DreamWorks Still a Snooze

Beyond <I>Shrek</I>, long-term prospects on the animation studio are uninspiring.
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When DreamWorks Animation (DWA) went public over two years ago, the movie studio was flying on the success of Shrek 2, which became the nation's third-highest grossing film in history and confirmed that the company had a blockbuster franchise on its hands.

Ownership stakes from big-name investors such as legendary filmmaker Stephen Spielberg, music mogul David Geffen,

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founder Paul Allen and the former

Disney

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animation guru Jeffrey Katzenberg only fueled the hype.

The initial public offering priced at $28, and shares of DreamWorks Animation soared nearly 38% on their first day of trading in October 2004.

But even though the company has a loveable green ogre and all that star power, those who bought shares at those lofty prices have nothing to show for their investment but red ink.

It's a tempting time to buy the stock. A number of thorns that had long been digging into the company's sides have been removed. Moreover, it has

Shrek the Third

and a Jerry Seinfeld movie on tap for 2007.

That said, investors who think that this time around will be any better than last time are probably dreaming.

Last year, investors were spooked by a perceived slowdown in the market for DVDs, a concern that, along with a dismal showing for its film

Flushed Away

, dragged DreamWorks shares down near the $20 mark in August.

Shares are now near their $28 IPO price, and a

stronger-than-expected fourth-quarter performance, bolstered by strong DVD sales of the film

Over the Hedge

, buoyed hopes that recent worries were overblown.

Meanwhile, yet another force has weighed on DreamWorks -- the perception that Allen, its largest shareholder, was wriggling out of his stake in the company. The investor opted last fall to unwind Holdco, DreamWorks' founding partnership that included him, Spielberg, Katzenberg and Geffen, among others.

That triggered a secondary offering through which a portion of Allen's DreamWorks shares were sold to the public. Spielberg, Geffen and Katzenberg didn't sell their stakes.

"The Holdco partnership was basically a vehicle to guarantee DreamWorks founding shareholders a minimum return in cash and stock equal to their initial investment in DreamWorks," says J.P. Morgan analyst Barton Crockett. "The secondary offering was a vehicle that Holdco used to achieve that aim."

On a conference call following DreamWorks' recent earnings release, Lew Coleman, the studio's president, told analysts that Allen still owns "about 21 million shares" and has an economic interest of roughly 21% in the company, along with 6.5% of the voting rights under control.

Analysts say Allen's decision to dissolve Holdco made economic sense for him based on the partnership's contractual agreements, but some observers say the move paves the way for him to abandon his position in an investment that has gone sour.

"It looks like Allen has one foot in the lifeboat," says Jim Hill, who maintains an influential fan Web site that tracks the animation industry at JimHillMedia.com.

He points to last month's departure of Chief Financial Officer Kristina Leslie and the planned exit of Chief Accounting Officer William Losch in May as evidence of internal misgivings at the company.

"When the chief financial officer and the chief accountant decide to leave within a three-month period, that sets off alarm bells," Hill says.

Looking for Another Monster

Unfortunately for DreamWorks Animation's public shareholders, the company has struggled to keep pace with Pixar, a business led by

Apple

CEO Steve Jobs, which was recently acquired at a hefty premium by its longtime partner, Disney.

DreamWorks Animation shares are supported by speculation that it too could be the subject of a rich acquisition, but any deal for the company will likely have to wait until its distribution partnership with

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Paramount Pictures ends in 2012.

"I don't see a lot of strategic buyers that would be interested in this company at this point," says Richard Dorfman, managing director with Richard Alan Inc., a financial advisory and investment firm focused on the media industry. "DreamWorks has always suffered from Pixar-like expectations, but it's not coming up with hit after hit. It's really a hit-and-miss situation. If you took Shrek out of the picture, it would not be a pretty picture."

Luckily for DreamWorks, Shrek will be front and center in 2007. The franchise's third installment will be released in May, and Hill says fans are looking forward to the movie.

"It would be hard for

Shrek the Third

to miss at this point," says Hill.

In addition to box office receipts, the new Shrek movie is expected to juice DVD sales of the previous two films.

Still, the movie is not without its financial concerns. The bulk of revenue from the film won't start showing up until the back half of 2007, and sequels like

Shrek the Third

can be less profitable than original films because they cost more to produce.

Also, the new Shrek movie comes at the same time as the release of

Sony's

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third

Spider-Man

film, as well as the third installment of Disney's

Pirates of the Carribean

franchise -- both of which are blockbusters in their own right with the ability to chew up a portion of Shrek's audience.

Then there's the question: How much more Shrek can audiences take? Katzenberg has agreed to produce

Shrek the Halls

, a Christmas special that is licensed to air for the next 15 years on Disney's broadcast network, ABC. DreamWorks also is in the development stage for

Shrek The Musical

for Broadway.

At this point, shares of DreamWorks Animation may boil down to a bet on whether the company can invent a new Shrek. This fall, the company will release

Bee Movie

, starring Seinfeld as Barry B. Benson, a character that Katzenberg described as "a bee who is convinced that there is more to life outside the hive."

Seinfeld, who also wrote and produced the movie, is expected to make a full publicity push on its behalf, which should bode well for success at the box office, but there's no guarantee of Shrek-like success.

In 2008, an original film called

Kung Fu Panda

starring Jack Black will hit the theatres in June. That will be followed by the sequel to the company's 2005 hit,

Madagascar

.

With that lineup in place, DreamWorks has dropped its relationship with Aardman Animations, a British clay-mation studio that worked on

Flushed Away

, as well as

Wallace & Gromit: The Curse of the Were-Rabbit

, another box-office fizzle that resulted in a write-off.

But even one more misstep could cause restlessness for shareholders.

"There's a sense now that this company has to hit a homerun every time it steps to the plate," says Hill.

Pali Research analyst Richard Greenfield wrote in a recent research note that DreamWorks Animation is somewhat expensive, trading at around 28 times Wall Street's average earnings estimates through 2008.

Greenfield upgraded the stock to neutral from a sell rating after the secondary offering was executed without a selloff, saying that "the last major negative near-term catalyst that supported our sell rating has played out."

Dorfman says the next catalyst that could damage the company's valuation may come in the form of more insider selling.

"Paul Allen is signaling that his investment here is getting a bit long in the tooth," says Dorfman. "He's a smart guy. If somebody was on the verge of buying this company, I think he'd have a hint of that, and I don't think he'd be disposing any shares."