|Shares Out. (in M):||85||P/E||0.0x||17.0x|
|Market Cap (in $M):||1,500||P/FCF||0.0x||0.0x|
|Net Debt (in $M):||0||EBIT||0||0|
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DreamWorks Animation (DWA) is the studio behind franchise hits such as Shrek, Kung Fu Panda, and Madagascar, deriving its revenue primarily from the animated feature films and TV programs it creates. Each animated feature film takes approximately four years and $150 million dollars to produce. The return on this investment is well worth the wait. The world-wide box office (just the movie ticket sales) for the Shrek franchise (including “Puss in Boots”) has grossed over $3.5 billion. While “in-release,” a film will also generate revenue from DVD sales, cable viewing, digital downloads, streaming, licensing, and merchandising. DreamWorks’ goal is to create a lasting franchise that kids and parents will watch in the theatres, in their homes, and will happily purchase branded merchandise as they wait for the next installment. The key to a successful franchise comes from story-telling. Computer animation may attract an audience, but it is the story that keeps them captivated. Over the years that a film is being produced, its costs are capitalized as inventory on the balance sheet. Once “in-release,” these production costs are then amortized over a 10-year schedule and applied against the movie’s incoming revenue. By the fourth year of amortization, approximately 75% of the production costs have been removed from the balance sheet.
Movie Industry Overview
In 1946, the movie industry sold over 4 billion tickets nationwide, generating over $1.4 billion in total box office sales. Of course, it was a different era for the movie industry back then. There were no competing formats vying for an audience; there were no home entertainment systems, let alone television. In addition, movie theatres doubled as a way to escape and get caught-up on the latest world news, the same role that television performs today. Since 1946, movie ticket sales have been in decline, however, ticket prices have more than made up for the downturn.
In 2011, the domestic movie box office was $10.2 billion on 1.3 billion tickets sold. Mathematically, that works out to be $7.85/ticket or an annualized growth in ticket prices of 4.9% over the past 65 years. In addition to the growth in ticket prices, the US has witnessed a slight growth in movie theatre screens. There are currently over 39,000 indoor movie screens nationwide, increasing approximately 1% annually over the past 10 years. It is not a huge growth rate, but imbedded in that number is the extinction of the small/rural town, self owned, single screen movie theatres which cannot compete with the growing multi screen complex. The movie theatre industry is dominated by a handful of theatre owners which represent over half of the nationwide movie screens. These theatres are able to run multiple showings of the same movie in different formats all at the same time (traditional, 3-D & Imax), as well as charge top dollar to do so.
As US ticket sales have been declining, overseas markets have stepped up, becoming a significant outlet for US movies. Overseas markets produce up to 2/3 of total world wide box office sales for studios like DreamWorks. In addition, overseas tickets sales and prices from countries like Brazil, Russia, India, and China are on the rise, as more and more of their population enter into the middle class.
Historically, animation has consistently been the most profitable segments in the movie industry. In 2011, there were seven animated feature films whose box office grossed over $100 million domestically. These seven films represented just over 1% of the films that were released and over 10.5% of the total US box office. These metrics have definitely captured the studio’s attention as more studios are now focusing on creating family entertainment.
Paramount Pictures (division of Viacom) is responsible for the world wide distribution of DreamWorks content. Paramount assumes the initial cost of distributing and marketing each of DreamWorks’ movies, costing Paramount approximately $150 million ($50 million in the US & $100 million overseas). The box office is split between the theatre owner and the distributor. It is not uncommon of for a distributor to make 90% of the box office in the first two weeks, 80% in the third, and 70% in the fourth. After the fourth week, the splits are often renegotiated more favorably for the theatre owners. Paramount Pictures receives 100% of the box office split until its distribution and marketing costs are recouped and then receives 8% of future revenue while DreamWorks gets the remaining 92%. This revenue sharing model is similar for distribution of DVD sales, cable viewing, digital downloads, and streaming.
The contract between Paramount Pictures and DreamWorks expires at the end of 2012 and Paramount has already indicated that it is looking for a larger percentage. DreamWorks faces three choices: Choose a new distributor – Warner Brothers, Sony and Fox are the three largest and cover both domestic and international markets, self distribute – which would take both an up front capital, as well as access to a credit facility for the capital needed to distribute 2-3 films per year, or they could go back and renegotiate with Paramount. DreamWorks and Paramount already collaborate on two TV series for Nickelodeon (Viacom property) starring the Penguin’s of Madagascar and Kung Fu Panda. So, there are other factors to consider during the negotiations. Whatever the choice, DreamWorks has announced that it will come to a decision by September of 2012.
DreamWorks currently has a film library consisting of 24 movies: three franchise hits (Shrek, Kung Fu Panda and Madagascar), with a potential fourth on its way (How to Train Your Dragon). Studios covet franchises because they allow studio executives to sleep a little easier at night knowing that after spending an enormous amount time and money creating a film, there is already an established audience. For an animation studio, franchises are the key to its success. Shrek 2 was DreamWorks’ most profitable film to date. In the first four years in release, the Shrek sequel generated revenue of $900 million from film, DVD, cable viewing, digital downloads, streaming, licensing and merchandising. In fact, it was the familiarity of the green ogre and his friends, along with good story-telling that created and maintained the Shrek franchise, paving the way for two additional movies and a spin-off (Puss in Boots).
The size, depth and number of franchises within DreamWorks’ library was a key factor in helping negotiate its deal with Netflix. Starting in 2013, Netflix will pay DreamWorks, on average, $30 million/movie in its library for the right to distribute over a 6-8 year period. This deal replaces and upgrades DreamWorks’ current deal with HBO which was struck at $20 million/movie over a 10 year period. In addition, the deal with Netflix also provides an outlet for some of DreamWorks’ holiday and short feature programming.
In July, DreamWorks announced the purchase of Classic Media for $155 million. Classic Media is the owner of a catalog of 450 entertainment titles (Casper the Friendly Ghost, Lassie, Mr. Peabody and Sherman, Rocky and Bullwinkel, The Lone Ranger), 6100 hours of animated and live action episodes, and the Golden Books Library. The deal immediately adds to DreamWorks expanding collection of branded characters, providing creative opportunities to introduce and rejuvenate established characters to a new generation of viewers.
The question that many are asking is whether Casper and Friends is worth $155 million. To answer that question, one really needs to look at the deal as two parts. The first part is determining the revenue that DreamWorks can generate through licensing, merchandising, and using the newly acquired characters to create feature films and TV programming. The second part is how much DreamWorks was willing to pay to keep Classic Media out of the hands of its competitors. When approaching the deal from that perspective, DreamWorks may have paid a fair price, especially if one considers that DreamWorks is already licensing the rights to make Mr. Peabody and Sherman scheduled for release in December of 2013.
Oriental DreamWorks & Indoor Theme Park
In 2011, DreamWorks entered into a joint venture with three Chinese companies to create Oriental DreamWorks. Besides creating new animated feature films (not based on current DreamWorks characters) for the Chinese market, the 47 acre media center will also include cinemas, restaurants and bars. The joint venture will allow DreamWorks expanded access to the Chinese market by circumventing quotas the Chinese government places to limit the number of foreign films.
In July of 2012, DreamWorks announced a deal with developer Triple Five to build an indoor theme park at Triple Five’s American Dream complex in the Meadowlands. The Meadowland’s theme park will be based in New Jersey and feature DreamWorks’ characters from movies such as Shrek, How to Train Your Dragon, Kung Fu Panda, Puss in Boots and Madagascar.
Headwinds facing DreamWorks and its industry
DreamWorks comprises many of the criteria one searches for in a company: It operates in a niche segment of its industry – animation; it has a competitive edge – creating lasting franchises through great story-telling; and its scarce resource is its growing 24 movie library, which would be very difficult and costly to reproduce in today’s market. That is not to say that there are not significant headwinds facing DreamWorks and its industry. Domestic movie attendance and DVD sales are in decline, competition for family viewing is increasing, and film production costs are rising. Some of these headwinds can be offset: DreamWorks gets over 2/3 of its world-wide box office revenue from overseas countries like Russia, Brazil, India and China where ticket sales and prices continue to climb. Three-D movies have also helped compensate for the domestic decline in ticket sales, as these ticket prices are 50% more expensive than a traditional movie ticket, while the additional cost in creating a 3-D movie only adds 10-15% to the production.
Some headwinds will continue to negatively impact revenue: DVD sales are in an industry-wide decline as viewers are embracing new viewing formats which carry lower margins. Even though DVD animation sales are down less than the industry averages, declining sales will continue to negatively impact DreamWorks’ revenue. Rising production costs will also continue to impact the studio’s profits. Their India office has begun to help out on film production, but even its lower cost structure has done little to slow the rising costs. Finally, although competition for family viewing is increasing, it can be seen as a benefit for DreamWorks. Of the 29 animation studios in the US, only four (Pixar/Disney, DreamWorks, Illumination and Blue Sky) are profitable; the rest breakeven at best. There is a reason why these four studios are successful: They tell great stories through animation. Audiences, theatre owners, and distributors recognize quality when making decisions on how to spend their money.
Valuation – What’s it Worth
DreamWorks currently has a book value of $1.5 billion with no debt, no intangibles, and $80 million in cash. To replicate just its library of 24 movies in today’s market would cost over $3.6 billion with no guarantee of creating a franchise hit. The company currently trades at 17x expected future earnings of $1.05 and 2.2x its price/sales ratio. Its revenue and earnings are lumpy, driven primarily by the number and scheduled film releases for the year. Choosing not to compete directly with the Summer Olympics, “Madagascar 3” has only been released to 60% of the world-wide market; as a result, present box office revenue and future revenue from cable and DVD sales will be delayed, pressuring current margins.
DreamWorks does not appear to be cheaply priced. However, the studio’s hidden value comes from its expanding revenue base and increasing earnings power. With the increase schedule of released movies from two every year to five every 2-years, the addition of Classic Media’s brands to the DreamWorks Library, licensing of its characters to the indoor theme park in New Jeserey, and its joint venture with China, the studio is de-emphasizing the impact of a box office failure while monetizing its established brands. But what makes DreamWorks unique is its ability to increase its earnings power by leveraging its growing library. Every year that passes will mean that DreamWorks’ library of content will grow by 2-3 movies. And every year that passes will mean the margins generated from that revenue will increase as well. The longer a film is part of the studio’s library, the lower the cost of its revenue (amortization) associated with the movie. A movie like the original Shrek, which was released in May of 2001, continues to generate revenue at little to no cost. With the decline in DVD sales, DreamWorks’ main focus will be to find new and creative ways to monetize its brands while working to create new franchises.
DreamWorks’ recent acquisition of Classic Media should positively impact both revenue and earnings in the 12 months after the deal is closed (expected in 3rd quarter 2012), helping the studio achieve $800 million in revenue and $132 million in earnings ($1.55/share). Applying a 15 multiple (DWA's mid-range P/E) to $1.55 in EPS gives DreamWorks a $23.25/share or a 30% appreciation in the stock price. However, as DreamWorks continues to grow its earnings power by monetizing its library as well as adding new franchises, then holding the position for the long-run will continue to generate respectable returns.
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