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Dreamworks - Value in the Works

Thesis

DWA is cheap (Forward consensus PE 13.6x, currently $16.96 near its 52 week low of 16.34).

Given that they have just released a hit movie (Puss in Boots), this is highly unusual. When weinvest in DWA, we are buying 1 thing the creative team (Jeffery Katzenberg and WilliamDamaschke).

Company Overview

Short Company HistoryDreamworks SKG was formed by Steven Spielberg, Jeffery Katzenberg and David Geffen. In

2004 Oct, Dreamworks Animation was spun off from the parent company.

Management/ Ownership StructureCurrently, DWA is being run by Jeffery Katzenberg. Jeffrey Katzenberg, David Geffen andentities controlled by them own 100% of DWAs Class B common stock, representingapproximately 13% of the companys common equity and approximately 69% of the total votingpower of its common stock. Katzenberg has 269,796 options (from compensation plan) with aweighted average exercise price of $35.30. At least, Katzenberg has some incentive to raise theshare price.

Bill Damaschke is head of Creative Production and Development. Bill has been with thecompany for 10 years. Bill has worked on Prince of Egypt, Shrek, Shrek 2 & Madagascar. Heowns 332,301 shares. Kristine Belson is head of Development. She just joined the firm. AnnDaly is the Chief Operating Officer. Lewis Coleman is the CFO.

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John Batter who was co-president of production has recently left to become CEO of MediaNavi.

In total, the Directors and executives own 69% of the company. I believe that this is sufficientincentive to ensure the creative team stays at DWA. The reason I belabor this point is becausewhen we buy DWA stock, we are buying the creative team.

Revenues Revenues/ earnings for DWA are unstable because one cannot predict if thefilms produced are going to be hits or not. Also, revenues are highly dependent on thenumber of films DWA is able to produce in a year. They target 3 films per year. But in2011, they were only able to produce 2 (Kungfu Panda 2 and Puss in Boots). Bear inmind that normally film studios produce 1 animated film every 18 to 36 months, so whatDWA is pushing for is ambitious. The instability is offset by the fact that DWA is debtfree.

Distribution DWAs distribution agreement with Paramount comes up for renewal in2012. I suspect that the reason DWA is trading at 52 week lows is due to the uncertaintysurrounding the renewal of the agreement. Currently, DWA pays Paramount 8% of boxoffice and home video revenues to distribute and market its films.

DWA has 3 options here renew with Paramount, find an alternative studio to distribute thefilms (Universal, Lionsgate etc) or setup its own distribution. Renewal with Paramount isdifficult because Paramount is likely to want more than 8% of revenues and DWA wants to payless. DWAs board has already said that renewing the theatrical and home-video distribution feehigher than 8% is out of the question. Furthermore, Paramount has announced that it is setting upits own animation division, which is targeted at making one $100m film per year. Paramount hasnow gone from distributor to competitor.

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With regards to DWA setting up its own distribution network, that could be costly, as it onlyproduces 2 to 3 films per year. Estimates on cost of distribution are around $235m per year ifdone independently.

Find an alternative distributor seems most likely. There are a few out there the majors

(Universal, Columbia), or a mini-major (Lionsgate). Distribution in the film business is acommodity. The true value is in the content. When DWA signed the contract with Paramount 7years ago, DWA was an unknown with no track record of being able to deliver good animatedfilms. Now DWA has a string of hits under its belt, there is no reason for it to pay more than the8% of revenues that it currently pays. In fact, DWA should pay less if it negotiates with otherdistributors as it has a track record already.

For the TV distribution side, DWA recently signed a deal with Netflix. Revenues from this dealare unlikely to materialize until FY 13/14.

Valuation It is very difficult to figure out how much DWAs intrinsic value is becausethe value lies in the creative team. Currently, DWA is trading at about 10x average past 6years earnings (P/E), 2x sales with no debt. Disney bought Pixar at 40x P/E and 21xsales.

Conclusion - Ordinarily, I would not recommend buying a company that is so difficult tovalue. But here are the facts, we have a company that is trading near its 52 week lows thathas produced 2 hit films this year. Why should this be so? It doesnt make any sense.Maybe its time to buy some DWA.