Following the lackluster opening of Turbo, DreamWorks Animation heard grumbling from Wall Street this afternoon, with shares in the company losing over 5% of their value on NASDAQ. Sterne Agee analyst Vasily Karasyo released a report this morning that offers a big-picture perspective on DreamWorks and explains why the weak Turbo debut highlights the erosion of DreamWorks’ business model, which relies largely on a few tentpole films every year.

Of course, DreamWorks management is well aware, too, that their reliance on blockbusters is not a sustainable long-term model, which is why Jeffrey Katzenberg is scrambling to diversify into other areas, such as acquiring Classic Media’s library, entering the Chinese animation and amusement park markets, and working with Netflix to create online series.

Here is Karasyo’s report:

Price: $24.90
Price Target: $21.50
Weak Turbo Opening Highlights Business Model Erosion

Our Call
We believe that the weak opening of Turbo is not a one time event but another illustration of the challenges to DreamWorks Animation’s business model due to decreasing box office opportunity and high legacy production and releasing costs. Although the management’s efforts to build new revenue streams received a lot of attention recently, they are not enough to offset decreasing film profitability. We reiterate our Underperform rating.

  • We estimate at this point that Turbo will generate $70 mln at the domestic box office, less than half of our and the Street’s pre-release estimate of $160 mln. A significant number of international territories don’t open till October but assuming IBO is in line with our forecast at $280 mln, we expect a $19 mln write-down which would drive $0.28 downside to our FY13 forecast. We don’t believe the company has to make a determination on the title’s profitability and therefore the write-down won’t happen until Q4.
  • If we are right about Turbo’s ultimate profitability, the risk to FY14 estimates is now significantly higher. There are two original releases, Peabody and Sherman and Happy Smekday, next year. With two out of the last three titles underperforming, we see the likelihood of another write-down as materially higher.
  • New revenue streams from the recent Netflix (NFLX – $264.58 – Neutral, Bhatia) deal only modestly decrease dependence on film earnings: we estimate they will account for $0.07 in EPS in FY14 assuming there are no execution issues. By comparison, Rise of The Guardians write-down impact on EPS was $0.68 and The Croods contribution to FY13 will be $0.26.
  • We think the execution risk associated with the Netflix deal is overlooked. In recent history, the company pursued several initiatives to drive incremental revenue which ran into challenges and did not yield expected results, e.g. Penguins of Madagascar consumer product licensing program and a shift to three films a year. The main challenge of the Netflix deal, in our view, is to produce high volume of content within tight time frame and at the target margin.

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