Valuhunteruk

Dreamworks Animation (hereafter, DWA) is a leading creator of animated feature films. DWA has released twenty one films including the Shrek, King Fu Panda, and Madagascar franchises. DWA projects to release five films every two years in the future. Paramount distributes DWA’s films and renders worldwide home video fulfillment and video-on-demand services. The company also signed a licensing deals with Netflix, making Netflix the exclusive subscription television service for streaming feature films from 2013 and opening certain catalogue titles to Netflix members over time.

DWA currently trades at $18.74 with 84.5m shares outstanding leaving a market cap of $1.57bn. LFY earnings were $1.96 and TTM earnings were $1.72. DWA is due to report fourth quarter and full year earnings on February 22.

DWA’ stock price has suffered over the past year and has traded down from $40 since early 2010. Investors have become concerned with both specific, short-term issues, such as the under-performance of certain films, to wider issues, such as how DWA will be affected by the massive changes in how feature films are being distributed.

2011 has been important as we have seen a combination of potentially short and long-term issues affecting the company. I will examine these points but conclude that short-term uncertainty has really been driving the pessimism expressed by changes in the stock price and that this uncertainty creates opportunity for investors.

The first question to ask is: what happened in 2011 to precipitate a 34% in the price since last year?

First, whilst Kung Fu Panda 2 had a good worldwide gross, both domestic box-office and home entertainment sales have, reportedly, disappointed. The company argues that the release date for Kung Fu Panda 2 was the main problem as Hangover 2, released at the same time, unexpectedly became a family film. Analysts have also noted how Kung Fu Panda 2 has performed well in the rental charts  but struggled in retail, apparently, leading DWA to cut the wholesale price it offers to retailers. Often this is linked to a wider trend towards far lower retail sales and higher rental sales of feature films.

Second, the theatrical release of Puss in Boots may have disappointed investors as well and, given the first point, they certainty are pessimistic about its future home entertainment sales. It opened on a weak $35m which although breaking the record for that opening weekend seems to have been slightly less than expected (or hoped for). However, since then it has done quite well (it is still in cinemas so the final performance is not in yet) especially seeing as it was a spin-off feature from the Shrek franchise. It probably won’t break into the Top 5 features for DWA but the fact that we are asking this question shows that it wasn’t a bad movie.

Finally, in both of the 2011 feature releases international revenues have made over 70% of total box-office revenues. International box-office sales produce far less revenue for DWA. Due to its distribution deal with Paramount, it retains roughly half of domestic box-office sales but perhaps only 20%-30% of international box-office sales. So whilst international success has boosted total box-office revenues it has meant less revenue for DWA.

Therefore, it seems that there were some quite legitimate reasons to sell DWA especially given that it was trading at around $30 in February last year. Projections for the future seem equally pessimistic:

One factor motivating these projections is the planned production schedule up to 2014. These films are largely unknown and there is a lot of uncertainty about where future revenues are going to come from:

Only two of these features are big names which investors are going to feel comfortable with (Madagascar 3 and How to Train Your Dragon 2) whereas the rest are all new, unknown titles (The Croods was originally scheduled for March of this year but “production delays” have set it back to 2013). The EPS estimates certainly imply that the company is not going to have a big film (like Shrek or Kung Fu Panda) in the next three years. We could roughly imply that after Madagascar 3 none of the other films will have a worldwide gross above $600m. Indeed, we can see from looking at the top 10 DWA feature films how the big franchises have dominated historical results:

So if we look forward at the titles to come and look back at the massive success the company has had it is difficult not to feel that the company cannot keep up with past growth.

DWA’s business model also affects how we should think about the potential for future hits. DWA is a pure content company and if cannot produce hits then it will not succeed. What is more, unlike other pure content companies it does not have  a vast library to dampen the financial effect of poor quality films. The library is growing and becoming a more significant source of revenue but it still isn’t big enough to have any faith in. There is some room for error as revenue from tv licensing continues for roughly two years after the release date which levels out revenue but again, the company is still reliant on coming up with new hits. DWA needs these upcoming films to work and investors really have no information to tell if the massive investments made over the four-year production cycle of animation features is going to pay off.

Another source of long-term uncertainty is the future of the distribution arrangement with Paramount. The terms of the agreement give Paramount worldwide distribution rights to all animated films to December 31, 2012. This includes domestic and international television licensing as well as theatrical exhibition. The first film that may be distributed under a new agreement will be The Croods. The company has hired a consultant, former Disney exec Chuck Viane, to look at the possibilities for independent distribution and will announce the result of this review in the Spring. It is also worth highlighting that Paramount appear to be moving into animation themselves releasing Rango in 2011 although DWA has stated this will have no effect on their decision-making.

Under the current arrangement, DWA does not receive any revenue from its feature films until all distribution and marketing costs that Paramount incurs have been recovered and a fee of 8% of revenue (without deduction for any costs) has been paid to Paramount. The fulfillment services agreement, under which marketing and distribution for home entertainment and video-on-demand is prepared, is linked to the main distribution agreement. Any film that Paramount distributes also comes under the fulfillment services agreement and the terms of the fulfillment agreement are substantially the same as the distribution agreement.

The merits of independent distribution are not clear but the CEO, Jeffrey Katzenberg, stated on the Q3 conference call that the main issue would not be with theatrical distribution but with international markets, home video, and marketing arrangements. He also highlighted that since 2006 DWA’ films have produced over $10bn in box office, home entertainment, and pay-tv revenues whilst paying $700m in distribution costs which gives some perspective on the figures involved.

Finally, investors have shown concern at the intensification of competition in animation. Pixar and Dreamworks have long been the dominant animators with 9 out of the top 10 worldwide grossing animations between them. However, in the last few years competition has intensified greatly. For example, Illumination Entertainment’s Despicable Me (Illumination are owned by NBCUniversal) grossed over $500m worldwide and broke into the top 10 domestic grossing animations of all time. The follow-up Hop was significantly less successful but Illumination is releasing Dr Suess’ The Lorax in March of 2012 (The Croods was originally set to be released in March 2012). Blue Sky Studios (owned by Fox) is also becoming a tough competitor especially with the Ice Age franchise and Rio. The last Ice Age achieved a worldwide gross of just under $900m. The latest Ice Age is being released in July 2012. However, what is more notable is the budget gap. Whilst the last Ice Age had a budget of $90m (the highest ever for Blue Sky) and Despicable Me had a budget of $69m, Puss in Boots had a budget of $130m. Although this was down from the extravagance of Monsters V. Aliens, $175m, and is less than Pixar which budgets around $200m (Cars 2, Toy Story 3) it is true that large budgets are a significant source of operating leverage. More agile competitors can make mistakes and experiment whereas Dreamworks really has to get it right (again, the lack of significant library hinders it significantly).

Despite these factors, I do not think anything of this alters the fact that DWA is still a leader in animation. Jeffrey Katzenberg is still a leading animation executive and has been for around twenty years. Whilst his career at Disney was overshadowed with how it ended, he had the leading role in turning around animation and producing some of the most well-known animated films of all time. If animation is worth anything as an entertainment medium then Katzenberg is a good CEO to get behind.

Equally, the underlying determinant of performance is always going to be on the quality of the features. Competitors here still do not have the expertise and experience of DWA however, they do have the potential to crowd the animation market. Consumers can only take so much but whilst the last two years appear to have been quite crowded, the next two years appear to be significantly less so. There are significant international opportunities developing for animation as well. At the moment, distribution fees here obscure the potential of these market but these will fall both as box-office sales grow and distribution costs fall. It also worth noting that the international market has far stronger demand for 3D which is more lucrative for DWA.

The most significant challenge is clearly the situation with distribution. Both the potential for independent distribution and the broader changes in how people access content are really significant. On the former point, I think it makes a lot of sense to wait and see what management is actually going to do as becoming an independent distributor totally changes the business model. I also think that short-term pressure of Q4 results will result in a further sell-off maybe even down to $15 which also suggests a wait. On the broader industry changes, the fact remains that consumers are always going to want content. It is way they consume content that is changing not their desire for it. Analysts suggest that DWA can never make as much money from rental or streaming as they did from retail. My view is that the marketplace for content is highly competitive and, as the Netflix deal suggests, to get content, companies will have to pay up.

So the core of my argument is that DWA is an excellent long-term investment. Certainly, the long production processes involved, the importance of creativity, and the big development expenses make DWA completely incompatible with the culture of the Street. The fact remains that DWA makes great movies and great content is always going to be in demand. Investors could wait until DWA announces the new distribution model as independent distribution will significantly alter the business model however, the company has shown it is aware of the challenges involved. Given the move of Paramount into animation, I would say independent distribution is quite likely. At least, it makes sense to wait for Q4 earnings as the troubles in home entertainment are likely to weigh on the stock further. There have been rumours of value being realized through a takeover but this seems totally implausible to me. More likely, the value of the business will increase substantially as it continues to make good films and shakes off the uncertainty around distribution.