Walt Disney Company (DIS)

Walt Disney founded his namesake company in 1923, and since then the business has gone on to become one of the most iconic brands on earth. Today, Walt Disney (DIS) is a leading entertainment company with over $55 billion in revenue. The company is highly diversified and vertically integrated, with four major business segments:

• Media Networks (41% of sales, 30% of profits): TV programming (ABC TV and cable channels like A&E, History, Lifetime and ABC Family, ESPN network), radio (radio Disney, ESPN radio network), eight television stations. In total the company has about 100 Disney-branded television channels, which are broadcast in 34 languages and 162 countries.

• Parks & Resorts (34% of sales, 34% of profits): owns theme parks and resorts around the globe including Walt Disney World In Florida, Disneyland in California, Disney Land Paris, Shanghai, and Hong Kong. Also operates Disney Resort & Spa in Hawaii, the Disney Vacation Club, Adventures by Disney, and the Disney Cruise Line.

• Studio Entertainment (16% of sales, 21% of profits): produces live action and animated films under the Walt Disney Pictures, Walt Disney Animation, Pixar, Marvel, and Lucasfilm (Star Wars, Indiana Jones) studio banners. This segment’s profitability is volatile

• Consumer Products & Interactive Media (9% of sales, 15% of profits): licenses its trade names, characters, and visual and literary properties, develops and publishes mobile games, and sells its products through its own online stores and various retail outlets around the globe.

In December of 2017, Disney announced it was buying the majority of Twenty-First Century Fox (FOXA) in a $66 billion deal. Assuming the deal closes, Disney will be getting all of Fox’s assets (film and TV studios, cable networks, stakes in Hulu and other key assets) except for the Fox Broadcasting network and stations, Fox News Channel, Fox Business Network, FS1, FS2, and the Big Ten Network.

 

Business Analysis

Disney is arguably the most effective storyteller in the world. Humans love stories and have been telling them for literally thousands of years. As an article in The Atlantic noted, “Humans are inclined to see narratives where there are none because it can afford meaning to our lives, a form of existential problem-solving.”

 

Not surprisingly, forming a business around this existential human need has worked out very well for Disney over the years – the company is one of the most iconic consumer brands and is routinely named one of the world’s top 15 most valuable brands. Star Wars, Snow White, Mickey Mouse, Cinderella, Thor, and Frozen are just a few of Disney’s well-loved storytelling assets.

 

The crux of the company’s success lies in its ability to consistently identify and create high-quality branded content. Thanks to nearly 100 years of developing timeless and beloved films and other forms of intellectual property, Disney has developed a powerful arsenal of brands that it plugs into one of the most impressive marketing and distribution machines ever created.

 

And in recent years, Disney has made incredibly well-executed acquisitions to grow its film franchises, including:

• 2006: Pixar ($7.4 billion deal)
• 2009: Marvel ($4 billion)
• 2012: Lucasfilm ($4 billion)

Disney now owns some of the most successful franchises and studios in the world, including:

• Pirates of the Caribbean
• Star Wars
• Indiana Jones
• The Marvel Cinematic Universe ($12 billion in global box office sales and counting)
• Pixar (Toy Story, Cars, Finding Nemo, The Incredibles, Monsters Inc)
• Disney Animation (famous for mega hits such as Frozen and the upcoming Frozen 2)
• Disney Live Action (another serial blockbuster machine)

In 2017 Disney’s studio segment produced seven of the world’s 25 biggest grossing movies. And if the Fox acquisition goes through, that figure would increase to 12 of the top 25 grossing films. In fact, combining Fox and Disney studios would mean that last year the company would have had about 35% market share in the U.S. box office.

 

And Disney shows no signs of slowing down either on the quantity or quality of its films. For example, with the third Star Wars trilogy ending, CEO Bob Iger recently reported that the company had signed Game of Thrones creators David Benioff and D.B. Weiss to spearhead a fourth trilogy, with films to be released every other year starting in 2021. Note that every single Star Wars film (including the spinoffs) released since Disney bought LucasFilm has gone on to gross over $1 billion globally.

 

Once Disney has created a new favorite character, movie, or show, it can leverage that content across almost all of its businesses and technology platforms, reinforcing their recognition with consumers and creating a long, diversified tail of income.

 

For example, the company’s vertically integrated structure means that it can produce a great movie, then later show it across its numerous TV channels. It can also merchandise its intellectual property via games, apps, clothing, and toys.

 

It’s amazing to think how much money a character like Mickey Mouse is still making for Disney after its initial launch in 1928 despite constantly evolving consumer tastes. Disney clearly has a knack for developing timeless content and stories that appeal to our foundational human traits.

 

Meanwhile, Disney owns seven of the 12 most popular theme parks on earth, where it is continuously incorporating its films and franchises into improvements that help drive strong visitor growth and strong occupancy.

 

Last year Disney unveiled a six-year plan (called D23) to further revamp its parks and set them up for continued success. Here are some examples:

• Star Wars: Galaxy’s Edge, part of Disneyland and Disney World Hollywood Studios, opening 2019 and featuring two feature rides, the Millennium Falcon, and Star Wars battle experience.
• Guardians Of The Galaxy ride at California Adventure will be expanded into a full-fledged Marvel Land.
• Star Wars Luxury Resort: the company’s “most experiential concept ever,” a starship themed hotel where every window has a view of space.
• Major upgrade of Epcot including a highly improved Future World, a Guardians Of The Galaxy ride, and a Ratatouille attraction in the French pavilion, a Mission to Mars ride, and a space-themed restaurant.
• An intense roller coaster Tron ride next to Star Wars Hotel in Magic Kingdom, as well as a new theater and show in that park.
• New Disney Riviera Resort near Epcot, part of the exclusive Disney Vacation Club.
• Pixar Land at Disney World California Adventure.
• New York Hotel in Disneyland Paris to be rebranded and refurbished as a Marvel-based resort.

Disney’s ability to continually improve its parks has given the company amazing pricing power over the years. For example, adjusted for inflation, a day pass to the Magic Kingdom at Disney world cost $21 in 1971, according to Travel and Leisure. Today a pass costs $129, indicating 4.5% inflation-adjusted ticket price increases for nearly 50 years.

 

Perhaps most impressively of all, Disney has seemed to crack the code on consistently producing quality movies that avoid genre burnout. For example, its Marvel films, while technically superhero blockbusters, are increasingly branching out into more diverse subgenres that include comedies, heist films, political thrillers, and include relevant social commentary that makes them a hit with both critics and global audiences.

 

This is largely why Disney’s studio segment has seen its revenues increase more than 30% since 2010, while operating margins have more than tripled, from 10%, to 33%. And with Black Panther being the studio’s most critically acclaimed film today (and earning over $700 million in just 10 days of international release and expected to gross well over $1 billion), it seems that Disney’s studio success isn’t showing any signs of decline.

 

Of course there’s also the big news that Disney is attempting to buy Twenty-First Century Fox. This would be the largest and most complicated deal in its history. In fact, CEO Bob Iger, whose been leading the company since 2005, has announced that should the acquisition close he will remain CEO through December 2021.

 

The potential for the Fox acquisition is indeed impressive for three main reasons. First, Fox brings numerous strong brands under Disney’s umbrella, including Avatar, The Simpsons, Alien, Predator, Die Hard, Kingsman, Planet of the Apes, and X-men.

 

Bringing Marvel’s X-Men under the same umbrella as Marvel Studios could be a big win for Disney. In the capable hands of Kevin Feige (who oversees the Marvel Cinematic Universe), that could mean even more ambitious team ups including all of the avengers, Spider Man (joint venture with Sony), the X-Men, and the Fantastic Four.

 

In other words, Disney is potentially gaining even more ammunition to make its $12+ billion Marvel film franchise even bigger and set it up for many more years of billion-dollar blockbusters. In fact, Feige has said that he has mapped out Marvel films through 2028, which bodes well for the future of the company’s studio segment.

 

The second strategic reason for the merger is that it will increase Disney’s impressive distribution network, especially in streaming. That’s because Fox owns 30% of Hulu, as does Disney. Thus, post merger Disney would own 60% of America’s second-largest (17 million subscribers) but fastest-growing streaming provider (over 40% subscriber growth in 2017).

 

Disney has seen the writing on the walls and knows that video on demand, or VOD, streaming is likely to become ever more important as consumers cut the cord and seek cheaper alternatives to cable.

 

This is why Disney announced that it’s ending its licensing deal with NetFlix (NFLX) in 2019, and launching its own competing streaming service late that year. Disney is also launching a standalone ESPN streaming offering in 2018 that Iger has promised would use advanced artificial intelligence and data analysis to create highly personalized viewing experiences. And with 60% of Hulu (and all of Fox’s TV and movie properties), the company would likely be well situated to compete in media environments of the future.

 

Finally, the Fox acquisition would provide Disney with increased global diversification, including a 39% ownership stake in Sky Europe, but more importantly 100% ownership of Star India. Star was founded in 1991 and bought by Fox in 1993. Its properties include 58 channels in eight languages, and it enjoys an audience of 650 million people per month.

 

With India’s population and economy rapidly growing, the purchase of Star India could be a major way for Disney to further leverage its existing intellectual property into ever more lucrative sales and earnings.

 

And thanks to its wide IP moat and giant economies of scale, Disney enjoys margins and returns on capital that put most of its peers to shame. For example, Disney’s operating margin, free cash flow margin, and return on invested capital, are 26%, 16%, and 27%, respectively. To put that in context, the industry average operating margin is 6%.

 

The company’s excellent profitability is a key reason why Disney has been able to consistently reward dividend investors with very safe and steadily growing income, including a 7% dividend hike for 2018.

 

Overall, Disney enjoys a number of enduring competitive advantages that help ensure it will maintain its world-class entertainment empire in the years ahead, especially if it adds Fox under its wing.

 

Many of the company’s assets are nearly impossible for competitors to replicate because of their dependence on Disney’s trademarked brands (e.g. Disneyworld). As a result, the company is able to create strong emotional attachment with consumers and command strong pricing power given its scarcity value (where else can you visit Magic Kingdom?).

 

With an ability to develop memorable content for practically any demographic, geographic region, and technology medium, Disney appears to have a long runway for profitable growth.

 

Key Risks

While Disney’s brand is undoubtedly strong, thanks to an ever-expanding number of highly successful entertainment brands, there are still numerous growth challenges it faces in the coming years.

 

For example, one of Wall Street’s major worries is over cord cutting, especially as it pertains to Disney’s long-time cash cow ESPN. Back in 2013 ESPN subscriptions peaked at 99 million, but since then they have been falling every year, to 88 million at the end of 2017.

 

The concern here is that ESPN has recently generated 13% of the company’s revenue and 25% of its free cash flows. Historically margins were very high as Disney was able to bundle ESPN into various cable TV rights packages. This means that Disney could charge cable companies up to $8 or more per user just for ESPN (highest affiliate fees of any cable channel).

 

In addition, Disney was able to leverage ESPN into further cable bundles, such as requiring companies to carry all of its other offerings, including ABC, ABC Family, and A&E networks, which also received hefty per user fees.

 

However, in recent years ESPN has been facing challenges on numerous fronts. First, content costs, such as exclusive rights to the NFL and college football, have been rising quickly. In fact, Disney recently had to renew its contracts with the MLB, NBA, and NFL at a cost of about $2 billion a year.

 

In addition, cord cutting and changing consumer tastes have meant falling ratings, and thus sluggish advertising revenue growth. This has caused ESPN’s (and the Media segment’s) margins to contract.

 

This trend is expected to continue as consumers continue abandoning cable in favor of lower cost, video on demand services such as Netflix (NFLX), Hulu, HBO Go, and Amazon Prime. In other words, ESPN subscriptions are expected to continue sliding, resulting in lower pricing power for this meaningful business segment.

 

This is why Disney invested $2.6 billion to purchase 75% of BAMTech, an internet video streaming service used by MLB, HBO, the NHL, and WWE. This deal clears the way for Disney to launch its own standalone streaming services for ESPN and its TV and movie content in 2018 and 2019, respectively.

 

However, the problem is that it will likely take the company many years to build up enough of a consumer base to generate sufficient revenue and earnings to offset the decline in its Media segment. And there is no guarantee that these streaming services will ever achieve high enough margins to replace the declining earnings and cash flow from ESPN’s glory days.

 

For example, Netflix is the world’s largest VOD streaming company, with over 115 million global subscribers. This means that it has the best economies of scale in the industry. However, in the past year the company’s operating margin was just 7.2%, and has never been higher than 13% (before they started focusing almost exclusively on streaming).

 

Netflix’s margins are lower because of its own very high content costs (estimated to be $8 billion in 2018), a problem that Disney won’t have since it owns 100% of the content it plans to stream. That being said, currently Media generates about 20% operating margins, which might be very hard to achieve with its own streaming services.

 

In fact, UBS estimates that Disney’s streaming service would need 32 million subscribers at $9 per month, just to break even. It’s far from certain that Disney could achieve even that level of monthly subscription fees. That’s because it recently announced its ESPN streaming service will cost $5 per month, and analysts believe that the TV/Movie streaming subscription may charge a similar price.

 

Along the way the company will have to give up $500 million a year in licensing revenue from Netflix (about a 1% decrease in revenue), and likely significantly increase its capex spending.

 

Note that if the Fox deal closes, then Disney will also own 60% of Hulu, America’s second most popular streaming service. But while Hulu has enjoyed significant gains in recent years, it still has only 17 million U.S. subscribers (with no major international expansion plans) and is generating steadily growing losses.

 

What about Disney’s booming businesses, such as parks and studio? It is true that these have been major successes and helped to drive top and bottom line growth in recent years by offsetting the steady slide in the Media segment.

 

However, keep in mind that these are two of Disney’s most volatile segments. For example, parks has seen boom times thanks to the second longest U.S. economic expansion in history, allowing it to generate consistently high occupancy while steadily raising ticket, food, merchandise, and lodging prices in its resorts.

 

When the next recession hits (and it will come at some point), parks is likely to see a major reversal of fortunes as cash-strapped consumers shy away from its high-priced parks and resorts.

 

And while Disney’s studio segment has been firing on all cylinders thanks to its unbelievably strong blockbuster franchises, never forget that movie profits are very lumpy and unpredictable. In addition, be aware that much of studio’s amazing growth has been due to Disney’s ability to grow strongly overseas, especially in fast-growing emerging markets such as China and India.

 

However, these countries have booming movie industries of their own, and China has a specific policy of limiting how many U.S. films can be released in its theaters each year. This means there is a risk that Chinese theater regulatory policy changes (such as a more protectionist stance) might end up limiting Disney’s studio growth in what is soon to be the largest movie market in the world.

 

Finally, the proposed acquisition of Twenty-First Century Fox poses significant risks. The brands that Disney is acquiring through this purchase (if it’s approved) are substantial and didn’t come cheap.

 

Disney is paying a lot for Fox, enough to make the deal non-accretive to earnings and free cash flow per share, at least initially. Remember this is an all-stock deal, and Disney’s share count will now increase by about 33%.

 

After factoring out the cash flow from the properties that Fox is spinning off into a separate company (that Disney isn’t buying), it will likely take at least a few years for this acquisition to bear fruit for shareholders. And that’s assuming it ever does.

 

This is because Fox movie studios has recently been growing sales at just 3% a year, while its cable networks have been growing at 10%. Only time will tell whether the properties that Disney gets will be able to grow to a point where they start adding to its bottom line.

 

Or to put it another way, Disney’s largest acquisition ever appears to be a strategic but highly uncertain bet that Disney will be able to leverage the new intellectual property it’s acquiring. Specifically, that Disney will be able to successfully integrate them into its even bigger global distribution and marketing machine, and figure out a way to cash in on them through multiple channels.

 

Closing Thoughts on Walt Disney

Disney has proven itself to be one of the most iconic and dominant entertainment empires in the world. The company’s ever-growing portfolio of beloved brands and fast-expanding distribution network have found amazing success across countless generations, and in nearly every country on earth.

 

Simply put, Disney possesses one of the strongest portfolios of hard-to-replicate assets in the world. With demand for content continuing to rise over the long run, the company’s ability to monetize its intellectual property should continue strengthening.

 

However, Disney is at a crossroads and faces the innovator’s dilemma with its lucrative ESPN business. The company seems likely to eventually figure out ways to maximize long-term profits from its media content, but it could realistically take several years for a clearer picture to emerge, and things could get worse before they get better.

 

Efforts to launch its own streaming services and acquire Twenty-First Century Fox are very bold moves that are far from guaranteed to drive profitable long-term growth. For now, Disney’s management deserves the benefit of the doubt, and the company seems likely to remain an appealing long-term dividend growth story.

 

To learn more about Walt Disney’s dividend safety and growth profile, please click here.