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February 25, 2009

Sold Dreamworks as Weak Quarter Raises Long-Term Issues

Despite my hopes that Dreamworks Animation (DWA) had a good set up going into last night's earnings reports, the stock is going to trade down sharply this morning. Adjusted for a one-time tax benefit, EPS missed estimates due to higher costs associated with new ventures to diversify revenue (TV, virtual worlds, Broadway) and an adjustment to reflect lower ultimate profitability for Kung Fu Panda related mostly to initial estimates for higher DVD sales. I think these trends will be very troubling for investors as they undercut near-term earnings potential with few signs yet that long-term earnings power is going to be enhanced.

CEO Jeffrey Katzenberg correctly noted on the call that not all the news is bad. Kung Fu Panda's DVD sales exceeded early December guidance by more than 10%. Madagascar 2 DVD sales since the February 6th release date are running strongly. In addition, Coraline, a 3-D animated film from another studio recently released is performing well.

The hope for the stock now is that Monsters vs. Aliens has good buzz leading into its March 27th opening followed by an opening weekend of $60 million and decent legs. I think those things are possible but it is an all or nothing bet that I am not inclined to make. More importantly, the message form the 4Q and 2008 results is that the profit model for even huge box office successes now faces much lower margins.

As a result, I sold all Northlake long positions in DWA despite the additional weakness. In the near-term, I could see the shares slipping as low as 10 times 2009 estimates, which will fall from $1.56 to under $1.50. There is asset value support, especially in a takeover, and the 2010 outlook has several positive catalysts, so this should be a worst case scenario.

Posted by Steve Birenberg at February 25, 2009 02:12 PM in DWA