DWA : A few thoughts

In my search for undervalued companies, I came across differing opinions for the value of Dreamworks (DWA). On the one hand, a professional analyst has rated DWA a sell, citing an EPS of only around $1 vs a stock price of around $16. On the other hand, two apparently independent financial bloggers, Frogskiss and Whopperinvestments, have come out with bullish calls on DWA, citing the deep library of films not carried on the balance sheet as the main reason why DWA should not be trading at close to book value, but rather way above book value. A difference of opinion is a potential profit opportunity, so I decided to do a little digging of my own. I was rooting for the bloggers (since I am one myself), but at the end of my analysis, I concluded that the analyst’s take is probably closer to the mark. For those who are interested, I set out my thinking below.

On DWA’s hidden asset

Hidden assets are the bread and butter of value investors. Many companies accumulate assets that are critical to their businesses but not well reflected on the balance sheet. A common example is land, which is typically carried at cost on the balance sheet, which can be vastly lower than its current market price. Typically, these hidden assets become important sources of value when the main business is failing and earnings fall off dramatically, but only when these hidden assets can be put to more productive use in another company’s hands. For example, a failing retailer with a lot of land can sell the land for residential or other uses, or a telco with a shrinking user base can sell excess wireless spectrum to other growing telcos. It is not clear to me that this is the case with DWA.

DWA’s hidden asset is its off-balance-sheet library of films, which contain such franchise films as Shrek, Madagascar, and Kung Fu Panda. These films cost $100-150M each to make, and were written down to zero when the films are released. However, the question that arises is, if the library is so valuable, why is DWA deriving only $80M of annual earnings from its library of content plus the 2 films it releases at the box office annually. DWA should be the company best able to monetize its own film library. If DWA is not able to monetize the library effectively, does that not mean that the library is not as valuable as anticipated? It seems unlikely to me that another company will be better able to monetize the library. Furthermore, film libraries are depreciating assets. With every year that passes, films become less valuable as memories fade and more competing films are made. Few films achieve evergreen status and continually generate a stable level of cash flow. With each year that DWA fails to monetize its content, chances are that the film library becomes less valuable.

On historical business models of movie companies

In the past, movie companies made films and released them in theaters, and the films had only 2-3 months in which to recoup their cost and make a profit at the box office. Box office earnings were everything to a movie. Then came VHS tapes, which allowed movies to be viewed at home on the TV. This increased the value of a film library, but only moderately, because the tapes were relatively expensive to manufacture, and picture quality degrades with time since the magnetic data was labile. The breakthrough technology came with the invention of the DVD, which costs pennies to make but retails for tens of dollars. Since the optical data was non-labile, for the first time, it was possible for the retail customer to acquire their own permanent personal movie library. The DVD revolution was further amplified because it coincided with the advent of the large screen LCD TV, the era of cheap credit. DVD, and the home theater craze. DVD earnings surpassed box office takings, and even decades-old films began to make serious money.

Then Armageddon struck in the form of Netflix, which made a personal movie library unnecessary. DVD sales has already began to decline. At this time, it seems inevitable that the DVD is headed for the trash bin of history, and the future of movie delivery is likely to be internet-based streaming. Blue-ray, the last best hope of the movie industry, has largely proved to be a dud. In the post-DVD streaming age, what is the likely value of DWA’s film library? Almost certainly lower than in the DVD age. In the best case scenario, Amazon may prove to be a viable opponent to Netflix, giving movie companies the possibility of a bidding war for their content library. However, Netflix has recently been laid low through its own missteps, and recently had to issue shares at a low price to shore up its balance sheet, and so is unlikely to be in a position to make rich bids for content. And Amazon, known as the Walmart of internet retailing, is unlikely to overpay for content. While the business model for internet streaming is still in flux, the final model is likely to be similar to the current model for theater delivery, that is, content companies receive a share of the revenue for each movie-viewer. In this scenario, cash flow from the film library will dramatically decrease, because while a large number of people may buy a DVD on the possibility that they may one day view the movie, in practice a far smaller number of people actually view the movie.

And matters could be worse. It is possible that executives at production companies have been misled by DVD earnings to splurge on their movie budgets. Certainly, the steadily rising movie budgets, now costing nearly $100-150M over 2-4 years for an animated film, suggests this. In other words, companies may have overpaid for their movies, and inventory write-downs will be required in the future. Furthermore, the large capital outlay makes companies more conservative. If you look at the upcoming slate of movies from DWA, they consist mainly of rehashes of their existing franchises (Kung Fu Panda 3, Puss in Boots 3 etc.). This paradoxically reduces the chances of getting a blockbuster movie.

My valuation for DWA

I predict that box office earnings will once again comprise the vast majority of film income, with only a trickle of cash flow from post-release streaming. Box office receipts are notoriously fickle and difficult to predict, so the earnings of movie companies will be lower and more bumpy. This means that the PE multiplier accorded should be lower. The professional analyst in question (Tony Wible, who also had the courage and foresight to correctly call the NFLX meltdown) gives DWA a PE of 12, for a price target of $12. I am more pessimistic and am personally inclined to give it a PE of only 10, for a $10 price target. As of Dec 15 2011, DWA had a shocking 37.7% of its float short, suggesting that many short-sellers are also of a bearish view. While I currently do not have a position in DWA, I am actively considering shorting it and other movie companies. To be sure, this is a highly hazardous short, since a blockbuster movie release could easily set off a massive short squeeze, so if you are thinking also of shorting this stock, I urge extreme caution. This is not for the faint-hearted, and certainly should not comprise a large portion of your portfolio.