In the last post, I listed the order of 15 stocks from the one I love the most to the least, along with a brief description of those companies. I’ll start talking more in details and explain why I like one more than another.
DreamWorks Animation (DWA)
DreamWorks produces animated movies. DreamWorks is similar to an insurance company. An insurance company’s underwriting supports its investment portfolio. If they break even on underwriting, they can turn a profit on their investment portfolio. Likewise, DreamWorks doesn't have to make money within the first few years of a movie’s release to break even. Part of a studio’s business is building a library. They invest in producing new movies, and grow revenue from their library. Hopefully on average they won’t lose money on new releases. And some movies will become a franchise, which in Warren Buffett’s words is like “having an oil well where all the oil seeps back in.”
DreamWorks’s Competitive Position is Stronger Than People Think
The budget for each movie is around $150 million. On top of that is another $150 million marketing expense. Those are big event movies. And studios usually announce their release schedule in advance. It’s hard to believe anyone spending 4-5 years and investing $300 million in producing and marketing a movie will compete directly with DWA by opening a big family movie the same weekend DreamWorks does.
Moreover, DreamWorks has an experience advantage in producing animated movies. The only studio that can match DreamWorks’s graphic quality is Pixar. And their production cost has been going down, while graphic quality going up. Some studios producing low cost movies will never get experience in producing high quality pictures. The quality gap will be widened. And the cost gap will be narrowed.
New Release Dominance Protects the Post-Theatrical Position
The new releases market is limited. DreamWorks and Pixar-type movies are big event animated movies. It’s hard for me to think there can be more than 6 successful animated movies a year. DreamWorks is producing 5 movies every two years. Their goal is to produce 3 movies every year. And Pixar will start producing 2 movies each year.
DreamWorks and Pixar have a higher chance to produce hits than other studios. And they produce more animated movies than anybody else. That means they’ll continue to dominate the new-releases market. And new release market dominance protects their after-theatre market position.
There are many low-cost animated movies lately. I hate those movies. Those movies can make animated movies less special. They can be a threat to DreamWorks. But those movies are more hit-or-miss. Hopefully other studios will be less enthusiastic with animation after seeing a lot of failures.
I like the organization. DreamWorks is the largest animation studio in the world. They are among the top places to work for. And they are hiring more animators. They have the best executive in Hollywood. Jefferey Katzenberg is famous for being hardworking. He has created an organization that values creativity, where every employee has the chance to pitch their ideas for new movies. Meanwhile he maintains financial discipline. And his compensation is tied to long-term average ROE.
Capital allocation is good. The management avoids using debt because of the inherent riskiness in the business. And they repurchased shares when they thought DWA’s financial position was strong.
Margin of Safety
I believe DreamWorks will be more profitable in the future.
Their movies are getting more consistent. The international market is growing. And DreamWorks depends on current releases (which I define as movies released in the last 2 years) much less than it did in the past.
People worry about declining DVD sales. True. The economics of their product may decline in the future. But DreamWorks didn’t have the library it has today just 5 years ago. Five years ago, they got little revenue from movies older than 2 years. And little revenue from the home entertainment market in developing countries like China, Russia, etc. Decent profitable streaming revenue of the bigger library in the US and the bigger international market in the future can replace the higher profitable DVD sales of a smaller library in the past.
Growth without Capital
The reason I like DreamWorks most is they can grow without capital. I don’t think they should produce more than 3 movies a year. That means they need a fixed amount of investment in new movies. That investment will grow their library. A bigger library generates more revenue. Assuming that they don’t invest in opportunities to further exploit their library, which I think is highly profitable, they will be able to return cash to shareholder while still maintaining the capacity to produce 3 movies a year. That is the ability to grow without capital.
As mentioned in the previous post, EBIX experienced astonishing growth in the last 10 years. EBIX has a CEO who is a Warren Buffett follower. He provides no guidance, and doesn’t care about promoting the stock. He owns roughly 11% of the company. He has rarely sold his shares except for his charitable fund. He knew the competitive advantage in the business and kept exploiting it. He made a lot of acquisitions, mostly without using financial advisors.
Network Effects and Cross-Selling Are Good Reasons For Making Acquisitions
Ebix (EBIX) provides electronic communication services between entities in the insurance industry. One example is by using Ebix’s data exchange, a broker can input data once and get quotes from every insurer using Ebix’s platform. The CEO is like a hedgehog. He knows one big thing. He talked many times about the network effect and cross-selling in this business. And he grows the company by making numerous acquisitions, integrating sales group and new features into Ebix’s products, and cross-sell new services to customers.
I’m wary of companies making a lot of acquisitions. But 10-year average ROE is 28%. Similarly, 5-year average ROE is 31%. As I include goodwill and intangibles in equity, and Ebix didn’t use a lot of debt in the past, high ROE proves the merit of their acquisitions.
They issued new shares for capital requirements. But earnings per share grew 55.1% annually from 2002 to 2011, and 53.5% annually from 2006 to 2011. That means share dilution still created economic value.
But… High Auditor Turnover
This is not a perfect story. A blemish is the high auditor turnover. Ebix had internal control deficiencies in the past. But Ebix didn’t change auditors since 2008. I think the past deficiencies in internal control were not intentional. It makes no sense to me that would happen when the CEO has most of his net worth in the company.
The reason I prefer DreamWorks to Ebix is I don’t know whether they can continue to make good acquisitions for growth in the future, although Ebix’s market potential is huge. But I totally trust the CEO.
I wrote an article about Nutrisystem (NTRI) not long ago. My opinion has not changed since then. Actually since March 2011. There are two reasons I don’t like NTRI as much as DWA and Ebix.
First, I don’t understand NTRI’s management as much as DWA’s. But I think NTRI’s capital allocation is fine.
Second is NTRI’s product economics. Although the product provides great value, it’s a big ticket item.
There’s a big hurdle for customers to commit to paying $250 (or normally $350) monthly. And customers will stop using the product once they get their weight target. It’s not like Weight Watcher (WTW)’s meetings for which people pay a small amount of money to try and then go as regularly as going to church.
But NTRI was able to get a lot of customers in the past. I didn’t see the brand image deteriorate. And the weight-loss market is huge. NTRI’s flexible cost structure allows it to survive weak macroeconomic condition. I believe NTRI will give patient investors a handsome return.
To be continued…