DreamWorks Is Trying to Recreate the Walt Disney Empire

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.

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.

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.

Valuation
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 Jersey, 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.

The Key Takeaways in understanding DreamWorks’ hidden value are:

• DreamWorks $1.5 billion book value understates company’s revenue generating assets – Replicating Movie Library would cost more than $3.6 billion with no guarantee of a franchise hit.

• Competition for family viewing is a benefit for DreamWorks. Audiences, theatre owners, and distributors recognize quality when making decisions on how to spend their money.

• DreamWorks’ deal with Netflix reveals that even though the future of delivery format(s) may be uncertain, what is certain is that quality, content, and franchise hits are coveted.

• DreamWorks is working to de-emphasize impact of a box office bomb through joint ventures (Oriental DreamWorks & Indoor theme park) & purchase of Classic Media.

• Katzenberg has shown himself to be a very capable CEO, an industry leader, deal maker, and visionary (first to incorporate 3-D). Financially, he has nothing to prove (salary of $1) but has aspirations to turn DreamWorks into the next Disney.

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