The house rules are simple in this weekly column.

  • I bash a stock that I think is heading lower.
  • I offset the sting by recommending three stocks as portfolio replacements.

Who gets tossed out this week? Come on down, DreamWorks Animation (Nasdaq: DWA).

Grin and bear it
Investors are generally pleased with the animator's latest quarter.

DreamWorks Animation saw its quarterly revenue climb 38% to $218.3 million. Earnings climbed even faster to hit $0.40 a share. This sounds great, but quarterly financials will always be lumpy given the nature of a studio that's at the mercy of theatrical release and DVD windows. Profitability growth is actually slightly down at $0.51 a share through the first two quarters of the year, with revenue climbing a mere 2%.

Looking out to all of 2011, analysts actually see earnings falling by 28% on a small top-line decline.

How good does one quarter seem now?

DreamWorks Animation was the subject of this weekly column last year under similar circumstances. Investors were rallying around the Shrek-maker after a strong single quarter, and the stock closed at $35.41. Nine months later the stock has shed nearly 40% of its value.

I was right then, and I'll probably be right now.

DreamWorks Animation is a simple model to grasp. The studio aims to put out two movies every year. One will be an original flick. The other will be a more reliable sequel to a proven franchise. As long as it can keep three solid character franchises going, it can put out a fresh installment in every series every third year.

There's a problem, though. Its three marquee franchises are falling out of favor. The latest installments in the Shrek, Madagascar, and Kung Fu Panda properties took in less at the domestic box office than their previous releases. Shrek-spinoff Puss in Boots may fare well come November, but it won't come anywhere close to Shrek 2's record-setting take seven years ago. Don't expect lines to snake at the local multiplex when Madagascar 3 hits the silver screen next year.

Are audiences too jaded, or is quality just plain slipping? Even Disney's (NYSE: DIS) Pixar finally proved mortal when Cars 2 hit theaters last month to mixed critic reviews.

The playing field is just too crowded. You don't need to be Pixar or DreamWorks Animation to put out a computer-rendered winner these days. The recent success of Despicable Me and Rio prove it, and now even Viacom's (NYSE: VIA) Paramount Pictures will be launching an in-house animation unit.

The playing field has never been this level. It's also a pity that DVDs aren't selling the way they used to.

Good news
As I do every week, I don't talk down a stock unless I have three alternatives that I believe will outperform the company getting the heave-ho. Let's go over the three fill-ins.

  • Netflix (Nasdaq: NFLX): DreamWorks Animation is reportedly in talks with Netflix for streaming rights. Time Warner's (NYSE: TWX) HBO had a deal with DreamWorks Animation through 2014, but The Hollywood Reporter is hearing that HBO is willing to cut the studio off a couple of years early so it could be on Netflix as early as next year. Why would HBO be so quick to surrender DreamWorks Animation rights to a fierce couch potato competitor unless it feels the value of the content will continue to crumble over time? On the other side of this equation, I may be skeptical about Netflix's plan to dramatically hike rates by splitting its DVD and streaming plans, but I can appreciate a proven disruptor that is now trading at a 12% discount to its recent all-time highs. As digital distributors replace studios as the true power brokers of Hollywood, Netflix will make out just fine.
  • Royal Caribbean (NYSE: RCL): The popular cruise line for young families struck a deal to feature DreamWorks Animation characters on its fleet. "Is that Shrek, honey, or is someone seasick about to hurl?" This may have seemed like a bigger coup for DreamWorks Animation than Royal Caribbean at the time, but it's easy to see which company is growing as we claw our way out of this recession. Analysts see Royal Caribbean's earnings soaring 49% this year, and climbing another 20% next year. Despite the healthy spurts, the stock is selling for less than 10 times next year's projected profitability.
  • KIT Digital (Nasdaq: KITD): The optical disc is dying. Netflix expects 22 million of its 25 million domestic subscribers -- and 23 million of its 26 million global subscribers -- to be paying to stream video content by the end of this quarter. It's time to smoke out companies that will cash in on this revolution, and KIT Digital is a speculative though intriguing wager. The Prague-based company helps content creators manage their digital video assets. Its popularity is undeniable. Last week KIT Digital pre-announced that revenue for its latest quarter will climb 39% sequentially and more than double year-over-year. Profitability is just around the corner, and in the meantime operating EBITDA is flying through the roof.

I'm sorry, DreamWorks Animation. These boots were made for walking.