In my last post, I talked about asset versus franchise investing. It’s extremely rare for franchises to get cheap, but when they do it’s generally because the market stops valuing them like a franchise and starts valuing them like a commodity or asset business or because the market is worried about some lingering uncertainty in the company’s industry. Maybe both. When that happens, it represents a pretty incredible long term buying opportunity if you’re confident the franchise is intact. However, even rarer than a franchise trading like a commodity business is a franchise trading at a discount to its assets. When that happens, you can invest in a long term compounding machine at a huge, huge discount. Your downside in the event the franchise has been breached is protected by the assets, while you can have enjoy huge, long term upside from growth within the franchise.
I think we’re getting close to such an opportunity at today’s prices with Dreamworks (DWA). A few month’s ago, Andrew over at Frog’s Kiss posted an analysis of DWA that doubled as probably the best value write up of a franchise I’ve seen. I really encourage you to check it out, as it clearly lays out the case for Dreamworks’ franchise and as a value investment. It also covers several points that I would traditionally cover in an article but will skip because they were so well done.
After reading Andrew’s piece, read this WSJ article on Dreamworks. It’s a good piece of reporting. It clearly summarizes all of the problems facing Dreamworks right now: monetizing in the DVD market evaporating, piracy, disappointing 3-D revenue, increasing competition in the family movie market. It’s also exactly the type of article that comes out when a franchise business starts trading like a commodity business.
But the WSJ article also misses several things about Dreamworks. My biggest problem is with this line- “With stock commanding 13.7 times next year’s consensus earnings, that dream isn’t worth the gamble.” My biggest problem is just a general quibble that it ignores DWA net cash (a problem the main stream press loves to make). My second is with the earning’s estimate itself. Finally, I also have some problems with the dreary long-term problems inferred by the piece. Let’s start with the second problem.
Something unique about analyzing Dreamworks as an investment is they release 2-3 films each year. Those films’ performance at the box office and subsequent DVD window are really the only directly-observable events that matter each year in terms of adding or subtracting value from Dreamworks, and they are certainly the most important in effecting Dreamworks’ cash flow each year. For example, since Andrew’s write up, Dreamworks has released Puss in Boots in theaters and Kung Fu Panda 2 on DVD. Once you know how those releases perform, its not hard to get pretty accurate in predicting a quarter. This quarter, Puss in Boots has done relatively solid in theaters, while Kung Fu Panda’s sales results seem to be a bit disappointing and seem to have required some discounting to move. It’s tough to see anything in these two performances that would account for the company losing ~20% of its value though, as the companies fall from ~$21 to $17 in the past few months would imply.
But that same earnings predictability once films come out makes it almost impossible to forecast future earnings. Anyone who pays any attention to the box office knows that it’s almost impossible to forecast movie’s box office takes even two days before the movie comes out. Dreamworks’ has two movies coming out in 2012- Madagascar 3 and Rise of the Guardians, as well as Puss in Boots on DVD. To forecast DWA’s earnings for next year requires predicting the box office takes for those two movies, which seems a fool’s errand to me. A box office flop could drive earnings way lower. A box office smash could make those numbers look silly.
Now let’s look at the ignoring DWA huge cash balance part of the article. At last quarter’s end, DWA had $150m in cash versus no debt. Given a market cap under ~$1.5B, that’s a pretty significant amount. In other words, the analyst saying it trades for under 14x earning ignores the value of all that cash while making a pretty crazy assumption on future earnings.
That rant done, here’s what I like about Deamworks as an investment at today’s prices.
First, it trades at about book value. Dreamworks writes down all of their films to “zero” after they’ve been released. This means their entire film library, with the incredibly valuable Shrek, Madagascar, How to Train your Dragaon, and Kung Fu Panda films and franchises don’t show up on the balance sheet. In some ways, buying them at book value is reminiscent of Buffett buying Disney when it traded for a huge discount to the value of its film library in the 60s.
Basically, I don’t think this is a company that deserves to trade for book value.
Let’s do a simple thought experience. Ignore all the concerns about monetization and everything for a second. Not only is Jeff Katzenberg (the CEO) responsible for the creation of all these great franchises at Dreamworks, he’s also one of the titans of the movie industry and widely created with turning around Disney’s film studios in the 80s and developing The Little Mermaid, Aladdin, Beauty and the Beast, and The Lion King (among others!). This is a man who was compared directly (and rather favorably) to Steve Job’s in Jobs’ biography (see Chapter 22, A Toy Story). Pretend he came to you and said he had invested $100m into a new company. The new company has seven movies that it’s completed or nearly completed and is getting ready to release over the next three years. After telling you this, he asks if you would like to buy in at the same level he invested in (book value) before he created all those movies. Wouldn’t you jump at the opportunity? That’s what you’re getting today with Dreamworks…. Except for the fact your getting all of the movies Dreamworks has already created sitting in their film library!!!
So why is DWA so cheap? Basically, the market is concerned with how Dreamworks will monetize its content. I don’t claim to be an expert on this by any means, but this seems to me to be the market over-worrying about a short term event (loss of DVD sales) and overlooking long term positive trends. If we’ve seen anything from Netflix recent decline, the Comcast/NBC mergers, Carl Icahn’s proxy fight with LGF, etc., it’s that content (more specifically: good content) is king. Content providers are absolutely desperate to grab consumers attention and dollars in today’s market. The only way to do that is to offer good content. It’s why Netflix is paying Dreamworks $30m per movie for their future movies.
Now let’s talk catalysts. Producing a movie requires a huge investment (~$150m per movie). Over the past few years, DWA has ramped up its film making, requiring a big investment. Now, they’re about to monetize that investment- Dreamworks is about to have a huge amount of cash pour into its balance sheet as Puss in Boots and Madagascar 3 release and Kung Fu Panda comes into the DVD market. Historically, they’ve returned all of their cash to shareholders through share repurchases; however, they’ve held off this year as they prepared to release those movies and prepared for their distribution agreement with Paramount to end. Most of the analysis I’ve seen said the current 8% of revenues that Paramount charges is higher than Dreamworks could get in the open market, and DWA is trying to get Paramount to agree to 6%. Paramount is resisting cutting their fee, and if they don’t DWA may decide to distribute themselves. Doing so would require a signifcant investment, thus the cash build up. If DWA can reach an agreement with Paramount or a competitor, they can really ramp up share repurchases, which should prove very beneficial to long term holders at today’s prices.
Remember this too- a spat over distribution is what lead to Disney acquiring Pixar. Do I think Paramount acquires DWA? No- but it’s certainly a possibility. Or maybe Time Warner looks to take their box office crown back from Paramount and uses a DWA acquisition to propel them towards that. Certainly seems like their would be some synergies between DWA’s franchises and Warner’s properties.
Disclosure- Short DWA puts
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