DreamWorks Animation Management Is Optimistic, Despite Disappointing Q2 Results

Jul.31.14 | About: Dreamworks Animation (DWA)

Summary

DreamWorks Animation fell short of expectations on Q2 results.

The company discussed its changing cost structure and release dates for future films.

Management is optimistic about the future of the company, particularly going into 2016.

DreamWorks Animation (NASDAQ:DWA) released second-quarter results on July 29. The company reported revenues of $122.3 million and a net loss of $15 million, or $0.18 per share. Analysts were expecting revenues of $139.4 million and a loss of $0.02 per share (excluding special items). Overall, revenue declined 43% compared to the prior-year revenue of $213.44 million. Net income and EPS for the same period in 2013 were $22.3 million and $0.26, respectively. The miss sent DreamWorks shares plunging almost 12% by the end of the July 30 trading day.

The Culprit

The company's bottom line was heavily impacted by Costs of Revenue, which totaled $87.5 million. The other notable contributor was Selling, General, and Administrative Expenses, which totaled $54.6 million; this is including a $2.9 million stock-based compensation expense. Together, these cost DreamWorks over $142 million this quarter; other contributors, like the reduction of their AwesomenessTV payout, were not enough to make up for their high costs and expenses.

These high costs are consistently impacting the company's bottom line. Management realizes this and are making aggressive changes regarding the cost of their films, which I will detail later.

The Positives

Although DreamWorks' performance was disappointing, there were some positives mentioned during their earnings call and Q&A session.

First, "How To Train Your Dragon 2" is currently the 9th highest grossing movie of the year. It has grossed $166 million domestically and $428 million worldwide, to date. DreamWorks expects "Dragon 2" to continue to bring in significant revenue next quarter as well, as the movie is still in theaters here in the U.S. The film opened at No. 1 in 33 territories just the other day, and will open in China, Italy, and Spain next month. So far the film looks like it will be a success for the company, and DreamWorks expects it to be a key franchise going forward.

Another major positive for the company is "The Croods". The film was released over 15 months ago, but contributed $25.5 million toward this quarter's Feature Film revenue. The film has also reached 7.4 million home entertainment units sold. The continued success of "The Croods" and the "How To Train Your Dragon" franchises bodes well for the company going forward. As I stated in my previous article on DreamWorks Animation, these franchises are in their infancy, and their success will provide additional revenue streams in sequels and spin-offs in the coming years.

Cost Structure Changes

During their earnings call, the company revisited the cost structure of their films going forward. The company had previously stated their goal was to keep production costs of all future films under $125 million (excluding incentive-based compensation), beginning with their November release of "Penguins of Madagascar." Their goal for sequels specifically is to get the production costs down to $120 million, and CEO Jeffery Katzenberg believes they are on track to do so. However, no specific time frame was given. The exception to this will be the upcoming films "Penguins of Madagascar" and "Home", which will have a production budget of $135 million. Jeffery Katzenberg stated that this was an exception specific to these two films and was a result of changing their release schedule. I previously explained that I was unhappy with the company production budget of their recent releases, so I was glad to hear both Katzenberg and President Ann Daly reemphasize this goal.

Jeffery Katzenberg also shed some light on cost structure changes regarding original pictures, in particular. Instead of making incremental changes, like they will be doing with their current franchises, the company will be experimenting with a "very different business model" in which they expect to see significantly more variability in the cost of production. The business model change is driven by film concepts and the style in which the films are made. The specifics of the new model will be made public at a later date. Management stated that 2014 will be an important investment year for the company; the steps they are taking to reduce costs and planning far ahead for business model changes shows that the company is concerned with their current model and is attempting to set itself up for future success.

Optimistic Going Forward

There are four major film releases for DreamWorks that will be critical for the company in the coming years; two of which are original films. Their next release will be "Penguins of Madagascar," which will hit theaters on Nov. 26 of this year. It will be followed by "Home," based on the children's book The True Meaning of Smekday, which stars Rihanna, Jim Parsons, and Steve Martin, on March 27, 2015; "B.O.O.: Bureau of Otherworldly Operation," a completely original film about a top-secret government agency that employs ghosts to protect humans from evil, on June 5, 2015; and "Kung Fu Panda 3" on December 23, 2015. "Penguins of Madagascar" and "Kung Fu Panda 3" are likely to be strong revenue drivers for the company, based on the prior success of the respective franchises. However, "Home" and "B.O.O." will determine if DreamWorks Animation's new cost structure can be profitable going forward. If so, DreamWorks will be in a very good position going into 2016.

Overall, management seems to be very optimistic about the company's future. The recent write-offs have hurt the company's bottom line in multiple quarters. But if DreamWorks is really on track to curb production costs down to $120-$125 million, as the CEO says, the company may even be able to see net profits from original films that are not box office hits. As I stated in my previous article on DreamWorks, with its recent acquisitions, if the company simply avoids future write-offs, it could realistically see total revenue increase by 10%-15% by year-end 2015; hits could push that figure even higher.

Conclusion

In the short term, I expect volatility in DreamWorks' stock going into Q3 and possibly going into Q4. The reason being no new revenue sources are emerging in that time frame. Their main revenue drivers will be the recent and upcoming international releases of "How To Train Your Dragon 2" and their library of content. The majority of "Penguins of Madagascar" revenue will only be realized in Q1 of next year, though we will likely learn about its success and figures through media outlets or box office sources much sooner than this, hence the "possibly" in my prior statement. Ultimately, this may be a good entry point for investors looking to add a long-term growth stock to their portfolio; but as with any investment, your own due diligence is required. If the cost cutting on their upcoming films proves to be more profitable than analysts expect, DreamWorks may have a very bright future.

Disclosure: The author has no positions in any stocks mentioned, but may initiate a long position in DWA over the next 72 hours. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.