Feature films are a hit and miss business. When a business is highly dependent on feature films, this results in a lot of uncertainty for investors; Hits are great, but flops can be disastrous. DreamWorks shareholders can relate: Shares fell to their lowest level in 2012 on news of underwhelming opening weekend sales for "Rise of the Guardians" last Monday. Many analysts are calling it one of the worst openings since the company's public offering in 2004. But flops are a part of the studio business. If you want in on the box office excitement without the volatility, look for a business in which feature films represent a smaller portion of revenue, like Disney .
Warren Buffett once said, "In business, I look for economic castles protected by unbreachable 'moats'." In other words, Buffett looks for businesses with a sustainable competitive advantage.
Though DreamWorks has rights to some valuable franchises, such as Shrek, Madagascar, and Kung Fu Panda, its heavy reliance on feature films leaves the business susceptible to flops and poor success streaks. In fact, the first risk the company outlines in its 10-K says, "Our success is primarily dependent on audience acceptance of our films, which is extremely difficult to predict and, therefore, inherently risky."
Time Warner and Disney, on the other hand, offer investors a great opportunity to buy into box office films without taking on the huge risks associated with flops.
Only an estimated 3.1% of Time Warner's stock price is attributable to feature films. As the largest media company in the world, its revenue comes from a wider variety of sources offering not only diversification, but greater sustainability. The majority of its revenue comes from its primary cable networks: HBO, TNT, TBS, and CNN.
Disney is also highly diversified. Though Disney is packed with a wide variety of very valuable feature film franchises--including franchises under Pixar, Marvel, and now Lucas Film--feature films are attributable for only an estimated 10% of Disney's stock price. In addition to feature films, its revenue comes from cable networks, broadcasting networks, theme parks and hotels. Furthermore, approximately 43% of its net income is derived from its highly reliable, cash cow: ESPN.
Contrary to DreamWorks, Time Warner and Disney offer investors an opportunity to own powerful box office franchises without too much exposure to flops.
Fundamentals and Valuation
Limiting exposure to box office flops, however, comes at a price. Measured by price-to-book value, Disney, Time Warner, and CBS all trade at premiums to DreamWorks. But in return for paying a premium, the investor receives more than just reliable revenue; All three companies are more profitable than DreamWorks. Take a look:
My favorite performance metric is free cash flow (FCF) divided by sales. This metric shows you what percentage of every dollar of sales is converted into the cold, hard cash that can be used for value building activities like investment, dividends, share-repurchase programs, and long-term debt repayment after short-term commitments have been met. While DreamWorks has been FCF negative for two years straight, Disney and Time Warner are converting 10% of every dollar of sales into FCF.
The Bottom Line
Some value investors may see the DreamWorks sell-off as a buying opportunity. After all, the stock is trading at book value. But with a very large exposure to box office flops there is more risk associated with the stock. On the other hand, there is greater potential for upside. If you are the type that likes to go all in on a bluff, DreamWorks might make a better fit for your portfolio. But if you're looking for a reliable stock to hold for the long haul, do yourself a favor and limit your exposure to box office flops and look to stocks like Disney and Time Warner as alternatives.
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