As Paramount Pictures moves to create an in-house animation division, its longtime partner DreamWorks Animation will be looking for a new home.
With the expiration of the studios' distribution agreement looming at the end of 2012, the relationship between the two companies has become increasingly strained over financial issues including how much DreamWorks would pay Paramount to release its films.
On Wednesday, it became apparent that negotiations had broken down and that the companies would almost certainly be going their separate ways, ending a partnership that began in 2006 when Paramount acquired DreamWorks Animation's live-action sibling studio, DreamWorks SKG.
To emphasize the schism, Paramount, owned by Viacom Inc., announced that it planned to start making its own slate of animated movies beginning in 2014.
The development means that DreamWorks Animation Chief Executive Jeffrey Katzenberg must find a new distribution partner or a buyer for his company, best known for the "Shrek" and "Kung Fu Panda" movie series.
Either move would be difficult at this time for several reasons: DreamWorks Animation's stock is at a two-year low; there is growing competition in the family animated movie business; and declining DVD sales are making it increasingly tough for studios to turn a profit on big budget productions.
Warner Bros. and Universal Pictures are the most likely distribution partners for DreamWorks Animation, say people familiar with the matter who were not authorized to speak on the record. Walt Disney Studios, 20th Century Fox and Sony Pictures have their own animation units and are said by people familiar with the matter not to be interested in releasing DreamWorks Animation's films.
Universal has a relatively new family entertainment unit — Illumination Entertainment — but could potentially add Katzenberg's movies to its roster.
Warner Bros. is now the only major Hollywood studio without its own animation division. Speculation in Hollywood has also centered on that studio's parent company, Time Warner, as a potential buyer for DreamWorks Animation. However, Time Warner chief Jeffrey Bewkes has told associates he would not overpay for the company.
Moreover, a person close to DreamWorks said the animation studio was not currently in talks with any potential buyers.
Selling the company now would clearly be a difficult pill for DreamWorks Animation shareholders to swallow. Over the last two years, the company's stock has declined 25% while the S&P 500 index has risen 49%. Investors are concerned because its financial results can swing so dramatically based on whether its two releases a year are hits or misses. In addition, DreamWorks growth prospects are limited because it hasn't developed any other significant revenue sources.
Katzenberg's decision to increase production to five movies every two years and to release all of his company's pictures in 3-D has not helped the stock. Family movies have been particularly hurt by the declining interest of American audiences in 3-D movies. Only 45% of opening-weekend receipts for May's "Kung Fu Panda 2" came from 3-D theaters.
"Jeffrey has pushed every lever he could and yet the stock is still at $20," said Doug Creutz, a media research analyst at Cowen Group. "He may be looking for an exit, but the question is whether he's willing to make an exit all the way down here."
Although the partnership between DreamWorks and Paramount has been largely successful with more hits than flops, tensions between the two grew when Paramount for the first time produced its own big-budget computer-animated feature, the March release "Rango."
Paramount recently offered Katzenberg a one-year extension to his company's deal for the same fee DreamWorks currently pays — 8% of film revenues — said people familiar with the terms. Beginning in 2014, the same year it will begin rolling out its own animated movies, Paramount is willing to accept only a higher fee. Katzenberg is unlikely to accept such an offer, as he has repeatedly told investors that he intends to seek a reduction in the fee.
Creating an animation division presents significant risks for Paramount, as it is entering a crowded field and will have to shoulder the high cost of production as well as marketing. The studio will probably not make a profit on "Rango," which cost close to $150 million and grossed about $243 million worldwide despite largely positive reviews.
Paramount said it intended to make its future animated movies for no more than $100 million.
"I don't think 'Rango' is the model for us going forward," said Paramount Chairman Brad Grey, noting that though he is proud of the movie creatively, "the price point will need to be more reasonable."
Paramount hopes its animation unit, which the studio is currently seeking a senior executive to oversee, will produce properties that can spawn sequels, consumer products and other business opportunities.
The studio will release DreamWorks' next film, "Puss in Boots," in November, followed by "Madagascar 3" and "Rise of the Guardians" in 2012.