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DreamWorks Animation SKG Inc. (DWA)

Q1 2006 Earnings Conference Call

May 2, 2006, 4:30 PM EST

Executives

Lou Coleman - President

Kris Leslie - Chief Financial Officer

Rich Sullivan - Investor Relations

Analysts

Michael Savner - Banc of America Securities

Anthony Noto - Goldman Sachs

Tuna Amobi - Senators Equity Group

Richard Greenfield - Pali Research

David Miller - Sanders Morris Harris

Kathy Styponias - Prudential Equity Group

Lowell Singer - SG Cowen & Co

Operator

Good afternoon, ladies and gentlemen. My name is Nicki and I will be your conference facilitator today. At this time, I would like to welcome everyone to the DreamWorks Animation Earnings Conference Call. All lines have been placed on mute to prevent any background noise. After the speaker’s remarks, there will be a question and answer period. If you would like to ask a question during this time, please press star, then the number one on your telephone keypad. If you would like to withdraw your question, press the pound key. Thank you.

It is now my pleasure to turn the floor over to your host, Rich Sullivan, from DreamWorks Animation’s Investor Relation Group. Sir, you may now begin your conference.

Rich Sullivan

Thank you and good afternoon, and welcome to DreamWorks Animation First Quarter 2006 Earnings Conference Call. I’m joined on today’s call by our President, Lou Coleman, and our Chief Financial Officer, Kris Leslie. Today’s call will begin with a brief discussion of our financials, that we released earlier today, 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’s website at www.dreamworksanimation.com.

Before we begin, we 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 risk factors and other factors contained in the company’s annual and quarterly reports that we filed with the SEC. The company undertakes no obligation to update any of its forward-looking statements.

With that, I would now like to hand the call over to DreamWorks Animation President, Lou Coleman. Lou.

Lou Coleman

Thanks, Rich, and good afternoon, everyone. I want to thank you all for joining us today. Due to a prior commitment, Jeffrey cannot be with us this afternoon, but he does send his apologies.

As you can see, we had a relatively quiet first quarter with the results driven by the continued performance of Madagascar home video, and by other revenues that we received earlier than we had originally anticipated. Madagascar video is now through its initial release run and has moved into catalogue.

Notably during the quarter, we began operating under our new distribution agreement with Paramount. We are pleased with the transition to date. Over the Hedge will be the first film released with Paramount, and we have been very impressed with their efforts in making this new relationship successful.

I would like to ask Kris to spend a few minutes going through the results in more detail, and then I’ll provide some final thoughts before opening the call up to some of your questions.

So with that, let me turn things over to Kris.

Kris Leslie

Thanks, Lou, and good afternoon, everyone. In the first quarter, the company reported total revenue of $60.1 million, and net income of approximately $12.3 million, or $0.12 per share on a fully diluted basis.

Results for the quarter were driven primarily by the performance of Madagascar home video, as well as some timing benefits between quarters. Madagascar generated $30.7 million in revenue in the first quarter, and through the end of March, the film has reached an estimated 17.5 million net units on a worldwide basis, and has now been released in all major territories around the world.

We recognize approximately $13.1 million of revenue in the quarter from Shark Tale, the majority of which was from international pay television, which became available in several of the larger territories in the first quarter. Through the end of the first quarter, Shark Tale reached an estimated 17.9 million net units in home video on a worldwide basis. The balance of our titles contributed about $16.3 million of revenue.

For both Shrek 2 and Wallace and Gromit, our distributor remains un-recouped in the amount of $13.2 million and $6.7 million respectively through the end of the first quarter. As a result, we did not recognize any revenue under the distribution agreement for either titles.

Wallace and Gromit was released into the home video market on February 7 of this year, and through the end of the first quarter, our distributor has recognized an estimated 3.3 million net units on a worldwide basis. To reiterate what we stated on the last call, we do not expect this title to make any significant contributions to the company’s earnings going forward.

Moving on to the remainder of the income statement, SG&A was approximately $18.7 million, which included $4.8 million in stock compensation expense. The $1.3 million increase in SG&A over last year was principally driven by additional costs in several corporate functions to accommodate the increased demands of a public company.

Looking at the tax expense for the quarter, the company recorded a tax benefit related to the tax basis step-up of approximately $4.5 million that lowered the effective tax rate in the first quarter. This was partially offset by an expense of $3.8 million, representing bulk and share of that tax benefit as part of our tax receivable agreement. The net impact of this tax benefit for the quarter was less than $0.01 per share.

Moving on to the balance sheet, we finished the quarter with a cash balance of $505.5 million. The increase in cash since year-end was primarily driven by the collection of theatrical and home video revenue earned in 2005 from Madagascar.

In the quarter, we used the proceeds from the $75 million signing bonus received from Paramount to help repay the $75.6 million in Universal advances and interest, reducing our debt balance at the end of the quarter to approximately $119.7 million.

Looking forward to the remainder of 2006, we do not anticipate any significant drivers of revenue in the second quarter. Results next quarter will be primarily driven by Madagascar’s debut on domestic pay television, as well as any additional home video sales for the title, which is now in catalogue.

Catalogue still remains very competitive, and as is typical for a title that falls into this phase, we expect this to be reflected in a lower-price and contribution per unit. As previously discussed, we anticipate that SG&A for the full year of 2006 will increase by approximately 15% over last year, driven by increased management costs, as well as additional corporate services that we have taken responsibility for under our new distribution agreement.

Under the distribution agreement, we will receive a reimbursement from Paramount to help offset some of these additional costs. Characterized as an effective reduction to our cost of distribution, we will be recording the total reimbursement due during the term of the agreement equally over the minimum number of films required under the new deal.

As a result, upon the release of each film, we will recognize the benefit of approximately $4.6 million, and this will be reported as revenue for the film in the quarter in which it is released. Therefore, we will recognize the first portion of this benefit on the release of our next movie, Over the Hedge, in the second quarter of 2006.

I would also like to remind everyone that as is the case with any of our films, we do not recognize any significant revenue until after our distributor has recovered its upfront distribution and marketing costs, which may not occur until the film is released in home video. Because box office performance is something we cannot predict with any level of certainty, we will need to wait and see how the year shapes up after the release of Over the Hedge.

With that, let me turn it back to Lou for some closing remarks.

Lou Coleman

Thank you, Kris. Before we get to your questions, I wanted to close with just a few thoughts. As Kris mentioned, our 2006 performance is primarily dependent upon Over the Hedge, which will be release domestically to general audiences on May 19th. Internationally, the film will be released throughout the summer starting with some territories in Asia on May 19th.

We will be posting the theatrical releases schedule for Over the Hedge to our website to help guide you in making assumptions about revenue timing for the film. Over the Hedge is a film that we’re all very proud of. It’s a good family story with great characters, using some really unique-looking and high-quality animation. It’s a fun movie, and we certainly hope that people will enjoy it. However, it’s a very competitive time to be releasing a film. In fact, we are opening within weeks of several major summer blockbusters, so we will all be watching closely to see how it holds up amongst the rest of the summer releases.

As I said earlier, Over the Hedge is also the first film that we are distributing through Paramount, and we have started to take advantage of some of their unique assets. In particular, we have expanded our relationship with Nickelodeon, and they have done an outstanding job supporting this release. Starting later this quarter, Paramount will take responsibility for our library titles, as well as all of our future releases. We are working closely with them to ensure a seamless transition.

Overall, it’s a very exciting time, and we’ll all know a lot more about 2006 in the next month or so. With that, let’s open it up for some of your questions. Operator, can we take the first question, please?

Question-and-Answer Session

Operator

(Operator Instructions)

The first question comes from Michael Savner from Banc of America Securities. Please go ahead.

Michael Savner - Banc of America Securities

Thanks, good afternoon. A couple of quick ones. First, on the cost side, SG&A was a bit lighter than we were expecting in the quarter. Kris, can you tell us a little bit how we should think about the timing of SG&A for the duration of the year, particularly when the incremental costs from the Paramount deal are going to be reflected, if that’s not already the case?

Second, Lou, on international release dates for Over the Hedge, I don’t know if that’s posted to your website now. If you could tell us if it is, and if it’s not, if you’re able to give us any of the major European territory dates.

Lastly, if it’s okay, obviously Ice Age opened to a great deal of success. I’m just kind of curious on your take on if that was a market driven success or you think there was a lot of pent-up demand for that particular title, but certainly it seemed to be a pretty polished indicator for the CG sector.

Kris Leslie

Mike, I’ll take your first question. As you know, we’re not giving any specific guidance on a quarterly basis. We are still believing that the SG&A for the year is going to be up about 15% over last year. I think the only comment I would make is as you remember, the Paramount transaction didn’t close until the end of January, so in the first quarter, we don’t have a full quarter worth of those incremental costs, plus some of them will ramp up over the coming months, so, you know, spread over the balance of the last three quarters, but still that same anticipated 15% increase overall.

Lou Coleman

The release dates have not yet been posted on the website. I think they will be shortly. Just to give you a sense, most of the major European countries are released in the first or second week of July. In particular, Germany is on July 6th, Spain is on July 16th -- they’re sort of clustered around there. We’re somewhat mindful, obviously, of the World Cup phenomenon, but we’re particularly anxious to sort of get these releases early in the summer period, so we’re satisfied with the release dates that we have in Europe.

Michael Savner - Banc of America Securities

Thanks, and the last one was just your thoughts on what drove the success of Ice Age.

Lou Coleman

I’m looking around the table to see if anybody else wants to answer that.

Michael Savner - Banc of America Securities

No one wants a piece of that one? Okay.

Lou Coleman

You know, I think it’s mostly speculation, other than we should probably mention that it does, in a certain respect, reaffirm the notion that sequels do well. I think that’s probably a relatively easy conclusion to get to.

The interesting thing about Ice Age was the release date that they picked was non-traditional and not entirely competitive, and time will see, as we produce more and more of these CG films, whether that becomes a more popular release strategy or not.

Michael Savner - Banc of America Securities

Thanks very much.

Lou Coleman

Beyond that, I don’t have much.

Rich Sullivan - Investor Relations

Thanks, Mike. Next question, please.

Operator

The next question comes from Anthony Noto from Goldman Sachs. Please go ahead.

Anthony Noto - Goldman Sachs

Kris, I was wondering if you could elaborate a little bit on the marketing and promotional spending behind Over the Hedge compared to other films. What is the relative basis? Do you find yourself potentially having to spend more because it is more competitive? As well as the cost of advertising going up, will you use at all a different strategy to market that film? Will you utilize the Internet more, or other vehicles that we’ve seen more recently from other studios?

The second question, Kris, you kind of alluded to the fact that the unit tie ratio to box office dollars, so home video tie ratios are not what they’ve been in the past, but they’re revenue dollars are, because ASP’s are better. Is that true, and could you elaborate a little bit on it? What is the trend line you’re seeing in tie ratios visa vi an increase in ASP expense?

Kris Leslie

Let me go back to your first question, at least in terms of the dollars. You know, Anthony, as we’ve said before, we typically spend $125 million to $175 million to market these titles on a worldwide basis theatrically. Over the Hedge is within that range, not dissimilar from the money that was spent on Madagascar.

In terms of tie ratios, I’m not sure I made any comment about tie ratios. I think what we have said is we are pleased with the way that our titles have performed in initial release and catalogue is really the place that we’ve seen some pressure. It completely depends on the type of the movie, the competitive landscape, the timing of the movie being released -- and remember, we only have one title in the market at any point in time, so I’m just not sure we’re in the best position to talk about a trend.

Lou Coleman

Just another comment on advertising, the amount of advertising we’ve received from our promotional partners on this film is up a bit from what we have seen in previous films.

Anthony Noto - Goldman Sachs

Thank you.

Rich Sullivan - Investor Relations

Thanks, Anthony. Next question, please.

Operator

The next question comes from Tuna Amobi from Senators Equity Group. Please go ahead.

Tuna Amobi - Senators Equity Group

Lou, you talk about keeping at least two movies worth of cash on the balance sheet, and it seems like the cash is building, so I guess the question is have you given any thoughts on how you might intend to spend this cash, perhaps in terms of any kind of shareholder return initiative? That’s question number one.

Question number two is can we get some kind of update on obviously Madagascar did pretty well, but I was just trying to get a sense of how the catalogue in general has been trending. Have you noticed any kind of change between the last call and now? Thank you.

Lou Coleman

Let me start with the question on the cash. As I indicated I think on the last call, we’re mindful of the fact that the cash is beginning to accumulate, and our view still remains that if we do not have a better investment in the cash, it belongs to the shareholder in some form that’s appropriate. We do have some debt maturities coming up in the next year or two, which we will take a look at from a cash standpoint, but we do not feel we’re over-levered at this point, so we will continue to review the cash in light of our desires to keep about two films around, and hopefully do what you all think is appropriate for the shareholders with that money.

Kris Leslie

On your second question about catalogue, I think that there was really nothing we saw in the first quarter that has changed our view on catalogue, so it seems to have stabilized, at least for the moment. So we obviously remain very cautious about that part of the market, and as Madagascar now is just really moving into that phase, we’ll be monitoring it very closely.

Tuna Amobi - Senators Equity Group

Thank you.

Rich Sullivan

Next question, please. Operator, any more questions?

Operator

Yes, the next question comes from Richard Greenfield from Pali Research. Please go ahead.

Richard Greenfield - Pali Research

Hi, a couple of questions. One for Kris, just in terms of the accounting of how you are going to deal with the money you get from Paramount. Since your corporate expense is essentially going up and that’s why SG&A is going to be up 15% this year, why doesn’t it just net down that incremental expense. Why does it actually turn into a revenue line item that actually increases revenues year over year?

Then, both Lou and yourself mentioned a timing issue. I believe this is related to Shark Tale. Did pay TV deals actually end up closing earlier than you had previously expected, or what was the timing issue you were talking about earlier in the call? Thanks.

Kris Leslie

Let me take the timing piece first. It’s not that the deal’s closed. As you probably recall, our films are generally all subject to output deals that are in place, so it’s really the timing of when they become available and when we can recognize the revenue, and there were a couple right at the end of the March time frame, so we got to recognize those a month earlier than we had otherwise anticipated.

Then in terms of the accounting, using the reimbursement to offset G&A, while it would perhaps be a little simple, as you look at the income statement, it is not the way it’s done under GAAP, and because under GAAP rules, it’s effectively viewed as a reduction in the cost of distribution, or an effective reduction to the fee. We therefore have to flow it through net revenue, which is where the fee flows through.

Richard Greenfield - Pali Research

Thanks very much. That makes a lot of sense.

Rich Sullivan

Next question, please.

Operator

Thank you. The next question comes from David Miller from Sanders Morris Harris. Please go ahead.

David Miller - Sanders Morris Harris

Just a couple brief questions. I believe that on the last call you also besides the brief revenue guidance you mentioned in your prepared remarks this afternoon, you also mentioned that you did not expect any significant earnings to be generated for the first half of 2006. I don’t believe I heard you reiterate that in your prepared remarks this afternoon. Are you prepared to do that?

Then also, could you just refresh my memory on what would have to happen for the principals of the firm to pull the trigger on a secondary offering? Thank you very much.

Kris Leslie

On the offering, the way the mechanics work, David and Jeffrey acting together can trigger a follow-on offering up through May 31st of 2006. Paul Allen also can trigger at any point during that time. After May 31st, that right moves to Paul Allen only. So that’s the only thing that has to occur, in terms of timing.

As far as the guidance question, I think we’re not giving any guidance, either quarterly or on a full-year basis, and my comments today were just really meant to reiterate that there are no real drivers of revenue for the company until the point at which our films recoup from their distribution and marketing costs, and depending on box office, that could be, in Over the Hedge’s case, the fourth quarter when the video comes out.

Rich Sullivan

Thanks, David.

David Miller - Sanders Morris Harris

Thanks very much.

Rich Sullivan

Next question, please.

Operator

The next question comes from Kathy Styponias from Prudential. Please go ahead.

Kathy Styponias - Prudential Equity Group

I have two quick ones as well. Kris, your stock option expensing in the quarter came in a little bit lighter than I anticipated. Is that a good run-rate going forward? Second, I was wondering if any of you can give us color as to the percent of total worldwide box-office that Asia typically represents for one of your films, even if it’s in rough terms, that would be helpful. Thank you.

Kris Leslie

I guess what I would say about the stock comp is what we’ve told you historically is we expect in the range of $20 million to $30 million a year, and I would just remind you that number fluctuates if you go along through the year, because we typically issue additional grants for employees during the course of the year.

Lou Coleman

Kathy, this is Lou. We’ll probably have to get back to you on the Asia question. It obviously varies film by film, particularly where there may well be some cultural sensitivities that we may or may not be aware of at the time. I would hate to give you an answer off the top of our head. Let’s get some numbers and we’ll get them to you.

Kathy Styponias - Prudential Equity Group

Thank you.

Rich Sullivan

Thanks, Kathy. Next question, please.

Operator

The next question comes from Lowell Singer from Cowen & Co. Please go ahead.

Lowell Singer - SG Cowen & Co

Thank you. Good afternoon. I just want to ask a couple of questions on the international piece of Over the Hedge. Lou, you alluded to the release window in a lot of European territories being I guess towards the end of the month-long World Cup. Why does that not concern you? Do you think it really just pushes out the box office on the film, or do you think you’ll compete successfully in those early couple of weeks against the world cup?

Second, can you talk about where Paramount’s international distribution is and how comfortable you are with it today, given the dissolution of UIP? Thanks.

Lou Coleman

I guess a couple of thoughts on the releases in Europe. You have to sort of look a bit on compared to what, because a good portion of Europe goes on vacation in August, so if you don’t get released in June or early July, you may not be in the market until the kids go back to school. These are children’s movies, which may be somewhat less impacted by the World Cup, assuming their parents are around to take them to the movies. So our belief is I think broadly that we’re a little less impacted by the World Cup and we want to get these movies out during the summertime.

In France in particular, I think there is the middle of July, a fairly large annual festival for everybody to go to the movies anyway. Given the choices, we think we’re better off putting these things out instead of holding them to what would really be the fall.

Rich Sullivan

Great, thanks, Lowell. Operator, next question.

Operator

At this time, there appear to be no further questions.

Rich Sullivan

Great. That concludes today’s first quarter earnings conference call. I’d like to remind everyone that a replay of this afternoon’s call will be available shortly and accessible on DreamWorks Animation’s website -- that address again, www.dreamworksanimation.com. Also, 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.

Operator

That concludes today’s DreamWorks Animation conference call. You may now disconnect.

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