I purchased Dreamworks Animation (DWA) across client and personal accounts near the open of trading on Monday. The purchase is intended as a “trading buy” which means I am expecting to be out of the position in less than one year. The holding period may be even shorter if the stock attains my target of $35-37.
The catalyst for the purchase of DWA was the much better than expected opening of the company’s latest animated film, Kung Fu Panda. Panda grossed just over $60 million at the North American box office during its opening weekend, exceeding expectations that centered around $45-50 million.
Panda is also expected to do very well internationally, potentially rivaling the success of Disney’s Ratatouille. The film only opened in nine countries on its first weekend but the results were excellent. Panda opened 158% ahead of Ratatouille in Russia and more than tripled the Rat in South Korea. Singapore, Malaysia, and the Philippines each set opening weekend records for an animated film. Larger markets in Europe will see openings later in the summer to avoid competition from the European soccer championship.
Normally, a single film would not be enough to drive the stock price of a movie production company….

….However, DWA only releases one or two films a year. Panda is a critically important film for DWA because the company needs to establish a third franchise after Shrek and Madagascar. Since DWA releases so few films it has limited sources of library revenue. An additional franchise will smooth future earnings by creating a higher base of revenues. More importantly, an additional franchise in the company’s library will raise the base level of earnings for the company. Stability and earnings power will also be enhanced now that Panda has cemented the company’s to strategy to release one original film and one sequel each year starting in 2010.
With global grosses heading north of $500 million, Panda should also drive better than expected ancillary revenues from US and foreign broadcast, pay, and cable TV rights and merchandising. The film has many merchandising options with action figures, plush toys, and video games particularly obvious.
Beyond the first few weekends of box office for Panda, DWA shares have other catalysts over the next six months. As mentioned, many major foreign markets will not get the film until later this summer. Panda will hit DVD for the 2008 holiday season. DWA’s next wide release is the sequel to Madagascar and will open on November 7th. The first Madagascar film was released in May 2005 and grossed almost $200 million in North America and over $300 million abroad. DWA also has some television projects coming late this year, including one involving Shrek, as it seeks to diversify its revenue stream. The next original film on DWA’s schedule is Monsters vs. Aliens on March 27th, 2009. This film will be the first animated film to heavily emphasize 3-D in thousands of upgraded theatres.
As noted, DWA shares have other catalysts beyond the opening weekend but the initial reaction should be positive as analyst estimates are increased. Rising earnings estimates are one the best predictors of future relative stock price performance. Entering the opening weekend, consensus estimates for DWA for 2008 and 2009 were $1.59 and $1.63, respectively. I believe estimates will increase to the high end of the current range or around $1.85 for both years. With earnings momentum and positive sentiment, a P-E of 19-20 times is achievable equating to a target of $35-37, up 13-19%. If this target is achieved by year end, the annualized return is extremely attractive.
Adding to the attraction of DWA shares is that they should be quite defensive in an uncertain market environment. With only Kung Fu Panda driving 2008 earnings and no “opening weekend” risk until Madagascar 2 in November (minimal risk given the past performance of animated sequels), news flow and sentiment should remain positive. Profit-taking is always a risk given the run in the stock off 2008 lows, but fundamentally the shares are in excellent shape which should limit the downside relative to the market.