You've made the highest-grossing animated feature of all time, and its sequel is due in six months. You're the largest independent animation studio. You are DreamWorks Animation (NYSE:DWA), yet you find your stock trading essentially where it was when you went public at $28 a share two years ago.

The lackluster share price doesn't mean that DreamWorks Animation has been stagnant. The volatile stock has ridden box-office winners and losers up and down, finally laying to rest a completed secondary offering that was weighing on the company.

That was the scene as CEO Jeffrey Katzenberg and CFO Kris Leslie addressed the Credit Suisse Media & Telecom Week conference last week. Despite the recent theatrical disappointment of Flushed Away, the company's prospects seem headed anywhere but down the drain.

So nice, they made it twice
Sequels are often a dirty word in animation. Disney's (NYSE:DIS) Pixar was initially against making Toy Story 2, and a sorry string of low-budget direct-to-video sequels by Disney sullied the image of sequels more thoroughly than TheGodfather Part III.

However, just as Toy Story 2 and Shrek2 have gone on to top their predecessors, follow-up flicks are once again establishing themselves as logical moneymakers for studios with hit franchises.

The economics of a sequel are interesting. Despite the ability to lean on established characters, they are usually costlier productions than the originals. One key reason is the voice talent. They sign on to do potential sequels when they come on board for the original, but the rates are set higher. So the first entry in a franchise may run about $130 million in up-front costs, but the second movie can be 15% to 30% more expensive. The voice talent also takes a meatier bonus if the film is successful, so what typically runs between 7% and 9% of the worldwide box office gross for an initial film can escalate to between 10% and 14% for the later installments.

"All things being equal," Leslie says, "an original film that generates $200 million at the box office will be more profitable than a sequel that generates the same $200 million at the box office."

However, Leslie qualifies that by saying that all it would take would be about $25 million more in domestic ticket sales to begin tipping the odds in the sequel's favor.

That's important. Sequels are good candidates to be top draws.

"If 2006 is any indication," Leslie notes, "five of the top six films released so far were from known properties."

Indeed. Pirates, James Bond, X-Men, and Ice Age were all sequels and The Da Vinci Code was based on a global best-seller. That leaves Pixar's Cars as the lone standout, and that, too, may be a strong selling point when it comes to the power of high-quality computer-assisted animation.

Sequels come with built-in character appreciation, but they also help renew interest in the franchise. In 2004, Shrek2 hit the big screen, and DreamWorks Animation moved 9.5 million home video copies of the original. Until then, the studio was selling around 5 million units of Shrek a year.

Other opportunities come up when you've got a productive franchise. Disney's ABC, despite being the parent of Pixar, has agreed to air the Shrekthe Halls holiday special for the next 15 years. There is also Shrekthe Musical in development talks, which may take to the stage as early as 2008.

The DWA buddy system
With sequels in its pipeline, DreamWorks is planning to hit audiences with both an original production and a sequel in 2007 and 2008. Next year, it will be Shrekthe Third in May, followed by Jerry Seinfeld's Bee Movie in the fall. In 2008, DreamWorks will have Kung Fu Panda, with voices from Jack Black and Jackie Chan, in June, and then come back with Madagascar2 in the fall.

That isn't all that's kicking around in the company's hopper. The company is working on two new animated shows for Viacom's (NYSE:VIA) Nickelodeon. One will be based on the popular and conniving penguins from Madagascar, while the other will be the launch vehicle for Kung Fu Panda. DreamWorks Animation doesn't stand to gain much materially from either show, it seems, but the ongoing visibility should help give both of the studio's 2008 releases favorable momentum leading into opening night.

It's the right approach. The environment was cutthroat in 2006. Katzenberg expects that there will be only about half as many animated full-length features in 2007 as the 18 that crept into your local multiplex this year. However, Katzenberg feels that the real reason why animation fatigue set in and Flushed Away was such a dud was that the "volume of the product" wasn't as problematic as the "sameness of the product." That similarity kept audiences away from most entries in 2006, save for Cars, Ice Age 2: The Meltdown, and DreamWorks' own Over the Hedge.

A stronger DreamWorks
DreamWorks Animation isn't looking to follow Pixar's path into acquisitive arms. Katzenberg is happy in his place as the stand-alone class in high-end animation.

"I think we feel the greatest opportunity for shareholders right now is in the configuration that we are in," Katzenberg says.

The independence has only helped it. DreamWorks Animation was able to ink a Happy Meal deal with McDonald's (NYSE:MCD) and it has ongoing technological partnerships with Hewlett-Packard (NYSE:HPQ) and AMD (NYSE:AMD) to help it save on outlays of capital for hardware.

On its own, DreamWorks Animation can also chart its own future in digital distribution. Unlike many of his peers, Katzenberg isn't jumping into the fray headfirst. He recognized digital delivery as the future, but not the near future. He points to Apple (NASDAQ:AAPL) and its impact on the music industry.

"We now have 70 million iPods, 250 million music cell phones, and I don't know what the MP3 players are," Katzenberg points out. "It's tremendous penetration into the marketplace but what percentage of music today is hard goods versus digital?"

84% is his response, for a medium that has been in digital mode since the late 1990s.

Sure, I can counter that he isn't accounting for this in terms of unit sales, with the singles-driven digital music field holding up well against the full-length nature of the CD market, but what's the point? Katzenberg is a proven winner. He was the architect behind Disney's animation revival two decades ago, and he's doing pretty well now, backed by an army of ogres, zoo animals, and a panda with a martial arts kick.

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Longtime Fool contributor Rick Munarriz loves the art of animated filmmaking. Yes, he owns shares of Disney. He is also part of the Rule Breakers newsletter research team, seeking out tomorrow's ultimate growth stocks a day early. The Fool has a disclosure policy.