This Day in Pixar History: Pixar's 1998 Annual Report

As I am fond of doing, let's step back about 17 years to early 1999, when Pixar released their 1998 annual report. 1998 was an exciting year for Pixar. Early in the year it won an Academy Award for its short film Geri's Game, and in November they had released their second feature length film, A Bug's Life. The film was an immediate success, opening at #1 in late November with over $33 million and going on to be the 4th highest grossing film of 1998 with over $363 million worldwide. But looking at the annual report you might not believe it - revenues declined almost 59% to $14.3 million from $34.7 million in 1997, and net income dropped over 64% from $22.2 million to $7.8 million. This was because Pixar hadn't received any revenue yet from A Bug's Life, and according to the Co-Production Agreement with Disney, Disney was allowed to recover all marketing and distribution costs before any remaining revenue was shared equally between the two. Pixar didn't expect to start receiving money from A Bug's Life until the second half of 1999.

Annual reports are full of lots of interesting details. Here are a just a few in Pixar's 1998 report:

•  As of January 2, 1999 Pixar had a total of 427 employees.
•  As of March 19, 1999, Steve Jobs owned 30,000,001 shares, or 65.8% of all outstanding shares of Pixar. John Lasseter, the Executive Vice President of Creative Development owned a little over 1 million shares (2.3% of shares outstanding) and Chief Technical Officer Ed Catmull almost 613,000 shares, or 1.3%.
• Pixar was busy working on its new Emeryville headquarters. The company had spent $21.2 million through 1998 on the new studio and expected to spend another $38 million in 1999 and $19 million in 2000.

The annual report also gave a nice summary of Pixar's filmmaking process, stating the process was very iterative and required continued re-working of each film. The report stated the process was divided in 4 stages: Creative Development, Pre-Production, Production and Post-Production. It also discussed their digital backlot, which they equated to a traditional movie studio backlot. For Pixar, it encompassed a database of their digital models that Pixar stated could be used multiple times in future films and other animated products. They also went into their core technology components, consisting of:

• Marionette - The in-house developed system used for modeling, animating and lighting. Also known as Menv, Marionette was replaced by Presto, which was first used on Brave.
• Ringmaster - A complex, distributed system used for scheduling and tracking their animation projects. A key piece of functionality in Ringmaster was its ability to coordinate and schedule the processors in Pixar's render farm.
• RenderMan - The company's award-winning rendering system. Not only does Pixar continue using RenderMan, Pixar licenses it to other studios and third parties, and it has become the de facto industry standard for rendering. RenderMan licensing generated revenues of approximately $3.8 million in 1998.

If you've never read an annual report, companies always include a section on the risks involved with their business. Pixar was no exception, and the report detailed how difficult it was to be successful in creating animated films:

It is rare for animated feature films to achieve extraordinary box office success. We believe, based on available information, that there is a reasonable basis to conclude that of the more than 40 animated feature films introduced since 1990, only two films generated domestic box office revenues greater than A Bug's Life and Toy Story, and both of those films were produced and distributed solely by Disney.

I actually found 3 Disney films that had been released in the 1990s and had done better than A Bug's Life and Toy Story - Aladdin ($217 million), Beauty and the Beast ($219 million) and The Lion King ($423 million).

While also demonstrating the risks involved, this next quote shows just how powerful the Disney and Pixar films were in regards to their competition:

During at least the last five years, we believe The Rugrats Movie is the only fully-animated feature film (other than Toy Story and A Bug's Life) produced or developed by a studio other than Disney that has achieved more than $100 million in domestic box office revenues.

The Prince of Egypt also was released in 1998 and went over the $100 million threshold, making a little over $101 million. The report pointed out though that the animated world was changing and competition was intensifying:

While the release of A Bug's Life was extremely successful, achieving domestic box office revenues over $160 million as of March 28, 1999, Antz, The Rugrats Movie and Prince of Egypt achieved domestic box office revenues of over $91 million, $100 million and $99 million, respectively. These three films were released during or near the 1998 holiday season and directly competed with A Bug's Life. Each of these films was more successful than any preceding animated feature film not released by Disney or Disney and Pixar.

Another section of risks covered availability of key personnel and the possible impact to the schedule of upcoming films:

In addition, John Lasseter, who, while directing A Bug's Life, was providing creative oversight for Toy Story 2 in his role as Executive Vice President, Creative, has now transitioned to the role of Director of Toy Story 2. Using the personnel of future films to meet the immediate deadlines of films nearing release, as we have for both A Bug's Life and Toy Story 2, may have the long term impact of pushing out the targeted release dates of future films, increasing film budgets, and adversely impacting our ability to generate creative concepts for subsequent films on a timely basis. [. . . ] Although we cannot provide any assurances that Toy Story 2 or Film Four will be released on schedule, the targeted release timing of mid 2001 for Film Four is particularly uncertain.

Film Four referred to Monsters, Inc., whose name had not yet been officially announced, and it in fact did end up getting delayed until November 2, 2001.

In all, Pixar spent 14 of their 71 page report discussing all sorts of risk factors in investing in the company. And this is for a company I consider fairly straight-forward to understand and analyze! I love a company with a simple-to-understand balance sheet that actually has a significant amount of cash, not one with millions of dollars of goodwill or intangibles. A company with a straight-forward cash flow statement where cash from operations exceeds net income. Granted, there were risks in investing in Pixar, but to me, the largest of those risks was easy to understand - Pixar revenue was driven by film releases, and since they weren't releasing films on a consistent basis it led to very lumpy earnings. I could look at the income statement and immediately understand why revenues in 1998 dropped 59% from 1997 - the majority of film, video and merchandise revenue from Toy Story has been collected, and revenues for A Bug's Life hadn't started flowing in. So while this "lumpy" behavior might scare off analysts and people looking for consistency, to me it made sense. With their sizable stockpile of cash, there was little risk of going bankrupt. It was just as unlikely that people would all of a sudden stop wanting to see family friendly films. To me, the only question was, would their future films continue to be successful? From what I had experienced, read and heard, that question was easy to answer. I had confidence Pixar would continue to generate excellent films, I just had to be patient. And in the periods between films, if the stock price began rising too much, like it did in the summer prior to the release of A Bug's Life, I could take some profit. Or, if the price dropped like Pixar would never create another film again, like it did immediately before the release of A Bug's Life, I could buy more shares. Pixar was not a company for investors looking for consistency but one for the patient investor. It was one of my most enjoyable investments, and actually still is as I continue to own the Disney stock I received when Pixar was bought out by them.

One of the best parts of being a Pixar investor in the early years was the cool merchandise the company sent with the annual report. As I mentioned in my post for the 1997 annual report, I received a VHS copy of the short Geri's Game. For 1998, I received 2 posters, one celebrating the release of A Bug's Life with Flik floating on a dandelion (shown at the top of this article), and the second teasing their next film, Toy Story 2 (shown below). These posters were large and beautiful, I think 16" x 40". Even after only 2 films, I had become accustom to the extras Pixar put in their works, such as the bloopers at the end of A Bug's Life. So as I analyzed the poster trying to figure out the roles of the new characters (remember, back in the late 90s, in-depth coverage and fan sites weren't as common as they are now!), I noticed tiny Flik waving from the grill of RC!

This Day in Pixar History: Pixar's 1997 Annual Report

© Pixar

I've written a number of articles on Pixar's financial reports when it was a public company. Today, let's turn time back about 26 years to look at their 1997 annual report, which came out in early 1998. As with many of Pixar's early annual reports, it started with an informative and entertaining letter from CEO Steve Jobs. They also often included a nice little gift - the 1997 annual report came with a VHS copy of the Academy Award winning short film Geri's Game. So I will try and minimize the financial information (much of it has already been covered in the individual quarterly posts I've done) and focus on the other content.

In their 1996 annual report, Pixar warned of a significant decrease in revenue for the upcoming year due to a decrease in revenue from Toy Story. This was logical; Toy Story was released more than 2 years earlier in late 1995, and Pixar's revenue in 1996 were over $35 million, primarily from the film. But in usual Pixar fashion, they were conservative in their guidance for 1997 and the company's revenue were almost as much as in 1996, $34.7 million. In fact, film revenue was higher in 1997 than 1996: $26.9 million versus $18.8 million, or an increase of 43%!! Not too bad given the expectations of a significant decline! The increase in film revenue was due to the Feature Film agreement between Pixar and Disney: as Toy Story revenue began to accrue, Disney was allowed to capture the majority of it to offset their marketing and distribution costs. As Disney's outstanding costs declined, Pixar received a larger percentage of the revenue. By the middle of 1997 Disney had recovered all their costs, allowing Pixar to capture a proportionally higher percentage of the Toy Story home video and merchandise sales.

© Pixar

You might then ask why were overall revenues down in 1997? This was due to 2 areas. First was in patent revenues - in 1996 Pixar received patent revenue of over $9 million from Silicon Graphics (SGI), which dropped to only $1.7 million in 1997. The second area of decreased revenue was in animation services, such as television commercials. Pixar decided to get out of doing animation services for external customers in 1996 to focus on its feature films which caused this revenue drop.

Pixar's gross margins continued to increase, which is amazing since they already were quite high. Overall gross margins increased from 86.6% in 1996 to 92.7% in 1997. Much of the increase came from Pixar getting out of animation services, which had the lowest gross margins of all their segments. Patent licensing revenue had no associated costs and the software segment (which derived revenues from sales of their RenderMan application) had very low costs (1.8% in 1997 versus 3.4% in 1996). Cost of film revenue also dropped to 5.5% versus 8.2%, mostly due to Disney recovering all their costs in mid-1997 which allowed Pixar to receive a proportionally higher amount of the revenue.

Overall, 1997 turned out to be a better year financially than 1996, except for the bottom line. Pixar ended up paying quite a higher amount of taxes ($9.9 million) in 1997 than 1996 ($2.0 million), due to the utilization of net operating loss carryforwards during 1996. In the end, Pixar reported net income of $22.2 million ($0.46/share) in 1997 versus $25.3 million ($0.54/share) in 1996. Still, I'd consider those pretty good results given the guidance Pixar gave at the beginning of the year!

Pixar's cash position also improved in 1997, growing from $161 million in 1996 to $176 million, even with the much larger outflow of cash Pixar experienced. Pixar spent $10 million on computers and other property to run the studio and $7.7 million on the new Emeryville studio. In addition, with the new Co-Production agreement Disney and Pixar signed in early 1997, Pixar was responsible for half of all film development costs, which totaled a little over $27 million. These costs were more than offset by the higher revenues and the $15 million Disney invested in Pixar on the signing of the Co-Production agreement.

© Pixar

OK, enough of the financial information. As I mentioned at the beginning of the post, Steve Jobs started the annual report with the shareholder letter, which he wrote after watching the 1997 Academy Awards. Pixar won their third Oscar that year, this time a Best Animated Short Film award for Geri's Game. Jobs congratulated director Jan Pinkava,  producer Karen Dufilho and the entire Geri's Game team. Besides the Oscar, Tom Duff, Eben Ostby and Bill Reeves each won an Academy Scientific and Technical Achievement award for their work on Pixar's Marionette 3-D Animation System. In addition, Tom Porter won a Scientific Academy Award for his work on digital painting. The addition of these awards brought Pixar's total count of Academy Science awards to 18.

A few other pieces of information Jobs shared:

• Hiring 97 employees during 1997 for a total of 391.
• Expecting to break ground on the new Emeryville studio that summer with a move-in date of early 2000.
• Investing over $8 million annually on research.
• Growing the size of their RenderFarm to 1000 Sun processors and having storage capacity of over 5 terabytes.
• Highlighting that Toy Story 2 had been upgraded to a full theatrical release, and that their still secret 4th film (Monsters, Inc.) was in development and was hoped to go into production by the end of the year.

Jobs was very clear on his goal for Pixar - to make it the second greatest feature animation studio in the world, only behind Disney Animation. As part of reaching this goal, Jobs stated they were trying to release one animated film per year for the next 3 years (A Bug's Life in 1998, Toy Story 2 in 1999 and Monsters, Inc. in 2000). But Monsters, Inc. would end up not being released until 2001 and Pixar did not accomplish the goal of 3 films in 3 years until 10 years later.

© Pixar

Jobs went into great detail on the making of A Bug's Life.  He highlighted how there were over a dozen major characters, and that each one was more complex than any characters in Toy Story. He talked about how a new subdivision surface technology developed for Geri's Game was used to bring more subtlety and lifelike expressions to the characters. He also explained how they were using simulation software for moving crowds of hundreds of ants or creating lifelike movement in blades of grass (Simulation would reach a new level of complexity and use in Monsters, Inc.). Finally, he discussed how the lighting team was challenged to create more sophisticated lighting to support the outdoors environment the film takes place in. He said the results were "breathtaking". Jobs was also excited about the wide-screen nature of the film, stating that it would look "epic".  A Bug's Life was the first film entirely transferred to film via lasers, and Pixar had to develop their own laser film recorder to perform the transfer. And with all the complexity and larger cast of characters, Jobs stated they were using 10 times more processing power to create the film as they did on Toy Story just three years earlier.

© Pixar

Jobs also explained how it was decided to upgrade Toy Story 2 to a full theatrical release. They originally felt that, with most of their key people from the original Toy Story working on A Bug's Life, they would not be able to find and recruit enough talent to meet the higher standard demanded of a theatrical release. But since the success of Toy Story, Jobs stated Pixar had "become one of the hottest places to work in our industry," and had pulled together a team capable of delivering the necessary quality, at that time being led by Ash Brannon and Colin Brady. The decision to expand Toy Story 2 to a full theatrical release occurred after a November, 1997 meeting in which teams from Disney and Pixar watched the completed story reels and felt the story was strong enough to receive a full theatrical treatment.

Readers of this blog are probably familiar with the story that, less than a year after Jobs wrote this letter, Pixar would realize the story wasn't as strong as originally thought, and in late 1998 production was stopped and the story underwent a major overhaul, with John Lasseter, Lee Unkrich and others coming on board to make sure the film was delivered on time.

© Pixar

To finish this post, many of you have probably seen the image above of Ed Catmull, Steve Jobs and John Lasseter. Interestingly, the image's origination was in this annual report but in a slightly different fashion. You can see the original image below, which is of Pixar's executive team at the end of 1997, including CFO Lawrence Levy and Vice President of Production Sarah McArthur.

© Pixar

© Pixar

This Day in Pixar History: Pixar 1996 Annual Report

Once again, I'm back looking at the financial earnings reports from Pixar when they were an independent public company. In my previous posts, I covered their quarterly earnings for the first, second and third quarters of 1996. In this post I'm going to cover their 1996 annual report.

1996 Annual Report cover

For their first year as a public company, Pixar did quite well. The studio ended the year with over $38.2 million in revenues, more than 200% higher than the $12.1 million made in 1995. Almost half of the revenue, $18.8 million, came from their first feature film, Toy Story, released November 22, 1995. $9.1 million came from patent licensing, primarily from Silicon Graphics. Another $6.3 million came from software, such as RenderMan licenses and their 2 Toy Story-based CD-ROM products, The Toy Story Animated Storybook and The Toy Story Activity Center. Finally, they made another $3.9 million from television commercials and other animation services.

Toy Story 2 art

Gross margins for the year were amazing - over 87%, higher than the 80% margins in 1995. As I mentioned in my post for the 3rd quarter of 1996, Pixar had very low cost of revenue. According to the Feature Film Agreement signed with Disney in 1991 (and the subsequent CD-ROM agreement), Disney reimbursed Pixar for almost all costs related to the development and production of Toy Story and the CD-ROM titles. In addition, there were no costs of revenues associated with their licensing revenue. Their total cost of revenue was only $4.7 million, of which $3 million was attributed to their television commercials and animation services. Pixar had announced in 1996 they would be getting out of the commercial business and moving those employees to their feature film development teams. As this segment had the lowest margins (23% vs 95% for the other business segments), it is not surprising that Pixar made the decision to exit it.

Research & Development expenses increased from $4.1 million in 1995 to $7.0 million in 1996, primarily in support of their software tools like RenderMan, Marionette (their animation system), and Ringmaster (a production management software system). General & Administrative expenses increased 87% from $3.0 million to $5.6 million. Pixar stated in the annual report that they expected G&A expenses to continue to increase, partly due to intense competition (and the corresponding higher salaries) for animators and other creative personnel. Pixar also experienced an increase in Sales & Marketing expenses in 1996 compared to 1995 (from $1.6 million to $1.8 million) due to the release of Toy Story and becoming a public company.

Net Income for the year was over $25.3 million, or $0.54/share, compared to only $1.6 million ($0.04/share) in 1995. This is a net profit margin of over 66%! Pixar's balance sheet was also very strong, courtesy of their IPO in late 1995 and the good results in 1996. Cash and short-term investments grew from $144.3 million in December, 1995 to $161.0 million in December, 1996, and liabilities were only $6.7 million with not a dollar of debt on the balance sheet!

Even with all this good news, Pixar raised concerns regarding their future financial situation. They stated they expected a substantial decline in their operating results in 1997. The primary cause of this was the expected drop-off in revenue from Toy Story. They only expected revenue from the Toy Story home video release, and the majority of that would occur in the first half of the year. And according to their agreement with Disney, they received a lessor amount of home video revenue than theatrical revenue.

In addition, Pixar had decided in early 1997 to discontinue its CD-ROM production business. The business had been successful, but Pixar wanted to reassign most of the 60 employees in that department to other groups such as feature film production. This meant Pixar would experience a "material adverse impact" (accounting lingo for "we're going to make less money than we expected") on its operating results in both 1997 and 1998.

Pixar also warned of a decline in RenderMan revenue, as the company focused more on their film business, plus they expected increases in operating expenses from continued growth in their operations and research and development efforts.

Finally, they had no new films due for almost 1 1/2 years. A Bug's Life was to be released in late 1998, and Pixar didn't expect to recognize any revenue until later half of 1999. Also, at this point, Toy Story 2 was still scheduled to be a direct-to-video release, also in late 1998, which meant no revenue from that would be received until 1999. I did find it interesting though that they mention the possibility of releasing Toy Story 2 to theaters rather than direct-to-video. I had always thought that decision had been made late in its production.

It should not be much of a surprise then, given all the cautionary talk on decreasing revenues and increasing expenses, that Pixar stock was stuck in the low to mid teens. I made my first purchase of Pixar stock in April, 1997 for $15/share. Obviously, I was in it for the long term!

I am probably one of those rare (some may say weird) people who enjoy reading annual reports, especially the ones from Pixar! They always started out with an entertaining and informative letter from Chairman and CEO Steve Jobs. His letter in this report was 15 pages long, and include some beautiful drawings, pre-production artwork and storyboards from Toy Story 2, Geri's Game and The Adventures of André and Wally B. In addition to discussing the previous year's results, Jobs provided a good summary of the what's and why's on the newly signed co-production agreement with Disney (I will discuss this agreement in detail in a future post). He also discussed Pixar's 3 core capabilities that would enable them to become a world-class animation studio: Creative, Technical and Production. The annual report also discussed their purchase of land in Emeryville to build a new studio facility. Pixar had put down a $300,000 non-refundable deposit for the land, and while they had not made the final decision to move ahead with building the new studio, the report stated that was their intention.

The next post in this series will cover results from the first quarter of 1997.

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