NEW YORK (CNN/Money) -
For at least two months now DreamWorks Animation chief executive Jeffrey Katzenberg has been scratching his head over a new and worrisome question: Why isn't the most popular animation film ever released in theaters, "Shrek 2," flying off video store shelves?
According to Katzenberg, teams from DreamWorks and its distribution partner, Universal Studios Home Video, have been working hard to find the answer ever since the computer animation movie studio startled investors two months ago with news that "Shrek 2" sales were softer than expected.
At the time of its May 10 bombshell -- part of a first-quarter earnings announcement that missed Wall Street forecasts by far -- company officials limited the "Shrek 2" downtrend to North American sales.
Now that bombshell has led to potential legal problems: DreamWorks also disclosed that the Securities and Exchange Commission is conducting an informal inquiry into trading of its securities and its first quarter earnings announcement.
Bob Feldman, a DreamWorks spokesman, declined to provide details about the SEC probe, other than to say that the company is cooperating.
Monday, DreamWorks acknowledged that its DVD problem appears to be wider than just one film and one market. Sales of "Shrek 2" -- and the studio's other 2004 release out on home video, "Shark Tale" -- are falling short of forecasts both at home and overseas.
Investors are not happy. Dreamworks (down $3.85 to $22.96, Research) shares tumbled more than 14 percent, to $23 a share, in trading Monday on the New York Stock Exchange. DreamWorks shares hit their lowest level since they started trading publicly last October and are now 46 percent off their all-time high.
Katzenberg tried to reassure analysts during a conference call early Monday. He said he's not entirely sure what's going on, but said the "Shrek 2" and "Shark Tale" falloff may reflect a broader disruption in the global DVD market.
"We don't know whether this is a short-term issue or some larger shift that is going on," he said.
Pixar joins the party
On June 30, DreamWorks' chief competitor, Pixar Animation Studios, said too that it was seeing lower-than-expected DVD sales of "The Incredibles," which earlier this year beat "Shrek 2" for an Oscar as the best animation film of 2004. Pixar (down $0.55 to $42.45, Research) lowered its second-quarter profit forecasts as a result.
DreamWorks also said Monday that lower DVD sales would cut into its second-quarter profits. For the quarter that ended June 30, DreamWorks said it expects to post a loss of between 7 and 9 cents a share.
Analysts on average were expecting the company to turn a profit of 7 cents a share for the second-quarter.
DreamWorks also slashed its full 2005 profit guidance to between 80 and 90 cents a share, down from their earlier guidance of $1.00 to $1.25 a share. Analysts were expecting earnings of $1.30 a share for the current fiscal year.
Some industry analysts are beginning to ask themselves whether DVD sales, now more profitable for Hollywood than box office receipts, are in the early stages of a prolonged slump. Given that fewer people are going to movie theaters this year, movie studios need the DVD market to stay strong.
The problem, according to some analysts, is an oversupply of DVD titles. From theater releases to television shows to movies made for video, too many titles are chasing too little shelf space. To read more about what analysts think of the DVD market, click here.
Katzenberg, however, thinks it's too early to know yet what's happening to the DVD market. "There are a lot of moving parts that are going on right now." He said it would be "imprudent" and a "mistake" to draw broader conclusions.
In response to the disclosure, at least one media analyst downgraded DreamWorks stock.
Richard Greenfield, an analyst with Fulcrum Global Partners, said he's concerned that the warning indicates a more fundamental shift in the revenue potential for DreamWorks films -- and the industry generally.
"We believe it is clear from listening to (DreamWorks and Pixar) management over the past couple of months that the overall home video environment has changed rapidly," Greenfield wrote in a research note Monday.
But Greenfield was also highly critical of Katzenberg and chief financial officer Kristina Leslie, both of whom declined requests by analysts for specifics on current sales of "Shrek 2" and "Shark Tale."
Leslie said she still expects "Shark 2" video sales to match the 50 million units that the first "Shrek" sold, in part through re-releases timed to the third "Shrek" installment planned for 2007.
Greenfield, however, suggested that he thinks DreamWorks executives are being too optimistic. The revenue potential for DreamWorks films, he said, appears to be coming down at a time when the company's costs are rising.
In other news, DreamWorks announced that key investors including Katzenberg, David Geffen and Paul Allen have delayed their plans to sell as much as $500 million worth of shares in a secondary offering.
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