3-D films hit some speed bumps. Is conventional wisdom off target?

This article originally appeared on SNL Kagan on April 6, 2010.

The two most recent 3-D releases have not lived up expectations set by Avatar and Alice in Wonderland. Theater owners probably don’t care but should studio owners?

The North American box office continues to chug along, up over 10.9% according to BoxOfficeMojo.com. Most of the press reports discussing box office attribute the gains to the growing slate of 3-D films. No doubt consumer interest in 3-D and especially their willingness to pay premium ticket prices for the 3-D experience is very good news for theater owners. However, for studios the news has been a little more mixed recently.

The massive, history-making success of Avatar, followed by the much stronger than expected performance of Alice in Wonderland was greeted by conventional wisdom that everything in 3-D worked for studios as well theaters. Produce in 3-D from the start or covert to 3-D in post production and studios had a sure thing with more tickets sold at premium prices.

I have always been a bit skeptical of 3-D phenomenon so the rapid convergence of conventional wisdom caught me off guard. It also cost me money as my skepticism kept me out of the theater stocks. What always concerned me was that as 3-D films become commonplace, consumers would not be willing to pay the premium ticket price. Either they would pass on the film altogether or just see the 2-D version.

I also kept reminding myself that opening a film and sustaining its box office was about marketing and the quality of the film. Eventually, the consumer interest in 3-D because of the novelty would wear off.

I think the recent performance and critical response to How To Train Your Dragon and Clash of the Titans suggests that for the studios 3-D can be a positive but is no guarantee. Given the added production costs, rumored at $25-50 million, and what often will be incremental advertising to promote 3-D awareness, just producing a movie in 3-D is no guarantee of success. It is still about opening the film with effective marketing and sustaining the box film because the movie is good.

How To Train Your Dragon opened to a disappointing $43.7 million two weekends ago. The film showed decent but not great legs with a 33.7% drop in its second weekend. Given the fantastic reviews – 98% at Rotten Tomatoes – and the strength of the Dreamworks Animation brand, the opening significantly underperformed expectations.

What happened will always remain a guess but there a few possibilities. There has been some speculation that dragons play poorly in the US based on past dragon-themed films like Eragon. The TV ads, billboards, and trailers looked good to me but maybe they missed the mark with the target family audience. 3-D screen availability was squeezed by Alice in Wonderland the first weekend and Clash of the Titans the second weekend although analysts seemed satisfied with the screen count relative to their box office estimates. Could it be that ticket buyers just did not want to pay up for another 3-D film? Maybe they decided spending $40-60 bucks for tickets for a family of four was too much? Maybe they decided the other Dreamworks films in 2-D were good enough so why pay for 3-D? Maybe they decided that after Avatar and Alice they just did not need to see another 3-D film?

Clash of the Titans is a different story. Warners did a great job of marketing. They made the decision to convert to 3-D after the film was complete and went all in on the marketing budget emphasizing the 3-D angle. The film got panned by critics. Many critics even suggested that 3-D made the film worse! The opening weekend of $64 million including Thursday night shows met expectations but the Friday to Saturday decline was steep, often a sign that a film will not have legs. 3-D clearly helped Titans but if film suffers a huge second weekend drop profits may be elusive on a film rumored to have cost $125 million with a marketing budget that must have been at last another $50 million. More importantly for the future of 3-D, does the fact the film got panned mean that ticket buyers will be more skeptical of future 3-D action films?

The bottom line is that the last couple of weekends suggest that the future of 3-D profits for studios may not be as simple as it seemed. With the coming surge in 3-D releases, consumers may become more discriminate in what they pay up for or pay to see at all. Constraints due to lack 3-D equipped theaters will quickly dissipate. A year from now will early industry and consumer fascination with 3-D prove to have been overhyped? I think so. I just hope my view still is not costing me money?

Disclosure: The Entermedia Funds are long Time Warner and Dreamworks Animation. Steve Birenberg is co-manager of the Entermedia Funds, co-owner of the Funds' investment management company, and has personal monies invested in the Funds.

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.

Monsters vs. Aliens Falling Short

I've written catuious commentary since Monsters vs. Aliens opened to $59 million in North America, in line with analyst estimates. The second weekend saw a drop of 45%, which is on the high side. The film is tracking close to Ice Age 2 over the past week but is $10 million behind overall. Ice Age 2 did $195 million so a figure around $180 million for MvA seems like a plausible estimate. This is a decent figure but is not enough to drive DWA shares higher.

Where the shortfall may be higher is in international box office. Opening weekends around the globe are well behind Kung Fu Panda and Madagascar 2, andin the few markets such as Russia, where the film has been open for at least two weekends, the grosses look signficantly behind KFP and Mad 2. KFP did $416 million outside of North America. Madgascar 2 did $414 million abroad. It looks to me like MvA will fall far short of these two films, potentially leaivng the global gross at less than $500 million. For DWA shares, that is a disappointing figure.

DWA was downgraded earlier this week by Rich Greenfield of Pali Research on concerns about the international numbers. Rich also asked a good question: will the dominance of the 3-D version of the film hurt DVD sales since 3-D is not available in the home? This is a critical question as DVD sales, even at recent lower tie ratios (ratio of DVD sales to box office), are the driver of EPS.

I think DWA shares are without a catalyst for the next six months with risk to the downside if MvA box office continues to lag Wall Street expectations. Downside risk exists to mid-teens if earnings fall to current low end estimates. In the very near-term, expect more cautious comments from analysts on the international box office numbers.

Monsters vs. Aliens Sets Up Two Way Trading in DWA

The next film from Dreamworks Animation (DWA) arrives in theaters on Friday. Monsters. vs. Aliens will easily be the #1 film this weekend and will drive the box office to very positive comparisons But for investors the more pertinent questions are whether the film has a strong enough opening to drive DWA shares higher or will it have a disappointing opening that sets up a good short?

I think the bar is set at $60 million for the opening weekend. Anything equal or greater will be positive for DWA shares. A figure below $55 million will probably be enough for the shorts to capitalize, especially as DWA has participated in the recent rally. I think a portion of DWA's gains this week are related to optimism about the movie which skews the immediate risk-reward slightly negative depending on the weekend gross.

Monsters vs. Aliens will be the first heavily marketed blockbuster focused on 3D animation. The film may roll out on as many as 7,000 screens of which 2,000 will be 3D. Theaters are expected to charge $2-5 extra per 3D ticket which will impact the grosses as 30% or more of the ticket sales could be 3D. At an average non-3D ticket price of $7 (lots of families at matinees), ticket sales could be 8.5 million. Add a $3 premium on 30% of those tickets and you could get an extra $8 million in box office receipts. Relative to the $60 million expectations bar that is enough to make the difference.

The opening is also important for DWA's long-term share price as the company is banking heavily on the revenue upswing from 3D. In addition, if Monsters vs. Aliens is a hit it cold become another franchise for DWA which means sequels, more merchandising and library revenue, and most importantly, greater earnings predictability.

I am not playing DWA on either side for Monsters vs. Aliens. I did get long unsuccessfully prior to Kung Fu Panda and Madagascar 2. Both films beat expectations but the weak market and collapsing DVD sales more than offset the box office upside.

Early reviews are positive (85% on Rotten Tomatoes after 13 reviews; UPDATE: 73% with 22 reviews) and the film has been massively marketed. I suspect the film will not fall short of the $55-60 million expectations bar but I don't expect a blowout either so if I do not expect an unusually large reaction in DWA sharse on Thursday and Friday or Monday after the grosses are known.

As mentioned, I think that risk is the stock should the film disappoint is greater than the reward for anything short of a massive blow out (greater than $65 million). As a result, if I had to put a trade on I would lean to the short side, especially if DWA shares firm up a bit more the next two days.

A few Northlake clients own DWA.

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.

Dreamworks Animation Earnings Preview

Several of Northlake's long positions report this week beginning tonight with Dreamworks Animation (DWA). DWA has been very weak as the collapse in DVD sales has crushed estimates and compacted long-term valuation. However, the stock may be a good setup for a rebound. Getting past the earnings report could allow investors to look forward where the outlook is more hopeful.

Consensus is for 60 cents in EPS on $232 in revenue. DWA's earnings are tough to predict due to limited revenue streams against mismatched timing of expenses. The revenue number looks a little high to me while the EPS number seems OK even on lower revenues. EPS estimates were 83 cents when the company last reported which tells me bias on tonight's report should be for below consensus.

The optimistic case looking ahead is that the company has a movie coming on March 27th, Monsters vs. Aliens, profitable DVD sales on that film and Madagascar 2 later this year, and three films to be released in 2010 including Shrek 4. DWA shares usually perform better in anticipation of movies than in reaction to movies.

The trade is that we are moving into an anticipation period with the stock and estimates reflecting a lot of bad news and negative sentiment.

Both Dreamworks in the News

Dreamworks is in the news. First, Dreamworks SKG, the privately held, live action movie studio that is home to Steven Spielberg, is changing plans and will use Disney (DIS) as a distribution partner as opposed to Universal Pictures (owned by GE). Second, Dreamworks Animation (DWA), the publicly held animation company, was the subject of a lengthy positive article in the New York Times.

To clear up any confusion, SKG and DWA are completely independent with the exception of overlapping shareholders (Spielberg, David Geffen, and Jeffrey Katzenberg). The news stories about SKG have absolutely no impact on DWA.

The SKG news does matter to DIS, however. I think it could be a modest positive. DIS has sharply reduced its own productions to its core family franchise, both animated and live action. The SKG deal gives DIS another 5-6 adult films per year to distribute and brings the prestige of having Spielberg as a partner. Reports indicate DIS may invest up to $400 million in SKG which should be recouped profitably through the distribution fee (8-10% of box office). Usually these deals give the distributor payment off the top, directly from gross box office receipts, generally producing a modest but consistent profit stream. DIS is strong financially despite its cyclical and secular challenges so the company is in a position to invest while other studios (NWSA/FOX, Warners/TWX, Paramount/VIA, Sony, Universal/NBC) have parent companies who need to preserve cash. On last week's conference call, CEO Bob Iger indicated DIS would its financial strength to invest and build the company for the long-term. SKG is not a huge deal but I think it is a good example of what Iger was referring to.

As for the article about DWA, I think it provides a balanced view that leans positive and supports my thesis that DWA is uniquely positioned among major media companies as insulated from the some, but not all, of the cyclical pressures currently buffeting the industry.

DWA reports on 2/24. Estimates have dropped sharply due to weak DVD sales at Christmas but I think the lagging performance of the stock reflects this fact. Slowing sales of tickets for Shrek The Musical on Broadway have also contributed to the lagging share performance. I think the earnings report and call will clear the stage for a rally into the March 27th release of Monsters vs. Aliens. Insider buzz on the film is good and the stock has rallied into movie releases in the past. I think DWA is a good long side trade in the current market environment.

Dreamworks Animation is Relative Safety in Media

There seems to be no place in media to hide as estimates continue to fall and no signs of recovery in advertising or other key revenue drivers is apparent.

One stock that largely avoids the potholes in media is Dreamworks Animation. The company is vulnerable on DVD sales but has no advertising exposure. In the next eight weeks DWA has several potentially positive catalysts.

First, 4Q08 earnings will provide a platform for discussing what could be a decent 2009 with rising estimates possible. 4Q results themselves may not provide a catalyst with slightly below expectations North American box office for Madagascar 2 ($180 million vs. $200 million expected) and risk to holiday DVD sales for Kung Fu Panda. I believe both of these issues are factored into street expectations.

As to 2009 expectations, the first positive is that Madagascar 2 is performing very well overseas. The film is at $380 million and probably has legs to cross to $400 million. This is very impressive given Kung Fu Panda's $415 million in a weaker dollar environment. 4Q08 international box office is reported in 1Q09 results. I think analysts may be underestimating international Madagascar 2 in their models.

The other catalyst is the March 27th release of Monsters vs. Aliens, the next film in DWA's release schedule. It is too early to get a read but clips of the film that have been shown to analysts were well received. Their will be a lot of discussion of 3-D related to this film. It is already clear that the number of 3-D screens available will be far short of what was initially expected but I do not expect this to have a material financial impact. What is likely to be real is a pre-opening rally in the shares of DWA something that occurred regularly on past releases including Kung Fu Panda and Madagascar 2.

Why You Should Own Dreamworks Animation

This will be the first in a new series of columns I will write titled "Why You Should Own..."

The first stock is Dreamworks Animation (DWA) . DWA is currently trading at $21, a new 52-week low. The 52-week high was $32.73 on Sept. 2. The market cap is $1.9 billion. At the end of 2008, DWA should have about $350 million in cash and less than $100 million in debt. DWA pays no dividend.

The consensus estimate for 2008 is $1.82. For 2009, the estimate is $1.67. At $21, the P-E on 2008 is 11.5. For 2009, the P-E is 12.6. The lower 2009 estimate is because there are minimal revenues from Shrek, DWA's most profitable franchise.

Why You Should Own DWA for the Short Term

DWA has very positive earnings momentum that should hold through at least the first half of '09. The fourth-quarter 2008 estimate has risen over the last 90 days. The momentum is being driven by success earlier this year from Kung Fu Panda. Panda grossed $215 million domestically and $416 million abroad, making it DWA's most successful film besides the Shrek series. Even with a $130 million production budget and another $100 million plus for marketing, the film is profitable before DVDs. The DVD just went on sale and immediately went to No. 1 on the charts.

DWA will also benefit in the near term from the successful release of Madagascar: Escape 2 Africa on Nov. 7. The film is on track to match Kung Fu Panda and exceed the original Madagascar. While the timing of revenue and expense recognition means that Madgascar 2 will not contribute greatly to EPS in the near term, the success is a great confidence boost for meeting or even beating 2009 estimates, something that very few companies can now offer.

DWA has two other near-term catalysts. First, on Dec. 10. the company will be holding its first- ever analyst meeting. DWA has lots of good things to say about the near term and long term, so the timing is good.

Second, Shrek the Musical debuts on Broadway in December. On its own, the musical will not be a big profit-driver, assuming it is successful. But if it is a success, it further diversifies DWA's revenue stream and builds a greater base of long-term earnings power.

Finally, and maybe most importantly for the near term, DWA is a major media stock that has zero advertising exposure. There is minimal cyclical or secular challenge to DWA's business model unlike almost every other media stock.

Why You Should Own DWA for the Long-Term

2009 has been a critical year for DWA. The massive worldwide success of Kung Fu Panda and the successful sequel to Madagascar has dramatically boosted the company's long-term earnings power and the consistency of its financial results. Along with Shrek, DWA now has three franchises that can spin sequels. Each new film in each franchise boosts profits from the library via the films, merchandising and TV rights. Three franchises make it easier for DWA to release two films per year, one sequel and one original. It also takes the pressure off every original to be a resounding success. Wall Street rewards consistent long-term earnings growth. DWA exits 2008 in its best shape ever.

What Could Go Wrong

DWA trades at a premium to other media stocks, which now generally have single-digit multiples on 2009 estimates. The shares have also held up very well compared to other major media stocks that are down 50%-90%. DWA is subject to disappointing box office for any of its films. In the near-term, weak holiday sales for the Kung Fu Panda DVD or poor international box office for Madagascar 2 (it has only opened in Russia so far) are a risk. In 2009, DWA will be releasing two original films. Originals are not as profitable as sequels and present greater odds for a disappointment. DWA is also planning on a boost from 3-D for its films in 2009 and beyond. So far, the rollout of 3-D theaters has severely lagged expectations.

My Position

DWA was purchased in early November at just under $27. I have not added to positions since that time.

The Bottom Line

DWA has positive earnings momentum, minimal estimate risk, the potential for upside earnings surprises, a debt-free balance sheet and identifiable catalysts. These all support near-term performance while the long-term outlook has greatly improved, thanks to the broader portfolio of hit movies and franchises that now exist in the company's library.

Update on DWA Trade

After sharp sell-off earlier this week, Dreamworks Animation shares reversed hard yesterday and are up again today even as the market trades to its daily lows. I got long DWA recently because of my confidence that (1) Madagascar 2 will exceed analyst estimates for domestic box office, and (2) Kung Fu Panda DVD sales will be solid. Following a positive surprise in 3Q results this would maintain the positive sentiment and set up 4Q08 and 1Q09 for more positive surprises.

We won’t know for sure about Madagascar 2 until we see how well the film holds this weekend but the opening weekend was excellent and an unprecedented surge on Veteran's Day's suggests interest in the film is high. Did the Veteran's Day steal the weekend sales? We will know soon enough. A dorp of less than 40-45% for the weekend is good news.

DVD sales Panda just started this week so there is no hard data but anecdotal evidence is promising. See here and here.

DWA is a media stock with no advertising exposure. It had held up well relative to the group. There are catalysts and the earnings outlook has minimal risk. I think it has upside of 15-20% if the market stabilizes and moves up from here.

Dreaming of Gains. Again.

The weak action yesterday in Dreamworks Animation (DWA) following the better than expected opening of Madagascar 2: Escape 2 Africa led me to buy DWA shares again for a trade. I am looking to for a move north of $30 assuming the film continues to track toward greater than $200 million domestically. The prior trade in DWA culminated with a very small loss when the shares were sold last summer just over $30.

The next catalyst for the shares will be second weekend box office. The two most comparable films are Madagascar and Kung Fu Panda. Madagascar 2 opened at $63 million, ahead of $60 million for Panda and $47 million for Madagascar. Panda and Madagascar opened on 6/8/08 and 5/29/05, respectively, so the summer run is not necessarily comparable as kids were out of school. As a result, it would be bullish for DWA shares if Madagascar 2 holds better than the other two films which fell by 40-44% in their second weekend.

Besides potential upside other positives exist for DWA. First, I'd expect analysts to reiterate buy recommendations after the big opening weekend followed by a decline in the shares. Second, the Panda DVD hit stores yesterday. Third, Shrek the Musical is opening on Broadway. If each of these items works positively the shares should respond especially flowing better than expected 3Q08 results announced at then end of October.

One last point is that DWA is a media stock with ZERO exposure to advertising. This makes it a good place for dedicated media investors to hide.

The Dream Is Over

I sold all client and personal positions in Dreamworks Animation (DWA) on Tuesday after it had rebounded from overzealous selling following its own 2Q08 report.

The sale of DWA was a result of my trading thesis falling apart when the company indicated that higher than expected international marketing costs would take away the earnings upside from the better than forecast worldwide box office performance of Kung Fu Panda.

I view DWA as a trading stock and it is now lacking catalysts until the 3Q report in late October followed by the early November opening of Madagascar 2. I could very well go long DWA again ahead of those events.

I held DWA for two months during which Northlake client positions produced a return of 0% to -3% loss. Relative to the S&P 500 it was a decent investment although it did not meet my goals of booking a 15% gain.

Dreamworks Thesis Falls Apart

My thesis on Dreamworks Animation fell apart when the company reported 2Q results after the close on Tuesday. While I understand the 10% decline in the stock, I think it is overdone and actually leaves value in the shares ahead of catalysts that are coming but not until October and November. The problem is there are fewer catalysts and they won’t help at all in the near term.

DWA reported better than expected 2Q revenue and EPS but all of the upside came from a one-time event. Excluding that the results were in line, maybe even slightly light. A good 2Q report was my first catalyst.

My second catalyst was more important: a big second half as revenues from Kung Fu Panda flowed through the income statement. Unfortunately, during the conference call, management guided international marketing expenses upward due to dollar weakness. I had been assuming that these expenses might be higher but the new guidance went up to 10% above the top end of the old guidance. Importantly to the story beyond the next few days is that despite the guidance change on expenses (which actually impacts DWA on the revenue line due to their distribution agreement with Paramount), most all analysts maintained their e2008 and 2009 estimates. It is the upside that was lost and upside is what was supposed to drive this stock.

As I mentioned, other catalysts remain but....

....they don’t have the same potential to positively impact the stock price and they won't occur before late fall. Until that time, one thing that will help is the new larger, share buyback announced yesterday. Based on comments on the call about how and when the buyback is used I am confident the company will be a buyer at current prices.

The other catalysts are the November release of Madagascar 2, the December opening of Shrek musical, and the launch of a new TV show on Nickelodeon based on Madagascar characters. DWA is an event driven stock so this is the sort of the stuff that allows for good trading opportunities. In particular, excitement surrounding Madagascar, which apparently already scores well on awareness surveys should lead to upside in the stock.

I am still long DWA for Northlake clients which was bought throughout June and early July at $29-31. I had a sell order in at a little over $30 today but it never went off. I'll be looking for a chance to sell near that price over the next few days. Hopefully, investors will realize that the sell-off was overdone. If not, I'll have to re-evaluate.

Dreamworks Estimates Begin To Rise

Dreamworks Animation (DWA) shares popped yesterday afternoon. I presume it was due to a report from Jessica Reif of Merrill Lynch which I received after the close. Jessica raised her 2Q08 and 2008 EPS estimates from below to above consensus on the basis of the strength in the Kung Fu Panda box office. She noted strength both in North America, where the film has had three full weekends, and international, where it has only opened in a few major markets.

Rising estimates is the first of several catalysts upon which my long position in DWA, established on June 9th, the Monday after Panda opened, is based. Look for more estimate increases next week, especially if Panda can hold its upcoming weekend-to-weekend box office decline to 40% or less against the opening of the extremely well-reviewed new film from Pixar/Disney, Wall-E....

....Future catalysts will include the 2Q and 3Q earnings calls which should have an optimistic tone, international box office receipts over the next month as Panda opens in major European markets, and the opening of Madagascar 2 in November.

I still believe the shares can move to $34-35 but the headwind from a poor market has been stiff. The shares have performed well on a relative basis since my initial purchase (I averaged down about 6% lower), unchanged against a 3% decline in the S&P 500. Hopefully, it won’t just be relative performance between now and November.

No Worries As Dreamworks Catches A Downgrade

An analyst I know well, Michael Morris of UBS, downgraded Dreamworks Animation (DWA) this morning driving the shares down more than 7%. I added a little to some smaller client positions on the weakness. The downgrade is based on Morris' belief that even after after raising his outlook for Kung Fu Panda the shares are slightly overvalued. Obviously, I disagree. I think Michael's valuation target and estimates are conservative. Supporting my case is the fact that through Tuesday, Panda is tracking almost exactly equal to Cars which grossed $$244 million in North America. Michael adjusted his DWA model by increasing his gross from $170 to $200 million. The upcoming second weekend will be critical to determining the ultimate North American gross for Panda but I remain very confident it will be comfortably north of $200 million.

Buying Dreamworks Animation

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.

Kung Fu Panda and the Upfront

A few brief items in the media world for this morning:

Kung Fu Panda opens today. The film has received good reviews and there has not been a major child focused film in theatres since Horton Hears A Who. A strong marketing campaign, good tracking data, and the usual optimism about funny talking animals has box observers optimistic about the opening. Most estimates are in the low $50 million range but I sense that a higher number might be what the experts are really thinking. DWA shares pulled back more than 2% in yesterday's strong market from a new recovery high. I think the stock will rally on anything over $50 million but that a significant up move will require $60 million plus. Analysts are projecting a healthy $200 million for the total North American box office run. I think this is the minimum required to support DWA shares at current levels. $250 million or more is necessary for significant and sustained upside.

AdAge.com is reporting that NBC completed its upfront sales with $1.9 billion, up $100 million from a year ago....

....This is a better than expected performance and boosts confidence that the total upfront could eke out a gain. A small gain is not as much as it seems however, as NBC's "up" year is at least partially fueled by its decision to sell a greater percentage of its inventory in the upfront. Analysts are speculating that advertisers are willing to lock in current pricing to avoid a repeat of last year when scatter pricing on unsold inventory soared to a 15-20% premium to the upfront. ABC and FOX are generally thought to be in the lead in this year's upfront seeking prices increases of high single digits and low double digits, respectively. These levels would be enough to offset last TV season's ratings declines and produce a flat to slightly higher industry wide upfront on similar inventory sellout ratios. I'd consider this outcome a success as far as national ad-supported media stocks are concerned.

Dreamworks: Good Results Ahead of Kung Fu Panda

Dreamworks Animation reported better than expected 1Q08 earnings with EPS of 28 cents and revenues of $156.6 million ahead of consensus of 24 cents and $135 million, respectively. The shares will probably lift a bit but the next major move in the stock will be associated with the June 6th release of Kung Fu Panda. Panda will debut at Cannes in two weeks which should give an early indication at least from a critical perspective.

Upside in the quarter came from solid DVD sales for Shrek 3 and Bee Movies and greater contribution form older titles. Flushed Away and Wallace and Gromit in particular look better than expected. Library revenue also may be ahead of expectations. Strength from older releases is good news for DWA shareholders as it suggests a higher base level of earnings power....

....In response to a question, management stated that negotiations with theatres on 3D installations has not made much progress in the last thirty days. This could hurt DWA earnings power in 2009 if there are not thousands of screens available for Monsters vs. Aliens, the company's first film produced in 3D, set for release in theatres on March 27th, 2009.

There was little very else that was covered in either the press release or the conference call. I view DWA as a trading stock based on its movie releases not a buy and hold investment. However, if Kung Fu Panda is a major hit (greater than $250 million in box office), the trade off the film's box office could prove greater and more sustainable than usual.

Dreamworks: Good Quarter But No Catalyst For Awhile

Dreamworks Animation reported better than expected 4Q07 results. EPS of 98 cents beat the 75 cent consensus even after backing out a tax benefit. Revenues of $290 million were ahead of the $285 million consensus and many recent estimates in the $265 million range. The upside came from higher than expected DVD sales of Shrek 4, which came in at 15.6 million versus expectations of 13 million. DVDs are very high margin so upside is good news for current results. It is worth noting that Shrek 4 DVD unit sales are well behind Shrek 3 which might negatively impact investor's views of future tie ratios on DWA's movie releases, especially sequels.

Shrek 4 produced $180 million of the $290 million in reported revenue. Madagascar produced $24 million and Over The Hedge $13 million, both benefiting form revenue in far out windows like pay TV and foreign TV. Bee Movie produced $12 million from merchandising but the box office revenue won’t be recognized until next quarter. Management did say that depending on DVD sales (due in stores later this quarter) Bee Movie would be profitable. No write down so far. Library titles produced about $64 million of revenue. Again for comparison, on its conference call Disney said that Toy Story merchandising was a $400 million business in 2007....

....Other important news out of the press release which was discussed on the conference call concerned the release schedule. DWA postponed its planned fall 2009 release until March 2010. This puts three releases in 2010 including Shrek 4 in May and another film in November. I believe this leaves just one film in 2009, the 3-D release of Monsters vs. Aliens. 2009 financial results, however, will be driven by the Madagascar sequel due in theatres this November.

The upside surprise in EPS and revenues and better than expected Shrek 4 DVD sales may pop the stock tomorrow but I don’t think it is anything to get excited about. If I were long I'd be a seller on that pop. The only sustained upward move of significant magnitude will come if Kung Fu Panda, to be released on June 6th, proves to be a big hit. It might be but I think it is too soon to play DWA on that basis

Looking More Favorably on Dreamworks Animation

Paul Allen announced that he is dramatically reducing his remaining position in Dreamworks Animation. Following up on the sale of 12 million shares last November, Allen will now sell an additional 15-17 million shares leaving him with just 6 million shares. Of the shares to be sold, 10-12 million will be sold in a secondary offering and DWA will buy back 5 million. The remaining 6 million shares will convert from Class C to Class A leading Allen to resign from the DWA Board. DWA has about 103 million shares outstanding so Allen's stake will be about 6%, down form over 30% prior to the November sale.

DWA shares took the news hard falling about 8%. I suspect the need to sell 10-12 million shares in a secondary in a difficult capital market weighed heavily on the shares. A secondary concern could be that a Board member is selling out following a 30% upward move in the shares since March.

I've been cautious and wrong on DWA this year. I feared that Shrek The Third would fall short of estimates given its launch date between Spiderman 3 and Pirates of the Caribbean 3. In addition, there has been a downward trend in box office for CGI animated films that has been attributed to too many films and moviegoers no longer seeing anything new. Finally, I am a little worried that all the summer blockbusters will make for a very crowded DVD marketplace later this year which could crowd out every film's sales by a modest amount.

All that said, I think the weakness in DWA ahead of the secondary might offer a good long side trade....

Shrek The Third has performed at least as well as analysts hoped. The studio's next film coming this November, The Bee Movie, starring Jerry Seinfeld has some good early buzz and what looks like an effective early marketing campaign. The stock has good support from a number of high profile analysts which should lead to a strong underwriting cycle and lots of positive commentary ahead of the Shrek DVD and release of The Bee Movie.

I do not own DWA but I have moved the stock up my list of potential media longs with my eye on a multi-month holding period as opposed to my usual multi-year time horizon. Consider this post a head's up, not a recommendation.

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.