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October 28, 2009

Will DVDs Bite An Otherwise Good Outlook for Dreamworks Animation?

Analysts and investors are rightly looking ahead to 2010 when deciding how to invest in Dreamworks Animation (DWA). The company has three films coming out next year including two originals and Shrek 4. 2009 is in the books and although Monsters vs. Aliens produced disappointing international box office and will not be a new franchise (management has ruled a sequel), the impact of the film is no longer a driver for the stock.

Mostly, the street has become more bullish on DWA over the lat six months. First, DVD sales for Madagascar 2 held up better than expected. In fact, animated films in general have weathered the DVD slowdown pretty well. Second, EPS estimates firmed up after falling sharply early in the year. The company is now expected to earn about $1.55, pretty darn close to where the estimate was entering 2009 and well above estimates that went as low as $1.20 in late winter/early spring. Third, the return of Shrek along with two other features and a few TV specials sets up 2010 as a big year for EPS. Current consensus of 2010 is $2.30, up 44%.

Assuming that Shrek 4 and the tow other new films in 2010 perform up to expectations at the box office and in DVD sales, it is hard to argue with a bullish view on DWA. However, on thing that is overlooked is that DVD unit trends are clearly in a downward trend.

For Kung Fu Panda, released in June 2008, 16 million DVDS were sold or 1 million per $39.5 million of worldwide box office. Madagascar 2, released in November 2008, sold 11.3 million units, or 1 million units per $53.4 of worldwide box office.

The latest release Monsters vs. Aliens debuted in March 2009 and underperformed at the international box office, bringing in just $181.5 million vs. over $400 million for each of Kung Fu Panda and Madagascar 2. Domestically, Monsters vs. Aliens performed in line with the other two films.

The concern is that Monsters vs. Aliens DVD sales got off to a slow start and by all indications will continue the deceleration seen in Madagascar. Management notes that wholesale pricing on Monsters DVDs is holding and that premium packages and blu-ray is making per unit profits and average selling prices higher.

However, what happens if 2010 releases see a continuation of the DVD slowdown? Will the two original films perform like Kung Fu Panda/Madagascar 2 or Monsters vs. Aliens? Will Shrek 4 be the film where the franchise shows maturity?

The answers are important because they get at what the profitability of DWA's films and business model will be looking out several years. None of this matters in the very near-term. The stock will be momentum driven responding to initial impressions of the films and then their open weekends. In the long run, however, the P-E, EBITDA, or free cash flow multiple could be pressured if animated films have finally succumbed to the DVD slowdown. And lower DVD prospects will diminish the takeout multiple should the recent speculation that DWA will be sold to a larger media company turn out to be true.

Posted by Steve Birenberg at October 28, 2009 10:50 AM in DWA