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Dreamworks Animation (NASDAQ:DWA)

Q4 2005 Earnings Conference Call

March 9th 2006, 4:30 PM EST

Executives

Rich Sullivan - IR

Kris Leslie - CFO

Jeffrey Katzenberg - CEO

Lew Coleman - President

Analysts

Anthony Noto - Goldman Sachs

Michael Savner -Banc of America Securities

Kathy Styponias - Prudential Equity Group

David Miller - Sanders Morris Harris

Lowell Singer - SG Cowen & Co

Richard Greenfield -Pali

Jeff Logsdon - Harris Nesbitt

Jessica Reif Cohen - Merrill Lynch

Presentation

Operator

Good afternoon. My name is Eduardo, and I will be your conference facilitator today. At this time, I would like to welcome everyone to the DreamWorks Animation earnings conference call. (Operator Instructions). It is now my pleasure to turn the floor over to Rich Sullivan from DreamWorks Animation Investor Relations Group. Sir, you may begin your conference.

Rich Sullivan

Thank you. Good afternoon, everyone, and welcome to DreamWorks Animation fourth quarter earnings conference call. I'm joined on today's call by our Chief Executive Officer, Jeffrey Katzenberg; our President, Lew Coleman; and our Chief Financial Officer, Kris Leslie.

Today's call will begin with some brief discussion of our financial results, followed by an opportunity for you to ask some 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 would like to remind everyone that certain statements made on this call may constitute forward-looking statements. Forward-looking statements are subject to a number of risks and uncertainties, which may cause them to vary materially from actual results. A description of these risks and other factors are contained in the Company's annual and quarterly report and in other SEC filings. The Company undertakes no obligation to update any of its forward-looking statements. With that, I would like to now hand the call over to our Chief Financial Officer, Kris Leslie. Kris.

Kris Leslie

Thanks, Rich, and good afternoon, everyone. In the fourth quarter, the Company reported net income of approximately $63.2 million or $0.61 per share on a fully diluted basis, bringing our reported earnings for the full year 2005 to $104.6 million or $1.01 per share. There were two offsetting items that impacted the fourth quarter EPS, including a $0.27 per share increase for the recognition of a tax benefit on two film projects that were previously written off for book purposes in 2003; as well as an incremental write-off for Wallace & Gromit, which resulted in approximately a $0.15 reduction to the fourth quarter EPS. I will discuss both of these items in more detail in a moment.

Excluding these items, results for the quarter were primarily driven by the home video performance of Madagascar. Of the $172.9 million of revenue for the quarter, Madagascar contributed approximately 88% or $152.3 million. By year end, we recorded approximately 14.2 million units on a worldwide basis, which reflects the first seven weeks of the title's initial release. Shark Tale, which contributed $5.7 million of revenue in the quarter, has now sold approximately 17.3 million home video units on a worldwide basis through the end of the year.

While this performance demonstrates the strength of our product in this very competitive environment, we remain cautious in our assessment of the home video market, especially as titles move into catalog. We're monitoring closely the impact of limited shelf space and the increasing pricing pressure on catalog titles. This is something that could have an impact on our titles going forward, but it is too early to conclude any long-term impact to our business. The remaining $14.9 million of revenue in the quarter was generated by our library and other titles.

Our latest release, Wallace & Gromit, has reached approximately $184 million in worldwide box office to date. The film has been released in most major territories with the exception of Japan, which is scheduled for release later this month. As anticipated, we did not see any revenue for this film in 2005, as our distributor did not recoup its marketing and distribution costs by the end of the fourth quarter.

However, due to the film's lower than expected home video performance to date, we have lowered the film ultimate, resulting in an incremental write-off of approximately $25.1 million, which is reflected in the fourth quarter's cost of revenue. Although the film was released on home video in the first quarter of 2006, the accounting rules dictate that we assess our inventory balances prior to filing our fourth quarter results. Accordingly, we have recorded the charge as part of cost of revenue in both our fourth quarter and year end 2005 results. As indicated by the write downs taken this year, we do not anticipate seeing any significant earnings from this film in the future.

Despite concerns with the home video market, we believe that the performance of Wallace & Gromit was more of a title-specific issue than an indication of an industry trend, as it did not achieve the consumer awareness we hoped for in the market.

Moving on to the remainder of the income statement, SG&A was approximately $15.7 million, which included approximately $2.6 million in stock compensation expense, reflecting a downward adjustment to awards that have performance criteria. SG&A also included costs for Sarbanes-Oxley compliance and legal fees related to the pending securities litigation.

Looking at the tax expense for the quarter, we recorded a non-recurring tax benefit associated with two previously-discontinued film projects. Both Tortoise and the Hare and Tusker were written off for book purposes in 2003. Because we plan to abandon the rights to these films in 2006, we recorded the associated tax benefit, resulting in an increase to net income of approximately $28 million in the quarter or $0.27 per share. So in total, the net income for the fourth quarter was $63.2 million, including $12.4 million related to the tax benefit and incremental write-off for Wallace & Gromit.

Looking at the year end balance sheet, the Company finished the year with a strong cash balance of $403.8 million and debt of approximately $194.5 million. As previously announced, the $75 million signing bonus received in the first quarter of 2006 as part of the new agreement with Paramount has been used to lower that debt obligation.

Looking forward to 2006, the Company's primary source of revenue and earnings will come from the performance of Over the Hedge, expected to be released in theaters on May 19. Because the success of our films is ultimately dependent upon consumer acceptance, it is extremely difficult to predict how they will perform prior to their theatrical and home video release. As a result, we have made the decision not to provide EPS guidance.

With that said, I would like to provide some general comments about 2006. While we will be releasing two CG animated films this year into theaters, unlike the first half of 2005 which benefited from the home video release of Shark Tale, we will not have a similar driver of earnings in the first half of 2006 due to the write-off of Wallace & Gromit. As a result, we do not expect to have any significant earnings in the first half of the year.

I would also like to remind everyone that while Over the Hedge will be released in the second quarter of 2006, we do not expect to recognize any revenue for this film until after our distributor has recovered their costs. As a result, it is possible that depending on box office, we will not recognize any significant amount of revenue or earnings until Over the Hedge is released in the home video market in the fourth quarter.

Our second film, Flushed Away, is scheduled for release in November of 2006. As is typical with our fall releases, we would not expect our distributor to be recouped by year end and therefore do not expect to see any significant revenue from this film in 2006.

I'd just like to close by updating you on our new distribution deal with Paramount, which became effective on January 31st. As we stated at the time of the announcement, we think it was a great opportunity for the Company to secure a long-term distribution deal under similar economic terms, while also providing access to new assets like Nickelodeon. We have already started transitioning the distribution of our future films over to Paramount, with Over the Hedge being the first of our films to be distributed under the new agreement.

In terms of our past titles, Universal remains committed to servicing our current releases through a transition period, which goes to the end of the second quarter of 2006. After that time, Paramount will take responsibility for all DreamWorks Animation titles. We will continue to work closely with Paramount to minimize any potential short-term issues that can arise when transitioning to a new distribution partner.

In terms of shared services with Paramount, DreamWorks Animation will absorb some of the corporate functions that were previously provided by DreamWorks Studios under a services agreement. The costs associated with these activities, as well as the costs associated with additional executive management added at the end of last year, will likely result in approximately a 15% increase in SG&A over the $76.5 million reported for 2005.

As part of the Paramount deal however, Paramount has agreed to reimburse us a predetermined cash amount on an annual basis, intended to offset any incremental costs as a result of the new distribution agreement. While the accounting treatment for this payment has yet to be determined, it is intended to keep us economically whole for these added costs on a free cash flow basis. In 2006, we will receive approximately $11 million in cash for cost reimbursement.

So with that, let me turn it back over to Rich, so we can take some of your questions.

Rich Sullivan

Thanks, Kris. That concludes our formal remarks today. I would like to welcome our Chief Executive Officer, Jeffrey Katzenberg, and our President, Lew Coleman, to join us for the Q&A portion of the call. I would also like the Operator to please once again repeat the procedures for logging in a question.

Question-and-Answer Session

Operator

(Operator Instructions). Your first question is coming from Anthony Noto of Goldman Sachs. Please go ahead.

Anthony Noto - Goldman Sachs

Thank you very much. Actually, I had two questions for Jeffrey and Kris. The first question is, you had mentioned on the call that you are cautious about the home video market. I was wondering if you could elaborate specifically on what you are seeing that keeps that caution very much at the forefront.

Secondly, you also mentioned that you are not ready at this point in time to change your film ultimates based on what you are seeing because you don't know what the long run outlook would imply because you haven't gotten through that time period. What types of things are you looking for before doing that, to justify if you don't need to or to actually lower the ultimate profits per film? Thanks.

Kris Leslie

I'm going to take the second part of your question first, Anthony. It's not exactly accurate to say we haven't made any changes to our film ultimates. Obviously, the ultimates for released films reflect our current view of the state of the market, which includes some of these pressures that I mentioned, particularly as the titles move into catalog. Clearly there's been a flood of product in the market; that creates shelf space issues and some pricing pressures, which we are reflecting in our release to ultimates.

I think the comment I made was, it's too early to tell whether that's going to be a permanent change to the business model, and we will wait and see what happens with Madagascar as it moves into catalog. We need to get a few more data points. Remember we have just a very limited number of titles in the market at any point in time. So, for us to draw a conclusion as to whether something is permanent or not, we are just not there yet.

Jeffrey Katzenberg

Anthony, with regard to the first question, I don't think there's anything new from what we discussed last time with you. We continue to watch an influx of catalog and television product into the market in all the same regards that Kris just mentioned -- shelf space, you know pricing all of these things in it. It is still a market that is adjusting to this. Nothing has changed remarkably one way or another from last time we discussed it.

Anthony Noto - Goldman Sachs

Kris, you know I probably didn't phrase the question correctly, but you did hit on what I was looking for in terms of the permanent changes to your film ultimates as opposed to the film ultimates for the product that's already come out. So, if I heard you correctly, and please correct me if I'm wrong, you're waiting to see what happens as Madagascar plays itself out before making that permanent change. Then, based on that, you'll make a decision, it sounds like.

Kris Leslie

If you're asking me about Madagascar in particular, let me step back one second Anthony. Currently given everything we know about the market, including our caution, Madagascar still fits within that overall generic business model that we laid out for you guys. I will add to that however, remember it did have performance, international box office versus domestic box office, in a higher ratio than what we have typically seen historically. But, all in, in general, it still fits within that business model.

Now, when it comes out in catalog, we will assess how it performs. If there is a change warranted at that point, obviously we will make the change. Even given everything we know today, we're still within that model.

Anthony Noto - Goldman Sachs

Thank you.

Operator

Our next question comes from Michael Savner, Banc of America Securities. Please go ahead.

Michael Savner - Banc of America Securities

Thank you very much. A couple of questions as well. First, could you maybe give us some specific examples of what kind of distribution changes we might see as the films start to move through the Paramount arm and what you might be able to do differently that might be additive to what you were doing previously?

Second, on Madagascar home video, maybe kind of what you're seeing in terms of pricing. It looks from the revenue you reported for Madagascar, the units it seems like probably not a lot of major changes. I'm sorry if I missed this, if you broke out domestic and international units.

Then lastly, your balance sheet strategy. Obviously, you've been holding a relatively full cash position and I'm wondering what your plans with your cash are going forward.

Jeffrey Katzenberg

On the first one, Michael, in terms of Paramount, we are in a transitional mode right now; with that I think are both the challenges of getting the organizations integrated and working with one another. So far, they have gone smoothly. There's a lot of strong organizational support there. As to new opportunities, I think those are things that we are just exploring and I think it's premature for us to try and quantify or qualify them.

Kris Leslie

Michael, on the pricing issue, as you know we don't get into specific pricing on any of our titles. But you've got the revenue and the units, so I think you've got at least some information. Can you repeat your last question on the balance sheet? I'm sorry.

Michael Savner - Banc of America Securities

Sure, before that though, did I miss -- did you provide a breakdown on the 14 million units? Did you provide a breakdown between domestic and international?

Kris Leslie

No, we did not.

Michael Savner - Banc of America Securities

You do not want to, right?

Kris Leslie

No, we're just providing worldwide.

Michael Savner - Banc of America Securities

Fair enough. The last question was, your plans for your cash use going forward, the optimal balance sheet strategy?

Lew Coleman

Michael, it's Lew Coleman. I'll just comment broadly. Our belief is obviously that if this business gets extremely successful, it is a big cash generator. We would like, as a matter of practice, to keep about two movies' worth of cash around, obviously invested in short-term. If we have nothing better to do with the remaining cash, we will return it appropriately to the shareholders.

Michael Savner - Banc of America Securities

Thanks, Lew.

Operator

Our next question comes from Kathy Styponias, Prudential Equity Group.

Kathy Styponias - Prudential Equity Group

Thanks. Question is for you, Kris. With respect to how 2006 is going to play out, in addition to the DVDs that you mentioned and the movie releases, are there any other smaller revenues or events that we should be thinking about, in terms of things that are coming into the broadcast window, for example, or anything of that ilk?

Then second, when you say that we shouldn't expect earnings for it sounds like the first three quarters of 2006, does that potentially mean negative earnings? Or are you talking about basically breakeven? Thanks.

Kris Leslie

Let me take the first part first, which is other sources of revenue. I don't want to go through the films specifically, but let me give you a couple rules of thumb in terms of TV revenue and expected timing, because I think this may be helpful as you look at all the films.

For domestic pay television, typically we recognize that revenue about 12 months after domestic theatrical release. For domestic network television, it's typically about two-and-a-half years after domestic theatrical release. International pay television begins about 18 months after domestic theatrical release and international free television about two-and-a-half years after domestic theatrical release.

In the domestic pay and domestic network, we typically recognize virtually all of the license fee immediately when it hits that window. In the international markets, obviously it's on a country-by-country basis, so those can flow out over several months from the point at which we start recognizing. So, hopefully that will be helpful in terms of the TV side. Then the second part of your question -- I am sorry; can you repeat it one more time, Kathy? I'm sorry.

Kathy Styponias - Prudential Equity Group

You basically said not to expect any earnings for the first three quarters of the year. I'm just wondering whether you are suggesting that it's going to be breakeven or potentially even negative earnings. Thanks.

Kris Leslie

Kathy, as I said, we're not giving any specific EPS guidance. I think we're just trying to give you some guidelines that help you to understand where the majority of the earnings are coming and what will drive them.

Kathy Styponias - Prudential Equity Group

Thanks.

Operator

Our next question comes from David Miller, Sanders Morris Harris.

David Miller - Sanders Morris Harris

Good afternoon, a couple of questions. Kris, I just wanted to make sure I have my math correct on the organic EPS number. Excluding the tax benefit and excluding the incremental Wallace & Gromit write-down, I have $0.49. If you could just confirm that for us that would be great.

Jeffrey, I was curious how much of Over the Hedge you will be showing next week at the ShoWest Convention in Vegas, whether or not you'll be showing the whole film or whether or not you'll just be showing select clips. Thanks very much.

Kris Leslie

David, I will take your first part. We only give GAAP EPS numbers. However, we've given you the components of the two non-recurring charges. So, the tax benefit again is $0.27 positive, and the Wallace & Gromit write-off is about a $0.15 charge.

Jeffrey Katzenberg

David, to the question of Over the Hedge, it will screen next Thursday in Las Vegas. We're showing the entire film. However, 80% of it is in color and the balance of the 20% is completely animated but not in color yet. It is a work in progress, and it's not fully dubbed, and various other things that still make it a work in progress.

David Miller - Sanders Morris Harris

Thank you very much.

Operator

Our next question comes from Lowell Singer, SG Cowen & Co.

Lowell Singer - SG Cowen & Co

Thanks, good afternoon. A couple of questions. Kris, I think you talked about Wallace & Gromit being a title-specific issue that really led to the write-downs on the film. I'm wondering if Jeffrey, you want to address this a little bit. But talk a little more about in your post-mortem, what you think didn't work about that film? In the context of that, what your general outlook -- I know you're not going to give specifics, but -- how should we think about the potential size of both Over the Hedge and Flushed Away as we head into those two releases? Kris, just one accounting question. The $75 million, what will the accounting treatment of that be?

Jeffrey Katzenberg

I think that trying to do a post-mortem on these things is a challenge because what you're doing is trying to gauge consumer appetite, which is obviously something difficult to predict. Wallace & Gromit was critically about as well-received a movie as one could hope for, and in certain places around the world performed sensationally well. In other places, particularly here in the U.S., was disappointing. I don't think that there's anything to be taken more or less as -- I think it is a unique product. It's a stop motion film. Really, I'm not sure that there's any way to relate it to any of our past or future films coming at this point.

Kris Leslie

On the $75 million, I'm sorry; I should have mentioned that earlier. That along with the cost reimbursements, we're still working through the accounting treatment. So, we will let you know in a subsequent call when we get that firmed up.

Lowell Singer - SG Cowen & Co

Jeff, I don't know if you wanted to make any comments about your thoughts on these two films that you'll be releasing this year?

Jeffrey Katzenberg

They are fine.

Lowell Singer - SG Cowen & Co

Okay, thanks.

Operator

Our next question comes from Richard Greenfield, Pali Research.

Richard Greenfield - Pali

Could you just give us a sense, Jeffrey, of the progress on the Bee Movie, how that movie is beginning to come together in terms of timetable? Then also, just comment on a financial type, Kris, on the cost structure of that film relative to what you're putting out during 2006 as well as your other film in 2007, in Shrek 3?

Jeffrey Katzenberg

I will be happy to do that if I want only because Rich is sort of sticking a piece of paper in front of me here. Just to clarify for everyone the fact that Over the Hedge is at the stage that I just mentioned to you -- 80% in color, 20% of black and white-- it's exactly on schedule for its delivery on this. So I think Rich was nervous that maybe it sounded as though we were not going to hit the finish line on time here. So, he now just calmed down.

On to the Bee Movie. It's again on schedule and I think has been moving through the process well. Jerry Seinfeld has been engaged in every step along the way with it. Again, I think the picture looks fine.

Kris Leslie

From the cost standpoint, we've talked a lot about the costs in the past. Typically, we say that films are about $130 million from a production cost standpoint. On top of that, we will have contingent compensation and we've talked about sequel versus original. I think what I would say about the Bee Movie is that given the people associated with the movie, the contingent compensation will be similar to a sequel versus an original. I think what we have said in the past is that can be somewhere in the range of 10% to 14% of worldwide box office.

Jeffrey Katzenberg

Rich, again, it is on schedule for its November 2007 release date -- the Bee Movie.

Richard Greenfield - Pali

Contractually, do you have to spend anymore on marketing, or do you have any base that you have to spend given Seinfeld's involvement?

Jeffrey Katzenberg

No.

Richard Greenfield - Pali

Thanks.

Operator

Our next question comes from Jeff Logsdon, Harris Nesbitt.

Jeff Logsdon - Harris Nesbitt

Jeff, perhaps a question for you. There has been a lot of discussions in analyst conferences recently about distribution windows, perhaps an HD window or a VOD window 60 days after theatrical, shrinking the pay-per-view window. You have such a high-profile product, might your distribution of those products be a little different than say the average studio that has 20 plus films a year to have out in the marketplace?

Jeffrey Katzenberg

Jeff, I don't think there's anything that's presented itself to date that changes our distribution strategy or our approach to the existing windows. We think that we are getting full value for our product, given the structures that exist in the marketplace today.

Jeff Logsdon - Harris Nesbitt

It just seems unbelievable that any of the studios -- including you -- want to take customers, who have paid you two or three times for a product and turned them into somebody that pays you only once. Is that an accurate assessment of how we can look at distribution windows?

Jeffrey Katzenberg

No, I think you would have to say it depends on what they are paying you and what your margins are when they pay you. So, I think there are couple of more elements that would go into that equation.

Jeff Logsdon - Harris Nesbitt

Thanks.

Rich Sullivan

Operator, I believe we have time for one last question.

Operator

Our final question is coming from Jessica Reif Cohen, Merrill Lynch.

Jessica Reif Cohen - Merrill Lynch

Thank you. Jeff, have you made any progress on the TV side of the Viacom agreement? Could you just talk about what you hope to get out of this over the next few years?

Jeffrey Katzenberg

Well, we're just at the beginning stages of it, Jessica. We have had a number of creative meetings with Nickelodeon and they continue. We've got some more scheduled over the next few weeks. So there's nothing really concrete yet, other than there seems to be great interest on their part in finding ways of moving some elements of our properties onto the Nickelodeon channel. As to when or what the impact of that is, I think it's just too early for us to speculate on that.

Rich Sullivan

Thanks, Jessica. That concludes today's earnings conference. I would like to remind everyone that a replay of this afternoon's call will be available shortly and accessible on our website. That address again, www.DreamWorksAnimation.com. If you have any follow-up questions, please feel free to contact DreamWorks Animation Investor Relations. Thank you very much for participating and have a great afternoon.

Operator

This concludes today's DreamWorks Animation earnings conference call. You may now disconnect.

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