, are both pledged as collateral to the film facility.

While theatrical films featuring the characters listed above may be financed and produced by us only through the film facility, we retain all other rights associated with those characters. In addition, we may continue to license our other characters for movie productions by third parties, obtain financing to produce movies based on those other characters ourselves or with others or, with the consent of the film facility lenders, finance and produce films based on those other characters through the film facility.

Terms of the Film Facility

Financing Available; Rate of Interest; Borrowings Outstanding

The film facility, which expires on September 1, 2016 or sooner if the films produced under the facility fail to meet certain defined performance measures, consists of $465 million in revolving senior bank debt and $60 million in debt referred to as mezzanine debt, which is subordinated to the senior bank debt. Both Standard & Poor’s, a division of the McGraw-Hill Companies, Inc., and Moody’s Investor Rating Service, Inc. have given the senior bank debt an investment grade rating. In addition, Ambac Assurance Corporation has insured repayment of the senior debt, raising its rating to AAA. The rate for the senior bank debt, including Ambac’s fees, is LIBOR or

 

 

 

 

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the commercial paper rate, as applicable, plus 1.635%. The interest rate for the mezzanine debt is LIBOR plus 7.00%. The mezzanine debt is to be drawn on first and to remain outstanding for the life of the senior bank facility. As of December 31, 2006, MVL Film Finance LLC had $33.2 million in outstanding mezzanine borrowings through the facility. The initial borrowings in 2005 were used primarily to finance transaction costs ($21.3 million) related to the closing of the facility and the purchase of an interest rate cap ($3.2 million) whereby LIBOR is capped at 6.0% for outstanding debt under the facility up to certain varying amounts. The remainder of the borrowings were used to fund the interest payments of the film facility, during 2005 and 2006.

Limitations on Recourse under Film Facility

The borrowings under the film facility are non-recourse to us and our affiliates, other than MVL Film Finance LLC. In other words, only MVL Film Finance LLC, and not its parent companies, will be responsible for paying back amounts borrowed under the film facility. MVL Film Finance LLC has pledged, as collateral for the borrowings, the theatrical film rights to the characters included in the facility. While the borrowings are non-recourse to us, we have agreed to instruct our subsidiaries involved in the facility to maintain operational covenants. If those covenants are not maintained, we may be liable for any actual damages caused by the failure, although our liability would be subject to limitations, including the exclusion of consequential damages.

Use of Funds

Funds under the film facility will be used for the production of up to ten films featuring characters included in the facility. Funds may be used to produce more than one film based on a single character or character family, so even if ten films are produced using the funds from the facility, not all characters and character families included in the facility will necessarily be the subject of a film financed under the facility.

Initial Funding Conditions

For any film included in the facility, an initial funding may be made only if certain conditions are met. The conditions include obtaining a satisfactory completion bond, production insurance and distribution for the film, and compliance with representations, warranties and covenants. The distribution requirements, described in detail below, require us to pre-sell the distribution rights to each film in Australia and New Zealand, Japan, Germany, France and Spain (the “Reserved Territories”) and to obtain an agreement with a major studio to distribute the film in all other territories. The proceeds from the Reserved Territory pre-sales will be used to fund the film in question. To obtain a completion bond, we will need to have in place the main operational pieces to producing a film, including approved production, cash flow and delivery schedules, an approved budget, an approved screenplay and the key members of the production crew, including the director and producer.

On February 27, 2007, the initial funding conditions were met with respect to Iron Man and an initial funding of the production of that film was made.

Additional Initial Funding Conditions for Fifth Film and each Film Thereafter

There are additional conditions to the initial funding for the fifth film and for each film thereafter, including (i) a minimum ratio of the assets of MVL Film Finance LLC to its liabilities and (ii) a minimum percentage of the aggregate production budgets for each film covered by pre-sale of the distribution rights to the Reserved Territories and/or the proceeds of any government rebate, subsidy or tax incentive program.

Unrestricted Proceeds of the Film Facility

Upon the release of each film, we will receive a fixed producer fee out of that film’s production budget as an advance against any profits of the film. We will also retain all film-related merchandising revenues, such as revenues from toy sales and product licensing based on the movies. These merchandising revenues and the film profits are neither pledged as collateral nor subject to cash restrictions under the facility.

Restricted Proceeds of the Film Facility

MVL Film Finance LLC will receive and retain funds from revenue streams such as the distributor’s share of box office receipts, DVD/VHS sales, television, and a royalty on soundtrack sales. Any sums remaining after

 

 

 

 

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payments of residuals and participations to talent, distribution fees and expenses (including marketing costs), interest expense and production costs will be placed into a blocked account maintained by MVL Film Finance LLC. Sums in that account may be used only for the production of films and repayment of indebtedness under the facility. After the release of the third film, funds may be withdrawn from the blocked account for our general corporate purpose if we have met conditions including compliance with financial coverage tests and a minimum balance requirement. After three films, funds may be withdrawn for our general purpose only if the balance in the blocked account is at least $350 million. For each film thereafter until film nine, the balance requirement is reduced by $50 million.

Ability to Refinance or Discontinue Film Facility

The film facility allows MVL Film Finance LLC to either refinance or simply discontinue the financing at any time without penalty by prepaying all outstanding indebtedness and reducing the amount available under the financing to zero.

Development and Distribution of the Films Financed through the Film Facility

As a film development company, MVL Productions LLC, a wholly-owned consolidated subsidiary of ours, will engage in a broad range of pre-production services. Those services will include developing film concepts and screenplays, preparing budgets and production schedules, obtaining production insurance and completion bonds and forming special-purpose, bankruptcy-remote subsidiaries to produce each film as a work-made-for-hire for MVL Film Finance LLC. MVL Productions LLC has also entered into studio distribution agreements with Paramount Pictures Corporation and Universal Pictures, a division of Universal City Studios, LLLP.

Distribution: Worldwide Excluding Reserved Territories

MVL Productions LLC’s studio distribution agreement with Paramount requires Paramount, at the request of MVL Productions LLC, to distribute up to ten films financed and produced under the film facility. Paramount is required to release each film during one of two prime release periods each year: the Spring/Summer and Fall/Holiday seasons. Under the studio distribution agreement, Paramount has guaranteed MVL Productions LLC wide distribution outside of the Reserved Territories with commensurate advertising and marketing efforts for each film. Included in Paramount’s distribution rights are exclusive theatrical and non-theatrical (e.g., exhibition on airplanes, schools and military installations), home video, pay television and international television distribution rights. Excluded are all distribution rights with respect to the Reserved Territories and free television distribution in the United States. As compensation for its services under the studio distribution agreement, Paramount is permitted to recoup its distribution costs (including print and advertising costs) and expenses for each film from the gross receipts of that film and to receive a distribution fee before we receive our share of gross receipts.

Universal Studios has agreed to distribute Marvel’s film The Incredible Hulk and sequels on essentially the same terms as those on which Paramount has agreed to distribute the other films financed and produced under the film facility.

Distribution: Reserved Territories

MVL Productions LLC is required to pre-sell the distribution rights for each film in the Reserved Territories. The proceeds of these pre-sale arrangements will provide a source of funding for the direct costs of the films in addition to the film facility. Obtaining a cumulative, minimum target budget percentage from such pre-sales and/or from the proceeds of any government rebate, subsidy or tax incentive program is a condition to the initial funding for the fifth film and for each film thereafter.

Iron Man Facility

We generate pre-sale proceeds from distributors in the Reserved Territories who buy from us the right to distribute our films there. As contemplated by the film facility, we intend to use Iron Man’s pre-sale proceeds to fund the production of that film. Most of the payments from our foreign distributors, however, are not due until after production is complete. In order to bridge the gap between Iron Man’s production and the distributors’ payment, we closed a $32.0 million financing on February 27, 2007. The financing was closed through our wholly-owned consolidated subsidiary, Iron Works Productions LLC, and may be used to partially fund the production of

 

 

 

 

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our Iron Man feature film.  Borrowings under this facility are non-recourse to us and our affiliates other than with respect to the collateral pledged to this facility, which consists of various affiliated film companies’ rights to distribute the Iron Man film in the territories of Australia/New Zealand, Spain, France, Germany and Japan and the contracts that our affiliate, MVL Productions LLC, has entered into with third-party distributors to distribute Iron Man in these territories.  This facility, which expires on July 25, 2008 or sooner if an event of default occurs, consists of $32.0 million in bank debt but contains an interest reserve of $2.5 million that will prevent us from borrowing the full amount. The rate for borrowings under this facility is the bank’s prime rate or LIBOR plus 1% at our election.  The facility contains customary event-of-default provisions and covenants regarding our film-related affiliates, the production of the Iron Man movie and our ownership of the intellectual property underlying the Iron Man movie. Funds are to be drawn under this facility proportionately with borrowings under the $525 million film facility.

For further information about our segments, see Note 12 to our accompanying consolidated financial statements.

Intellectual Property

We believe that our most valuable assets are our library of proprietary characters, the stories we have published for decades, the associated copyrights, trademarks and goodwill and our “Marvel” and “Marvel Comics” trade names. We believe that our library of characters and stories could not easily be replicated. We currently conduct an active program of maintaining and protecting our intellectual property rights in the United States and abroad. Our principal trademarks have been registered in the United States and in certain of the countries in Western Europe, Latin America, Asia (including many Pacific Rim countries), the Middle East and Africa. While we have registered numerous trademarks in these countries, and expect that our rights will be protected there, certain countries either do not have laws that protect United States holders of intellectual property equivalent to laws in the United States, or our rights can be difficult to enforce, and there can be no assurance that our rights will not be violated or our characters “pirated” in certain countries.

Advertising

Although a portion of the advertising budget for our toy products is expended for newspaper advertising, magazine advertising, catalogs and other promotional materials, we allocate a majority of the advertising budget for our toy products to television promotion. We advertise on national television and purchase advertising spots on a local basis. We believe that television programs underlying our toy product lines increase exposure and awareness. We do not do significant advertising for our Licensing or Publishing segments.

Competition

The industries in which we compete are highly competitive.

The Licensing segment competes with a diverse range of entities that own intellectual property rights in characters. These include DC Comics (a subsidiary of Time Warner, Inc.), The Walt Disney Company, NBC Universal, Inc. (a subsidiary of General Electric Company), DreamWorks Animation SKG, Inc. and other entertainment-related entities. Many of these competitors have greater financial and other resources than we do.

The Publishing segment competes with numerous publishers in the United States. Some of the Publishing segment's competitors, such as DC Comics, are part of integrated entertainment companies and may have greater financial and other resources than we do. The Publishing segment also faces competition from other entertainment media, such as movies and video games.

In its capacity as a licensor to Hasbro, the Toy segment faces competition similar to that of the Licensing segment. In its capacity as a producer and seller of toys such as Curious George toys, the Toy segment competes with many larger toy companies in the design and development of new toys, in the procurement of licenses and for adequate retail shelf space for its products.

 

 

 

 

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The Film Production segment competes with other film producers, including major studios such as Twentieth Century Fox and Sony Pictures (which also produce films licensed by our Licensing segment). Many of these producers are part of integrated entertainment companies and have greater financial and other resources than we do. Paramount and Universal, who have agreed to distribute the Film Production segment’s films, are also competitors of the Film Production segment in their capacity as film producers.

Employees

As of December 31, 2006, Marvel employed 255 persons. We also contract for creative work on an as-needed basis with over 500 active freelance writers and artists. Our employees are not subject to any collective bargaining agreements. Management believes that Marvel’s relationship with its employees is good.

Financial Information about Geographic Areas

The following table sets forth revenues from external customers by geographic area:

 

 

*Includes U.S. and Foreign revenue derived from the Joint Venture of $3.4 million and $0.7 million, respectively, for the year ended December 31, 2006. Includes U.S. and Foreign revenue derived from the Joint Venture of $13.1 million and $11.6 million, respectively, for the year ended December 31, 2005. Includes U.S. and Foreign revenue derived from the Joint Venture of $59.5 million and $8.0 million, respectively, for the year ended December 31, 2004.

**In 2006, $4.4 million of U.S. toy revenue and $0.8 million of foreign toy revenue is attributable to royalties and service fees generated by Hasbro. $37.1 million and $11.4 million of the U.S. toy revenue and $14.7 million and $3.7 million of the foreign toy revenues for 2005 and 2004, respectively, are attributable to royalties and service fees from toy sales generated by TBW.

Government Regulations

Our toy operations are subject to laws such as the Federal Hazardous Substances Act and the Federal Consumer Product Safety Act. Those laws empower the Consumer Product Safety Commission (the “CPSC”) to protect children from hazardous toys and other articles. The CPSC has the authority to exclude from the market articles that are found to be hazardous. Similar laws exist in some states and cities in the United States and in other countries throughout the world. We maintain a quality control program (including the inspection of goods at factories and the retention of an independent quality-inspection firm) designed to ensure compliance with applicable laws.

Available Information

The public may read and copy any materials that we file with the U.S. Securities and Exchange Commission (SEC) at the SEC’s Public Reference Room at 100 F Street, NE, Washington, D.C. 20549. Information on the Public Reference Room may be obtained by calling the SEC at 1-800-SEC-0330. In addition, the SEC

 

 

 

 

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maintains an Internet site that contains reports, proxy and information statements, and other information regarding issuers that file with the SEC at http://www.sec.gov.

Our Internet address is http://www.marvel.com. Through our website, we make available, free of charge, our annual reports on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K, and amendments to those reports, as soon as reasonably practicable after we electronically file them with the Securities and Exchange Commission. We also make available on our website our Code of Business Conduct and Ethics, our Code of Ethics for the Chief Executive Officer and Senior Financial Officers, our Corporate Governance Guidelines and the charters of the following committees of our Board of Directors: the Audit Committee, the Compensation Committee and the Nominating and Corporate Governance Committee. We are providing our Internet address here solely for the information of investors. We do not intend to incorporate the contents of the website into this report. Printed copies of the information referred to in this paragraph are also available on written request sent to: Corporate Secretary, Marvel Entertainment, Inc., 417 Fifth Avenue, New York, New York 10016.

Certification with the New York Stock Exchange

On May 25, 2006, our chief executive officer filed, with the New York Stock Exchange, the CEO certification regarding our compliance with the exchange’s corporate governance listing standards as required by Listed Company Manual Rule 303A.12.

Forward-Looking Statements

The Private Securities Litigation Reform Act of 1995 provides a “safe harbor” for forward-looking statements that Marvel or its representatives make. Statements that are not statements of historical fact, including comments about our business strategies and objectives, growth prospects and future financial performance, are forward-looking statements. The words “believe,” “expect,” “intend,” “estimate,” “anticipate,” “guidance,” “forecast,” “plan,” “outlook” and similar expressions, in filings with the SEC, in our press releases and in oral statements made by our representatives, also identify forward-looking statements. The forward-looking statements in this report speak only as of the date of this report. We do not intend to update or revise any forward-looking statements to reflect events or circumstances after the date on which the statements are made, even if new information becomes available.

The risk factors listed below, among others, could cause our actual results to differ significantly from what is expressed in our forward-looking statements.

Risk Factors

A decrease in the level of media exposure or popularity of our characters. If movies or television programs based on Marvel characters are not successful, or if certain Marvel characters lose some of their popularity, our ability to interest potential licensees in the use of Marvel characters in general could be substantially diminished, as could the royalties we receive from licensees.

Financial difficulties of licensees. We have licensed to other parties the exclusive right to manufacture and sell various character families in important merchandise categories such as video games. Our revenues could be adversely affected if those licensees or any of our other significant non-exclusive licensees, many of whom have significant future payment obligations to us, experience financial difficulties or bankruptcy.

 

 

 

 

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Changing consumer preferences. Our products (and those of our licensees) are subject to changing consumer preferences. In particular, products based on feature films are, in general, successfully marketed for only a limited period of time following the film's release. Existing product lines might not retain their current popularity or new products developed by us or our licensees might not meet with the same success as current products. Our licensees and we might not accurately anticipate future trends or be able to successfully develop, produce and market products to take advantage of market opportunities presented by those trends. Part of our strategy (and the strategy of many of our licensees) is to make products based on the anticipated success of feature film releases and TV broadcasts. If these releases and broadcasts are not successful, these products may not be sold profitably or even at all.

Movie- and television-production delays and cancellations. We do not control the decision to proceed with the production of films and television programs based on characters that we license to studios, and we do not control the timing of the releases of those films and programs. Delays or cancellations of proposed films and television programs could have an adverse effect on our business. Dates we express for the anticipated release of films and launch dates for television programs are anticipated dates only and those events could be delayed or, in some instances, even cancelled.

Concentration of Toy Business in One Licensee. Most of our toy revenue is now generated from Hasbro. Disruption to our relationship with Hasbro or financial difficulties of Hasbro could adversely affect our revenues. In addition, the retail toy business is highly concentrated, and an adverse change in the relationship between Hasbro and one or more of its major customers could have a material adverse effect on us. The bankruptcy or other lack of success of one or more significant toy retailers could materially decrease our earnings under the Hasbro license.

Uncertainties to do with our entry into the film production business. We have only recently entered into the film-production business, with the closing in September 2005 of a $525 million financing for a slate of films to be produced by our Film Production segment. Though we have acted as a co-producer and worked alongside film studios that have licensed our characters, we have never produced films by ourselves before and we will not necessarily be successful. In addition, we will have to make significant up-front investments in film development costs and we will not be able to borrow those amounts from the Film Financing if for some reason the film in question does not meet the lenders’ conditions for funding. If the lenders’ conditions are met, repayment of their loan will depend on the films’ financial success. Should proceeds from the films be insufficient to repay the loan, we could lose the film rights to some important Marvel characters. In addition, our consolidated statements of net income (also known as our “income statement” or “profit and loss statement”) will reflect any losses suffered by the film slate even if we do not have to fund those losses, and as a result, the volatility of our consolidated financial results could increase. Among the factors that might cause the developments described above or other material adverse developments are the following:

 

 

 

 

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Not applicable.

Marvel has the following principal properties:

 

 

Marvel is involved in various legal proceedings and claims incident to the normal conduct of its business. Although it is impossible to predict the outcome of any legal proceeding and there can be no assurances, we believe that our legal proceedings and claims, individually and in the aggregate, are not likely to have a material adverse effect on Marvel’s financial condition, results of operations or cash flows.

 

 

 

 

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During the fourth quarter of 2006, no matters were submitted to a vote of Marvel’s security holders.

 

PART II

ITEM 5.               MARKET FOR REGISTRANT'S COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND ISSUER PURCHASES OF EQUITY SECURITIES

Market Price of and Dividends on our Common Stock

The principal United States market in which our common stock is traded is the New York Stock Exchange. Our common stock is not listed for trading on any other securities exchange registered under the Securities Exchange Act of 1934. The following table sets forth, for each fiscal quarter indicated, the high and low closing prices for our common stock as reported in the New York Stock Exchange Composite Transaction Tape.

 

 

As of February 26, 2007, the number of holders of record of our common stock was 3,200.

Marvel has not declared any dividends on its common stock.

 

 

 

 

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Performance Graph

The following graph compares the cumulative total stockholder return on shares of our common stock with that of (i) the New York Stock Exchange Composite Index and (ii) the Amex Media (Communications) Index.

The comparison assumes that, immediately after the close of business on December 31, 2001, $100 was invested in shares of our common stock and in the stocks included in the NYSE Composite Index and the Amex Media (Communications) Index, and that all dividends were reinvested. These indexes, which reflect formulas for dividend reinvestment and weighting of individual stocks, do not necessarily reflect returns that could be achieved by individual investors.

 

Value of $100 Invested Over Period Presented:

 

 

 

 

 

 

 

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The following table presents selected consolidated financial data, derived from our audited financial statements, for the five-year period ended December 31, 2006. Marvel has not declared dividends on its common stock during any of the periods presented below.

 

 

 

 

 

 

 

 

 

 

 

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ITEM 7.               MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

The following discussion should be read in conjunction with our financial statements and the related notes thereto, and the other financial information included elsewhere in this Report.

Set forth below is a discussion of our financial condition and our results of operations for the three fiscal years in the period ended December 31, 2006.

Overview

Management Overview of Business Trends

We principally operate in four integrated and complementary operating segments: Licensing, Publishing, Toys and Film Production. The expansion of our studio operations to include feature films that we produce ourselves began in late 2005 with our entering into a $525 million film facility to fund the production of our films. This expansion has resulted in the creation of the Film Production segment. During 2006, we substantially completed the ramp-up of our movie production business, including the addition of key personnel, to support the development and production of our self-produced films. Consequently, we have presented the Film Production segment separately as of December 31, 2006. Previously, Marvel Studios’ operations related solely to the licensing of our characters to third-party motion picture and television producers. Those licensing activities were included, and are still included, in the Licensing segment. However, the operations of developing, producing and distributing our own theatrical releases are reported in our newly created Film Production segment, as these operations are inherently different than that of licensing our characters. The film facility is described below.

We remain committed to expanding our brands through licensing them to third parties for developing movies and television shows. The increased exposure of Marvel characters in these media can create revenue opportunities through increased sales of publishing materials and licensed merchandise. This media licensing strategy, however, has inherent limitations, both in terms of profit potential and control over items such as content, release dates, advertising and merchandising support. Accordingly, on September 1, 2005, MVL Film Finance LLC, a newly formed, special-purpose, bankruptcy-remote, wholly-owned consolidated Marvel subsidiary, closed a $525 million financing facility that will enable us to produce our own slate of feature films. The film facility provides us with another vehicle for potential growth. Films produced by the Film Production segment through the film facility could provide us with a meaningful source of profits and more control over the destiny of our film projects. It will also give us greater flexibility to coordinate the timing of licensing programs around Marvel-branded theatrical releases.

The year 2006 was a transitional one for our Toy segment operations. As discussed below, in late 2005 we terminated our agreement with our then exclusive toy licensee, and in early 2006 entered into multi-year licensing and services agreements with Hasbro. Toys made by Hasbro under its license became, in general, available for retail sale starting on January 1, 2007. Consequently, during 2006, we made and sold almost all Marvel-branded action figure toys ourselves rather than licensing to others the right to do so.

Licensing

Our Licensing segment is responsible for the licensing, promotion and brand management for all of Marvel’s characters worldwide. Since 2004, we have pursued a strategy of concentrating our licensee relationships with fewer, larger licensees who demonstrate the financial and merchandising capability to manage Marvel’s portfolio of both classic and movie properties.  A key focus is a continued effort on negotiating strong minimum guarantees while keeping royalty rates competitive.

Another strategy of the Licensing segment’s consumer products program is to create new revenue opportunities by further segmenting our properties to appeal to new demographic profiles. Initiatives such as Spider-Man and Friends, Marvel Retro and Marvel Juniors have all helped the licensing business expand beyond its traditional classic and event-driven properties.

 

 

 

 

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Major entertainment events play an important role in driving sales of licensed products, and a significant portion of the Licensing segment’s 2006 initiatives were focused on the movie Spider-Man 3, which is scheduled to be released in May 2007. Revenue from Spider-Man 3 merchandise licenses will be recognized beginning in the first quarter of 2007.

Our results can be significantly affected by the release of movies and television shows based on our characters, which can fuel demand for products based on the featured characters. For example, in 2004, we benefited from the theatrical release of the movie Spider-Man 2. This release resulted in increased awareness of the Spider-Man character family, which subsequently drove sales of licensed products, published materials and toys based on that character family. We hoped to similarly benefit from the July 2005 theatrical release of the movie Fantastic Four. However, although Fantastic Four experienced significant box-office success, our Toy and Licensing segments did not achieve benefits in sales based on the Fantastic Four character family for the year ended December 31, 2005 commensurate with the benefits achieved in 2004 from Spider-Man 2. Similarly, in 2006, we did not significantly benefit from the release of X-Men: The Last Stand, although that movie was also a box office success. We expect that our 2007 revenue will benefit significantly from the May 2007 release of Spider-Man 3.

We typically enter into multi-year merchandise license agreements that specify minimum royalty payments and include a significant down payment upon signing. We recognize license revenue when the earnings process is complete, including, for instance, the determination that the credit-worthiness of the licensee reasonably assures collectibility of any outstanding minimum royalty payments (in which case the minimum royalty payments would be immediately recognized as revenue). If the earnings process is complete with respect to all required minimum royalty payments, then we record as revenue the present value of those payments.

The earnings process is not complete if, among other things, we have significant continuing involvement, we have placed restrictions on the licensee’s ability to exploit the rights conveyed under the contract or we owe a performance obligation to the licensee. In the case where we have significant continuing involvement or where any restrictions remain on the licensee’s rights (e.g., no sales of products based on a specific character allowed until a future date), we recognize revenue as the licensee reports its sales and corresponding royalty obligation to us. Where we have a performance obligation, minimum royalty payments are not recognized until our performance obligation has been satisfied. Minimum payments collected in advance of recognition, or future minimum payments that are assured of collection (because of the licensee’s creditworthiness) in advance of recognition, are recorded as deferred revenue. In any case where the licensee is not sufficiently creditworthy, we recognize revenue only to the extent that cash is received. When cumulative reported royalties exceed the minimum royalty payments, the excess royalties are recorded as revenue when earned and are referred to as “overages”.

We did not recognize as much revenue in 2006 from renewals of merchandise licenses with our U.S.-based licensees as we did in either 2005 or 2004 because a relatively small number of those licenses came up for renewal in 2006. In addition, the one major Marvel-branded entertainment event that occurred in 2006, the movie X-Men: The Last Stand, as expected did not contribute significantly to Licensing segment revenue. However, we expect licensing segment revenue to benefit significantly in 2007 due to the release of Spider-Man 3, scheduled for May 2007 and, as a result, Licensing segment revenue is projected to be higher in 2007 than in 2006 and 2005. Two other Marvel-branded entertainment events, Ghost Rider (released in February 2007) and Fantastic Four: Rise of the Silver Surfer (scheduled for release in July 2007), are also expected to contribute to 2007 Licensing segment revenue, although not as significantly as Spider-Man 3.

Publishing

We have experienced continued growth from the direct market and bookstores in 2006. The Publishing segment is focused on expanding distribution to channels such as the mass market, and expanding its product line to a younger demographic. We are in the process of expanding our advertising and promotions business with an increased emphasis on custom publishing. In the second quarter of 2006, the Publishing segment began publishing Civil War, a limited special comic book series which has tie-ins to certain established comic book series. The five issues of Civil War published in 2006 were the year's five top-selling comic books in the U.S.  We expect continued momentum from Civil War and its tie-ins into the first half of 2007. Our Incredible Hulk character will also be featured in a Marvel Universe crossover event, scheduled for 2007, that will have tie-ins to other established comic book series.

 

 

 

 

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Toys

Marvel’s Toy segment has been in a period of transition during 2006 driven by the signing of our agreement with Hasbro effective January 1, 2006, and the termination of our agreement with Toy Biz Worldwide, Ltd. (“TBW”). The Toy segment was run differently in 2006 than in 2005 and has changed again for 2007 now that products are being produced and sold by Hasbro.

Toys in 2005 and in Prior Years

During 2005, our Toy segment created, designed, developed, marketed and distributed a limited line of toys to the worldwide marketplace. Our toy products were based upon the Spider-Man movies and upon characters that we licensed in, such as characters from the movie trilogy The Lord of the Rings, the television shows for TNA wrestling and the Curious George movie. Additionally, we had an agreement with TBW since 2001, under which we licensed to TBW the right to use the Marvel characters (other than characters based on the Spider-Man movies) in producing and selling action figures and accessories, and certain other toys. We provided product development, marketing and sales services for TBW in exchange for a service fee and therefore recorded royalties and service fees from TBW in the Toy segment.

Toys in 2006

Most Marvel character-based toys previously produced for retail by TBW were produced and sold by us in 2006. We also continued to produce toys based on Spider-Man movies and based on licensed-in characters such as Curious George and characters from Code Lyoko and TNA wrestling. As expected, 2006 was not as significant a year for Marvel-branded toys as 2005 (when the movie Fantastic Four was released).

The transition from TBW has resulted in an increase in toy sales compared with 2005, and a related increase in cost of sales, as we have been selling our products directly to the retailer and incurring the manufacturing and selling costs of these products. However, the 2006 transition from TBW disrupted production and caused cancellation of certain sales orders.

We entered into a license agreement with Hasbro under which Hasbro has the exclusive right to make action figures, plush toys and certain role-play toys, and the non-exclusive right to make several other types of toys, featuring our characters. The license gives Hasbro the right to sell those toys at retail from January 1, 2007 (earlier, in some cases) through December 31, 2011 (subject to extension). Under a service agreement with Hasbro, we have agreed to provide brand expertise, marketing support and other services to Hasbro in connection with the licensed toys. In 2006, royalty and service fee income recognized from the license with Hasbro aggregated $5.2 million.

Toys in 2007

In 2007, most of the Toy segment’s sales will come in the form of royalties and service fees from Hasbro. The Toy segment will also generate revenue from sales of its licensed-in properties such as Curious George. In 2007, films featuring the Marvel characters Spider-Man, Fantastic Four and Ghost Rider have been released or are scheduled for release. For that reason, we expect that sales by Hasbro of Marvel-branded toys in 2007 will be greater than in 2006.

 

 

 

 

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Film Production

The expansion of our studio operations to include feature films that we produce ourselves has resulted in the creation of a new segment, the Film Production segment. Previously, Marvel Studios’ operations related solely to the licensing of our characters to third-party motion picture and television producers. Those licensing activities were included, and are still included, in the Licensing segment. However, the operations of developing and producing our own theatrical releases are reported in our newly created Film Production segment, as these operations are inherently different than that of licensing our characters. Our self-produced films will be financed with our $525 million film facility, which is described below.

The first two films produced by the Film Production segment, Iron Man and The Incredible Hulk, are scheduled for release in 2008. During 2006, we substantially completed the ramp-up of our movie production business, including the addition of key personnel, to support the development and production of our self-produced films. Consequently, we have presented the Film Production segment separately as of December 31, 2006. The Film Production segment was created in September 2005, upon execution of the film facility, but did not require separate presentation in 2005.

During 2006, the Film Production segment had capitalized film production costs of $15.1 million, primarily for the production of Iron Man and The Incredible Hulk. This asset is expected to increase significantly coinciding with our production efforts. In addition, for the year ended December 31, 2006, the Film Production segment incurred $7.5 million of operating costs, consisting primarily of employee compensation and its share of the expenses associated with our California office. Operating costs of the Film Production segment also reflect a $1.5 million decline in the fair value of our interest rate cap associated with our film facility. There were no significant operating costs within the Film Production segment in 2005.

We expect the Film Production segment’s operations to look very different starting in 2008, when we first release our self-produced films. At that time, we will begin recognizing revenue. As we recognize revenue for a particular theatrical release, we will amortize the related capitalized film production costs in the proportion that the recognized revenues bear to the total estimated lifetime revenues of the theatrical release.

Film Facility

The film facility enables us to independently finance the development and production of up to ten feature films, including films that may feature the following Marvel characters, whose theatrical film rights are pledged as collateral to secure the film facility:

 

Iron Man and The Incredible Hulk, included in the above list, were added to the film facility during the quarter ended September 30, 2006. Also included as collateral for the film facility are the theatrical film rights to many of the supporting characters that would be most closely associated with the featured characters and character families. For example, the theatrical film rights to Captain America’s sidekick, Bucky Barnes, and his nemesis, Red Skull, are both pledged as collateral to the film facility.

 

 

 

 

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We expect to fund, from working capital and other sources, the incremental overhead expenses and costs of developing each film to the stage at which the conditions for an initial borrowing for the film are met under the film facility. At that stage, if the film’s initial funding conditions are met, we will be able to borrow under the film facility an amount equal to the incremental overhead expenses incurred by us related to that film in an amount not exceeding 2% of the budget for that film under the film facility, plus development costs. If the initial funding conditions are not met, we will be unable to borrow these amounts under the film facility. On February 27, 2007, Iron Man met its initial funding conditions and an initial funding of the production of that film was made.

We recorded expenses (primarily interest expense) related to the film facility of $14.5 million and $4.0 million during the year ended December 31, 2006 and 2005, respectively. We expect that our interest and other expenses related to the film facility will increase in 2007. We are capitalizing, and not treating as expense, other amounts to develop the films for which borrowings are expected to be made under the film facility. In addition, interest charges associated with borrowings to fund the productions will also be capitalized. During 2006, interest associated with film productions of $0.2 million was capitalized and is included in film inventory on the accompanying consolidated sheet. As of December 31, 2006, $15.1 million has been capitalized associated with concept development and pre-production costs of various film projects associated with the above Marvel characters, of which $11.3 relates to Iron Man.

While theatrical films featuring the characters listed above may be financed and produced by us only through the film facility, we retain all other rights associated with those characters. In addition, we may continue to license our other characters for movie productions by third parties, obtain financing to produce movies based on those other characters ourselves or with others or, with the consent of the film facility lenders, finance and produce films based on those other characters through the film facility.

Our Results of Operations

Year ended December 31, 2006 compared with the year ended December 31, 2005

Net Sales

Our net sales are generated from (i) licensing the Marvel characters for use on consumer products, promotions, feature films, television programs, theme parks and various other areas; (ii) publishing comic books and trade paperbacks, including related advertising revenues; and (iii) selling our toys.

 

 

 

 

 

 

 

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Our consolidated net sales of $351.8 million for 2006 were $38.7 million lower than net sales in 2005. A 45% decrease in Licensing segment sales was partially offset by a 17% increase in Publishing segment sales and a 71% increase in Toy segment sales.

Licensing segment net sales decreased $102.9 million during 2006. The decreases were in domestic merchandise licensing ($79.1 million), Joint Venture licensing ($20.6 million) and Studio media licensing ($8.0 million). The reduction in domestic revenues resulted from a decline in new and renewal contract revenues in 2006. Included in 2005 Licensing segment net sales was $50 million from the extension of an interactive game license. Also, the 2006 licensing program for the theatrical release of X-Men: The Last Stand did not generate as much in merchandise royalties as the 2005 program for the theatrical release of Fantastic Four. The Joint Venture (associated with licensing around Spider-Man movies) had revenue of only $4.1 million in 2006, primarily related to licensing overages collected in 2006 from the July 2004 release of Spider-Man 2. Studio media licensing revenues decreased as a result of fewer movie releases and the timing of payments for major theatrical releases: significant revenues from Spider-Man and X-Men movie properties were recorded in 2005 as compared to smaller revenues from the Fantastic Four movie property in 2006. These decreases were partially offset by increased revenues from international licensing ($5.3 million) caused by overage increases net of a decline in new and renewal contract revenues. The net decrease in Licensing segment net sales, combined with higher net sales generated from the Publishing and Toy segments, caused Licensing segment net sales to decline as a percentage of consolidated net sales. We expect that 2007 revenues in our Licensing segment will increased compared to 2006. Consequently, license revenues as a percentage of consolidated net sales, are also expected to increase due to the licensing programs for the three Marvel-branded motion pictures released or scheduled for release in 2007, Spider-Man 3, Fantastic Four: Rise of the Silver Surfer and Ghost Rider.

Net sales from the Publishing segment increased $16.1 million to $108.5 million for 2006. Of the increase, $7.5 million was in sales of trade paperbacks and hard cover books into the direct and book market channels and $6.4 million was in comic book sales into the direct market. Comic book increases were primarily due to strong sales associated with Civil War, a limited special comic book series which has tie-ins to established comic book series. 2006 also benefited from the April 2006 increase in the cover price of comic books, which accounted for $1.5 million of the comic book increase noted above. In addition, custom publishing revenue increased $1.1 million for 2006. These increases also caused Publishing segment net sales to increase as a percentage of consolidated net sales. We expect that the Publishing segment net sales will continue to benefit from the Civil War series and strong sales of related trade paperbacks and hard cover books in 2007.

In 2005, Toy segment net sales consisted mostly of royalty and service fee revenues earned from TBW. As a result of terminating the TBW license at the end of 2005, 2006 Toy segment net sales of $116.1 million were based on our sales to retailers. Primarily as a result of this change, Toy segment net sales increased $48.1 million compared to the prior year period and also increased as a percentage of consolidated net sales. Those increased revenues, however, reflect a decrease in sales to retailers compared to 2005. In 2005, Toy segment net sales included $51.8 million of royalty and service fee revenue earned by us associated with TBW’s sales to retailers. Sales to retailers decreased from $185.1 million in 2005 to $116.1 million in 2006 partly because of the launch of the Fantastic Four movie toy line in 2005 and also due to the transition from TBW, which disrupted production and caused cancellations of certain sales orders. We expect that in 2007 (when several films featuring Marvel characters are scheduled for release, as described above) Marvel-branded toys will be more significant at retail than in 2006. Toy segment net sales in 2007 will consist primarily of royalty and service fee revenues earned from Hasbro. We anticipate that Toy segment net sales will decrease as a percentage of consolidated net sales in 2007 due to significantly higher licensing revenue, as described above. During the fourth quarter of 2006, we recorded $5.2 million of royalty and service revenue from Hasbro.

 

 

 

 

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Cost of Revenues

 

 

Consolidated cost of revenues increased $53.1 million to $103.6 million for 2006 compared with 2005, primarily due to increased toy-production costs, resulting from our direct manufacture and sale of toys formerly licensed to TBW. Consequently, our consolidated cost of revenues as a percentage of sales increased to 29% for the year ended December 31, 2006, as compared to 13% in the comparable 2005 period.

Publishing segment cost of revenues for comic book and trade paperback publishing consists of art, editorial, and printing costs. Art and editorial costs, consisting of compensation to editors, writers and artists, account for the most significant portion of publishing cost of revenues. We generally hire writers and artists on a non-exclusive freelance basis but we also have exclusive contracts with certain key writers and artists. In addition, we contract-out the printing of our comic books to unaffiliated companies and these costs are subject to fluctuations in paper prices. Publishing segment cost of revenues as a percentage of Publishing segment net sales remained consistent at 44% in 2006 and 2005. Rising costs of talent and paper costs in 2006 were offset by higher unit sales of comic books, which more effectively absorb these costs. In addition, we instituted price increases (in April 2006) on certain comic book titles to help offset the rising talent and paper costs. The increase in cost of revenue of $6.2 million from $41.0 million to $47.2 million is primarily associated with increased sales.

Toy segment cost of revenues consists of product and package manufacturing, shipping and agents' commissions. The most significant portion of cost of revenues is product and package manufacturing. The increase in Toy segment cost of revenues from 14% of Toy segment net sales during 2005 to 49% during 2006 reflects manufacturing costs to produce toys formerly produced under license by TBW, for which we incurred no manufacturing costs. We expect that Toy segment cost of revenue will decrease in 2007, both in dollars and as a percentage of Toy segment net sales, when Hasbro will be manufacturing Marvel-branded toys.

 

 

 

 

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Selling, General and Administrative Expenses

 

 

Consolidated selling, general and administrative (“SG&A”) expenses of $123.1 million in 2006 were $43.4 million below SG&A expenses in 2005, primarily due to the reduction in Licensing SG&A described below. Consolidated SG&A as a percentage of net sales decreased to 35% in 2006, from 43% in 2005.

Licensing segment SG&A expenses consist primarily of payroll and of royalties owed to movie studios for their share of license royalty income, which is a variable expense based on licensing revenues. We pay movie studio licensees up to 50% of merchandising-based royalty revenue from the licensing of both “classic” and “movie” versions of characters featured in the films. Licensing segment SG&A expenses of $49.2 million for 2006 were $37.9 million below the prior year principally as a result of a $27.1 million decrease in royalty provisions to studios due to the decline in Licensing revenue, and a one-time $10 million charge in 2005 associated with the settlement of litigation. As a percentage of Licensing segment net sales, Licensing segment SG&A increased slightly from 38% to 39%. We expect that SG&A will decline as a percentage of sales in 2007 as significant licensing revenue will be derived from the Joint Venture, for which Sony Pictures’ share of the Joint Venture’s licensing activities is reflected as minority interest expense rather than royalty provisions to studios.

Publishing segment SG&A expenses consist primarily of payroll, distribution fees and other miscellaneous overhead costs. Publishing segment SG&A expenses increased $2.1 million in 2006 over 2005, principally due to increased distribution fees associated with increased sales. Publishing segment SG&A expenses as a percentage of Publishing segment net sales remained consistent at 16%.

Toy segment SG&A expenses consist primarily of payroll, advertising, development costs, royalties payable to movie studios for their share of certain toy sales, and royalties payable on toy sales based on characters licensed from third parties, such as Universal Studios Licensing LLLP (licensor of the Curious George character), and on toys developed by outside inventors. Toy segment SG&A expenses decreased $11.5 million in 2006 principally as a result of reduced advertising ($9.8 million), lower salaries and related expenses ($1.2 million) due to lower infrastructure and the non-recurring expense in 2005 for the early termination of TBW ($12.5 million). These decreases were partially offset by the absence of SG&A reimbursements from TBW ($7.5 million) and increased warehousing fees ($1.1 million), as a result of our manufacturing and distributing a higher volume of our own products. In addition, during 2006 we established reserves for uncollectible amounts due from TBW in the amount of $2.6 million, and realized a loss of $0.8 million from the sale of our Mexican land and building. The net decrease in expense, combined with the increased Toy segment sales, caused Toy segment SG&A expenses to decrease as a percentage of Toy segment sales from 58% in 2005 to 24% in 2006.

SG&A for our Film Production segment consists primarily of employee compensation and the allocated SG&A associated with our California office. The Film Production segment was created in September 2005, upon execution of the film facility. There were no significant SG&A costs within the Film Production segment in 2005.

 

 

 

 

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Corporate overhead expenses in 2006 decreased $2.1 million compared with 2005 due to decreases in legal fees and settlements ($5.6 million) and charitable donations ($2.5 million), partially offset by increases in compensation expense of $6.2 million primarily related to the accounting for stock options and increased executive compensation.

Depreciation and Amortization

Depreciation and amortization expense increased $9.8 million to $14.3 million in 2006 (from $4.5 million in 2005) as a result of increased tooling required for our production of toys and the short period of time over which the majority of these costs were being amortized in 2006. Tooling, product design and packaging design costs attributable to the toy business, are normally amortized over the estimated life of the respective products, which typically range from one to three years. As a result of the year-end 2006 transition to Hasbro, the life of the tooling, product design and development and packaging design costs associated with Marvel character-based toys expired by year-end 2006, as we will no longer be producing these toys.

We account for our goodwill under the provisions of SFAS No. 142, “Goodwill and Other Intangible Assets” (“SFAS 142”). Accordingly, goodwill is no longer amortized but is subject to annual impairment tests. Our most recent annual impairment review did not result in an impairment charge.

Other Income

Other income decreased $0.4 million to $1.8 million in 2006 (from income of $2.2 million in 2005), primarily as a result of a decline in the fair value of our interest rate cap associated with our film facility. Changes in the cap’s fair value are recorded as other income. During 2006, the cap’s fair value decreased by $1.5 million. During 2005, the cap’s fair value increased by $0.3 million. This $1.8 million decrease in the year-to-year changes of the interest rate cap’s fair value was partially offset by payments received aggregating $1.6 million for our agreement to vacate leased property earlier than provided for in a lease and for another agreement to allow our tenant to vacate property owned by us earlier than provided for in our lease.

Operating Income

 

 

Consolidated operating income decreased $58.6 million to $112.6 million in 2006, primarily due to lower sales in the Licensing segment, which generates the highest margins. This also resulted in decreased operating margins from 44% in 2005 to 32% in 2006.

 

 

 

 

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Operating margins decreased slightly in the Licensing segment from 62% in 2005 to 61% in 2006 as a result of lower overall licensing sales and a revenue mix that was lower in high-margin Joint Venture licensing. The margins of Joint Venture licensing are higher than others in the Licensing segment because Sony’s share of the Joint Venture’s operating results is classified as minority interest expense whereas royalty expense due to other studios is recorded within SG&A expense. The decrease caused by the changes in revenue noted above were partially offset by reduced SG&A costs allocated to the Film Production segment, which were previously recorded in the Licensing segment.

Operating margins improved slightly for the Publishing segment from 39% in 2005 to 41% in 2006 due to comic book and trade costs increasing proportionately with increased sales.

Operating income in the Toy segment increased $5.6 million in 2006 compared with 2005 predominantly due to the $12.5 million non-recurring expense in 2005 for the early termination of TBW. Operating margins decreased to 18% in 2006 from 23% in 2005 predominantly as a result of the margin being calculated on sales to retailers in 2006, compared with margins calculated on royalty and service fee income in 2005.

The Film Production operating costs reflect the SG&A costs noted above and the $1.5 million decline in the fair value of our interest rate cap associated with our film facility.

Interest Expense

We had interest expense of $15.2 million in 2006, compared to interest expense of $4.0 million in 2005. The $11.2 million increase in net interest expense is a result of borrowings related to the film facility and borrowings under the HSBC Credit Facility. Borrowings under the HSBC Credit Facility were repaid in early January 2007. Borrowings under the film facility commenced in September 2005.

Interest Income

Interest income reflects amounts earned on our cash equivalents and short-term investments. Interest income decreased $2.4 million to $1.5 million in 2006 (from $3.9 million in 2005).

Income Taxes

Our effective tax rate differs from the federal statutory rate due to the effects of state and local taxes, income taxes related to the minority share of the Joint Venture, and income taxes related to unremitted foreign earnings. Our effective tax rates for the years ended December 31, 2006 and 2005 were 39.5% and 36.7%, respectively. The 2.8% increase in the effective tax rate primarily results from several factors with partially offsetting impacts. The effective rate increased 1.7% due to unremitted foreign earnings, increased 1.4% for foreign taxes, and increased 3.1% as a result of the Joint Venture (discussed below). These increases were partially offset by a decrease in state and local taxes of 2.7%, attributable primarily to a reduction in state tax reserves, and a decrease of 0.8% attributable to valuation allowance changes.

We are not responsible for the income taxes related to the minority share of the Joint Venture income, and as such, our tax rate is reduced for the taxes associated with the minority share of the Joint Venture income, which lowers our effective tax rate. The impact of this reduction to our effective tax rate is greater in periods when the operating results of the Joint Venture are higher (2004) and lesser in periods when the operating results of the Joint Venture are lower (2005-2006). For 2005, the reduction in our tax rate related to the minority interest share of Joint Venture income also includes the benefit of the correction of 2004 tax expense related to the Joint Venture, a 1.9% decrease to the 2005 tax rate.

 

 

 

 

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We retain various state and local net operating loss carryforwards of $411 million, which will expire in various jurisdictions in the years 2007 through 2026. As of December 31, 2006, there is a valuation allowance of $1.1 million against certain capital, state, and local net operating loss carryforwards, as it is more likely than not that such assets will not be realized in the future. The net change in the valuation allowance during the year ended December 31, 2006 was a decrease of $1.5 million, of which $0.2 million affected income and $1.7 million was recorded against our related deferred tax assets that were deemed to be permanently unrealizable.

We or one of our subsidiaries file income tax returns in the U.S. federal jurisdiction, and various state, local and foreign jurisdictions. We are no longer subject to tax examinations in any jurisdiction for the 2002 and prior tax years. The Internal Revenue Service has recently commenced an examination of our 2003 through 2005 tax years.

We are also under examination by various other local jurisdictions.

Minority Interest

Minority interest expense, related to the Joint Venture, amounted to $1.0 million in 2006 and $5.4 million in 2005. This decrease of $4.4 million reflects the continued decreased operations from licensing associated with the July 2004 release of Spider-Man 2. Minority interest expense is expected to increase in 2007, as significant licensing revenues associated with the May 2007 release of Spider-Man 3 are recognized.

Earnings per Share

Diluted earnings per share declined from $0.97 in 2005 to $0.67 in 2006 reflecting an 43% decrease in net income partially offset by a 18% reduction in the weighted average number of shares outstanding due to the effect of the treasury share repurchases of 15.6 million shares made in 2006.

 

 

 

 

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Year ended December 31, 2005 compared with year ended December 31, 2004

Net Sales

Our net sales are generated from (i) licensing the Marvel characters for use on consumer products, promotions, feature films, television programs, theme parks and various other areas; (ii) publishing comic books and trade paperbacks, including related advertising revenues; and (iii) marketing and distributing our toys, including, during 2005, 2004 and 2003, Spider-Man movie toys and toys based on characters from the Lord of the Rings movie trilogy, and, until mid-2003, kites through our former Spectra Star product line.

 

 

 

Our consolidated net sales of $390.5 million for the year ended December 31, 2005 were $123.0 million lower than net sales in 2004, due to decreased sales from the Toy segment.

2005 Licensing net sales increased in absolute dollars and as a percentage of total net sales due to continued momentum in domestic and international contract renewals, which offset a decline in licensing related to the Spider-Man 2 movie. The overall increase in Licensing segment sales of $15.4 million was due to increases in domestic ($54.7 million) and international ($3.5 million) licensing, which were partially offset by a decrease in licensing by the Joint Venture. For the year ended December 31, 2005, the Joint Venture generated $24.7 million of sales compared with $67.5 million recorded by us for the period from April 1, 2004 (the initial date the Joint Venture was consolidated) through December 31, 2004. Included in the 2005 licensing results was $50 million from the extension of an interactive game license during the quarter ended December 31, 2005.

Sales from the Publishing segment increased $6.4 million to $92.4 million for the year ended December 31, 2005 primarily due to $5.1 million of higher sales of trade paperbacks and comic books into the direct market channel.

 

 

 

 

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Toy revenues shifted in 2005 from lines for which we record the wholesale value as sales, such as Spider-Man movie toys, to lines for which a royalty and service fee are recorded as sales, such as Fantastic Four toys. The main toy line in 2005 was Fantastic Four movie toys, which was produced by TBW under our license and for which only the royalty and service fee percentages of the wholesale sales price were recorded as revenue. Sales from the Toy segment decreased $144.8 million to $68.0 million in the year ended December 31, 2005, and also decreased as a percentage of total net sales, as sales of toys based on Spider-Man 2 decreased by $170.0 million in 2005 due to the movie’s release in June 2004 and limited carry forward into 2005. Sales of action figures and accessories based on the Lord of The Rings movies also declined $12.6 million to $7.7 million. These decreases were partially offset by an increase in royalty and service fee revenue from $15.2 million in 2004 to $51.8 million in 2005 derived from licensed toy sales made by TBW, primarily resulting from increased sales of toys based on the Fantastic Four movie and classic Spider-Man.

Cost of Revenues

 

 

Consolidated cost of revenues decreased $109.1 million to $50.5 million for the year ended December 31, 2005, primarily due to decreased toy-production costs, resulting from lower direct sales of action figures and accessories associated with the July 2004 theatrical release of Spider-Man 2. Consequently, our consolidated cost of revenues as a percentage of sales decreased to 13% for the year ended December 31, 2005, as compared to 31% in 2004.

Publishing segment cost of revenues for comic book and trade paperback publishing consists of art, editorial, and printing costs. Art and editorial costs account for the most significant portion of publishing cost of revenues. Art and editorial costs consist of compensation to editors, writers and artists. We generally hire writers and artists on a freelance basis but have exclusive contracts with certain key writers and artists. We contract-out the printing of our comic books to unaffiliated companies. Our cost of printing is subject to fluctuations in paper prices. Publishing cost of revenues as a percentage of sales was relatively stable, increasing from 43% in 2004 to 44% in 2005. Cost of revenue increased slightly as a result of higher talent expenses for comic books and higher printing costs that were primarily driven by increased paper costs, offset by a higher proportion of publishing net sales of trade paperbacks, which have lower talent costs.

Toy segment cost of revenues consists of product and package manufacturing, shipping and agents' commissions. The most significant portion of cost of revenues is product and package manufacturing. The decrease in Toy cost of revenues from 58% of net sales during the year ended December 31, 2004 to 14% during the year ended December 31, 2005 reflects a change from sales by us of action figures and accessories based on characters associated with Spider-Man 2 to royalties and service fees received from TBW’s sales, for which there are no production costs.

 

 

 

 

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Selling, General and Administrative Expenses

 

 

Consolidated selling, general and administrative (“SG&A”) expenses increased $23.7 million to $166.5 million for the year ended December 31, 2005, primarily due to a $12.5 million charge included in the Toy segment associated with the early termination of the license with TBW in the fourth quarter of 2005. Included in the Licensing segment, an $11.7 million increase in studio royalty share expenses payable to studios, related to higher sale of movie related products. Consolidated SG&A as a percentage of net sales increased to 43% for the year ended December 31, 2005 as compared to 28% for the year ended December 31, 2004, as a result of this increase in SG&A and the decrease in consolidated net sales.

Licensing segment SG&A expenses consist primarily of payroll and royalties owed to movie studios for the studios’ share of royalties. We generally pay movie studio licensees up to 50% of merchandising-based royalty revenue from the licensing of both “classic” and “movie” versions of characters featured in the film. Licensing segment SG&A increased $17.1 million (24%) as a result of a $5.4 million increase, primarily in compensation for senior executives, coupled with the increase in the studio share expense. As a percentage of sales, licensing SG&A increased to 38% during the year ended December 31, 2005 from 33% in the prior year as a result of a decline (from 31% in 2004 to 11% in 2005) in revenues derived from the Joint Venture, for which Sony Pictures’ share of the Joint Venture’s licensing activities is reflected as minority interest expense.

Publishing SG&A expenses, consisting primarily of payroll, distribution fees and other miscellaneous overhead costs, remained relatively flat as an absolute dollar value and percentage of net sales.

Toy segment SG&A expenses consist primarily of payroll, advertising, development costs, merchandise royalties payable to movie studios for their share of license income, and royalties payable on toys based on characters licensed from third parties, such as New Line Cinema (licensor of the Lord of the Rings characters), and on toys developed by outside inventors. Toy segment SG&A expenses increased $9.5 million to $39.5 million for the year ended December 31, 2005 from $30.0 million for the year ended December 31, 2004 as a result of the charge related to the early termination of the license with TBW. This was partially offset by a $2.4 million decline in royalty fees owed to studios, due to the reduction of direct sales of action figures and accessories based on characters associated with Spider-Man 2. Toy segment SG&A expenses increased as a percentage of sales from 14% during the year ended December 31, 2004 to 58% during the year ended December 31, 2005, primarily as a result of the decline in Toy sales.

Corporate overhead expenses, consisting primarily of payroll, rent and legal costs associated with active litigation matters, decreased $3.9 million for the year ended December 31, 2005 principally due to lower legal fees.

 

 

 

 

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Depreciation and Amortization

Depreciation and amortization expense increased $0.7 million to $4.5 million in 2005 (from $3.8 million in the 2004). Tooling, product design and development and packaging design costs, which are attributable to the toy business, are normally amortized over the estimated life of the respective product.

We account for our goodwill under SFAS 142. Accordingly, goodwill is no longer amortized but is subject to annual impairment tests (See Note 2 to the Consolidated Financial Statements). Our annual impairment reviews did not result in an impairment charge.

Other Income

Other income decreased $6.8 million to $2.2 million in 2005 (from $9.0 million in 2004). This decrease reflects insurance collections in 2004 totaling $5.0 million as well as $2.4 million in gains recorded in 2004 in the Publishing segment for settlements related to the bankruptcy of Marvel Entertainment Group, Inc. We acquired Marvel Entertainment Group in 1998.

Equity in Net Income of Joint Venture

For the year ended December 31, 2004, we recognized $8.1 million in equity income related to the Joint Venture. In early 2004, we and Sony Pictures resolved litigation and mutually agreed to restructure the Joint Venture. This resulted, commencing April 1, 2004, in the consolidation of the operations of the Joint Venture in our Licensing segment, rather than accounting for our share of the Joint Venture operations under the equity method.

Operating Income

 

 

Consolidated operating income decreased $53.2 million to $171.2 million for the year ended December 31, 2005, primarily due to the lower sales in the Toy segment. As a percentage of sales, consolidated operating margins for the year ended December 31, 2005 were consistent with the consolidated operating margins for the year ended December 31, 2004.

Operating margins decreased in the Licensing segment from 71% in 2004 to 62% in 2005 as a result of higher costs. Such higher costs were primarily due to increased compensation for senior executives and increased studio share expenses associated with higher domestic and international sales. The margin was further reduced by the decrease in sales generated from the Joint Venture. The studio share expense associated with Joint Venture revenues is classified as minority interest expense, and therefore, such revenues have higher margins than other License segment revenue streams, where the related royalty expense payable to studios is recorded within SG&A expense.

Operating margins decreased in the Publishing segment from 43% in 2004 to 39% in 2005 as a result of non-recurring gains ($2.4 million) in 2004 associated with the wrap-up of claims in the bankruptcy of Marvel Entertainment Group.

 

 

 

 

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Operating margins decreased in the Toy segment to 23% in 2005 from 27% in 2004 as a result of a $12.5 million charge related to the early termination of TBW, which was only partially offset by an increase in higher- margin royalty and service fee revenue from licensed toy sales.

Interest Expense

We had interest expense of $4.0 million for the year ended December 31, 2005, compared to interest expense of $20.5 million for the year ended December 31, 2004. This reduction in interest expense resulted principally from the redemption of our 12% senior notes on June 15, 2004, including a non-recurring charge of $3.2 million associated with the accelerated write-off of previously unamortized deferred financing costs, and a non-recurring charge of $9.0 million related to the 6% premium stipulated by the terms of the redemption. Interest expense in 2005 is associated with borrowings under the film facility.

Interest Income

Interest income reflects amounts earned on our cash equivalents and short-term investments. Interest income increased $1.0 million to $3.9 million in 2005 (from $2.9 million in 2004).

Out-of-Period Adjustment

 

During the fourth quarter of 2005, we identified errors of $3.3 million in our 2004 consolidated income tax expense related to an accounting entry made in connection with book and tax basis differences related to the Joint Venture as of April 1, 2004 and the tax impact of our share of Joint Venture earnings for the period April 1, 2004 through December 31, 2004. We corrected these errors in the 2005 year-end close process, which had the effect of reducing 2005 consolidated income tax expense by $3.3 million and increasing 2005 consolidated net income by $3.3 million. We do not believe this adjustment is material to the consolidated financial statements for the years ended December 31, 2005 or 2004, and as a result we have not restated our consolidated financial statements for the year ended December 31, 2004.

Income Taxes

Our effective tax rate differs from the federal statutory rate due to the effects of state and local taxes, the recognition of tax benefits relating to state and local net operating losses, income taxes related to the minority share of the Joint Venture, and federally tax-free investment returns. Our effective tax rates for the years ended December 31, 2005 and 2004 were 36.7% and 31.2%, respectively. The 5.5% increase in the effective tax rate results from several factors with offsetting impacts. The effective rate increased 4% due to an increase in reserves for potential state and local exposures and increased another 4% due to additional valuation allowances established for deferred tax assets in 2005 compared to valuation allowance reversals in 2004. The decreased operating results from the Joint Venture contributed 1.8% of the increased rate, as discussed below. These rate increases were partially offset by the $3.3 million out-of-period tax benefit (1.9% decrease to rate) related to the Joint Venture, as discussed above, and a 1.4% decrease to the rate as a result of higher federally tax exempt interest income during 2005 than in 2004.

We are not responsible for the income taxes related to the minority share of the Joint Venture income, and as such, our tax provision has been reduced for the benefit associated with the minority share of the Joint Venture income, which lowers our effective tax rate. The impact of this reduction on our effective tax rate is greater in periods when the operating results of the Joint Venture are higher and lesser in periods when the operating results of the Joint Venture are lower.

 

 

 

 

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We completely utilized our federal net operating loss carryforwards in 2004. We retain various state and local net operating loss carryforwards of $322 million, which will expire in various jurisdictions in the years 2006 through 2023. As of December 31, 2005, there is a valuation allowance of $2.6 million against certain capital, state and local, and foreign net operating loss carryforwards, as it is more likely than not that such assets will not be realized in the future. The net change in the valuation allowance during the year ended December 31, 2005 was an increase of $1.7 million.

We are under examination by various local jurisdictions.

Minority Interest

Minority interest expense, related to the Joint Venture, amounted to $5.4 million in 2005 and $17.4 million in 2004. This decrease of $12.0 million reflects the decreased operations of the Joint Venture subsequent to the July 2004 release of Spider-Man 2.

Earnings per Share

Diluted earnings per share declined from $1.10 in 2004 to $0.97 in 2005 reflecting an 18% decrease in net income partially offset by a 7% reduction in the weighted average number of shares outstanding due to the effect of the treasury share repurchases of 16.2 million shares made in 2005.

Liquidity and Capital Resources

Our primary sources of liquidity are cash and cash equivalents, cash flows from operations, our film facility, the HSBC Credit Facility (defined below) and the $32.0 million Iron Man facility described below. We anticipate that our primary uses for liquidity will be to conduct our business and to repurchase our common stock.

Net cash provided by operating activities increased $20.5 million to $158.2 million during the year ended December 31, 2006, compared to $137.7 million during the prior year primarily due to the receipt of an advance of $105 million paid by Hasbro under its license. The advance was classified as deferred revenue, and was partially offset by payments made in connection with the termination of the TBW license and interest payments. The Hasbro payment more than offset the decrease in cash that was due to a 34% decrease in operating income. Net cash provided by operating activities decreased $23.7 million to $137.7 million for the year ended December 31, 2005, compared to $161.4 million for the year ended December 31, 2004, primarily because we fully utilized our federal net operating loss carryforwards in early 2004, resulting in the generation of larger current tax obligations during 2005. Income tax payments (net of refunds) in 2005 totaled $68.9 million, compared with $48.1 million in 2004. In addition, we had a $7.9 million increase in cash distributions to the Joint Venture partner in 2005 versus 2004. These increased operating cash outflows were partially offset by strong collections on accounts receivable during 2005.

We had working capital of ($58.6) million and $2.5 million at December 31, 2006 and 2005, respectively, a decrease of $61.1 million. This decrease in working capital is primarily the result of our using short-term investments and operating cash to finance our stock repurchase plan described below and the increase in current deferred revenue related to Spider-Man 3 merchandise licensing, which is expected to be recognized as revenue during the first half of 2007 as licensees are permitted to begin exploiting their licenses in advance of the release of Spider-Man 3. Deferred revenue related to Spider-Man 3 merchandise licensing was less at December 31, 2005 than December 31, 2006 and was classified as long-term.

Net cash flows from investing activities for the year ended December 31, 2006 reflect the sale of short-term investments to finance our common stock repurchase program and the sale of property we owned in Mexico, partially offset by capital expenditures of $16.3 million, principally required by our transition from the TBW license. Net cash flows from investing activities for the year ended December 31, 2005 reflect the sale of short-term investments to finance our common stock repurchase program described below. Net cash flows from investing activities for the year ended December 31, 2004 reflect the sale of short-term investments to repay long-term debt and finance our common stock repurchase program described below.

 

 

 

 

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Early in 2004, we had outstanding senior notes due June 15, 2009, which bore interest at 12% per annum. We redeemed all of these notes on June 15, 2004 with available cash resources, which resulted in a non-recurring charge of $3.2 million associated with the accelerated write-off of previously unamortized deferred financing costs, and a non-recurring charge of $9.0 million related to the 6% premium stipulated by the terms of the redemption, both recorded during the second quarter of 2004.

During 2006, we repurchased 15.6 million shares of our common stock at a cost of $287.4 million under stock repurchase programs authorized in November 2005, and May 4 and June 5, 2006. The 2006 repurchases were financed through the sale of short-term investments, cash generated from operations and borrowings under the HSBC Credit Facility (defined below). During the year ended December 31, 2005, we repurchased 16.2 million shares of our common stock at a cost of $304.5 million (including $7.4 million for repurchases settled in January 2006) under two stock repurchase programs. During 2004, we spent $58.0 million for the repurchase of our common stock. The 2005 and 2004 repurchases were financed through the sale of short-term investments and cash generated from operations. As of March 1, 2007, $50.0 million remains authorized to repurchase outstanding shares of stock.

MVL Film Finance LLC maintains a $525 million credit facility for the purpose of producing theatrical motion pictures based on Marvel’s characters. The film facility consists of $465 million in revolving senior bank credit and $60 million in credit referred to as mezzanine debt, which is subordinated to the senior bank debt. Both Standard & Poor’s, a division of the McGraw-Hill Companies, Inc., and Moody’s Investor Rating Service, Inc. have given the senior bank debt an investment grade rating. In addition, Ambac Assurance Corporation has insured repayment of the senior debt, raising its rating to AAA. The rate for the senior bank credit, including Ambac’s fees, is LIBOR or the commercial paper rate, as applicable, plus 1.635%. The interest rate for the mezzanine debt is LIBOR plus 7.00%. We entered into an interest rate cap agreement in connection with the film facility whereby LIBOR is capped at 6.0% for outstanding debt under the film facility up to certain stipulated notional amounts which vary over the term of the film facility. Pursuant to the terms of the financing, the mezzanine credit will be drawn on first and will remain outstanding for the life of the senior bank facility. As of December 31, 2006, MVL Film Finance LLC had $33.2 million ($25.8 million at December 31, 2005) in outstanding mezzanine borrowings through the film facility. The borrowings were used primarily to finance transaction costs, and interest thereon, related to the development and closing of the facility. We must comply with a minimum tangible net worth covenant and various administrative covenants. In addition, conditions to the initial funding of the fifth film to be produced under the film facility, and each film thereafter, are the satisfaction of an interim asset test and foreign pre-sales test, as defined in the film facility. We have maintained compliance with our covenants under the film facility since its inception.

We generate pre-sale proceeds from distributors in the Reserved Territories who buy from us the right to distribute our films there. As contemplated by the film facility, we intend to use Iron Man’s pre-sale proceeds to fund the production of that film. Most of the payments from our foreign distributors, however, are not due until after production is complete. In order to bridge the gap between Iron Man’s production and the distributors’ payment, we closed a $32.0 million financing on February 27, 2007. The financing was closed through our wholly-owned consolidated subsidiary, Iron Works Productions LLC, and may be used to partially fund the production of our Iron Man feature film.  Borrowings under this facility are non-recourse to us and our affiliates other than with respect to the collateral pledged to this facility, which consists of various affiliated film companies’ rights to distribute the Iron Man film in the territories of Australia/New Zealand, Spain, France, Germany and Japan and the contracts that our affiliate, MVL Productions LLC, has entered into with third-party distributors to distribute Iron Man in these territories.  This facility, which expires on July 25, 2008 or sooner if an event of default occurs, consists of $32.0 million in bank debt but contains a $2.5 million interest reserve that will prevent us from borrowing the full amount. The rate for borrowings under this facility is the bank’s prime rate or LIBOR plus 1%, at our election.  The facility contains customary event-of-default provisions and covenants regarding our film-related affiliates, the production of the Iron Man movie and our ownership of the intellectual property underlying the Iron Man movie.

 

 

 

 

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We maintain a credit facility with HSBC Bank USA, National Association, as amended, to provide for a $125 million revolving credit line (this amount decreases to $100 million on March 31, 2007) with a sub limit for the issuance of letters of credit. Borrowings under the HSBC Credit Facility may be used by us for working capital and other general corporate purposes and for repurchases of our common stock. As of December 31, 2006, $0.3 million of letters of credit were outstanding, and borrowings under the HSBC Credit Facility aggregated $17.0 million, which we repaid in January 2007. The HSBC Credit Facility, which expires on March 31, 2008, contains customary event-of-default provisions and covenants regarding our net worth, leverage ratio, and free cash flow. The HSBC Credit Facility is secured by a first priority perfected lien in (a) our accounts receivable, our rights under the toy license with Hasbro and (c) all of our stock repurchased by us after November 9, 2005, the date of the HSBC Credit Facility. Borrowings under the facility bear interest at HSBC’s prime rate or, at our choice, at LIBOR-plus-1.25% per annum. We have maintained compliance with our covenants under the credit facility since its inception.

During the second quarter of 2006, there was an unusually high amount of nonqualified stock option exercises. These exercises, which generate tax deductions, have put us into a federal tax loss position in 2006. As a result, in January 2007 we received a refund of estimated taxes previously paid with respect to the 2006 year in the amount of $19.0 million and we expect to secure an additional $22.5 million refund of tax resulting from the carryback of the 2006 year tax loss to offset taxable income in prior years and a $4.8 million refund of tax resulting from a carryback of foreign tax credits to offset taxes paid in prior years. These refunds are expected to be received in 2007.

Capital expenditures by us during the years ended December 31, 2006, 2005 and 2004 were $16.3 million, $4.3 million and $3.6 million, respectively.

The following table sets forth our contractual obligations as of December 31, 2006:

 

 

*Scheduled repayment based on the minimum expected term of the film facility. Such amount may be repaid earlier depending on the success of theatrical releases under the film facility.

We believe that our cash and cash equivalents, cash flows from operations, the film facility, the HSBC Credit Facility, the Iron Man facility and other sources of liquidity will be sufficient for us to conduct our business and repurchase our common stock in accordance with such authorizations as may be provided by our Board of Directors.

 

 

 

 

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