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DreamWorks Animation SKG, Inc. (NASDAQ:DWA)

Q1 2007 Earnings Call

May 1, 2007 4:30 pm ET

Executives

Rich Sullivan - Investor Relations

Jeffrey Katzenberg - Chief Executive Officer, Director

Lew Coleman - President, CFO

Analysts

Michael Savner - Banc of America Securities

Glen Vogelman - Goldman Sachs

David Miller - SMH Capital

Eric Handler - Lehman Brothers

Barton Crockett – JP Morgan

Rich Greenfield - Pali Capital

Kathy Styponias - Prudential

Presentation

Operator

Thank you for standing by. Welcome to the DreamWorks Animation first-quarter earnings conference call. (Operator Instructions) At this time I would now like to turn the conference over to your host, Rich Sullivan. Please go ahead.

Rich Sullivan

Thank you and good afternoon, everyone. Welcome to DreamWorks Animation's first quarter 2007 earnings conference call. I am joined on today's call by our Chief Executive Officer Jeffrey Katzenberg; and our President and Chief Financial Officer, Lew Coleman.

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, I 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 in other filings with the SEC. I would encourage all of you to review the risk factors listed in these documents. The company is under no obligation to update any of its forward-looking statements.

With that, I would like to now hand the call over to DreamWorks Animation Chief Executive Officer, Jeffrey Katzenberg.

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Jeffrey Katzenberg

Thank you, Rich and good afternoon, everyone. I'm going to keep my comments brief today, but I do want to take a few minutes to talk about what is ahead for our company. Our results for the quarter were solid, driven by a strong performance from Over The Hedge in home video, which did better than we had expected. This provided yet another data point that our product continues to do well in what is a healthy home video market. I hope that this quarter is historic and a very successful year for the Company and its shareholders.

As I have said recently, I believe we're entering the next chapter for DreamWorks Animation. We have all the pieces in place and are ready to execute on the business model we originally envisioned. As a company, we have certainly had some notable successes, but have not been as consistent as we would have liked. However, I think that our film slate over the next two to three years gives us the best opportunity since we started the company to achieve that consistent level of success.

It begins this month with Shrek the Third, which I believe lives up to the creative standards set by the previous two chapters of our most successful franchise. Clearly the competitive environment is not ideal. We're facing some very tough competition, and there is no way to predict how it will affect our performance. But I am confident that there is enough capacity in the market for each film to be very successful.

Later in the year we will release the much anticipated Bee Movie written, produced and starring Jerry Seinfeld. I think with this movie we have a real opportunity to bring a new audience to a DreamWorks animated film. Like all of our films, Bee Movie at its core is a family film, and as a DreamWorks movie, we strive to provide an experience that can be enjoyed by the broadest of audiences. But Jerry gives us an opportunity to add to our broad fan base, and we look forward to entertaining them with a very original story.

In addition to our unique film slate, this past quarter we also announced that starting in 2009 all of our movies will be created and distributed in 3-D stereoscopic animation. I believe the move to 3-D has the potential to reinvent the movie-going experience. For our films, as well as for other big event films, it allows theaters to differentiate our products as a premium experience. It is a little too early to predict how this will affect the business economically, but we are confident that the incremental dollars we spent to produce a 3-D film will be more than offset by the ticket premium we believe consumers would be willing to pay to see them. From a business perspective, as well as a creative one, I believe that 3-D is a significant opportunity for our company and the industry as a whole.

Aside from our theatrical releases, we have a few other exciting things going on. Later this year we will be airing our first-ever DreamWorks holiday special on ABC, Shrek the Halls. We have also made significant progress on the development of Shrek the Musical for Broadway. Both of these projects are good examples of how we are expanding our franchises into ancillary markets as a way to support the properties.

So with that, I will turn it over to Lew for a few words.

Lew Coleman

Thank you, Jeffrey. Good afternoon, everyone. I would like to highlight a few items from the first quarter before we open the lines to your questions. As Jeffrey said, it has been a fairly quiet quarter for us. We have seen stronger performance from our library of films, and we are also beginning to see the benefit of having two movies per year moving through the later revenue windows, like television.

As you saw in the press release, the company achieved net income of $15.4 million or $0.15 a share on $93.7 million of revenue. This operating performance was mainly driven by Over The Hedge home video, which has now sold approximately 12.6 million units net through the end of the first quarter. We also had contributions from network television for both Shrek 2 and Shark Tale.

Also during the quarter, we changed the way we estimate capitalized film costs, which will have a meaningful impact on how we report our results going forward. As you are aware, most of our operating costs directly relating to the production of a movie are capitalized. After assessing the changes we have made in our production processes over the past several months, including the technological unification of our production pipelines, we have concluded that a portion of previously capitalized costs should be expensed going forward.

For the quarter, this change resulted in expensing as opposed to capitalizing $4.2 million of operating costs. It is likely that we will expense a similar amount for each quarter going forward. This is not an increase to our overall cost structure, but it does impact the timing of when certain expenses are recognized. Over a four-year production cycle, the film's capitalized costs will be reduced by roughly $10 million per film, the full effect of which will not occur until our 2009 releases.

As required, we also adopted FIN 48, Accounting for Uncertainties in Income Taxes this quarter, which led to an immaterial one-time downward adjustment to our retained earnings of $2.1 million.

Looking ahead for the rest of the year, we anticipate that the performance of Shrek the Third will be our most important financial event. We will know a lot more about that in the coming weeks.

As a final note, before I get to your questions, we purchased approximately 1.2 million shares of our stock in the open market at an average price of $28.41 through the end of the first quarter.

With that, Rich, let's open it up for questions.

Rich Sullivan

Operator, can you please provide the instructions on how to log in for a question?

Question-and-Answer Session

Operator

(Operator Instructions) Your first question comes from Michael Savner - Banc of America Securities.

Michael Savner - Banc of America Securities

Jeffrey, one strategic question, and then Lew, two quick housekeeping questions. First Jeffrey, can you just talk about the strategy for the Friday release of Shrek 3 given the first two films were released on a Wednesday? Why the change, and could you have been incentivized to also do this one on a Wednesday to maybe capture another day and a half or so prior to Pirates? I don't know if Spider-Man maybe affects that.

Jeffrey Katzenberg

Sure, Michael. I think that going back, you really have to actually go back to Shrek 1 for a little bit of insight into that. We released Shrek 1 on that date really most of all to capitalize on wanting a couple of extra days for reviews, to break the reviews earlier on the film. And then on Shrek 2, we did it because we thought we could see some incremental business from those first two weekdays. Really analyzing it and going back and taking a look at it, with so much of the marketplace, kids and families really not available on weekdays at that time of year, I think looking back probably was not the best strategic move. It did not hurt us in any way, but it certainly did not help. It's a minor tweak to the market, really not indicative of anything other than a little bit of learning that we got. We were actually pretty disappointed in those Wednesday/Thursday openings three years ago.

Michael Savner - Banc of America Securities

Lew, can you just remind us, are there any films that are going to be eligible for the television distribution sale window during the second quarter?

Secondly, is there any restriction from you buying back stock over the coming next few weeks and months as Shrek opens? Anything that would preclude you from doing that?

Lew Coleman

Let me see, television windows in the second quarter, Over the Hedge domestic pay-TV is probably the significant item. There is a number of smaller items that come available in the second quarter, but that is probably the big item.

Michael, on the stock repurchase, obviously as you know we keep track of the various security rules at any time, and at any given time, that may or may not cause us a problem. So I would rather not make a blanket statement on what we can and cannot do in the second quarter or subsequent quarters. We will obviously report to you guys at the end of every quarter what we have done.

Operator

Your next question comes from Glen Vogelman - Goldman Sachs.

Glen Vogelman - Goldman Sachs

Jeffrey, just wondering what you think is helping the outperformance in home video conversion versus the box office? In other words, is it industry or company specific, and are these trends something that is sustainable?

Jeffrey Katzenberg

This seems to have been the case now for the last couple of releases for us. The industry itself I think has seen some solid performance and stronger performance than we have in the past for first run releases in general. Specifically our titles, the animated CG animated titles have been holding particularly strong. We saw it on Madagascar and now again on Over The Hedge and we've also seen it on Flushed Away. The titles are doing well.

Glen Vogelman - Goldman Sachs

Lew, on the buyback, I was just wondering whether or not you would consider increasing that once the initial 150 is completed?

Lew Coleman

We are always looking at our cash position and alternative cash positions and we will go to the board when we think it is appropriate. Beyond that, I would not want to anticipate any actions that we may do in the future.

Operator

Your next question comes from David Miller - SMH Capital.

David Miller - SMH Capital

Congratulations on the stellar results. You guys have generally taught us that negative costs for non-sequel-oriented projects should hover in the $130 million to $150 million range, and the sequels should hover in the $150 million to $170 million range. I guess Bee Movie is the exception to that because that is going to obviously be higher than that original range that you gave us. Is there any reason to expect that looking out into 2009, possibly 2010, that that model will deviate at all? Inflation notwithstanding, deviate either on the upside or the downside?

Secondly, should we assume that for participations on Madagascar 2, should we assume just for modeling purposes that those should mirror Shrek 3? Thank you very much.

Jeffrey Katzenberg

Going back on this, David, I think the thing that we have announced in terms of 3-D is going to deviate from the model in the past. I think that we have said that we are talking about a $10 million to $15 million per title incremental cost. So that is something that you would need to factor in.

Lew Coleman

David, also what I just described to you by 2009 would be a reduction in capitalized film costs of approximately $10 million. Essentially what is happening there is that we are picking up the expense earlier and we are recovering it with a slightly higher revenue amortization as the revenue comes in on the film.

Jeffrey Katzenberg

And onto whether Madagascar is going to be in anyway be indicative of where and how Shrek 3 performs, I am just not sure yet and I don't think we should speculate on whether they are going to be analogous or not. I think that you can look at Madagascar vis-a-vis a $190 million grossing movie, and I think probably be safe in using that to a like movie. But for a lesser performing film or a greater performing film, I think we would have to look at the specifics of it.

Operator

Your next question comes from Eric Handler - Lehman Brothers.

Eric Handler - Lehman Brothers

First, it looks like the motion picture exhibitors are going to be starting their transition to digital projectors towards the end of this year. Essentially, the major studios are all contributing to a fund to get the digital projectors into the facilities. Is DreamWorks contributing to that? If so, what is their proportionate share of that?

Secondly, as I look at your SG&A, it has been ramping up considerably the last couple of quarters. Is there anything specifically for that, and is your first quarter SG&A a good number to use as a straight line going forward for the rest of the year?

Jeffrey Katzenberg

I will take the first one, and I will let Lew do the second. We are, through Paramount, our distributor, we are supporting the rollout of digital. The way that that is actually working is that there is really, what in effect is a phantom fund that is created, in that we're funding the digital projectors as though we continue to make prints and contribute what would have been the cost of those prints. That is just sort of the theory behind how this is being financed and Paramount is a participant in that.

Lew Coleman

On the SG&A the single biggest item this quarter was an increase in stock comp expenses. A chunk of that had to do with the fact that a good portion of the stock comps expenses are performance shares, and we increased the probability that we would hit the performance targets. As a result, there was a bit of a jump in SG&A.

The SG&A line has been a bit lumpy over the last year or two, particularly as we went through some of our more well-publicized problems and had to pay all the legal bills we did and all the SEC investigations. When it came back down a bit last year, we're now beginning to turn to more regular rates. I have a feeling it is going to be a bit volatile here, particularly with regard to stock comp. So I would be careful about how I would project it forward.

Eric Handler - Lehman Brothers

What was stock comp for the quarter?

Lew Coleman

Stock comp for the quarter was $9.6 million.

Operator

Your next question comes from Barton Crockett – JP Morgan.

Barton Crockett - JP Morgan

I was wondering if you could comment a little bit on your expectation for how the opening weekend for Shrek the Third may compare to opening weekends for the first and the second given the different competitive slate with Spider-Man and Pirates? Do you think that the opening weekend will have to be a much larger percent than what we have seen historically, and will this kind of accelerate the velocity really, which you have to sell the tickets?

Over the Hedge the home video, the DVD, could you give us some sense of how to think about per unit pricing there? It is just relative to my model I came in closer, much closer on the units than on the revenues, and I am just wondering if there was anything unusual in terms of maybe the pricing there or the returns? Just any color there would be helpful. Thank you.

Jeffrey Katzenberg

In terms of the opening weekend of Shrek, you know I really don't feel comfortable speculating about it. It is a very competitive marketplace. At the same time, I feel that we have a great effort going on behind the marketing of the film. I think the uniqueness of the marketplace and the unprecedented nature of the marketplace really has us all just wanting to see it play itself out and not try and speculate about what is going to happen out there in it.

We're confident about the movie and confident about the launch of the film and all the materials and efforts that are being made behind the film and you are just going to have to wait and see. It is a couple of weeks away, and the only thing I will say is that we're looking forward to it with enthusiasm.

On the Over the Hedge video, I don't think there is anything unique about our wholesale pricing or any of the other policies in terms of co-op advertising or return policy or anything. I think it has followed pretty much on form what we have done in the past.

Operator

Your next question comes from Rich Greenfield - Pali Capital.

Rich Greenfield - Pali Capital

A question on day and date VOD. Obviously DVD is so important to you as a company. How do you think about the risk reward of trying to shift around or basically to consolidate windows the way some of your peers are in trials with both Comcast and Time Warner Cable? I see notably Sony has actually decided not to participate, and I was just wondering how you are thinking about it? Obviously Paramount is participating, but I don't know if that includes your films or not.

Jeffrey Katzenberg

Thanks, Rich. It does not include our films yet. I think that the profile of our product is very, very different and very unique. If you think a little bit about who the primary customers and consumers are for our titles and the fact that they are titles that are, in fact, valued most for their multiple plays, we tend to just fall in a slightly different profile than everybody out there with our two movies a year. So I'm interested in it in terms of how it plays out, but I don't think that it is going to cause a significant shift for us.

Rich Greenfield - Pali Capital

What about on the flip side of an HD VOD earlier window than DVD that would be a significantly premium price window, the way Fox has talked about in the past?

Jeffrey Katzenberg

Yes, that is something I'm interested in seeing, but remember we are a mass market product in the greatest definition of that word. When you start to talk about a niche market, which is what HD or Blu-ray represent right now in it, it is a little bit tail wagging the dog for us.

Operator

Your next question comes from Kathy Styponias - Prudential.

Kathy Styponias - Prudential

I have two questions as well. First, I'm wondering if, Jeffrey or Lew, if one of you can comment on the economics of the Shrek Christmas Special later on this quarter both from a revenue standpoint as well as a cost standpoint? What does something like that cost?

Rich, if you can give us a sense of where sell side expectations are currently for Shrek 3 domestic box office and for worldwide, an average?

Jeffrey Katzenberg

Kathy, I think as far as looking at the economics of Shrek the Halls, as far as your models are concerned, essentially we are making the film for a fee, and you can safely assume we're not losing money. The television show then gets shown by ABC for multiple years long term, and we get rights to the video. It then becomes an issue of how you think about video sales of a television special as far as the economic impact on our books is concerned.

Kathy Styponias - Prudential

Can you give us a sense of where sell-side domestic and/or worldwide box office expectations are for Shrek, either an average or a range for Shrek 3?

Rich Sullivan

You know, Kathy, I probably could do that off line. I feel a little bit uncomfortable talking about other analysts' models on the call. So maybe you would like to discuss it afterwards.

Operator, next question, please.

Operator

(Operator Instructions)

Rich Sullivan

Great, it looks like we have no more questions so I think that concludes today's first quarter earnings conference call. I would like to remind everyone that a replay of this afternoon's call will be available shortly and accessible on DreamWorks Animation website. That address again, www.DreamWorksAnimation.com. If you have any other further questions, please feel free to contact DreamWorks Animation Investor Relations department.

Thank you, again for participating and have a great evening.

TRANSCRIPT SPONSOR

MF logo

Did the analysts get it right?

Wall Street hires some smart cookies. But it’s not always in their best interest to put the hard questions to management. Are YOU even their top priority?

Motley Fool co-founder David Gardner is still bullish on DreamWorks. It’s up 27% since he recommended it to his Motley Fool Stock Advisor subscribers back in August 2005. Now, discover the ONE company David calls “The NEW American Super Brand” in a new stock research report.

Read the complete report courtesy of Seeking Alpha FREE.

* Returns as of 4/17/2007

To sponsor a Seeking Alpha transcript click here.

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