Wednesday, September 13, 2006

Food for Thought: DreamWorks (NYSE:DWA)

Since DreamWorks Animation (DWA) came public in Oct'04, I have kept my eye on it. I have traded the stock couple of times (mostly being long), currently not holding, but planning to buy.

DreamWorks principally engages in developing and producing computer generated (CG) animated feature films. The co has theatrically released a total of 12 films. Most known, and successful, Shrek 2 and Madagascar were both the highest grossing animated films in the domestic box office in their respective years of release, and Shrek 2 remains the highest grossing animated film of all time in the domestic box office. The movie generated $556m in revs for DWA. DreamWorks is owned and run by entertainment heavyweights, including Steven Spielberg, Jeffrey Katzenberg and David Geffen. Also Jerry Seinfeldt is related, he wrote and stars in upcoming Bee Movie.

Unlike some of its competitors, the co has sustained a release slate of two CG films each year, with current schedule of: Flushed Away, Nov'06; Shrek 3, May'07; Bee Movie, Nov'07; Kung Fu Panda, May'08; Madagascar 2, 4Q08. In addition, the co has a number of projects in development that are expected to fill release schedule in '09 and beyond.

What's keeping shares down? Possible secondary offering by key shareholder Paul Allen, increased competition, inherent volatility of financial results, a lack of business diversification and general negativity among analysts, avg recommendation is Hold, with 14 analyst covering.

Investment thesis:
It seems like all negative is priced into the stock (down 25% since May'06) and expectations for upcoming movies are pretty low. Pixar's most recent movie called Cars was a disappointment at the box office, causing analyst cautiousness on Flushed Away. The Street expects Flushed Away to achieve at least $250-275m in revs at the box office, with some ests as low as $200m.

DreamWorks' mkt cap stands at 2,2bn, the co has $527m in cash as of June 30. The co could use this cash for a large buyback or issue a one time or yearly dividend. According to BofA, DWA could takeout most or all of Paul Allen's equity stake in DWA either through a negotiated transaction or an open mkt purchase. Thus offsetting "Paul Allen fear".

Consensus expects the co to achieve $1.78 EPS in '07. After offsetting debt (118M) and cash (527M), the mkt values co's operations at 1,8bn, or 9.2x '07 earnings. I believe that analysts will revisit their investment thesis before the release of Shrek 3 and will become more positive on the stock, causing a rally ahead release of the movie.

So, my recommendation is to buy the stock at current levels. Would sell the stock around $28 or just before release of Shrek 3.

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