Greetings, everyone - here's a writeup of one of my favorite ideas at the moment, Dreamworks Animation (DWA).

The business: animated family movies

Dreamworks Animation (DWA) produces animated family movies in the relatively high-budget, aiming-for-blockbuster category. They were originally the animation division of Dreamworks SKG, which was formed in 1997 by Steven Spielberg, Jeffrey Katzenberg, and David Geffen. DWA is now an independent company, spun off from Dreamworks SKG in 2004, with Katzenberg at the helm. Before Dreamworks, Katzenberg was head of the movie division at Disney from 1984 to 1994.

DWA has in the past produced movies using three types of animation: CGI (computer animated using solid models, ex. Shrek), traditionally drawn (ex. Prince of Egypt), and stop-motion or claymation (i.e. Wallace and Gromit). Currently and going forward they are exclusively producing CGI animated movies.

Does DWA have a moat (durable competitive advantage)?

I believe one of the most reliable ways of checking for a moat is to look back in time and see how competitors have fared over the years. If you see the same names on top year after year, it's a good bet there is some sort of moat operating there. In DWA's field of CGI-animated films, the history available is not that long - I believe the first CGI animated feature film was Toy Story, produced by Pixar in 1995. However, I think it's long enough to be significant, considering that there have been many attempts by other companies to enter the field due to the rich rewards for success. Let's take a look at the all-time top ten CGI-animated films in terms of worldwide box office (note - the source for most of the box office information in this writeup is the excellent website www.boxofficemojo.com):
Shrek 2 (DWA, 2004) $920.7M
Finding Nemo (Pixar, 2003) $864.6M
Ice Age: The Meltdown (Fox, 2006) $651.6M
The Incredibles (Pixar, 2004) $631.4M
Shrek the Third (DWA, 2007) $574.9M - note this is still running in many foreign markets and will probably wind up around $800M
Madagascar (DWA, 2005) $532.7M
Monsters, Inc. (Pixar, 2001) $525.4M
Toy Story 2 (Pixar, 1999) $485.0M
Shrek (DWA, 2001) $484.4M
Cars (Pixar, 2006) $462.0M
In other words, in spite of many well-financed attempts by other major film production companies, only one of the top 10 CGI films of all time has been produced by a company other than Pixar and DWA. So, in order to be successful in this field there is clearly some required combination of management, talent, and distribution that is difficult to duplicate. Another interesting bit of trivia - if we include traditionally drawn animation, there are two films that would crack the top-10 list above: The Lion King and Aladdin. Is it entirely coincidental that both of these were produced at Disney under Katzenberg?

As another check, we can look at the record of DWA's movies in particular. At first glance, it appears a bit mixed. However, I think we have to separate a few things out. As mentioned above, DWA in the past produced several traditionally-drawn and stop-motion movies, and these have had mixed results. This is probably a result of the surprising fact that audiences in general have really fallen for CGI animation and are no longer willing to go to traditionally animated movies regardless of quality; in fact, no one has produced a megahit using traditional animation since The Lion King in 1994 (or, charitably, Tarzan in 1999).

If we look at just the CGI films that DWA has produced, the record is much more consistent. Of the eight such films DWA has produced since 1998, there are two megahits (Shrek 2 and Shrek the Third), two big hits (Madagascar and Shrek), two moderate hits (Shark Tale and Over the Hedge), and two disappointments (Antz and Flushed Away - note even these made over $170M each). Even in the case of the two disappointments, there are some extenuating circumstances - Antz was their first CGI movie, and Flushed Away was made for them by Aardman Studios, a British stop-motion studio with which they are no longer associated. In sum, DWA's record in their current business of CGI movies is remarkably consistent for a field that is so unpredictable in general.

Is DWA Cheap?

DWA is currently trading at a market cap of around $3B, and has around $500M in cash on the balance sheet. Thus the business is valued by the market at around $2.5B. Does DWA have the earnings power to support that value?

At first glance, the answer may appear to be no; DWA had minimal earnings in the past year. This, however, is deceptive. DWA is a classic case of what Buffett calls lumpy earnings - they earn a lot in periods where megahits are released, and much less in periods with box office disappointments. Let's try a few different approaches to estimating how reasonable DWA's valuation is. In the spirit of Buffett's saying that it's better to be roughly right than precisely wrong, these will be back of the envelope rather than 20-year discounted cash flow analyses.

As a first hack, let's smooth DWA's earnings over the past three years (2004-2006). I believe this is reasonably conservative since this period contains one megahit (Shrek 2), one big hit (Madagascar), two moderate hits (Shark Tale and Over the Hedge), and two disappointments (Wallace and Gromit and Flushed Away). The last two were made for DWA by Aardman, which as mentioned above is a British stop-motion studio with which DWA is no longer associated. DWA will now make all its own movies using CGI animation, so based on their CGI track record above I believe the results of their next three years are likely to be better. However, even taking the past three year's earnings, we get a total of around $450M, or around $150M a year - giving a reasonable adjusted price/earnings of 16 or 17.

Coming at it from another angle, we might note that DWA can reasonably expect to come out with a sequel to its megahit Shrek franchise every three years. Judging by the success of Shrek the Third, this franchise seems to be so well established that as long as the sequels meet minimal quality standards they should do $700M-800M in worldwide box office (as I argue below, this number should actually go up over time). Considering the additional high-margin revenue from DVD sales and licensing, I think you could make a reasonable argument that the value of the Shrek franchise alone is not that far from what DWA as a whole is selling for, so you're paying very little for an option on all their other movies and characters.

As one more check, let's look at buyout transactions of comparable companies. Unfortunately there's only one I can think of, the Disney buyout of Pixar in 2006. Disney paid a rather eye-opening $7.4B in stock to acquire Pixar. This discrepancy with DWA's current market cap naturally leads to two questions:
1) Was Disney nuts, i.e. did they wildly overpay for Pixar?
2) Was Pixar worth a lot more than DWA?
These are impossible to answer precisely, but in my opinion the answer to 1) would be that Disney was not nuts, and if there was some overpayment it was mild, not wild. My answer to 2) would be that one could reasonably argue Pixar was worth more than DWA or vice versa, but in any case the difference is not large.

And a few hidden kickers

The previous section argued that DWA's is probably selling at a reasonable valuation. But for me, what promotes DWA from good-company-at-fair-price to trembling-with-greed territory are a few hidden kickers not reflected in the above valuation discussion. These extras are hard to quantify, but I think each is significant and together they give a very nice bump to DWA's ultimate value:

Rapid growth of a middle class in developing countries, both in the BRIC countries and elsewhere. This middle class may still be too poor to afford many SUV's or Mcmansions, but they sure can afford treating the family to a movie. This effect is already quite visible. For example, here are the grosses for the Shrek series in Brazil:
Shrek (6/22/01): $4,565,267; Shrek 2 (6/18/04): $9,457,271; Shrek 3 (6/15/07): $14,325,005 after 17 days
and in Russia:
Shrek (11/2/01): $1,070,302; Shrek 2 (8/19/04): $5,647,027; Shrek 3 (5/17/07): $22,797,727 after 7 weeks

Development of new formats and outlets over time, for example hidef DVD, 3D movie exhibition, TV on cellphones/iPods. DWA can with minimal effort and cost re-release its old movies on these formats. Or, in other words, same sh*t ... mo' money! Also, DWA owns the rights to its characters and so can license them for even newer-fangled outlets that may come along such as new game systems or Web virtual worlds.

Wonderful economics of a successful family movie franchise - this is somewhat related to the previous point. DWA ultimately plans to release two movies a year, one of which will be a sequel in a franchise such as Shrek or Madagascar. These sequels have some delightful properties. For one thing, they allow for re-release of earlier episodes on whatever newfangled home format is current. For another, the typical three year interval between sequels is great for increasing the fan base for family movies: older kids want to see the sequel to see what happens to the characters they loved, and younger kids want to be included in whatever their older siblings are doing.

Deflation in the cost of computer processing over time. This is a major expense for DWA, and the availability of cheaper computing power over time will enable DWA to either increase their animation quality or reduce production costs.

Defensive quality of cheap entertainment: spending on this tends to hold up even in hard economic times. My favorite example is Gone With the Wind. This movie is almost four hours long, and was released at the tail end of the Great Depression (1939) at a time when the U.S. population was less than half the current 300M. Yet it still is the all-time U.S. box office champion in inflation adjusted terms.

World trade rebalancing - if you believe that the current mammoth U.S. trade deficit will explode into a financial catastrophe the likes of which the world had never seen, you can skip this point. If, however, you think trade will over time come back closer toward balancing, it strikes me that this might happen in part by having the big trade surplus countries enable their citizens to spend more on goods produced in the U.S. (as I said above, this effect is already visible to some extent). I think cheap entertainment is a good candidate for some of this spending.