Last Friday’s sumzero dispatch included a little blurb on Dreamworks (NASDAQ: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 with 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 $155 million a company doing over $19 million in operating income (see this WSJ on Classic acquisition for revenur and EBIT figures). They’re financing the purchase with a draw down on their new credit line, which will carry interest at less than 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% or higher 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 theme park, 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 adds up to this: Dreamworks is finding multiple new ways to monetize their properties. Both in new geographies (expanded China distribution) and new forms (theme park 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 asymmetrical 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.
Okay, 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 $1.4 billion.
Dreamworks currently has just under $1 billion in movie inventory on its books. They don’t break out how much is assigned to what, but (by my estimates) well under $50 million of that is assigned to the Kung Fu Panda and How to Train Your Dragon franchises, and at most $100 million is assigned to the entire Shrek franchise (this would relate to the Puss in Boots movie, and the number is likely closer to $65 million).
So, what you’re buying for $1.4 billion is basically as follows
- $850 million in book value for the new movies they are producing and the Madagascar franchise (Madgascar 3 is in there for approximately $150 million) plus some TV shows in production
- $150 million for Shrek, How to Train Your Dragon, and Kung Fu Panda franchises
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 $3 billion to take control of it.
But let’s just assume the value of Dreamworks’ inventory is $1.4 billion.
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.