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March 13, 2006

Dreamworks Animation: No Reason To Own

Dreamworks Animation (DWA) 4Q05 earnings were slightly better than expected, coming in at 49 cents after adjustment for two one-time items. Before adjustments, EPS were 61 cents. Consensus expectations called for 42 cents. Revenue exactly matched estimates, coming in at $173 million.

As expected, 4Q results were driven almost entirely by DVD sales of Madagascar which entered the home video window on November 15th. In fact, $152 million of the $173 million in 4Q05 revenue came from DVD sales of the film. On the conference call, management stated they sold 14.2 million units. This would equate to an ASP of slightly less than $11, at the low end of analyst estimates.

The low ASP confirms management commentary on the call that they are still cautious about the home video market. The comments were focused on catalogue/library sales where shelf space is hard to come by and wholesale pricing is collapsing. However, an $11 ASP on a big selling first run title like Madagascar is not great, in my opinion. Until recently, a film like this would have easily commanded a $15 wholesale price. It is pure speculation but I'd say that management decided it was more important to move units than maximize revenue. First run DVD sales still carry very high margins, even if they have come down, so if my speculation is correct, I'd say it was a wise decision....

Anthony Noto of Goldman Sachs asked a good question on the call. He wanted to know if changes in the home video market had led management to change its assumptions for determining profitability on upcoming new theatrical titles. Movie accounting requires an assumption on ultimate profitability be made up front. Management indicated that since the issue is still mostly catalogue sales they wouldn’t make a decision on ultimates until they saw how Madagascar did once it aged a bit.

For 2006, management is providing no EPS guidance. As outlined in the preview, the upcoming release, Over The Hedge, due in theatres on May 19th, won’t produce any revenue for DWA until the distributor, Paramount, recoups all of its distribution costs. Distribution costs could easily reach $100 to $130 million. Consequently, after the 50/50 split with theatre owners, domestic box office probably must head north of $250 million for the film to positively impact DWA's financial statements prior to the 4Q06 release of the DVD.

There are no there revenue drivers for 2006, as Wallace and Gromit was written down in the latest quarter. Small additional sales of Madagascar and library titles will provide revenue but I'd be surprised if it was enough to prevent a cumulative loss for the first three quarters of the year where SG&A alone will run over $55 million.

One final note I want to get down for history….DWA stated that they receive revenue from sales of domestic pay TV rights 12 months after theatrical release; for network TV the reveue is not realized until 2.5 years after theatrical release. For international pay TV the revenue lag is 18 month, while the 2.5 year lag for international network TV is consistent with domestic. Those rights are often negotiated much sooner which explains a lot about movie accounting.

I remain on the sidelines for DWA. It is a two product a year company with economics on its small library under severe pressure. Cash of $400 million, or about $4 per share is a nice bonus, but management likes to keep two movies worth of cash on the balance which is over half the current balance at a production cost of $130 million per film. Given the distribution agreement outlined above, this business model is just too risky for my blood.

As an aside, putting the similar, though historically much more successful business model of Pixar inside a big studio likes DIS makes a lot of sense. That is not to say DWA should be a seller but it might not be a bad idea.

Posted by Steve Birenberg at March 13, 2006 09:16 AM in DWA