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DreamWorks Animation SKG, Inc. (NASDAQ:DWA)

Q4 2006 Earnings Call

February 27, 2007 4:30 pm ET

Executives

Rich Sullivan - Investor Relations

Kristina M. Leslie - Chief Financial Officer

Jeffrey Katzenberg - Chief Executive Officer, Director

Lew W. Coleman - President, Director

Analysts

Michael L. Savner - Banc of America Securities

Anthony Noto - Goldman Sachs

Lowell Singer - Cowen & Company

David Miller - Sanders Morris Harris

Barton Crockett - JP Morgan

Jessica Reif-Cohen - Merrill Lynch

Richard Greenfield - Pali Research

Katherine Styponias - Prudential Equity Group

Tuna Amobi - Standard & Poor’s

Jolanta Masojada - Credit Suisse

Evan S. Wilson - Pacific Crest Securities

Presentation

Operator

Ladies and gentlemen, thank you for standing by and welcome to the DreamWorks Animation earnings conference call. (Operator Instructions)

I would now like to turn the conference over to our host, Mr. Rich Sullivan. Please go ahead.

Rich Sullivan

Thank you and good evening, everyone. I want to welcome you to DreamWorks Animation fourth quarter 2006 earnings conference call. I am joined on today’s call by our Chief Executive Officer, Jeffrey Katzenberg; our President, Lew W. Coleman; and our Chief Financial Officer, Kris Leslie.

Today’s call will begin with a brief discussion of the quarterly financials disclosed in today’s press release followed by an opportunity for you to ask questions. I would like to remind everyone that today’s release is available on the company website at www.dreamworksanimation.com.

Before we begin, we need to remind you that certain statements made on this call may constitute forward-looking statements. Forward-looking statements can vary materially from actual results and are subject to a number of risks and uncertainties, including those contained in the company’s annual and quarterly reports, as well as other filings with the SEC. I encourage all of you to review the risk factors listed in these documents. The company takes no obligation to update any of its forward-looking statements.

With that, I would like to now turn the call over to DreamWorks Animation’s Chief Financial Officer, Kris Leslie.

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Kristina M. Leslie

Thanks, Rich, and good afternoon, everyone. In the fourth quarter, the company reported a net loss of approximately $21.3 million, or $0.20 per share on a fully diluted basis, bringing reported earnings for the full year 2006 to $15.1 million, or $0.15 per share.

As anticipated, the fourth quarter and full year results included a charge of approximately $109 million, or $0.80 per share related to a write-down of film costs for Flushed Away. This charge offset an otherwise solid performance by our other titles in the quarter, primarily driven by the home video release of Over the Hedge.

Of the $204.3 million of total revenue in the quarter, Over the Hedge contributed approximately 50%, or $104.1 million. By year-end, the title had reached approximately 9.8 million home video units net of actual returns and estimated future returns on a worldwide basis.

Our 2005 release, Madagascar, contributed $36.2 million of revenue for the quarter, driven by international pay television and continuing catalog home video sales. Through the end of 2006, it has recorded approximately 22.2 million units shipped net of actual returns and estimated future returns, making it one of the best-selling domestic catalog titles of 2006.

Shrek 2 generated sufficient revenue during the fourth quarter to cause the title to become recouped. As a result, the company recognized $31.1 million of revenue, primarily from television and home video. At year-end, the title had reached approximately 41.2 million units on a net shipped basis worldwide.

Home video sales also drove revenue of approximately $9.5 million and $8.6 million for Shark Tale and Wallace & Gromit respectively. Through the end of the year, Shark Tale had shipped approximately 20 million units net of actual returns and return reserves on a worldwide basis, while Wallace & Gromit reached approximately 5.2 million units.

Flushed Away, although unrecouped at the distributor, contributed $6.2 million of revenue from the Paramount reimbursement as well as merchandising and licensing activities. The remaining $8.6 million of revenue was generated by our library and other titles.

Our cost of sales for the quarter totaled $219.9 million and includes the previously mentioned $109 million write-off for Flushed Away. Flushed Away has reached approximately $175 million in worldwide box office to date and is nearing the end of its theatrical run, having already been released in all major territories.

Film accounting standards require that we evaluate capitalized film costs by comparing the current capitalized film costs on our balance sheet to the discounted future cash flows the film is expected to generate. Based on its performance to date, as well as its expected future performance in all markets, we determined that a write-down to net realizable value was required.

While the film will continue to generate revenue for the company in the future, it will be offset by the amortization of the remaining film costs and as a result, the film will likely not have any significant earnings impact going forward.

Moving on to the rest of the income statement, SG&A for the quarter was $21.9 million, which included approximately $8 million in stock compensation expense. For the year, SG&A was $78.8 million, up approximately 3% on a year-over-year basis.

Looking at taxes for the period, the company tax provision was approximately $31 million for the quarter, which results in a significantly higher effective tax rate than the 35% statutory federal rate. Because of the substantial tax benefit the company has the opportunity to recognize from the asset step-up and tax-sharing arrangement, we have taken a conservative view and assumed that we will not be able to recognize any additional tax benefits in the future like the one potentially created by the write-down of Flushed Away film costs.

As a result, we have established a full valuation allowance against the deferred tax asset created by the write-down, which resulted in the high effective tax rate in the period. This was offset by a benefit of approximately $38.9 million, representing the true-up for fiscal 2006 of Vulcan share of our tax expense from its tax-sharing agreement with the company.

The net loss for the quarter, including the charge for Flushed Away, totaled $21.3 million, bringing total net income for 2006 to $15.1 million.

So overall, the quarter was impacted by the lower-than-expected performance of Flushed Away, which more than offset an otherwise strong performance of our titles in the home video market.

Looking forward to 2007, due to Flushed Away’s write-off, neither the film nor its video release in the first quarter of 2007 is expected to provide a significant source of earnings. As a result, 2007’s financial performance will largely be determined by the release of Shrek the Third, which will be in theaters on May 18th. As we have said before, it is extremely difficult to predict how a film will ultimately perform prior to its theatrical and home video releases. As such, we will continue not to provide specific EPS guidance.

I would however like to remind you that because of our distribution agreement, it is very likely that the company’s financial performance will be heavily weighted toward the second-half of 2007.

Our second film of 2007, Bee Movie, is scheduled for release in November. As is typical with our fall releases, we do not expect to see any significant revenue or earnings from this film until 2008.

Finally, I would like to remind you of the cost structure for our 2007 films. As previously discussed, both Shrek the Third and Bee Movie should be viewed as sequels from a cost perspective. Accordingly, each will have higher negative costs as well as a higher contingent cost component if successful.

While we do not discuss specific film costs or ultimates, in general, the product costs for a sequel is roughly 15% to 30% higher than our estimated $130 million for an original film. In addition, contingent compensation, or box office bonuses, are also higher in the case of a sequel and can be estimated at approximately 10% to 14% of worldwide box office, versus roughly 7% to 9% for an original film.

As is the case with these films and sequels in general, we are hopeful that the incremental costs are more than offset by a higher likelihood of success, as well as the ancillary opportunities that can be created around the franchise.

Lastly, we announced today that our Board of Directors has approved a share repurchase program of $150 million that we expect to execute at our discretion over the next 18 months. Based on our strong cash position, we believe that this repurchase program is in the best interest of the company and its shareholders.

With that, I will turn things over to Jeffrey.

Jeffrey Katzenberg

Thank you, Kris, and good afternoon, everyone. Thank you for joining us here today. Looking at our performance over the past year, I think it is fair to say we have had mixed results. However, I do think that we have taken some important steps towards positioning ourselves for a successful future.

Looking at our 2006 theatrical releases, Over the Hedge was a solid success, finishing as the eighth highest grossing film of the year at the domestic box office. That means that we have had a film in the top 10 domestic box office in each of the three years since going public.

In addition to its box office performance, Over the Hedge has also done well as a new home video release. In fact, in 2006 we had strong home video performance from several of our titles, including our 2005 release, Madagascar. I believe that the performance of our titles has demonstrated the home video market is still strong, especially for new CG hit titles. While the industry has gone through a transition, I believe that the catalog market has stabilized, which is good news.

While both of our overall home video performance and the theatrical success of Over the Hedge were positive this year, our second release, Flushed Away, did not live up to our expectations. Creatively, I believe it was a quality film and many critics felt the same way. Unfortunately, the film did not yield the kind of box office performance we need from our films and clearly we need to do better.

Increased competition has made it essential that our movies be unique and different from others. Looking out at our film slate over the next couple of years, I believe the projects that we have in development have the potential to clearly set us apart from the competition. And while there is no way to guarantee a film’s success, I hope the hard work we have put into improving our story process will begin to show in the quality and originality of our stories.

In May of this year, we will be releasing Shrek the Third, and I believe it is a satisfying next chapter of the franchise. And in a way, I believe it also marks the next chapter for DreamWorks Animation. For the first time since going public, we will be executing on the business model that we first envisioned, releasing one original film and one sequel.

Sequels help us to mitigate some of the risk and more importantly, allow us to build franchises through ancillary markets.

Looking at Shrek as the model, we are using these characters to expand the business, first in TV with the Shrek the Halls Christmas Special for ABC and Shrek the Musical potentially on Broadway in 2008.

To make this business model work, we need to complement our franchises with innovative original films like our 2007 fall release, Bee Movie. As many of you already know, the movie showcases the talents of Jerry Seinfeld as writer, producer, and star of the film. I have wanted to work with Jerry for a long time and collaborating with him has turned out to be an even better experience than imagined.

So I am pleased with our film slate this year and proud of how both these movies have come along. I believe they are real creative achievements, and I feel the same way about our 2008 slate. Next year we are releasing Kung Fu Panda starring Jack Black and we will follow with a sequel to Madagascar, another important step in our franchise strategy.

Over the next two years, I believe that our films are not only different from each other but also different from anything else in the marketplace. This is crucial if we want to remain among the leaders in animation, even though the number of animated films has decreased from last year. Competition in animation is here to stay.

It is also important to remember that we are not only competing with animated films but also with live action event films as well. Looking at the release of Shrek the Third in particular, the film will face an unprecedented level of competition this May. It opens along with two of the other most successful franchises of all time all within a four-week period.

I believe the market is big enough for each of these films to be successful and we have thought long and hard in choosing the optimal release date for the film.

Having said that, it is more than likely that having these films out at the same time will have some impact on our performance. How much impact we just do not know -- we will all have to wait and see.

Before we begin the Q&A portion of the call, I wanted to take a minute to first thank Kris Leslie. As you know, Kris will be leaving the company and I wanted to thank her for her years of dedicated service. Her leadership has been instrumental in shaping this company for almost 11 years. The company is in the process of searching for a replacement and in the interim, Lew Coleman will be assuming the role of Chief Financial Officer.

With that, let met turn things back to Rich so we can begin with the Q&A portion of the call.

Rich Sullivan

Thanks, Jeffrey. Before we start the Q&A process, I would like to have the operator please go over the procedures for logging the questions.

Question-and-Answer Session

Operator

(Operator Instructions)

Our first question comes from the line of Michael Savner from Banc of America Securities. Please go ahead.

Michael L. Savner - Banc of America Securities

Just two questions, if I could. First, Jeffrey, could you talk a little bit about your plans for Shrek 2 now that you are back in a recouped position and obviously that franchise still has a tremendous amount of value? How are you going to look to exploit that franchise further in the back-half of the year when the Shrek 3 home video comes out? Would you imaging a box set that includes the first two Shrek franchises immediately, or is that something you would hold off until 2008 or further out?

Secondly, just to follow-up on your last comments about Kris -- and good luck to you, Kris -- but could you give us a little bit more granularity in terms of what you are looking for in your candidate to fill that role and over what time period you would like to find that successor for the CFO? Thanks.

Jeffrey Katzenberg

I will do the first question, Michael, and I will actually let Lew do the second. As to the first, our plans will be to follow very much the playbook of what we did on Shrek 1 when we released Shrek 2. We will be back in the market place, in the video market place with a campaign supporting Shrek 1 and Shrek 2 as Shrek 3 is released in the spring, and then we will follow up with a strong program for the fourth quarter to accompany Shrek 3 when it is release in home video.

I think you can expect to see just about every variation on packaging that -- one with three, three with two, two with one and any other factor that we could think of there, all three together, maybe even backwards. We will package it up in a lot -- there is some very creative work that is done here by the home video people in anticipation of that. Lew.

Lew W. Coleman

In terms of requirements, I think what we are really looking for is a CFO candidate who first of all has public company experience, secondly has entertainment experience, probably in that order, and obviously we want to find somebody whose personality fits the personality of the company and the energy of the company.

We are going through about 10 of the more obvious names right now, have begun interviews but I do want to let you know that we are going to probably be very careful wit this hire and do not feel particularly rushed at the moment.

Operator

Our next question comes from the line of Anthony Noto from Goldman Sachs. Please go ahead.

Anthony Noto - Goldman Sachs

Jeffrey, you had made comments about the home video market strength behind new releases and I was just wondering, do you think there are specific things that you change at DreamWorks to help reinvigorate the sell-through of your titles? Looking at just Madagascar and Shark Tale, it looks like they are on track to hit some of the historical norms of tie ratios and I was wondering if it was more of an industry recovery or things specifically that DreamWorks had done, and then I have one follow-up. Thank you.

Jeffrey Katzenberg

I think it is probably both. I think that the fact that there has been some real stability in the market and that the avalanche of catalog product, which has slowed, has created a better profile again for our product. I also think that our marketing and distribution teams have done very, very good work in selecting not only the strategically the best date to release our product and how to position it at retail and to work with retail, creating unique programs with them, but I think it is probably a combination of those two things that certainly have allowed our product to perform well.

Anthony Noto - Goldman Sachs

My follow-up, as you think about Shrek the Third and going into that event and the competition that follows on, will you change your marketing on the front-end of that to try to drive a greater volume in that first box-office weekend, using things such as the Internet or maybe even some more innovative ideas, as a short tie-in to maybe Shrek 2 to Shrek the Third? Then, on the back-end of the home video, is there a new technology that you can use as it relates to high-def or Blu-ray to really capture some incremental sales of Shrek 1 and Shrek 2 in better technological advances in the release of those DVDs in conjunction with the DVD release of Shrek the Third?

Jeffrey Katzenberg

Again, just to give you sort of flavor, we have actually been -- we are well, well along on our plans for the fourth quarter release of Shrek the Third. We are probably several months into programs that have been worked out with retailers, and we are continuing to fine-tune those programs. I guess all I can say is I think we are incredibly well-positioned to have a very, very big impact and a very big event at retail with the Shrek franchise as a whole. I think there are some very exciting elements that we are looking for. I think there are some unique merchandising opportunities that exist creatively within Shrek 3 that I think are going to have a tremendous impact of what we are able to do in the fourth quarter -- in particular, the Shrek babies.

We have some very fun packaging and elements that are coming together on it, so without going into the very specific details of it, the only thing I can share with you is that it is a set of programs that have been in the works for over a year.

Operator

Our next --

Jeffrey Katzenberg

Wait, I’m sorry. Anthony, you asked about HD and DVD in terms of that as a platform and what the value and opportunities of that, it is still very, very small and we keep watching it carefully to find out when there is an opportune moment for us to put our product into it. Whether we will be there in the fourth quarter or not, it is too early to tell.

Right now, in the larger scheme of the Shrek franchise at home video in the fourth quarter, it will be small.

Operator

Our next question comes from the line of Lowell Singer from Cowen & Company. Please go ahead.

Lowell Singer - Cowen & Company

I actually have a couple of questions. Kris, one for you; can you talk at all about the drivers of the Over the Hedge revenue in the quarter? I know you gave the lifetime to date home video numbers. I am wondering if you can give the -- a little bit more granular.

Jeffrey, two questions. First, can you talk about the merchandising side of Shrek 3 and how you think in qualitative terms, compared to the first two Shrek films? How much progress have you made on that revenue line?

Second, you talked in your prepared comments a little bit about changes that you have made in story development. Can you compare and contrast what you guys are doing today as you think about of the development for the four films coming out over the next two years, versus where you were as a company in this movie-making process two and three years ago?

Kristina M. Leslie

I will take your first question. As you know, we do not get into revenue specific to any individual market, but if you think through how the recoupment process works, the majority of the revenue that you are seeing recognized in the quarter relates to international, theatrical, and then obviously the fourth quarter home video release.

Lowell Singer - Cowen & Company

There was no big chunk from merchandising in there?

Kristina M. Leslie

It includes merchandising in there, but not a big piece of the overall number that we have recorded.

Rich Sullivan

Just to be clear, I know you started the question saying the home video units we have given were inception to date. In actuality, the units we disclosed today were actually through the end of the year of ’06.

Jeffrey Katzenberg

The first is on merchandising on three as compared to two, I do not actually remember back what one to two was, but it was significantly greater one to two. I do not know -- Kris, do you remember? Was it double?

Kristina M. Leslie

More than double.

Jeffrey Katzenberg

More than double, so from one to two, it more than doubled. It is a little bit early to tell on three, other than what I will say is that without going into more detail of it, the minimum guarantees on three are 50% higher than they were on two.

On to the second part in terms of what are the things that we have done and the impact on the storytelling creative side of it, I think it really falls into three things. The first is that we added from six months to 18 months for the front-end story development on our films. That is something we did a year-and-a-half ago, so that is not going to be felt in all of these films fully until ’09, although it has -- we have seen some impact on it for the ’08 slate of films.

The second thing is is that we have really now fully integrated a system called electronic storyboarding into our process here, which has allowed us to see our movies in a much, much more robust story-reel fashion much earlier and allows the filmmakers to get them up and in front of audiences considerably earlier which is just a great process. It’s great feedback as a filmmaker’s tool and aid.

Thirdly is just the fact that our talent frankly is just much more experienced here. Most of our filmmaking team are either on their second, third and in some cases now fourth film, so the maturity of the staff here and our creative leadership I think is now being felt in a meaningful way, and their experience shows in the quality of work that is getting done.

Operator

Our next question comes from the line of David Miller from Sanders Morris Harris.

David Miller - Sanders Morris Harris

A couple of questions. Kris, you guys really seem to do pretty well with a lot of these -- let’s just call them older titles or library titles that are still contributing handsomely to the revenue line, one of which looks like it’s Wallace & Gromit, which has now reached 5.2 million units shipped. I believe you guys took a $0.04 per share write-down on that asset in Q1 of ’06. I am wondering is that asset still in a deficit situation? Do you see reversing that write-down or is the asset still in a deficit situation? Then I have a follow-up, thanks.

Kristina M. Leslie

I think the right way to think about it is that at the time we took the write-off on Wallace & Gromit and as we have done now with Flushed Away, it is always a calculation based on what we think it is going to earn across all these markets, so obviously as that changes over time, the ultimate moves up or down. But you do not reverse the write-off. If you were to see improvement, you would prospectively recognize that over time but the improvement of Wallace & Gromit has not gotten rid of the write-off that we took.

David Miller - Sanders Morris Harris

Lew, on the $150 million share repurchase program, just analytically, how did you guys come to the decision of $150 million? Was it just a nice round number, or how should we think about that? Thanks.

Lew W. Coleman

I think what you need to do is think about, as much as anything else, the fact that of our hundred and two or three million shares outstanding, about 50% of those are actively traded and about 50% of them are not. The $150 million number therefore sort of becomes 10% of the float, which is considered a fairly robust program.

Obviously we are trying to return cash to the investor and still balance the fact that we would like to keep reasonable float in our stock, and when you put those two forces together, you come up with $150 million.

Operator

Our next question comes from the line of Barton Crockett from JP Morgan. Please go ahead.

Barton Crockett - JP Morgan

Great, thank you. A couple of questions here, if I can. First, getting at the DVD market in the fourth quarter, one of my concerns was just that it looks so competitive with so many strong movies released to DVD in the quarter. It seemed to kind of an unusually strong period for new releases and yet you guys did very well. I was just wondering if you could comment a little bit on the units at Over the Hedge and how those compared to some of the other big movies that were released in the quarter, like Cars and Ice Age.

Also, on your sense of the consumer and retailers’ ability to handle a periodic kind of big increase in the number of CG titles released in a quarter, since that may be something that recurs as we look ahead with competition, a continuing factor. That would be the first question.

The second question, getting to the share repurchase which you guys have announced, strategically, given that you are now in the market for buying back some of your shares, can you just talk about what the rationale is for at this point even continuing as a public company, or whether you see a strategic value in having that currency out there or whether strategically there is any need for that or potential for a change in the ownership structure there? Thank you.

Jeffrey Katzenberg

To the first question, the fourth quarter absorbed the new releases I think very effectively. The marketplace expanded and we certainly enjoyed solid performance. I cannot compare us against the other titles because we do not actually have the details, specific numbers on their titles and I do not want to speculate on what they were doing, but everybody did do well. It has been well-reported that there have been great successes -- Pirates, Cars, a number of other titles did well. I think the good news for us is that there certainly was not any cannibalization of our product by the others in the marketplace. I cannot comment about theirs. I can only comment about ours.

As to the amount of CG product coming into the marketplace, there is clearly going to be significantly less of it this year than there was last year. We do not really have a final count yet on what the titles will be, but I think we were 16 or 17 titles last year and it would like it is probably in the neighborhood of about 10 or so this year, and probably along those lines in 2008. That is a meaningful thinning of the market.

Nevertheless, more than ever we feel we have to do a number of things, we are working on a number of things here to make sure that we are unique and very differentiated from anybody else in the marketplace in every respect.

Lew, do you want to --

Lew W. Coleman

Yes, on the big question about our rationale, being a public company. First of all, obviously we are. We have invested a lot in the process over the last three years. We like our niche in this marketplace of being one of the few pure plays available. We are convinced that it provides us with very competitive cost of capital and we are quite comfortable being a public company.

Jeffrey Katzenberg

We are the last independent movie company that is in the mainstream of movie-making and believe as we build these franchises and our name and our brand, there will be significant opportunities for us to build the company with success.

Operator

Our next question comes from the line of Jessica Reif-Cohen from Merrill Lynch. Please go ahead.

Jessica Reif-Cohen - Merrill Lynch

Thank you. I have two questions. Can you discuss the wholesale pricing for Shrek 1 and Shrek 2 on home video when you re-release them? Is it possible for you to give us the Shrek 2 units sold in the fourth quarter of 2006?

Jeffrey Katzenberg

To the first one, I know the answer is no. No, we do not discuss the wholesale pricing of the product in advance of its release, Jessica.

Rich Sullivan

I know we gave inception to date it was about 41.6 million units for Shrek 2 through the end of the fourth quarter. Let me give you the actual units in the quarter. I will get that for you in a second.

Why don’t we move on to the next question while we find that number?

Operator

Our next question comes from the line of Richard Greenfield from Pali Research. Please go ahead.

Richard Greenfield - Pali Research

A couple of questions. When you look at the hold-co structure, which dissolved when you did your following offering recently, could you just give us a sense of the actual share ownership now among hold-co partners and whether those shares are currently registered or whether they would actually need to be registered for them to be sold, now that the period has expired when shares could be sold?

Secondly, assuming Paul Allen, who initiated the last secondary sale, chose to sell stock again, I think he has somewhere between $500 million and $600 million worth of stock, would the company think of significantly increasing its share buy-back given its balance sheet to acquire those shares versus letting them come to market? Thanks.

Lew W. Coleman

Let me give you a couple of pieces here. As far as the major ownership remaining in the company, as you know, Paul has about 21 million shares and essentially has an economic interest of about 21% in the company. His voting interest is about 6.5%. David and Jeffrey control voting about 73% of the company, and there are a few other sort of medium-sized shareholders in there beyond what you see in the public records, which do not have a lot of rights to influence what happens here and can generally sort of piggy-back along.

Registration statements would be required for a public offering of Paul’s stock, and he has the rights to ask for those registrations, I think another three, maybe.

I do not think at the moment that we would be interested in buying out all of Paul’s stock all at once. I do not think we want to make the size of the financial commitment required to do that, although obviously we would be influenced by price at the time.

Jeffrey Katzenberg

But also, Paul has not stated any interest in reducing his interest in the company, so it is all speculative in that he had not expressed interest one way or another.

Lew W. Coleman

That is correct.

Operator

Our next question comes from the line of Katherine Styponias from Prudential. Please go ahead.

Katherine Styponias - Prudential Equity Group

I have a couple of questions as well. Kris, you were helpful in articulating what the negative costs might look like for Shrek 3. I am wondering if you can do the same with respect to marketing both theatrical and DVD, whether you would anticipate that outlook similar to other films more or less.

The second question I have is whether or not DreamWorks has any plans to release Shrek in 3-D, and then I have a follow-up.

Kristina M. Leslie

On your marketing question, I think it is fair to assume that the marketing costs will be in line with any of the rest of our movies. So as you know, typically theatrically we spend between $125 million and $175 million, and obviously the video spending will depend on the ultimate performance of the title in the theatrical market, but it is in line with the ranges that we have talked about before.

Jeffrey Katzenberg

There are no plans for Shrek 3 theatrically to be released in 3-D.

Katherine Styponias - Prudential Equity Group

Kris, one follow-up on home video and the strength that you saw in terms of the revenues that you posted. I am just wondering if there were any, in light of the scare that the company went through with respect to DVD sales about a year-and-a-half ago and the increases in reserves that you took at the time, does any of the strength in your revenue numbers reflect reversal of home video reserves, in light of the fact that it is coming in stronger than anticipated?

Kristina M. Leslie

Kathy, as you know, we constantly evaluate our level of reserves and we change them, either increase or decrease them on any given title on any given quarter, so certainly there were changes in reserves this quarter like there were any other, but not at a level that was material enough to get into on the call.

Operator

Our next question comes from the line of Tuna Amobi from Standard & Poor’s. Please go ahead.

Tuna Amobi - Standard & Poor’s

I was wondering if there was anything else we can read into your decision to end the Aardman relationship. Does that perhaps signal a shift in strategy, the kind of films that you intend to make in the future, or even the number of films? I have a follow-up.

Jeffrey Katzenberg

Well, the answer is yes. We now really have built the resources internally here to make two CG films a year and we really felt that that Aardman relationship really no longer fit our business plan and model here. They have been great and we certainly liked being with them creatively for the past 10 years. We had some success with them and obviously some disappointment, but I think we really grew to have a very different agenda going forward than we have in the past and this was the time to make the break. We wish them well.

Tuna Amobi - Standard & Poor’s

So it is safe to assume that you are not going to make any stop-motion films in the future, right?

Jeffrey Katzenberg

We have no plans to do so.

Tuna Amobi - Standard & Poor’s

I have a follow-up for Kris. It seems like the write-off on Flushed Away came in higher than at least I was expecting. By my calculation, it seems like you wrote off approximately 75% of the capitalized cost. While I understand you mentioned in the last call that the write-off was going to be material, I am just trying to get the sense of what kind of -- how these dynamics work. Clearly this film is coming in close to $200 million in the worldwide box office, similar to Wallace & Gromit, so I am just trying to balance the two films and get a sense how this dynamic works in terms of the DVD units, the box office, and so on, just for the future, if we find ourselves in this situation again. Hopefully not.

Kristina M. Leslie

Yes, hopefully not. As you know, the write-off is a function of the ultimate that we create for the film. So we go through the process of evaluating what we think it is likely to generate in all the markets and we do not get into the details of that with you guys, but one way to think about it might just be if you think back to Wallace & Gromit and the write-off we took there, what you do know is that the costs for Flushed Away were significantly higher than the capitalized costs for Wallace & Gromit. We also, from a marketing perspective, approached it much more like a traditional CG film from a spending standpoint versus Wallace & Gromit. So the sum of those two things is really what is driving the magnitude of the write-off.

Tuna Amobi - Standard & Poor’s

Okay, so Wallace & Gromit has done now, what, 5.2 million units, DVD units? Would you say that your expectations for Flushed Away that is baked into this write-off is within this number, or more or less?

Kristina M. Leslie

We do not comment specifically on our expectations in terms of units for a title, but obviously in coming up with our estimate for Flushed Away, we have taken into account what we have seen on all of our titles plus what we know is going on in the marketplace.

Operator

Our next question comes from the line of Jolanta Masojada with Credit Suisse. Please go ahead.

Jolanta Masojada - Credit Suisse

I wonder if you could, Jeffrey, talk about your perception of the opportunity for revenue growth from digital and how meaningful it was in your 2006 revenue, how big can it become in 2007, and is it your view that digital revenues are going to be replacement or additional?

Jeffrey Katzenberg

It is very, very, very small at this point. The digital marketplace for the industry as a whole right now is in the very low single digits -- very low. So it really is not a meaningful contributor. It was not in ’06 and we do not expect that to change in ’07.

I do think it has great promise for us. Any time a new platform comes on board that gives us the ability to deliver our product to our customers, and in this case, since our product is digital, to be able to deliver it digitally I think is a quality product.

So we do and will be supporting digital delivery and whether or not it becomes incremental or replacement, again I just do not think that any of us have enough insight as to what that marketplace is going to look like in the coming years.

Operator

Our next question comes from the line of Evan Wilson from Pacific Crest Securities. Please go ahead.

Evan S. Wilson - Pacific Crest Securities

First, could you comment on the health of the DVD business internationally? I am assuming the catalog avalanche being over was referring to the U.S. Also, could you give us some sense of the breakdown in DVD revenue, U.S. versus international for Over the Hedge?

Also, could you also give us some sense of how the international competitive windows have shaped up for Shrek 3 versus Spidey and Pirates when we are talking about especially Western Europe.

Jeffrey Katzenberg

The international DVD market has been stable also. I think it actually was even more challenged than the domestic market, going back two years ago. We started to see some stability in that in 2006 and it does also seem to have stabilized, particularly in the fourth quarter and what we are seeing year-to-date.

Kris will have to look at and see if you she can give you domestic versus international numbers.

Kristina M. Leslie

In terms of the split, we do not get into that level of detail but the vast majority of the revenue in the quarter came from domestic because as you know, we released the title internationally on a territory-by-territory basis and we report those sales on a one-month lag, so what that tells you is anything released in December in the international markets does not get recorded in 2006, so the vast majority is domestic.

Jeffrey Katzenberg

For the last question in terms of the release internationally of Shrek, we are the only one of the three titles that is not going day-in-date, so Spidey will actually go day-in-date the first week in May. Pirates will go day-in-date Memorial Weekend. We begin, other than two or three territories which will go day-in-date, Russia, Taiwan, a couple of the Asian territories, the vast majority of ours roll out into the middle or end of June and into July for Shrek.

So it is a very, very competitive summer internationally as well as domestically. It is just going to be different competition than Pirates and Spidey.

Evan S. Wilson - Pacific Crest Securities

One more follow-up; as we have had the increased competition in CG animation, have you guys on the back-end seen any changes in gross film revenue, coming from pay or free television?

Jeffrey Katzenberg

Most of those arrangements we have are long-term output deals, so there is again stability for us in terms of those revenues.

Operator

(Operator Instructions)

Rich Sullivan

Okay, well, I guess that concludes today’s fourth quarter earnings call. I would like to remind everyone that a replay of this afternoon’s call will be available shortly and accessible on our DreamWorks Animation website -- that address again, www.dreamworksanimation.com. Also, if you have any further questions, please feel free to contact DreamWorks Animation’s investor relations department.

Thank you again for participating and have a great evening.

Operator

Ladies and gentlemen, this conference will be available for replay after 6:45 today through March 11th at midnight. You may access the AT&T teleconference replay system at any time by dialing 800-475-6701, using access code 862439. International participants dial 320-365-3844. Those numbers again are 800-475-6701 and 320-365-3844, using access code 862439. That does conclude our conference for today. Thank you for your participation and for using AT&T executive teleconference. You may now disconnect.

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Source: DreamWorks Animation Q4 2006 Earnings Call Transcript
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