Description

Company Snapshot

Executive Summary

• Enviable portfolio of IP including classic animated movie library, Marvel Cinematic Universe, Star Wars, Pixar

• Able to monetise the IP not only through Affiliate Fees/Distribution agreements, but also through their network of theme parks, resorts, cruise ships and retail outlets

• $60bn of revenues, $15bn of operating profit, $10bn of FCF pre-covid

• As well as investing in outside content, the company has invested heavily in technology and distribution via BAMTech and 21st Century Fox Acquisition

• Now in the early innings of moving their business model away from pure production towards a hybrid production/distribution via the launch of a DTC offering

• DTC offering should enjoy nearly 120m subs for core Disney+ offering by 2021 y/e, with growth to 240m by 2024

• I expect that, with sub and ARPU growth, DTC business will grow from $16bn revs in 2021 to $33bn by 2024, while the division will swing from a $1.4bn loss to a $3.7bn profit

• Will drive the company to a record operating profit of $16.2bn by 2024

• Meaningful risks around the transition due to:

• Limited content focused around just a few key franchises

• Doubts on if Disney culture permits required high volume/high fail rate approach

• Question marks on what this ultimately means for engagement/churn/ARPU

Company Description

Disney has traditionally been a global media IP producer, enjoying iconic IP across movies and TV. They would initially monetise this IP though theatre/cable deals, collecting distribution fees from movie theatre chains in exchange for the right to distribute their movies, while collecting affiliate fees from cable companies for the right to carry their channels, as in the case of ESPN. They would then further monetise the IP through selling merchandise (videos, DVDs, soft toys, video games and so on), either through partners or through directly owned stores, many of which were on site on their collection of theme parks across the US (e.g. Disneyland, Disneyworld), Europe (e.g. Disneyland Paris) and Asia (e.g. Disneyland Shanghai, Disneyland Tokyo). The company also generated meaningful advertising revenues historically, mainly through their highly-rated networks such as ABC and ESPN.  

The term “flywheel” is thrown around often these days in relation to internet-related businesses trading at aggressive multiples of near-term earnings, but Disney is probably one of the companies that one can safely say was an early proponent of such a model – to wit, note the schematic below from 1957, put together by the man himself, Walt Disney:

To give a rough idea of the scale of the business before the transition being undertaken, we can briefly look at financials from 2018, where DTC (more on this later) revenues were still de minimis. 

Linear

In this year, the company generated $21bn in revenue from their “Linear Networks” (i.e. traditional cable distribution business), over half of which came from affiliate fees. An affiliate fee is paid from a cable operator such as Cablevision, to a content producer, such as Disney, for the right to include the producer’s network (such as ESPN) in the operator’s package to the end consumer. The cable operator pays the content producer a monthly fee per customer they deliver the network to. While the company do not disclose exact fees received by network, I was able to find that the fee paid for ESPN alone is around $8-$10 per subscriber, as sports is seen as a “must have” in any cable package – ESPN has about 84m subscribers, putting affiliate fees from this channel alone at $6.7bn-$8.4bn in 2018. Most of the other revenue in Linear comes from advertising. The major cost base in this business is paying for programming, in particular the rights to broadcast various sports leagues such as the NFL, MLB, NBA and so on (the rights to which are owned by the leagues themselves), which made up about 85% of the cost base. Networks have faced spiralling content costs in recent years, as content has become increasingly valuable – for instance, NFL rights saw a 28% YoY step up in 2014 when a new contract was negotiated, with an additional 6% annual inflation built into the contract:

Despite rising content costs, Linear Networks has traditionally been a great business for Disney, generating mid-30’s operating margins. A report from the UBS media team in the early 00’s estimated that, at the time, ESPN alone was driving about 50% of Disney’s market cap.

Parks & Experiences

The other major revenue generator for the business has been the Parks & Experiences business, which was even larger than the networks business, at $25bn in revenues in 2018. While the basis of reporting has changed slightly, I think that the approximate revenue split is 25% tickets to the various parks (Disneyworld in Florida, Disneyland in California, Disneyland Paris, Hong Kong Disneyland (48% interest), and Shanghai Disney (43% interest) – they also license IP to a third party to operate Tokyo Disney, but they don’t consolidate this), 20% merchandise sold at the parks, 20% resorts, and the rest merchandise not sold in the parks. Prior to covid, this was also a very good business, generating mid to high 20’s operating margins. The business was obviously heavily impacted by covid, with revenues down 37% and EBIT down 94%, mostly driven by parks and resorts having to remain shut, however the division is now seeing a strong bounce back in revenues and the expectation is that profitability will exceed prior highs upon full reopening, as the company implements a more efficient ticket pricing mechanism to capitalise on the strong pent-up demand more precisely.

The Linear Risk/DTC Opportunity

In recent years, as streaming TV gained popularity, the company would also license their content to providers, most notably Netflix, in exchange for yearly distribution fees, which were pure incremental profit to Disney, though the exact terms were never disclosed. The Netflix licensing was seen as low-risk, high-multiple earnings for Disney – they could continue to produce content and leave the distribution to others. To understand why this was so attractive to them, it is important to understand that, historically, combining content and distribution has led to bad outcomes. There are many reasons for this, but cultures are typically quite different (content is seen as more of a creative pursuit, distribution more “number crunching”), which seemed to be a stumbling block. The roll call of content/distribution disasters includes AOL/Time Warner, Comcast/NBC Universal, and AT&T Time Warner. In 2018, however, the company began to execute on a dramatic volte face. The distribution arrangement with Netflix expired and, rather than renewing on what would certainly have been more favourable terms, the company under then-CEO Bob Iger announced that they would “go it alone”, abandoning hundreds of millions, if not billions, of guaranteed revenue in the hopes of capturing the long-term asset of a direct connection with their fans. The company is, I think, trying to execute this strategy as they correctly understand that the landscape is changing. Netflix, now their competitor, have done a very good job in building out distribution technology and creating content. Meanwhile, Disney’s traditional distribution partner channels, movie theatres and cable companies, are experiencing structural decline that seems to be accelerating. 

The chart above shows domestic cinema attendance and box office in the US – while box office has been steadily rising, attendances actually peaked in 2002 and have been declining since, now down about 20%-30% from the peak, and a trend that was well-established before covid. While pricing is important for the movie theatre business, volumes are really what matters to Disney – they require attendances to build brand equity and feed the parks/merchandise flywheel, which was over 40% of operating profit before covid.

The second chart shows the trend of pay TV subscribers in the US – it is a similar story to movie theatres, with subscribers peaking in 2012 and, since then, declining about 11% as of the time of the report I took the data from being published, with most of those declines coming recently. In terms of the cable companies, their model has been similar to that of the movie theatres – take pricing aggressively to offset volume declines, which has allowed them to keep revenues relatively stable in this part of their business. Again, from the perspective of Disney, while at the time of the strategy change, they had not been that badly affected by the viewer declines their distribution partners were suffering, in the long run it would not be a particularly healthy dynamic, with less eyeballs on the new IP, leading to weaker brand equity and less fodder for the flywheel. One should also note that it seems inevitable that the trends noted in the two charts above would ultimately take a toll on Disney were they not to diversify. From the perspective of the cable providers - with subscribers declining at mid-single digit rates, while pricing action can be taken to offset the volume declines, the end game of subscribers down by 99% with pricing up by a factor of 100 seems unrealistic – at some point, the policy of taking pricing to maintain revenue growth becomes unsustainable and they will hit a wall and would need to consider either seeking pricing concessions from Disney or simply abandoning their video offerings. Disney will then face inevitable pressure on affiliate fees.  Advertising revenues (40% of Linear, to recap) would also inevitably see pressure, an no advertiser in their right mind would continue to pay the same rates for an audience shrinking every year as viewers migrate onto other platforms. At the same time, content costs are rising relentlessly (note the earlier chart on NFL rights. The following link illustrates the inflation in English Premier League rights (and the same can be said for most professional sports leagues): 

https://www.theguardian.com/media/2021/jan/11/tension-everywhere-premier-league-back-foot-uk-tv-rights-auction-nears

The concept regarding the economics is fairly clear, with operating profit being stuck between the jaws of declining audiences and relentless programming cost inflation. Linear TV will likely be sticky, but I think it is not unrealistic to fear that profitability from the Linear business could be gone by the end of the decade.

The numbers look alarming, but the important thing to consider when analysing the business is that the value in this chain sits not with the cable networks, but with the content producers. This has been well-established since the early 80’s, when ESPN was in its early days. Though it may seem unbelievable now, in the early days of ESPN, cable networks did not pay affiliate fees to ESPN – in fact, ESPN paid a fee to the networks for the privilege of having their signal carried. An ESPN affiliate relationship manager, George Bodenheimer, noticed from conversations with cable executives that they loved the ESPN product. Bodenheimer floated the idea of the cable networks paying an affiliate fee, which was scoffed at. In response, ESPN pulled their signal and a couple of the cable companies, notably Cablevision, returned a few days later and agreed to pay 10 cents per subscriber (it is now somewhere around $8-$10 per subscriber). The product has value, and the consumer has the emotional relationship with the producer (ESPN), not the distributor (cable networks). If the cable audience is declining, the solution for producers might be simply to control distribution and go direct to the viewer.

Bob Iger as CEO

To his credit, then-CEO Bob Iger was early to understand all of this. He became CEO of Disney under unlikely circumstances in 2005. He had previously been COO of the company under Michael Eisner, who himself had enjoyed a wildly successful first 10 years as CEO of Disney, before suffering a less good second decade and suffering the ignominy of being ousted in a proxy battle after a vote of no confidence orchestrated by Roy Disney. Given he had been second-in-command during a time when Disney struggled with new IP, it was widely expected that he would be fired along with Eisner. He was, incredibly, promoted to CEO after pitching a new strategy to the board with the following key pillars:

1. Devote most of our time and capital to the creation of high-quality branded content 

2. Embrace technology to the fullest extent, first by using it to enable the creation of higher quality products, and then to reach consumers in more modern, more relevant ways

3. Become a truly global company

From 2005 onwards, I would argue that the current strategy was beginning to be executed, however it would take over a decade to assemble all of the pieces required. 

Building an IP Portfolio

Iger’s first step was to purchase Pixar (Toy Story, Monsters Inc, Finding Nemo, The Incredibles, Cars, Up) for $7.4bn in 2006. It is hard to overstate the uproar this caused at the time to a board wedded to the view that their animated content should be hand-drawn and internally generated. Nonetheless, Iger was able to convince the board that, following numerous commercial failures, assembling better IP through selective deal making was the way forward. A quick glance at worldwide box office data for selected movies would indicate that this was probably a wise decision:

This data is just revenues at the box office, which Disney must share with the movie theatres (they take 45%-50%), and does not include costs, but my reading indicated that profit margins on Pixar films are just under 30%, indicating about $1.5bn in profits from the box office alone, without factoring in TV series revenues, affiliate fees from the movies being show on TV, merchandise sales, and footfall to theme parks generated by the IP. The next to IP purchases were Marvel Studios for $4bn in 2009 and Lucasfilm for $4.1bn in 2012. The Marvel deal in particular will probably go down as one of the most accretive deals of all time. Below, I include the box office figures for just the top 10 grossing Marvel movies since the acquisition. Again, this does not include TV series (of which there are many) or merchandise:

Building Technology Capability

Regarding the second strategic pillar, technology, the company acquired 75% of BAMTech for about $2.6bn in stages from 2016-2017, with the minority interest consisting of 15% owned by Major League Baseball (MLB) and 10% owned by the National Hockey League (NHL). BAMTech could be a report within itself, but the basics are that it was created in the early 00’s by the MLB, with its origins being as a centralised function to create and maintain websites for the various MLB teams, with initial seed capital being provided by the teams. It was early in providing streaming audio to games, initially so that Japanese fans were able to follow the games of a player who happened to be particularly popular at the time. They then progressed to streaming video, a technically challenging product to deliver in a user-friendly way. As an example of what I mean by this – if I am watching a game live on my (at the time) PC and then pause the game for an hour to go and make dinner, if I then come back to the game, unpause the game, refresh my browser and the feed goes back to the live game and “forgets” I paused an hour ago, the experience is ruined for me. The technology proved to be very valuable. When HBO launched their own streaming service and tried to produce the streaming technology in-house, they experienced issues when Game of Thrones was released via the on-demand platform, with viewers complaining very publicly that the service didn’t work at all. Ultimately, HBO decided to outsource to BAMTech, demonstrating the value to Disney, who eventually made their move. The final step for Disney was the acquisition of 21st Century Fox after a bidding war with Comcast in 2018. For a final price of $71bn, Disney got TFCF’s film and TV studios, the right the X-Men franchise and a few other pieces of comic book IP that they may now integrate into the Marvel cinematic universe, TV channels such as FX and National Geographic, a foothold in India through broadcaster Star India, along with 30% of Hulu (since increased to a controlling interest), which is a streaming platform best summarised as a mini-Netflix

The Rollout

With the technology in place via BAMTech and Hulu, and what the company view as a sufficient start on content with their “legacy Disney” library and the purchased content relating the the Star Wars Universe, the Marvel Cinematic Universe, and the Hulu content, the DTC product was rolled out in 2018 and received enthusiastically by investors. The company initially offered year long trials at attractive prices via telco partners to drive adoption, and then at the CMD in 2020 laid out ambitious targets for 230m-260m paid subscribers to Disney+ by 2024, driven by $14bn-$16bn of content spend that year. It is important to note that this number includes 85m Hotstar subscribers in India where ARPUs are considerably lower (while ARPUs are not disclosed to this degree of granularity, sell side estimates are that Hotstar ARPUs are below $2 vs Disney+ at $7.99). Nonetheless, given they will probably end 2021 with around 118m subscribers globally, the targets leave considerable room for growth, with sell side estimates putting the addressable market at as many as 700m households. Given the current Disney+ blended ARPU of just $4.08), the combination of subscriber growth and ARPU growth is potentially a mouth-watering one. For context on the ARPU growth potential, the current ARPU of Netflix stands at around $13.50 – while Disney+ will probably not be able to get close to this due to the more niche offering they have (more focused on kids/Marvel/Star Wars as opposed to Netflix; Netflix will probably spend about $17bn this year on a broad variety of content vs Disney guidance for $14bn-$16bn by 2024, and less in the immediate future; Netflix has already amassed a formidable library relative to Disney), even if Disney+ were to get to 40% of the Netflix ARPU by 2024 (roughly what I have in my model), it would drive an attractive double-digit revenue growth at the group level. 

In addition to the targets laid out for Disney+, the company is targeting 50m-60m paid subscribers for Hulu (at a considerably higher ARPU), along with 20m-30m ESPN+ paid subscribers. The economics around ESPN+ in particular are quite opaque. At the moment, the live games that Disney licences from the likes of the NFL and the NBA are not offered by ESPN+, which means that the ARPU on ESPN+ sits below $4. The live games are a big part of the value (as evidenced by the cost inflation in the rights to show the games, and the $8-$10 per subscriber affiliate fees that ESPN is able to charge. Though Disney has thus far remained tight-lipped on any plans to move the live content over to ESPN+ (it would likely leave their cable partners very unhappy), as I have argued above, the real value in the chain is the relationship between ESPN and the end customer, not the relationship between the cable provider and the customer (customers generally hate their cable providers), so a transition seems inevitable. In this case, simply transposing the affiliate fee onto the current ESPN+ ARPU would suggest potential ARPU growth from $4 to $12-$14 in the event that Disney make the call to take distribution in-house. I have not included this in my model as the economics are unclear to me in terms of how many households would be willing to pay that much for sports, and what the impact would be on affiliate fees and advertising in the Linear business (presumably cable subscribers would cut cords in droves post this offering), but it is probably a source of additional upside. I have modelled ARPU growth of 5% per annum at ESPN+, but that could be too conservative. Below, I lay out the summary of my divisional model on DTC Revenues, along with the key drivers of the biggest part of revenues, subscription fees, which will be determined by subscriber numbers and ARPU growth:

So, I have 2024 subscribers for Disney+, Hulu and ESPN+ of 239m, 57m and 26m, respectively, vs company guidance of 230m-260m, 50m-60m and 20m-30m, respectively; ARPU grows from $4.82, $12.63 and $3.78, respectively, to $5.43, $15.51 and $5.29, respectively. Given the ramp up in subscribers and what I think are reasonable assumptions on ARPU growth, I think that the company’s guidance of DTC breakeven will prove to be far too conservative, and I have them getting above breakeven in 2022, with almost $4bn of operating profit by 2024 as they benefit from leverage on SG&A and other opex:

As I laid out in the section above on Linear Networks, this part of the business is likely to see meaningful pressure, thus I think that the way to look at the transition that the company is attempting is to combine the two divisions and try to understand what the combined economics will look like:

I think that margins are likely to come under pressure, with combined margins not likely to come anywhere near the level that they enjoyed under the “Linear” model as the company shoulders the considerable distribution costs themselves. The sheer quantum of the revenue growth, however, will mean that Disney will be able to generate impressive operating income growth as they scale the DTC offering. At the group level, it should translate into strong revenue growth and even better earnings growth:

In the scenario that I envisage, the company would surpass the pre-covid level of earnings by 2025, however they would take until 2026 to surpass pre-covid EPS levels, as a result of the dilution from the TFCF deal, which had a large stock-based element. By the time they reach the 2024 subscriber base platform they are aiming for, they will be generating about $11.5bn of equity free cash flow per annum. 

Disney+ Discussion Points

Before going on to discuss valuation and what to do with the stock, it’s worth discussing the DTC business and some of the risks around it, as thus far all I have really done is laid out why the transition is a rational one to attempt and then put some numbers around it. The challenge for Disney is really a twofold one along the lines that Bob Iger laid out many years ago – they must build enough programming volume two drive everyday engagement, and secondly improve the product experience (something that Netflix excels at). The two challenges are linked, as improving the experience requires more data, and data is gathered via more engagement. While it is anecdotal based on my own experience and the experience of discussing it with friends and reading around on the topic, my view is that Disney+ has not improved a great deal since the launch – the limited consensus seems to be “good library of old movies, The Mandalorian is great…” and then not much else. There is a bullish narrative that Disney enjoys timeless brands loved by children, and there will always be a place for that in the home, particularly at such an attractive monthly price point. I think that is probably true to an extent, but I would question how deep the connection between kids and Disney is relative to the relationship between the parents of kids and Disney. To illustrate the point, I have included a couple of screenshots below from Brand Love, which compiles lists of favoured brands in the US. The two surveys I include are ones on the most favoured brands for kids by the parents of the kids, and then the brands that the kids themselves like the most. The survey is broken down into 6–8-year-olds, 9–12-year-olds, and 13–17-year-olds. For me, it is notable that in every age group, the parents seem to like Disney more than the kids themselves – in the 6-8 group, Disney+ ranks 4th for parents (behind Netflix) but 6th for the kids (behind Youtube and Netflix); in the 9-12 group, Disney+ ranks 18th for parents (behind Netflix, Amazon and Youtube) but 23rd for kids; for the 13-17 group, Disney+ ranks 21st for parents (behind Netflix, Amazon and Youtube) and is not in the top 50 brands that the kids themselves like. The other thing of note, of course, is that Disney+ trails competing draws of viewing attention such as Netflix and Youtube on every metric.

The lagging behind on impressions is not just among kids, either – among the top 10-rated streaming shows in 2021 in terms of debut ratings, all came from Netflix, none from Hulu or Disney+. 

https://www.businessinsider.com/most-viewed-streaming-tv-show-debuts-of-year-nielsen-2021-9?r=US&IR=T

This is obviously a reflection of the greater critical mass that Netflix currently enjoys relative to Disney+, but I think that it does underscore the challenge ahead of Disney in terms of the spending they will need to do in order to generate a sufficiently diverse library to compete. I think that, psychologically, for a company like Disney with a stated objective of producing quality, “tentpole” content, it is going to be difficult to shift to the mindset of just producing a lot and seeing what sticks. return. It is going to be a structural disadvantage for Disney to be in the tentpole business with Disney+, driving huge viewing of a few big titles--but little repeat and daily viewing. There is potentially more long-term value in maximising engagement, and I think that, currently, and for the next few years at least, Disney will be at a structural disadvantage. This structural disadvantage is going to drive higher churn, as evidenced by the chart below – volume, variety, newness and engagement matter:

The library is possibly not going to be enough to sustain the engagement levels and lower the churn to levels that will garner a Netflix-like valuation for the DTC business that the bulls hope for. I read that in any given non-English speaking market, local content is about 90% of viewing – Disney is going to have a spend a lot of money on locally-produced content and get comfortable with being less risk averse and having more of an appetite for failure. As the chart below from Morgan Stanley alludes to, net adds have been slowing lately. There are some timing issues here around the start of the IPL cricket season, together with the timing of new series releases, but the issue around lack of content depth, excessive dependence on big franchises such as Star Wars and Marvel superheroes (where there might be the risk of consumer fatigue – no signs of that yet, though) is one that is omnipresent in the minds of investors – slowing momentum in net adds is only likely to add to those anxieties. 

The comparison with Netflix in terms of churn and content brings to the fore the bear case around Disney, namely that DTC will fall short of expectations on subscriber numbers as customers are unwilling to pay for multiple subscription services, and Netflix ends up winning due to a greater variety of product and a better user interface. I don’t see this as a major risk, and the best argument I have seen for this is that the typical household cable bill is $105 with 50% of the price going to content companies themselves. The typical household only wants 10-15 channels but because of cable bundling they end up with much more. The rough split of TV viewing minutes by parent company is Disney at 25%, Comcast/CBS/Fox about 10% each, Discovery and AT&T at about 6% each with the other 33% outside the top 6. Looking at the pricing of the big streaming packages taking Amazon Prime, HBO, Netflix, the Disney bundle, CBS, NBC, ROKU and Amazon Prime would cost about $52. It is a large saving for the consumer and points to latent pricing power for the content producers, and to the fact that it is not a zero-sum game – Netflix and Disney can both win, in my view.

Valuation

In terms of valuing the company, I think that the right way to look at it is to look at earnings power towards the middle of the decade when the DTC transition should be well underway and the earnings power is more apparent, and then to apply a multiple to those earnings and calculate the IRR based upon those assumptions. Looking at near-term earnings doesn’t work, as the DTC part, which is likely to be the largest earnings driver in the future, is currently unprofitable, while the parks business is still suffering depressed earnings as a result of covid. Prior to covid, the company traded on a (broad) P/E range of 14x-20x. I’d feel comfortable valuing the shares at the high end of that range if the transition is complete – the margins and returns will be lower than they historically have been, but if they can build a base upon which to roll out their content to a more global audience than they historically have been able to, then the growth potential should offset the lower returns and I think that a multiple at the higher end of the historical range is reasonable. As I laid out in my forecasted income statement above, if the DTC rollout is about in line with company expectations in terms of subscribers, and they are able to take some pricing, then ~$7.40 of EPS should be achievable by 2025 (with some conservatism built into that estimate). 20x that would be $150/share, suggesting the shares are undervalued. Of course, the DTC business could really begin to gain momentum by 2025, and there is the possibility that EPS could nearly double again by 2030. That would suggest about 140% upside by 2030 for an IRR of about 10%. For me, a 7% a double-digit IRR is probably attractive enough to compensate for the various uncertainties over the churn rates we are currently seeing at Netflix, and what the right terminal multiple should be.

I also looked at the company on a sum of the parts basis. The benefits of the SOTP approach in this case are that the drivers of the different business units are fairly different, as are the appropriate multiples to value those units; it also has the benefit of allowing us to “back into” the value that the market is implying for the DTC business (acknowledging that various assumptions must be made). Again, I have taken then liberty of basing the valuation on 2025 estimates, to allow for the DTC ramp up.

The SOTP valuation suggests upside to $170/share by 2024/2025, which would be about 50% upside for an IRR of 10.4%, probably making the case attractive enough to invest in.

Looking at what the current EV implies for the DTC business – if my estimates of the value of the other assets excluding DTC are about right, then the market is implying that Disney’s streaming business is worth about $40bn by 2025 vs Netflix’s current market cap of about $90bn. A discount is warranted due to Disney’s relatively lower addressable market and far lower ARPU, however the validity of a 55% discount is certainly a valid discussion point to frame the argument around downside protection, as there seems to be some implicit view from the market that the DTC transition will not be successful.

The average of the two valuations above gets me to upside of about 40% by 2025, or an IRR of just over 10%, which I think is attractive enough to bear the risk around current net add headwinds we are seeing in Netflix, and the overall risk around the transition that Disney are attempting.

Catalyst

none