Why Change is Not as Bad For DreamWorks (DWA) as People Think

by Geoff Gannon


Quan here.

Someone who reads the blog sent me this email:

I've looked at DWA at various stages. I still can't get past 2 concerns:

(1) How will the migration from cable/DVD to online streaming impact DWA's revenue? As we've seen in the music industry, a shift in distribution mechanism changes the power structure. The shift from CD to iTune has allowed Apple to capture more value in the value chain. (This value is not limited to pure monetary. It also includes the valuable customer relationship.) 

(2) How will the unstoppable pirating hurt DWA's revenue in the future?

Good Investing,
John

In the post theatrical market, DreamWorks (DWA) makes money from pay TV, DVDs, and free TV. Investors see changes in distribution mechanism and declining in DVD sales, and they conclude movie economics is getting worse. While that may be true for general movie business, I don’t think it’s as bad for DreamWorks as people think.

 

Competition in the Pay TV Window = High Prices Paid to Content Owners

DreamWorks is already the beneficiary of changes in the distribution mechanism. Netflix (NFLX) made a deal to pay DreamWorks $30 million for each movie DreamWorks makes starting in 2013. Analysts estimate that HBO used to pay DreamWorks $20 million per movie.  So HBO’s replacement, Netflix, is paying more per DreamWorks movie.

If you look at Note 8 in DWA’s 2011 10-K, or 2011 third quarter 10-Q, you’ll see that HBO paid an advance to DreamWorks of $13.3 million per movie before 2011 and then increased it to $15 million per movie in 2011.

DreamWorks will get about 50% more revenue per movie from Netflix than what they made from HBO. And DreamWorks will produce 25% more movies per year since they increased production from 2 movies per year in the years where HBO had the pay TV window to 5 movies every two years now when Netflix will have the pay TV window. So that’s an 87.5% overall increase in revenue from that window each year. Netflix will pay for each movie DreamWorks makes. And DreamWorks will release an average of 2.5 movies a year. So that works out to an average payment of $75 million a year from Netflix starting in 2013.

 

DreamWorks is In a Transitional Period – Had an ROE of Just 6% in 2011

DreamWorks only earned a 6% return on equity last year. There are several reasons for this.

One is the mix of DreamWorks’s 2011 revenue. DreamWorks released two movies in 2011. Both were considered “sequels” by American audiences. And American audiences – unlike moviegoers in much of the rest of the world – are a little less eager to go see a sequel and a lot less eager to buy a DVD to a sequel.

The two movies DreamWorks released in 2011 were Kung Fu Panda 2 and Puss in Boots. Both scored well with critics and audiences in terms of approval. These were good, solid movies. And both were global successes that will make enough money to make both Paramount (the distributor) and DreamWorks (the producer) back all the money they put into them. DreamWorks will also earn a profit on each movie. This is more than many movie studios can say about many of the movies they release.

However, Kung Fu Panda 2 and Puss in Boots were much bigger movies overseas than in the U.S. Kung Fu Panda 2 made $165 million in U.S. box office and $500 million in foreign box office (for obvious reasons, it was a blockbuster in China). It didn’t help that Kung Fu Panda 2 opened again The Hangover 2 in the U.S. – but not anywhere else in the world. Puss in Boots (which is an original movie but is based on a character first appearing in Shrek 2) made $149 million in U.S. box office and $405 million in foreign box office. It was not released in China. Outside China, Puss in Boots and Kung Fu Panda 2 did about equally well.

DreamWorks movies do well overseas. But these two had especially wide differences between U.S. and foreign box office. And since U.S. box office is a good predictor of U.S. DVD sales – and America accounts for a much larger share of global DVD sales than global box office – DreamWorks had less new release DVD revenue than might be expected in a year where their movies have a more “normal” mix between domestic and foreign theater attendance.

But, obviously, there are big industry tends as well. Here is how Katzenberg summed up the year:

At the same time, 2011 revealed some challenges for the broader industry, in particular the declining home video market. While animation titles remain at the top of the charts, domestic box office-to-DVD conversion ratios throughout the industry continued to weaken. And, internationally, box office success has not translated as well into home video sales, since many emerging territories still lack mature post-theatrical markets. Consequently, the profitability of our films was adversely affected. As has occurred in the past, the film business is experiencing a period of transition. This time, the home entertainment market is increasingly moving toward online delivery. Our landmark agreement with Netflix is evidence of this transition. Starting with our new releases in 2013, Netflix will be the exclusive subscription television service for our feature films, as well as a number of our television properties before then. This is part of the evolving market for digital content, which is generating value beyond the traditional theatrical and home entertainment windows—a positive development for high quality, branded content like DreamWorks Animation’s.

DreamWorks is in a transitional period. I don’t know exactly what the future economics of movies will look like. It’s too hard to predict. But I think even if future product economics is not as good as in the past, DreamWorks still has a favorable future.

Why?

 

Broader Market and Bigger Library

First, past financial results at DreamWorks did not fully reflect the industry’s past favorable product economics. Companies like Disney (DIS) had big libraries in the good years for home video. DreamWorks never did. Home video revenue was a huge blessing for new releases like Shrek. But DreamWorks had not yet built a strong library.

They have one now.

DreamWorks made little money from their library 5 years ago. And as they added more valuable titles to the library, DVD sales declined. DreamWorks’s library would have made a lot more money in late 1990s and early 2000s. Shrek was only released in 2001. And DreamWorks had much less consistent movie quality – Shark Tale, Bee Movie, Over the Hedge, etc. – in the early 2000s than it did in recent years. In recent years, the company has released original movies like:

  • Kung Fu Panda
  • Monsters vs. Aliens
  • How to Train Your Dragon
  • Megamind
  • Puss in Boots

Most studios would be very happy with the audience reception, critical reception, and financial results of a string of original releases like that.

Those movies are now part of DreamWorks’s library. That’s why library and other non-new release revenue has been rising as a percent of DreamWorks total revenue over the last few years.

So, the earning power of DreamWorks will not decline nearly as much as the magnitude of the decline in DVD sales of new releases. Revenue per movie can decline a lot without causing total revenue at DreamWorks to decline. They simply have more library titles, more TV series, more characters to license, more ongoing franchises, etc. than they did years ago. They are also producing one extra movie every 2 years (2.5 movies a year) and are being paid more by Netflix per movie than they were paid by HBO.

Second, the home market will be much broader in the future. It just won’t be on discs. Even today, DVDs sales are mostly from the U.S. and other developed markets. It’s true that there is rampant piracy in much of the world. What is overlooked is that a lot of that piracy is in places where studios like DreamWorks never had much post theatrical revenue at all. The DVD market barely exists in developing countries. People in Vietnam can buy a DVD for 50 cents. But that’s pirated. I suspect the same thing happens in China and other developing countries. I don’t expect DVD markets will ever develop in those countries. People in those countries will jump directly to digital streaming much like the way they bypassed landline telephones and went straight to cell phones.

Then comes the piracy issue. A lot of piracy is actually economically irrelevant for DreamWorks. Piracy is mainly in developing markets. And DreamWorks’s revenue in those countries is limited to theaters. So, piracy that cuts into theater revenue is very bad. Piracy that simply provides DVDs to people who would never go to the theater – is not something DreamWorks wants to see, but it’s hardly a source of lost revenue for them.

Let’s consider how bad piracy can get.

Do we expect parents in the US, UK, France, etc. will download pirated movies for their children to watch? DreamWorks movies are rarely rented. They are usually bought. Often by parents for their kids. And in 50% of those cases, the family first saw the movie in theaters and now owns the DVD so the kids can watch the movie at home over and over again. Pirating movies for your children to watch doesn’t seem like a huge risk in countries like the United States – especially considering an $8 a month subscription to Netflix will get your kids access to these same movies (legally) starting in 2013.

And despite the piracy in Russia and China, DreamWorks has been growing theatrical revenue in these markets like crazy. The numbers for DreamWorks movies in Russia and China today versus three or four years ago are mind blowing. They have been growing so fast that new box office records were constantly being made with each release.

In contrast to your concern, I think that as after-theatrical markets (streaming, not DVD) in these countries develop; people will be willing to buy if the price is affordable.  These are family movies. People will pay for convenience at an affordable price.

As evidence of the lack of piracy concerns at DreamWorks, it is worth mentioning that DWA does not usually go “day and date” on its releases the way some studios do. DreamWorks prefers to time its releases with local school holidays so families in Asia, Europe, South America, etc. can go to theaters when it makes cultural sense for them – not when Americans are off from school.

However, where piracy is a major concern for cutting into theatrical revenue – like in Russia – DreamWorks is willing to release a movie faster so people don’t just watch the pirated version on the internet instead of going to theaters.

So, with a broader market and bigger library, I think DreamWorks’ future prospects are more favorable than their past results even if movie industry economics decline.

 

Future Product Economics are Not as Bad as People Think

New distribution mechanism will tend to shift value to content owners. Studios initially saw TV as a threat but then they made a lot of movie from TV. The major broadcast networks had to bid against each other for the best movie studio content. Networks hadn’t paid much for sporting events but then Fox came and bid up the price to the point that networks make little money from those events. Now, Netflix started bidding for DreamWorks’ movies. I think digital distribution will reduce delivery cost and increase competition. That’s good for DreamWorks.

The music industry is different. In the past, if people wanted some songs, they had to buy a whole album. Then digital distribution allowed them to pay only for songs they like. I don’t see that problem with movies. It’s worth mentioning that a DreamWorks movie – unlike a song – is almost always experienced for the first time in a specially designed venue and is 20 times longer than your average song.

Part of the music business’s problem was that people loved individual hit songs. They did not love albums. Part of the appeal of piracy was not just the possibility of saving money – it was the possibility of getting the content in a digital, single only form delivered directly to your home.

I don’t know what the distribution of movies will look like in the future. But 60 years ago, when TV burst onto the scene – no one knew what the distribution of movies would look like then either.

In fact, movies have gone through three very different periods of distribution:

  • Theater only era
  • Theater and TV era
  • Theater, TV, and home video era

Home video was actually a very late addition to the distribution options for movies. And studios were afraid of it at first. It ended up being a huge source of profits.

Now investors are afraid home video revenue is going away. They feared it when it came. And they feared it when it left. 

I can't predict the future. I don't know exactly how DreamWorks will get paid for content and where that content will be consumed in each window. 

What I do know is that if DreamWorks has great content somebody will pay them for it.

Talk to Quan about DreamWorks (DWA)