dreamworks (dwa) - 8.28.15

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DreamWorks (DWA)

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  • DreamWorks Animation (Nasdaq:DWA) Investment Memo 8/28/15

    Recommendation: Short DreamWorks (Nasdaq:DWA) equity

    Current Stock Price: $20.29

    Thesis

    DreamWorks Animation (DWA) is a low quality business that trades at an elevated valuation

    due to the belief that the struggling film studio can turn itself around and capitalize on the

    growing market for animated films. However, DWA will be unlikely to create meaningful

    shareholder value over the long-run because its business model provides better economics to its

    supply chain. Opaque and gimmicky accounting practices, revenue that is inherently

    unpredictable and a management team that has consistently broken promises and missed targets

    raise red flags that call into question the economic reality of the Company. After recently

    resetting expectations and declaring 2015 to be another transitional year, DWA still trades for

    sky high valuation multiples. Using optimistic assumptions, DWA is at least ~30% overvalued

    on a sum-of-the-parts basis and likely worth much less if the studios next slate of movies underperform at the box office

    Company Overview

    Description: DWA operates an animation studio that produces box office films and TV shows. Since its founding, it has developed many famous characters (e.g. Shrek, Kung Fu

    Panda) which it also licenses for toys and consumer products. DWA has recently

    expanded to managing YouTube channels in its New Media segment

    Customers: DWA targets the global childrens entertainment market o ~55% of revenue is international

    Strategy: DWA releases 1-3 animated feature films per year. DWAs goal is to develop lasting intellectual property that it can monetize across multiple channels over many

    years (film releases, sequels, TV spin-offs, merchandising, licensing)

    o Historically, the Company focused on film production and merchandising; however, DWA has diversified into TV production, managing YouTube channels

    and extending its licensing to destination attractions in order to better monetize its

    intellectual property and generate more consistent financial results

    The Bull Case Argument

    DreamWorks is a mini-Disney with highly valuable intellectual property that can be better monetized by current diversification initiatives

    According to the Motion Picture Association of America (MPAA), global box office ticket sales have grown 24% from 2010 to 2014 and are expected to keep growing due to

    Capitalization Financials Valuation

    Market Cap $1,748 LTM Sales $752 EV / LTM Sales 3.0x

    Cash $122 LTM Growth 20.9% EV / 2016E Sales 2.3x

    Debt $649 LTM EBITDA $104 EV / LTM EBITDA 21.9x

    Enterprise Value $2,275 LTM Margin 13.8% EV / 2016E EBITDA 18.2x

    $ in millions. Data as of 8/28/15 (Q2 2015). Financial projections based on Wall St. consensus estimates.

  • 2

    rising ticket prices in the developed world and larger audiences internationally.1 This is a

    strong trend for DreamWorks because it has global distribution and its films appeal to

    international audiences

    In recent years, animated films like Frozen, Toy Story 3 and Shrek have generated large box office revenues and point to the trend for animated films having a higher commercial

    success rate than live action films

    DWAs stock is undervalued because the Company has under-earned its potential in recent years due to poorly performing films

    o The Companys legacy includes a run of 17 box office hits in a row between 2000 and 2012. This legacy shows that DWA has a proven formula for churning out

    theatrical hits

    o The recent announcement to hire Bonnie Arnold and Mireille Soria as co-presidents of Feature Animation and downsizing the production budget to 2 films

    per year (from 3) will increase the quality of upcoming film releases

    DWA is experiencing rapid growth in its highly profitable Consumer Products, TV and New Media businesses which will help the company generate more consistent financial

    results because these segments do not depend on film release cycles

    DWAs JV in China, Oriental Dream Works (ODW), will allow the Company to tap into the large, growing Chinese box office market

    CEO Jeffrey Katzenberg is a Hollywood legend with 4 decades of experience at top studios. His vision for DreamWorks and industry relationships will help propel the studio

    to success. His 10% ownership of DWA aligns his economic interests with shareholders

    Poor Business Model Quality

    DreamWorks discloses that the process of making each animated films takes three four years. Each film involves writers, artists, software engineers and managers and can

    involve hundreds of people along the way

    Given the long process of making each film and the amount of man hours spent, making an animated film is extremely capital intensive and the studio (DreamWorks) must make

    the upfront investment and assume all the financial risk in production 1 MPPA, 2014 Theatrical Market Statistics. http://www.mpaa.org/wp-content/uploads/2015/03/MPAA-Theatrical-

    Market-Statistics-2014.pdf

  • 3

    Since 2007, the average production budget for a DreamWorks film has been $145 million. DWA has targeted bringing down production costs to $130 million per film

    In addition to the production budget, a marketing budget of $50 - $90 million is used to place advertisements and market a film. The marketing expenses are borne by the

    distribution partner (Fox for DWA)

    After three to four years of work and spending upwards of $200 million to make and market a film, the film can be released. However, regardless of how much money is

    spend on a film, there is no proven formula to guarantee box office success

    o For example, DreamWorks highest budget film, Monsters vs. Aliens, had a budget of $175 million and was a flop. The film grossed $382 million. After

    paying for expenses, DWA lost over $60 million on the film

    o Disney, a best of breed studio, has also had inconsistent box office runs, losing money on several animated films in recent years including Treasure Planet, Home on the Range and Chicken Little

    Grossing $382 million on a movie like Monsters vs. Aliens sounds like a lot, but the money is split between distributors and marketers before DWA gets paid

    o Marketing costs must be fully recouped. The marketing partner also gets an additional 8% of the gross box office revenue

    o Theater operators and distributors receive ~40% of gross ticket proceeds o DWAs estimated economics on this film = $382mm box office sales - $88mm

    marketing budget - $31mm marketing fee - $153 theater & distributor revenue

    share = $111mm DWA revenue on this film - $175mm production budget =

    $64mm loss on this film (before corporate overhead costs)

    From 2004 to 2012, DWA had an average gross profit of 32% per film. From 2012 to 2015, DWAs gross profit per film has been 2% (see appendix for details)

    o In order to turn a profit, DWA must successfully monetize its intellectual property through merchandising and product licensing

    In addition to taking on all of the upfront financial risk, DWA is paid last (after distributors and marketers). At the end of 2014, DWA had $432 million in outstanding

    receivables or 230 receivable days

    Why is Disney successful and DreamWorks not? o Disney as well as the other major studios is a fully integrated media platform with

    control over marketing and distribution, Disney has greater scale in production

    with more studios and more channels for monetization (TV, radio, parks, ect.)

    o Disney is able to capture greater economics in its distribution of films and is better able to monetize its intellectual property outside of theatrical releases with

    its numerous media and vacation properties

    o With DWA only producing 2 movies a year, it has a much higher concentration of

    risk if a film is not a commercial success

    Accounting Issues

    Aggressive Cost Capitalization o Because of the long timeline in making and releasing a film, DWA uses accrual

    accounting to attempt to represent the economic relationship between sales and

    expenses. This has resulted in DWA having a great deal of discretion and use of

    estimates with its accounting practices

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    DWA capitalizes production costs for film and TV and amortizes the capitalized costs over the exhibition period that DWA recognizes the

    revenue. Overhead costs are expensed as incurred

    o While a majority of cash costs are capitalized, DWA does not go into detail as to how much costs are being capitalized

    From DWAs 10K: Capitalized production costs represent the costs incurred to develop and produce our animated films and television

    series/specials, which primarily consist of compensation (including

    salaries, bonuses, stock-based compensation and fringe benefits) for

    animators, creative talent and voice talent (which, in the case of sequels,

    can be significant), equipment and other direct operating costs relating to

    the production (including production overhead) o Looking at the statement of cash flows, the Film Inventories item tracks cash

    production costs; however, the line item shows that DWA is incurring higher cash

    costs than it is reporting in the income statement

    o

    o Another sign that DWAs capitalization policy is aggressive is the amount of capitalized stock based compensation (SBC). SBC is typically reserved for

    division heads and executive mana

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