Last Friday’s sumzero dispatch included a little blurb on Dreamworks (DWA) (it also included a write up on ATPG, my first foray into high yield bonds that I was lucky to escape with my shirt still on (it just went bankrupt)!). The timing was awfully coincidental, as just last Thursday I had opened up a solid sized position in Dreamworks by selling March 2013 $17.50 puts.
We can save the put conversation for another time.
For now, let’s discuss why I’m reopening a position in Dreamworks (you may recall I’ve mentioned them before , and I refer readers to this awesome discussion over at frog’s kiss. I also liked this presentation on them, and you can find their valueline here).
I think the basics of investment in Dreamworks are pretty simple. As a matter of fact, I’ll lay them out for you in a neat little paragraph right here.
Dreamworks has been sold off by the market on fears of how the will monetize their product going forward (DVD sales, the biggest driver of profitability, are going away). However, on just about any measure (reproduction value, value to a strategic acquirer, etc.), Dreamworks is trading at a huge discount to its intrinsic value.With a true creative genius at its helm (Katz) and multiple strategic initiatives that will require little incremental cost and the potential to create huge value, DWA stands on the precipice of big value creation.
Much of this can be covered in the previous write ups, especially the Frog’s Kiss one, so I don’t want to simply rehash those. Instead, I want to update on all of the new initiatives (of which there are many) and why I think they’ll be so value creating, and then maybe throw a few rambling thoughts on value in at the end.
Starting with the most recent news, Dreamworks announced a new distribution deal w/ Fox replacing Paramount. This Bloomberg article has an excellent discussion and analysis of the deal, but I think this quote from Katz sums it up nicely:
Our new agreement with Fox presents more favorable economics overall
Later in the article, an analyst says he thinks the deal works out to 1% fee reduction (versus his 1.5% estimate). Personally, I’m with the analyst: I thought Dreamworks would be able to extract slightly better terms out of whoever was their new distributor, but I’m fine with the deal.
So that’s change number 1- going forward, there should be slightly better economics to their movie launches.
Next, there’s the Classic acquisition, which I think is an absolute stroke of genius (see Press release on acquisition).
First, the company acquired for $155m a company doing over $19m in operating income (see this WSJ on Classic acquisition for rev and ebit figures). They’re financing the purchase with a draw down on their new credit line, which will carry interest at <4% (though it is floating).
Given the nature of their business, I see absolutely no reason why Classic’s revenue and income shouldn’t be incredibly stable, so the fact they can buy this business at a 12%+ pretax yield and finance it with 4% debt is pretty interesting in and of itself. Maybe I’m wrong; maybe the earnings were affected by one time items. This NYT article suggests that DWA won by way outbidding everyone else, and analysts on the call seemed shocked that there wouldn’t have been other interested parties if the deal was as good as Katz made it out to be.
But there also are multiple, multiple synergies here. We will discuss them soon, but for now let’s leave it with this quote from the Q2 call
Well I think we actually have a bit of a gold mine here in that the breadth and depth of this library is really quite extraordinary and that it seems as though there are many, many opportunities for us I think first and foremost just to simply continue to operate the business as it has been which has been very effectively by the co CEOs of the business and leveraging what we have here existing today DreamWorks Animation vis-à-vis our film library, our distribution platform will have I think a meaningful impact on their immediate earnings in next 12 to 24 months.
Lastly, there was the announcement of their new China JV and follow up announcement, their Netflix streaming deal article, and the licensing of a characters to a new themepark, and Dreamworks is showing great success licensing their characters for TV shows.
Phew- that’s a lot happening in the past few months!
But I think it all sums up to this: Dreamworks is finding multiple new ways to monetize their properties. Both in new geographies (expanded China distribution) and new forms (themepark licensing), Dreamworks characters command a premium when being licensed.
And I think Dreamworks has also set themselves up very, very nicely to launch a cable channel. Consider this: the only time I’ve heard of a cable channel being unprofitable was when their production costs ran out of control. Dreamworks’ acquisition of Classic (in addition to their own characters) gives them a huge backlog of properties to fill airtime at basically no additional incremental cost.
Does that guarantee success for a cable channel? Of course not!
But it sets Dreamworks up for a completely asymetrical bet: if the channel is a success, it will deliver tons of cash at little additional cost. If it just does alright, it should still result in decent profits. If it’s a complete bust, losses should be limited.
Heads, I win. Tails, I breakeven.
And what I think makes all of this even more interesting is the potential synergies between each division and new venture. The brilliance of Disney is that each part fits with each other: the channels provide a way for building character awareness and advertising new movies, the movies provide a way for introducing new characters and building new brands, and the brands lure people to the parks and keep them familiar with all of the brands while selling merchandise. It’s quite a virtuous cycle.
And look at what Dreamworks is recreating: parks, channels, and movies.Will they be as successful?
Probably not. I doubt a mall in Jersey is going to be a “must visit” like Disney World is. But, at the same time, it’s much more accessible, and will likely be much more popular for day trips in the northeast.
And it doesn’t have to be as successful as Disney World to create the brand synergies DWA is looking for.
Ok, so those are all the positives that have been developing. But, as investors, we know that just because a company is not a good investment simply because it is experiencing a bunch of positives.
But the price Dreamworks is trading at makes all the sense in the world to me.
Let’s assume Classic Media is worth exactly what they are paying for it. If we do, the rest of Dreamworks is being valued at $1.4B.
Dreamworks currently has just under $1B in movie inventory on its books. They don’t break out how much is assigned to what, but (by my estimates) well under $50m of that is assigned to the Kung Fu Panda and How to Train Your Dragon franchises, and at most $100m is assigned to the entire Shrek franchise (this would relate to the Puss in Boots movie, and the number is likely closer to $65m).
So, what you’re buying for $1.4B is basically as follows
- $850m in book value for the new movies they are producing and the Madagascar franchise (Madgascar 3 is in there for ~$150m) plus some TV shows in production
- $150m for Shrek, How to Train Your Dragon, and Kung Fu Panda franchises
Do I think that makes any sense?
Absolutely not- Kung Fu Panda 3 and How to Train Your Dragaon 2 are both on their way, and both are likely to be blockbusters. The Shrek franchise is one of the highest grossing franchises in history, with a Puss in Boots sequel on the way.
It would absolutely shock me if the movies in production are worth “only” book value- Madagascar is a tremendous franchise, and the other new movies have received positive early hype from everything I’ve heard (and, if you don’t believe that, are likely to do pretty well simply based on Dreamworks record).
So, if you believe me, Dreamworks inventory is well undervalued. I think a strategic player would likely pay well more than $3B to take control of it.
But let’s just assume the value of Dreamworks’ inventory is $1.4B.
At that price, the market is effectively saying it is indifferent between Dreamworks taking the cash flows their business throws off and paying it out as a dividend / stock repurchase or reinvesting them into making new movies. In other words, it thinks Dreamworks will simply own its cost of capital when it produces movies.
I think that’s incredibly silly. Katz and Dreamworks have a proven ability to create incredibly valuable, long lived franchises. Put simply, I think they will be able to compound to grow the business at above cost of capital returns by reinvesting into new monies, new tv shows, channels, new brands, etc.
Long DWA
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Hi Whopper,
A few questions:
1.) What do you think of the options issuance and executive compensation practices in general (the proxy is about 60 pages long)?
2.) Who do you think are possible strategic buyers and what are they waiting for? And why would Katzenberg sell if he’s making the next Disney?
3.) Why do you think they got “less better” terms in the negotiation than they got with the Classic Media properties?
4.) What do you think about them partnering with a competing studio– could this create organizational problems when their movies are competing with the distributor’s films?
5.) On the inventory… don’t they fully expense films over 2-3 years, so why would any of the legacy Shrek or KFP films, for example, still be included in that number? (Have you read 10-K? They break out the inventory across in development, in production and in release films… remember, these are “current assets” so films that are over a year old don’t below there, right?)
6.) What do you think of their buyback strategy? They’ve spent almost $400M on buybacks over the last 4 years, but most of it has been at the top end of the price range over that period rather than the bottom end– they don’t seem to have much of an idea of when their stock is “cheap” and no analyst ever questions them on it
7.) What do you think of the ongoing payable with Paul Allen… that “Payable to Former Stockholder” is essentially a bond guaranteed by the company. It’s a strange arrangement and because of the duration over which it’ll be paid off the company really should be considered somewhat levered
8.) How much of the cash flows being generated by the company right now (which are lumpy) do you think ACTUALLY belong to shareholders? Have you tried creating an adjusted “Owner’s Earnings” number in terms of what you think must be reinvested to maintain the biz and what can actually be pulled out? They seem to actually reinvest a substantial amount of FCF in the business but the business doesn’t get much bigger. And now that shares are treading near all-time lows, they are essentially abandoning the buybacks because they need money to fund more film development and these acquisitions
9.) What kind of capital do you think they’ll ultimately have to put up to take the Chinese JV, an independent cable channel, the NJ mall, etc., to the finish?
10.) Does it concern you that the opportunity on the movie side of the business is essentially fixed because they can really only develop a maximum of 3-4 films per year without crowding out their own offerings as well as running into the films of their competitors (exclusive release windows are critical in this business)?
1) no
2) I’m not saying they’re in play. But plenty of media companies would covet their assets. Katz has said they are not for sale. I’m just pointing out they are well below what they would sell for.
3) I don’t understand the question
4) they’ve been doing the same deal w/ paramount since they went public
5) read the 10-k for the accounting. films are capitalized as they are created and then amortized over 10 years, with the bulk occuring in the first four. inventories are not current assets in this case. on this note, please don’t accuse me of not having read the 10-k when both this question and number seven are so easily addressed by reading the footnotes i’m doing them from memory.
6) yes, i think it was silly buying back all of those shares at higher prices. but what’s done is done, and at least they have a history of share repurchases, which i would enjoy going forward.
7) payable to former stockholder is only payable in the event they generate taxable earnings. it’s related to their deferred tax asset.
8) cash is being reinvested into new franchises. i’m perfectly ok with that.
9) nothing into the mall, a decent amount into the china jv (but mainly funded through IP i believe, not positive but shouldn’t be too bad), and tv channel depends on the structure, but probably not too much.
10) no- does that concern you with disney? there are plenty of other ways to monetize these assets
Hi Whopper,
Question #1 wasn’t a binary yes or no, it was a qualitative question.
Your response to #2 is fine it’s just that if they’re not for sale this isn’t much of a margin of safety leg to lean on.
Question #3 was worded poorly, I apologize. What I was meaning to say there was in their negotiations with Fox, why do you think they ended up with only a 1% decrease in total distribution costs and no decrease on film distribution specifically? Does this say something about their competitive position or the demand for their product?
As far as #4, I don’t know if Paramount had their own animation unit since the IPO. I know they formed one recently that released Rango or whatever.
Apologies on #5. I didn’t accuse you of anything. I asked a question. Apparently my memory isn’t as good as yours because I had to go back and double-check this. It says “up to 10 years” is used in calculating ultimate revenues, it didn’t sound like they’d take ten years to amortize the charges. And looking at the table of inventory, I see development, production, completed but not released and in release. It’s not really clear what’s in that “box” and what isn’t and the company seems to be purposefully obscure about it. Again, I guess this is arbitrary but inventory is listed ahead of prepaid expenses which makes it seem like a current asset, although I’ll admit it’s not open and shut because things that are “in development” take years.
Your response to #6 is not robust for a value investor concerned with protecting his principal. If they overpaid for shares then they damaged the value of the company and wasted your capital as a shareholder. I don’t really get the nonchalance, especially given that if they did overpay they’ve demonstrated a pattern of habitually overpaying for things, meaning their record as capital allocators is impaired. Share repurchases are not a good thing no matter what, they’re only good if they’re done at a true discount to intrinsic value. Or do you regularly pay more for company shares than their worth and consider this good investing and business practice on your part?
#7, they generate fairly substantial taxable earnings. This whole thing is odd. I found the history behind this investment strange. Paul Allen seemed to capitalize the company partly as an ego/prestige thing. Then Dreamworks ran into some trouble and they IPOed the animation company in large part to cash him out. The fact that a sophisticated insider wanted out so badly in the first place always troubled me. if this thing is such a great investment why did Paul Allen run for cover? And more importantly, why does he get this golden parachute-seeming tax sharing agreement along with it? I’ll say at the very least the accounting is way above my head on this one– do you feel you can confidently explain what’s going on here?
#8, just to play devil’s advocate here… if these franchises are so profitable in the long run and such valuable assets, I wonder why the company’s ability to generate cash flow outside of the movie premiere/release model still seems so limited? When do all the Shrek tshirts and toys and what have you start generating steady cash flows for shareholders each year?
#9, the company is $1.4B mkt cap and this question is tied closely to #8… that capital has to come from somewhere. In some sense I wonder if the ambition here isn’t a bit bigger than the company’s resources at the current time. My guess is a lot of debt gets raised at some point to handle all of this and I’m not sure if that’s a good thing or a bad thing right now.
#10, I don’t follow Disney and I don’t think it’s a valid comparison because Disney is a mature company… totally different dynamic and set of opportunities and risks. Care to name many of these monetization pathways and their probabilities of occuring, and what it looks like for DWA shareholders?
Hi Whopper,
Nice post. I owned Dreamworks but after the release of Madagascar 3 (great movie) I decided to sell my position.
Here are the numbers behind the rational.
Cost of the movie $145 mill
Distribution $ 125 mill
Fee to Paramount 8% of grossings (approx $48 mill, it will be 7% going forward)
Theatres keep an average of 50% in America and 60% overseas.
They barely make any money on a $600 million blockbuster. What if it is not succesful the movie?
They rely on DVD and Netflix. (first decreasing and second yet to be probed the business model)
The way I see it every movie is a big bet and it has to go right otherwise they are in trouble.
Other issue to consider is that some of the important markets (Venezuela and Argentina) currently have capital restrictions to repatriate funds (it was disclosed in the last 10Q)
Again great post and happy to read your thoughts on my view
Cheers
Seba
Why did you have to see Madagascar 3 released to figure this out? You could’ve crunched the numbers on any other film in their library and seen the economics are always the same.
Not sure what you were thinking here. I take it you’re not a value investor.
Hey valueprax (or should I call you Warren or Benjamin)
I crunched the numbers and costs seem to go up movie after movie.
I would much appreciate it if you could tune down the condescending tone of your replies.
I believe that the idea of whopper is to share ideas and views.
If you feel that my contribution is not adding any value simply don’t answer it.
Have a good day.
It’s not condescending to point out that selling the company after the release of Madagascar 3 makes no sense when you could’ve come to the same realization about any previously released film. The economics didn’t suddenly change with Madagascar 3.
Or maybe you were saying “Coincidentally, I happened to sell my shares after Madagascar 3 came out” in which case it’s my mistake for assuming you meant that your sale of shares was motivated by the movies release and your apparent sudden realization that they don’t make money off movie releases.
You have yourself a great day as well, thanks
Take a look at LGF. I think you will find a better value with an excellent pipeline.
I don’t disagree that they are undervalued. But they are quite levered and don’t have the same levers to pull.
With one of the biggest movie releases in recent memory (Hunger Games), I’m sure this is a really undiscovered gem that hasn’t been bid up by speculative investors.
They are retiring debt and will probably be debt free in a couple of years. Hunger Games series has three more movies to go. Plus they will have several other big projects coming. Value stocks can take many forms.
Harry,
In my understanding of value investing, they tend to take a particular form along a specific line of consistent principles.
That being said, would you be so kind as to treat us to the thesis in a bit more detail than “retiring debt” and “excellent pipeline”?
Listen to the LGF last CC call. The plans to retire debt are clearly laid out. The pipeline of movies can be found on LGF website. You can judge for yourself about the quality of the movies. LGF turned down a bid by Carl Ican last year for $7 a share. This bid was before the merger of Summit which brought in a great library and pipeline of movies. It was also before anyone put much value on the Hunger Games series. Another example of how the management seeks value opportunities is the signing of Charlie Sheen to the Anger Management TV show. They took a chance on Sheen when no one else was interested. Anger Management will be renewed for a 100 episodes and then syndication. It will be a huge money maker.
Hey Whopper,
I see a lot of reverse valuations that make it clear that the current valuation doesn’t fit, but I was wondering if you could share your opinion on DWA’s valuation, and how you got to it(the number alone doesn’t really help since I have to do my own research anyways).
Thanks!
Shamapant
*to clarify, i meant opinion on what the intrinsic value is*
Shamapant,
One interesting thing to note… there was something like 4,000 different IP properties in the Classic Media package. The number itself is kind of meaningless (like a national debt that is $222T… what ever the hell that even means, once you get past about $100B it’s not getting paid off so what does it matter how many billion, trillion, zillion it is at that point? Point is it’s a lot… same with the Classic Media package).
DWA paid $155M for it and that was the HIGH bid. These are supposed to be well known franchises that are quite valuable. DWA has about 30 films in its library now, several of which belong to the same franchises.
That presents a few questions:
1.) How much of DWA’s mkt cap is rightfully attributable to the existing film library as a long-lived asset?
2.) On what basis is the apparent exorbitant multiple justified? For example, you get 4000 properties for $155M with Classic, or you can have less than 30 for $1.4B with DreamWorks.
I liked Shrek. I finally watched it and the sequels, as well as most of the rest of DWA’s library for the first time a few months ago. It’s witty, it’s entertaining and there is some marketability there. But it’s no Mickey Mouse and it’s not even a Toy Story franchise in terms of its broad appeal. (I’m not saying it doesn’t have broad appeal, I’m just saying, let’s be realistic, we’re talking about different quality and different optionality and different things here.)
DreamWorks is the “runner-up”. Pixar/Disney is the king and dominates the market. The question really comes down to, are they a close runner-up (in which case DWA is massively undervalued) or are they a few laps behind though still ahead of 3rd, 4th, 5th place, in which case maybe this is a fair valuation?
By the way, Pixar uses fairly well-known voice talent and smashes at the box office every time. DreamWorks uses primo talent which is supposed to be a competitive advantage and they do well. Meanwhile, Fox/Blue Sky use kind of a blend of well-known-in-other-mediums and not-so-well-known talent, they keep their production costs almost half of DWA, and they do about as well at the box office.
But I don’t think you’ll catch as many people with an Ice Age wristwatch as you will a Shrek wristwatch, and certainly those people will never be as many in number as Mickey Mouse wristwatch wearers.
DreamWorks has something interesting with their overseas penetration though. Russia, China, even Brazil, those countries seem to really get a kick out of DreamWorks franchises. Maybe they could dominate internationally and be happy with a distant 2nd in the US?
So I just took a position in DWA and I’d love to see more discussion on the name — especially on downside risk (and to a lesser extent their less obvious opportunities). I think the downside risk in the name is limited (due to the value of their library, but the upside is unclear. Fortunately the movie studios have seen how the music industry was impacted by digital — and hopefully they can get in front of it instead of getting steamrolled.
Valueprax: While I personally have preferred Pixar movies to DWA movies I think Pixar definitely has benefited (from the very start) from being distributed by Disney. It was a perfect FIT for their movies. It is also incredible that Pixar got the $$ they did from Disney considering Disney actually co-owned the library and actually owned OUTRIGHT the characters that Pixar had developed under their original distribution deal. But to be fair DIS needed PIXAR. I would love it if DWA found a partner that needs it as much as Disney needed Pixar — more on this later.
2013 should be an interesting year for DWA.
- We will start to see the exact economics of the Netflix deal
- How will DWA do distributed by FOX. (Would FOX be interested in acquiring DWA?)
- Progress on China JV?
- Clarity on Classic Media IP.
I think concerns about the profit model are definitely relevant — can they produce each movie for $10-15 million less? Will digital distribution make up for lost DVD sales? Will foreign emerging economies drive enough revenues? DWA dominates 3D — will they continue this? Will increased competition saturate the animated feature market?
Back to a potential take over. Obviously companies like Time Warner and Fox would be potential acquirers but one interesting takeover/merger opportunity would be Hasbro. I wonder if it would be a good fit. Hasbro could make toys from the DWA franchises (without fees) and DWA could produce kids programming for the HUB. And they could produce the programming and movies from Hasbro’s IP.
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