Why I Like DreamWorks (DWA) More Than Disney (DIS)

by Geoff Gannon

Quan here.

Someone who reads the blog sent me this email:

Why would you buy DWA over Disney? Disney has an infinitely larger collection of animated assets if that space becomes profitable plus it has the media networks, and parks and resorts. At a 16 P/E? With control over media networks and the content, Disney has a greater ability to control and profit off of their animated content. Don't you think your favorite stock idea should be independent from the distribution channels of another company? Seems like that's a bit of a vulnerability there?

This is a great question!


Are Disney and DreamWorks Comparable?

A quick look at Disney’s 2011 10K - shows that Disney makes most of its money from media networks and theme parks. About 70% of Disney’s operating earnings were from media networks, and 17.6% was from parks and resorts. That means Disney made 87.6% of their earnings in the areas that DreamWorks is not involved in.

Disney’s financial results over the last 10 years were not really impressive. Free cash flow margin has been 4% to 11% with a lot of single digits in the last 10 years. What is holding that down?

Within the media network segment, the cable networks (ESPN, Disney Channel, A&E, etc.) have an operating margin of 40% while broadcasting (ABC) has an operating margin is only 13%. I doubt that Disney can make much money from retail stores. And the interactive media segment consistently burns cash.

So, Disney is much more diversified (or diworsified) than DreamWorks. That leads to the question: which organization do I prefer?


DreamWorks Resembles Disney in its Heyday More Than Disney Today

Disney has so many different assets. People in each segment don’t deal with the CEO of the whole company. They know only their department head. And the culture of each segment is different from each other. People at Pixar are more artistic and take their time with big projects. People at Disney Channel care more about making the right shows on time. And people at the other cable networks buy television shows to fill the networks’ schedule. How do these people see each other?

You may argue that the segments are independent of each other. But subsidiary heads compete with each other for Bob Iger’s attention and resources. And isn’t there sometimes a conflict of long-term interests between different subsidiaries. What if Pixar, facing the declining home video sales, wants to make a deal with Netflix? Isn’t that against Hulu, which is partially owned by ABC? How would Bob Iger reconcile them? Doesn’t this became a corporate level decision even though the deciding issue should be maximizing the long-term value of Pixar’s content? Should Pixar do what is best for Pixar? And ABC do what is best for ABC? Or should Disney try to balance what is best for all of them? Is this kind of synergy really an advantage? Or just a complication?

Then comes another question. Would Pixar be better off as an independent company? I suspect the answer is yes. Although Pixar remains a separate entity, isn’t it better if John Lasseter doesn’t have to report to someone else? What if Disney’s CEO pushes Pixar to produce more movies? And John Lasseter may not, but would someone who succeeds him worry about job security that would hurt their creativity?

On the contrary, DreamWorks is much more focused. DreamWorks has only a few projects at a time. Katzenberg works closely with producers to make sure that the projects run within budget and balance artistic creativity with financial discipline. The distance between employees and top management almost doesn’t exist. Have you ever heard of a CEO calling a writer to let him know the opening week box office result? Katzenberg has done that. The distance between the roles of movie producer, studio head, and CEO is long at most big media companies. At DreamWorks, it is very short.

Disney has had periods of strong value creation and periods of stagnation. Most of Disney’s franchises were created during a few bursts of value creating activity: when Walt Disney was running the animation studio, when Walt Desney was designing the theme parks, and then later when Katzenberg was running the movie studio. After Katzenberg along with a lot of artists left the company, Disney depended on Pixar for new franchises.

So, DreamWorks is more focused and more resembles Disney in its prime than Disney today.

There's a reason why Warren Buffett likes focused companies. This is what he said in his 1996 letter to shareholders:

Loss of focus is what most worries Charlie and me when we contemplate investing in businesses that in general look outstanding.  All too often, we've seen value stagnate in the presence of hubris or of boredom that caused the attention of managers to wander.


DreamWorks Has Better Growth Potential Than Disney

I’m not sure I agree with you that Disney has an infintely larger collection of valuable animated assets. Most of those assets are hand drawn. Kids today are in the habit of watching CG animation. In the days before the acquisition of Pixar, almost all of Disney’s successful new characters from the last decade or so – the characters they license, put in theme parks, etc. – had all been introduced in Pixar movies. Not Disney movies.

It would be a great idea to remake some of Disney’s classic franchises in CG. In some ways, although it is an original movie, Tangled was a move in that direction. It was a CG movie that fit the Disney formula not the Pixar formula.

But I’m not sure Disney’s animated assets in their current state are more valuable than DreamWorks’s, except in so far as they own Pixar. That is a very valuable (modern) brand.

Which company's past growth is more repeatable in the future? In other words, which company has the formula to repeat its success? Both of them have the same formula. They have the capabilities to build new characters and to tell beautiful stories. They can leverage their core capabilities to produce television series. They can also use their capabilities to create an imaginative experience in theme parks.

Disney did all that. DreamWorks has not. That means DreamWorks has more potential. Disney can repeat the formula by creating a new character. But it’s so big now that each new franchise doesn’t create much value as a percentage of total company’s value. And most of the company’s value is in theme parks.


High Quality Content Matters More Than Distribution

I hate the idea that DreamWorks distribute movies themselves. The fixed cost is so high that they would like to distribute movies for other studios. But their capability is to produce big movies. They might be good at marketing their own movies. But there aren’t enough $150 million family movies opening at 4,000 theaters for them to distribute. And there are too many risks and distractions with distributing other kind of movies. I totally don’t want them to distribute something like War Horse or I am Number Four. Those are the kinds of movies Disney distributes for the (now) unrelated DreamWorks live action studio.

I think content matters more than distribution. I think the disagreement between DreamWorks and Paramount is more because DreamWorks wants a lower fee. And Paramount’s announcement to start an animated studio was just a desperate act. Paramount would have to lose their mind to refuse to distribute DreamWorks’s movies. They made a good return on distributing those movies. I don’t think DreamWorks’ great movies couldn’t find a way to the market.

Remember, Disney didn’t distribute its own animated movies for the first few decades. It wasn’t until they started Buena Vista in the 1950s, that Disney was both a consistent producer and distributor of its own movies.

And Pixar was once an independent studio like DreamWorks is today. Pixar was totally dependent on Disney for distribution. Yet, Disney bought Pixar by selling part of itself (through issuing shares). Disney felt they needed Pixar, not the other way around. Viacom (VIAB) might be interested in buying DreamWorks someday. There would be a great synergy between Nickelodeon and DreamWorks.

Personally, I think DreamWorks will be better off standing alone.

Talk to Quan about Why He Likes DreamWorks (DWA) More Than Disney (DIS)