Dreamworks Is In The Dumps — Time To Buy?
Every Friday, I scan the movie reviews to see if there is a new film I want to go see. And every week, I fail to find anything that appeals to me.
Many others must feel the same way, seeing as box office receipts are off sharply this year, making this a season of misery for film studios. And no studio is feeling the pain more than Dreamworks Animation SKG (NYSE: DWA), which has slid 25% since I panned the company’s business model five months ago.
Shares had already been in freefall and are now off more than 40% this year.
Yet with much of the bad news now priced into the stock, Dreamworks deserves a fresh look. The company is making moves now that should yield solid rewards in a few years.
Sequels And More Sequels
For a studio that was founded by three industry visionaries — Steven Spielberg, Jeffrey Katzenberg and David Geffen — Dreamworks hasn’t shown a lot of creative vision lately. It hasn’t won an Academy Award for any of its films since 2005, and the studio is increasingly content to simply churn out repeated sequels of key titles, whether they were box-office hits or not.
#-ad_banner-#Lately, at least if second-quarter results are any guide, then the creative mojo is really gone. Sales fell 43% from a year ago on the heels of box-office flops such as “Mr. Peabody & Sherman” and “Turbo.” (The SEC is actually investigating improper accounting with the production of “Turbo.”)
A key metric behind this studio’s weak performance: Free cash flow is on track to be negative for the third straight year. To be sure, Dreamworks isn’t getting out of the film business. Looking beyond the dismal box office results of 2014, the company’s operating history suggests that the company will make money on this platform, even if just a few films are breakout hits.
Yet there is another reason to suspect that DWA’s dismal free cash flow won’t persist. The company is spending heavily now to augment the slate of films it produces every year with a tried-and-true brand extension.
Simply put, Dreamworks — which is run by former Disney (NYSE: DIS) executive Katzenberg — is taking a page right out of the Disney playbook: It is opening theme parks.
Management realizes that there are now enough animation characters in its stable to draw crowds, especially in places like China, where the company’s Kung Fu Panda franchise has become quite popular.
Dreamworks and its partners are investing $2.4 billion in a new entertainment complex called DreamCenter, slated for opening in 2017. Much of the upfront spending for the complex will take place in 2015, which is why analysts at Merrill Lynch anticipate a rebound in free cash flow to around $400 million in 2016. (Katzenberg also predicts that the company’s film release slate in 2016 will be more robust than prior years.)
It’s tempting to note that Dreamworks is valued at less than five times Merrill’s 2016 free cash flow forecast. Of greater import, the company is building a set of assets (such as the China theme park and another one in Russia), which will turn this into an asset play. Hollywood accounting is notoriously murky, but the company’s shift towards theme parks should help investors to better understand the sustainable value of this business model, and shift the focus away from box office hits and flops.
Assuming the new theme parks and a moderately successful slate of films help Dreamworks to get back on the path of $400 million in annual free cash flow, then DWA would start to merit a multiple of around 10 times free cash flow, which suggests that the company’s value would rise to around $4 billion from the current $1.7 billion. For context, Lions Gate Entertainment (NYSE: LGF) — which has built a stronger recent track record but lacks marketable children’s characters such as Shrek and Kung Fu Panda — is valued at around $4.4 billion.
Risks to Consider: If the recent box office weakness for Hollywood is a reflection of a permanent shift away from movie-going, then the value of movie studios such as Dreamworks may erode even further.
Action to Take –> To be sure, DWA lacks near-term catalysts: “Penguins of Madagascar” is the only film yet to be released for 2014, though its prequel, “Madagascar 3: Europe’s Most Wanted” did a spectacular $746 million in global box office receipts in 2012. Instead, it’s important to focus on the long-term value creation that Dreamworks is now pursuing. It may take time for investors to begin to appreciate the appeal of theme parks in this business model, but it does appear as if this company is finally learning the lessons imparted by industry leader Disney.
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