Exactly 20 years ago, a trio of Hollywood moguls (Spielberg,
Katzenberg and Geffen) realized that by combining their
considerable resources and Rolodexes, they could create the
world's most powerful movie studio. This studio would in effect
become the "new Disney," thanks to a strong emphasis on
#-ad_banner-#Two decades later,
Dreamworks Animation SKG (NYSE:
has failed to fulfill its promise. Ironically, an obscure
Canadian entertainment company has stolen Dreamworks' thunder
with a savvy strategy that is now reaping huge rewards.
Back in 2007, many thought Dreamworks was hitting its stride.
After all, it takes more than a decade to build a new movie
studio from the ground up. That year, sales had nearly doubled,
to $767 million; earnings before interest, taxes, depreciation
and amortization (EBITDA) reached nearly $300 million -- and the
future looked bright.
Instead of spreading its cash flow among many projects to help
lower the risk that any one project might turn out badly,
Dreamworks stood by its plan to release five films every two
years. There have been some notable blockbusters in that slate,
including the Shrek franchise, but also a lot of duds. And the
duds are becoming more frequent.
The just-released "Mr. Peabody & Sherman," which will do a
fraction of the box office that "The Lego Movie" did, is another
black eye. "'Peabody' continues a string of disappointing films
(now 3 of the last 4) and raises critical questions about DWA's
ability to create new film franchises," note analysts at Goldman
Sachs, who predict Dreamworks' shares will fall from a recent $27
The poor reception at movie theaters has long-term
implications: A weak box office "not only suggests that
performance expectations for future originals need to be revised
but also means that the appeal of the properties created by DWA
is declining and the expected ramp in TV and consumer product
licensing revenue is incrementally less likely," notes Sterne
Agee analyst Vasily Karasyov, who rates shares as "underperform"
with a $17 price target.
The weak string of movies is already impacting the company's
financial strategies. Though Dreamworks generated an average $175
million in free cash flow from 2005 through 2008, that metric has
turned negative in each of the past three years.
Some of the company's woes are attributable to the sharp
increase in the quality of TV shows in recent years and the
surging popularity of
, which has made consumers less inclined to go out to the
Lions Gate Entertainment (NYSE:
identified the changing industry landscape early on, and they've
managed to capitalize on the transition. Most of its films and TV
shows are made on tight budgets, and the company's strategy of
lining up distribution in advance helps mitigate the risk that
any one project will blow up the financial statements.
Lions Gate controls many highly-valued
franchises, such as the Hunger Games movie
This is no industry small fry: Lions Gate controls
highly-valued franchises, from the Hunger Games movie series to
the "Mad Men" TV show. Hopes are high that the
soon-to-be-released film "Divergent" (opening March 20) will
create another strong franchise.
Still, most of the 13 to 15 films it releases each year are
made on modest budgets. To control costs, Lions Gate enters into
co-production agreements, aggressively seeks film and TV
production tax credits, and pre-arranges upfront sales to
And while other studios have warily eyed the DVD and streaming
video firms such as Netflix and
-- which my colleague Dave Goodboy
-- Lions Gate sees them as a vital partner. The company derives
nearly 40% of its revenue from electronic delivery of its
content, versus the industry average of 30%. Netflix's highly
acclaimed TV series "Orange Is the New Black," for example, was
produced by Lions Gate. The company's home entertainment segment
represents a greater percentage of total sales than its movie
production business (23%) and its TV show development studio
Lions Gate has both produced and acquired movies and shows,
and now owns 15,000 titles, which it can exploit through several
distribution platforms. One example: A 31% stake in premium movie
channel Epix is a leading acquirer of Lions Gate's film library.
A joint venture with Mexico's Televisa is helping Lions Gate
become a leading content provider for the fast-growing Hispanic
This is a business model that has really matured. Free cash
flow hit a record $274 million in fiscal (March) 2014. That has
enabled the company to begin paying dividends while maintaining a
share buyback program.
Ascendiant Capital analyst Marla Backer thinks "shares are
compelling on existing growth businesses and offer an option on
the franchise potential of 'Divergent.'" Her $40 price target
(representing 30% upside) is based on a fiscal 2015 target EBITDA
multiple of 13.7.
Risks to Consider:
The biggest near-term risk for LGF is a very poor box office
for "Divergent." Dreamworks' ability to mimic Lions Gate's
successful lower-risk business model offers the best path for
that stock's upside.
Action to Take -->
Dreamworks' swing-for-the-fences approach carries too much risk.
Moreover, a lack of recent hits bodes ill for future post-box
office revenue streams. Lions Gate, in contrast, has enough irons
in the fire to smooth out any bumps in the road. That lower-risk
approach is why shares deserve a full EBITDA multiple. These two
stocks appear set up for a solid pairs trade based on current box
office momentum alone.
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