The Strategy Strengthening DreamWorks Animation Stock

Jeffrey Katzenberg's diversification efforts are helping insulate his company from the volatile film biz

DreamWorks Animation’s stock price went on a tear since reporting better-than-expected earnings last week, up 26% (before falling back a bit Wednesday). Here’s why: The diversification strategy the company announced a couple of years ago is finally paying off.

As CEO Jeffrey Katzenberg explained Tuesday at the Morgan Stanley Technology, Media & Telecom conference, TV was now DreamWorks’ most valuable segment, whereas three years ago the company was “barely in the TV business.”

DWA’s diversification was intended to lessen the reliance on its high-risk feature film business, including a transition from traditional pay TV licensing to a focus on subscription video on demand (SVOD) services, and the acquisition of YouTube content provider AwesomenessTV.

This strategy has really begun to kick in effectively over the past year. In the full-year results reported last week, DWA’s revenue mix was significantly more diverse than in prior years, generating record revenues despite a middling year on the feature film side:

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What made the difference was significantly higher TV revenue, as well as increasing contributions from its Consumer Products and New Media divisions. The chart below shows the percentage contribution from these segments, which illustrates the diversification even more starkly:

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As you can see, feature film revenues dropped to just 57% of the total, down from the high 70s just a few years ago, while television revenues were a quarter of the total in 2015, up from just 10% three years earlier.

Netflix becomes DWA’s largest distributor

The diversification in revenues isn’t just about segments, but also about destinations. Whereas pay TV and broadcast TV channels were major outlets for much of its content in the past, DWA made a conscious shift to new digital platforms in the past few years. Its 10-K filing from last week summarizes its new strategy crisply:

“We expect that television market revenues from licensing arrangements with digital subscription-based services will generally replace the traditional pay television arrangements.”

This past year, DWA’s relationship with Netflix, which is easily the largest of these new arrangements, became its biggest distribution channel of all by revenue, bigger than its relationship with primary theatrical distributor Fox:

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DWA’s Netflix revenues tripled from around $100 million in 2014 to around $300 million in 2015, as it both produced significantly more original television content for the SVOD service, and licensed a big chunk of its theatrical library. For context, that $300 million is 50% higher than combined revenues from “Home” and “The Penguins of Madagascar” in 2015.

Margins in new segments are high, too

One worry about new revenue streams is always dilution of margins in the core business, but that isn’t happening here. Gross margins in the television segment in 2015 were equal to those in the feature film segment, at 37%, and margins outpaced feature films over the last three years in aggregate.

Beyond Netflix, AwesomenessTV is also producing both great revenue growth and increasingly strong margins. DWA paid a total of around $110 million for its acquisition of ATV, but this business is now generating over $70 million a year in revenue, with gross margins in 2015 of 56%, higher than any of DWA’s other segments. The chart below shows gross margins for DreamWorks’ segments, of which new media represents primarily the AwesomenessTV business:

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The feature film business has always been the least predictable of these segments, but with two other major segments now delivering strong and growing margins on a more consistent basis, the company is on much sounder footing going forward. Even Consumer Products, the company’s merchandising and IP licensing business, is growing. There, an investment in new “experiences” around shopping malls and cruise ships is helping to drive new revenues with very little incremental cost to DWA.

Significant uncertainties remain

These revenues and profits should help insulate the company somewhat from the uncertainties of the feature film business. However, those uncertainties themselves haven’t gone away. For all that went well in 2015, DWA had to push back a major theatrical release (“Kung Fu Panda 3”) into the following year to avoid going up against the “Star Wars” franchise, and its only remaining theatrical release (“Home”) was poorly reviewed and didn’t do as well as other DWA franchise launches including “Shrek,” “Madagascar” and “Kung Fu Panda.”

The new “Panda” film has provided a bright start to 2016, but the “Trolls” picture coming in November comes with some uncertainty as well. DWA’s strategy of pairing sequels with originals each year going forward should buoy performance somewhat – none of its sequels has ever grossed less than half a billion dollars – but with a budget of at least $125 million per feature, flops still cost the company dearly.

The other risk is that the company is putting too many eggs in the Netflix basket. Though not subject to the vagaries of box office receipts, DWA’s Netflix relationship is arguably vulnerable to uncertainties of a different kind. Netflix’s business is inherently opaque from the outside, and management may conclude that DWA’s properties are not meeting its goals, and cut spending in future years.

Though the company takes pains to point out that Netflix is not its only digital distributor, it’s by far the largest, and a significant cut in spending would be at least as damaging as a flop in theaters. For now, though, the relationship looks to be on a solid footing, as does the company as a whole.

Jan Dawson is the founder and chief analyst at Jackdaw Research, an advisory firm which covers the consumer technology market.

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