It's a debate that goes back to the early days of the market: Value or growth? Do you pick through the bargain bin or pay up for glory and shoot for the moon? Do you buy something that's out of favor and demonstrably cheap or do you count on future success to make the current price look cheap in retrospect? Do you want to try to find the next Pixar
What if you didn't have to choose? DreamWorks Animation
How cheap is it?
Let's start with the superficial. Judging by the old price-to-earnings ratio (P/E), DreamWorks Animation -- I'm going to just call it DWA -- looks like an absolute steal. What's this 6.5 about? That's the kind of P/E you see on steel companies such as Tenaris
What's the deal? Well, the deal is that DWA is cyclical, too -- though it cycles not with the economy at large, but with the fate of its films. And there's the rub. Last year's earnings were highly unusual, swelling on the popularity of Shrek 2 and Shark Tale. (Of course, the IPO was timed precisely to take advantage of this bonanza.) What it means now is that the "E" in that P/E is juiced by those unusual results. For next year, the E isn't going to be nearly as big as 2004's $4.05 per share. Earnings may be close to a buck, if they fall in at the low end of the firm's current expectations -- and keep in mind that's a lot less than the $1.90 per share analysts were expecting only a few weeks ago. That puts it at a forward P/E between 24 and 30, which doesn't look nearly so nice.
The Street reacted predictably: the price sank, downgrades followed, and today the class action jackals have begun to nibble the carcass. Those who encouraged us all to buy it at $40 can't stand it at $30.
Why the big dive?
The drop in both DWA earnings and stock price can be traced to one big, boogery problem: Shrek. Shrek2, actually. In a sense, DWA was victimized by its own success. Having knocked the cover off the ball with Shrek2's $900 million worldwide box office success, DWA expected similar results from the retail DVD. Alas, that didn't come to pass. When Q4 numbers were released back in March, the company was touting the "blockbuster" potential of the DVD. But by May's Q1 numbers, the truth was out. Returns from retailers were much higher than expected. As a result, the company barely expects Shrek2 DVDs to meet their costs. That's strike one.
It gets worse. Not only is the Street freaked out because Shrek2 DVDs didn't do the business that was expected, it's also spooked because DWA management seemed to hang on to this information for just a bit too long.
As a result of the soggy Shrek sales, the firm downgraded its previous earnings expectation for 2005 to $1.00-$1.25 per share, with the bulk of that coming in the fourth quarter. Strike two: The Street hates to wait.
Let's move on to strike three, Madagascar. Well, you know how that went. Pretty well, actually, but pretty good -- even against Revenge of the Sith -- doesn't keep the Street happy. So, despite the $61 million Memorial Day weekend opening, the stock was hammered again.
Is it cheap yet?
That, of course, depends on who you ask. Putting a price tag on the business is much more an art than a science. I've seen valuations purporting to be based on discounted cash flows (DCFs), but there are so many assumptions built into them (box office gross, marketing costs, video game fees, etc.) that they may be completely at odds with what actually happens. I'll be honest: I sat down to run my own DCF, but the numbers on the front end are a fantasy. And you know the old saying, "DreamWork in, DreamWork out." Suffice it to say that the DCF and peer P/E valuations I've seen peg the current value of the stock anywhere from $10 a stub on up past $60.
Since 1995, DreamWorks animated films have averaged $260 million in worldwide box office gross, with the computer-graphics versions putting up a more robust $390 million. But keep in mind those averages are completely skewed by Shrek, and in the end, DWA's take from smaller movies often ends up being less than the box office gross. A movie like Shark Tale, which put up about $340 million in box office revenue, has brought in about $200 million in revenues (from all channels) for DWA.
Buying by the gut
This may be one of those situations in which an investor simply has to buy by the gut, or not buy at all. While DWA's movies have done well lately, they certainly haven't matched Pixar's successes. To my mind, the quality of DWA's films -- except Shrek -- is a step down from Pixar's movies, but that doesn't mean the company can't produce. (Hey, if an Adam Sandler prison comedy can make money, anything's possible.) Furthermore, DWA has no trouble signing top talent to its features, which limits the potential for complete bombs, to some extent.
The pipeline looks good, with a Wallace & Gromit movie slated for the fall of 2005, an animated feature with Jim Carrey coming up in the spring of '06, and another with Hugh Jackman and Ian McKellen for that fall. But the next guaranteed blockbuster, Shrek3, won't be up until May 2007. It could be a long time before DWA regains its Hollywood glamour.
Insider dumpathon imminent?
Another situation that could provide some potent downward pressure for the near term is the looming threat of secondary shares. As of May 29, Paul Allen and other major stakeholders can sell about 12.5 million shares, about 12% of the total shares outstanding. That's a significant chunk -- it would increase the float by some 30% -- and it might take weeks to clear the market at usual trading volumes. If those stubs hit the market, expect the price to get even cheaper.
Foolish bottom line
With the strength of its creative team and a history of making some big hits, I've got little doubt that DWA will be worth more in five years than it is now, but how much more is the question. If you're a Rule Breaker type, or a value fan who doesn't mind the occasional walk on the wild side, you may want to start a position here.
But be prepared to see it languish in the red. I'm also pretty confident that the market will give us a better buy-in price than the one we're currently seeing. But absent any concrete way of coming up with some workable numbers, real value hounds would do better to add this to a watch list and wait until people are really scared. At today's prices, DreamWorks Animation looks like a good company at a good price, but I'll be holding out for another discount.
If you like your stocks cheap, take a peek at Motley Fool Inside Value. If you want super growth prospects, turn a few pages of Motley Fool Rule Breakers. Or try them both for free -- with no hassles, if you don't like what you see. (You won't get that deal when you pay up for a stinker at the cinema.)
For related Foolishness:
- Last November, DreamWorks was a good example of the trouble with the next big thing.
- Rick Munarriz thought DreamWorks Animation was too pricey long ago.
- It's not the medium, it's the message. And yes, they are distinct.
- The problem is that success isn't good enough.
- Is DreamWorks causing an about-pace at Pixar?
- Is DreamWorks a Rule Breaker?
Seth Jayson loves DWA movies, but at the time of publication, he had no positions in any firm mentioned here. View his stock holdings and Fool profile here . Pixar is a Motley Fool Stock Advisor recommendation. Fool rules arehere.