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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION WASHINGTON, D.C. 20549
 FORM 10-Q QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT
OF 1934 For the quarterly period ended September 30, 2004 Commission file number 001-32337 DREAMWORKS ANIMATION SKG, INC. (Exact name of Registrants as specified in their charters) Delaware
(State or other jurisdiction
of incorporation or organization)
    
    68-0589190
(I.R.S. employer identification no.)1000 Flower Street
Glendale, California
(Address of principal executive offices)
    
    91201
(Zip code)
 (818) 695-5000
(Registrants telephone number, including area code) Indicate by check mark whether the Registrants (1) have filed all reports
required to be filed by Section 13 or 15(d) of the Securities Exchange Act of
1934 during the preceding 12 months (or for such shorter period that the
Registrant was required to file such reports), and (2) have been subject to
such filing requirements for the past 90 days.  Yes  o  No  x. Indicate by check mark whether the Registrants are accelerated filers (as
defined in Rule 12b-2 of the Exchange Act).  Yes  o  No  x. Indicate the number of shares outstanding of each of the Registrants classes
of common stock: As of November 2, 2004, there were 53,752,884 shares of Class
A common stock, 51,384,082 Class B common stock and 1 share of Class C common
stock of the registrant outstanding.




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TABLE OF CONTENTS PagePART I.FINANCIAL INFORMATIONITEM 1.Financial Statements  DreamWorks Animation (unaudited)
    
    
    3ITEM 2.Managements Discussion and Analysis of Financial Condition and Results of Operations
    
    
    19ITEM 3.Quantitative and Qualitative Disclosure About Market Risk
    
    
    50ITEM 4.Controls and Procedures
    
    
    51PART II.OTHER INFORMATIONITEM 1.Legal Proceedings
    
    
    52ITEM
4.Submission of Matters to a Vote of Security Holders
    
    
    52ITEM 6.Exhibits
    
    
    52SIGNATURES
    
    
    53EXHIBIT INDEX
    
    
    54Exhibit 31.1Exhibit 31.2Exhibit 32.1
  2




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PART I  FINANCIAL INFORMATION 
 ITEM l. Financial Statements (unaudited) DreamWorks Animation
(A Division of DreamWorks L.L.C.)
Combined Balance Sheets September 30,
    
    December 31,2004
    
    2003In thousands(Unaudited)AssetsCash and cash equivalents
    
    $
    4
    
    
    $
    41Accounts receivable, net of allowance for doubtful
accounts and reserve for returns
    
    
    99,708
    
    
    
    132,329Receivables from employees
    
    
    1,823
    
    
    
    2,480Film inventories
    
    
    661,333
    
    
    
    427,463Property, plant, and equipment, net of accumulated depreciation and
amortization
    
    
    81,499
    
    
    
    85,064Deferred costs, net of amortization of $1,217 and $838, respectively
    
    
    1,263
    
    
    
    1,641Goodwill
    

    

    26,462
    
    
    
    26,462Other assets
    



    
    5,400
    
    
    
    1,644Total assets
    



    $
    877,492
    
    
    $
    677,124Pro
FormaSeptember
30,2004(Unaudited)Liabilities and owners equity (deficiency)LiabilitiesAccounts payable
    




    $
    3,941
    
    
    $
    1,615
    
    



    $
    3,941Accrued liabilities
    





    
    164,702
    
    
    
    97,280
    
    




    
    73,823Advances and unearned revenue
    






    
    117,535
    
    
    
    89,009
    
    





    
    105,604Obligations under capital leases
    




    
    3,245
    
    
    
    3,732
    
    







    
    3,245Debt allocated by DreamWorks Studios
    


    
    447,464
    
    
    
    418,379
    
    





    
    Other debt
    







    
    91,613
    
    
    
    76,612
    
    





    
    243,013Total liabilities
    



    
    828,500
    
    


    
    686,627
    
    
    
    429,626Commitments
and contingenciesNon-controlling minority interest
    

    
    2,941
    
    

    
    2,941
    
    
    
    2,941Stockholders
and owners equityOwners
equity (deficiency)
    
    
    46,051
    
    
    
    (12,444
    )
    
    
    Class A
common stock, par value $.01 per share, 350,000,000 shares
authorized, 53,752,884 shares outstanding pro forma
    
    
    
    
    
    
    
    
    
    
    54Class B
common stock, par value $.01 per share, 150,000,000 shares
authorized, 51,384,082 shares outstanding pro forma
    
    
    
    
    
    
    
    
    
    
    51Class C
common stock, par value $.01 per share, one share authorized and
outstanding pro forma
    
    
    
    
    
    
    
    
    
    
    Deferred
compensation
    
    
    
    
    
    
    
    
    
    
    (64,223
    )Additional
paid-in capital
    
    
    
    
    
    
    
    
    
    
    737,877Retained deficit
    
    
    
    
    
    
    
    
    
    
    (44,820
    )Total stockholders and owners equity (deficiency)
    
    
    46,051
    
    
    
    (12,444
    )
    
    $
    628,939Total liabilities and owners equity (deficiency)
    
    $
    877,492
    
    
    $
    677,124
    
    
    $
    1,061,506
 The accompanying notes are an integral part of these statements. 3




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DreamWorks Animation
(A Division of DreamWorks L.L.C.)
Unaudited Combined Statements of Operations Three months ended
    
    Nine months endedSeptember 30,
    
    September 30,2004
    
    2003
    
    2004
    
    2003In thousandsOperating revenue
    
    $
    241,343
    
    
    $
    47,828
    
    
    $
    582,461
    
    
    $
    166,352Costs of revenue
    
    
    196,311
    
    
    
    72,973
    
    
    
    394,526
    
    
    
    267,677Gross profit (loss)
    
    
    45,032
    
    
    
    (25,145
    )
    
    
    187,935
    
    
    
    (101,325
    )Provision for doubtful accounts
    
    
    116
    
    
    
    476
    
    
    
    1,877
    
    
    
    849Selling, general and administrative expenses
    
    
    12,543
    
    
    
    7,187
    
    
    
    29,817
    
    
    
    21,956Operating income (loss)
    
    
    32,373
    
    
    
    (32,808
    )
    
    
    156,241
    
    
    
    (124,130
    )Interest expense, net of interest income
    
    
    (6,439
    )
    
    
    (2,500
    )
    
    
    (13,228
    )
    
    
    (9,983
    )Other expense, net
    
    
    (4,365
    )
    
    
    (265
    )
    
    
    (238
    )
    
    
    (15,269
    )Income (loss) before income taxes
    
    
    21,569
    
    
    
    (35,573
    )
    
    
    142,775
    
    
    
    (149,382
    )Provision for income taxes
    
    
    1,256
    
    
    
    325
    
    
    
    1,784
    
    
    
    1,210Net income (loss)
    
    $
    20,313
    
    
    $
    (35,898
    )
    
    $
    140,991
    
    
    $
    (150,592
    )Unaudited pro forma combined statement
of operations data (See Note 11)Income (loss) before income taxes
    
    $
    21,569
    
    
    $
    (35,573
    )
    
    $
    142,775
    
    
    $
    (149,382
    )Pro forma provision for income taxes
    
    
    7,861
    
    
    
    325
    
    
    
    52,041
    
    
    
    1,210Pro forma net income (loss)
    
    $
    13,708
    
    
    $
    (35,898
    )
    
    $
    90,734
    
    
    $
    (150,592
    )Unaudited net income (loss) per share data (See Note 11)Basic net income (loss) per share
    
    $
    0.18
    
    
    $
    (0.47
    )
    
    $
    1.18
    
    
    $
    (1.97
    )Diluted net income (loss) per share
    
    $
    0.18
    
    
    $
    (0.47
    )
    
    $
    1.18
    
    
    $
    (1.97
    )Shares used in computing unaudited net income
(loss) per share (1):Basic
    
    
    76,636
    
    
    
    76,636
    
    
    
    76,636
    
    
    
    76,636Diluted
    
    
    77,123
    
    
    
    76,636
    
    
    
    77,123
    
    
    
    76,636
 The accompanying notes are an integral part of these statements. 4




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DreamWorks Animation
(A Division of DreamWorks L.L.C.)
Unaudited Combined Statements of Cash Flows Nine Months EndedSeptember 30,2004
    
    2003In thousandsOperating activitiesNet income (loss)
    
    $
    140,991
    
    
    $
    (150,592
    )Adjustments to reconcile net income (loss) to net cash
used by operating activities:Amortization and write off of film inventories
    
    
    139,890
    
    
    
    151,563Stock compensation expense
    
    
    409
    
    
    
    (2,253
    )Depreciation and amortization
    
    
    4,214
    
    
    
    2,939Revenues recorded against advances and
unearned revenue
    
    
    (16,355
    )
    
    
    (4,335
    )Provision for doubtful accounts
    
    
    1,877
    
    
    
    849Provision for video returns
    
    
    26,744
    
    
    
    484Change in operating assets and liabilities:Accounts receivable
    
    
    4,000
    
    
    
    95,010Receivables from employees
    
    
    657
    
    
    
    (333
    )Film inventories
    
    
    (373,760
    )
    
    
    (156,098
    )Other assets
    
    
    (3,756
    )
    
    
    (156
    )Accounts payable and accrued expenses
    
    
    69,339
    
    
    
    (26,015
    )Unearned revenue
    
    
    (6,863
    )
    
    
    5,202Net cash used in operating activities
    
    
    (12,613
    )
    
    
    (83,735
    )Investing activitiesPurchases of property, plant, and equipment
    
    
    (270
    )
    
    
    (2,229
    )Net cash used in investing activities
    
    
    (270
    )
    
    
    (2,229
    )Financing ActivitiesTransfers to DreamWorks Studios
    
    
    (82,496
    )
    
    
    (83,082
    )Deferred debt costs
    
    
    (1
    )
    
    
    (152
    )Payments on capital leases
    
    
    (487
    )
    
    
    (465
    )Increase in debt
    
    
    29,085
    
    
    
    156,026Other debt
    
    
    15,001
    
    
    
    Advances
    
    
    51,744
    
    
    
    14,718Net cash provided by financing activities
    
    
    12,846
    
    
    
    87,045(Decrease) increase in cash and cash equivalents
    
    
    (37
    )
    
    
    1,081Cash and cash equivalents at beginning of period
    
    
    41
    
    
    
    3Cash and cash equivalents at end of period
    
    $
    4
    
    
    $
    1,084
 The accompanying notes are an integral part of these statements. 5




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DREAMWORKS ANIMATION
(A Division of DreamWorks L.L.C.) NOTES TO COMBINED FINANCIAL STATEMENTS
(Unaudited) 1. Organization and Summary of Significant Accounting Policies Basis of Presentation and Business The combined financial statements of DreamWorks Animation (DreamWorks
Animation or the Company) present the stand-alone financial position,
results of operations, and cash flows of the animation businesses and
activities of DreamWorks L.L.C. and its consolidated subsidiaries (DreamWorks
Studios or the Parent). The businesses and activities of DreamWorks L.L.C.s
animation business include the development, production and exploitation of
animated films in the domestic and international theatrical, home video,
television and other markets, as well the activities of its consumer products
division. DreamWorks Studios is a limited liability company engaged primarily
in the businesses of development, production and distribution of live action
and animated feature films. The combined financial statements of the Company
reflect all adjustments, including allocations of costs incurred by DreamWorks
Studios, necessary for a fair presentation of the operations of the Company.
(See Note 2). On October 27, 2004 (the Separation Date), the Company ceased to be a
majority owned subsidiary of DreamWorks Studios and was spun off from
DreamWorks Studios as part of an initial public offering that closed on
November 2, 2004. Interim Financial Data The unaudited combined financial statements of the Company for the three
month and nine month periods ended September 30, 2004 and 2003 have been
prepared on the same basis as the audited combined financial statements and, in
the opinion of management, include all adjustments (consisting only of normal
recurring adjustments) necessary to state fairly the financial information set
forth therein, in accordance with U.S. generally accepted accounting
principles. The results of operations for the nine months ended September 30, 2004 are
not necessarily indicative of the results to be expected for the full fiscal
year. Cash and Cash Equivalents and Concentration of Credit Risk Cash and cash equivalents consist of cash on deposit and high quality
money market investments, principally commercial paper and commercial paper
mutual funds, with maturities when purchased of three months or less. Financial instruments that potentially subject the Company to concentrations of
credit risk consist primarily of cash and cash equivalents and accounts
receivable. Cash and cash equivalents consist of cash on deposit and
high-quality money market investments, principally commercial paper and
commercial paper mutual funds, with maturities when purchased of three months
or less. The Company limits its exposure to credit loss by placing its cash and
cash equivalents in short term investments with high-credit, quality financial
institutions. Significant accounts receivable are due from Universal Studios,
Inc. (Universal), the Companys international theatrical distributor and
worldwide home video fulfillment services provider. As of September 30, 2004,
and December 31, 2003, approximately 70% and 68%, respectively, of accounts
receivable was due from Universal (See Note 3). Accounts receivable resulting
from revenues earned in other markets are derived from sales to customers
located principally in North America, Europe and Asia. The Company performs
ongoing credit evaluations of its customers and generally does not require
collateral. Financial Instruments The fair value of cash and cash equivalents, accounts receivable, accounts
payable, and 6




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advances approximates carrying value due to the short-term
maturity of such instruments. The fair value
of interest rate swap and foreign exchange agreements is the estimated amount
the Company would receive or pay to terminate the agreements, taking into
account current interest or exchange rates and the current creditworthiness of
the counterparties. DreamWorks Studios had entered into interest rate swap agreements to serve
as a hedge against interest rate fluctuations associated with the Companys
payment obligations under its real estate lease agreement. (See Note 5). These interest rate swap agreements had not qualified for special
hedge accounting and, as a result, changes in the fair value of such interest
rate swap agreements were reflected in Other Income (Expense) in the combined
statements of operations. DreamWorks Animation has entered into loan agreements with two banks for
financing of the production of a film (see Note 5). In connection with these
agreements, the Company entered into foreign currency exchange transactions to
limit the Companys foreign exchange rate exposure associated with its purchase
of British pounds to finance the film. These agreements do not qualify for
special hedge accounting and, as a result, the fair value of such foreign
currency exchange transactions has been included in Other Income (Expense) in
the combined statements of operations. The accompanying combined financial statements also reflect the
allocations of DreamWorks Studios indebtedness and the effects of DreamWorks
Studios interest rate swap agreements as described in Note 5. Inventories, Revenue and Costs Inventories Film inventories are stated at the lower of cost or fair value. These
inventories consist of development and production costs, including capitalized
overhead and interest. The Company also maintains home video product in
inventory, which primarily consists of digital videodiscs and videocassette
tapes and are stated at the lower of cost or market. Revenue The following are the conditions that must be met in order to recognize
revenue in accordance with the SOP: (i) persuasive evidence of a sale or
licensing arrangement with a customer exists; (ii) the film is complete and has
been delivered or is available for immediate and unconditional delivery; (iii)
the license period of the arrangement has begun and the customer can begin its
exploitation, exhibition or sale; (iv) the arrangement fee is fixed or
determinable and (v) collection of the arrangement fee is reasonably assured.
Amounts received from customers prior to the availability date of the product
are included in unearned revenue. On October 7, 2004, the Company entered into
a distribution agreement with DreamWorks Studios (the
Distribution Agreement) (See Note 10). Prior to the
effective date of the Distribution Agreement, revenue is recognized upon
meeting the criteria for revenue recognition required by the SOP as follows: Theatrical: Revenue from the theatrical distribution of films is
recognized as the films are exhibited in theaters. Pay Television and Free Television: Revenue from both pay and free
television licensing agreements are recognized at the time the production is
made available for exhibition in those markets. Home Video: Revenue from the sale of home video units is recognized at the
later of (i) when product is made available for retail sale or (ii) when video
sales to customers are reported to the Company by third parties, such as
fulfillment service providers or distributors. The Company follows the practice
of providing for future returns of home video product at the time the products
are sold. The Company calculates an estimate of future returns of product by
analyzing a combination of historical returns, current economic trends,
projections of consumer demand for our product and point-of-sale data available
from certain retailers. Based on this information, a percentage of each sale is
reserved provided that the customer has the right of return. Customers are
currently given varying rights of return, from 15% 7




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up to 100%. However,
although the Company does allow various rights of return for our
customers, the Company does not believe
that
these rights are critical in establishing return estimates, as other factors,
such as historical experience with similar types of sales,
information received from retailers, and managements assessment of the products appeal based on
domestic box office success and other research, are more important in
estimating returns. Generally, payment terms are within 90 days from the end of
the month in which the product was shipped. Actual returns are charged against
the reserve. Revenue associated with the licensing of home video product under
revenue-sharing agreements is recorded as earned under the terms of the
underlying agreements. Licensing and Merchandising: Revenue from licensing and merchandising is
recognized when the associated films have been released and the criteria for
revenue recognition have been met. In most instances, this generally results in
the recognition of revenue in periods when royalties are reported by licenses
or cash is received. After October 7, 2004, (the effective date of the Distribution Agreement),
the Company will recognize revenue with respect to each film in accordance with
the SOP, net of the recovery by DreamWorks Studios of (i) a distribution fee of
8.0% of revenue (without deduction for any distribution and marketing costs or
third-party distribution and fulfillment services fees) and (ii) all of its
unrecouped distribution and marketing costs with respect to such films.
DreamWorks Studios distribution fee will not apply to licensing and
merchandising revenue. Costs Inventories are amortized and contingent compensation and residuals are
accrued on an individual film basis in the proportion that current revenues
bear to total remaining estimated lifetime revenues as required by the SOP. Distribution and marketing costs, including advertising, marketing and
distribution and fulfillment service fees are expensed as incurred. Theatrical
print costs are expensed upon release of the film. During the three month and
nine month periods ended September 30, 2004, the Company included $110.3
million and $228.5 million, respectively, of distribution and marketing costs
in costs of revenue. During the three month and nine month periods ended
September 30, 2003, the Company included $43.3 million and $100.9 million,
respectively, of distribution and marketing costs in costs of revenue. Home video manufacturing costs are charged to costs of revenue at the time
home video revenues are recognized. After October 7, 2004 (the effective date of the Distribution Agreement),
the Company generally will no longer incur advertising, marketing and
distribution and fulfillment services fees in the markets covered by the
Distribution Agreement. Property, Plant and Equipment Property, plant and equipment are stated at the lower of cost or fair
value. Depreciation of property, plant and equipment is calculated using the
straight-line method over the useful life of the asset, ranging from three to
forty years. Leasehold improvements are amortized using the straight-line
method over the life of the asset, not to exceed the length of the lease.
Amortization of assets acquired under capital leases is included in
depreciation expense. Talent Commitments The Company enters into contracts with talent (primarily performers,
writers and producers) for the development of new product. Advance payments
made under such contracts, net of expected recoupments from productions, are
amortized on a straight-line basis over the term of the commitment. Income Taxes DreamWorks Studios paid no federal income taxes as an entity as the
operations of DreamWorks Studios were included in the taxable income of its
individual members. The tax expense in the 8




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accompanying combined statements of
operations principally represent foreign withholding taxes and
state franchise taxes. Use of Estimates The preparation of financial statements in conformity with U.S. generally
accepted accounting principles requires management to make estimates and
assumptions that affect the amounts reported in the financial statements and
accompanying notes, including estimates of ultimate revenues and ultimate costs
of film and television product and estimates of product sales that will be
returned and the amount of receivables that ultimately will be collected.
Actual results could differ from those estimates. Goodwill Goodwill
of approximately $26.5 million, net of amortization, associated
with DreamWorks Studios 2000 acquisition of a majority interest in Pacific
Data Images, Inc. (PDI) has been allocated to the Company. At September 30,
2004, the Company has determined that there was no impairment of goodwill. Deferred Costs Costs associated with negotiating the Companys animation facility lease,
which consist principally of legal costs and bank fees, are deferred and
amortized to rent expense (interest expense commencing on
January 1, 2004) using the straight-line method over the life of the
lease. Stock-Based Compensation The Company follows the provisions of FAS 123, Accounting for Stock-Based
Compensation (FAS 123). The provisions of FAS 123 allow companies to either
expense the estimated fair value of equity awards or to continue to follow the
intrinsic value method set forth in Accounting Principles Board Opinion No. 25,
Accounting for Stock Issued to Employees (APB 25). The Company has elected
to continue to apply APB 25 in accounting for its preexisting stock options
which were outstanding at the time of the acquisition of PDI. DreamWorks
Studios uses stock appreciation rights (which allow all employees to share in
the growth in value of DreamWorks Studios) as its principal stock-based
compensation plan. The vested amount of these awards are recorded at their
redemption value, and DreamWorks Studios has allocated to the Company the
redemption liability and the associated compensation expense related to the
Companys employees. Compensation expense, determined using the accelerated
expense attribution method under FASB Interpretation No. 28, Accounting for
Stock Appreciation Rights and Other Variable Stock Option Plans, is adjusted
to reflect changes in redemption value (See Note 6). As of the
Separation Date, the Companys incentive compensation
arrangements were significantly changed. See Note 10. Impairment of Long-Lived Assets The Company records impairment losses on long-lived assets used in
operations when indicators of impairment are present and the undiscounted cash
flows estimated to be generated by those assets are less than the assets
carrying amount. In such cases, the amount of the impairment is determined
based on the relative fair values of the impaired assets. Recent Accounting Pronouncements In December 2002, the FASB issued FAS No. 148, Accounting for Stock-Based
Compensation  Transition and Disclosure (FAS 148). FAS 148 amends FAS 123
to provide alternative methods of transition for an entity that voluntarily
changes to the fair value method of accounting for stock-based employee
compensation. In addition, FAS 148 amends the disclosure provisions of FAS 123
to require prominent disclosure of the effects of an entitys accounting policy
with respect to stock-based employee compensation on reported operating
results, including per share amounts, in annual and interim financial
statements. The disclosure provisions of FAS 148 were effective immediately
upon issuance in 2002. 2. Relationship to DreamWorks Studios During the periods covered by the combined financial statements,
DreamWorks Studios provided all marketing and overhead services to the Company,
including executive management, domestic 9




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theatrical marketing and distribution,
oversight of international theatrical distribution and worldwide home
video distribution, worldwide television sales, accounting and finance, legal,
employee benefits, risk management and information technology. DreamWorks
Studios has allocated such costs to the Company to reflect the amounts that
DreamWorks Studios believes is a fair and reasonable allocation of its costs to
provide these services to the Company. In general, these allocations have been
calculated based on the percentage that the Companys films, headcount, revenue
or other criteria constitute of the total films, headcount, revenue or other
criteria of DreamWorks Studios (including those of the Company). Certain of
these costs that are significantly or exclusively related to the production of
films are included in capitalized overhead in accordance with the SOP and are
reported as Film Inventories in the accompanying combined balance sheets. All
other allocations have been included in Selling, General and Administrative
Expenses in the accompanying combined statements of operations. Costs,
including capitalized costs, allocated from DreamWorks Studios for the three
month and nine month periods ended September 30, 2004, were $9.5 million and
$28.5 million, respectively. Costs, including capitalized costs, allocated from
DreamWorks Studios for the three month and nine month periods ended September
30, 2003, were $8.7 million and $27.1 million, respectively. DreamWorks Studios
has provided all working capital required for the development, production, and
marketing of films, as well as overhead, through centralized cash management.
The net impact of DreamWorks Studios funding of the Companys operations,
after the allocation of its indebtedness (Note 5), have been reflected as a
component of Owners Equity (Deficiency) in the accompanying combined financial
statements. Allocations Worldwide Marketing and Distribution: Certain overhead expenses for the
marketing and distribution of the Companys films have been allocated to the
Company by DreamWorks Studios. These costs include the salaries, fringe
benefits, and operating expenses of the employees in DreamWorks Studios
theatrical, home video, marketing and television sales/distribution
departments. The allocation of the overhead associated with these functions has
been based on several factors, including: (1) marketing costs incurred for the
Companys films as a percentage of marketing costs incurred for all DreamWorks
Studios films; (2) the number of films the Company has released as a
percentage of all DreamWorks Studios films released in a given year and (3)
estimates of time spent on the Companys releases as a percentage of time spent
on all DreamWorks Studios releases. Executive Management: Executive management expense is comprised of the
expenses relating to the principals and chief operating officers employed by
DreamWorks Studios, including the costs associated with transportation provided
by DreamWorks Studios to the Companys executives. These costs have been
allocated to the Company based on a combination of (1) revenue generated by the
Company as a percentage of DreamWorks Studios consolidated revenue and (2) the
Companys headcount as a percentage of DreamWorks Studios consolidated
headcount. Finance and Accounting: DreamWorks Studios has allocated accounting and
finance services related costs, including the costs of financial systems, to
the Company based on several factors, including: (1) revenue generated by the
Company as a percentage of DreamWorks Studios consolidated revenue; (2) the
Companys headcount as a percentage of DreamWorks Studios total headcount and
(3) estimates of time spent on the Companys finance projects as a percentage
of time spent on all DreamWorks Studios finance projects. Legal: Costs related to legal services, other than outside legal fees and
film specific trademark related expenses, which have been directly charged to
the Company, have been allocated to the Company based on actual time spent by
DreamWorks Studios attorneys on matters related primarily to the Company or
the Companys films. Human Resources: DreamWorks Studios has allocated human resources costs,
including management, benefits administration and employee relations to the
Company based on the Companys headcount as a percentage of the consolidated
headcount of DreamWorks Studios. Other costs related to human resources, such
as recruiting and relocation costs have been directly incurred by the Company. Occupancy and Facilities Management: The costs of facilities, facilities
management and mail services have been allocated to the Company based on the
square footage that the Company has occupied at of the Companys Glendale
animation campus and the Companys Redwood City production 10




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facility as a
percentage of total square footage of all DreamWorks Studios facilities. Insurance: Property insurance premiums have historically been allocated to
the Company based on the Companys insurable asset values as a proportion of
DreamWorks Studios total insurable asset values. Asset values are
representative of the assets fair market or replacement value as determined at
the time of premium renewal. The insurance premiums for policies such as errors
and omissions, directors and officers, travel, and excess liability, have been
allocated to the Company based on (1) the Companys headcount as a percentage
of the consolidated headcount of DreamWorks Studios and (2) the number of films
the Company has released as a percentage of all DreamWorks Studios films
released in a given year. Information Technology: DreamWorks Studios has allocated to the Company
the costs of network infrastructure and administrative desktop computer
support. This allocation has been based on the Companys headcount as a
percentage of total DreamWorks Studios headcount, in each case excluding the
headcount of the Companys Redwood City facility, as the costs related to Redwood City
have been directly incurred by the Company. For telecommunications, the Company
has been allocated a fixed fee for every telephone user, which includes the
costs of the equipment and related maintenance and support costs. The Company
has also been charged for actual local and long distance usage. Other Allocations: The Company has been allocated certain other costs,
including (1) costs to track, deliver and store various film and film related
content (for example, film elements, photos and artwork); (2) costs to oversee
dubbing of the Companys films and (3) costs to oversee the placement of
musical content in the Companys films. DreamWorks Studios provides fringe benefits to the Companys employees.
DreamWorks Studios pays all costs of the employer provided benefits package,
including health and 401(k) plans and employer payroll taxes, and allocates
such costs to the Company based on a percentage of total salaries incurred by
or allocated to the Company in relation to the total salaries incurred by
DreamWorks Studios. Employee fringe expense allocated to the Company for the
three month and nine month periods ended September 30, 2004, were $2.4 million
and $7.8 million, respectively. Employee fringe expense allocated to the
Company for the three month and nine month periods ended September 30, 2003,
were $2.5 million and $7.0 million, respectively. The employee fringe expense
allocated costs were recorded as Selling, General and Administrative expenses. The Company leases its animation campus in Glendale, California (see Note
5). The Company incurs all costs related to the operation of the facility, and
allocates occupancy costs to DreamWorks Studios. DreamWorks Studios was
allocated occupancy expense of approximately $1.2 million and $4.8 million for
the three month and nine month periods ended September 30, 2004, respectively.
DreamWorks Studios was allocated occupancy expense of approximately $1.3
million and $4.4 million for the three month and nine month periods ended
September 30, 2003, respectively. A portion of these costs has been
reallocated to the Company through the departmental allocations discussed
above. 3. Distribution, Licensing and Other Operating Agreements In prior years, DreamWorks Studios entered into several agreements with
Universal and its affiliates to provide international theatrical distribution
and international and domestic home video fulfillment services. In 2001,
DreamWorks Studios amended and extended its agreements with Universal (the
2001 Universal Agreement). In accordance with the Universal Agreement,
DreamWorks Studios received an advance against amounts due to DreamWorks
Studios based on the projected net receipts, as defined, of pictures in release
and pictures in production or pre-production (the 2001 Advance). DreamWorks
Studios is required to provide to Universal quarterly estimates of projected
cash receipts, net of projected expenses, distribution and service fees, due to
DreamWorks Studios from Universal in the markets where Universal provides
distribution and fulfillment services (the Pipeline Estimate). The 2001 Advance is calculated as the lesser of $100 million or 87% of the
Pipeline Estimate. At September 30, 2004, the 2001 Advance was calculated to be
$100 million. A portion of the 2001 Advance has been allocated to the Company
based on the relative share of the Companys net receipts included in 11




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the
Pipeline Estimate. Accordingly, at September 30, 2004 and December 31, 2003,
$11.9 million and
$12.8 million, respectively, of the 2001 Advance has been allocated to the
Company and is included in Advances and Unearned Revenue in the accompanying
combined balance sheets. In October 2003, DreamWorks Studios entered into a new amended and
restated agreement with Universal (the 2003 Universal Agreement). The 2003
Universal Agreement extends the terms of the international theatrical
distribution and international and domestic home video fulfillment services
agreements until December 31, 2010, with an option for Universal to extend the
term for an additional one or two years if certain performance thresholds are
not met. Pursuant to the 2003 Universal Agreement, DreamWorks Studios retains
responsibility for all direct distribution costs and Universal receives a fee
for distribution and fulfillment services. Pursuant to the 2003 Universal Agreement, $50 million of the 2001 Advance
was forgiven in May 2004 upon the change in ownership of Universal. The Company
is amortizing its allocable share of the forgiveness of the advance over the
remaining term of the 2003 Universal Agreement. Pursuant to the 2003 Universal Agreement, Universal agreed to pay to
DreamWorks Studios an additional advance of $75 million (the 2003 Advance),
of which $37.5 million was received in December 2003 and $37.5 million was
received in March 2004. The entire 2003 Advance is based on projected net
receipts, as defined, of the Companys animated features released subsequent to
December 31, 2002. As a result, 100% of the 2003 Advance has been allocated to
the Company and is included in Advances and Unearned Revenue in the
accompanying combined balance sheets. The 2003 advance bears interest at a rate
of 8.75% per annum. Pursuant to the Companys separation from DreamWorks
Studios, the Company assumed the obligation to repay the entire $75 million of
the 2003 advance from DreamWorks Studios. If future Pipeline Estimates fall below the levels required to maintain
the maximum advance, the excess advance must be repaid within five business
days. The advances are otherwise not recoupable or refundable until the earlier
of a payment default or termination of the Universal Agreements. DreamWorks Studios has received advances from Home Box Office, Inc.
(HBO) against license fees payable for future film product under an exclusive
10-year domestic pay television license agreement between HBO and DreamWorks
Studios. Since the advances are identified for each film, the Company has been
allocated the portion of the advances related to its animated features. During
the nine months ended September 30, 2004 and 2003, the Company recognized as
revenue $10 million and $10 million of such advances, respectively, in each
case representing a portion of the license fee due from HBO upon availability
of the underlying films. As of September 30, 2004, and December 31, 2003, there
were no unrecognized advances from HBO. DreamWorks Studios and the Company are
obligated to refund the advances if the advances exceed the license fees earned
by the films in accordance with the HBO agreement. 4. Film Inventories The following is an analysis of film inventories (in thousands): September 30, 2004
    
    December 31, 2003In development:Animated feature films
    
    $
    57,585
    
    
    $
    31,633In production:Animated feature films
    
    
    187,785
    
    
    
    299,213Television series
    
    
    
    
    
    
    10,414Completed, not released:Animated feature films
    
    
    150,391
    
    
    
    In release (net of amortization):Animated feature films
    
    
    248,037
    
    
    
    86,203Television series
    
    
    17,535
    
    
    
    Total film inventories
    
    $
    661,333
    
    
    $
    427,463
 12




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The Company anticipates that 95% of completed and released film
inventories will be amortized over the next three years. The Company further
anticipates that 71% of in release inventory will be amortized during the
next twelve months. This forecast does not include Shark Tale which was
released on October 1, 2004. Interest capitalized to film inventories during the three month and nine
month periods ended September 30, 2004 totaled $2.1 million and $5.8 million,
respectively. Interest capitalized to film inventories during the three month
and nine month periods ended September 30, 2003 totaled $1.4 million and $5.3
million, respectively. 5. Debt DreamWorks Studios has allocated its debt and related interest to the
Company based on the proportion of the Companys capital invested in films in
production as a percentage of total capital invested by DreamWorks Studios in
all films in production. Management of the Company believes that this
allocation best reflects the Companys actual use of capital. For the three
month and nine month periods ended September 30, 2004, interest allocated to
the Company amounted to $5.3 million and $14.1 million, respectively. For the
three month and nine month periods ended September 30, 2003, interest allocated
to the Company amounted to $4.3 million and $16.3 million, respectively. Of
these amounts, interest capitalized to Film Inventories in accordance with FAS
34 Capitalization of Interest Cost, totaled $2.1 million and $5.8 million for
the three month and nine month periods ended September 30, 2004, respectively,
and $1.4 million and $5.3 million for the three month and nine month periods
ended September 30, 2003, respectively. DreamWorks Studios indebtedness is principally based on variable rates
based on LIBOR, Eurodollar or commercial paper rates, plus a margin. Prior to
the Separation Date, substantially all of the assets of the Company had been
pledged as collateral to the lenders under the revolving credit facility of
DreamWorks Studios, and its subsidiaries, including the Company, guaranteed
this facility. In addition, prior to the Separation Date, a portion of the
Companys assets held by DW Funding, L.L.C., a wholly owned subsidiary of
DreamWorks Studios, had been pledged as collateral under its securitization
documents. Prior to the Separation Date, DreamWorks Studios credit facility
placed restrictions on its ability to sell assets or make distributions to its
members, and such restrictions extended to the Company. DreamWorks Studios utilizes interest rate swap agreements to hedge the
interest rate sensitivity of its indebtedness. These agreements do not qualify
for special hedge accounting and, as a result, changes in the fair value of
such agreements have been charged to operations. The impact of these agreements
has been allocated to the Company in a manner similar to the allocation of
debt. Accordingly, the net change in the fair value of these contracts has been
charged to Other Income (Expense), and the allocated fair value of these
contracts has been reflected in Accrued Liabilities. For the three month and
nine month periods ended September 30, 2004, the Company recorded other expense
of $2.9 million and other income of $8.2 million, respectively, related to the
allocated changes in the fair value of these instruments. For the three month
and nine month periods ended September 30, 2003, the Company recorded other
income of $2.7 million and other expense of $4.8 million, respectively, related
to the allocated changes in the fair value of these instruments. At September 30, 2004 and December 31, 2003, the Company estimates it
would have been required to pay approximately $24 million and $31.8 million,
respectively, to terminate all the aforementioned swap agreements. These
amounts have been recorded in Accrued Liabilities in the accompanying combined
financial statements. 13




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In May 1996, DreamWorks Animation entered into an agreement with a
financial institution for the
construction of an animation campus in Glendale, California, and the subsequent
lease of the facility upon its completion in early 1998. The lease on the
property, which was acquired and financed by the financial institution for
$76.5 million, qualified as an operating lease for the Company. In March 2002,
the Company renegotiated the lease through the creation of a special-purpose
entity that acquired the property from the financial institution for $73.0
million and the special-purpose entity leased the facility to the Company for a
five-year term. This transaction was structured to qualify as an operating
lease and obligated the Company to provide a residual value guarantee of
approximately $61 million. The entire amount of the obligation, $70.1 million
at September 30, 2004, is due and is payable in March 2007. In connection with
the adoption of Financial Accounting Standards Board Interpretation No. 46,
Consolidation of Variable Investment Entities, the special-purpose entity has
been consolidated by the Company as of December 31, 2003. In October 2003, the Company entered into an agreement to acquire an
animated film currently in production. Pursuant to the acquisition agreement,
the Company will pay approximately $45.0 million to acquire substantially all
distribution rights to the film. In connection with the acquisition, DreamWorks
Studios entered into loan agreements for the financing of the production costs
of up to approximately $28.7 million. Of this amount, $21.6 million and $6.6
million had been incurred as of September 30, 2004 and December 31, 2003,
respectively. This obligation is included in Other Debt and Film Inventories in
the accompanying combined balance sheets. The Company has entered into certain
foreign exchange transactions intended to hedge the fluctuations of foreign
currency payments related to the acquisition of this film. Pursuant to these
transactions, the Company is obligated to purchase up to 16.7 million British
pounds at an exchange rate specified in the transaction documents. At September
30, 2004, and December 31, 2003, the banks would be required to pay the Company
approximately $1.6 million and $1.2 million, respectively, to terminate the
foreign currency agreements. These amounts have been recorded in Other Assets
in the accompanying combined financial statements. 6. Employee Benefit Plans 401(k) Plans During the periods presented, the Company participated in DreamWorks
Studios defined contribution retirement plan (the Plan) under provisions of
Section 401(k) of the Internal Revenue Code (IRC). Substantially all
employees not covered by collective bargaining agreements were eligible to
participate in the Plan. The maximum contribution for the employer match was
equal to 50% of the employees contribution, up to 4% of their compensation, as
limited by Sec. 415 of the IRC. The costs of the employer match, as well as all
costs of administering the Plan are included in DreamWorks Studios fringe
benefit allocation to the Company. Employee Equity Participation Plan During the periods presented the Company participated in DreamWorks
Studios Employee Equity Participation Plan (the Equity Plan). Pursuant to
the Equity Plan, DreamWorks Studios could grant to employees or consultants
either actual or phantom shares of Class E stock (the Shares) or alternative
Class E stock (the Alternative Shares), with the aggregate outstanding Shares
or Alternative Shares not to exceed 10% of the equity of DreamWorks Studios.
Most of the Shares or Alternative Shares granted vested ratably over seven
years and the employees become fully vested in their Shares or Alternative
Shares on the seventh anniversary date of the granting of such Shares or
Alternative Shares. The employees and consultants were permitted to redeem the
Shares or Alternative Shares for cash or subordinated debt of DreamWorks
Studios, at a predetermined interest rate, at the greater of a percentage of
fair market value or the stipulated minimums provided in the Equity Plan, after
a three-year blackout period, provided that DreamWorks Studios achieves certain
defined operating performance thresholds. If these thresholds were not
achieved, the redemption price will be based on a percentage of fair market
value only. For the three month and nine month periods ended September 30, 2004,
compensation expense attributable to the Companys employees pursuant to the
Equity Plan of $1.7 million and $0.4 million, respectively, was allocated to
the Company. For the nine month period ended September 30, 2003, the Company
reversed previously recorded compensation expense related to the Equity Plan
aggregating 14




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$2.3 million to reflect the reduction in fair market value of the
Shares and Alternative Shares. For the
three month period ended September 30, 2003, the compensation expense
attributable to the Company was not material. As of September 30, 2004 and
December 31, 2003, deferred compensation liabilities associated with the Equity
Plan of $6.8 million and $6.4 million, respectively, were allocated to the
Company. In connection with the acquisition of PDI in 2000, the Company inherited a
stock option plan that was previously established by PDI. As of September 30,
2004, there were approximately 2.5 million stock options outstanding under this
plan, for the purchase of approximately 18% of the outstanding stock of PDI,
substantially all of which were vested. There have been no additional grants or
exercises of stock options since the acquisition of PDI in 2000. 7. Related Party Transactions The Company has made loans to certain of its executives and employees
pursuant to various notes receivable arrangements. These arrangements require
interest to be paid at rates ranging from 0% to 5.88%. Payments are due under
terms ranging from 1 to 10 years. Amounts due at September 30, 2004 and
December 31, 2003 are reflected in Receivables from Employees in the
accompanying combined balance sheets. Interest income associated with these
notes receivable for the three month and nine month periods ended September 30,
2004 and 2003 was not material. The Company provides services to DreamWorks Studios related to the
licensing of products based on DreamWorks Studios films and characters in such
films. For the three month and nine month periods ended September 30, 2004,
revenues earned from licensing activities on behalf of DreamWorks Studios
totaled $0.6 million and $4.8 million, respectively. For the three month and
nine month periods ended September 30, 2003, revenues earned from licensing
activities on behalf of DreamWorks Studios totaled $0.7 million and $3.0
million, respectively. 8. Significant Customer, Segment and Geographic Information In the first nine months of 2004 and 2003, Universal Studios represented
44% and 48%, respectively, of total revenue. The Company operates in a single segment: the production and distribution
of animated films. Revenues attributable to foreign countries were
approximately $201.7 million and $278.6 million for the three month and nine
month periods ended September 30, 2004, respectively. Revenues attributable to
foreign countries were approximately $23.2 million and $84 million for the
three month and nine month periods ended September 30, 2003, respectively.
Long-lived assets located in foreign countries were not material. Pursuant to the terms of the distribution agreements in place at
DreamWorks Studios, whereby DreamWorks Studios has not been responsible for
collecting foreign currency, there is a relatively short period between revenue
recognition and cash payment. DreamWorks Studios generally has not used foreign
currency swap transactions to hedge foreign currency exchange risks associated
with these distribution agreements. The following is an analysis of the Companys revenue by film title or
category: Three Months Ended
    
    Nine Months EndedSeptember 30,
    
    September 30,2004
    
    2003
    
    2004
    
    2003(In thousands)Shrek 2
    
    $
    194,926
    
    
    $
    
    
    
    $
    430,234
    
    
    $
    Sinbad:
Legend of the Seven Seas (1)
    
    
    (813
    )
    
    
    26,793
    
    
    
    20,046
    
    
    
    26,780Spirit: Stallion of the Cimarron
    
    
    2,870
    
    
    
    4,906
    
    
    
    15,570
    
    
    
    56,285Film
library/other (2)
    
    
    35,610
    
    
    
    16,129
    
    
    
    107,861
    
    
    
    83,287Television series
    
    
    8,750
    
    
    
    
    
    
    
    8,750
    
    
    
    $
    241,343
    
    
    $
    47,828
    
    
    $
    582,461
    
    
    $
    166,352
  (1)
    
    During the three month period ended September 30,
2004, the Company had a change in estimate which reduced Sinbad:
Legend of the Seven Seas domestic and international home video
revenues after receiving updated information from Universal that
reflected higher domestic and international home video return
percentages than had been originally anticipated. This change in
estimate reduced film revenues by $1.6 million.(2)
    
    Primarily includes film library revenue from Antz, Prince of Egypt, The Road
To El Dorado, Chicken Run, Joseph: King of Dreams and Shrek 15




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9. Valuation and Qualifying Accounts and Reserves The following is a summary of the valuation and qualifying accounts
included in the combined balance sheets for the year ended December 31, 2003
and the nine months ended September 30, 2004 (in thousands): Deductions(actualreturnsBalance at
    
    
    
    
    
    and bad
    
    Balance atbeginning
    
    Charged to
    
    debt write
    
    the end ofof period
    
    operations
    
    offs)
    
    periodSeptember 30,
2004 (unaudited)Reserve for returns
    
    $
    30,074
    
    
    $
    26,744
    
    
    $
    (43,867
    )
    
    $
    12,951Allowance for doubtful accounts
    
    
    2,346
    
    
    
    1,877
    
    
    
    (306
    )
    
    
    3,9172003Reserve for  returns
    
    
    40,785
    
    
    
    30,313
    
    
    
    (41,024
    )
    
    
    30,074Allowance for doubtful accounts
    
    
    1,847
    
    
    
    824
    
    
    
    (325
    )
    
    
    2,346
 10. Subsequent Event In July 2004, DreamWorks Animation SKG, Inc. filed a registration
statement with the Securities and Exchange Commission to issue shares of Class
A common stock of DreamWorks Animation SKG, Inc. In
October 2004, DreamWorks Studios separated the assets, liabilities and
subsidiaries that comprise the Company into DreamWorks Animation SKG, Inc.
(the Separation). In connection with the Separation, the Company assumed $325
million of debt that DreamWorks Studios had borrowed under its revolving credit
facility and $80 million of subordinated debt DreamWorks Studios owes to HBO.
In addition, the Company borrowed $101.4 million under a new revolving credit
facility to repay an equivalent amount of debt of DreamWorks Studios. In connection with the separation, the Companys board of directors
approved the 2004 Ominbus Incentive Compensation Plan (Ominbus Plan). The
Ominbus Plan provides for the grant of incentive stock options to Company
employees and nonstatutory stock options, restricted stock, stock appreciation
rights, performance units, performance shares, restricted stock units and other
stock based awards to the Companys employees, directors and consultants. In
connection with the Ominbus Plan, the Company issued various equity awards to
its employees and advisors as well as to employees of DreamWorks Studios as
described below. The Company issued fully vested shares to employees of
DreamWorks Studios and the Company who had fully vested awards granted by
DreamWorks Studios on an equivalent value basis. Outstanding unvested equity
awards previously issued by DreamWorks Studios were exchanged for equity awards
granted by the Company with the same intrinsic value and remaining vesting
terms. Awards to certain key employees of the Company will vest only in the
event that certain performance criteria are met. The Company also granted fully
vested stock to certain employees and advisors of the Company and DreamWorks
Studios, and the Company will record a charge of approximately $20 million to its
statement of operations in the fourth quarter of 2004. In addition to the
compensation recorded for fully vested stock, the Company recorded deferred
compensation related to grants of 16




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unvested awards to its employees, including
awards granted upon conversion of awards as described
above, of approximately $64 million that will be amortized over a four to seven
year period. The Company will account for its vested and unvested equity awards
granted to employees of DreamWorks Studios as a dividend to DreamWorks Studios
determined based upon the fair value of the awards at the date of grant. In
connection with the Separation, DreamWorks Studios contributed to the
Company its interests in Pacific Data Images, Inc. (PDI) and its subsidiary,
Pacific Data Images LLC (PDI LLC). Prior to the contribution, PDI was an
approximately 92% owned subsidiary of DreamWorks Studios. PDIs
sole asset was
its 60% ownership interest in PDI LLC. The remaining 40% interest in PDI LLC
was owned directly by DreamWorks Studios. As part of the contribution,
DreamWorks Studios contributed its 40% interest in PDI LLC to the Company in
exchange for shares of Class A common stock of the Company. Following the
contribution, PDI merged with and into a newly formed subsidiary of the
Company. Both DreamWorks Studios and the minority stockholders of PDI received
shares of the Companys Class A common stock pursuant to the merger. As a
result of these transactions, PDI became a wholly owned subsidiary of the
Company and PDI LLC became a wholly owned subsidiary of PDI. The acquisition of the approximately 8% minority interest in PDI will be
accounted for as a purchase of minority interest of PDI and, accordingly, the
acquired assets and liabilities, including goodwill and other intangibles,
pertaining to the acquired minority interest in PDI will be recorded at their
estimated fair values. In
October 2004, the Company entered into the Distribution Agreement with
DreamWorks Studios. Pursuant to the Distribution
Agreement, the Company has granted DreamWorks Studios the exclusive right to
distribute throughout the world all of its animated feature films that it
delivers to Dreamworks Studios through the later of (i) delivery of 12 animated
feature films, beginning with Shark Tale, and (ii) December 31, 2010.
DreamWorks Studios will be responsible for (1) the domestic and international
theatrical exhibition of our films, (2) the domestic and international home
video exhibition of our films and direct-to-video pictures, (3) the domestic
and international television licensing of the films, including pay-per-view,
pay television, network, basic cable and syndication, and (4) non-theatrical
exhibition of the films, such as on airlines, in schools and in armed forces
institutions. DreamWorks Studios was also granted Internet, radio (for
promotional purposes only) and new media rights with respect to the films. The
Company has retained all other rights to exploit the films, including the right
to make sequels and commercial tie-in and promotional rights with respect to
each film, as well as merchandising, interactive, literary publishing, music
publishing, soundtrack, radio, legitimate stage and theme park rights. Pursuant to the Distribution Agreement, DreamWorks Animation is
responsible for all of the costs of developing and producing its animated
feature films and for contingent compensation and residual payments. DreamWorks
Studios is generally responsible for all out-of-pocket costs, charges and
expenses incurred in the distribution (including prints and the manufacture of
home video units), advertising, marketing, publicizing and promotion of the
films, and has agreed to make expenditures consistent with historical levels
with respect to its films. The Distribution Agreement also provides that
DreamWorks Studios will be entitled to (1) retain a fee of 8.0% of revenue
(without deduction for any distribution and marketing costs and third-party
distribution and fulfillment services fees) and (2) recoup all of its
distribution and marketing costs prior to the Company recognizing any revenue.
In the event that the Distribution Agreement with DreamWorks Studios is
terminated, the Company remains subject to the terms of the 2003 Universal
Agreement, including the obligation to pay distribution fees and to pay
distribution expenses as they are incurred. The Company will not have the right
to terminate the 2003 Universal Agreement unless and until (i) DreamWorks
Studios has repaid all amounts it owes to Universal Studios, including in
respect of investments and advances, (ii) the Company has repaid all amounts
owed to Universal Studios, and (iii) Universal Studios has received an
aggregate of $75 million of net proceeds from the sale of shares of the
Companys common stock. Upon
the Separation, the Company entered into a services agreement with
DreamWorks Studios (the Services Agreement) that provides
for certain services to be provided to the Company by DreamWorks
Studios, including risk management, information systems management,
payroll, legal and certain business affairs advisory, human resources
administration, procurement, and other general support services. The
Services Agreement requires the Company to reimburse DreamWorks
Studios for its actual costs incurred, plus 5%. In
November, 2004 the Company received approximately $625.0 million in net
proceeds from the closing of our initial public offering after deducting
underwriting discounts, and commissions and offering expenses. From those net
proceeds the Company repaid the $325 million of debt assumed with respect to
DreamWorks Studios revolving credit facility and $30 million of the $80 million
assumed with respect to DreamWorks Studios subordinated debt to HBO. 17




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11. Pro Forma Information Pro Forma Balance Sheet Data The pro forma balance sheet data as
of September 30, 2004 presents the Company's historical balance
sheet adjusted for the pro forma effect of the Distribution Agreement
as if it had become effective on September 30, 2004, to give
effect to the issuance of shares of Class A, B and C common
stock and the assumption of debt in connection with the Separation
and incurrence of debt under the new revolving credit facility and to
give effect to the sale of Class A common stock in the initial public
offering and the repayment of a portion of the debt from the proceeds. Pro Forma Income Taxes As a result of the transactions described in Note 10, the Company will be
taxed at regular corporate rates. Deferred tax assets and liabilities will be
recognized for the tax consequences attributable to differences between the
financial statement carrying amounts of existing assets and liabilities and
their respective tax basis. Deferred tax assets and liabilities will be
measured using enacted tax rates expected to apply to taxable income in the
years in which those temporary differences are expected to be recovered or
settled. A deferred tax asset valuation allowance will be recorded if it is
more likely than not that all or a portion of the recorded deferred tax assets
will not be realized. For informational purposes, the combined statements of operations include
a pro forma adjustment for income taxes that would have been recorded if the
Company had been incorporated historically, calculated in accordance with FAS
No. 109, Accounting for Income Taxes. Pro Forma Earnings per Share Data Pro forma basic per share amounts are calculated using the number of
shares of common stock outstanding immediately following the Companys
separation from DreamWorks Studios as if such shares were outstanding for all
periods presented, excluding 3,501,007 shares granted upon consummation of the
offering. Unless the effects are anti-dilutive, pro forma diluted per share
amounts are calculated using the number of shares of common stock that will be
outstanding immediately following the Companys separation from DreamWorks
Studios as if such shares were outstanding for all periods presented, diluted
by 486,944 shares of Class A common stock that will underlie the DreamWorks
Studios equity-based compensation awards being converted into equity-based
compensation awards of the Company upon the consummation of the offering.
Equity awards totaling 3,501,007 shares granted upon consummation of the public
offering have been excluded. 18




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ITEM 2. Managements Discussion and Analysis of Financial Condition
and Results of Operations This Managements Discussion and Analysis of Financial Condition and
Results of Operations contains forward-looking statements that have been made
pursuant to the provisions of the Private Securities Litigation Reform Act of
1995, particularly statements referencing the targeted release dates of our
feature films, our anticipated operating expenses and capital expenditures, and
our expectations regarding any future distribution agreement into which we may
enter. In some cases, forward-looking statements can be identified by the use
of words such as may, could, would, might, will, should, expect,
forecast, predict, potential, continue, anticipates, expects,
intends, plans, believes,
seeks, estimates, is scheduled for, targeted, and variations of
such words and similar expressions. Such forward-looking statements are based
on current expectations, estimates, and projections about our industry,
managements beliefs, and assumptions made by management. These statements are
not guarantees of future performance and are subject to certain risks,
uncertainties and assumptions that are difficult to predict; therefore, actual
results and outcomes may differ materially from what is expressed or forecasted
in any such forward-looking statements. Such risks and uncertainties include
those set forth herein under Risk Factors on pages 37
through 51. Particular
attention should be paid to the cautionary language in Risk Factors  Our
success is primarily dependent on audience acceptance of our films, which is
extremely difficult to predict and therefore inherently risky, Our business
is dependent upon the success of a limited number of releases each year and the
commercial failure of any one of them could have a material adverse effect on
our business, Our operating results fluctuate significantly, The production
and marketing of CG animated films is capital intensive and our capacity to
generate cash from our films may be insufficient to meet our anticipated cash
requirements, and Our scheduled releases of CG animated feature films will
place a significant strain on our resources. Unless required by law,
we undertake no obligation to update publicly any
forward-looking statements, whether as a result of new information, future
events or otherwise. Our actual results may differ materially from those
discussed in the forward-looking statements as a result of various factors,
including but not limited to those listed under Risk Factors and included in
other portions of this prospectus. Overview We have been developing and producing animated films as a division of
DreamWorks Studios since its formation in 1994 and our assets, liabilities and
operating results have been included in DreamWorks Studios financial
statements since that time. Our business (the Animation Business) includes
the development, production and exploitation of animated films in the domestic
and international theatrical, home video, television and other markets, as well
as consumer products activities. Prior to October 27, 2004 (the Separation
Date), we were a division of DreamWorks Studios and our operations were
conducted through DreamWorks Studios. DreamWorks Studios is a limited liability
company that, prior to the Separation Date, engaged primarily in the
businesses of development, production and distribution of live action and
animated feature films. As a result of the separation, the assets and
liabilities that comprised the Animation Business have been transferred to
DreamWorks Animation SKG, Inc., the entity through which we now conduct our
business. We have theatrically released a total of nine animated feature films,
including Antz, Shrek, Shrek 2 and Shark Tale. We have a substantial number of
projects in development that are expected to fill our release schedule in 2007
and beyond. The table below lists our next five films and their
anticipated release schedule.  
    
    Madagascar (release on May 27, 2005)
    
    Wallace and Gromit: Tale of the Were Rabbit (release on October 7, 2005)
    
    Over the Hedge (release on May 19, 2006)
    
    Flushed Away (release in fall 2006)
    
    Shrek 3 (release in May 2007). In December, 2004,
we decided to move the release of this film from November 2006 to
May 2007. Release dates are tentative. Due to the uncertainties involved in the
development and production of animated feature films, the date of their
completion can be significantly delayed. Our unaudited combined financial statements, which are discussed below,
reflect the historical financial position, results of operations and cash flows of the
Animation Business prior to the separation. The financial information, however,
does not reflect what our financial position, results of operations and cash
flows will be in the future or what our financial position, results of
operations and cash flows would have been in the past had we been a separate,
stand-alone company during the periods presented. Sources of Revenue Our feature films are the source of substantially all of our revenue,
which is derived through their worldwide exploitation in sequential domestic
and international distribution channels, typically beginning 19




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with domestic
theatrical exhibition. Historically, we have released an average of one film
per year. In the
future, we expect to release two films per year. In addition, in the past, our
sources of revenue have principally been the domestic and international
theatrical, home video and television markets, although we have also derived
revenue from ancillary sources, such as through the merchandising and licensing
of our characters and films. Under the Distribution Agreement, which is
described below, receipts from the domestic and international theatrical
exhibition of a film will be used by DreamWorks Studios to recover the
distribution and marketing expenses it incurs for the film and to cover its
distribution fee relating to these markets. Accordingly, we will only record
revenue from domestic theatrical receipts to the extent they exceed these
costs. In addition, we expect that our revenue will be principally derived from
the home video and television markets and from the same ancillary sources as in
the past. Because DreamWorks Studios will be recouping distribution and
marketing costs and its distribution fee, our revenue from theatrical markets
will be significantly lower than it would have been had we not entered the
Distribution Agreement. Historically, there has been a close correlation between domestic box
office success and home video and international theatrical box office success,
such that films that achieve high domestic box office receipts also tend to
sell large numbers of home videos and achieve a high international theatrical
box office gross. In addition, license fees derived from pay and broadcast
television are often based on the box office success of a film. Therefore, we
consider domestic box office sales to be the most important indicator of how
much revenue our films will ultimately generate. Regardless of the number of
films we make or how we report our revenue, our revenue will always be
dependent on the performance of our films. Our films are distributed in foreign countries and, in recent years, we
have derived approximately one-third of our revenue from foreign sources. As a
result, fluctuations in foreign currency exchange rates can adversely affect
our business, results of operations and cash flow. Due to the nature of the
distribution agreements that have been in place at DreamWorks Studios, whereby
DreamWorks Studios has not been responsible for collecting foreign currency,
there is a relatively short period between revenue recognition and cash payment
under those agreements. As a result, neither we nor DreamWorks Studios
generally have hedged foreign currency exchange risks associated with those
distribution agreements (although we have used hedging transactions in
connection with foreign currency denominated production costs), and we do not
expect to do so in the future. Our historical financial statements do not reflect any material
allocations of revenue from DreamWorks Studios and we do not expect any
material allocations in the future. Costs of Revenue and Selling, General and Administrative Expenses Historically, our costs of revenue have included distribution and
marketing costs; third-party distribution and fulfillment services fees; the
amortization of capitalized production, overhead and interest costs; contingent
compensation and residual costs; and write-offs of film inventory for
unreleased films. Selling, general and administrative expenses include
salaries, employee benefits, rent and other routine overhead expenses described
below under  Allocations, net of expenses included in capitalized overhead.
Over the past decade, expenses in the motion picture industry have increased
rapidly as a result of increased production costs and distribution and
marketing costs. See Risk Factors  The costs of producing and marketing
feature films have steadily increased and may increase in the future, which may
make it more difficult for a film to generate a profit or compete against other
films. Distribution and marketing costs consist primarily of the costs of
advertising, preparing release prints and manufacturing home video units. The
costs of advertising a CG animated feature film for the theatrical market are
significant and typically involves national and target market media campaigns,
as well as public appearances of the films stars. In addition, there are
significant advertising costs associated with other distribution channels, such
as home video marketing. Capitalized production costs include all of the costs incurred to develop
and produce animated films, which primarily consist of salaries and fringe
benefits for animators and voice talent (which, in the case of sequels such as
Shrek 2, can be significant), equipment and other direct operating costs.
Capitalized production overhead generally represents the salaries of individual
employees or entire departments with exclusive or significant responsibilities
for the production of our films. 20




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We are responsible for certain compensation paid to creative participants,
such as writers, producers, directors, voice talent, animators and other
persons associated with the production of a film, which is dependent on the
performance of the film and is based on factors such as domestic box office and
total revenue recognized by the distributor related to the film. In some cases,
particularly with respect to sequels (such as Shrek 2), these contingent
compensation costs can be significant. We are also responsible for residuals,
which are payments based on similar factors and generally made to third-parties
pursuant to collective bargaining, union or guild agreements or for providing
certain services such as recording or synchronization services. Accordingly,
residual payments generally increase as total revenue for a film increases. Under the Distribution Agreement, our costs of revenue will include the
amortization of capitalized production, overhead and interest costs, contingent
compensation and residual costs and write-offs of film inventory for unreleased
films, but generally will not include distribution and marketing costs or
third-party distribution and fulfillment services fees. Distribution and
marketing costs will be included in our costs of revenue only to the extent
that we cause DreamWorks Studios to make additional expenditures in excess of
agreed amounts or to the extent we become obligated under the Universal
Agreements. Our selling, general and administrative expenses will no longer
include allocated costs of DreamWorks Studios selling and marketing
departments. After the separation, our selling, general and administrative
expenses will include payments to DreamWorks Studios under the Services
Agreement described below for services it will provide to us, as well as costs
we incur for providing the services on our own, net of reimbursement for
services we provide to DreamWorks Studios under the Services Agreement. We
expect that we will have additional general and administrative expenses as a
result of becoming a public company. In connection with our separation from DreamWorks Studios, we issued
various equity awards to our employees and advisors, as well as to employees of
DreamWorks Studios as described below. We issued fully vested shares to our and
DreamWorks Studios employees who had fully vested awards granted by DreamWorks
Studios on an equivalent value basis. Outstanding unvested equity awards
previously issued by DreamWorks Studios were exchanged for equity awards
granted by us with the same intrinsic value and remaining vesting terms. Awards
to certain of our key employees will vest only in the event that certain
performance criteria are met. We granted fully vested stock to certain of our
and DreamWorks Studios employees and advisors upon the consummation of the
offering, and will record a charge of approximately $20 million to our
statement of operations during the fourth quarter of 2004. In addition to the
compensation recorded for fully vested stock, we will record deferred
compensation related to grants of unvested awards to our employees, including
awards granted upon conversion of awards as described above, of approximately
$64 million that will be amortized over a four to seven year period. We will
account for our vested and unvested equity awards granted to employees of
DreamWorks Studios as a dividend to DreamWorks Studios determined based upon
the fair value of the awards at the date of grant. As described in Note 1 to our unaudited combined financial statements,
Statement of Financial Accounting Standards No. 123, Accounting for
Stock-Based Compensation, allows companies to either expense the estimated
fair value of equity awards or to continue to use the intrinsic value method of
determining stock-based compensation. We continue to use the intrinsic value
method, but will be required to disclose the potential impacts on our financial
statements had we used the fair value method. We have not yet determined the
fair value of the equity awards, described above, we granted upon the
separation from DreamWorks Studios. However, we have made preliminary estimates
of the impact on our financial statements, and currently believe that our
annual compensation expense would likely range from $20 million to $30
million. This estimate is subject to change upon the completion of our
analysis. Changes to our underlying stock price or satisfaction of performance
criteria could significantly impact compensation expense to be recognized in
future periods. In addition, future grants of equity awards will result in
additional compensation expense in future periods. Allocations Our
unaudited combined financial statements include allocations of the combined assets, liabilities and expenses of
DreamWorks Studios and DreamWorks Animation. As an 21




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operating division of
DreamWorks Studios, we have historically been allocated a portion of DreamWorks
Studios total overhead expenses for the marketing and distribution of all
DreamWorks Studios films (including our films), and for corporate functions,
such as executive management, finance, accounting, legal, human resources,
facilities management, insurance and information technology. In general, these
allocations have been calculated based on the percentage that our films,
headcount, revenue or other criteria constitute of the total films, headcount,
revenue or other criteria of DreamWorks Studios (which amounts include our
films, headcount, revenue or other criteria). In the future, to the extent that
DreamWorks Studios provides these or other services to us that are not covered
by the Distribution Agreement, we will reimburse DreamWorks Studios pursuant to
the Services Agreement. A brief description of these services is also included
below. Worldwide Marketing and Distribution: Historically, certain overhead
expenses for the marketing and distribution of our films have been allocated to
us by DreamWorks Studios. These costs include the salaries, fringe benefits and
operating expenses of the employees in DreamWorks Studios theatrical, home
video, marketing and television sales/distribution departments. The allocation
of the overhead associated with these functions has been based on several
factors, including: (1) marketing costs incurred for our films as a percentage
of marketing costs incurred for all DreamWorks Studios films; (2) the number
of films we have released as a percentage of all DreamWorks Studios films
released in a given year and (3) estimates of time spent on our releases as a
percentage of time spent on all DreamWorks Studios releases. Although
DreamWorks Studios has historically allocated a portion of the overhead costs
of these departments to us, these services will be provided to us in the future
pursuant to the Distribution Agreement. Executive Management: Executive management expense is comprised of the
expenses relating to DreamWorks Studios principals, chief operating officers,
and their respective administrative staffs, including costs associated with
transportation. These costs have historically been allocated to us based on a
combination of (1) revenue generated by us as a percentage of DreamWorks
Studios consolidated revenue and (2) our headcount as a percentage of
DreamWorks Studios consolidated headcount. As a result of our
separation,
executive management expense, including costs associated with transportation,
will be incurred directly by us. Finance and Accounting: DreamWorks Studios has historically allocated
accounting and finance services related costs, including the costs of financial
systems, to us based on several factors, including: (1) revenue generated by us
as a percentage of DreamWorks Studios consolidated revenue; (2) our headcount
as a percentage of DreamWorks Studios total headcount and (3) time spent on
our finance projects as a percentage of time spent on all DreamWorks Studios
finance projects. As a result of our separation, we will directly incur the
costs of some accounting and finance services, such as strategic planning,
financial reporting, treasury and investor relations. Other accounting and
finance services, such as billing and collection of receivables (except
receivables derived from rights retained by us, such as licensing and
merchandising rights) and contingent compensation and residual reporting
oversight services, will be provided pursuant to the Distribution Agreement. As
a result, DreamWorks Studios will no longer allocate any of these costs to us.
However, DreamWorks Studios will provide other accounting services to us, such
as payroll, pursuant to the Services Agreement. Legal and Business Affairs: Costs related to legal and business affairs
services, other than outside legal fees and film specific trademark related
expenses, which have been directly charged to us, have historically been
allocated to us based on actual time spent by DreamWorks Studios attorneys on
matters related primarily to us or our films. As a result of the separation, we
will directly incur the costs of most legal and business affairs services,
either through our employees or through our direct retention of outside legal
counsel. However, some legal and business affairs services, such as work
related to employment and music law, will be provided to us by attorneys
employed by DreamWorks Studios under the Services Agreement. We will reimburse
DreamWorks Studios for these services pursuant to the Services Agreement. Human Resources: DreamWorks Studios has historically allocated some human
resources costs, including management, benefits administration and employee
relations to us based on our headcount as a percentage of the consolidated
headcount of DreamWorks Studios. Other costs related to human resources, such
as recruiting and relocation costs have been directly incurred by us. As a
result of the separation, we will directly incur the costs associated with
human resources management and employee 22




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relations. DreamWorks Studios will
provide other services, such as benefits management, for which we
will reimburse DreamWorks Studios pursuant to the Services Agreement. Occupancy and Facilities Management: The costs of facilities management
and mail services have been allocated to us historically based on the square
footage that we have occupied at our Glendale animation campus and our Redwood
City production facility as a percentage of total square footage of all
DreamWorks Studios facilities. As a result of the separation, we will incur
the costs of facilities management and mail services directly. We will charge a
portion of our occupancy costs to DreamWorks Studios pursuant to the Glendale
lease arrangement. Insurance: Property insurance premiums have historically been allocated to
us based on our insurable asset values as a proportion of DreamWorks Studios
total insurable asset values, based on the assets fair market or replacement
value as determined at the time of premium renewal. The insurance premiums for
policies such as errors and omissions, directors and officers, travel, and
excess liability, have historically been allocated to us based on (1) our
headcount as a percentage of the consolidated headcount of DreamWorks Studios
and (2) the number of films we have released as a percentage of all DreamWorks
Studios films released in a given year. As a result of the separation
beginning January 1, 2005, we expect to directly incur all insurance costs. Information Technology: DreamWorks Studios has historically allocated to
us the costs of network infrastructure and administrative desktop computer
support. This allocation has been based on our headcount as a percentage of
total DreamWorks Studios headcount, in each case excluding the headcount of
our Redwood City facility, as the costs related to Redwood City have been
directly incurred by us. As a result of the separation DreamWorks Studios will
provide network infrastructure and administrative desktop support services to
us, and we will reimburse DreamWorks Studios for these services, pursuant to
the Services Agreement. For telecommunications, we have historically been
allocated a fixed fee for every telephone user, which includes the costs of the
equipment and related maintenance and support costs. We have also been charged
for actual local and long distance usage. Other Allocations: We have historically been allocated certain other
costs, including (1) costs to track, deliver and store various film and film
related content (for example, film elements, photos and artwork); (2) costs to
oversee dubbing of our films and (3) costs to oversee the placement of musical
content in our films. As a result of the separation we will directly incur some
of these costs, such as the placement of musical content in our films.
DreamWorks Studios will provide some of these services to us, such as the
dubbing of our films, as set forth in the Distribution Agreement. Other of
these services, such as the costs of storing various film and film related
content, will be provided to us, and we will reimburse DreamWorks Studios
pursuant to the Services Agreement. Debt, Interest and Other Expense Allocations: DreamWorks Studios has
historically allocated to us debt and interest expense associated with its
debt, and other income and expense associated with its interest rate swap
agreements. This allocation has been based on the proportion of capital
invested in our films in production as a percentage of total capital invested
by DreamWorks Studios in all films in production. A portion of this allocated
interest expense has been capitalized to film inventory. In connection with our
separation from DreamWorks Studios, we did not assume any obligations with
respect to any of DreamWorks Studios interest rate swap agreements. In the
future, to the extent we incur debt and interest expense, we will do so
directly. Distribution and Services Agreements We have entered into several agreements with DreamWorks Studios in
connection with our separation, including the Distribution Agreement and the
Services Agreement. Distribution Agreement. Pursuant to the Distribution Agreement, we have
granted to DreamWorks Studios the exclusive right to distribute all of our
completed animated feature films, including our previously released films,
throughout the world that are available for delivery through the later of (i)
delivery of 12 animated feature films, beginning with Shark Tale, and (ii)
December 31, 2010. However, in general, the term of the Distribution Agreement
will be extended to the extent of the term, if longer, of any of DreamWorks
Studios sub-distribution, servicing and licensing agreements that we
pre-approve (such 23




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as the Universal Agreements and DreamWorks Studios existing
arrangements with CJ Entertainment
nd Kadokawa Entertainment). In addition, even if we terminate our distribution
relationship with DreamWorks Studios, our existing and future films generally
will still be subject to the terms of pre-approved agreements. DreamWorks
Studios will be responsible for (1) the domestic and international theatrical
exhibition of our films, (2) the domestic and international home video
exhibition of our films and direct-to-video pictures, (3) the domestic and
international television licensing of our films, including pay-per-view, pay
television, network, basic cable and syndication, (4) non-theatrical exhibition
of our films, such as on airlines, in schools and in armed forces institutions.
DreamWorks Studios has also been granted Internet, radio (for promotional
purposes only) and new media rights with respect to our films. We retain all
other rights to exploit our films, including the right to make sequels and
commercial tie-in and promotional rights with respect to each film, as well as
merchandising, interactive, literary publishing, music publishing, soundtrack,
radio, legitimate stage and theme park rights. However, to the extent we wish
to exploit theme park rights, we will only do so through Universal Studios for
so long as Steven Spielberg has certain contractual relationships with us or if
he, his wife, his or her issue (or trusts for the primary benefit of any of
them) or a private charitable foundation organized by him and/or his wife
directly or indirectly owns or controls our Class A common stock. DreamWorks Studios will be directly responsible for the initial U.S.
theatrical release of all of our animated films, but may engage one or more
sub-distributors and service providers for all other markets, subject to our
prior written approval with respect to entities not currently so engaged by
DreamWorks Studios. Pursuant to the Distribution Agreement, we are solely
responsible for all of the costs of developing and producing our animated
feature films and for contingent compensation and residual costs. DreamWorks
Studios is responsible for all out-of-pocket costs, charges and expenses
incurred in the distribution (including prints and the manufacture of home
video units and distribution and fulfillment services fees payable to
third-parties), advertising, marketing, publicizing and promotion of the films,
and has agreed to make expenditures consistent with historical levels with
respect to our films. If we make a good faith determination that the
expenditure of additional distribution and marketing amounts will enhance a
films gross receipts, we may cause DreamWorks Studios to spend additional
amounts. In such a case, we will be solely responsible for advancing such
additional amounts to DreamWorks Studios for those additional expenditures and
we will expense such additional costs in the period in which they are incurred.
The Distribution Agreement also provides that DreamWorks Studios is entitled to
(i) retain a fee of 8.0% of revenue (without deduction for any distribution and
marketing costs or third-party distribution and fulfillment services fees) and
(ii) recoup all of its distribution and marketing costs prior to our
recognizing any revenue. Once the license to distribute one of our animated
films or direct-to-video pictures is acquired by DreamWorks Studios, it will
have the right to exploit the animated film or direct-to-video film in the
manner described above for 16 years from initial general theatrical release or
10 years from initial direct-to-video release. Services Agreement. We have also entered into the Services Agreement with
DreamWorks Studios that provides for certain services to be provided to us by
DreamWorks Studios. The services to be provided include (i) risk management;
(ii) information systems management; (iii) payroll services; (iv) legal and
business affairs advisory and consulting services; (v) human resources
administration; (vii) certain procurement services and (viii) other general
support services. We expect that these services will generally
require us to pay the actual costs incurred by DreamWorks Studios of
providing these services, plus 5% of the actual
costs. Critical Accounting Policies Revenue Recognition Both historically and under the Distribution Agreement, we have recognized
and will recognize revenue from the distribution of our animated feature films
when earned, as reasonably determinable in accordance with the Accounting
Standards Executive Committee of the American Institute of Certified Public
Accountants Statement of Position 00-2, Accounting by Producers or
Distributors of Films (the SOP). The following are the conditions that must
be met in order to recognize revenue in accordance with the SOP: (i) persuasive
evidence of a sale or licensing arrangement with a customer exists; (ii) the
film is complete and has been delivered or is available for immediate and
unconditional delivery; (iii) the license period of the arrangement has begun
and the customer can begin its exploitation, exhibition or sale; (iv) the
arrangement fee is fixed or determinable and (v) collection of the arrangement
fee is 24




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reasonably assured. Revenue from the sale of home video units is recognized at the later of
(i) when product is made available for retail sale or (ii) when video sales to
customers are reported to us by third parties, such as fulfillment service
providers or distributors. We follow the practice of providing for future
returns of home video product at the time the products are sold. We calculate
an estimate of future returns of product by analyzing a combination of
historical returns, current economic trends, projections of consumer demand for
our product and point-of-sale data available from certain retailers. Based on
this information, a percentage of each sale is reserved provided that the
customer has the right of return. Customers are currently given varying rights
of return, from 15% up to 100%. However, although we allow various rights of
return for our customers, we do not believe that these rights are critical in
establishing return estimates, as other factors, such as our historical
experience with similar types of sales, information we receive from retailers,
and our assessment of the products appeal based on domestic box office success
and other research, are more important in estimating returns. Generally,
payment terms are within 90 days from the end of the month in which the product
was shipped. Actual returns are charged against the reserve. Revenue associated
with the licensing of home video product under revenue-sharing agreements is
recorded as earned under the terms of the underlying agreements. Revenue from licensing and merchandising is recognized when the associated
films have been released and the criteria for revenue recognition have been
met. In most instances, this generally results in the recognition of revenue in
periods when royalties are reported by licenses or cash is received. For periods prior to the effective date of the Distribution Agreement, we
have recognized revenue from our films net of reserves for returns, rebates and
other incentives. Under the Distribution Agreement, which has become effective
as of October 7, 2004, we are entitled to recognize revenue after DreamWorks
Studios (i) retains a distribution fee of 8.0% of revenue (without deduction
for any distribution and marketing costs or third-party distribution and
fulfillment services fees) and (ii) recovers all of its distribution and
marketing costs with respect to our films. As of October 7, 2004, DreamWorks
Studios began retaining its 8.0% fee for all revenue recognized by it
subsequent to the effective date, regardless of whether the revenue relates to
a film released prior to the effective date of the Distribution Agreement and
regardless of whether it has recouped the distribution and marketing expenses
related to that film that it has incurred. Because DreamWorks Studios will be the principal distributor of our films,
in accordance with the SOP, the amount of revenue that we will recognize from
our films in any given period following the effective date of the Distribution
Agreement will depend on the timing, accuracy and sufficiency of the
information we receive from DreamWorks Studios. Although DreamWorks Studios has
agreed to provide us with the most current information available to it to
enable us to recognize our share of revenue, we may make adjustments to that
information based on our estimates and judgments. For example, we may make
adjustments to our revenue derived from home video units for estimates on
return reserves, rebates and other incentives that may differ from those that
DreamWorks Studios recommends. The estimates on reserves may be adjusted
periodically based on actual rates of returns, inventory levels in the
distribution channel, as well as other business and industry information. We
will also review expense estimates and may make adjustments to these estimates
in order to ensure that our revenue and gross margin are accurately reflected
in our financial statements. In addition, as is typical in the movie industry,
our distributor and its sub-distributors may also make subsequent adjustments
to the information that they will provide and these adjustments could have a
material impact on our operating results in later periods. Costs of Revenue Film Production Costs. We capitalize film production costs to film
inventories in production in accordance with the provisions of the SOP. Direct
film production costs include costs to develop and produce CG animated films,
which primarily consists of salaries and fringe benefits for animators and
voice talent, equipment and other direct operating costs. Production overhead,
a component of film inventory, includes allocable costs of individuals or
departments with exclusive or significant responsibility for the production of
our films. In addition to the films being produced, we are also working on
development of several new projects. Costs of these projects are capitalized as
film inventories in development in accordance with the provisions of the SOP
and are transferred to film inventories in production when a film is set for
production. We evaluate each project in development and production on 25




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a
quarterly basis to determine whether capitalized costs are in excess of our
estimate of fair value. If they
are in excess, then we write-off the excess cost and reflect these in costs of
revenue. In addition, after three years, if the project is still in development
and has not been set for production, it is written off and reflected in costs
of revenue. Contingent Compensation and Residuals. Certain compensation paid to
creative participants, such as writers, producers, directors, voice talent and
other persons associated with the production of a film is dependent on the
performance of the film, based on factors such as domestic box office and total
revenue recognized by the distributor related to the film. We are also
responsible for residuals, which are payments based on similar factors and
generally made to third-parties pursuant to collective bargaining, union or
guild agreement or for providing certain services such as recording or
synchronization services. These forms of contingent compensation and residual
costs are accrued in accordance with the SOP, using the
individual-film-forecast-computation method, which accrues and amortizes such
costs in the same ratio that current period actual revenue (numerator) bears to
estimated remaining unrecognized revenue as of the beginning of the current
fiscal year (denominator), as described below. Amortization. Once a film is released, the amount of film inventory
relating to that film, including film production costs and contingent
compensation and residual costs, is amortized and included in costs of revenue
in the proportion that the revenue during the period for each film (Current
Revenue) bears to the estimated total revenue to be received from all sources
for each film (Ultimate Revenue) under the
individual-film-forecast-computation method in accordance with the provision of
the SOP. The amount of film costs that are amortized each quarter will
therefore depend on the ratio of Current Revenue to Ultimate Revenue for each
film. We make certain estimates and judgments of Ultimate Revenue to be
received for each film based on information received from DreamWorks Studios,
and our knowledge of the industry. Estimates of Ultimate Revenue and
anticipated contingent compensation and residual costs are reviewed
periodically and are revised if necessary. A change to the Ultimate Revenue for
an individual film will result in an increase or decrease to the percentage of
amortization of capitalized film costs relative to a previous period.
Unamortized film production costs are evaluated for impairment each reporting
period on a film-by-film basis in accordance with the requirements of the SOP.
If estimated remaining revenue is not sufficient to recover the unamortized
film inventory for that film, the unamortized film inventory will be written
down to fair value determined using a net present value calculation. We expect that, in periods following the effectiveness of the Distribution
Agreement, the amount of revenue that we recognize in the periods immediately
following a films release will be substantially less than the amounts that we
have historically recognized in similar periods, due to the fact that, under
the Distribution Agreement, we will be recognizing revenue net of DreamWorks
Studios 8.0% distribution fee and the distribution and marketing costs that it
incurs. Consequently, although the total amount of production costs that are
amortized for any particular film will be the same over the life of the film,
the timing of the amortization will change, since amortization is calculated
based on the ratio of Current Revenue to Ultimate Revenue. Marketing and Distribution Expenses. The costs of marketing a film consist
primarily of prints and advertising costs, as well as third-party distribution
and fulfillment services fees. Print costs are expensed upon the theatrical
release of a film, and advertising and third-party distribution and fulfillment
services fees are expensed as incurred in accordance with the SOP and are
included in costs of revenue. Third-party distribution and fulfillment services
fees have historically included fees earned by our distributors and fulfillment
services providers, which in the periods up to the effectiveness of the
Distribution Agreement were primarily Universal Studios and CJ Entertainment.
Manufacturing costs (including duplication and replication) related to home
video units are expensed when the related product revenue is recognized. We
periodically evaluate inventories of such products for impairment and
obsolescence and make appropriate adjustments to their carrying value as
necessary. Although our historical financial statements include these costs, as
described above, pursuant to the Distribution Agreement, DreamWorks Studios
will generally be responsible for all costs associated with the distribution
and marketing of our films. Accordingly, in the future, our costs of revenue
will be lower than historical because they will not include distribution and
marketing costs and third-party distribution and fulfillment services fees. Our
revenue will also be lower because it will be net of the distribution and
marketing costs that DreamWorks Studios recoups, as well as its 8.0%
distribution fee. Results of Operations 26




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Three Months Ended September 30, 2004, compared to Three Months Ended
September 30, 2003. For the three months ended September 30, 2004, our results were primarily
driven by the international theatrical release of Shrek 2, and from continuing
revenue from our library of films. This was partially offset by theatrical
distribution and marketing costs associated with the release of Shrek 2 and
Shark Tale which was released on October 1, 2004. Revenue. For the three months ended September 30, 2004, revenue increased
by $193.5 million, from $47.8 million to $241.3 million, as compared to the
three months ended September 30, 2003. Film revenue for the three months ended
September 30, 2004 was primarily driven by the success of Shrek 2 in the
international theatrical market. For the three months ended September 30, 2004,
Shrek 2 generated total revenue of $194.9 million, including revenue earned
through merchandising and licensing. Our library titles
contributed $35.6 million of revenues primarily due to the home video reissue and free television release of Shrek which contributed revenues of $25.6 million. Film revenue for the
three months ended September 30, 2003 was derived primarily from domestic and
international theatrical revenue from Sinbad: Legend of the Seven Seas of $26.8 million.
Also contributing to revenue in the three months ended of September 30, 2003
was our library titles which contributed revenue of $16.1 million primarily
from the home video and international television markets. Costs of Revenue. Costs of film revenue were $196.3 million in the three
months ended September 30, 2004, as compared to $73.0 million in the three
months ended September 30, 2003. For the three months ended September 30, 2004,
theatrical distribution and marketing costs incurred in connection with the
release of Shrek 2 and Shark Tale were substantially higher than those incurred
for all films in the same period of 2003. Amortization of
Shrek 2 production costs (including contingent compensation) also contributed to the increase. Amortization of
film costs for released films as a percentage of film revenue in the three
months ended September 30, 2004 was 28%, compared to 45% for the three months
ended September 30, 2003. Amortization of film inventory as a percentage of
film revenue may vary from period to period due to several factors, including:
(i) changes in the mix of films earning revenue, (ii) changes in any films
Ultimate Revenue and capitalized costs and (iii) write offs of film inventory
due to changes in the estimated fair value of unamortized film inventory, as
required by the SOP. The decline in amortization of film inventory as a
percentage of film revenue for the three month period ended September 30, 2004
was primarily due to the change in the mix of films earning revenue. Shrek 2,
which has a low amortization percentage due to the size of its ultimate revenue
in comparison to ultimate costs, earned substantially more revenue than any of
our other films during the three month period ended September 30, 2004. This
resulted in a lower overall amortization percentage when compared to the three
month period ended September 30, 2003, where substantial revenue was earned
from Sinbad: Legend of the Seven Seas, which had a higher amortization
percentage due to the size of its ultimate revenue in comparison to ultimate
costs. Selling, General and Administrative Expenses. Total selling, general and
administrative expenses were $12.5 million for the three months ended September
30, 2004 as compared to $7.2 million for the three months ended September 30,
2003. This $5.3 million increase was primarily due to an increase in sales and
distribution department overhead allocated to us by DreamWorks Studios, which
was due in part to our higher revenue as a percentage of DreamWorks Studios
consolidated revenue. We expect that selling, general and administrative
expenses will be reduced in future periods to the extent that we are no longer
allocated overhead costs for selling and marketing and shared services.
However, this reduction will be offset to the extent of increases in direct
general and administrative and new compliance costs that result from our
becoming a public company. Interest Expense and Other Income and Expense. Total interest expense and
other expense was $10.8 million for the three months ended September 30, 2004
as compared to total interest expense and other expense of $2.8 million for the
three months ended September 30, 2003. This $8 million increase in expense was
primarily due to other income and expense associated with interest rate swap
agreements allocated to us by DreamWorks Studios and
an increase in interest expense allocated to us by DreamWorks Studios. For the three months ended
September 30, 2004 DreamWorks Studios allocated to us $6.7 million of other
expense and unrealized losses associated with these interest rate swap
agreements. For the three months ended September 30, 2003, DreamWorks Studios
allocated
to us $1.2 million of other expense and unrealized losses associated with these
interest 27




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rate swap agreements. In addition, the increase in expense was due to
an increase in interest expense allocated to us by DreamWorks Studios for the
three months ended September 30, 2004, as compared to 2003. Operating Results. The three months ended September 30, 2004 resulted in
operating income of $32.4 million and net income of $20.3 million, as compared
to operating losses of $32.8 million and a net loss of $35.9 million for the
three months ended September 30, 2003. This was primarily due to substantial
profits generated from the success of the May 2004 release of Shrek 2 in the
international theatrical markets. Because we operated as a division of a
limited liability company for both periods, we incurred only minimal income
taxes related to foreign withholding and state franchise taxes. Nine Months Ended September 30, 2004, compared to Nine Months Ended
September 30, 2003. For the nine months ended September 30, 2004, our results were primarily
driven by the domestic and international theatrical release of Shrek 2, and
from continuing revenue from our library of films. This was partially offset by
theatrical distribution and marketing costs associated with the release of
Shrek 2 and Shark Tale which was released on October 1, 2004. Revenue. For the nine months ended September 30, 2004, revenue increased
by $416.1 million, from $166.4 million to $582.5 million, as compared to the
nine months ended September 30, 2003. Film revenue for the nine months ended
September 30, 2004 was primarily driven by the success of Shrek 2 in the
domestic and international theatrical markets. Through September 30, 2004,
Shrek 2 generated total revenue of $430.2 million, including revenue earned
through merchandising and licensing. Sinbad: Legend of the Seven Seas and
Spirit: Stallion of the Cimarron contributed worldwide revenue of $35.6
million. Our library titles contributed revenue of
approximately $107.9 million in the nine months ended September 30, 2004,
primarily from the $82.1 million of revenues from Shrek. Film revenue for the
nine months ended September 30, 2003 was from our library titles in the amount
of $83.3 million primarily from the world wide home video and international
television markets. Also contributing to revenue in the first nine months of
2003 was revenue of $83.1 million from Sinbad: Legend of the Seven Seas and
Spirit in the domestic and international theatrical and worldwide home video
markets. The substantially higher revenue in the nine months ended September
30, 2004 as compared to 2003 was primarily due to the success of Shrek 2 in the
domestic and international theatrical markets. Costs of Revenue. Costs of film revenue were $394.5 million in the nine
months ended September 30, 2004, as compared to $267.7 million in the nine
months ended September 30, 2003. For the nine months ended September 30, 2004,
theatrical distribution and marketing costs incurred in connection with the
release of Shrek 2 and Shark Tale were substantially higher than those incurred
for all films in the same period of 2003. When comparing the nine months ended
September 30, 2004 and 2003, however, the effect of the higher marketing costs
for Shrek 2 in 2004 is offset by an inventory write-down in the first nine
months of 2003. For the nine months ended September 30, 2003, we recorded a
pre-release write-down for a change in the estimated fair value of unamortized
film inventory for Sinbad: Legend of the Seven Seas, which was released on July
2, 2003. Amortization of film costs for released films as a percentage of film
revenue in the nine months ended September 30, 2004 was 24%, compared to 89%
for the nine months ended September 30, 2003, which includes the impact of the
pre-release write-down of Sinbad: Legend of the Seven Seas. Amortization of
film inventory as a percentage of film revenue may vary from period to period
due to several factors, including: (i) changes in the mix of films earning
revenue, (ii) changes in any films Ultimate Revenue and capitalized costs and
(iii) write offs of film inventory due to changes in the estimated fair value
of unamortized film inventory, as required by the SOP. The decline in
amortization of film inventory as a percentage of film revenue for the first
nine months of 2004 was primarily due to the change in the mix of films earning
revenue. Shrek 2, which has a low amortization percentage due to the size of
its ultimate revenue in comparison to ultimate costs, earned substantially more
revenue than any of our other films in the first nine months of 2004. This
resulted in a lower overall amortization percentage when compared to the first
nine months of 2003, where substantial costs were impacted due to the
pre-release write-down of Sinbad: Legend of the Seven Seas. 28




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Selling, General and Administrative Expenses. Total selling, general and
administrative expenses were $29.8 million for the nine months ended September
30, 2004 as compared to $22 million for the nine months ended September 30,
2003. This $7.8 million increase was primarily due to an increase in sales and
distribution department overhead allocated to us by DreamWorks Studios, which
was due in part to our higher revenue as a percentage of DreamWorks Studios
consolidated revenue. We expect that selling, general and administrative
expenses will be reduced in future periods to the extent that we are no longer
allocated overhead costs for selling and marketing and shared services.
However, this reduction will be offset to the extent of increases in direct
general and administrative and new compliance costs that result from our
becoming a public company. Interest Expense and Other Income and Expense. Total interest expense and
other expense was $13.5 million for the nine months ended September 30, 2004 as
compared to total interest expense and other expense of $25.3 million for the
nine months ended September 30, 2003. This $11.8 million decrease in expense
was primarily due to other income and expense associated with interest rate
swap agreements allocated to us by DreamWorks Studios. For the nine months
ended September 30, 2004 DreamWorks Studios allocated to us $4.3 million of
other expense, net of unrealized gains, associated with these interest rate
swap agreements. For the nine months ended September 30, 2003, DreamWorks
Studios allocated to us $17.6 million of other expense and unrealized losses
associated with these interest rate swap agreements. This was partially offset
by an increase in interest expense allocated to us by DreamWorks Studios for
the nine months ended September 30, 2004, as compared to 2003. Operating Results. The nine months ended September 30, 2004 resulted in
operating income of $156.2 million and net income of $141 million, as compared
to operating losses of $124.1 million and a net loss of $150.6 million for the
nine months ended September 30, 2003. This was primarily due to substantial
profits generated from the success of the May 2004 release of Shrek 2 in the
domestic and international theatrical markets. In addition, for the nine months
ended September 30, 2003, we recorded a write-down for a change in the
estimated fair value of unamortized film inventory for Sinbad: Legend of the
Seven Seas. Because we operated as a division of a limited liability company
for both periods, we incurred only minimal income taxes related to foreign
withholding and state franchise taxes. Liquidity and Capital
Resources We retained small amounts of cash and cash equivalents in the year ended
December 31, 2003, and in the nine month period ended September 30, 2004.
During the periods covered by the unaudited combined financial statements,
DreamWorks Studios provided all working capital required for development,
production and marketing of our films and other operations through centralized
cash management. In the future, we expect to fund our operating activities with
cash that is generated from the films that we release, a portion of the
proceeds from our initial public offering described below and with borrowings
from a revolving credit facility which is described in the following paragraph.
As a result of the separation we are responsible for all costs of developing
and producing our animated feature films and direct-to-video films, while
DreamWorks Studios will generally be responsible for all costs of distributing
and marketing those products. As a result of the completion of our initial
public offering in November 2004, we received approximately
$625.0 million of
net proceeds after deducting underwriting discounts, and commissions and
offering expenses. A portion of those net proceeds was used to repay an
aggregate of $355 million of revolving credit and subordinated debt that we
assumed from DreamWorks Studios in connection with our separation.
Later in the fourth quarter of 2004 we also repaid
the $101.4 million of debt borrowed under our new revolving credit facility.
For the remainder of 2004 and the first half of 2005 we intend to use the
remaining proceeds of the initial public offering and cash received pursuant to
the Distribution Agreement from revenue related to Shrek 2, Shark Tale and our
other films to fund our operating activities. Although we expect that,
beginning in 2005, cash from operations will be sufficient to satisfy our
anticipated cash needs for working capital and capital expenditures, in the
event that these cash flows are insufficient, we expect to be able to draw
funds from the revolving credit facility or issue additional debt or equity
securities to meet these needs. However, there can be no assurance that cash
from operations in 2005 will be sufficient to fund our operations or that we
will be able to draw on our revolving credit facility or issue additional debt
or equity securities at that time. If cash from operations is insufficient to
fund our operations in 2005 and we are unable to draw on our credit facility or
issue additional debt or equity 29




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securities, in order to manage our cash needs
we would most likely seek alternative financing for films
and/or delay or alter production or release schedules. Revolving Credit Facility In
connection with our separation from DreamWorks Studios, on November 2,
2004 we entered into a five-year $200 million revolving credit facility with a
number of banks, including JPMorgan Chase Bank, an affiliate of J.P. Morgan
Securities Inc., and affiliates of certain of the other underwriters. We expect
to use the credit facility, which will be secured by substantially all of our
assets, to fund our working capital needs. The maximum amount of borrowings
that will be available to us under the credit facility will be the lesser of
$200 million and an available amount generally determined by applying an
advance rate against estimated receipts from all sources (net of estimated cash
expenses directly associated with such receipts) for all of our released films
and an advance rate against our cash on hand to the extent the lenders have a
perfected security interest in such cash and by reducing such available amount
by the amount of our outstanding debt (other than subordinated debt owing to
HBO and up to $50 million of other subordinated debt). Interest on borrowed
amounts will be determined at either a floating rate of LIBOR plus 1.75% or the
alternate base rate (which is generally the prime rate) plus 0.75% per annum.
In addition, we will pay a commitment fee on undrawn amounts at an annual rate
of 0.50% on any date when more than $100 million is outstanding under the
credit facility and 0.75% on any other date. The credit agreement will require
us to maintain certain financial ratios and will have customary terms that
restrict our ability to make fundamental changes to our business, sell assets,
incur secured debt, declare dividends and make other distributions. Our historical balance sheets reflect a portion of DreamWorks Studios
indebtedness that has been allocated to us. This allocation has been based on
the proportion of capital invested in our films in production as a percentage
of total capital invested by DreamWorks Studios in all films in production.
Because DreamWorks Studios has funded all of our operations in the past, we did
not directly incur any debt to fund production of our films and our historical
balance sheets do not reflect any of this debt other than the debt allocated by
DreamWorks Studios. However, we directly incurred debt related to our Glendale
animation campus and an animated film currently being produced by Aardman
Animations. If we had historically operated as a stand-alone company, the
amount of debt that we would have incurred would have depended on our
evaluation of then-current economic and industry conditions and factors such as
our optimal capital structure, our funding needs, our acquisition and capital
investment activity and other considerations relevant to a stand-alone company
operating in the animated filmmaking industry. In connection with our
separation from DreamWorks Studios, we assumed (i) approximately $325 million
of indebtedness that DreamWorks Studios had borrowed under its revolving credit
facility, (ii) $75 million in advances that Universal Studios had made to
DreamWorks Studios related to the animated motion pictures and (iii) $80
million of subordinated debt owed to HBO. We have repaid all of the revolver
debt and $30 million of the subordinated debt owed to HBO with proceeds of the
offering, and DreamWorks Studios was released from its obligation to repay this
indebtedness. In addition, on the closing date of the initial public offering,
we borrowed $101.4 million under our revolving credit facility to repay an
equivalent amount of debt of DreamWorks Studios. We have subsequently repaid
this debt in full. Universal Advance As part of their distribution and home video fulfillment services
relationship, DreamWorks Studios and Universal Studios have entered into
agreements pursuant to which Universal Studios advances amounts to DreamWorks
Studios based on projected cash receipts, net of projected expenses, due to
DreamWorks Studios for pictures that DreamWorks Studios intends to license to
Universal Studios for distribution in the international theatrical and
worldwide home video markets. These advances are generally based on quarterly
estimates of projected cash receipts, net of projected expenses, distribution
and service fees, that will become due to DreamWorks Studios from Universal
Studios in the markets where Universal Studios provides distribution and
fulfillment services. In October 2003, Universal Studios agreed to advance to DreamWorks Studios
a maximum of $75 million, which was based on the projected net receipts of our
animated feature films released subsequent to December 2002 (the 2003
advance). The 2003 advance carries an effective annualized interest rate of
8.75% and matures, subject to certain conditions upon the expiration or
termination of the 30




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Universal Distribution Agreement and the Universal Home
Video Agreement. We have agreed to assume
the obligation to repay the entire 2003 advance and comply with its terms
and conditions. Our agreement with Universal Studios provides that the existing
arrangements between Universal Studios and DreamWorks Studios related to the
international theatrical distribution and the worldwide home video fulfillment
services of our films will continue to apply to us following our separation
from DreamWorks Studios.

HBO Subordinated Debt

In connection with our separation from DreamWorks Studios, we assumed $80
million of subordinated notes issued by DreamWorks Studios to HBO in December
2000 pursuant to a subordinated loan agreement, $30 million of which we repaid
with proceeds of the initial public offering.

The subordinated notes bear interest in an amount equal to the Eurodollar
rate plus 0.50% per annum and are due in November 2007. Subject to the consent
of the lenders under our revolving credit facility (or any replacement senior
credit facility), we will be able to prepay all or a portion of the principal
amount of the subordinated notes. The notes are not subject to any sinking fund
obligations.

The subordinated notes are currently secured by a lien in favor of HBO
that is junior to the security interest in certain exhibition rights related to
DreamWorks Studios films granted to HBO in connection with a 1995 licensing
agreement between DreamWorks Studios and HBO. We have granted substantially the
same security interests in rights to exploit our films when we assumed the
subordinated indebtedness.

The terms of the subordinated notes require us to maintain certain
financial ratios and they will have customary terms that restrict us from
making fundamental changes to our business, selling assets, incurring secured
debt, declaring dividends and making other distributions. Additionally, we are
restricted from entering non-arms-length transactions with our affiliates.

Liquidity

Nine Months Ended September 30,2004
    
    2003(in thousands)Net cash used in operating activities
    
    $
    (12,613
    )
    
    $
    (83,735
    )Net cash used in investing activities
    
    
    (270
    )
    
    
    (2,229
    )Net cash provided by financing activities
    
    
    12,846
    
    
    
    87,045


Cash used by operating activities for the nine months of 2004 and 2003 was
$12.6 million and $83.7 million, respectively, and was primarily attributable
to film production, contingent compensation and other operating uses partially
offset by collection of domestic and international theatrical
receipts and revenues from our film library. Cash
used in investing activities for the nine months of 2004 and 2003 was $0.3
million and $2.2 million, respectively, stemming mainly from investment in
equipment. Cash provided by financing activities for the nine months of 2004
and 2003 was $12.8 million and $87 million, respectively.
Cash provided by financing activities for both periods was primarily
provided by advances from distributors and DreamWorks Studios.

In 2004, our principal source of liquidity has been cash generated by
operations and contributions from DreamWorks Studios. Our commitments prior to
the Distribution Agreement becoming effective were primarily for production
funding, contingent compensation and residual payments, distribution and
marketing costs and technology capital expenditures. Following the
effectiveness of the Distribution Agreement, our primary commitments are to
fund production costs of our feature films, to make contingent compensation and
residual payments and to fund technology capital expenditures. For the full
year 2004, we expect that our commitments to fund production costs (excluding
capitalized interest and overhead expense), to make contingent compensation and
residual payments and to fund technology

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capital expenditures will total
approximately $325 million. For 2005, we expect that these commitments
will be approximately $370 million, which includes the obligation to acquire
certain distribution rights to Wallace & Gromit: Tale of the Were Rabbit and
additional production spending related to the ramp up of our direct-to-video
business. New Accounting Pronouncements In December 2002, the Financial Accounting Standards Board (FASB) issued
FAS No. 148, Accounting for Stock-Based Compensation  Transition and
Disclosure (FAS 148). FAS 148 amends FAS No. 123, Accounting for
Stock-Based Compensation (FAS 123), to provide alternative methods of
transition for an entity that voluntarily changes to the fair value method of
accounting for stock-based employee compensation. In addition, FAS 148 amends
the disclosure provisions of FAS 123 to require prominent disclosure of the
effects of an entitys accounting policy with respect to stock-based employee
compensation on reported operating results, including per share amounts, in
annual and interim financial statements. The disclosure provisions of FAS 148
were effective immediately upon issuance in 2002. As of December 31, 2003, we
have no immediate plans to adopt the fair value method of accounting for
stock-based employee compensation. In January 2003, the FASB issued FIN 46, Consolidation of Variable
Interest Entities. In November 2003, the FASB revised certain provisions of
FIN 46. FIN 46 requires a variable interest entity (defined as a corporation,
partnership, trust or any other legal structure used for business purposes that
either does not have equity investors with voting rights or has equity
investors that do not provide sufficient financial resources for the entity to
support its activities) to be consolidated by a company if that company is
subject to a majority of the risk of loss from the variable interest entitys
activities or entitled to receive a majority of the entitys residual returns,
or both. The consolidation requirements of FIN 46, as revised, apply
immediately to variable interest entities created after January 31, 2003. The
consolidation requirements for older entities were effective on December 31,
2003. Upon our adoption of FIN 46 as of December 31, 2003, we consolidated the
special-purpose entity that acquired our Glendale animation campus. Such
consolidation has resulted in an increase in property, plant and equipment of
approximately $70.2 million, net of accumulated depreciation, an increase in
debt and a non-controlling minority interest of $70.1 million and $2.9 million,
respectively, and a cumulative effect of a change in accounting principle of
$2.5 million. PRO FORMA FINANCIAL INFORMATION The following pro forma financial information should be read in
conjunction with our Managements Discussion and Analysis of Financial
Condition and Results of Operations and our unaudited combined financial statements and
the notes to our unaudited combined financial statements included elsewhere in this
document. The pro forma combined statements of operations were prepared (i) as
if the Distribution Agreement had become effective on January 1, 2003 and had
been in effect in all periods since and (ii) as if we had been taxable as a
corporation since January 1, 2003 in all periods presented. The
pro forma impact of these transactions on our historical results for
the year ended December 31, 2003 have been previously presented
in our Registration Statement on Form S-1. The pro forma
combined balance sheet was prepared as if the Distribution Agreement had become
effective on September 30, 2004. The pro forma adjustments are based upon available information and
assumptions that we believe are reasonable and do not give effect to any
transactions other than those mentioned above, including those contemplated by
the Services Agreement that we entered with DreamWorks Studios in connection
with our separation. Please see the notes to our pro forma combined financial
statements for a 32




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more detailed discussion of how the adjustments described
above are presented in our pro forma combined financial statements. The
primary effect on our pro forma combined statements of operations of
giving pro forma effect to the Distribution Agreement as of January 1, 2003 is
that we recognize revenue net of (i) DreamWorks Studios 8.0% distribution fee
and (ii) the distribution and marketing costs that DreamWorks Studios incurs
for our films. In all periods presented, this results in a substantial
reduction to our revenue. In addition, our costs of revenue decline because we
no longer incur distribution and marketing costs and third-party distribution
and fulfillment services fees. Also, selling, general and administrative
expenses are reduced because we are no longer allocated overhead costs related
to DreamWorks Studios marketing and distribution departments. The
pro forma effect of these adjustments is to increase our operating
income in the three month and nine month periods ending
September 30, 2004. As a result of the timing differences
arising from giving effect to the Distribution Agreement, to the
extent distribution and marketing costs were incurred during the
three and nine month periods ended September 30, 2004 but the related
film was not released until after September 30, 2004 (as was the case
with Shark Tale), the costs are deducted in our pro forma costs of
revenue but there is no corresponding reduction to pro forma revenue. The pro forma effects of the Distribution Agreement also shift the timing
of amortization of film inventory from period to period, although the total
amount of film inventory amortized does not change. Under the Distribution
Agreement, the revenue that we recognize from our films is net of the
distribution fee and the distribution and marketing costs that DreamWorks
Studios incurs. Because amortization of film inventory is based on the ratio
that current period actual revenue bears to estimated remaining unrecognized
revenue, the pro forma reductions in revenue result in pro forma changes in
film amortization for the periods presented. Because DreamWorks Studios will recoup its distribution and marketing
costs and 8% distribution fee on a cash basis, the primary effect of giving pro
forma effect to the Distribution Agreement as of September 30, 2004 on our
unaudited pro forma combined balance sheet is to reclassify amounts from
accounts receivable to receivable from affiliate (DreamWorks Studios) and to
partially offset these amounts with a reduction in our accrued liabilities.
Both our accounts receivables and accrued liabilities are reduced upon
implementation of the Distribution Agreement because they become assets and
liabilities of DreamWorks Studios under the Distribution Agreement. The pro forma combined statement of operations also include a provision
for pro forma income tax to reflect federal income taxes that we would have
been required to pay had we been a taxable corporation for the entire
year.
These pro forma federal income taxes are separate from and in addition to the
foreign withholding taxes and state franchise taxes shown in our historical
financial statements. The following pro forma combined financial statements have been derived
from the unaudited combined financial statements included elsewhere in this quarterly
report and do not
purport (i) to represent what our financial position and results of operations
actually would have been had we been a stand-alone taxable corporation
operating under the Distribution Agreement for the periods presented or (ii) to
project our financial performance for any future period. 33




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DreamWorks Animation
Pro Forma Combined Balance Sheet Data
As of September 30, 2004
(in thousands) Historical
    
    Adjustments
    
    Pro FormaAssetsCash and cash equivalents
    
    $
    4
    
    
    $
    
    
    
    $
    4Accounts receivable, net of allowance for
doubtful accounts and reserve for returns
    
    
    99,708
    
    
    
    (88,745
    ) (1)
    
    
    10,963Receivables from employees
    
    
    1,823
    
    
    
    
    
    
    
    1,823Receivable from affiliate
    
    
    
    
    
    
    88,745
    (1)
    
    
    3,009
    (3)(85,736
    ) (2)Film inventories
    
    
    661,333
    
    
    
    
    
    
    
    661,333Property, plant, and equipment, net of
accumulated depreciation and amortization
    
    
    81,499
    
    
    
    
    
    
    
    81,499Deferred costs, net of amortization
    
    
    1,263
    
    
    
    
    
    
    
    1,263Goodwill
    
    
    26,462
    
    
    
    
    
    
    
    26,462Other assets
    
    
    5,400
    
    
    
    
    
    
    
    5,400Total assets
    
    $
    877,492
    
    
    $
    (85,736
    )
    
    $
    791,756Liabilities and Owners EquityAccounts payable
    
    $
    3,941
    
    
    $
    
    
    
    $
    3,941Accrued liabilities
    
    
    164,702
    
    
    
    (85,736
    ) (2)
    
    
    78,966Advances and unearned revenue
    
    
    117,535
    
    
    
    
    
    
    
    117,535Obligations under capital lease
    
    
    3,245
    
    
    
    
    
    
    
    3,245Debt allocated by DreamWorks Studios
    
    
    447,464
    
    
    
    
    
    
    
    447,464Other debt
    
    
    91,613
    
    
    
    
    
    
    
    91,613Total liabilities
    
    
    828,500
    
    
    
    (85,736
    )
    
    
    742,764Non-controlling minority interest
    
    
    2,941
    
    
    
    
    
    
    
    2,941Owners equity
    
    
    46,051
    
    
    
    
    
    
    
    46,051Total liabilities and owners equity
    
    $
    877,492
    
    
    $
    (85,736
    )
    
    $
    791,756
  (1)
    
    Reflects the reduction of accounts receivable related to amounts which would
be collected by DreamWorks Studios pursuant to the Distribution Agreement.
Accordingly, the amount has been reclassified as a receivable from
affiliate.(2)
    
    Reflects a reduction in accrued liabilities relating to distribution
and
marketing costs of approximately $85.7 million, as payment of these
liabilities will be borne by DreamWorks Studios under the terms of the
Distribution Agreement. Such amounts would be recouped by DreamWorks
Studios
out of the proceeds received from the distribution of our films.
Accordingly,
this liability has been reclassified as a reduction to a receivable from
an
affiliate.(3)
    
    Reflects remaining amounts after the reclassifications and reductions
described in footnotes (1) and (2) that would be owed to us after
DreamWorks Studios recoups distribution fees and costs it has incurred. 34




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DreamWorks Animation
(A Division of DreamWorks L.L.C.)
Unaudited Condensed Statements of Operations
Pro Forma Adjustments Three months ended
    
    Nine months endedSeptember 30, 2004
    
    September 30, 2004Operating revenue
    
    $
    241,343
    
    
    $
    582,461Proforma adjustments to operating revenue (1)
    
    
    (79,740
    )
    
    
    (239,372
    )Proforma operating revenue
    
    
    161,603
    
    
    
    343,089Cost of revenue
    
    
    196,311
    
    
    
    394,526Proforma adjustments to costs of revenue (2)
    
    
    (129,826
    )
    
    
    (268,341
    )Proforma costs of revenue
    
    
    66,485
    
    
    
    126,185Gross profit
    
    
    45,032
    
    
    
    187,935Total adjustments
    
    
    50,086
    
    
    
    28,969Proforma gross profit
    
    
    95,118
    
    
    
    216,904Provision for doubtful accounts
    
    
    116
    
    
    
    1,877Selling, general and administrative expenses
    
    
    12,543
    
    
    
    29,817Proforma adjustments to selling, general and
administrative expenses (3)
    
    
    (4,804
    )
    
    
    (12,160
    )Proforma selling, general and administrative
expenses
    
    
    7,739
    
    
    
    17,657Operating income
    
    
    32,373
    
    
    
    156,241Total adjustments to operating income
    
    
    54,890
    
    
    
    41,129Proforma operating income
    
    
    87,263
    
    
    
    197,370Interest expense, net of interest income
    
    
    (6,439
    )
    
    
    (13,228
    )Other expense, net
    
    
    (4,365
    )
    
    
    (238
    )Provision for income taxes
    
    
    1,256
    
    
    
    1,784Proforma adjustments to income taxes (4)
    
    
    27,887
    
    
    
    68,317Proforma provisions for income taxes
    
    
    29,143
    
    
    
    70,101Net income
    
    
    20,313
    
    
    
    140,991Total adjustments to net income
    
    
    27,003
    
    
    
    (27,188
    )Pro Forma net income
    
    $
    47,316
    
    
    $
    113,803Proforma:Basic net income per share (5)
    
    $
    0.46
    
    
    $
    1.11Diluted net income per share (6)
    
    $
    0.45
    
    
    $
    1.08Shares used in computing proforma:Basic net income per share (5)
    
    
    102,393
    
    
    
    102,393Diluted net income per share (6)
    
    
    105,627
    
    
    
    105,627
 35




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Notes to Unaudited Condensed Statement of Operations Pro Forma Adjustments (1) Reflects the reduction in operating revenue that would have occurred had
the
Distribution Agreement been in effect for the entire year. Under the
terms
of the Distribution Agreement, DreamWorks Studios would have been entitled
to
retain a distribution fee equal to 8.0% of revenue (without deduction for
any
distribution and marketing costs or third-party distribution and
fulfillment
services fees) with respect to our films, or approximately $17.7 million
and $43.0 million for the three and nine month periods ended September 30,
2004, respectively. DreamWorks Studios would also have been entitled to recoup
distribution and marketing costs out of this revenue in the amount of
approximately $62.0 million and $196.4 million for the three and nine month
periods ended September 30, 2004, respectively. (2)The pro forma adjustment for cost of revenues reflects a reduction in
distribution and marketing costs of approximately $110.3 million and $228.5
million for the three and nine month periods ended September 30, 2004,
respectively, as these costs are borne by DreamWorks Studios under the terms of
the Distribution Agreement. These amounts do not match the
$62.0 million and $196.4 million for the three and nine
months ended September 30, 2004, respectively, noted in
footnote (1) above that DreamWorks Studios would have recouped
under the Distribution Agreement. For the three and nine months ended
September 30, 2004 distribution and marketing costs for Shark
Tale were deducted in our pro forma costs of revenue, but there is no
corresponding reduction to pro forma revenue because the film had not
been released. In addition, the pro forma adjustment to costs of
revenue reflects the elimination of distribution and fulfillment services fees
payable primarily to Universal Studios and CJ Entertainment, in the amount of
approximately $17.5 million and $21.6 million for the three and nine month
periods ended September 30, 2004, respectively, as these costs are solely borne
by DreamWorks Studios pursuant to the Distribution Agreement. In addition, the
pro forma adjustment to costs of revenue reflects a decrease in production
costs amortization of approximately $2.0 million and $18.2 million for the
three and nine months periods ended September 30, 2004, respectively, as, under
the individual-film-forecast-computation-method, the revenue that we would have
recognized in this period would have represented a lower proportion of the
total revenue that we would have estimated our released films to ultimately
produce. (3)Reflects the elimination of allocated overhead costs that are primarily
related to the salaries and benefits of employees in DreamWorks Studios
distribution and marketing departments, as these costs will be solely
borne
by DreamWorks Studios pursuant to the Distribution Agreement. (4)Reflects federal and state income taxes that we would have been required to
pay, if any, had we been a taxable corporation for the entire year. (5)Pro forma basic net income per share is calculated using the number of
shares
of common stock that was outstanding immediately following our separation
from DreamWorks Studios and our initial public offering which
included the 25 million shares issued to the public and the
757,285 fully vested shares issued to our and DreamWorks Studios
employees and advisors upon consummation of the offering as if such shares
were outstanding for all periods presented. (6)Pro forma diluted net income per share is calculated using the number of shares
of common stock that was outstanding immediately following our
separation from DreamWorks Studios and our initial public offering as if
such shares were outstanding for all periods presented diluted by 486,944
shares of our Class A common stock with respect to the
DreamWorks Studios equity based compensation awards that
were converted into equity based compensation awards of the Company
upon the consummation of the initial public offering, and diluted by
2,746,722 shares of unvested restricted stock issued
to directors and our and DreamWorks Studios employees upon
consummation of the offering. This calculation excludes the 2,526,258
shares of Class A common stock that underlie options granted to
both our employees and employees of DreamWorks Studios at the initial
public offering. 36




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RISK FACTORS If the events discussed in these risk factors occur, the Companys
business, financial condition, results of operations or cash flows could be
materially adversely affected. In such case, the market price of the Companys
Class A common stock could decline. Risks Related to Our Business Our success is primarily dependent on audience acceptance of our films,
which is extremely difficult to predict and therefore inherently risky. We cannot predict the economic success of any of our motion pictures
because the revenue derived from the distribution of a motion picture (which
does not necessarily bear any correlation to the production or distribution
costs incurred) depends primarily upon its acceptance by the public, which
cannot be accurately predicted. The economic success of a motion picture also
depends upon the publics acceptance of competing films, the availability of
alternative forms of entertainment and leisure time activities, general
economic conditions and other tangible and intangible factors, all of which can
change and cannot be predicted with certainty. Furthermore, part of the appeal
of CG animated films may be due to their relatively recent introduction to the
market. We cannot assure you that the introduction of new animated filmmaking
techniques, an increase in the number of CG animated films or the resurgence in
popularity of older animated filmmaking techniques will not adversely impact
the popularity of CG animated films. In general, the economic success of a motion picture is dependent on its
domestic theatrical performance, which is a key factor in predicting revenue
from other distribution channels and is largely determined by (i) our ability
to produce content and develop stories and characters that appeal to a broad
audience and (ii) the effective marketing of the motion picture. If we are
unable to accurately judge audience acceptance of our film content or to have
the film effectively marketed, the commercial success of the film will be in
doubt, which could result in costs not being recouped or anticipated profits
not being realized. Moreover, we cannot assure you that any particular feature
film will generate enough revenue to offset its distribution and marketing
costs, in which case we would not receive any gross receipts for such film from
DreamWorks Studios. In the past, some of our films have not recovered, after
recoupment of marketing and distribution costs, their production costs in an
acceptable timeframe or at all. For example, in 2003 we released our final
primarily hand-drawn animated feature film, Sinbad: Legend of the Seven Seas,
which we estimate will not generate sufficient revenue over its first 10 years
in distribution to fully recover, after recoupment of marketing and
distribution costs, its production costs. Our business is dependent upon the success of a limited number of releases
each year and the commercial failure of any one of them could have a material
adverse effect on our business. We expect to theatrically release a limited number of animated feature
films per year for the foreseeable future. The commercial failure of just one
of these films can have a significant adverse impact on our results of
operations in both the year of release and in the future. For example, for the
remainder of 2004 and into 2005, we will be dependent on the continuing success
of Shrek 2 and Shark Tale. Historically, there has been a close correlation
between domestic box office success and international box office, home video
and television success, such that feature films that are successful in the
domestic theatrical market are generally also successful in the international
theatrical, home video and television markets. Because of this close
correlation, we believe that Shrek 2, which has been very successful in the
domestic and international theatrical markets, will also strongly perform in
the home video and television markets, although there is no way to guarantee
such results. Our success in 2004 and 2005 also significantly depends on
continued audience acceptance of Shark Tale, which was successfully released in
the domestic theatrical market on October 1, 2004. If Shark Tale fails to
continue its international box office success, because of the close correlation
mentioned above, its home video success and our business, results of operations
and financial condition could be adversely affected in 2005 and beyond.
Further, we cannot assure you that the historical correlation between domestic
box 37




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office results and international box office and home video results will
continue in the future. In addition, the limited number of films that we
release in a year magnifies fluctuations in our earnings. Therefore, our
reported results at quarter and year end may be skewed based on the release
dates of our films, which could result in volatility in the price of our Class
A common stock. Our operating results fluctuate significantly. We continue to expect significant fluctuations in our future quarterly and
annual operating results because of a variety of factors, including the
following: - the success of our feature films; - the timing of the domestic and international theatrical releases and home
video release of our feature films; and - DreamWorks Studios costs to distribute and market our feature films under
the Distribution Agreement. We also expect that our operating results will be affected by the terms of
the Distribution Agreement. Under the Distribution Agreement, film revenue will
be used by DreamWorks Studios to recover (i) the distribution and marketing
expenses it incurs for the film and (ii) to cover its distribution fee relating
to these markets before we recognize any revenue for that film. Accordingly, we
expect to recognize significantly less revenue from a film in the period of
that films theatrical release than we would absent the Distribution Agreement.
Furthermore, in the event that the Distribution Agreement were terminated,
depending on the arrangement that we negotiate with a replacement distributor,
we could be required to directly incur distribution and marketing expenses
related to our films, which under the Distribution Agreement are incurred by
DreamWorks Studios. Because we would expense those costs as incurred, further
significant fluctuations in our operating results could result. In response to these fluctuations, the market price of our common stock
could decrease significantly in spite of our operating performance. We principally operate in one business, the production of CG animated feature
films, and our lack of a diversified business could adversely affect us. Unlike most of the major studios, which are part of large diversified
corporate groups with a variety of other operations, we depend primarily on the
success of our feature films. For example, unlike us, many of the major studios
are part of corporate groups that include television networks and cable
channels that can provide stable sources of earnings and cash flows that offset
fluctuations in the financial performance of their feature films. Substantially
all of our revenue is derived from a single source  our CG animated feature
films  and our lack of a diversified business model could adversely affect us
if our films fail to perform to our expectations. Animated films are expensive to produce and the uncertainties inherent in
their production could result in the expenditure of significant amounts on
films that are canceled or significantly delayed. The production, completion and distribution of animated feature films are
subject to a number of uncertainties, including delays and increased
expenditures due to creative problems, technical difficulties, talent
availability, accidents, natural disasters or other events beyond our control.
Because of these uncertainties, the projected costs of an animated feature film
at the time it is set for production may increase, the date of completion may
be substantially delayed or the film may be abandoned due to the exigencies of
production. Delays in production may also result in a film not being ready for
release at the intended time and postponement to a potentially less favorable
time, which could result in lower gross receipts for that film. In extreme
cases, a film in production may be abandoned or significantly modified
(including as a result of creative changes) after substantial amounts have been
spent, causing the write-off of expenses incurred with respect to the film.
This was the case in 2003 when we wrote-off a significant amount of expenses
that we had incurred for two of our animated films. Animated films typically take longer to produce than live-action films, which
increases the uncertainties inherent in their production and distribution. 38




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Animated feature films typically take three to four years to produce after
the initial development stage, as opposed to an average of twelve to eighteen
months for live-action films. The additional time that it takes to produce and
release an animated feature film increases the risk that our films in
production will fall out of favor with target audiences and that competing
films will be released in advance of or concurrently with ours, either of which
risks could reduce the demand for, or popular appeal of, our films. The production and marketing of CG animated feature films is capital
intensive and our capacity to generate cash from our films may be insufficient
to meet our anticipated cash requirements. The costs to develop, produce and market a film are substantial and some
of our competitors have more capital and greater resources than we and
DreamWorks Studios have. In 2004, for example, we expect to spend approximately
$325 million to fund production costs (excluding capitalized interest and
overhead expense) of our feature films, to make contingent compensation and
residual payments and to fund technology capital expenditures. For 2005, we
expect that these costs will be approximately $370 million, which includes a
one-time payment to Aardman Animations related to Wallace & Gromit: Tale of the
Were Rabbit and additional production spending related to an increase in our
direct-to-video business. In addition, historically, we made substantial
expenditures on distribution and marketing costs, which, in the future, will
generally be incurred by DreamWorks Studios under the Distribution Agreement.
Although we retain the right to exploit each of the nine feature films that we
have previously released, the size of our film collection is insubstantial
compared to the film libraries of the major U.S. movie studios, which typically
have the ability to exploit hundreds of library titles. Library titles can
provide a stable source of earnings and cash flows that offset fluctuations in
the financial performance of newly released films. Many of the major studios
use these cash flows, as well as cash flows from their other businesses, to
finance the production and marketing of new feature films. We will not be able
to rely on such cash flows and will be required to fund our films in
development and production and other commitments with cash retained from
operations and the proceeds of films that are generating revenue from
theatrical, home video and ancillary markets. If our films fail to perform, we
may be forced to seek substantial sources of outside financing. Such financing
may not be available in sufficient amounts for us to continue to make
substantial investments in the production of new CG animated feature films or
may be available only on terms that are disadvantageous to us, either of which
could have a material adverse effect on our growth or our business. The costs of producing and marketing feature films have steadily increased
and may increase in the future, which may make it more difficult for a film to
generate a profit or compete against other films. The production and marketing of theatrical feature films requires
substantial capital and the costs of producing and marketing feature films have
generally increased in recent years. According to the MPAA, the average
negative cost of a motion picture produced by a major U.S. studio, which
includes all costs associated with creating a feature film, including
production costs, allocated studio overhead and capitalized interest, but
excludes abandoned project costs, has grown at a compound annual growth rate of
7.9%  from $29.9 million in 1993 to $63.8 million in 2003  and the average
domestic marketing costs (which includes prints and advertising costs) per
picture has grown at a compound annual growth rate of 10.7% over the same
period  from $14.1 million in 1993 to $39.1 million in 2003. Although these
growth rates include the costs of both live-action and animated films, they are
indicative of the cost trend for motion pictures generally. These costs may
continue to increase in the future, which may make it more difficult for our
films to generate a profit or compete against other films. Historically,
production costs and marketing costs have risen at a rate faster than increases
in either domestic admissions to movie theaters or admission ticket prices. A
continuation of this trend would leave us more dependent on other media, such
as home video, television, international markets and new media for revenue. We compete for audiences based on a number of factors, many of which are
beyond our control. Despite a general increase in movie theater attendance, the number of
animated and live-action feature films released by competitors, particularly
the major U.S. motion picture studios, may create an oversupply of product in
the market, and may make it more difficult for our films to succeed. In
particular, we compete directly against other animated films and family
oriented live-action films. Oversupply of such products may become most
pronounced during peak release times, such as school holidays, national 39




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holidays and the summer release season, when theater attendance has
traditionally been highest. Although we seek to release our films during peak
release times, we cannot guarantee that we will be able to release all of our
films during those times and, therefore, may miss potentially higher gross
box-office receipts. In addition, a substantial majority of the motion picture
screens in the U.S. typically are committed at any one time to only 10 to 15
films distributed nationally by major studio distributors. If our competitors
were to increase the number of films available for distribution and the number
of exhibition screens remained static, it could be more difficult for us to
release our films during optimal release periods. The market for CG animated films is relatively new, and the entrance of
additional film studios into the CG animated film market could adversely affect
our business in several ways. CG animation is a relatively new form of animation that has been
successfully exploited by a limited number of movie studios since the first CG
animated feature film, Toy Story, was released by Pixar in 1995. Because there
are currently only a few studios capable of producing CG animated feature
films, there are a limited number of CG animated feature films in the market
each year, a fact that may enhance their popular appeal. If additional studios
were to enter the CG animated film market and increase the number of CG
animated films released per year, the popularity of the CG animation technique
could suffer. Although we have developed proprietary technology, experience and
know-how in the CG animation field that we believe provide us with significant
advantages over new entrants in the CG animated film market, there are no
substantial technological barriers to entry that would prevent other film
studios from entering the field. Furthermore, advances in technology may
substantially decrease the time that it takes to produce a CG animated feature
film, which could result in a significant number of new CG animated films or
products. The entrance of additional animation companies into the CG animated
feature film market could adversely impact us by eroding our market share,
increasing the competition for CG animated film audiences and increasing the
competition for, and cost of, hiring and retaining talented employees,
particularly CG animators and technical staff. Our success depends on certain key employees. Our success greatly depends on our employees. In particular, we are
dependent upon the services of Jeffrey Katzenberg. We do not maintain key
person life insurance for any of our employees. We have entered into an
employment agreement with Mr. Katzenberg and have entered or will enter into
employment agreements with all of our top executive officers and production
executives. However, although it is standard in the motion picture industry to
rely on employment agreements as a method of retaining the services of key
employees, these agreements cannot assure us of the continued services of such
employees. The loss of the services of Mr. Katzenberg or a substantial group of
key employees could have a material adverse effect on our business, operating
results or financial condition. Our scheduled releases of CG animated feature films will place a
significant strain on our resources. We have established multiple creative and production teams so that we can
simultaneously produce more than one CG animated feature film. As of October
2004, we have released four CG animated feature films and five non-CG animated
feature films and have limited experience sustaining the ability to produce and
release more than one CG animated feature film at the same time. Due to the
strain on our personnel from the effort required to produce a film and the time
required for creative development of future films, it is possible that we will
be unable to consistently release two CG animated feature films per year. In
the past, we have been required, and may continue to be required, to expand our
employee base, increase capital expenditures and procure additional resources
and facilities in order to accomplish the scheduled releases of our animated
feature films. This growth and expansion has placed, and continues to place, a
significant strain on our resources. We cannot provide any assurances that any
of our animated feature films will be released as targeted or that this strain
on resources will not have a material adverse effect on our business, financial
condition or results of operations. We are dependent on DreamWorks Studios and others for the distribution and
promotion of our feature films and related products. We have entered into the Distribution Agreement with DreamWorks Studios,
pursuant to which 40




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DreamWorks Studios is responsible, with some exceptions, for the worldwide
distribution of all of our films in all media. Although the Distribution
Agreement obligates DreamWorks Studios to distribute our films, DreamWorks
Studios will be able to terminate the agreement upon the occurrence of certain
events of default, including a failure by us to deliver to DreamWorks Studios a
minimum number of films over specified time periods. If DreamWorks Studios
fails to perform under the Distribution Agreement or the agreement is
terminated by DreamWorks Studios or otherwise (including as a result of
DreamWorks Studios ceasing to be engaged in the motion picture distribution
business), we may have difficulty finding a replacement distributor, in part
because our films would become directly subject to the terms and conditions of
Universal Studios international theatrical distribution agreement with
DreamWorks Studios and Universal Studios worldwide home video fulfillment
services agreement with DreamWorks Studios (the Universal Home Video
Agreement and, together with the Universal Distribution Agreement, the
Universal Agreements) and would continue to be subject to the terms of the
existing sub-distribution, servicing and licensing agreements that DreamWorks
Studios has entered into with CJ Entertainment, Kadokawa Entertainment and our
other third-party service providers. We cannot assure you that we will be able
to find a replacement distributor on terms as favorable as those in the
Distribution Agreement. In addition, in general, the term of the Distribution
Agreement will be extended to the extent of the term, if longer, of any of
DreamWorks Studios sub-distribution, servicing and licensing agreements that
we pre-approve (such as the Universal Agreements and DreamWorks Studios
existing arrangements with CJ Entertainment and Kadokawa Entertainment). As a
result, our ability to terminate the Distribution Agreement is effectively
limited. Moreover, under the Universal Agreements, we would be required to pay
Universal Studios distribution fees and reimburse them for distribution
expenses as they are incurred, regardless of the performance of our films. As a
result, we would have to record such expenses as they were incurred and we
would recognize revenue consistent with the method we recognized revenue prior
to the effectiveness of the Distribution Agreement. DreamWorks Studios currently distributes, and we expect will continue to
distribute, our motion pictures in international theatrical markets through the
Universal Agreements and distribution agreements with CJ Entertainment (in
Korea and the Peoples Republic of China) and Kadokawa Entertainment (in
Japan). In addition, DreamWorks Studios has engaged Universal Studios to be our
worldwide principal fulfillment services provider for our home videos,
excluding only Japan and Korea. We are therefore dependent on the ability of
each of these companies to exploit our feature films in the territories in
which they distribute them and any termination of these agreements could
adversely affect DreamWorks Studios ability to distribute our films. In
addition, if Universal Studios, CJ Entertainment or Kadokawa Entertainment were
to experience financial difficulty or file for bankruptcy, our revenue could be
substantially reduced with respect to the films in distribution. DreamWorks Studios provides a number of services to us pursuant to the
Services Agreement. If the Services Agreement were terminated, we would be
required to replace those services on terms that may be less favorable to us. Under the terms of a Services Agreement that we have entered into with
DreamWorks Studios, DreamWorks Studios provides to us certain accounting,
insurance administration, risk management, information systems management, tax,
payroll, legal and business affairs, human resources administration,
procurement and other general support services. In addition, pursuant to the
Services Agreement, we provide DreamWorks Studios office space at our Glendale
facility, facilities management, information technology purchasing services and
limited legal services. DreamWorks Studios and we will charge the receiving
party so that it or we generally recover the actual costs of providing these
services, including allocable employee salaries, fringe benefits and office
costs and all out-of-pocket costs and expenses, plus 5% of the actual costs.
While our historical financial statements reflect our allocated costs of these
services, neither the historical financial statements nor the pro forma
financial statements necessarily reflect what the costs of these services will
be in the future. Both DreamWorks Studios and we have the right, upon notice,
to terminate any or all of the services either party is providing under the
Services Agreement. As a receiving party, both we and DreamWorks Studios may
exercise our termination rights generally upon 45 days notice. As a providing
party, both we and DreamWorks Studios may exercise our termination rights
generally upon 45 days notice, provided that the party exercising termination
rights is not providing such service for itself. If the Services Agreement is
terminated, DreamWorks Studios will no longer be obligated to provide these
services to us or pay us for the services we are providing it, and we will be
required to either enter a new agreement with DreamWorks Studios or another
services provider or assume the responsibility for these functions ourselves
and, in the case of 41




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office space, seek to find a new tenant. If we were to enter a new agreement
with DreamWorks Studios, hire a new services provider, assume these services
ourselves or find a new tenant, the economic terms of the new arrangement may
be less favorable than our current arrangement with DreamWorks Studios, which
may adversely affect our business, financial condition or results of
operations. If DreamWorks Studios were to experience financial difficulty or file for
bankruptcy, our business, results of operations and financial conditions could
be materially adversely affected. Under the terms of the Distribution Agreement, DreamWorks Studios is
entitled to collect all amounts relating to our films from the various
distribution channels  including from domestic theatrical exhibitors,
international sub-distributors, domestic and international home video services
providers and television licensees. DreamWorks Studios is obligated to remit
the amounts that it collects to us after it has deducted its distribution fee
and distribution and marketing costs. If DreamWorks Studios were to default in
its obligations to pay us these amounts, our revenue with respect to films in
distribution at that time could be substantially reduced. Moreover, because we
rely on DreamWorks Studios relationships and agreements with its
sub-distributors, home video fulfillment services providers and licensees, if
DreamWorks Studios were to experience financial difficulty or file for
bankruptcy, we could lose the benefit of some of those relationships and
agreements. In addition, DreamWorks Studios is responsible for the costs of
marketing our films in substantially all media and markets. If DreamWorks
Studios were to experience financial difficulty or file for bankruptcy,
DreamWorks Studios may not have sufficient resources to market our films as
effectively as the major studios market their films, which could adversely
affect our revenue. In addition, pursuant to the terms of the Services
Agreement we have entered into with DreamWorks Studios, we rely on DreamWorks
Studios for specified services and we share expenses relating to some of these
services and receive payments from DreamWorks Studios for certain services we
provide, including office space. If DreamWorks Studios were not able to pay its
share of these expenses, or ceased to provide these services, we may be
required to absorb a greater portion of these expenses or obtain them from
other sources or seek a new tenant, which could be more costly. Also, under the
Separation Agreement, we may share certain insurance policies with DreamWorks
Studios (other than directors and officers insurance) until December 31,
2004. As a result, the policy limits on these insurance policies may be eroded
or exhausted by DreamWorks Studios and may not be sufficient to cover our
liabilities. Accordingly, if DreamWorks Studios were to experience financial
difficulty or file for bankruptcy, our business, results of operations and
financial conditions could be materially adversely affected. We face risks relating to the international distribution of our films and
related products. Because we have historically derived approximately one-third of our
revenue from the exploitation of our films in territories outside of the United
States, our business is subject to risks inherent in international trade, many
of which are beyond our control. These risks include: * laws and policies affecting trade, investment and taxes, including laws and
policies relating to the repatriation of funds and withholding taxes, and
changes in these laws; * differing cultural tastes and attitudes, including varied censorship laws; * differing degrees of protection for intellectual property; * financial instability and increased market concentration of buyers in foreign
television markets, including in European pay television markets; * the instability of foreign economies and governments; * fluctuating foreign exchange rates; and * war and acts of terrorism. Piracy of motion pictures, including digital and Internet piracy, may decrease
revenue received from the exploitation of our films. 42




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Motion picture piracy is extensive in many parts of the world and is made
easier by technological advances and the conversion of motion pictures into
digital formats, which facilitates the creation, transmission and sharing of
high quality unauthorized copies of motion pictures in theatrical release, on
videotapes and DVDs, from pay-per-view through set top boxes and other devices
and through unlicensed broadcasts on free TV and the Internet. The
proliferation of unauthorized copies and piracy of these products has an
adverse affect on our business because these products reduce the revenue we
receive from our legitimate products. Under the Distribution Agreement,
DreamWorks Studios is primarily responsible for enforcing our intellectual
property rights with respect to all of our films subject to the Distribution
Agreement and is required to maintain security and anti-piracy measures
consistent with the highest levels it maintains for its own motion pictures.
Other than the remedies we have in the Distribution Agreement, we have no way
of requiring DreamWorks Studios to take any anti-piracy actions, and DreamWorks
Studios failure to take such actions may result in our having to undertake
such measures ourselves, which could result in significant expenses and losses
of indeterminate amounts of revenue. Even if applied, there can be no assurance
that the highest levels of security and anti-piracy measures will prevent
piracy. Unauthorized copying and piracy are prevalent in territories outside of
the U.S., Canada and Western Europe and in countries where we may have
difficulty enforcing our intellectual property rights. The MPAA, the American
Motion Picture Marketing Association and American Motion Picture Export
Association monitor the progress and efforts made by various countries to limit
or prevent piracy. In the past, some of these trade associations have enacted
voluntary embargoes on motion picture exports to certain countries in order to
pressure the governments of those countries to become more aggressive in
preventing motion picture piracy. In addition, the U.S. government has publicly
considered implementing trade sanctions against specific countries that, in its
opinion, do not make appropriate efforts to prevent copyright infringements of
U.S. produced motion pictures. There can be no assurance, however, that
voluntary industry embargoes or U.S. government trade sanctions will be enacted
or, if enacted, effective. If enacted, such actions could impact the amount of
revenue that we realize from the international exploitation of motion pictures
depending upon the countries subject to such action and the duration and
effectiveness of such action. If embargoes or sanctions are not enacted or if
other measures are not taken, we may lose an indeterminate amount of additional
revenue as a result of motion picture piracy. We cannot predict the effect that rapid technological change or
alternative forms of entertainment may have on us or the motion picture
industry. The entertainment industry in general, and the motion picture industry in
particular, continue to undergo significant changes, primarily due to
technological developments. Due to rapid growth of technology and shifting
consumer tastes, we cannot accurately predict the overall effect that
technological growth or the availability of alternative forms of entertainment
may have on the potential revenue from and profitability of our animated
feature films. In addition, certain outlets for the distribution of motion
pictures may not obtain the public acceptance that is or was previously
predicted. For example, while we have benefited from the rapid growth in the
digital versatile disk, or DVD market, we cannot assure that such growth will
continue, or that other developing distribution channels, such as
video-on-demand, will be accepted by the public or that, if they are accepted
by the public, we will be successful in exploiting such channels. Moreover, to
the extent that other distribution channels gain popular acceptance, it is
possible that demand for existing delivery channels, such as DVDs, will
decrease. If we are unable to exploit new delivery channels to the same extent
that we have exploited existing channels, our business, results of operations
or financial condition could be materially adversely affected. We have not operated as an independent company, and we do business in a
relatively new industry, each of which makes it more difficult to predict
whether our business model is sound. Prior to our separation from DreamWorks Studios, we were a business
division of DreamWorks Studios. Accordingly, we have very little experience
operating as an independent company implementing our own business model and an
evaluation of our prospects is difficult to make, particularly in light of the
fact that CG animation constitutes a relatively new form of animated filmmaking
and has been successfully exploited since only 1995. Our prospects must be
considered in light of the risks, expenses and difficulties encountered by
companies in the early stages of independent business operations, particularly
companies in highly competitive markets. To address these risks, we must, among
other things, respond to changes in the competitive environment, continue to
attract, retain and motivate 43




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qualified persons and continue to upgrade our technologies. We cannot provide
any assurances that we will be successful in addressing such risks. Our historical and pro forma financial information may not be indicative
of our results as a separate company. Because we were a division of DreamWorks Studios during all of the periods
presented, our historical financial information presented in this document does
not reflect what our results of operations, financial condition and cash flows
would have been had we been a separate, stand-alone entity pursuing independent
strategies during the periods presented. For example, our historical combined
financial statements do not reflect what our results of operations, financial
condition or cash flows would have been had the Distribution Agreement been in
place for all periods presented or had we shifted to our current business model
of primarily producing CG animated films at an earlier date. Furthermore, the
pro forma financial information presented in managements discussion and
analysis of financial condition and results of operation do not necessarily
reflect what our results of operations would have been had we been a
stand-alone company operating under the Distribution Agreement in all periods.
As a result, our historical and pro forma financial information is not
necessarily indicative of our future results of operations, financial condition
or cash flows. We could be adversely affected by strikes and other union activity. Along with the major U.S. film studios, we employ members of the
International Alliance of Theatrical and Stage Employees, or IATSE, on many of
our productions. We are subject to a collective bargaining agreement with the
IATSE that expires in August 2006. We are also subject to a collective
bargaining agreement with Local 839 of IATSE. We also employ members of the
Screen Actors Guild, or SAG, and we have signed an industry-wide collective
bargaining agreement with SAG that expires on June 30, 2005. We may also become
subject to additional collective bargaining agreements. A strike by one or more
of the unions that provide personnel essential to the production of our feature
films could delay or halt our ongoing production activities. Such a halt or
delay, depending on the length of time involved, could cause the delay of the
release date of our feature films and thereby could adversely affect the
revenue that the film generates. To be successful, we must continue to attract and retain qualified
personnel and our inability to do so would adversely affect the quality of our
films. Our success continues to depend to a significant extent on our ability to
identify, attract, hire, train and retain qualified creative, technical and
managerial personnel. Competition for the caliber of talent required to make
our films, particularly for our film directors, producers, animators, creative
and technology personnel, will continue to intensify as other studios build
their in-house CG animation or special effects capabilities. For example, a
number of movie studios and production companies have announced their intent to
make CG animated feature films, and we believe Disney and Sony, in particular,
have begun to focus more heavily on CG animated feature films. The entrance of
additional film studios into the CG animated film industry or the increased
production capacity of existing film studios will increase the demand for the
limited number of talented CG animators and programmers. There can be no
assurance that we will be successful in identifying, attracting, hiring,
training and retaining such qualified personnel in the future. If we are unable
to hire and retain qualified personnel in the future, particularly film
directors, producers, animators, creative personnel and technical directors,
there could be a material adverse effect on our business, operating results or
financial condition. We depend on technology and computer systems for the timely and successful
development of our animated feature films and related products. Because we are dependent upon a large number of software applications and
computers for the development and production of our animated feature films, an
error or defect in the software, a failure in the hardware, a failure of our
backup facilities or a delay in delivery of products and services could result
in significantly increased production costs for a feature film. Moreover, if a
software or hardware problem is significant enough, it could result in delays
in one or more productions, which in turn could result in potentially
significant delays in the release dates of our feature films or affect our
ability to complete the production of a feature film. Significant delays in
production and significant delays in release dates, as 44




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well as the failure to complete a production, could have a material adverse
effect on our results of operations. In addition, because we seek to make
cutting edge CG animated films, we must ensure that our production environment
integrates the latest CG animation tools and techniques developed in the
industry. To accomplish this, we can either develop these capabilities by
upgrading our proprietary software, which can result in substantial research
and development costs, or we can seek to purchase third-party licenses, which
can also result in significant expenditures. In the event we seek to obtain
third-party licenses, we cannot guarantee that they will be available or, once
obtained, will continue to be available on commercially reasonable terms, or at
all. Our revenue may be adversely affected if we fail to protect our
proprietary technology or enhance or develop new technology. We depend on our proprietary technology to develop and produce our CG
animated feature films. We rely on a combination of patents, copyright and
trade secret protection and nondisclosure agreements to establish and protect
our proprietary rights. We currently have five patents in force and 11 patent
applications pending in the United States. We cannot provide any assurances
that patents will issue from any of these pending applications or that, if
patents do issue, any claims allowed will be sufficiently broad to protect our
technology or that they will not be challenged, invalidated or circumvented. In
addition, we also rely on third-party software to produce our films, which is
readily available to others. Failure of our patents, copyrights and trade
secret protection, non-disclosure agreements and other measures to provide
protection of our technology and the availability of third-party software may
make it easier for our competitors to obtain technology equivalent to or
superior to our technology. If our competitors develop or license technology
that is superior to ours or that makes our technology obsolete, our films could
become uneconomical to make. In such a case, we may be required to incur
significant costs to enhance or acquire new technology so that our feature
films remain competitive. We cannot assure you that such costs would not have a
material adverse affect on our business, financial condition or results of
operations. In addition, we may be required to litigate in the future to enforce our
intellectual property rights, to protect our trade secrets, to determine the
validity and scope of the proprietary rights of others, or to defend against
claims of infringement or invalidity. Any such litigation could result in
substantial costs and diversion of resources and could have a material adverse
effect on our business, financial condition or results of operations. Third-party technology licenses may not continue to be available to us in the
future. In addition to our proprietary technology, we also rely on certain
technology that we license from third-parties, including software that we use
with our proprietary software. We cannot provide any assurances that these
third-party technology licenses will continue to be available to us on
commercially reasonable terms or at all. The loss of or inability to maintain
any of these technology licenses, or our inability to complete a given feature
film, could result in delays in feature film releases until equivalent
technology could be identified, licensed and integrated. Any such delays or
failures in feature film releases could materially adversely affect our
business, financial condition or results of operations. Others may assert
intellectual property infringement claims against us. One of the risks of the CG animated film production business is the
possibility of claims that our productions and production techniques
misappropriate or infringe the intellectual property rights of third-parties
with respect to their technology and software, previously developed films,
stories, characters, other entertainment or intellectual property. We have
received, and are likely to receive in the future, claims of infringement of
other parties proprietary rights. There can be no assurance that infringement
or misappropriation claims (or claims for indemnification resulting from such
claims) will not be asserted or prosecuted against us, or that any assertions
or prosecutions will not materially adversely affect our business, financial
condition or results of operations. Irrespective of the validity or the
successful assertion of such claims, we would incur significant costs and
diversion of resources with respect to the defense thereof, which could have a
material adverse effect on our business, financial condition or results of
operations. If any claims or actions are asserted against us, we may seek to
obtain a license of a third-partys intellectual property rights. We cannot
provide any assurances, however, that under such circumstances a license would
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Forecasting film revenue and associated gross profits from our feature
films prior to release is extremely difficult and may result in significant
write-offs. We are required to amortize capitalized film production costs over the
expected revenue streams as we recognize revenue from the associated films. The
amount of film production costs that will be amortized each quarter depends on
how much future revenue we expect to receive from each film. Unamortized film
production costs are evaluated for impairment each reporting period on a
film-by-film basis. If estimated remaining revenue is not sufficient to recover
the unamortized film production costs, the unamortized film production costs
will be written down to fair value. In any given quarter, if we lower our
previous forecast with respect to total anticipated revenue from any individual
feature film, we would be required to accelerate amortization of related film
costs. Such accelerated amortization would adversely impact our business,
operating results and financial condition. In addition, we base our estimates
of revenue on information supplied to us from DreamWorks Studios and other
sources. If the information is not provided in a timely manner or is incorrect,
the amount of revenue and related expenses that we recognize from our animated
feature films and related products could be wrong, which could result in
fluctuations in our earnings. Risks Related to Investing
in Our Stock Prior to our initial public offering, there was no public market for
shares of our common stock. Although a market has developed for our Class A
common stock since the initial public offering, we cannot predict the extent to
which investors will maintain interest in our company and thereby maintain
a trading market on the New York Stock Exchange (or any other market) or how liquid that
market might become. The market price of our stock may be influenced by many factors, some of
which are beyond our control, including those described above under  Risks
Related to Our Business and the following: * the failure of securities analysts to cover our Class A common stock in the
future or changes in financial estimates by analysts; * announcements by us or our competitors of significant contracts, productions,
acquisitions, or capital commitments; * variations in quarterly operating results; * general economic conditions; * terrorist acts; * future sales of our common stock; and * investor perception of us and the filmmaking industry. As a result of these factors, investors in our Class A common stock may
not be able to resell their shares at or above the price at which they
purchased such stock. In addition, the stock market in general has experienced
extreme price and volume fluctuations that have often been unrelated to and
disproportionate to the operating performance of movie studios. These broad
market and industry factors may materially reduce the market price of our Class
A common stock, regardless of our operating performance. We have agreed to effect up to two follow-on secondary offerings of our
Class A common stock after this offering in respect of the Holdco arrangements.
Sales of our Class A common stock in such follow-on offering or offerings may
cause the market price of our Class A common stock to drop significantly, even
if our business is doing well. As described below, certain members of DreamWorks Studios who received
shares of our common stock in connection with the separation transactions have
entered into an arrangement among themselves with respect to the allocation of
such shares among such members. Entities controlled by 46




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Paul Allen, Steven Spielberg, Jeffrey Katzenberg and David Geffen, together
with Lee Entertainment and Universal Studios, have contributed a total of
50,230,003 shares of our common stock to DWA Escrow LLLP, an entity we
refer to in this document as Holdco. In connection with the establishment of
Holdco, we agreed that Jeffrey Katzenberg and David Geffen (or entities
controlled by them), acting together, or Paul Allen (or entities controlled by
him) may select the timing of one follow-on secondary offering of Class A
common stock, which must occur during the period beginning
May 2, 2005 and ending on May 31, 2006. Such follow-on offering must be of
a sufficient size to permit the Holdco partners to receive a minimum of
approximately $345 million of aggregate net cash proceeds from sales of
secondary shares in the follow-on secondary offering and such follow-on
secondary offering (assuming participation by all Holdco partners in such
offerings, subject in the case of entities controlled by Steven Spielberg,
Jeffrey Katzenberg and David Geffen, to the 365 day lock-up described in the
following risk factor). Shares to be sold in such follow-on offering will
consist of shares of common stock retained by Holdco partners and certain of
the common stock contributed to Holdco. Under no circumstances will we be
obligated to issue additional shares of our common stock for sale in the
follow-on offering, regardless of the size of such offering. If such follow-on offering has not occurred by May 31, 2006, then Paul
Allen (or entities controlled by him) will have the ability to initiate a
follow-on offering during the 18-month period (or 24-month period if Universal
Studios triggers a follow-on offering as described below) beginning June 1,
2006. If such follow-on offering has not occurred by December 1, 2007 (or June
1, 2008 if Universal Studios triggers a follow-on offering as described below),
then Jeffrey Katzenberg and David Geffen (or entities controlled by them) will
have the right to initiate a follow-on offering on or prior to December 31,
2007 (or June 30, 2008 if Universal Studios triggers a follow-on offering as
described below). In addition, if a follow-on offering has not been consummated
prior to December 1, 2006, then during the period from December 1, 2006 through
February 28, 2007, Universal Studios will have the right to initiate a
follow-on offering of a portion of the stock contributed to Holdco of a
sufficient size to generate aggregate net proceeds of $75 million for Universal
Studios, when combined with the net proceeds received by Universal Studios in
the initial public offering (which totaled approximately $29 million). The follow-on offering or offerings may cause the market price of our
Class A common stock to drop significantly, even if our business is doing well
and even though we will not issue any additional shares to be sold in such
offering or offerings. Shares eligible for future sale may cause the market price of our Class A
common stock to drop significantly, even if our business is doing
well. The market price of our Class A common stock could decline as a result of
sales of a large number of shares of our Class A common stock in the market or
the perception that these sales could occur. These sales, or the possibility
that these sales may occur, also might make it more difficult for us to sell
equity securities in the future at a time and at a price that we deem
appropriate. As of November 2, 2004, there were 53,752,884 shares of our Class A common
stock, 51,384,082 shares of our Class B common stock and one
share of our Class C common stock outstanding. The shares of Class B common stock and Class C
common stock are convertible into Class A common stock on a one-for-one basis.
As of November 2, 2004, approximately 36 million shares of the Class A common
stock sold or delivered in connection with our initial public offering were
freely tradeable without restriction or further registration under the
Securities Act of 1933, as amended, by persons other than our affiliates within
the meaning of Rule 144 under the Securities Act. In addition to the follow-on secondary offerings described in the previous
risk factor (which will occur no earlier than May 2, 2005), following the final allocation of shares by Holdco to the
Holdco partners, each of Steven Spielberg, Jeffrey Katzenberg, David Geffen and
Paul Allen or entities controlled by them or their permitted transferees,
subject to the lock-up described below, will be able to sell their shares in
the public market from time to time without registering them, subject to
certain limitations on the timing, amount and method of those sales imposed by
regulations promulgated by the Securities and Exchange Commission (the SEC).
Entities controlled by each of Paul Allen, Steven Spielberg, Jeffrey Katzenberg
and David Geffen (and certain of their permitted transferees), as well as
Universal Studios in limited circumstances, also have the right to cause us to
register the sale of shares of Class A common stock beneficially owned by them.
In addition, substantially all of our stockholders that were members of
DreamWorks Studios on the closing date of our initial public 47




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offering have the right to include shares of Class A common stock beneficially
owned by them (including the Class A common stock into which our Class B and
Class C common stock is convertible) in certain future registration statements
relating to our securities. If any of Paul Allen, Steven Spielberg, Jeffrey
Katzenberg, David Geffen, Holdco, Universal Studios, entities controlled by
them or their respective permitted transferees were to sell a large number of
their shares, including in the follow-on secondary offerings described above,
the market price of our Class A common stock could decline significantly. In
addition, the perception in the public markets that sales by them might occur
could also adversely affect the market price of our Class A common stock. Entities controlled by Steven Spielberg, Jeffrey Katzenberg and David
Geffen have agreed to a lock-up period, meaning that they and their permitted
transferees may not sell any of their shares without the prior consent of the
underwriters of this offering for 365 days following October 27, 2004. Holdco,
and an entity controlled by Paul Allen and each other DreamWorks Studios member
have agreed to a minimum 180 day lock-up period beginning on October 27, 2004
with the underwriters. In addition to these lock-up agreements, sales of our
Class A common stock are also restricted by lock-up agreements for a minimum of
180 days that we, our directors and executive officers entered into with the
underwriters or our initial public offering. Certain of our other stockholders
holding non-public shares are also restricted by lock-up agreements for a
minimum of 180 days from October 27, 2004 with respect to 50% of their share
ownership (collectively, approximately 465,000 shares held by these
stockholders will not be restricted by lock-up agreements). Generally, our
other existing stockholders (who collectively own approximately 1.5 million
shares, including options that have vested or will vest within 60 days of
October 27, 2004) are not restricted by lock-up agreements. These lock-up
agreements restrict us and these stockholders, subject to specified exceptions,
from selling or otherwise disposing of any shares for a minimum period of 180
days following October 27, 2004 without the prior consent of the underwriters
of our initial public offering. The underwriters may, in their sole discretion
and without notice, release all or any portion of the shares from the
restrictions in any of the lock-up agreements described above. In addition to
the lock-up agreements described above, we and entities controlled by Paul
Allen, Steven Spielberg, Jeffrey Katzenberg and David Geffen and the other
Holdco partners (and their parent entities) have agreed to certain trading and
hedging limitations until the final allocation of shares by Holdco to the
Holdco partners. In addition, Holdco and members of DreamWorks Studios that did not
participate in Holdco (other than Universal Studios and Thomson) have pledged
12,500,000 shares of our common stock as security for DreamWorks Studios
obligations under its revolving credit agreement. Under certain circumstances,
including an event of default by DreamWorks Studios under that revolving credit
agreement, the lenders will be entitled to take possession of the pledged
shares of common stock (after converting any pledged Class B common stock into
Class A common stock) and sell them in the open market, subject to applicable
bankruptcy, securities and other laws, as well as any applicable lock-up
agreements. Also, in the future, we may issue our securities in connection with
investments and acquisitions. The amount of our common stock issued in
connection with an investment or acquisition could constitute a material
portion of our then outstanding common stock. A few significant stockholders control the direction of our business. The
concentrated ownership of our common stock and certain corporate governance
arrangements will prevent you and other stockholders from influencing
significant corporate decisions. As of November 2, 2004, Holdco, which is controlled by Jeffrey Katzenberg
and David Geffen or entities controlled by them (subject to certain approval
rights of Holdcos limited partners) prior to the final allocation of shares
contributed to Holdco, owns 97.2% of the outstanding shares of our Class B
common stock (which represents 44.2% of our common equity and 91.2% of the
total voting power of our common stock). In addition, Jeffrey Katzenberg and
David Geffen each own shares of our Class B common stock outside of Holdco,
which represents the remaining outstanding shares of Class B common stock and
in the aggregate 1.3% of our common equity and 2.6% of the total voting power
of our common stock. Accordingly, Jeffrey Katzenberg and David Geffen or
entities controlled by them generally have the collective ability to control
all matters requiring stockholder approval, including the nomination and
election of directors (other than the director elected by an entity controlled
by Paul Allen as the holder of Class C common stock), the determination of our
corporate and management policies and the determination, without the consent of
our other stockholders, of the outcome of any corporate transaction or other
matter submitted to our stockholders for approval, including potential mergers
or acquisitions, 48




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asset sales and other significant corporate transactions. In addition, the
disproportionate voting rights of the Class B common stock relative to the
Class A common stock and the Class C common stock may make us a less attractive
takeover target. The interests of our controlling and significant stockholders may conflict
with the interests of our other stockholders. We cannot assure you that the interests of Jeffrey Katzenberg, David
Geffen, Steven Spielberg, and Paul Allen, or entities controlled by them, will
coincide with the interests of the holders of our Class A common stock. For
example, Jeffrey Katzenberg and David Geffen, or entities controlled by them,
could cause us to make acquisitions that increase the amount of our
indebtedness or outstanding shares of common stock or sell revenue-generating
assets. Additionally, DreamWorks Studios (which is controlled by Jeffrey
Katzenberg, David Geffen and Steven Spielberg) is in the business of making
movies and derivative products and may, from time to time, compete directly or
indirectly with us or prevent us from taking advantage of corporate
opportunities. Jeffrey Katzenberg, David Geffen, Steven Spielberg and
DreamWorks Studios may also pursue acquisition opportunities that may be
complementary to our business, and as a result, those acquisition opportunities
may not be available to us. Our restated certificate of incorporation provides
for the allocation of corporate opportunities between us, on the one hand, and
certain of our founding stockholders, on the other hand, which could prevent us
from taking advantage of certain corporate opportunities. So long as Jeffrey
Katzenberg, David Geffen, or entities controlled by them, continue to
collectively own shares of our Class B common stock with significant voting
power, Jeffrey Katzenberg and David Geffen, or entities controlled by them,
will continue to collectively be able to strongly influence or effectively
control our decisions. Under certain circumstances, Jeffrey Katzenberg and David Geffen, or
entities controlled by them, could cease to have a majority of the voting
control of our common stock, in which case other significant stockholders may
be able to strongly influence or effectively control our decisions. Additionally, we have entered into a tax receivable agreement with an
entity controlled by Paul Allen in connection with our separation from
DreamWorks Studios. As a result of certain transactions that an entity
controlled by Paul Allen has engaged in, future income taxes that we will be
required to pay to various tax authorities may be reduced as a result of a
partial increase in the tax basis of our tangible and intangible assets. We
will be required to pay to such entity a portion of the amounts by which our
income taxes are actually reduced, subject to repayment provisions if it is
determined that these tax savings should not have been available to us. As a
result, the interests of Paul Allen and entities controlled by him and the
holders of our Class A common stock could differ. While the actual amount and
timing of any payments under this agreement will vary depending upon a number
of factors, we expect that, as a result of the size of the increase in the tax
basis of our tangible and intangible assets, during the amortization period for
such increased tax basis, the payments that may be made to the entities
controlled by Paul Allen could be substantial. Anti-takeover provisions of our charter and by-laws, as well as Delaware
law may reduce the likelihood of any potential change of control or unsolicited
acquisition proposal that you might consider favorable. The anti-takeover provisions of Delaware law impose various impediments to
the ability of a third-party to acquire control of us, even if a change in
control would be beneficial to our existing stockholders. Additionally,
provisions of our charter and by-laws could deter, delay or prevent a
third-party from acquiring us, even if doing so would benefit our stockholders.
These provisions include: * the division of our capital stock into Class A common stock and Class C
common stock, each entitled to one vote per share, and Class B common stock,
entitled to 15 votes per share, all of which Class B common stock will
initially be owned or controlled by Jeffrey Katzenberg and David Geffen; * the right of the holder of Class C common stock (voting as a separate class)
to elect one director; * the authority of the board to issue preferred stock with terms as the board
may determine; 49




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* the absence of cumulative voting in the election of directors; * following such time as the outstanding shares of Class B common stock cease
to represent a majority of the combined voting power of the voting stock,
prohibition on stockholder action by written consent; * limitations on who may call special meetings of stockholders; * advance notice requirements for stockholder proposals; * following such time as the outstanding shares of Class B common stock cease
to represent a majority of the combined voting power of the voting stock,
super-majority voting requirements for stockholders to amend the by-laws; and * stockholder super-majority voting requirements to amend certain provisions of
the charter. It is possible that we may be treated as a personal holding company for
Federal tax purposes now or in the future. The Internal Revenue Code currently imposes an additional tax at a rate of
15% on the undistributed personal holding company income (as defined in the
Internal Revenue Code) of a corporation that is a personal holding company
and such rate of tax is scheduled to increase for taxable years beginning after
December 31, 2008. A corporation is treated as a personal holding company for a
taxable year if both (i) five or fewer individuals directly or indirectly own
(or are deemed under attribution rules to own) more than 50% of the value of
the corporations stock at any time during the last half of that taxable year
and (ii) 60% or more of the corporations gross income for that taxable year is
personal holding company income (which includes, among other things,
dividends, interest, annuities and, under certain circumstances, royalties and
rents). We believe that the applicable attribution rules will result in five or
fewer individuals being deemed to own more than 50% of the value of our stock
and the stock of our subsidiaries. We also believe, however, that less than 60%
of the gross income of us and our subsidiaries will be deemed to consist of
personal holding company income and, as a result, we expect that neither we nor
any of our subsidiaries will be a personal holding company. There can be no
assurance, however, that we or any of our subsidiaries will not be treated as a
personal holding company and thus become subject to the tax imposed on our or
our subsidiaries undistributed personal holding company income. 
 ITEM 3. Quantitative and
Qualitative Disclosure About Market Risk Market and Exchange Rate
Risk Interest Rate Risk. During the periods presented, we were exposed to the
impact of interest rate changes as a result of our variable rate long-term debt
and debt allocated to us by DreamWorks Studios. DreamWorks Studios has used
derivative instruments from time to time to manage the related risk. Because
DreamWorks Studios allocated to us the income and expense associated with these
derivative instruments, this has resulted in short term gains or losses. As
part of our separation from DreamWorks Studios, we are no longer allocated
interest expense or other income and expense associated with derivative
instruments, although we have assumed the interest rate swap agreements
associated with our Glendale animation campus. We continue to actively monitor
fluctuations in interest rates. A hypothetical 1% change in the interest rates
applicable to the debt associated with our Glendale animation campus,
subordinated notes owed to HBO and
Wallace & Gromit: Tale of the Were Rabbit obligation would
result in a $1.5
million increase or decrease in interest expense. Because we have repaid the
obligations that we assumed from DreamWorks Studios with the proceeds of our
initial public offering, other than $50 million of subordinated notes owed to
HBO, we have not performed an analysis of our interest rate risk for any of the
debt that has been allocated to us by DreamWorks Studios and repaid with
proceeds of the initial public offering. Foreign Currency Risk. We are subject to market risks resulting from
fluctuations in foreign currency exchange rates through our non-U.S. revenue
sources and we incur certain distribution and production costs in foreign
currencies. However, there is a natural hedge against foreign currency 50




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changes due to the fact that, while significant receipts for international
territories may be foreign currency denominated, significant distribution
expenses will be similarly denominated, mitigating fluctuations to some extent
depending on their relative magnitude. Wallace & Gromit: Tale of the Were
Rabbit, currently in production in the United Kingdom, is the only project
currently being produced abroad, and we have therefore entered into a hedge
agreement intended to reduce our exposure to changes in the British pound. Credit Risk. We are exposed to credit risk from DreamWorks Studios and
third parties, including customers, counter parties and distribution partners.
These parties may default on their obligations to us, due to bankruptcy, lack
of liquidity, operational failure or other reasons. 
 ITEM 4. Controls and
Procedures Evaluation of Disclosure Controls and Procedures. Our management
evaluated, with the participation of our Chief Executive Officer and our Chief
Financial Officer, the effectiveness of our disclosure controls and procedures
as of the end of the period covered by this Quarterly Report on Form 10-Q.
Based on this evaluation, our Chief Executive Officer and our Chief Financial
Officer have concluded that our disclosure controls and procedures are
effective to ensure that information we are required to disclose in reports
that we file or submit under the Securities Exchange Act of 1934 is recorded,
processed, summarized and reported within the time periods specified in
Securities and Exchange Commission rules and forms. Changes In Internal Control Over Financial Reporting. There was no change
in our internal control over financial reporting that occurred during the
period covered by this Quarterly Report on Form 10-Q that has materially
affected, or is reasonably likely to materially affect, our internal control
over financial reportings. 51




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PART II  OTHER INFORMATION 
 ITEM 1. Legal Proceedings From time to time we are involved in legal proceedings arising in the
ordinary course of our business,
typically intellectual property litigation and infringement claims related to
our feature films, which could cause us to incur significant expenses or
prevent us from releasing a film. We also have been the subject of patent and
copyright claims relating to technology and ideas that we may use or feature in
connection with the production, marketing or exploitation of our feature films,
which may affect our ability to continue to do so. In the opinion of management, there is no litigation pending against us,
including the matters described above, that should have, individually or in the
aggregate, a material adverse effect on our financial position or results of
operations. However, the results of legal proceedings cannot be predicted with
certainty. Should the DreamWorks Animation fail to prevail in any of the legal
matters pending against it or should several of the matters pending against it
be resolved adversely within the same reporting period, the operating results
of a particular reporting period could be material adversely affected. 
 ITEM 2. is not applicable and has been omitted. 
 ITEM 3. is not applicable and has been omitted. 
 ITEM 4. Submission of Matters to a Vote of Security Holders. On
September 9, 2004, DreamWorks L.L.C., as the sole shareholder of the
Company, approved the change of the Companys name from
DreamWorks Animation, Inc. to DreamWorks Animation SKG, Inc. 
 ITEM 5. Other Information. Procedures for Submitting
Stockholder Proposals Proposals
for Inclusion in the Proxy Statement. Pursuant to Rule 14a-8
under the Exchange Act, stockholders may present proper proposals for
inclusion in the Companys proxy statement and for consideration
at the first annual meeting of its stockholders by submitting their
proposals to the Company in a timely manner. In order to be included
in the Companys proxy statement for the 2005 annual meeting,
stockholder proposals must be received by the Company no later than
December 31, 2004, and must otherwise comply with the requirements of
Rule 14a-8. Proposals
not Included in the Proxy Statement. In addition, the
Companys bylaws establish an advance notice procedure with
regard to certain matters, including stockholder proposals not
included in the Companys proxy statement, to be brought before
an annual meeting of stockholders. In general, notice must be received
by the Secretary of the Company not less than 90 days nor more than
120 days prior to the anniversary date of the immediately preceding
annual meeting and must contain specified information concerning the
matters to be brought before such meeting and concerning the
stockholder proposing such matters. For purposes of the 2005 annual
meeting, the anniversary date has been set by our bylaws as May 15,
2005. Therefore, to be presented at the Companys 2005 annual
meeting, such a proposal must be received by Secretary of the Company on or after
January 16, 2005, but no later than February 15, 2005. If a stockholder who has
notified the Company of his intention to present a proposal at an
annual meeting does not appear or send a qualified representative to
present his proposal at such meeting, the Company need not present
the proposal for a vote at such meeting. 
 ITEM 6. Exhibits Exhibit 31.1
    
    Certification of Chief Executive Officer Pursuant to Exchange
Act Rule 13a-14(a) or 15d-14(a), as Adopted Pursuant to
Section 302 of the Sarbanes-Oxley Act of 2002.Exhibit 31.2
    
    Certification of Chief Financial Officer Pursuant to Exchange
Act Rule 13a-14(a) or 15d-14(a), as Adopted Pursuant to
Section 302 of the Sarbanes-Oxley Act of 2002.Exhibit 32.1
    
    Certifications of Chief Executive Officer and Chief Financial
Officer Pursuant to 18 U.S.C. Section 1350, as Adopted
Pursuant to Section 906 of the Sarbanes-Oxley Act of
2002.
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SIGNATURES Pursuant to the requirements of the Securities Exchange Act of 1934, the
Registrant has duly caused this report to be signed on its behalf by the
undersigned thereunto duly authorized. DREAMWORKS ANIMATION SKG, INC.Date: December 10, 2004
    
    By:
    
    /s/ KRISTINA M. LESLIEName:  Kristina M. LeslieTitle:    Chief
Financial Officer
(Principal Financial Officer
and Duly Authorized Officer)
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Exhibit Index ExhibitNumber
    
    DescriptionExhibit 31.1
    
    Certification of Chief Executive Officer Pursuant to Exchange Act Rule 13a-14(a) or 15d-14(a), as Adopted
Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.Exhibit 31.2
    
    Certification of Chief Financial Officer Pursuant to Exchange Act Rule 13a-14(a) or 15d-14(a), as Adopted
Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.Exhibit 32.1
    
    Certifications of Chief Executive Officer and Chief Financial Officer Pursuant to 18 U.S.C. Section 1350, as
Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.
 54