Animation Niche's Overdrawn

If DreamWorks has its way, it won't be just Shrek fans seeing a little green later this year. With Shrek 2 lapping Pixar's (Nasdaq: PIXR  ) Finding Nemo to become the highest-grossing animated feature film of all time this summer, the announcement of DreamWorks Animation filing to go public couldn't have come at a better time.

On the surface, it seems like a can't-miss proposition. When rival Pixar went public in 1995, just as Toy Story was making its holiday season debut, it commanded a $1.5 billion market cap at its December peak. Investors bid up the shares despite the fact that Pixar was a relatively unproven studio and partner Disney (NYSE: DIS  ) had it tied to a Machiavellian pact that found Pixar surrendering the lion's share of the profits as well as the characters it created.

Now consider DreamWorks Animation. Not only does it have the most productive franchise in theatrical animation history under its belt before tapping Wall Street for greenery, it owns it all -- down to the last slime-covered toadstool. While it is shackled to its parent company as a distribution partner through 2010, it still stands to reap 100% of the profitable fruit of its laborious harvest while retaining complete creative and licensing control of its rendered releases. That's huge, especially when you have a hit on your thick, grubby ogre hands.

While Pixar has been challenged to produce a new flick every year, DreamWorks has the pipeline stocked with enough productions to release two a year. That's not just rhetoric. Even as Shrek 2 continues to play at a movie theater near you, its fishy-fueled Shark Tale is now just months away from splitting the celluloid curtains.

And, as if to paint market leader Pixar as an industry slacker, DreamWorks is also putting out a prime-time animated TV series with Father of the Pride debuting this fall on General Electric's (NYSE: GE  ) NBC.

With the company looking to raise $650 million, assuming that the firm is ultimately valued in the ballpark of $3 billion, it might appear to be a compelling value if one didn't know any better. Pixar is nearly a $4 billion company today, but it will be splitting profits with Disney through the end of next year, and all of its handiwork up to that point will still have Disney howling out "mine" like a flock of hungry Australian seagulls.

So even though I ran -- I ran so far away -- I couldn't get away from the financials.

NightmareWorks
While Pixar earned $124.8 million last year on $262.5 million in revenues last year, DreamWorks Animation managed to lose $160 million on $167.9 in operating revenue. While Pixar has been consistently profitable (with fat margins to match), DreamWorks hasn't turned a profit since it milked the last of its Shrek juice back in 2001.

Naturally, this will all change as the money from the popular Shrek sequel starts trickling in. It's not just the global box-office receipts. In November, Shrek 2 will hit the home video and DVD market. Pixar's last two releases, as well as the original Shrek, moved more than 25 million copies apiece, and this one should shatter those milestones.

It's obviously fair to say that animation has been taken too kindly in the retail space. Even DreamWorks' five hand-drawn releases, averaging a rather ordinary $72 million at the multiplex, still managed to sell a cumulative 44 million units in the home video and DVD market.

Once you start tacking on broadcasting rights to the lucrative licensing rights that come from rich characterizations, then you begin to realize how a pure play in animation can truly rock. If you like Pixar's numbers now, just imagine how good they'll look in a couple of years when it doesn't have to share the pie. But in hyping up the prospects for DreamWorks Animation, it seems as if the numbers keep getting in the way.

Pixar has gone through the cyclical lulls between releases, yet it has always managed to produce healthy income statements. Its hefty net margins have kept the company afloat through thick and thin. So why did DreamWorks Animation report a loss that was almost as wide as the company's top line last year, and is there any hope that it will ever become the lean, green money-printing machine that is Pixar?

The balance sheet isn't very encouraging. The amount of debt that has been allocated to the company by its parent over the past two years has more than doubled from $168 million to $380 million. Those saddles wear heavy, especially given the bottom-heavy balance sheet that finds the company coming to market with negative book value before the offering's proceeds trickle in.

Pixar's consistency, efficiency, and potential earned the stock props in our Motley Fool Stock Advisor newsletter, but DreamWorks has a long way to go if it wants to get there.

Some investors might also grimace at the diluted voting power behind the class of shares being offered by DreamWorks Animation. The insiders will retain Class B stock that carries 15 times the voting power of the freshly minted shares. That doesn't bother me as much as knowing that Apple's (Nasdaq: AAPL  ) Steve Jobs owns a controlling stake in Pixar, so it's not as if the shareholders have any material say in that company either. Then again, if you know DreamWorks Animation CEO Jeffrey Katzenberg, then you don't want to tinker with his power.

Katz and dogs
Katzenberg led Disney's studio through the rebirth of its feature animation division in the 1990s. Pumping out classics such as Beauty & the Beast, Aladdin, and The Lion King, he wanted more and felt cheated when he was passed over for the vacant president position by CEO Michael Eisner.

He left the company, helped launch DreamWorks, and has been sparring with Eisner ever since. Katzenberg sued Disney to claim his share of the royalties during the animation studio's gravy days -- and won. Katzenberg has also taken his battle with Eisner to the big screen. DreamWorks' releases Antz and the upcoming Shark Tale are suspiciously similar in subject matter to Disney-distributed Pixar flicks. Watch Shrek, and you will fill up a laundry list of salvos flung toward Disney and Eisner.

Yet success is the ultimate revenge. That's why it has to make Katzenberg's pride swell to see his company ready to take the public markets by storm just as Disney is backpedaling out of animated supremacy.

There will be computer-rendered collateral in this animation war. My biggest concern is the one that no one sees yet. The same thing that all but killed traditional hand-drawn animation -- Disney's reckless disregard of the standards of excellence -- is threatening to nip computer-rendered features short as well.

There are some who argue that the days of ink and paint just sauntered toward extinction, but I firmly believe that it was Disney's decision to fill up the distribution channels with substandard direct-to-video releases that sullied the Disney brand as well as the medium.

Computer-generated features would have been unlikely to create this kind of buzz if Pixar had never existed -- or if Pixar had chosen to color by hand instead of by microchip. Pixar puts out a great product. Period. Delivered on an Etch-a-Sketch, it would still blow the public away.

But now that Disney is in John Derek mode -- by teaming up with smaller studios to replace the computer animation void that will be left behind when Pixar moves out come 2006 -- and DreamWorks Animation is bent on pumping out two new features annually, you're going to see quite a bit of junk being put out. It will be a lot like Jessica Simpson. Breathtakingly gorgeous on the outside. Disappointingly hollow on the inside.

Yes, there will be hits -- some of them huge -- but it will be the misses that will ultimately scare away the public from automatically lining up for new releases based on the format alone. That's significant because the average cost of marketing a movie has nearly tripled to $39 million over the past 10 years. That raises the bar on what it takes to succeed, and it should be even more worrisome if the format is about to suffer from the dilution.

So does DreamWorks Animation's upcoming IPO mean that the niche is about to become overdrawn? If quality gets butchered, how can the format itself not follow it onto the block?

Longtime Fool contributor Rick Munarriz may still buy into DreamWorks Animation if the price is right. He already owns shares in Disney and Pixar. Rick's other stock holdings can be viewed online, as can the Fool's disclosure policy.


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