Exactly 20 years ago, a trio of Hollywood moguls (Spielberg, Katzenberg and Geffen) realized that by combining their considerable resources and Rolodexes, they could create the world’s most powerful movie studio. This studio would in effect become the “new Disney,” thanks to a strong emphasis on computer-driven animation.

#-ad_banner-#Two decades later, Dreamworks Animation SKG (NYSE: DWA) has failed to fulfill its promise. Ironically, an obscure Canadian entertainment company has stolen Dreamworks’ thunder with a savvy strategy that is now reaping huge rewards.

Back in 2007, many thought Dreamworks was hitting its stride. After all, it takes more than a decade to build a new movie studio from the ground up. That year, sales had nearly doubled, to $767 million; earnings before interest, taxes, depreciation and amortization (EBITDA) reached nearly $300 million — and the future looked bright.

Instead of spreading its cash flow among many projects to help lower the risk that any one project might turn out badly, Dreamworks stood by its plan to release five films every two years. There have been some notable blockbusters in that slate, including the Shrek franchise, but also a lot of duds. And the duds are becoming more frequent.

The just-released “Mr. Peabody & Sherman,” which will do a fraction of the box office that “The Lego Movie” did, is another black eye. “‘Peabody’ continues a string of disappointing films
(now 3 of the last 4) and raises critical questions about DWA’s ability to create new film franchises,” note analysts at Goldman Sachs, who predict Dreamworks’ shares will fall from a recent $27 to $20.

The poor reception at movie theaters has long-term implications: A weak box office “not only suggests that performance expectations for future originals need to be revised but also means that the appeal of the properties created by DWA is declining and the expected ramp in TV and consumer product licensing revenue is incrementally less likely,” notes Sterne Agee analyst Vasily Karasyov, who rates shares as “underperform” with a $17 price target.

The weak string of movies is already impacting the company’s financial strategies. Though Dreamworks generated an average $175 million in free cash flow from 2005 through 2008, that metric has turned negative in each of the past three years.

Some of the company’s woes are attributable to the sharp increase in the quality of TV shows in recent years and the surging popularity of Netflix (Nasdaq: NFLX), which has made consumers less inclined to go out to the movies.

Executives at Lions Gate Entertainment (NYSE: LGF) identified the changing industry landscape early on, and they’ve managed to capitalize on the transition. Most of its films and TV shows are made on tight budgets, and the company’s strategy of lining up distribution in advance helps mitigate the risk that any one project will blow up the financial statements.

	YouTube/LionsgateFilmsUK
	Lions Gate controls many highly-valued franchises, such as the Hunger Games movie series.

This is no industry small fry: Lions Gate controls highly-valued franchises, from the Hunger Games movie series to the “Mad Men” TV show.  Hopes are high that the soon-to-be-released film “Divergent” (opening March 20) will create another strong franchise.

Still, most of the 13 to 15 films it releases each year are made on modest budgets.  To control costs, Lions Gate enters into co-production agreements, aggressively seeks film and TV production tax credits, and pre-arranges upfront sales to international partners.

And while other studios have warily eyed the DVD and streaming video firms such as Netflix and Outerwall (Nasdaq: OUTR) — which my colleague Dave Goodboy profiled recently — Lions Gate sees them as a vital partner. The company derives nearly 40% of its revenue from electronic delivery of its content, versus the industry average of 30%. Netflix’s highly acclaimed TV series “Orange Is the New Black,” for example, was produced by Lions Gate. The company’s home entertainment segment represents a greater percentage of total sales than its movie production business (23%) and its TV show development studio (12%).

Lions Gate has both produced and acquired movies and shows, and now owns 15,000 titles, which it can exploit through several distribution platforms. One example: A 31% stake in premium movie channel Epix is a leading acquirer of Lions Gate’s film library. A joint venture with Mexico’s Televisa is helping Lions Gate become a leading content provider for the fast-growing Hispanic market.

This is a business model that has really matured. Free cash flow hit a record $274 million in fiscal (March) 2014. That has enabled the company to begin paying dividends while maintaining a share buyback program.

Ascendiant Capital analyst Marla Backer thinks “shares are compelling on existing growth businesses and offer an option on the franchise potential of ‘Divergent.'” Her $40 price target (representing 30% upside) is based on a fiscal  2015 target EBITDA multiple of 13.7.

Risks to Consider: The biggest near-term risk for LGF is a very poor box office for “Divergent.” Dreamworks’ ability to mimic Lions Gate’s successful lower-risk business model offers the best path for that stock’s upside.

Action to Take –> Dreamworks’ swing-for-the-fences approach carries too much risk. Moreover, a lack of recent hits bodes ill for future post-box office revenue streams. Lions Gate, in contrast, has enough irons in the fire to smooth out any bumps in the road. That lower-risk approach is why shares deserve a full EBITDA multiple. These two stocks appear set up for a solid pairs trade based on current box office momentum alone.

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