CUT! DreamWorks' script needs rewrite, say investors

The house of Shrek is a shambles.

After going public to much fanfare 10 years ago, Jeffrey Katzenberg's DreamWorks Animation has become one of the biggest disappointments on Wall Street. And recently, the signs have only gotten worse.

Shrek and Jeffrey Katzenberg attend a DreamWorks event
James Devaney | WireImage | Getty Images
Shrek and Jeffrey Katzenberg attend a DreamWorks event

In the last few months, Japan's Softbank and toymaker Hasbro each reportedly looked at buying the computer-animation studio and quickly turned away. All but one of 12 Wall Street analysts who cover DreamWorks—who are known for keeping positive views—have abandoned positive ratings on the stock. Adding to the frustration, the company's last film of the year—"Penguins of Madagascar"—fell short of expectations when it opened last weekend.

That has translated into pain for investors: Following a number of failed rallies, the stock now trades at $21.75—about 22 percent lower than an IPO price of $28 in 2004. Softbank didn't respond to requests for comment on this article while DreamWorks and Hasbro declined to comment.

How did DreamWorks lose its mojo? The studio got into the computer-animation game early and captivated audiences with a series of four "Shrek" films between 2001 and 2010. All of those films were blockbusters, delivering more than $200 million in domestic box office sales each—sufficient to earn profits even with monster-sized budgets.

Unfortunately, even the best film franchises don't last forever and DreamWorks hasn't been able to find a replacement. Not one of the studio's films has topped the domestic box office gross of $239 million attained by "Shrek Forever After" in 2010, according to industry research firm Rentrak.

At the same time, the studio has maintained heavy fixed costs that have made it difficult to earn much money. Studio accounting can be complicated, but one simple gauge of profitability is telling: Free cash flow at DreamWorks has been negative since 2011 and analysts expect another $86 million decline in 2015, according to FactSet.

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One reason the animated film industry has become so tough is that there are simply more movies being produced. In 2005, just six animated features were distributed nationwide in the U.S., two of which were DreamWorks movies, according to Rentrak. In 2014, there were 11 films, of which three came from DreamWorks.

Perhaps surprisingly, a movie has to be a serious blockbuster to make much money. "Mr. Peabody And Sherman" generated a respectable $112 million in domestic box office in 2014, ranking it the fifth most successful animated film this year. But the company made a $57 million impairment charge related to the movie, which now has an estimated fair value below its production costs.

To assuage investors, DreamWorks has tried hard to find ways to improve its business. Back in 2010, Katzenberg was one of the most vocal proponents of 3-D movies, a hot new feature being added to theaters around the world. When "Shrek Forever After" generated about 60 percent of its global box office in 3-D, Katzenberg said it was a sign that consumers were "embracing this revolutionary format."

But 3-D movies, which are more expensive for consumers to watch, didn't turn out to be something moviegoers wanted on every visit. In 2011, "Kung Fu Panda 2" was the biggest domestic box office winner at DreamWorks, but just 45 percent of its opening weekend sales came from 3-D tickets.

3-D sales are likely an even smaller contributor now. DreamWorks doesn't break out 3-D sales for each movie, but overall sales in the format seem to have slowed. RealD, the main provider of 3-D equipment used in theaters, provides estimates for global box office sales from screens using its equipment. In the last 10 quarters, such 3-D box office sales have fallen by an average of 2 percent, according to a CNBC analysis of data on its website.

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More recently, DreamWorks has tried to convince investors it can generate more profit by unlocking hidden value in its properties. Licensing revenue from toys, for instance, could potentially mean big profits. Just look at Walt Disney's blockbuster "Frozen." Some 20 percent of parents in the U.S. plan to purchase "Frozen" merchandise for girls, more than any other toy including Barbie at 16.8 percent, according to the National Retail Federation.

But as Sterne Agee analyst Vasily Karasyov points out, it's difficult to make toys or TV shows out of movies that haven't already demonstrated significant appeal in theaters. In the third quarter, DreamWorks earned just $12.1 million in revenue from its consumer products division. That's less than 1 percent of companywide sales.

Even the company's own forecasts aren't very inspiring. The company said it expects total consumer products revenue from "Penguins" to be $8 million by the end of 2017.

Meanwhile, costs continue to creep up. The company recently adjusted the budgets for "Penguins" and the 2015 movie "Home" to $135 million from $125 million. DreamWorks said in an investor call the higher costs related to a scheduling change. The company also said its general and administrative expenses would rise to a range of $65 million to $70 million in the fourth quarter, up from $55 million in the third quarter.

One big hope for DreamWorks is that it will finally find a buyer for the entire company. Even if studios or other strategic buyers aren't interested, a private buyer might take a look. At $1.9 billion, the market capitalization is small enough for many buyers to afford it. And surely there are costs that could be reduced under different ownership.

But it's unclear if Katzenberg, who is CEO and has a controlling stake in the company through voting shares, would be willing to sell at prices anywhere near these levels. The more realistic outcome is that the company creates another heavyweight film franchise, which is possible but very hard to predict. The DreamWorks saga could keep plodding along without a reward for investors.