Why Dreamworks Animation May Be Causing Nightmares

| About: Dreamworks Animation (DWA)

If only Dreamworks Animation (NASDAQ:DWA) stock was as beloved as its characters Puss in Boots and Po from Kung Fu Panda. Instead, on December 30, 2011, DWA had a short interest of 25% of the float.

That would seem to suggest a company that’s in trouble. So let’s look at some possible reasons people may be short this stock, giving nightmares to longs who have watched the price plummet over the past year.

1. Everyone is making computer animated movies.

It’s true there’s more competition than years ago when Dreamworks and Pixar (now a unit of Disney (NYSE:DIS)) were the only games in town. But it’s also true that there are now many more towns, namely cities like Shanghai and Moscow, as studios recognize that growing consumer classes worldwide want to see the best entertainment Hollywood has to offer. If there are more players in more towns, you want the best players in those towns. So what was the best animated film that Hollywood had to offer in 2011? Well, if you base such a ranking on global box office revenues, according to Box Office Mojo, the answer is DWA’s Kung Fu Panda 2, grossing $665.7 million worldwide. In fact it was the fifth highest grossing movie of any variety worldwide. It bested Pixar’s Cars 2; Columbia/Sony’s (NYSE:SNE) the Smurfs; and Fox’s (NASDAQ:NWS) Rio. Those other three movies are worth mentioning, because they are the only three animated movies on the list that beat DWA’s only other release in 2011, Puss in Boots, the thirteenth highest grossing movie worldwide of 2011.

2. People are not buying as many DVDs as they used to.

Sure, there are people out there who will buy today’s current releases on a street corner abroad, getting a version of the movie recorded on a camera phone in a crowded theater, resulting in the kind of motion sickness that used to be exclusively induced by films like the Blair Witch Project. And there are others who know what web sites to go to for illegal downloads, that may or may not be accessible in the future, depending on what happens with the Stop Online Piracy Act (SOPA). Fortunately, DWA is recognizing the importance of the transition to digitally streamed movies, having decided to end its deal with Time Warner's (NYSE:TWX) HBO in 2013 and entering an exclusive contract similar to HBO's pay-TV deal with Netflix (NASDAQ:NFLX). Netflix allows viewers to choose from a selection of movies to watch on various devices now. And if there is any demographic that wants to watch something immediately, it’s young kids. Incidentally, young kids also like to watch the same things more than once, so repeated viewings, whether on Netflix, or some future version of Apple TV (NASDAQ:AAPL) that allows movies to be quickly purchased (instead of the current rental-only Apple TV) may be of benefit to DWA.

3. Dreamworks wants to do risky things, like potentially distribute its own movies, and put on live arena Kung Fu Panda shows in China.

Dreamworks acknowledged in its last conference call that it is contemplating the various possibilities for distribution, including self-distribution, as its current distribution deal with Paramount nears expiration at the end of 2012. It also noted that it spent $700 million on distribution costs over the eleven-picture life of its current contract. If Dreamworks can save distribution costs, that’s good news, especially since it seems the world likes the characters it’s been putting on screens recently, and will hopefully continue to demand to see some of these characters. DWA also will be opening a live arena How to Train Your Dragon Show in Australia this March, and a similar live Kung Fu Panda show in China in the fall. Some might view these plans as risky, and others might view them as a valiant attempt to try to follow in Disney’s footsteps. However, even if they are risky moves, DWA is a profitable company that can afford some risks, with approximately $150 million in cash, and no long term debt. The live action Dragon show is a joint venture, and if self-distribution does not improve costs, DWA can always try to negotiate a new distribution deal with someone else.

So, just like every good animated film needs a devilish character, this article has included some counterpoints to play devil's advocate for some of the possible explanations as to why DWA stock is out of favor right now, despite trading at less than ten times trailing earnings, and near seemingly nightmarish multi-year lows.

Disclosure: I am long DWA, AAPL.