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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Nice writeup. Interested in why you shorted the puts instead of just going long the stock? If it’s a disney situation, surely going long the stock would ultimately be better? Or do you think the takeover/merger catalyst is more likely?
Most of my excess cash is invested in a merger arb situation right now- just sold the puts so I could simulate being long the stock while waiting for some money to free up.
I’m wondering why you sell puts instead of buying calls. It looks like your thinking is, the downside is minimal and the stocks will move up slowly. Is that right?
Btw, when it comes to options, I’m a novice. They introduce 2 variables I don’t know how to handle if I merely want to simulate longing or shorting the underlying stocks: how much out of money and what maturity. And since options are internally geared, I also don’t know how to size my stake. I haven’t seen a book discussing these. Would you be able to point me to the right direction?
I was cash strapped- selling puts allowed me to collect premium and sell volatility when i thought it was unreasonably high. If it had allowed me to go long at a lower level, I would have been more than happy to do that!
When I first started out, I was super enthused about very long term options. I’m no longer a big fan, as they still expire and can expose you to huge capital losses, though I would still consider going long them in the right situations.
First I wouldn’t call Puss a ‘hit”.
I have to respectfully question whether DWA at forward PE of 13.6X is all that compelling a risk/reward for the several reasons set forth, below, that create doubt in my mind that DWA can monetize its output (movies) like it did in the past. With that headwind to growth, the valuation multiple on DWA’s cash flows and earnings should not be as high as in the past as increasing competition raises the question on whether DWA is indeed the “franchise” it may have been in the past.
Here are some of my reasons:
1) The rapid decline in the home entertainment market as consumers shift from buying to renting is far outweighing any box office benefits that may come from an increased release pipeline, even when that pipeline contains more 3D product and expanded International markets. It appears, recent DVD releases (eg. KFP2) have had to be heavily discounted to obtain unit sales targets.
2) DWA’s specific films of late have under-performed overall and when the films have performed, it was with underperformance in markets (US in particular) subject to greater supplemental/ancillary revenue opportunities (licenses/toys/cross promotions, etc.) with outperformance in int’l geographies that don’t yet provide as much supplemental/ancillary revenue opportunities.
3) Prior consensus was DWA was going to get improved terms from its current distribution deal when it expired. However, the opening salvo by Paramount saying they won’t be renewing and the impacts of both #1 and #2, above, along with Paramount joining the entrants COMPETING with DWA reduce DWA’s negotiating power and thus hurt fee terms with whoever is going to be DWA’s distribution partner going forward.
4) As more and more of DWA’s studio competitors successfully develop their own animated infrastructure and content (and several have done so already), not only does DWA’s negotiating power for distribution weaken, prospective acquisition premium from multiple bidder competition also fades away. There won’t be anymore multiples paid even closely approaching what DIS paid for Pixar.
5) The cash balances you refer to not only are needed for potential self distribution infrastructure investment but also you need to realize that the making of movies is very venture capital-like where a project can be hit/miss for millions. A company like that needs to have a sizable net cash balance.
While DWA has declined sharply this year and may not decline as much or at all in the coming year, that does not mean it will or should recover to its past glory days. The market and competition for DWA’s products has greatly shifted to lower margin channels and greater competition for the same eyeballs.
I’d like to follow up on Shapiro’s comments
I work(ed) in film (now its video) and the big change in the market since I got started is that the price of everything is collapsing on the production side. As the barriers to entry continue to drop more and more product finds its way into the market place at lower cost.
You’d think that distributors love this. However, there is so much competition for eyeballs they are constantly having to reduce rates for access to content. Primarily digital distribution.
Some of us refer to what we call the 1% rule. Less than 1% of films get made. Less than 1% of those get distribution. Less than 1% of those make a profit. Its a tough business.
So we have an industry where costs are dropping on both ends. Fantastic for movie fans. (I would also argue that cheaper tech is improving avg quality of content, but that’s not necessarily relevant).
The big studios have had to respond to this by making features even more of an event, 3D, huge budgets, well known stars. The industry is ever more captive to upfront speculative investments and the big opening weekend (for some reason having a big opening weekend means the film is “good”, which I will never understand, but its irrefutable that opening weekend numbers are correlated to foreign distribution and home sales).
So to get back on point. I think the competition for content will continue to intensify (not just Disney-Pixar and Fox, but original content produced overseas) and at the same time digital distribution is driving down returns earned on that content (ease of access = no customer switching cost).
Now obviously DWA and DIS have earned a reputation in family entertainment, but I worry that the long term trend is that margins have to march downward. (Supply growing much faster than demand)
Any thoughts?
There are some pretty obvious counter arguments. Reduction in production costs in animation should outpace prices in traditional movies. Specifically above the line costs. Also, theatre experience will change but never really go away, so big name films from big studios won’t ever have to compete with the indie market. Rational competitors should limit the saturation level of content.
But a study of Paramount, Miramax, etc. reveals that studios, specifically pure content producers versus conglomerates, are always getting squeezed on returns. They take all the risk upfront and then have to settle for whatever payback they can get. As box office becomes a smaller part of viewers consumption behaviour, content producers have less bargaining power on price of access to content.
Still focusing on this as a supply-demand issue. DWA’s is a great franchise, but that talent can leave for another studio, or go independent, if someone waves a check in their face, so its hard to value the brand equity. Each movie is like a small business unto itself. I’d run over someone with a bus to work there, but I’m not sure I’d want to own it.
Hi Tony,
Really great analysis. I agree with almost all of it.
But just because the future is going to be different (in this case, worse) than the past doesn’t mean the business is a sell at any price.
DWA is selling at book value, which means the market is forecasting that they will basically earn their cost of capital in the future. Remember that book value includes almost no value for all of their historical content and thus basically no value for their brands.
This is a business with a super strong balance sheet and management with a proven history of creating hits and franchises. Buying them at the same level that implies they are basically a commodity business, perhaps cheaper given it ignores their brands, seems like a good deal to me.
I agree with Andrew Shapiro that the cash isn’t “excess cash” in that it is needed to operate the business. Therefore it should not be added to DWA’s valuation.
I don’t know anything about the movie business other than if Tom Hagen asks you to cast Johnny Fontaine in a war movie you should do so, but I wonder about the value of the film library. Once a film has been out for a couple of years how does DWA generate revenue? Wouldn’t almost everyone who wants to own a copy have bought it by then? How much would you pay for a DVD of an older film, assuming you could not find a used copy at a flea market or garage sale? I don’t buy very many movies so I really don’t know the answer to this. When Buffett bought Disney consumers could only view the films if and when Disney allowed them to. These days the consumer is in control.
I think your analysis was very good but I’m really uncertain about the margin of safety.
I’m having some concerns about the margin of safety and the ‘quality of the assets’ as well. Here’s my reasoning:
The liquidation value (runoff as Andrew calls it) will only be realised in a situation where the company is actually doing well, and won’t have to liquidate. In Andrew’s scenario’s for the value of the inventory and into what amount of cash it can be converted he’s painting revenues that are no reason for Dreamworks to liquidate, so in that scenario you are actually ‘stuck’ with Dreamworks as a going concern. Looking at the free cash flow over the past 3 years, it has been around 100 million, so in this scenario you are basically paying 14x FCF for Dreamworks as it needs to be valued as a going concern. This is a bit of a steep price if you ask me.
Now to come back at this point, but look at it another way: I don’t think there is only a binary outcome, either Dreamworks liquidates, or they’ll thrive. I think it is actually much more plausible that Dreamworks will do the same as they have done, or do a little bit less (given all the concerns in the comments above). If they’ll do the same, you again pay 14x FCF as I just mentioned, if they do worse, two things happen:
1) The asset side is greatly reduced, since not all of the inventory will probably converted to cash and some of their cash pile will probably be reduced. In my opinion it’s not a far stretch to say book value could be reduced to about $8,- per share (cut the inventory in half and reduce cash to $100 million).
2) In this scenario, obviously earnings are down as well. Let’s assume FCF is only down to about $75,- million. This yields a multiple of 18.5.
So in this case your asset cushion is greatly reduced (stock needs to half again to go back to book value) and the multiple you pay is really steep in my opinion.
I might be overly pessimistic here, but I really think in an adverse situation the assets might not be as big a cushion as you think.
Any Updates on DWK? Even cheaper today, and the thesis seems to remain in tact.
DWA sorry.
Hey Blaine,
No real updates to report. The China JV is very interesting, their movies are performing well, the stock still looks cheap! Think the overall thesis very much holds