Why Dreamworks Should Never Make An R-Rated Movie

| About: Dreamworks Animation (DWA)

Summary

Fellow contributor Steven Mallas raises the at first glance a compelling idea for DWA to explore R-rated movies.

This would increase the company's hit potential with the demographic 17-plus.

In reality this is the worst thing shareholders could ask management to do.

Fellow contributor Steven Mallas recently penned a thought-provoking article called DreamWorks Animation And R-Rated Cartoons: A Recipe For Growth. Its core thesis being DreamWorks Animation (NASDAQ:DWA) could potentially have more success by expanding into R-rated territory. I love being challenged in my beliefs but ultimately can't conclude anything other than that his premise is a dangerous one that would be harmful to the long-term health of the company. I'll argue the main points Mallas makes one by one in order to explain why I hold the exact opposite view.

DreamWorks Animation has done well with family comedies, but the company has had some trouble at the box office in recent years, and its stock could be doing better.

Any stock I hold, both Mallas and I hold Dreamworks, could be doing better. It is true that Dreamworks Animation hasn't had tremendous success (Shrek-like) at the box office in recent years. Investors tend to forget how difficult it is to manufacture or predict hits. Although firms like Epagogix are making inroads into the field, what if everyone consulted them? That would mean no one had an advantage and when competitors only have very slight edges on each other, box office results will have a higher standard deviation. In short, the more intense competition for hits, the more unpredictable each firm's results. Competition in Animation has undeniably intensified since the early days when Dreamworks produced Shrek. Although that is one excuse for the disappointing box office results, the company did take steps to improve its results. The creative officer was replaced by two fresh creative officers and the firm decreased its slate from 2.5 movies to 2 movies per year in order to increase focus and find better release dates.

DreamWorks Animation may want to use more adult-oriented material to expand its brand value.

Although moving away from family friendly territory to appeal more readily to a more mature audience is compelling at first glance it is the worst possible strategic mistake. This is a quote from a speech Warren Buffett gave at Florida University that's very enlightening on the subject (emphasis mine):

Think of Disney (NYSE:DIS). Disney is selling home videos for $16.95 or $18.95 or whatever. All over the world - people, and we will speak particularly about mothers in this case, have something in their mind about Disney. Everyone in this room, when you say Disney, has something in their mind about Disney. When I say Universal Pictures, if I say 20th Century Fox, you don't have anything special in your mind. Now if I say Disney, you have something special in your mind. That is true around the world. Now picture yourself with a couple of young kids, whom you want to put away for a couple of hours every day and get some peace of mind. You know if you get one video, they will watch it twenty times. So you go to the video store or wherever to buy the video. Are you going to sit there and preview 10 different videos and watch them each for an hour and a half to decide which one your kid should watch? No. Let's say there is one there for $16.95 and the Disney one for $17.95 - you know if you take the Disney video that you are going to be OK. So you buy it. You don't have to make a quality decision on something you don't want to spend the time to do. So you can get a little bit more money if you are Disney and you will sell a lot more videos. It makes it a wonderful business. It makes it very tough for the other guy. How would you try to create a brand-Dreamworks is trying - that competes with Disney around the world and replaces the concept that people have in their minds about Disney with something that says, Universal Pictures? So a mother is going to walk in and pick out a Universal Pictures video in preference to a Disney. It is not going to happen.

I couldn't explain any better why the Disney or DWA brand and its family friendliness is so invaluable. It enables the company to charge a premium for its content because there is actually value for the customer - saving time while having the assurance kids are safe.

The reality is that some R-rated tentpoles do well in the marketplace: Seth MacFarlane's Ted and the Hangover franchise are two examples.

Sure there are a few R-rated movies that do well in the market place just as well there are a huge number of them that are complete flops. Do you really want to destroy the brand equity DWA has (again, parents can put on DWA content completely blind and have faith the content will be appropriate) just to increase your chance at a box office hit a little bit? No.

DreamWorks instead is expanding its reach across channels and across media. Its OTT/TV content segment is growing fast and it is even publishing books now and licenses its character rights for live entertainment ventures and video games. A strategy that is both effective and protects the brand equity.

Nevertheless, it's notable that R-rated cartoons represent a chance for DreamWorks Animation to find something which could truly differentiate its identity from that of a second-tier Disney-type studio.

Yes it would differentiate itself from a Disney type studio but it would make Dreamworks just another Paramount/Lionsgate (NYSE:LGF). At some studios you don't have any idea what they stand for and whether its publishing standards live up to your expectations. Meaning they have zero competitive advantage through brand value.

As always, another factor to consider is the budget - actually, that is the factor to consider. These kinds of experiments can be performed so long as the costs are kept reasonable. It can be done, at least according to some reported budgets. Minions supposedly was very reasonable at $74 million. Hotel Transylvania required $85 million to produce. Kung Fu Panda 3, in comparison, had a budget of $145 million.

These experiments should under no circumstance be performed. Any potential (and questionable) additional profits cannot compensate for the loss of brand value. Second, why would DreamWorks Animation be any more competitive outside of the niche of family friendly entertainment that it serves so well than the countless competitors that are already slugging it out in that space?

DreamWorks has already unveiled plans to cut back on the costs per movie. The target rate for a production is now $120 million in 2017 and beyond. We will see new productions trend toward this number as the past few releases were still (partly) developed with less budget constraints. However, an important aspect of box office performance is finding the optimal release dates. Kung Fu Panda 3 was initially planned to be released in the December 16th weekend. Unfortunately Disney moved Star Wars to that weekend. Wisely, the company postponed the release of Kung Fu Panda 3. This has the effect of increasing costs but ultimately saves a lot more money in lost revenue.

DreamWorks Animation stockholders should lobby the company to explore storylines that exist beyond its core competency of family films and enter the brave (depraved?) new world of pop-culture comedy. Let Rogen and Goldberg be a template.

In conclusion DreamWorks Animation shareholders shouldn't concern themselves with the storylines of the company. If you don't like the storylines invest in Sony (NYSE:SNE), Lionsgate or some or other media production companies but don't push a perfectly sound brand to prostitute itself for a quick box office hit that you will end up paying up for forever.

Disclosure: I am/we are long DWA.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.