Someone who reads my articles asked me a question about my article on DreamWorks Animation (NASDAQ:DWA).
He wanted to know how to avoid information overload when analyzing a company like this. There is so much publicly available information about DreamWorks and every one of its movies – that an investor can get lost in all the data.
I agree this can be a waste of time. Although it can also be important to think a lot about the company, its industry, its products, etc. without necessarily looking for what it means for the investment case. It’s not a good idea to let every piece of data tip the scales in your analysis of a stock.
But it is a good idea to sketch out a portrait of the company, its culture, its management, its industry, its products and its customer. For a stock like DreamWorks – going to see the company’s movies is an absolute must.
You can rent DVDs or buy digital copies of the DreamWorks’ older movies. And you should. In fact, you should see these movies before you check how they did at the box office and on DVD.
It is easy to let your own biases get into a stock. Especially if you already own it or have recommended it (or recommended selling it).
I’ve already talked about DreamWorks Animation once in a full article. And I mentioned it in my article “12 Stocks to Consider.” So it’s very important to take everything I say about DreamWorks as coming from someone very, very biased. Once you take a stance on a stock – and I don’t even own this stock (yet?), but I’ve publicly said good things about it – you are absolutely infected with a bad case of bias.
So, listen to what I have to say. But doubt my every word.
If you want to understand my thinking on DreamWorks let’s start with what I said about DWA back in October. I’ve left my words completely unchanged with the sole exception of removing references to the “upcoming” Puss in Boots since it was released right after I wrote the article. Otherwise, this is exactly what I said about DreamWorks five months ago.
What I Think About DreamWorks
This is an intangible business. But it's a very investment heavy intangible business. DreamWorks invests heavily in big budget movies. It makes two movies a year. It's going to make three movies every other year from now on. So that's 2.5 movies a year. That sounds like a small amount. But these are not small movies… Those ads aren’t cheap. Paramount pays for them. And before DreamWorks can make a profit on the movie, Paramount needs to recoup all its expenses plus pocket 8% for itself. That’s the hurdle a DreamWorks movie has to clear before it even reports any revenue.
A DreamWorks production costs between $135 million and $165 million. Let's call it $150 million. Right now they have a distribution deal with Paramount. And the distribution of a DreamWorks movie is normally supported by a huge amount of marketing. We’re talking another $125 million to $175 million. So the entire undertaking shared by the studio producing the movie and the distributor is about $300 million. These are movies like: Shrek, Kung Fu Panda, Madagascar, How to Train Your Dragon, etc…
I love this company. You have Jeffrey Katzenberg running it. It gets half of its revenues from overseas. Foreign box office is getting better and better.
You had some tremendous results for Kung Fu Panda 2 in China. Kung Fu Panda 2 was a disappointment in the United States. Not critically. It was a fine movie. Audiences liked it. Critics liked it. But it opened against The Hangover 2.
They go for the big opening weekend at DreamWorks. They look for the week where you have the biggest movie audience going to theaters and you don't have another competing family film. They thought that going up against an R-rated comedy was a safe bet. They were wrong. And they admitted as much on the conference call.
Kung Fu Panda 2 did fine worldwide. And I would expect DreamWorks movies to skew more and more towards the foreign box office in the future. That's partially because of doing sequels. Sequels play better overseas than in the U.S. These movies have done great overseas. And they're building more theaters in places like China.
They're scared about the home video market. Studios made a lot of money on VHS, DVDs and Blu-Ray. That's in the developed world. Those have never been big sellers in developing countries. And DreamWorks makes a lot of money from that part of the business. About half of the people who buy a DreamWorks DVD also saw the movie in theaters. So you have some extra profits in there that come from people seeing the movie in theaters and then buying the DVD. That's going to go away over time.
Of course, if movie streaming increases, there will be very strong competition for exclusive content. There will only be a few viable streaming options because of exclusivity. A company like DreamWorks will get paid tens of millions of dollars for each movie it grants streaming rights on if they are sold as an exclusive package. Will that offset DVD sales? It could. At streaming right sales of around $50 million a movie, it might fully offset the profits from DVDs. But streaming competes both with DVDs and with TV rights. So, it would take even bigger payments to offset all those sources of income.
You can do all the math you want. It won’t solve the basic problem. You’re going to guess wrong. The studios thought TV and VHS were both threats to their business. They later turned into big profit sources. And today studios aren’t moaning about a lack of people in theaters — their biggest concerns are home video sales and TV rights. Cable is less interested in movies now that it has its own original series.
When you factor in 3D and the foreign box office, it’s much less clear where revenues per DreamWorks movie are being taken by the course of history. There are trends pushing in different directions. And the biggest long-term trend will be having a much larger worldwide audience for their movies. Will DreamWorks get paid for this content?
Some people say no. Without DVDs, there is no hope for DreamWorks. Movies shown in theaters and streamed to people will not be enough.
What about me?
I'm very positive on this company. It's a stock I would like to buy and hold forever. Is it cheap? This is a hard company to value.
Each movie they make is a very large portion of its total value. As I write this the stock is trading around $17. That's close to an all-time low. The stock has never been below $16.50. They went public in the middle of last decade. It’s down about 50% from where it went public. And yet DreamWorks is clearly a much stronger company today than it was back then…
…DreamWorks is not a conglomerate. It does one thing. It puts out two or three movies a year. And the press reports on those movies. It's an easy company to understand. But it's a risk-taking business. Every movie is a huge project. They take up to four years to develop. There is no established market for an original movie. You have to sell the public on that movie all over again. Every movie is a new product launch. The market cap is only $1.4 billion right now. So each movie they make is risking 10% of that market cap. And DreamWorks is plowing about 25% of their market cap into new movies each year.
So DreamWorks is an unusual company. But it's at the top of the list of companies I would consider buying and holding forever.
I pretty much feel the same way. I think the above comments are the most honest overview of what I actually think about DreamWorks as a company. And how I value the stock.
I’m not sure how much value there is in reading my take on the company. You can obviously study DreamWorks for yourself and come away with a totally different take.
But I know there’s value in reading what I had to say. Because I took in a lot of information about DreamWorks over time. And what you just read is basically a dozen paragraphs. If your take on a stock is a lot longer than that – you probably are suffering from information overload.
When I write an article about a stock I may try harder to bring in all the supporting evidence and so the investment case gets pretty long. But if you’re standing in front of the mirror telling yourself why you’re going to buy a stock and you’re giving an answer longer than the one I just gave about DreamWorks – you’re probably doing something wrong.
You’re probably having trouble separating the stuff that matters from the stuff that doesn’t.
You’re probably suffering from information overload.
How do you remedy this?
In the past, I've talked about focusing on three Cs. Here, I will add a fourth C.
Focus on what is:
Try to write down the few things you know from everything you've looked at with DreamWorks that might fit these four criteria. Think about the investment case for DreamWorks. What could make or break an investment for you? It has to be something you think you know now or something you could find the answer to – and be comfortable you have the right answer.
Whether some movie will be a huge, surprise hit like the original Shrek is probably unknowable.
Whether Katzenberg will keep the company independent and run it until he's as old as Warren Buffett is today – or whether he will sell it next year is probably unknowable. It might be guessable. But it is not something to obsess about in detail. Not because it’s unimportant. But because you’ll start looking to body language for clues. It’s just a waste of your time to try to guess people’s motives like that. Understand Katzenberg as best you can. Get an idea of who he is. How he thinks about DreamWorks. Then move on. It is enough if to the best you can tell he's the person you want running the studio, he likes running the studio, and he seems to intend to keep running the studio for as long as possible. Beyond that we’re entering the realm of clairvoyance. Katzenberg probably doesn’t even know how long he’ll be running the place. You certainly can’t know. It’s just one of the uncertainties you can’t think away. You either accept it as an uncertainty or you don’t buy the stock.
Now, let's think about the things that are constant, consequential, calculable and comfortable. In other words, something that is not related just to this year or next year or even the year after that. Something you can put a number on even if it is a very rough number. Something that matters. And something you can get comfortable with your estimate, belief, etc.
So probably not something that hinges on the behavior of DreamWorks’s Chinese joint venture partners, the Chinese government, the actions of other studios, or public taste as it relates to any one movie.
For me, there are two things that I think are very high up on the list of:
And those two things that fit the bill are:
1. The number, cost, and kind of movies DreamWorks will make over the next 10 years.
2. And the amount DreamWorks carries these movies for on its books.
These will not exactly be estimates we're talking about here. It's more like we're looking at a possible rough sketch of the future and asking whether that is a future that would justify today's price.
Today, DreamWorks has a library of 23 movies. Of these I will throw out movies like Sinbad (that were hand drawn) and movies where DreamWorks co-produced with Aardman. I am not sure of the value of these movies. But, luckily, DreamWorks does not seem interested in making these kinds of movies in the future. So, I'll focus on the remaining 17 movies.
By the way – we’ll talk more about this in a minute – but when I say I’m throwing out these movies I mean I’m not venturing a guess as to what they are worth in economic terms. We know what they are worth in accounting terms. You can check DreamWorks’ accounting methods and its past record and see which movies they wrote off as unprofitable and which movies have been fully amortized because they are more than 10 years old.
I’m just setting those other movies aside because they really don’t fit with what DreamWorks is today. They aren’t what I’d consider a core asset of the company. And they aren’t the same type of movie DreamWorks has been making – and intends to keep making – in the future.
So that leaves 17 movies. One of these – Bee Movie – was a bit of a special case because it was much more influenced by an outsider (Jerry Seinfeld) than is normal for a DWA movie. (Check the writing credits on the movie and you’ll notice Seinfeld’s name and the name of a couple people he’s worked with in the past.) But, let's say DWA's most important assets are the 17 original CG movies which include:
- Bee Movie
- Puss in Boots
- The Kung Fu Panda Series
- Over the Hedge
- The Madagascar Series
- Shark Tale
- Monsters vs. Aliens
- How to Train Your Dragon
- The Shrek Series
- The Shrek Series
- The Madagascar Series
- The Kung Fu Panda Series
- And the (eventual) How to Train Your Dragon Series
- The Penguins of Madagascar
- Kung Fu Panda: Legends of Awesomeness
So, these are the assets of DreamWorks:
1. The DreamWorks brand
2. The organization, management, culture, etc.
3. The existing intellectual property (17 CG solo productions/4 franchises)
I like to think of the first two assets as being related to future production. And item No. 3 as being the sort of thing that should appear on a DWA balance sheet if it reflected economic reality rather than a certain accounting treatment.
Okay, now DreamWorks has plans to make five movies every two years. So, if I plan to hold DWA stock for the next 10 years, when I want to sell, DWA will have the following three assets:
1. The DreamWorks Brand
2. The organization, management, culture, etc.
3. The existing intellectual property (42 CG solo productions/? franchises)
So I ask myself what I think about the quality of DWA's imagined intellectual property in 2023. Well, we know DreamWorks will own everything it owns now. We know there will be more Madagascar movies (at least one more), and are pretty sure there will be at least one more How to Train Your Dragon movie (it's already scheduled for release), and we think there will be at least one more Kung Fu Panda movie.
Okay. What else?
Well, there will be a lot of original movies. DWA's hit rate of turning their CG animated solo productions into series is very high. I'm not sure that can be sustained with the current DVD market. In fact, I don’t think it can. But there is always the possibility of future franchises.
While we can't know what success or failures DWA will have when making totally original movies it is not out of the question to imagine that they will release the first movie in what turns out to be three new ongoing franchises within the next decade. Maybe it will be two. Maybe it will be one. Maybe DWA will strike out completely and not make even one movie in the next decade for which a sequel is one day released. But it's something to think about.
So my thoughts on DWA's library over the next 10 years is that I think it will be bigger in terms of size. And I – you can disagree with me if you want on this one, but I feel strongly about it – DreamWorks’ library will be better in terms of quality. I actually think DWA has been making some of the most consistent movies in recent years. I think when you look at (let's put Bee Movie aside) and just take Over the Hedge and Shark Tale – I don't think they've made movies like that recently. For me, even their financial misses have been solid pieces of work. The kind of movies that if you put five out there in front of the public every two years you are bound to have some real hits and hopefully start a beloved franchise or two.
Offsetting this belief that the size and quality of DWA's library will be much greater 10 years from today is the fact that movies are not as profitable to make on a per audience member basis as they were back when Shrek was made or when DWA went public or even just in the last couple years.
This is what everyone who is negative on DWA is focused on. And I think they are right. The future is darker than the past. The same amount of mindshare isn’t going to deliver the same amount of money to the bottom line.
But I think there are some other things these correctly pessimistic folks don't talk as much about.
DWA had one ongoing series when it went public. It was a monster hit: Shrek. One of the biggest franchises in movie history. But, back when DWA went public, Shrek was just one franchise with only two movies released.
Today, DWA has four franchises:
- How to Train Your Dragon
- Kung Fu Panda
- Shrek (inactive)
Still, it's worth keeping these ancillary revenue sources in mind. Because, ultimately, most of the great entertainment companies you can think of grew through revenue from sources other than the medium in which they began. By the time Warren Buffett bought 5% of Disney for his partnership it was making very little money from animated films. DC and Marvel intellectual property ended up being very valuable – more so in movies than comics.
And without merchandising in the early years, Disney’s finances would have been – well, let’s face it Walt probably would’ve bankrupted the company.
So, here are the places DreamWorks can find other revenue to offset declining profits per movie audience member:
- Profits from other media (non-movie income)
- Profits from new overseas markets
In addition to these factors we can mention the importance of streaming agreements (Netflix) and distribution. These are both important. And we'll see a pretty dramatic change in DWA's financials by – let’s say – 2014 where we have the combination of a Netflix agreement instead of an HBO agreement, a new distribution arrangement of some sort, and the release of 25% more movies (five movies every two years vs. two movies a year).
But that is more of an exercise in estimating earnings a year or two out. And I'm not sure how we can know what DWA will choose to do in terms of a distribution agreement.
Instead, I like to focus on what DWA's intellectual property is worth. To me – because I don't think of DWA's co-productions and hand drawn movies as part of the core assets of the company – I imagine a release pace of five movies every two years will increase DWA's intellectual properties by about 9% a year. This will be accomplished through heavy reinvestment in the business with DWA retaining a lot of earnings.
That is all very straightforward.
What isn’t so straightforward is whether the dollar value of each of these properties will be more or less than what DreamWorks already owns.
Here we have the big question on which those who like DWA stock and those who hate it differ – what will the value of a DWA movie be in the future?
About the same?
Or much, much less?
This is basically the DVD vs. 3D, foreign and streaming argument. We all have different views on different parts of the equation.
I think the entire idea of purchasing a movie will go away over time. I do not believe there will ever be much of a digital alternative to DVDs. And DVDs are going away. So, I'm probably more bearish on DVDs and certainly digital downloads than most people are.
On the other hand, I am more bullish on streaming. I believe the per movie price to be paid for the exclusive rights to DWA's movies in a country will eventually be very, very high. If there is really going to be a Netflix of (insert country name here) that is not based on piracy – that company is going to be paying a hell of a lot of money to show DWA's movies to its subscribers in 2022.
As far as 3D, I think it was a wonderful investment for DWA and give Katzenberg credit for being willing to look foolish by being very fast and very vocal in his support. But I think 10 years from now, 3D will be everywhere (especially outside the U.S.) that the idea of premium pricing is probably meaningless in 10 years.
To me, the focus is on the movies as assets. What do I think a DWA movie is worth the day it is released in theaters until the end of time?
If I was looking at an oil company, I would be interested in their proved reserves and where else I thought they could strike it rich.
DreamWorks is no different.
So, for me, I look at DWA's capitalized costs (movies, series, specials, etc.) on the balance sheet. And I think about how the accounting works. I think about what they have or haven't written off in the past. And I ask myself if DreamWorks' intangible assets are worth more or less than those capitalized costs.
With their intangible assets carried at the capitalized costs of their productions, DWA's book value is $15.73 a share.
The stock is trading at $17.21 a share.
That's a 10% premium to book value.
Now, I ask myself if DreamWorks' book value is a reasonable approximation of the value of the company to a private owner?
And my answer is: no.
I think the way DWA's intellectual property appears on its balance sheet is an unreasonable approximation of the value of the company to a private owner.
Let me put this another way.
Let's look at the book value of DWA's movies. Total inventory costs – including live shows, TV specials, TV series, and movies – is $883 million.
A majority (55%) of that inventory is related to productions that have not yet been released. So none of that amount is attributable to movies you've heard about.
The 4 Shrek movies aren't in there. The 2 Kung Fu Panda movies aren't in there (maybe development on the third one is), the 2 Madagascar movies aren't in there (but the soon to be released Madagascar 3 definitely is), and How To Train Your Dragon isn't in there (though early production costs on the second one probably are).
Those movies aren't included in that amount. So, all the movies that DWA has ever released are included in one line for...
(Note: This is "films in release" minus the cost of live shows as per DWA's footnote to note #5. Film and Other Inventory Costs in its latest 10-K).
That's $338 million for everything DWA has ever released. Remember, it costs $150 million to make a new DreamWorks/Pixar quality animated movie. And it costs $60 million to make a new Illumination ("The Lorax") quality animated movie.
Also remember, all of DWA's inventory is carried at cost. And these movies generally cost the same for an original, more for a sequel, etc., due simply to higher pay for the voice talent on sequels. Inventory isn’t an estimate of discounted future cash flows. Whatever DWA spends gets capitalized.
So, imagine that DWA was going bankrupt. They've stopped production on all those $484 million in not yet released material. It's over. Gone.
The studio will never make another movie. It's not alive. It's dead. Katzenberg is out. The artists are all released. The lovely campus seized. You get the picture.
And now the company's last remaining assets are up for sale:
- The DreamWorks brand
- The movie library
- The rights to DreamWorks characters
- The sequel rights to DreamWorks movies
Would the winning bid at that auction be $338 million?
I think it would be higher.
And, if I think it would be higher than I'm pretty much saying that at $15.73 a share DreamWorks would be selling for less than it's worth dead.
Now, you can quibble with this by saying that yes, yes maybe the brand, characters, and sequel rights are worth more than $300 million – but there's actually a big enough negative number attached to DreamWorks’ production pipeline – that the company actually destroys value by continuing to produce new animated movies. But I think that's a silly argument. Unreleased movies are carried at cost. The costs are what anyone has to pay to make a DreamWorks/Pixar visual quality CG movie. And that would be true whatever property the movies were based on.
Okay. So, if at $15.73 a share I'm saying DWA is worth less alive and publicly traded than dead and sold at a private auction – what can I say to justify that?
Do I hate the company's future plans?
No. I love them. They're focused on the very CG animated worldwide family event movies that I think have the greatest value on a DCF basis the moment they're released. The releases build on existing goodwill for the DreamWorks brand and good movies add to the brand.
Do I hate the management?
No. If I inherited a movie studio tomorrow I'd try to get Katzenberg to run it for me.
Are there other factors peculiar to the corporation as an entity itself – not just as a bucket of assets – that hurts DreamWorks’s value?
Again, no. They have a joint venture in China. They have an agreement with Netflix. And they have a chance to change their distribution arrangement.
None of those things subtracts value from the assets they own. One of them adds some value. So, I’m not sure why the corporation holding the assets should be worth less than the assets it holds.
So, to me, if something is alive and selling for what it's worth dead – I’m interested.
Of course, there are other situations like that out there right now. I can probably name a couple dozen public companies around the world that are selling for less than they would be worth dead.
I own six net-nets in Japan that are selling for less than they’d be worth dead. There are some closed-end funds and other companies of that type – Capital Southwest (CSWC) and Boulder Total Return Fund (BTF) and Urbana come to mind – that are also arguably being priced by the market below where you could liquidate them.
What do I think of their chances of compounding intrinsic value at an acceptable rate over the next decade?
And what do I think of DWA's chances of compounding intrinsic value at an acceptable rate?
I like DreamWorks' odds a lot better.
We could go down the whole list of intangible qualities – culture, management, etc. – of DreamWorks versus my Japanese net-nets and DreamWorks versus various closed end funds and I’d keep saying: advantage DreamWorks, advantage DreamWorks…
The Big Question
So, now the question becomes if I feel comfortable DWA is worth more than $15.73 a share – I pay $17.21 a share?
This is a tough question. But a simple one. The simple answer is obviously yes. If you buy the right company, you don't worry about paying a 10% higher price.
Let's say I think DreamWorks will be worth $70 a share in 2022. If I wait until the stock comes down to its book value of $15.73 a share my annual return will be 16% a year. And if I pay $17.21 a share today, my annual return will be 15% a year.
So, if I don't buy the stock today, I'm betting on a 10% decline in DWA stock in the hopes of earning 1% more a year over 10 years.
I think that's a dumb bet. And a dumb thing to focus on. The difference in price between $15.73 a share and $17.21 a share is not something I should worry about.
If I'm right about the culture, the brand, the management and the intellectual property, DreamWorks is a buy at $15.73 a share and $17.21 a share.
And, if I'm wrong – paying 10% less is not going to save me.
Then Why Don’t I Own It?
If I like DreamWorks stock, why don’t I own it? That’s a great question. And, yes, quite a few people have emailed me asking it.
I have two excuses – neither of which is especially rational:
1. I’m used to paying certain price-to-earnings ratio, price-to-book ratios, etc. DreamWorks doesn’t fit the Ben Graham mold. And old habits die hard.
2. When I really like a company, I like to put 25% of my portfolio into it. I don’t have 25% of my portfolio in cash right now. And the things I own are very, very cheap.
The first reason is idiotic. Honest but idiotic.
The second reason has more merit. I don’t want to get into the habit of betting small on the stocks I like best. And when you own a net-net you like, it’s a good idea not to sell.
So, the natural question people have asked is: If you can put something like 10% into DreamWorks stock right now, why not do it?
If you get lucky, you can add to your position later when your other stocks are at higher prices and you sell them. And if you get unlucky and DreamWorks shares rise faster than your net-nets – at least you have 10% of your portfolio in DWA instead of cash.
Wouldn’t that leave me better off?
But I’m extremely reluctant to take small positions.
I know, it’s irrational. But I’m not convinced it’s impractical. The road to over diversification is paved with rational little compromises like this.
I’ll let you know if and when I buy shares of DreamWorks.
Ask Geoff a Question about DreamWorks Animation (NASDAQ:DWA)
Check out the Buffett/Munger Best Bargains Newsletter
Check out the Ben Graham: Net-Net Newsletter