Notes – Stanford Graduate School of Business Search Fund Primer

Notes on “A Primer On Search Funds” produced by the Stanford Graduate School of Business

“The Search Fund”

  • Greater than 20% of search funds have not acquired a company
  • Stages of the Search Fund model:
  • Raise initial capital (2-6mos)
  • Search for acquisition (1-30mos)
  • Raise acquisition capital and close transaction (6mos)
  • Operation and value creation (4-7+ years)
  • Exit (6mos)
  • SFs target industries not subject to rapid tech change, easy to understand, fragmented geographic or product markets, growing
  • Highest quality deals are found outside broker network/open market due to lack of auction dynamics
  • Research shows that partnerships are more likely to complete an acquisition and have a successful outcome than solo searchers (71% yielded positive return, 15 of top 20 performing funds were partnerships)
  • Principals budget a salary of $80,000-120,000 per year w/ median amount raised per principal $300,000~
  • Majority of the economic benefit of SF comes through principal’s earned equity; entrepreneur/partners receive 15-30% equity stake in acquired company in three tranches
  • Investors typically receive preference over the SFer, ensuring investment is repaid, with return attached, before SFer receives equity value
  • Individual IRR from 2003-2011 median was not meaningful, heavily skewed toward 75th percentile where median was 26% in 2011; 57% of individual IRRs were not meaningful in 2011; the median fund destroyed capital in 2009 (0.5x) and 2011 (0.8x); 58% in 2011 broke even or lost money
  • Half of the funds that represent a total or partial loss were funds that did not acquire a company; biggest risk is in not acquiring a company at all
  • Median acquisition multiples: 1.1x revenues; 5.1x EBITDA
  • Median deal size, $8.5M

“Raising a Fund”

  • Search fund capital should come from investors with the ability and willingness to participate in the acquisition round of capital raising

“Search Fund Economics”

  • Search fund investors often participate at a stepped up rate of 150% of original investment in acquired company securities

“Setting Criteria and Evaluating Industries”

  • Desirable characteristics for a target industry: fragmented, growing, sizable in terms of revenues and number of companies, straightforward operations, early in industry lifecycle, high number of companies in target size range
  • Desirable characteristics for a target company: healthy and sustainable profit margins (>15% EBIT), competitive advantage, recurring revenue model, history of cash flow generation, motivated seller for non-business reasons, fits financial criteria ($10-30M in revs, >$1.5M EBITDA), multiple avenues for growth, solid middle management, available financing, reasonable valuation, realistic liquidity options in 3-6 years
  • Key challenge is “know when to take the train” lest a SF never leaves the station waiting for the perfect opportunity
  • Ideally, seller is ready to transition out of the business for retirement or personal circumstances or has something else they’d like to do professionally
  • Experience shows it is better to pay full price for a good company than a “bargain” for a bad one
  • Idea generation: SIC and NAICS codes, Yahoo! Finance, Thomson Financial industry listings, Inc. 5000 companies, public stock OTC and NASDAQ lists and even the Yellow Pages; generate a list of 75 potential industries to start
  • Target industries buoyed by a mega-trend
  • Can also target an industry in which the SFer has worked and possesses an established knowledge base and network
  • Some focus on 2-3 “super priority” industry criteria (eg, recurring revenues, ability to scale, min # of potential targets, etc.)
  • Objective is to pare down the industry target list to 5-10 most promising
  • Basic industry analysis (Porter’s five forces, etc.) is then used to narrow from 10 to 3; SFers use public equity research and annual reports for market size, growth, margin benchmarks; also Capital IQ, Hoover’s, Dun & Bradstreet and One Source
  • Industry insiders (business owners, trade association members, sales or business development professionals) and industry trade associations or affiliated ibanks and advisory firms are primary methods of research and often have general industry research or white papers available
  • Next step is to create a thesis to codify accumulated knowledge and compare opportunities across common metric set in order to make go/no-go decision
  • In order to become an industry insider, SFers typically attend tradeshows, meet with business owners, interview customers and suppliers and develop “River Guides”

“The Search”

  • Median # of months spent searching, 19
  • 54% spend less than 20 months searching, 25% spend 21-30 months, 21% spend 30+ months
  • Track acquisition targets with CRM software such as Salesforce, Zoho, Sugar CRM
  • Bring up financial criteria and valuation ranges as early as possible when speaking to potential acquisition targets to save everyone time
  • A company that is too large or too small as an acquisition target may still be worth talking to for information
  • You must immediately sound useful, credible or relevant to the owner; deep industry analysis should already have been performed at this stage
  • Trade shows can be a critical source of deal flow
  • If a particular owner is not willing to sell, ask if he knows others who are
  • “River Guides” are typically compensated with a deal success fee, usually .5-1% of total deal size
  • Boutique investment banks, accounting firms and legal practices specializing in the industry in question are also a good source of deals
  • The business broker community itself is extremely large and fragmented; could be a good rollup target?
  • Often, brokered deals are only shown if a private equity investor with committed capital has already passed on the deal, presenting an adverse selection problem
  • Involve your financing sources (such as lenders and investors) early in the deal process to ensure their commitment and familiarity

“Evaluating Target Businesses”

  • Principles of time management: clarify goals of each stage of evaluation and structure work to meet those goals; recognize that perfect information is an unrealistic goal; keep a list of prioritized items impacting the go/no-go decision
  • Stages: first pass, valuation/LOI, comprehensive due diligence
  • It is in the best interest of the SFer to tackle core business issues personally during due diligence as it is the best way to learn the details of the business being taken over
  • Adding back the expenses of a failed product launch rewards the seller for a bad business decision; adding back growth expenses gives the seller the double benefit of capturing the growth without reflecting its true cost
  • Due diligence may also uncover deductions to EBITDA or unrealized expenses that reduce the “normalized” level of earnings (undermarket rents, inadequate insurance coverage, costs to upgrade existing systems, etc.)

“Transitioning Ownership and Management”

  • Create a detailed “Transition Services Agreement” with the seller, a legal contract where specific roles, responsibilities, defined time commitments and compensation are agreed prior to the transaction close
  • The first 100 days should be dedicated to learning the business
  • Businesses consist of people, and people need communication; great leaders are always great communicators
  • “Don’t listen to complaints about your predecessor, this can lead to a swamp and you don’t want to be mired there.”
  • The goal is to learn, not to make immediate changes
  • Outwork everyone; be the first person in and the last to leave
  • Many SFers insert themselves into the cash management process during the transition period by reviewing daily sales, invoices and receipts and signing every check/payment made by the company
  • The company’s board should be a mix of deep operational experience, specific industry or business model experience and financial expertise
  • The seeds of destruction for new senior leaders are often sown in the first 100 days
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Recession Risk, The Ultimate Risk Paradigm Of Modern Business Operations

The business cycle rotates periodically between boom and bust. This is one of the inevitable consequences of centrally planning the economy’s interest rates and forcing them below their market equilibrium levels. Because it is inevitable, it is “predictable” and thus every business person must conduct their affairs in light of the fact that at some point in the future they will be faced with a recession. The key measure of risk for a business person operating in a central bank-managed economy, then, is “How will I feel when the recession comes?”

If a recession poses no risk to the financial structure of his holdings and he is positioned in his operations to weather a storm, he may be termed “low risk.” If instead a recession represents an existential threat and/or the potential for severe hardship for his operations, he may be termed “high risk.”

As an ideal, a sufficiently low risk operator should eagerly anticipate a recession as it will represent a cheap buying opportunity during which he will consolidate the failing enterprises of his competitors, scooping up their assets at bargain prices and thereby leap ahead of them without the use of leverage or cheap competitive tactics. Conversely, a sufficiently high risk operator will find the economic Sword of Damocles plunging through his neck in a recession, permanently severing the connection between himself and his former assets. How then to manage financial and operational risk so that continued growth can occur in a manner that is sustainable in all possible economic environments?

In terms of financial risk, we could sort our assets in two ways, by asset quality and by financing quality. The asset with the highest asset quality is the one which has the largest earnings yield relative to its current value. The asset with the highest financing quality is the one which is cheapest to own (ie, annual interest cost).

Practically speaking, sorting assets by asset quality and financing quality and then selling low quality assets and paying down outstanding debt would move an organization toward a more favorable balance between asset quality and finance quality, with an emphasis on equity in the balance sheet. The capital that is freed up in the process is now available to purchase a higher quality asset in the future.

In a recession, the cash flows from low quality assets dwindle while the finance charges on debt remain fixed; not only does such a mixture create a problem in a recession but it falsifies the true “free cash” position of the company in a boom because, to operate prudently, extra cash must be maintained on the balance sheet to offset the risk this low quality asset and debt represent should a recession appear.

The insistence on focusing on the management of financial risk first offers us clues as to a sound growth strategy overall. To be successful and sustainable through all potential economic conditions, growth must be purposeful and planned and should only occur when three conditions are met: there is abundant free cash on the balance sheet, the organization has people “on the bench” and ready for new opportunities and a good buying opportunity (represented by a fair or discount to fair value price) presents itself.

A debt-laden balance sheet is not cash rich because the cash which may be present is actually encumbered by the debt as an offset in a recessionary environment. When we are talking about a cash rich balance sheet, we’re by implication talking about an unlevered balance sheet. Otherwise, the cash is not “free” but rather is “phantom” cash– it will disappear the moment adverse economic conditions present themselves.

The organizational bench condition may be harder to evaluate objectively, but there is a decent rule of thumb. When people in each position in the organization are sufficiently organized to handle their own responsibilities with time to spare, there is organizational bandwidth to spend on promotions and new responsibilities, such as management of newly acquired assets. In contrast, when people in relatively higher positions within the organizational hierarchy are spending their time doing the work of people relatively lower in the organizational hierarchy, it indicates that there is a shortage of quality personnel to fill all positions and that those personnel available are necessarily being “mismanaged” with regards to how they are spending their time as a result.

Further, it implies the risk that growth in such a state might further dilute and weaken the culture and management control of both legacy assets and those newly acquired. This is a risky situation in which every incremental growth opportunity ends up weakening the organization as a whole and creating hardships to come in the next recession. If it’s hard to find good people, inside the organization or without, and there is a general attitude of complacency about what could go wrong in a recession, it is a strong indicator that underperforming assets should be sold and the balance sheet delevered to reduce organizational risk in the event of a recession.

Growth should be fun, exciting and profitable. If it’s creating headaches operationally, or nightmares financially, it should be avoided. You shouldn’t own or acquire assets you don’t love owning. Perhaps the best rule of thumb overall is to ask oneself, “Does owning this asset bring us joy?” If yes, look for opportunities to buy more. If no, sell, sell, sell!

Ultimately, there are three ways to get rich: randomly, with dumb luck and unpredictable market euphoria for the product or service offered (billion-dollar tech startups); quickly, with a lot of leverage, a lot of luck in terms of market cycles and a lot of risk that you could lose it all with poor timing (private equity roll-up); and slowly, with a lot of cash, a lot of patience and a lot less risk while taking advantage of the misery of others during inevitable downward cycles in the economy.

If you were fearful in the last economic cycle, it suggests your financial and organizational structures were not as conservative as you might have believed. It may be an ideal, but it’s one worth reaching for: a recession represents a golden buying opportunity for a cash rich organization to leap ahead of the competition and continue its story of sustainable growth and success.

A Record Of Some Misgivings

I’ve had a little back and forth with some other value investors recently on my concerns about some of DreamWorks Animation’s outstanding corporate governance and capital allocation issues. I figured it was probably time to put pen to paper and formally record some of these thoughts.

Capital mis-allocation

To start, I want to mention the capital allocation issues. Over the last four years (2008-2011), DWA generated approximately $508M in operating cash flow, or about $127M/yr. In that same period, DWA invested $217M in their business, or about $54M/yr, while it bought back $389M, or about $97M/yr, worth of stock and finally they retired $73M worth of debt, which occurred in one year (2009) and represented the last of their LT debt on the books at that time.

As you can quickly surmise, there was only $291M of FCF or about $73M/yr over that period to support $462M in buybacks and debt paydown, a deficit of $171M which appears to have been financed by drawing down cash on the balance sheet and potentially leaning on the revolving credit facility as well.

I see a couple problems here:

  1. This is a growth company but the company will not be able to finance its growth ambitions on its own now because it has used a ton of its own financial resources buying back stock, which means it’ll have to either issue substantial new equity at low prices or take on more debt to finance its future growth
  2. The buybacks occurred at a range of prices and therefore market valuations of the company, with many of them clustered at the high end of that range, implying the company is not good at determining its own value and buying back only when the company is on sale

The first issue concerns me especially so given the nature of DreamWorks Animation’s business– in the end, it is highly speculative and could easily fail, meaning the most appropriate financing type is equity, not debt. Debt is more appropriate for a low-risk, predictable, consistent enterprise (such as financing a real estate venture). Equity provides the kind of flexibility and endurance one needs to weather the potential storms in a business like DWA’s.

But by using up much of its cash, DWA has put itself in the position where it will have to either dilute existing shareholders at potentially disadvantageous prices, or else it’ll have to raise debt which I believe adds substantial extra risk because of the way it mismatches with their business fundamentals.

The second issue concerns me because I think it directly explains a lot of the apparent value destruction that has occurred at DWA over the last 4 years as communicated by the fluctuating market capitalization and I think it sets a precedent that is in the long-run bad for minority shareholders, not good, as people of the “buybacks are good no matter what” school of thought seem to believe.

In 2008, the peak price of DWA was $32/share and with 91M FDSO at the time, that amounted to a market cap of $2.9B. In early 2010, the company climbed to an all-time peak price of nearly $43.50/share and with 87M FDSO that amounted to a market cap of nearly $3.8B. The shares now linger back below their 2009 low of $18.56/share and very close to the all-time low of $16.52/share reached in January of 2012, trading around $17/share for a total market cap of about $1.43B.

Slice it how you like it but according to the market the company has conservatively destroyed almost $1.5B of value in that time and I’d say that’s primarily due to spending $460M on buybacks and debt reduction that could’ve been spent on growing the business or waiting for opportunities to grow the business. If you add that capital back into the business you’d get a market cap closer to $2B right now.

Most of the buybacks occurred near the $30/share range with relatively little of the buybacks occurring near the lows of around $17/share. This kind of capital allocation “discipline” can not be put to bed by arguing that “share buybacks are good if they happen at all”– the latter price represents a 50% discount to the former (or the former a nearly 100% premium to the latter, depending on how you want to look at it)! Are we supposed to be comforted by the fact that DWA’s management and board seem to think the company is cheap anywhere between $3B and $1.5B in market cap?

That isn’t a reasonable way to manage capital. You’ll never catch Warren Buffett making that kind of argument and I highly doubt you’d have much money to manage on your own if you adhered to that philosophy for long.

One of the replies I got back from another investor (see below) on this was that “what’s done is done.” That is an unacceptable response. What’s done is not done because it could very easily happen again and it is more than likely to do so given that the pattern set, the discipline demonstrated so far, is that the management and board of DWA is incompetent when it comes to allocating capital to share buybacks. This is a red flag and a way they could continue to destroy whatever value they create through their growth strategy in the future.

Golden parachutes for the pilot and the flight crew, but not the passengers

At the behest of another money manager with a value-based approach I had been communicating with, I decided to review the Form DEF-14A filed 4/11/12 for DWA. I had (admittedly) skim-read the thing when first performing due diligence several months ago, but I had not read it line-by-line as he had urged me to do, more on that fact in a bit.

As I read through it, I noticed a few things.

For one, I noticed that FRMO-owned companies own 9,614,089 shares or 13.1% outstanding, ostensibly for their ETF products. I am impressed with the strategic thinking of this organization and for the purposes of their own business they seem to be great capital allocators (of course, I have no idea at what prices they accumulated their position). But then it dawned on me that most of their products are passively-managed index ETFs and that took the wind out of my sails. I’m not necessarily under the impression at this point that they hold a stake because they think it’s a great buy, but just because it fits some strategy or theme for one of their proprietary indexes. So, that’s about 13% of the company potentially owned by “dumb money” in this case.

Then I noticed that the company utilizes Exequity and Frederic W. Cook & Co., compensation consultants, to determine executive pay. I’m working on a “digest” post of articles I’ve been reading about corporate governance and activism over at a now-defunct website nominally belonging to Carl Icahn (man, that guy seems a bit ADD at times the way he starts and stops investments, grass roots activism platforms, etc.) and I came across this post on compensation consultants which really set off alarm bells for me.

Think about it for a second– the managers are using company money, which belongs to shareholders, to hire consultants (multiples in this case) who charge millions of dollars and spend hundreds of hours trying to outdo each other in justifying outlandish executive compensation packages. In other words, they use your money to figure out how much they should pay themselves at your expense. It’s kind of like gilt-edged unionism for corporate executives. Why the hell is this such a mystery? Why do you need consultants to figure stuff like this out for you?

This is a corporate governance red flag– this is not treating minority shareholders like equal partners but rather treating them like the sucker at the table. After all, Katzenberg owns about 15% of the company and because of the dual class share structure (another red flag, by the way), effectively controls the company himself which makes him an owner-operator (to be fair, a good thing)… you think he can’t figure out how much to pay his other executives in terms of what’s good for K-man and what’s not?

Preposterous!

Then I get to the actual executive compensation itself. Katzenberg is now paid a $1 annual salary, choosing to receive most of his compensation via stock options and other perks. Other executives are compensated quite generously and compensation has been growing. The value of options grants is $17M annually, or over 1% of market cap each year. Long-term incentive compensation is worth another $9.2M. Combined, that is $26M or almost 2% of the company’s market cap for a handful of top execs and board members.

Other things of note:

  • Lew Coleman, president and CFO, recently exchanged higher annual cash salary structure in return for decreased long-term incentive awards, does this show lack of faith in the long-term value of the company?
  • Ann Daly, the COO, has part of her compensation tied to performance of the company’s stock price, which is an idiotic practice given that it incentivizes her to manipulate the company’s operations to game short-term numbers meanwhile the company’s management has no direct control, in the long-run, over what the investing public thinks of the value of the company (yes, their actions will translate into better or worse valuations but in the end it’s like tying someone’s compensation to the weather)
  • Overall, tons of golden parachutes for just about everyone in the case of a change of control or a termination with or without cause, which are more blatant red flags and give minority shareholders an unfair shake

Then there’s the income tax savings-sharing agreement with Paul Allen, a former shareholder and financial enabler of the company which the proxy explains constitutes “substantial” payments to Mr. Allen over time (this fact being confirmed by the multi-hundred million dollar payable on the balance sheet). To put it simply, I don’t get this or how it works and so far no one has been able to explain it to me. It could be harmless, it could be disastrously unfair to minority shareholder. I really have no clue, it’s beyond my accounting and income tax liability knowledge.

My overall impressions were thus: it takes 66 pages to explain/justify DWA’s compensation practices and related-party special transactions. The company hires compensation and other consultants with shareholder money to determine what management should be paid. And shares are locked up and all change of control decisions will be made by Katzenberg. This company gets maybe a C in terms of corporate governance, which is average in relative terms but sucks in my absolute opinion.

In general, I am concerned about my own ability to understand the accounting behind the company’s compensation practices. And this dovetails with my lingering concern that neither I nor anyone else seems to be able to confidently and accurately model just how much cash specific or even any single movie title in DWA’s library generates for the company at different points over its life.

Bringing it full circle

A few days ago I posted a video interview of Rahul Saraogi, a value investor operating in India, along with my notes of the interview. I found the interview surprisingly impactful (I’ve been watching other interviews from the Manual of Ideas folks and unfortunately none of them have come anywhere close in terms of profundity) and the item that stuck out the most from the whole thing was Saraogi’s comments on the importance of corporate governance and capital allocation for the long-term investment results of minority shareholders.

To reiterate, according to Saraogi good corporate governance means dominant shareholders who treat the minority shareholders like equal partners, who do not treat the company like a personal piggy bank or a tool for furthering their own personal agendas at others’ expense. He says good corporate governance is binary– it either exists or it doesn’t, there are no shades of grey here. The issues I’ve cited above make it clear that DWA does not have good corporate governance practices. The fact that the Form 14A discloses the fact that both David Geffen and Jeffery Katzenberg are essentially using the company resources to the tune of over $2M per year to subsidize their ownership and maintenance of private aircraft is another good example– it is one thing to have the company reimburse them for expenses occurred in doing business but it is quite obvious from the way this agreement is structured that the company is basically paying for the major costs of ownership while they are deriving the personal benefits and exercising discretion as owners in name and title.

Similarly, capital allocation is critical in Saraogi’s mind and many companies and their management don’t get it– they either don’t understand it’s importance or how to do it, or they don’t care because they’re rich enough. I think a little bit of both is operating here. Certainly Jeffery Katzenberg is “rich enough” at this point. He’s worth several hundred million dollars at least, he has the company paying for his private aircraft and other perks and he has even said in interviews I’ve read that he’s got all the money he could need or want at this point and continues to work out of passion and interest. Normally that’s a good thing but in this respect it’s a bad thing because a person who operates as an artist rather than a businessman probably doesn’t care what their ROC looks like as long as they get to put their name on the castles they build.

And people who get capital allocation don’t pay prices that range nearly 100% in value for shares they purchase, unless of course they’re absolutely convinced the intrinsic value still far exceeds such prices. I note here that while there is no evidence from the company that this isn’t the case, there’s similarly no evidence that there is, and I don’t think faith is a good basis on which to form a valuation. As an aside, none of the grade-A elite Wall St analysts on the earnings calls ever ask about this, and my e-mail to DWA’s IR on this topic and numerous others went completely unanswered, which is another embarrassing black mark for the company in terms of corporate governance.

Other voices in the wild

For those who are interested, there are now two recent write-ups on DWA over at Whopper Investments, the first on the value case for DWA and the second analyzing the company’s potential takeover value when compared to Disney’s acquisition of Pixar in 2004.

I really enjoy Whopper’s blog for the most part but I consider these two posts to be some of his weaker analytical contributions to date (which should be obvious from my remarks in the comments section of each, 1 and 2) and if anything that makes me even more queasy with this one– he mimicked a lot of my own unimpressive reasons for investing and I don’t generally find the sound of my own voice that soothing in cases like these, and he seemed unable to answer some of my deeper concerns, which could be evidence of his own shortcomings as an analyst or it could be evidence that these are questions with unsatisfactory answers by and large (I prefer to believe the latter at this point).

In a nutshell, at this point my major concern is that, even if the company successfully executes on its grand growth strategy it might not mean as much for minority shareholders as we might like due to outstanding corporate governance and capital allocation concerns. I seriously wonder if I and many other value investors like me are not blinding themselves to these “binary” concerns because the potential home-run hit possibility of getting in near all-time lows on “the next Disney” is just too exciting to resist.

Whatever I do, I’ve now written this post and put it in the public domain so I won’t be able to excuse myself later on by claiming I hadn’t thought about these issues.

DreamWorks Animation Trading At Unreasonable Multiples Of Current And Future Value

A bet on DWA is, in a macro sense, a bet on the current paradigm of the value of Hollywood studios as creators and distributors of valuable entertainment IP. The fate and value of DWA, even though it’s its own company with its own strategy, its own management and its own niche within the industry, is inalienably tied up with that model of sourcing IP, producing a theatrical event centered around the IP and then profiting off of the multi-channel distribution and licensing bonanza related to that IP across time (multiple years/decades after the initial theatrical event) and space (around the globe).

How does DWA make money?

Like most film studios, DWA is essentially a vehicle for financing and marketing computer-animated family film IP. The process begins with an idea, the eventual IP in natal form, which is either pitched to the studio by an outsider and then purchased, or developed internally by the studio’s internal staff. Over the next 3-4 years, at a cost of $125-175M per IP property, the idea is nurtured, developed and finally produced into a feature length film “event”. Working with the studio’s distribution partner, the film is released first in the US and then worldwide to theater audiences. Several months after theatrical release, the film property is put into home entertainment– DVD/Blu-ray, domestic and foreign Pay-per-View/VOD, domestic and foreign free TV and eventual distribution to in-flight entertainment and US military theaters. Toys, corporate licensing partnerships, clothing and other spin-off opportunities may follow, and if the IP is especially successful at the box office it may spawn sequels, live stage performances, TV spin-off franchises and TV holiday specials– a franchise title is born! Eventually, the cost of development of all IP in release is fully amortized or written off against revenues and the title is transferred to the “film library”, at which point it no longer exists on DWA’s balance sheet even though it will likely continue to generate licensing revenues for years to come.

The major threats to this model right now are:

  • the secular decline of the high-margin DVD distribution model and the uncertainty of the rise of digital distribution, which is not only (currently) a lower margin business, but whose time-footprint threatens the value of the traditional time-delay release of a film events IP across traditional distribution channels (free TV, pay TV, DVD/home video, etc.) because of the opportunity for worldwide simultaneous release
  • the hard costs of digital animation are falling, inviting more non-studio (independents) and amateur creators to enter the space

Some mitigating factors are:

  • assuming that internet/digital distribution proves to be a sustaining rather than disruptive technology, even if the cost of creating computer-animated film properties is falling, it still costs hundreds of millions of dollars to distribute that IP to a global audience and create the kind of “film event” that allows for a blockbuster franchise to be born
  • computer-animated family film IP has proven more resilient than live-action film IP within the declining DVD biz, because parents view their purchase decisions toward CG-film IP like that of a long-life toy that will be used to entertain their children again and again, preserving the value proposition of such a purchase
  • though this author is skeptical of the bullish case for emerging markets generally, and though emerging market territories generally have stingier revenue-sharing agreements with foreign (read: DWA) studios, and while the foreign home entertainment markets are currently weak to non-existent, these markets are in a secular growth pattern, their home entertainment markets are developing and they will mean larger and larger worldwide audiences for each film event as time passes; the risk of failure becomes less and less and the profitability of a homerun becomes greater and greater
  • DWA is intelligently pursuing growth in the emerging market nations– it has developed animation partnerships and facilities in Bangalore, India; it has recently announced a JV with state-owned media enterprises in China where it will not only develop original IP exclusively for the Chinese/Asian market, but it will likely also have the opportunity to distribute its US IP through that channel and thus earn future film rentals as a “local” rather than “foreign” producer, increasing its share of box office and other revenue-streams
  • DWA/Katzenberg have fully embraced theatrical 3D, which allows for premium pricing (typically, +$5 to cost of theater admission) which exit surveys of theater-goers rate as a huge value add. 3D is extremely popular in overseas markets, as well, and already over 50% of new release film rentals have been generated by 3D ticket sales on a per-film basis. 3D requires a small up-front additional investment to add the effect to films yet can be leveraged into a huge additional premium on ticket sales.

If you think those threats are overrated, then DWA is probably extremely cheap. If you think those threats haven’t been fully priced in, DWA is either fairly valued or expensive, the ominous “value trap” every value investor fears walking into.

I am more and more of the opinion that DWA is a classic, Buffett-style good company at a great price-type business. Management is competent and trustworthy, and because Katzenberg and other officers and insiders of the company hold substantial equity stakes, their incentives are aligned (most of Katzenberg’s outstanding stock options, by the way, have strike prices in the $30/share range). While the development of the company’s IP is capital intensive (again, costing $125-175M per film to produce), the IP generates a multiple of that expense in ultimate profits on average. This means the company retains a substantial proportion of its earnings and is able to fund future production internally. The company is conservatively financed with no debt and sufficient cash and receivables (which is cash awaiting release from their distribution partner) to fund the development of two or more films at any given time. The business consistently earns a high post-tax ROE and pre-tax ROIC. While every studio has tried to get in on the computer-animated family film space, Pixar and DreamWorks are largely dominant (with near third place going to Fox’s Blue Sky) and the brand awareness and market share of each studio has not changed significantly over the last decade, implying high barriers to entry and strong competitive advantages to the entrenched firms like DWA.

Looking at earnings on a 10yr, 8yr (since 2004 IPO) and 5yr (since the secular DVD decline began in 2006, and including the traumatic period of 2008-2009) average, earnings are growing.

On a GAAP basis, the company trades close to book value, but this is a book value which holds the fully-amortized prior release films in the “film library” at a $0 value on the balance sheet. They’re obviously worth a great deal more, especially to a strategic buyer. On an adjusted basis, DWA is trading at a significant discount to book value.

The market cap of the company is about $1.44B at a share price of $17 with 85M fully diluted shares outstanding. The beauty of DWA is that it is not so small that it can get blown over in the wind with a poorly-received film event release, but it is not so large that it is already a fully-integrated media conglomerate in its own right, with theme parks and all the rest. In other words, it’s got a long run way and the market capitalization could grow significantly overtime, so it isn’t hard to imagine where DWA will find additional revenues and earnings streams over the next 10 years like a person might wonder with a competitor such as DIS. It’s trading near all-time lows and right now it trades for less than it did at the fear-induced trough in the markets in late 2008, early 2009.

Management has aggressively bought back shares since the 2004 IPO and secondary offering, reducing shares outstanding by over 20% during the last 8 years. The board has authorized an additional share repurchase plan which represents about 10% of market cap at current prices.

There are some challenges and uncertainties for DWA. There always are, for every business. If this is a value trap, then we are on the verge of the complete dismantling and dissolution of the Hollywood studio system of film production and distribution. If we are not on the eve of that armageddon, then DWA is not being fairly priced. And there is a significant margin of safety in the numerous growth opportunities available to this “wide-niche”, focused and ambitious firm with strong brand reputation. With the studio committed to producing 2.5 films/yr from the previous strategy of 2 films/yr (one sequel and one original), earnings will be growing and yet you pay the already discounted 2 films/yr price.

It’s hard to imagine this company worth less than $1.44B 10 years from now and it seems likely it will be worth significantly more over that period of time, with an additional 25 films in the stable (a greater than doubling of the current film library of 23 films).

Any way you slice it, DWA seems cheap– <10x GAAP EBIT, <15x GAP Net, 2x GAAP Rev, <10x adj OE (net income + amortization – film costs – avg MCAPX), <8x adj Net OE (OE minus cash taxes paid) and around 5x the 2.5 films/yr pre-tax OE calculation… not to mention a significant discount to adjusted book value.

Pure valuation metrics:

Metric 10yr Avg 8yr Avg 5yr Avg
GAAP EBIT/share  $1.71  $2.18  $2.20
mult 10.0 7.8 7.8
GAAP Net/share  $1.19  $1.80  $1.81
mult 14.4 9.5 9.4
GAAP Rev/share  $7.42  $8.19  $8.55
mult 2.3 2.1 2.0
Adj OE/share  $2.04  $2.38  $2.51
mult 8.4 7.2 6.8
Adj Net OE/share  $1.94  $2.47  $3.00
mult 8.8 6.9 5.7
Adj 2.5 films/yr Pre-tax OE  $2.18  $3.06  $3.28
mult 7.8 5.6 5.2
Share price  $17.08  $17.08  $17.08

Notes on insider ownership:

According to the latest 14A, Jeffrey Katzenberg, the CEO of the company, owns 13,193,947 shares, or 15.6% of total fully diluted shares outstanding. He also controls a number of options awarded to him as executive compensation (he draws a $1/yr salary), most of which vest only if the share price maintains around $30+/share for approximately one year within the multi-year window of the stock option compensation agreement. So, Katzenberg is highly incentivized through both equity ownership and stock options to see a valuation for the company significantly higher than it currently stands.

Additionally, current executives as a whole (including Katzenberg) control 19.1% of FDSO.

Former founders David Geffen and Steven Spielberg, who are no longer actively involved in managing the company, continue to hold 2,355,216 shares or 2.8% and 5,222,726 shares or 6.2%, respectively, of FDSO. (Note: David Geffen and Jeffrey Katzenberg jointly own approx 10M shares of Class B voting stock, which I did not account for in Geffen’s total holdings but did include in Katzenberg’s holdings because of Katzenberg’s current role in active management of the company. The Class B stock controls 67.4% of the total voting power of all shareholders.)

Catalyst:

There is no short-term, identifiable catalyst to unlock the value here. This is a long-term, buy-and-hold value compounder. You are making a bet on the market severely mispricing the value of this company in the present while assuming the market will be able to better ascertain the value (which continues to grow within a strong franchise) in the future. The company has a number of values to different owners (including potential acquirers or even management itself) and any one of those events, or none of them, could ultimately result in the true value of this firm being realized.

This is not a trade, it’s an investment. Wall St hates things like this.