DreamWorks Animation (DWA.O) has reshaped the movie landscape with hits like “Shrek” and “Madagascar”, but its earnings quality leaves investors with less to celebrate.
In the animated film ‘Madagascar 3: Europe’s Most Wanted’, a bunch of escapees from the Central Park Zoo in New York find themselves revitalizing the business fortunes of a travelling circus. The question now is whether the film itself, along with other forthcoming 3-D productions from DreamWorks Animation (DWA.O) will be enough to sustain the quality of the company’s earnings over the coming quarters.
That’s an important question, given that DreamWorks’ share price has climbed almost 15% over the course of the last month as ‘Madagascar 3’ has grossed some $700 million worldwide. That makes the film, which cost a mere $145 million to create, a slam-dunk hit for the studio, but the question remains as to whether the company can repeat that success, especially as it plans to increase its number of new releases from two a year to three in 2013 and beyond.
DreamWorks clearly has tied its fortunes to the future of the 3-D movie market, as Jeffrey Katzenberg, the company’s CEO, confirmed during its last earnings conference call at the end of July. “We have made more 3-D product and have more 3-D expertise working at this studio today than any other company,” he said. But will consumers be willing to fork over an extra $5 to $10 each – from $20 to $40 on top of the normal ticket price for a family of four — in order to get the full 3-D experience at a time when the economic outlook remains uncertain both in North America and Europe? DreamWorks relies increasingly on 3-D receipts to drive total box office revenues; indeed, a third of the ‘Madagascar 3’ revenues came from 3-D ticket sales. It remains to be seen, however, whether the 3-D market to which it has linked its future prosperity is too shaky to sustain the weight of those expectations.
DreamWorks is in the midst of some other significant transitions. The company announced on August 20 that it had ended a distribution agreement with Paramount, a subsidiary of Viacom (VIAB.O) and would replace that firm with Twentieth Century Fox, part of News Corp (NWS.O) as distributors for its upcoming movies. Last year, it announced that it had reached a new post-theatrical release licensing pact with Netflix (NFLX.O). Now movie fans can turn to Netflix’s streaming or DVD rentals rather than the broadcast channels of HBO, a Time Warner Company (TWC.N) to stay up to date with antics of the critters from Madagascar. The new deal will be more lucrative for DreamWorks, which will receive an estimate $30 million per movie, as reported in this Reuters news article, as content has become available on Netflix, it has taken a bite out of sales of DreamWorks DVDs. Sales of DVDs of popular DreamWorks titles, such as the Shrek franchise, have fallen alarmingly in recent months, so it will be interesting to watch how‘Madagascar 3’ performs when it is released on DVD.
The current stock price likely reflects the strong performance in theaters of ‘Madagascar’, so these issues – along with the company’s financial metrics – likely will be important to consider in contemplating an investment. And at present, while DreamWorks’ films may be an overwhelming success with audiences, its financial fundamentals look more uneven. Indeed, the company scores a mere 9 on the StarMine Earnings Quality (EQ) model, indicating that its earnings may not be coming from sustainable sources.
In the chart below, the red section of the bars represents the amount by which the company’s free cash flow(FCF) lags its net income. In the last three quarters, DreamWorks has reported negative free cash flow totaling $57 million. While it has reported small profits in each of those quarters, earnings that aren’t supported by strong free cash flows tend not to be sustainable. The pattern depicted in the chart below is one reason for DreamWorks’ low EQ score.
Another component of the EQ model is a company’s operating efficiency, which measures how efficiently it uses its assets and serves as an indicator of future profitability. In the case of DreamWorks, the company’s return on net operating assets has been steadily declining over the last 5 years, going from a peak of 44% in 2007 to only 7% in the last quarter. More worrying is that that number was once far above the industry median but now lags ten full percentage points below the current median of 17%, which for its part has begun to climb.
The margins, too, have been falling at Dreamworks, as shown by the chart below on the right, which depicts the three most common margin measures: gross margin, operating margin and net margin. All three have been declining and linger below the industry median.
Despite the questions surrounding earnings quality at DreamWorks, the company’s shares aren’t cheap. Its stock trades at a forward 12-month P/E of 20.1, well above the 10-year median of 16.6. As you can see in the chart below, the green line ( representing the forward 12-month P/E) has crept above the blue line that represents the 10-year median). Unless the company can accelerate the rate at which its earnings are growing, that P/E ratio may be too high.
Can DreamWorks pull off the feat of propelling its earnings significantly higher? Certainly, ‘Madagascar 3’may be a hit that generates both revenues and profits for DreamWorks, but the company will have to continue to roll out a string of such blockbusters – a tough proposition in the uncertain movie industry. It also will need to convince moviegoers that the 3-D is worth the additional expense. The next evidence of whether it is succeeding in these efforts will come next month, with the release of DreamWorks’ second feature film of the year, ‘The Rise of the Guardians’, set to arrive at a movie theater near you on November 21.
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