New Threads Only:  Add to Google Reader or Homepage
New Threads & Replies:  Add to Google Reader or Homepage
Forums are for serious investors only. GuruFocus Forum Rules.

Forum List » Value Ideas and Strategies
Share and discuss value investing ideas and investing strategies.
New Topic
Goto Thread: PreviousNext
Goto: Forum ListMessage ListNew TopicLog In
DreamWorks Animation (DWA): Owner Earnings
Posted by: Geoff Gannon (IP Logged)
Date: March 1, 2012 11:49AM

Someone who reads my articles asked me this question:

Hi Geoff,

I was particularly interested in your last email to me, which you posted on the website. In it, you discussed DreamWorks Animation quite a bit and how you ended up not buying it because it never reached the price you wanted to pay -- although it came very close. The reason I was particularly interested in your discussion was that I happened to buy DWA last year at just under $17/share. After steadily climbing the last few months, the latest quarterly report sent shares down to just over $17/share at today's close.

I'm looking at the current price as a potential opportunity to build a more meaningful stake in the company. However, I'll admit I find the company difficult to value. I thought the write-up on DWA at The Frog's Kiss (Oct 2011) was extremely thorough, but also illustrated that a lot of the valuation process for this company involves assumptions and educated guesses.

Given what you said in our last discussion (about having missed buying DWA possibly being a mistake), do you feel more tempted to jump on board at this opportunity? How do you put a value on this company?

Dan


Yes. I feel tempted to jump on board DreamWorks Animation (DWA) at this opportunity. And, no, I probably won’t actually do it.

I have less than 15% of my account in cash at the moment. I own a bunch of stocks – all originally bought as net-nets – that are very illiquid and that are (in my opinion) still trading at discounts to conservatively calculated intrinsic value.

I’m not inclined to sell something like that.

At least not at the moment. It could be a mistake. But net-nets provide good returns. For a new idea to bump a net-net out of the portfolio, it has to clear a very high hurdle. It has to be a 20% annual return worthy idea – at least.

I have to look into some of the things I own a little more deeply and think about this. Regardless, I would never buy DreamWorks as something like a 10% position (which is about how much cash I have on hand). It would be a 25% position. And I’d hold it for a couple years at least. I wouldn’t make a purchase like DreamWorks unless I expected it to be about a 25% position for around three years. And at the moment I don’t have enough cash to make it a big enough position. My first instinct is not to hold everything I own. So, at the moment, I’m thinking that, no, I won’t be able to buy DreamWorks. My cash is tied up in good stuff already. But we’ll see. That decision can change really, really fast. I’ll tell you if it does.

Ways to Value DreamWorks

There are a few ways to look at DreamWorks:

· Price to owner earnings

· Price to book (GAAP)

· Price to present day control buyer

· Price to future day control buyer

Owner Earnings

The price to owner earnings calculation is pretty straightforward. And it’s the one I like best.

DreamWorks is a movie studio. It makes movies. Movies are to DreamWorks what warships are to Huntington Ingalls (HII) and passenger jets are to Boeing (BA). DWA movies take over four years from idea to release. Each movie costs about $150 million to make. And another $150 million to distribute.

Right now, DreamWorks pays the $150 million to make the movie. And Paramount – part of Viacom (VIA) – pays the $150 million to market the movie. Paramount gets paid first. But their upside is limited (to 8% of revenues after recouping costs). DreamWorks gets paid last. But their upside is unlimited. This arrangement can change in the future.

DreamWorks invests about $150 million per movie. DreamWorks releases five movies every two years (2.5 movies a year). So, DreamWorks maintenance cap-ex on movies alone is $375 million. Unless DreamWorks plows $375 million back into the production of new movies, it will not be able to maintain the same competitive position. DreamWorks’ competitive position – and its annual earning power – is dependent on releasing 2.5 computer animated global family “event” movies. The cost to do that is $375 million.

Yes, you can make computer animated movies for less. But, no, you can’t make a DreamWorks computer animated movie for less.

DreamWorks also invests – a lot – in its facilities, technology, etc. It has a fancy campus. And pays HP (HPQ) a lot of money for all sorts of technology. So, there is additional – non-project specific – capital spending at DreamWorks. However, this spending has been accompanied by significant growth in the number of DWA’s projects in development, movies released, employees, etc., over the last 10 years. DreamWorks is the biggest animation studio in the world. And the non-project specific cap-ex is probably attributable to this growth. Anyway – this is simple property, plant and equipment capex. And that’s something you should be used to dealing with in your owner earnings calculations.

Film Amortization

DreamWorks capitalizes the costs of its movies and then amortizes those costs using the ultimate revenue method. This means that DWA recognizes costs in proportion to the amount of revenue as a percent of expected ultimate revenue it recognizes in the same period. There are two exceptions to this rule:

1. DreamWorks does not include revenue expected to be received more than 10 years after a movie’s release when calculating film amortization.

2. DreamWorks can write-off a movie’s costs immediately whenever it believes the movie’s ultimate revenue will not cover the movie’s capitalized costs.

Obviously, adding back film amortization is the first step in any owner earnings calculation for DWA.

Here is DreamWorks’ operating income and film amortization for each of the last three years:

(in millions) Operating Income Film Amortization Pre-Amortization Income
2009 $193.3 $349.27 $542.57
2010 $166.9 $424.17 $591.07
2011 $109.9 $388.17 $498.07


Now, that we have DWA’s pre-amortization income we need to subtract DWA’s maintenance cap-ex. This will change DWA’s statements from GAAP form to a more economically accurate way of accounting. To do this, we’re going to count the number of DWA movies “in release” each year – defining “in release” as any movie that was released in either the current calendar year or the prior calendar year.

For example, “How to Train Your Dragon” was “in release” in 2010 and 2011 – because it was released in March 2010. We expect that a large portion of a movie’s initial revenue – from its run in U.S. and foreign theaters, to its DVD sales, to its pay TV fees – will come in the first two calendar years. After that, the movie is essentially a library title.

This is not entirely accurate. It’s possible a movie could generate quite a bit of original run revenue in the third calendar year depending on how late in the year it was released and how staggered certain windows were – especially foreign pay TV.

Regardless, this is a pretty good working definition of a “new” movie versus an “old” movie. A new DWA movie is one that was released this year or last year. So, new DWA movies for 2012 will be: Madagascar 3 (coming June 2012), Rise of the Guardians (coming November 2012), Puss in Boots (released October 2011), and Kung Fu Panda 2 (released May 2011).

You can easily find the estimated costs of each of these movies online. Within pretty tight ranges, all of the movies had their costs discussed by DreamWorks itself or by an industry trade publication or other source. For this exercise, we’re going to simply assume that all DWA movies cost the company $150 million to make. For that reason, we will multiply the number of DWA’s “in release” movies for each year by $75 million to get our maintenance capex estimate for the year.

We’ll do this for each of the last three years. In 2011, DWA had five movies “in release” (Puss, Panda 2, Megamind, Shrek Forever, and Dragon). In 2010, DWA had four4 movies “in release” (Megamind, Shrek Forever, Dragon, and Monsters). And in 2009, DWA had three movies “in release” (Monsters, Madagascar 2, and Panda 1).

So, here is our owner earnings calculation for DreamWorks for 2009, 2010 and 2011 using a cost of $75 million per “in release” movie – just to be clear, that means we’re charging off each movie completely over two years (the year it was released and the next year).

(in millions) Pre-Amortization Income Movie Maintenance Cap-Ex Pre-Tax Owner Earnings
2009 $542.57 ($225) $317.57
2010 $591.07 ($300) $291.07
2011 $498.07 ($375) $123.07


Remember, this assumes that the only thing DreamWorks has to spend to maintain – at a zero percent growth rate – is its slate of movies. If you think DreamWorks has to constantly invest in new facilities, computer hardware, etc., at a rate greater than deprecation – then you should factor that into your analysis.

Putting that issue aside, we would just apply taxes to DWA’s owner earnings to make it an apples to apples comparison with the EPS numbers you’re used to seeing. Taxes would reduce owner earnings at DWA to $206.42 million in 2009, $189.20 million in 2010, and $80 million in 2011.

To get a better idea of DWA’s normal earning power we’ll average those three after-tax owner earnings numbers – for 2009, 2010 and 2011 – which gives us $158.54 million in estimated after-tax owner earnings.

DreamWorks has 84.03 million shares outstanding. And $158.54 divided by 84.03 is $1.89 a share.

I should caution you that this owner earnings estimate is a smidge high – my guess is about 7% – for technical reasons that I don’t want to go into. Basically, my maintenance capex estimate is a little low because DreamWorks makes other things besides movies. Read note No. 5 to DreamWorks’ latest 10-K for details on the amortization of television specials, etc. Or just take my word for it and lower our owner earnings estimate to $1.75 a share.

So $1.75 a share is our owner earnings estimate for DWA.

DreamWorks stock trades at $17.79 a share. Which is 10 times DWA’s three-year average owner earnings.

So, you can see why I’m interested in the stock.

Also, there are certain factors that make me believe DreamWorks’ owner earnings will be at least 25% higher in a couple years. So, just based on already announced production schedules, agreements, etc. I think DreamWorks is trading at more like 8 times its near-future owner earnings.

We need to compare this cheap valuation to negative industry trends – like much lower revenues per developed country viewer outside of theaters. These could lower DWA’s earnings per movie. However, DWA will earn a lot more revenue from Russia and China three to five years from now than they did three to five years ago.

(Hint: They earned next to nothing from those countries a few years ago.)

Obviously, most of DreamWorks' revenue will come from overseas from now on.

They are also starting to move into exploiting their properties in other mediums. So far, revenue from these sources – outside of movies – has been unimportant.

But check out the TV shows: The Penguins of Madagascar and Kung Fu Panda: Legends of Awesome. Or read reviews of the various Shrek stage productions. DreamWorks is already making high-quality product outside of theaters. And this is a growth-oriented company.

Any discussion beyond this is speculative. We know how many movies DreamWorks is going to make. I think I know how much they will cost. And I think I know what the stock is selling for versus its present earning power.

So owner earnings is the valuation method I prefer to use for DreamWorks.

Like I said, you can also attempt to value DreamWorks based on its value to a private owner right now. Or, for example, what a similar company of increased size would be worth after DreamWorks has released another 10 years' of movies, and then discount your 2022 control buyer valuation back to today.

Finally, you can just look at GAAP book value. Remember that this is mostly equivalent to just valuing DreamWorks based on the film costs it hasn’t charged off yet. I don’t think the logic behind such a valuation is particularly compelling. But I think it’s obvious that at any price less than DWA’s book value – according to GAAP – the stock is clearly undervalued.

You can see this just by looking at reported EPS divided by book value. DWA’s historical return on equity – which is actually a performance target for CEO Katzenberg – is too high for a company trading around book value.

I would love to buy DreamWorks right now. But, I’d have to sell something to do that. So, it’s just a question of whether I choose to sell something I own.

I like my current portfolio – which is mostly profitable companies trading below their net cash value – quite a lot. More than I’ve liked my portfolio at any time in the last two years. So, a stock has to clear a very high hurdle to get me to tinker with my portfolio right now.

But, if I do buy a new stock – it’ll definitely be DreamWorks.

Ask Geoff a Question about DreamWorks (DWA)
Check out the Buffett/Munger Bargains Newsletter
Check out the Ben Graham Net-Net Newsletter


Stocks Discussed: DWA,
Rate this post:

Rating: 4.1/5 (26 votes)



Re DreamWorks Animation DWA Owner Earnings
Posted by: mohmand (IP Logged)
Date: March 1, 2012 05:17PM

Quick question about owner's earnings. When calculating, you would not include capex for growth? Also, when management does not breakdown capex for maintenance and growth, what do you feel is the best way to estimate?


Stocks Discussed: DWA,
Rate this post:

Rating: 4.0/5 (1 vote)



Re DreamWorks Animation DWA Owner Earnings
Posted by: Munger200 (IP Logged)
Date: March 1, 2012 06:43PM

Geoff, why does Dreamworks need to be a 25% position if you buy? Surely starting with it as 10% of your portfolio is significant and you can always add as you see fit. You mention you have a bunch of stocks in your present portfolio, what are they and what as a percentage of the portfolio do they comprise of? Is your portfolio made up of 4 stocks? I am very interested. As always your articles are excellent.


Stocks Discussed: DWA,
Rate this post:

Rating: 5.0/5 (2 votes)



Re DreamWorks Animation DWA Owner Earnings
Posted by: hschacht (IP Logged)
Date: March 2, 2012 12:06PM

I'm a little surprised that nobody has mentioned the huge liability owed to Paul Allen, the dual share class structure, the odd compensation agreements with SKG, etc. You can calculate owner's earnings all you want, but what if they do not accrue to the Class A holders? What you are in the "wrong" group? Or the "right" one? That would be the "B" group.

Read the small print in the 10k, 10q, and proxy and you will run (not walk) away from DWA.

P.S. I like how DWA mysteriously refers to Paul Allen as a "former shareholder"... he's not alone.


Stocks Discussed: DWA,
Rate this post:

Rating: 2.0/5 (1 vote)



Re DreamWorks Animation DWA Owner Earnings
Posted by: Adib Motiwala (IP Logged)
Date: March 3, 2012 09:39PM

Henry,

Thanks for pointing out.

Accordingly, the amount payable to former stockholder on our consolidated balance sheet as of December 31, 2010 increased by $262.1 million to $329.6 million, when compared to the balance as of December 31, 2009. As of December 31, 2011, the amount payable to former stockholder was $294.4 million



Stocks Discussed: DWA,
Rate this post:

Rating: 3.7/5 (3 votes)



Re: Re DreamWorks Animation DWA Owner Earnings
Posted by: rnagarajan (IP Logged)
Date: March 4, 2012 10:59AM

There's nothing mysterious about the tax liability, it's all in the annual report. I'm undecided on Dreamworks but not bothered by the tax receivable agreement.

"Additionally, in connection with the Separation we entered into a tax receivable agreement with an affiliate of Paul Allen, who was previously a director and significant stockholder. As a result of certain transactions in which entities controlled by Paul Allen engaged, the tax basis of our assets was partially increased (the “Tax Basis Increase”) and the amount of tax we may pay in the future is expected to be reduced during the approximately 15-year amortization period for such increased tax basis. Under the tax receivable agreement, we are required to pay to such affiliate 85% of the amount of any cash savings in certain taxes resulting from the Tax Basis Increase and certain other related tax benefits, subject to repayment if it is determined that these savings should not have been available to us. During the years ended December 31, 2010 and 2011, we made payments (net of refunds) totaling $26.9 million and $29.7 million, respectively, to Mr. Allen’s affiliate. As of December 31, 2011, we have recorded a liability of $294.4 million to Mr. Allen’s affiliate. We expect that $14.2 million will become payable during the next 12 months (which is subject to the finalization of our 2011 tax returns) and the remainder will become payable over the next several years. This liability may increase in the future to the extent that new deferred tax assets result in realized tax benefits that are subject to the tax receivable agreement. See Risk Factor entitled “Changes in effective tax rates or adverse outcomes resulting from examination of our income tax returns could adversely affect our results.”


Stocks Discussed: DWA,
Rate this post:

Rating: 3.0/5 (2 votes)



Re DreamWorks Animation DWA Owner Earnings
Posted by: hschacht (IP Logged)
Date: March 5, 2012 11:46PM

Nobody said the liability is mysterious... it is in plain sight (though perhaps not plain enough), but apparently it is lost on the investment community that the bulk of the cash flow at DWA will not accrue to equity holders in a certain "class". Here read: Anyone not in the B class.

And yes, I am surprised that the lengthy analysis above did not mention the liability I mentioned or the other arrangements that siphon capital away from equity holders.

And the fact that DWA refers to Paul Allen often as "a former shareholder" (a rather vague term) is indeed mysterious. Perhaps the reason Mr. Allen is no longer a shareholder is that he read the proxy?

I'm frankly glad that you copied that section in your comment so all can read it. That said, it is far from the only relevant section when it comes to governance and the ordinary equity holder.

The title of the above article talks about "owner's earnings". Honestly, my reading of the DWA financials and governing documents leads me to wonder what it refers to. I don't see much earnings... and certainly I don't see much in the way of owner's earnings... more specifically, Class A owner's earnings.

After all, that is all we have access to anyway. But again, if there are any, I missed them... certainly there are not enough of these earnings to justify the current valuation.

If my kids are any guide, the Dreamworks movies have a lifespan more akin to a gnat than to any Boeing or Huntington Ingalls product. So I wouldn't put too much stock in that vaunted film library.


Stocks Discussed: DWA,
Rate this post:

Rating: 4.0/5 (2 votes)



Re DreamWorks Animation DWA Owner Earnings
Posted by: dgenchev (IP Logged)
Date: March 6, 2012 09:43AM

Why are you so concerned with the Class B shares? They represent only 13% economic interest. It is a common structure to separate economic and voting control, and keep the latter with the CEO/founder. All the latest social IPOs had this feature. And, who would you rather have in control of Dreamworks than the SKG team?

I find the retarded repurchases and the lavish compensation concerning. But if they stop the former, I can live with the latter, if that's the price of having those guys in charge of the company.

As for kids, doesn't everything have the lifespan of a gnat with them? As long as they saw the movie in the theater or bought the DVD, Dreamworks is doing a good job.

@Geoff: Congratulations on your new job. You are very prolific. Got me back to GuruFocus.


Stocks Discussed: DWA,
Rate this post:

Rating: 3.5/5 (2 votes)





Sorry, only registered users may post in this forum.

Please Login if you have an account or Create a Free Account if you don't
Get WordPress Plugins for easy affiliate links on Stock Tickers and Guru Names | Earn affiliate commissions by embedding GuruFocus Charts
GuruFocus Affiliate Program: Earn up to $400 per referral. ( Learn More)
Free 7-day Trial
FEEDBACK