DreamWorks Animation Trading At Unreasonable Multiples Of Current And Future Value ($DWA, #hollywood, #valueinvesting)

A bet on DWA is, in a macro sense, a bet on the current paradigm of the value of Hollywood studios as creators and distributors of valuable entertainment IP. The fate and value of DWA, even though it’s its own company with its own strategy, its own management and its own niche within the industry, is inalienably tied up with that model of sourcing IP, producing a theatrical event centered around the IP and then profiting off of the multi-channel distribution and licensing bonanza related to that IP across time (multiple years/decades after the initial theatrical event) and space (around the globe).

How does DWA make money?

Like most film studios, DWA is essentially a vehicle for financing and marketing computer-animated family film IP. The process begins with an idea, the eventual IP in natal form, which is either pitched to the studio by an outsider and then purchased, or developed internally by the studio’s internal staff. Over the next 3-4 years, at a cost of $125-175M per IP property, the idea is nurtured, developed and finally produced into a feature length film “event”. Working with the studio’s distribution partner, the film is released first in the US and then worldwide to theater audiences. Several months after theatrical release, the film property is put into home entertainment– DVD/Blu-ray, domestic and foreign Pay-per-View/VOD, domestic and foreign free TV and eventual distribution to in-flight entertainment and US military theaters. Toys, corporate licensing partnerships, clothing and other spin-off opportunities may follow, and if the IP is especially successful at the box office it may spawn sequels, live stage performances, TV spin-off franchises and TV holiday specials– a franchise title is born! Eventually, the cost of development of all IP in release is fully amortized or written off against revenues and the title is transferred to the “film library”, at which point it no longer exists on DWA’s balance sheet even though it will likely continue to generate licensing revenues for years to come.

The major threats to this model right now are:

  • the secular decline of the high-margin DVD distribution model and the uncertainty of the rise of digital distribution, which is not only (currently) a lower margin business, but whose time-footprint threatens the value of the traditional time-delay release of a film events IP across traditional distribution channels (free TV, pay TV, DVD/home video, etc.) because of the opportunity for worldwide simultaneous release
  • the hard costs of digital animation are falling, inviting more non-studio (independents) and amateur creators to enter the space

Some mitigating factors are:

  • assuming that internet/digital distribution proves to be a sustaining rather than disruptive technology, even if the cost of creating computer-animated film properties is falling, it still costs hundreds of millions of dollars to distribute that IP to a global audience and create the kind of “film event” that allows for a blockbuster franchise to be born
  • computer-animated family film IP has proven more resilient than live-action film IP within the declining DVD biz, because parents view their purchase decisions toward CG-film IP like that of a long-life toy that will be used to entertain their children again and again, preserving the value proposition of such a purchase
  • though this author is skeptical of the bullish case for emerging markets generally, and though emerging market territories generally have stingier revenue-sharing agreements with foreign (read: DWA) studios, and while the foreign home entertainment markets are currently weak to non-existent, these markets are in a secular growth pattern, their home entertainment markets are developing and they will mean larger and larger worldwide audiences for each film event as time passes; the risk of failure becomes less and less and the profitability of a homerun becomes greater and greater
  • DWA is intelligently pursuing growth in the emerging market nations– it has developed animation partnerships and facilities in Bangalore, India; it has recently announced a JV with state-owned media enterprises in China where it will not only develop original IP exclusively for the Chinese/Asian market, but it will likely also have the opportunity to distribute its US IP through that channel and thus earn future film rentals as a “local” rather than “foreign” producer, increasing its share of box office and other revenue-streams
  • DWA/Katzenberg have fully embraced theatrical 3D, which allows for premium pricing (typically, +$5 to cost of theater admission) which exit surveys of theater-goers rate as a huge value add. 3D is extremely popular in overseas markets, as well, and already over 50% of new release film rentals have been generated by 3D ticket sales on a per-film basis. 3D requires a small up-front additional investment to add the effect to films yet can be leveraged into a huge additional premium on ticket sales.

If you think those threats are overated, then DWA is probably extremely cheap. If you think those threats haven’t been fully priced in, DWA is either fairly valued or expensive, the ominous “value trap” every value investor fears walking into.

I am more and more of the opinion that DWA is a classic, Buffett-style good company at a great price-type business. Management is competent and trustworthy, and because Katzenberg and other officers and insiders of the company hold substantial equity stakes, their incentives are aligned (most of Katzenberg’s outstanding stock options, by the way, have strike prices in the $30/share range). While the development of the company’s IP is capital intensive (again, costing $125-175M per film to produce), the IP generates a multiple of that expense in ultimate profits on average. This means the company retains a substantial proportion of its earnings and is able to fund future production internally. The company is conservatively financed with no debt and sufficient cash and receivables (which is cash awaiting release from their distribution partner) to fund the development of two or more films at any given time. The business consistently earns a high post-tax ROE and pre-tax ROIC. While every studio has tried to get in on the computer-animated family film space, Pixar and DreamWorks are largely dominant (with near third place going to Fox’s Blue Sky) and the brand awareness and market share of each studio has not changed significantly over the last decade, implying high barriers to entry and strong competitive advantages to the entrenched firms like DWA.

Looking at earnings on a 10yr, 8yr (since 2004 IPO) and 5yr (since the secular DVD decline began in 2006, and including the traumatic period of 2008-2009) average, earnings are growing.

On a GAAP basis, the company trades close to book value, but this is a book value which holds the fully-amortized prior release films in the “film library” at a $0 value on the balance sheet. They’re obviously worth a great deal more, especially to a strategic buyer. On an adjusted basis, DWA is trading at a significant discount to book value.

The market cap of the company is about $1.44B at a share price of $17 with 85M fully diluted shares outstanding. The beauty of DWA is that it is not so small that it can get blown over in the wind with a poorly-received film event release, but it is not so large that it is already a fully-integrated media conglomerate in its own right, with theme parks and all the rest. In other words, it’s got a long run way and the market capitalization could grow significantly overtime, so it isn’t hard to imagine where DWA will find additional revenues and earnings streams over the next 10 years like a person might wonder with a competitor such as DIS. It’s trading near all-time lows and right now it trades for less than it did at the fear-induced trough in the markets in late 2008, early 2009.

Management has aggressively bought back shares since the 2004 IPO and secondary offering, reducing shares outstanding by over 20% during the last 8 years. The board has authorized an additional share repurchase plan which represents about 10% of market cap at current prices.

There are some challenges and uncertainties for DWA. There always are, for every business. If this is a value trap, then we are on the verge of the complete dismantling and dissolution of the Hollywood studio system of film production and distribution. If we are not on the eve of that armageddon, then DWA is not being fairly priced. And there is a significant margin of safety in the numerous growth opportunities available to this “wide-niche”, focused and ambitious firm with strong brand reputation. With the studio committed to producing 2.5 films/yr from the previous strategy of 2 films/yr (one sequel and one original), earnings will be growing and yet you pay the already discounted 2 films/yr price.

It’s hard to imagine this company worth less than $1.44B 10 years from now and it seems likely it will be worth significantly more over that period of time, with an additional 25 films in the stable (a greater than doubling of the current film library of 23 films).

Any way you slice it, DWA seems cheap– <10x GAAP EBIT, <15x GAP Net, 2x GAAP Rev, <10x adj OE (net income + amortization – film costs – avg MCAPX), <8x adj Net OE (OE minus cash taxes paid) and around 5x the 2.5 films/yr pre-tax OE calculation… not to mention a significant discount to adjusted book value.

Pure valuation metrics:

Metric 10yr Avg 8yr Avg 5yr Avg
GAAP EBIT/share  $1.71  $2.18  $2.20
mult 10.0 7.8 7.8
GAAP Net/share  $1.19  $1.80  $1.81
mult 14.4 9.5 9.4
GAAP Rev/share  $7.42  $8.19  $8.55
mult 2.3 2.1 2.0
Adj OE/share  $2.04  $2.38  $2.51
mult 8.4 7.2 6.8
Adj Net OE/share  $1.94  $2.47  $3.00
mult 8.8 6.9 5.7
Adj 2.5 films/yr Pre-tax OE  $2.18  $3.06  $3.28
mult 7.8 5.6 5.2
Share price  $17.08  $17.08  $17.08

Notes on insider ownership:

According to the latest 14A, Jeffrey Katzenberg, the CEO of the company, owns 13,193,947 shares, or 15.6% of total fully diluted shares outstanding. He also controls a number of options awarded to him as executive compensation (he draws a $1/yr salary), most of which vest only if the share price maintains around $30+/share for approximately one year within the multi-year window of the stock option compensation agreement. So, Katzenberg is highly incentivized through both equity ownership and stock options to see a valuation for the company significantly higher than it currently stands.

Additionally, current executives as a whole (including Katzenberg) control 19.1% of FDSO.

Former founders David Geffen and Steven Spielberg, who are no longer actively involved in managing the company, continue to hold 2,355,216 shares or 2.8% and 5,222,726 shares or 6.2%, respectively, of FDSO. (Note: David Geffen and Jeffrey Katzenberg jointly own approx 10M shares of Class B voting stock, which I did not account for in Geffen’s total holdings but did include in Katzenberg’s holdings because of Katzenberg’s current role in active management of the company. The Class B stock controls 67.4% of the total voting power of all shareholders.)

Catalyst:

There is no short-term, identifiable catalyst to unlock the value here. This is a long-term, buy-and-hold value compounder. You are making a bet on the market severely mispricing the value of this company in the present while assuming the market will be able to better ascertain the value (which continues to grow within a strong franchise) in the future. The company has a number of values to different owners (including potential acquirers or even management itself) and any one of those events, or none of them, could ultimately result in the true value of this firm being realized.

This is not a trade, it’s an investment. Wall St hates things like this.