Dreamworks Animation: Not Entertaining Enough (DWA, MVL, IMAX, LGF)

Includes: DWA, IMAX, LGF.A, MVL
by: Travis Johnson

I sold my small position in Dreamworks Animation (NASDAQ:DWA) this morning, offloading the shares at $23.25 for a loss of about 35% (average purchase price was about $35) Unfortunately, I bought the shares over a year ago, before and during the Shrek 2 DVD fiasco.

This represents a significant change of heart from my last note about DWA, back in December. At that time I thought 2006 would be a buying opportunity as we awaited 2007's Shrek the Third and Jerry Seinfeld's Bee Story film, then Jack Black's Kung Fu Panda and maybe a Puss-in-Boots movie in 2008.

That's still entirely possible, and several analysts see it that way. But after taking a closer look at my portfolio I've decided that I'm uncomfortable with the size and scope of my basket of entertainment stocks. I also own shares in Imax (NYSE:IMAX) , Lionsgate (LGF) , and Marvel Entertainment (MVL) and I've decided both that I've got too much hit-reliance and entertainment in my portfolio, and that I prefer the other three over Dreamworks. DWA was also the smallest position in this group, so this move also helps with my effort to consolidate and focus more of my time and energy on my larger holdings.

But the size of the position wasn't enough of a reason to sell it Each of those three entertainment companies has a more compelling upside, I think, than does Dreamworks, though it's also possible that they are also higher risk.

I'm a little concerned about Imax given their very poor luck at choosing their first two films this year (V for Vendetta and Poseidon were tough on them), but I see potential catalysts in the Superman movie and, more importantly, in their possible acquisition or reinvigoration in partnership with someone. That's a large part of the reason I prefer holding IMAX to DWA. I'm waiting to see what happens as the company "explores its options" with regard to a possible tighter partnership with a big studio or an outright sale of the operation.

Lionsgate, likewise, had a rough spring. Its highest profile film was the Starbucks-partnered Akeelah and the Bee, which never was able to capitalize on the feel-good word-of-mouth marketing from Starbucks and break through into the public consciousness. Still, Lionsgate has a few things going for them that Dreamworks does not: they have a huge film library that makes them a very enticing acquisition target if all else fails; they have several franchises that are very profitable (Saw, Tyler Perry); and they have a corporate commitment to profitability, not hitmaking -- they're willing to make or release anything for film or TV as long as they think that they can make it profitable, they don't rely on "winning the weekend" for each of their releases (though their low-cost horror and "urban" films have occasionally done just that). This seems a safer bet, and a source for more compelling opportunities for profit, than a hit-reliant animation studio that has so far had trouble even turning hits into profit (which makes me quite nervous about the impact a serious flop would have on DWA).

And finally Marvel. As a kid who grew up reading Spiderman and X-Men comics I may be simply letting nostalgia firm up MVL's place in my portfolio -- but I don't think so. What I like about Marvel at this point is just the same thing that some, including Jim Cramer, don't like -- they're adding more risk and greater potential reward to their business plan.

Marvel, like Dreamworks, is hit-driven. It was Avi Arad's work in building Hollywood franchises for X-Men and Spiderman that allowed the company to recover and attain profitability over the past several years, and it will be successful films and similar entertainment properties that drive the bus forward. I very much like that Marvel has chosen to continue with their licensed film production, which will build on the monster hit X-Men 3 to bring us Spiderman 3 next year, and a Wolverine film probably by 2008. It will also build a parallel production capacity to bring more Marvel heroes to the silver screen.

This will mean more risk, as Marvel has entered into a $500 million financing agreement to put these films together starting in 2008. It will also mean much more reward if they can continue building hits based on more of their characters. Instead of a few percentage points of the gross like they get with their older deals for X-Men and Spidey, they'll be pocketing all the profit after paying off debt and covering Paramount's distribution fees. Of course, that means that if the films flop or fail to pay off the debt nut, they'll be in trouble. But the company will survive, thanks to what I think is very clever non-recourse financing that puts up only the characters themselves as collateral. A flop of a film will mean, if Marvel can't pay the bank, that they lose the right to make any more movies with that character -- that seems fair to me.

The two things that make me a little nervous about Marvel are their penchant for adding debt right now for no good reason (they're borrowing money to buy back shares, which seems foolish to me -- much less sensible than borrowing money to make movies), and the changing nature of their relationship with Avi Arad. Avi was the one who brought Marvel to Hollywood and made it work, but now he's moved on to create his own independent production company that will subcontract to produce Marvel's films. This is fine if it just means he has more time to focus on the films, but I'm not crazy about adding another middle man company that will siphon off a bit more profit from Marvel. Avi has done great things for Marvel, but he's also the one who put together the laughable Nick Fury film with David Hasselhof a number of years ago, so he's not infallible.

So four stocks, among which Marvel is the only one I'm holding at a paper profit right now, and I'm offloading one. It should be an interesting couple of years (or months, even) for some of these companies as hits emerge and recede, takeovers are rumored or offered for Imax and Lionsgate, the DVD format war heats up, and online and cable film offerings become more and more flexible and, hopefully, create new revenue streams for Marvel and Lionsgate.

Dreamworks Animation may well have a very good 2007 at the box office, but I'm not convinced that they'll profit from it or that they'll be able to stand out in an increasingly competitive animation landscape. I could very well be wrong, but right now I'm more confident in the prospects for my other entertainment holdings.

DWA 1-yr chart: