Dreamworks - Value in the Works

Dreamworks - Value in the Works

Thesis

DWA is cheap (Forward consensus PE 13.6x, currently $16.96 near its 52 week low of 16.34). Given that they have just released a hit movie (Puss in Boots), this is highly unusual. When we invest in DWA, we are buying 1 thing – the creative team (Jeffery Katzenberg and William Damaschke).

Company Overview

• Short Company History

Dreamworks SKG was formed by Steven Spielberg, Jeffery Katzenberg and David Geffen. In 2004 Oct, Dreamworks Animation was spun off from the parent company.

• Management/ Ownership Structure

Currently, DWA is being run by Jeffery Katzenberg. Jeffrey Katzenberg, David Geffen and entities controlled by them own 100% of DWA’s Class B common stock, representing approximately 13% of the company’s common equity and approximately 69% of the total voting power of its common stock. Katzenberg has 269,796 options (from compensation plan) with a weighted average exercise price of $35.30. At least, Katzenberg has some incentive to raise the share price.

Bill Damaschke is head of Creative Production and Development. Bill has been with the company for 10 years. Bill has worked on Prince of Egypt, Shrek, Shrek 2 & Madagascar. He owns 332,301 shares. Kristine Belson is head of Development. She just joined the firm. Ann Daly is the Chief Operating Officer. Lewis Coleman is the CFO.

John Batter who was co-president of production has recently left to become CEO of MediaNavi.

In total, the Directors and executives own 69% of the company. I believe that this is sufficient incentive to ensure the creative team stays at DWA. The reason I belabor this point is because when we buy DWA stock, we are buying the creative team.

• Revenues – Revenues/ earnings for DWA are unstable because one cannot predict if the films produced are going to be hits or not. Also, revenues are highly dependent on the number of films DWA is able to produce in a year. They target 3 films per year. But in 2011, they were only able to produce 2 (Kungfu Panda 2 and Puss in Boots). Bear in mind that normally film studios produce 1 animated film every 18 to 36 months, so what DWA is pushing for is ambitious. The instability is offset by the fact that DWA is debt free.

• Distribution – DWA’s distribution agreement with Paramount comes up for renewal in 2012. I suspect that the reason DWA is trading at 52 week lows is due to the uncertainty surrounding the renewal of the agreement. Currently, DWA pays Paramount 8% of box office and home video revenues to distribute and market its films.

DWA has 3 options here – renew with Paramount, find an alternative studio to distribute the films (Universal, Lionsgate etc) or setup its own distribution. Renewal with Paramount is difficult because Paramount is likely to want more than 8% of revenues and DWA wants to pay less. DWA’s board has already said that renewing the theatrical and home-video distribution fee higher than 8% is out of the question. Furthermore, Paramount has announced that it is setting up its own animation division, which is targeted at making one $100m film per year. Paramount has now gone from distributor to competitor.

With regards to DWA setting up its own distribution network, that could be costly, as it only produces 2 to 3 films per year. Estimates on cost of distribution are around $235m per year if done independently.

Find an alternative distributor seems most likely. There are a few out there – the majors (Universal, Columbia), or a mini-major (Lionsgate). Distribution in the film business is a commodity. The true value is in the content. When DWA signed the contract with Paramount 7 years ago, DWA was an unknown with no track record of being able to deliver good animated films. Now DWA has a string of hits under its belt, there is no reason for it to pay more than the 8% of revenues that it currently pays. In fact, DWA should pay less if it negotiates with other distributors as it has a track record already.

For the TV distribution side, DWA recently signed a deal with Netflix. Revenues from this deal are unlikely to materialize until FY 13/14.

• Valuation – It is very difficult to figure out how much DWA’s intrinsic value is because the value lies in the creative team. Currently, DWA is trading at about 10x average past 6 years earnings (P/E), 2x sales with no debt. Disney bought Pixar at 40x P/E and 21x sales.

• Conclusion - Ordinarily, I would not recommend buying a company that is so difficult to value. But here are the facts, we have a company that is trading near its 52 week lows that has produced 2 hit films this year. Why should this be so? It doesn’t make any sense. Maybe it’s time to buy some DWA.