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?
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
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.
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|
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|
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.
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