Despite Q2 Losses, DreamWorks Sees Bright Future

Remy Merritt |

Dreamworks, Dreamworks SEC investigation, dreamworks turbo, how to train your dragon

DreamWorks Animation SKG Inc. (DWA) reported disappointing losses in its second quarter earnings report, resulting in an immediate 13% drop in share value from the previous day’s close of $22.66. Share price has stagnated around $19.80, representing a year-to-date plunge of 44%.

Analysts had been expecting a loss of $0.02 per share, but the report announced a net quarter loss of $15.4 million, placing shareholder’s losses 9 times higher at $0.18 per share. While the data appear significantly disappointing when compared to DreamWorks’ 2Q13 report in which it earned an income of $22.3 million and gains of $0.26 per share, it is important to note that the animation company fared far better this quarter than it did last quarter.

Write-Downs, SEC Investigations and Wage-Fixing Exposure

2014 got off to a rocky start, and at the end of March DreamWorks reported first quarter losses of $42.9 million. Those losses were largely attributed to the $57 million write-down of “Mr. Peabody & Sherman,” but DreamWorks execs promised a turnaround with the June 13 release of “How to Train Your Dragon 2.” However, the film did not live up to its hype and underperformed in its opening weekend. Investors who had held on to their shares in the hopes of an improvement quickly dropped out, and DreamWorks emerged from its highly anticipated opening weekend with a loss of 11% in stock value. Since then, its stock has continued to lose energy and is currently plateauing around the $20 mark.

To add insult to injury, the SEC is not buying DreamWorks most recent write-down of $13.5 million on yet another underperforming feature film, “Turbo.” DreamWorks is cooperating with authorities, but declined to share any more information on the investigation.

It is common practice in the film industry to report write-downs larger than what was actually lost on a box office release. Studios report an underperforming film as having been overinflated in value, using cash flow records and inventory to demonstrate that the film’s fair value was below unamortized film costs. However, cash outflow can be and is often exaggerated, and DreamWorks’ write-down for “Turbo” has drawn unanticipated legal attention to the studio. This is DreamWorks’ third write-down in only 17 months representing a loss of $157.5 million.

Analysts expect third quarter earnings will be driven by international distributions of its feature films, primarily “How to Train Your Dragon 2”. And their projections are not unsubstantiated. In 2011, “Kung Fu Panda 2” was expected to underperform based on low domestic box office sales. Largely in part to growing international interest in 3D (which alone contributed 53% of Kung Fu Panda 2’s worldwide gross, even without the benefit of IMAX (IMAX) ), foreign distributions boosted the film’s total revenue from $165 million to $665 million.

However positive its future prospects may be, confidence is certainly hampered by recently exposed holes in DreamWorks’ fabric. While it cooperates with the SEC’s investigation of the “Turbo” write-down, the animation corporation is involved in another much more convoluted story unfolding in Silicon Valley.

An inquiry into a potential wage-fixing cartel involving Apple (AAPL) , Google (GOOG) and five production studios, also known as “Techtopus,” has been ongoing since 2010. While the case previously focused on the behavior of executives at Apple and Google — namely, Steve Jobs — Hollywood has since been pulled into the mix over a no-poaching deal between Pixar and DreamWorks. Internal emails have revealed past conversations between DreamWorks CEO Jeffrey Katzenberg and Pixar’s president and co-founder Ed Catmull, in which they agreed to refrain from capturing each other’s employee talent with higher wages. The result was artificially and systematically suppressed wages, which has since sent employees to seek legal retribution.

DreamWorks Diversifies, Gets Animated over Original Online Content

While DreamWorks is slipping in the feature film department, Katzenberg is using 2014 as an investment year and staking claims in the online streaming market. In May 2013, DreamWorks acquired AwesomenessTV to the tune of $33 million and an additional $84 million in earn-out fees. This marked a clear initiative to capture the online market: AwesomenessTV is a multi-channel YouTube network, and as of May 2013 had more than 55,000 channels and 14 million subscribers. In April 2014, AwesomenessTV dropped $15 million on Big Frame, a boutique YouTube network with more than 39 million subscribers. Together, Big Frame and AwesomenessTV will reach nearly one billion views per month.

DreamWorks’ Q2 earnings report revealed that it does not yet have a segment designated specifically for online content, but this is likely to change in the near future. AwesomenessTV was the primary contributor to a $2.3 million profit from miscellaneous DreamWorks holdings, and in June, the animation company launched its DreamWorksTV channel on YouTube, which targets the same child and teen demographic as its feature films.

The channel’s short videos feature DreamWorks trademark characters like Shrek and Puss in Boots, as well as a new production project called “I Pranked My Parents” in which kids take on the ever-popular theme of “Punk’d.” The channel also features RecordSetter Kids hosted by young vlogger Jennxpenn, a series reminiscent of Nickelodeon shorts. Given recent shortfalls at the box office, Katzenberg is looking for new avenues of production while moving away from dependence on three-month theater runs of feature films and post-release earnings through on-demand airing and streaming availability.

This effort to boost Internet presence follows multiple production companies’ moves to online streaming, including Disney’s (DIS) $500 million buyout of Maker Studios. Disney also owns Pixar and Lucasfilm, the two animation studios widely considered to be DreamWorks’ primary competition.

Despite its alleged history of no-poaching deals, DreamWorks has acquired Disney’s talent and is pushing back against the entertainment colossus. Just one day before it released its most recent quarterly earnings, DreamWorks announced the appointment of new COO Mark Zoradi, a former Disney executive who directed Walt Disney Home Entertainment and the Disney Channel. Zoradi boasts 30 years of experience in the motion picture industry and will be instrumental in DreamWorks’ transition away from box office volatility and into television. The animation company has committed to producing more than 1100 episodes of original programming while maintaining television deals with Netflix (NFLX) and Cartoon Network.

It remains to be seen how rapidly DreamWorks will be able to adapt to the original content market. Disney has already staked a major claim in the sector, and a DreamWorks turnaround appears to hinge on international box office results paired with a restructuring of its internal business model. While foreign response to its upcoming films is uncertain, DreamWorks is making an active effort to breathe new life into its slipping animation brand.

DISCLOSURE: The views and opinions expressed in this article are those of the authors, and do not represent the views of equities.com. Readers should not consider statements made by the author as formal recommendations and should consult their financial advisor before making any investment decisions. To read our full disclosure, please go to: http://www.equities.com/disclaimer

Companies

Symbol Name Price Change % Volume
DWA Dreamworks Animation SKG Inc. n/a n/a n/a 0
DIS Walt Disney Company (The) 104.86 1.48 1.43 12,173,909
NFLX Netflix Inc. 122.88 -0.36 -0.29 4,700,783
BSD.UN:CX2 Brookfield Soundvest Split Trust n/a n/a n/a n/a

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