DreamWorks is the CG animation studio behind the Shrek, Madagascar, Kung Fu Panda and How to Train Your Dragon franchises. The stock has lost 45% of its value in 2011 and has been flat so far this year. With a market valuation of about $1.5 billion, DWA trades at 65% of net asset value. There is so much focus on the lumpy nature of revenue and the secular decline of DVDs that investors are ignoring the true value of its movie content sitting on the balance sheet.
The CG animation studio industry
Even though the CG technology barrier is low for new entries, major studios are protected from competition due to heavy upfront production cost ($135 million - $165 million per movie). Major studios have the film library as cushion for any movie bust. The historical release dates for movies from Disney, Blue Sky and DreamWorks show that they try not to step on each other's toes, by spreading the movies' releases out.
Business Model
The value driver comes from the movies of DreamWorks. DreamWorks's revenue is coming from theatrical distribution (According to 2011 10K, the percentage of box office take-in ranges from 49% to 56% in the U.S. and 37% to 44% internationally), home entertainment distribution, digital distribution (Video-on-Demand or streaming), TV distribution, licensing and merchandising. Cost of revenue primarily includes the amortization of capitalized costs and inventory on the balance sheet, according to the ratio of current revenue over ultimate revenue over a 10-year period. According to the 10-K, 50%, 75% and 90+% would be amortized in the first, second and third year of a movie release. Therefore, when a movie enters the film library after 3-4 years, 90+% of cost would have been amortized already.
There is plenty of SG&A leverage in DreamWorks's business model. SG&A consists primarily of employee compensation, rent, insurance, fees for professional services and general marketing costs. This expense category has been $100 - $110 million in the past four years. When DreamWorks was spun off in 2004, they were producing two films a year. In 2009, they accelerated that to 5 films every 2 years (2.5 films/ year). Recently, they announced that they will do now 3 films per year from 2013 - 2016. Given the uneven film release timetable, top line has been lumpy. However, SG&A is much more stable.
2005 | 2006 | 2007 | 2008 | 2009 | 2010 | 2011 | |
Top-line growth | -57.1% | -14.6% | 94.3% | -15.3% | 11.5% | 8.2% | -10.0% |
SG&A growth | 2.6% | 3.8% | 31.5% | 16.9% | -15.5% | 9.3% | 7.6% |
Note: DreamWorks released Shrek 2 in 2004 and Shrek the Third in 2007
Bears are saying…
DWA's pure-play animation business model is structurally challenged by declining DVD sales, a waning 3D interest among movie-goers and alternatives that compete for the family entertainment budget. There is only upside if DreamWorks's movies exceed expectations in the box office. As traditional film revenue streams like DVDs continue to decline, management has been shifting its focus on new investments to monetize the film library content, including TV series and live entertainment, casual gaming and social networking, and international expansion, like the JV in China. These investments, which carry a lot of execution risk, will compress margin.
Investment Thesis
Projecting an income statement involves projecting box office performance, which is just a number guessing game. Current market valuation means DreamWorks is now a balance-sheet play. I estimate the Net Asset Value of DreamWorks using the capitalized film inventory cost, the cash flow from the film library that is not on the balance sheet, receivable, PP&E, cash and operating liabilities. DreamWorks's $1.5 billion market valuation implies a 35% discount to its Net Asset Value.
Net Asset Value calculation
Capitalized production cost (inventory)
The production cost of DreamWorks's animated feature films is stated at the lower of cost less accumulated amortization. Initial production cost of a movie is $135 - $165 million. As of the latest 10Q, the net inventory on the balance sheet is about $960 million. I will exclude the $20 million capitalized live performance cost. Since DreamWorks can't recognize revenue until Paramount recovers the $150 marketing cost, it will recover the value of the inventory (production cost) if revenue from the film exceeds $165 million.
Revenue FY after release | ||||||
Title | Release date | 1 | 2 | 3 | 4 | Revenue before entering the library |
Spirit: Stallion of the Cimmaron | May 02 | 153,234 | 67,282 | 32,307 | 252,823 | |
Sinbad: Legend of the Seven Seas | Jul 03 | 78,915 | 22,704 | 4,944 | 106,563 | |
Shrek 2 | May 04 | 790,324 | 19,413 | 37,997 | 47,207 | 894,941 |
Shark Tale | Oct 04 | 62,273 | 158,272 | 37,935 | 45,722 | 304,202 |
Madagascar | May 05 | 228,579 | 128,806 | 48,869 | 38,578 | 444,832 |
Wallace & Gromit | Oct 05 | 29,144 | 29,500 | 19,373 | 78,017 | |
Over the Hedge | May 06 | 116,886 | 91,211 | 35,176 | 21,585 | 264,858 |
Flushed Away | Nov 06 | 6,253 | 38,939 | 25,274 | 26,824 | 97,290 |
Shrek the Third | May 07 | 380,599 | 119,985 | 54,320 | 37,388 | 592,292 |
Bee Movie | Nov 07 | 111,386 | 11,688 | 36,653 | 38,542 | 198,269 |
Kung Fu Panda | Jun 08 | 211,513 | 106,132 | 41,412 | 26,578 | 385,635 |
Madagascar: Escape 2 Africa | Nov 08 | 23,966 | 232,374 | 30,354 | 47,172 | 333,866 |
Monsters vs. Aliens | Mar 09 | 83,331 | 58,787 | 30,115 | 25,274 | 197,507 |
How to train your dragon | Mar 10 | 174,233 | 66,904 | 241,137 | ||
Shrek Forever After | May 10 | 244,464 | 78,596 | 323,060 | ||
Megamind | Nov 10 | 26,584 | 82,975 | 109,559 | ||
Kung Fu Panda 2 | May 11 | 144,815 | 144,815 | |||
Puss in Boots | Oct 11 | 23,752 | 23,752 | |||
Source: DreamWorks's 10-K
Looking at the historical revenue by films, there were three busts during the past ten years that DreamWorks has to write down the inventory cost. In addition, since DreamWorks is accelerating the movie release schedule, net inventory will be increasing in value.
2004 | 2005 | 2006 | 2007 | 2008 | 2009 | 2010 | 2011 | 2012 Q2 | |
Film Inventory | 519.9 | 535.9 | 502.4 | 555.9 | 638.2 | 696.0 | 772.7 | 882.6 | 960.0 |
Source: DreamWorks's 10-K
The film library
This category includes movies that are more than 3-4 years old. Currently, the library has 15 films up until Kung Fu Panda. The library carries minimum incremental cost (>90% amortized when films enter the library). 2-3 movies are added to the library every year. That schedule will accelerate now that DreamWorks changes from 5 films two years to three films/year. 10-year average revenue from the library is $200,000. I estimate the value of the film library by calculating the present value of the perpetual annuity, assuming 10% cost of revenue, 35% tax rate and 10% cost of capital. Base case is that DreamWorks can maintain the 10-year average run rate at $200 million.
The rest
I assume DreamWorks can only recover receivables from Netflix and Paramount. Total receivable is $250 million. Net PP&E at cost is $200 million, cash is $80 million and total operating liabilities are $450 million.
Net Asset Value calculation
To get to market valuation, I need to take a 60% haircut on the film library annual revenue assumption:
In million | |
Inventory | 940 |
Film library annuity (60% haircut) | 486 |
Receivable | 250 |
PP&E at cost | 200 |
Cash | 80 |
Operating liabilities | 450 |
Net Asset Value | 1,506 |
Market Cap | 1,500 |
The question is whether they can maintain the $200 million monetization run rate from the film library
There are multiple ways to monetize the content. In August 2012, DreamWorks announced the plan to build a $3.1 billion cultural and entertainment district in Shanghai with a group of Chinese partners, which will be completed in 2016. DreamWorks is opening an amusement park in Meadowland Park, New Jersey and working towards a DreamWorks cable channel. Starting in 2013, Netflix will pay $30m/movie for the distribution rights over 6-8 years vs. the current HBO deal at $20m/movie over 10 years. Classic Media acquisition gives DreamWorks a huge backlog of IP.
Target price with different haircut scenarios shows margin of safety
Haircut | Stock Px | Upside |
90% | 13.4 | -24% |
80% | 14.9 | -16% |
70% | 16.3 | -8% |
65% | 17.0 | -4% |
60% | 17.7 | 0% |
50% | 19.1 | 8% |
40% | 20.6 | 16% |
30% | 22.0 | 24% |
20% | 23.4 | 32% |
10% | 24.9 | 40% |
0% | 26.3 | 48% |
Conclusion
Bears are focusing on the income statement. DreamWorks has a moat from its IP and scale. Jeff Katzenberg, the founder and CEO, turned around the Pixar studio at Disney and his comp is entirely tied to the stock performance ($1 base salary). DreamWorks is pursuing multiple initiatives to monetize the film library and announced an accelerated film release schedule to three movies a year for the next four years. With the 35% Net Asset Value discount, DWA is poised for upside.
Disclosure: I am long DWA.
