Description

Disney is a buy because I believe the market does not understand the unit economics and industry structure of D2C streaming video. There is talk of a streaming war. while the transition will be painful for sub-scale companies, I believe the unit economics allow for much greater revenues and profits for a handful of companies, with DIS topping the list.

I also believe that movies business will go D2C to some extent. Right now, Disney only gets 50c on the dollar in this business with movie theaters and cable companies getting the rest. The street is modeling D2C costs without much of this associated revenue stream. This forecast provides substantial downside protection.

My forecasts are done at a high level. I think you must make a call as to whether DIS has the content to scale in D2C with substantial pricing power. What I like is that I don’t think you are paying much for the incremental value D2C creates for DIS and if I am right about the movie business it should be hard to do worse than a 10% IRR owning DIS.

1 – Unit economics of cable TV versus streaming video – Suggests that streaming will dominate, creating value for consumers and the top tier media companies.

The typical household cable bill is $105 with 50% of the price going to content companies themselves. The rest pays for: the set top box ($12), depreciation on the cable network ($10), profits for the cable companies ($20), customer service ($5) and tech support ($5). I believe the typical household can re-create the channels they want to see for ~$75 OTT, including a nearly $10 increase is their internet bill (cable companies raise the price of internet by $7.50 when a sub goes to internet only).

The typical household only wants 10-15 channels but because of cable bundling they end up with much more. Households will save money by dropping channels they do not want. Here is a rough estimate of share of TV viewing minutes by ultimate parent company. DIS is around 25%, CMCSA/CBS/FOX arre around 10% each, DISCA and AT&T are around 6% each.  ~35% of viewing minutes occurs outside the top 6 media companies. I expect the typical OTT home to include almost all of the big media companies' streaming services while only picking 2 channels outside of the big ones.  That can save them $25-35. Here is a look at the big streaming packages: AMZN Prime (Free), HBO (with TBS, TNT etc) $15, NFLX $13, DIS bundle $13 (Disney+, HULU with ads, ESPN+), CBS $6 and it seems NBC will be $5, ROKU channel (Free, with ads). The total cost is $52. While the content lacks some news and sports, I think that will eventually migrate over as media companies follows subs. 

the other source of savings comes from disintermediating some of the bloat, duplicative costs and profits of cable companies. Cable companies will recapture some of it by raising internet prices. Set top boxes will be replaced by streaming operating systems built into the TV (or a 1x purchase of a $40 streaming stick made by Roku or Amazon). Tech and customer support costs are lower as now cable companies only need to support your internet line.

Another source of value creation for the consumer is that they can watch the content they want at the time they want on whatever device they want. for example, the average American watches 35 hours of video a week. perhaps 20 hours of that is the content they love and the rest is second rate, they watch whatever is on at the time. In the OTT world, they can chose the best 35 hours of content. In general, this option deserves a premium. So does the user interface which is much better than cable TV. 

The result is that I believe the typical household can increase the value they get from traditional cable TV by going OTT while saving money. My ballpark estimate is that a typical household bill will drop from $105 to $75 without losing any content that matters to the household. This will allow some room for the best content companies to raise prices and capture more value.

2 – Unit economics of the movies industry – Suggests most movies should go D2C through a subscription service. Substantially increasing the profits of DIS film studios.

I believe D2C streaming will upend the movie business. I think than in a few years DIS and others will go direct with most of their new movies. This will create enormous value to both film studios and consumers and further accelerate the adoption of OTT video.

These are my estimate current unit economics for the movie theater industry: the typical person watches 4 movies a year in theater, pays $10 for the ticket, $5 for food. The film studio receives $5 per ticket and makes an operating profit of $1.50. 

Consumers surveys show that 2/3 of the population consistently prefers to watch movies at home.

I believe movies will go OTT through a subscription model. All but the biggest movies will go direct.  Instead of paying $60 a year per person to watch 4 movies in theaters consumer will get the option to pay $x a month to see most/all new movies at home right away. You can see this trend already with NFLX, which has 3 Oscar contending movies out this quarter. NFLX usually releases one mediocre movie a quarter that is watched by 40M households. That tells you there is very strong appetite to see first run movies at home. I believe the typical NFLX movie that is watched by 40M households is only good enough to generate $50-100M in box office revenue, or get watched by 5-10M people. NFLX is increasing their spend on hit movies considerably, to over $1bn a year. Their bet is that consumers will pay an extra $1 a month for such unique content.

I believe NFLX is making the correct bet and that it makes sense for DIS to do the same once its subscriber base reaches mass adoption. DIS has > 40% share of the US box office. It is in the best position to go D2C with its films. Let’s look at the unit economics per dollar of revenue. Right now, DIS gets 50c on the dollar and the consumer gets to watch a limited number of movies. The other 50c goes to movie theaters and cable companies (VOD rentals). DIS makes ~17c in EBIT (30% margin) for every $1 consumers spend on movies. Relative to this baseline, I believe the future is that DIS will get to charge > $1 or more for the right to watch most movies right away as often as you want, from the comfort of your own home. EBIT will rise to 67c (17c current + 50c re-pricing) less the incremental costs of going direct. The question to me is how much of the movie related revenues will go direct. I believe Marvel movies belong in theaters, I think DIS will make much more money going direct with Pixar and other movies. Then there is the opportunity to re-price at home viewing (disintermediate cable companies on VOD purchases).

A further conclusion is that DIS streaming business becomes much more unique and valuable over time once it offers first run movies D2C. This will give DIS substantial pricing power and make it a must have for most homes. I asked DIS management if they would go this route and they declined to comment but made it clear they will do whatever maximizes shareholder value. I believe the analysis of the unit economics suggests that once DIS crosses 50% adoption it makes a lot of sense to start moving many movies D2C. it is simply much more profitable for them.

3- the industry structure of streaming video: Scale will limit the number of viable streaming services. DIS will be the #1 or #2 service

To reach material scale (>50M global households) I think a company will have to spend over $5bn in total costs (content, marketing, opex). In the US alone, NFLX spent $5.5bn last year and > $7.5bn this year. They now have approximately 30% EBIT margins in the US including corporate overhead. They have 60M subs and grew with minimal competition. I think it is realistic to assume a new company will have to spend over $5bn to have 50M subs in the US. There are not many media companies that can spend this amount. The barriers of scale favors very large companies. The likes of AMC Networks will fail. Others like VIAB need to consolidate.

A strong media company makes a 30% EBIT margin on 50c on the dollar (the rest goes to the cable company, or the movie theater). For those with scale, there is ample room to raise prices while still creating a lot of value for consumers. I think over time you will see the largest D2C streaming companies show margins closer to 40% than 30%, if not higher.

I disagree with bears that view streaming as a “War”.  Most content companies simply lack the scale. I believe only 5 traditional content companies have the scale (listed above, minus DISCA), then you can add AAPL and AMZN. That makes 7 total companies. While that is far from a tight oligopoly, I believe it is much more benign than bears think. They will pay up for the best content which raises annual content costs by $5bn.  While bears look at this relative to current streaming revenues. I believe the proper benchmark is total content spend across TV and movies. Relative to that pie, it is not damaging. Furthermore, DIS is best positioned because they own the bulk of the IP that drives their profits.

My forecast is that there will be a handful of companies that become much more profitable in the D2C business model while the smaller companies fail or decline. DIS will be one of the winners.

4 – run rate normalized earnings is $7.50 to $8.00

Current EPS is depressed by FOXA costs ($2bn in synergies) and D2C losses (~$3bn) plus elevated interest expense (~$650M). adding those back brings run rate EPS to around $7.75. DIS trades at 19x run rate EPS. It normally trades at 16.5x FWD EPS. If we allow for normal growth, FWD EPS should be $8.25. at 16.5x that is worth $136. There is $8.75 of excess debt right now. That brings fair value to $127. I believe you are paying approximately $20 for the incremental DCF benefit of D2C. if you believe that going direct will be a failure for DIS, then it’s a short, but otherwise the current valuation assumes a modest premium for a strategy that I believe completely transforms DIS into a much better business.

 5 – forecasts

I think the right way to think about DIS is to first decide if you think D2C will fail. If you do, it’s a short. Otherwise, I would start with that normalized EPS of approximately $7.75 and think about how much of existing film studio and media revenue will migrate over to D2C and at what margin (how much will prices rise and with what incremental cost).

My own model is based on a 10 year forecast once the transition to D2C is complete. But a simpler way to think about is to start with normalized earnings and then add on incremental value from the D2C business that we will see over the next few years.

Normalized run rate EPS ~$7.75, adding FOXA synergies, bringing D2C to breakeven EBIT and reducing interest expense.

Media/Broadcasting business – 1) what % of baseline media subs never make the transition and churn off: without a doubt some subscribers, particularly ESPN subs, will not transition over to Disney+, HULU or ESPN+. 2) is there any incremental international opportunity. 3) how much can DIS re-price D2C subs relative to the cut they receive from traditional cable TV. I would not look at initial prices for their bundles. The correct approach is to price low because customers are not price sensitive. DIS will raise prices a lot over several years. 4) can DIS improve ad revenue. They can offer advertisers much better targeting. My approach to modeling the impact of #3 and #4 is to that about how much can they re-price and what is a realistic margin. I think DIS is likely to see the highest margins in the industry because it will reach the most scale and owns the best content. I think > 40% EBIT margins for the D2C business is sensible, relative to a traditional media company that earns a 30% margin while sharing half the revenue with cable companies.

Film studio entertainment business – Current EBIT ix ~$3.3Bn on over $12.5bn in revenue. I think ~50% of movie revenues will go D2C at high incremental margins. I think Marvel belongs on screen but Pixar and other movies will make much more profit D2C. Incremental costs are minimal as most fixed costs run through the media D2C business.

The analysis is high level, but I don’t think it is a stretch to see $15 in FY 2024 EPS v $9.20 street. That includes organic growth and buybacks. Most of the EPS increase comes from my view that D2C is going to be much more profitable that people think and scale much faster than they think. If I am wrong about how long it takes DIS to substantially increase D2C margins, I still feel the stock works well as long as the D2C business becomes the #1 or #2 global streaming service. You can infer that future margins will be strong because of that dominant position. The PE should expand relative to its historical 16.5x as the margins improve and the predictability of the business improves as well. I think that gets you to a $300 stock in 4 years.

Risks

I’m wrong and D2C fails. 1) More subs cancel DIS’s network and cable channels and do not transition to DIS’s streaming services. 2) The industry structure in the streaming world ends up a bloodbath.

execution – the FOX merger, a new streaming platform…

recession 

Catalyst

DIS announces a faster than expected ramp in D2C streaming subs, which pushes EPS higher.

Over time, they raise prices and within a couple of years start moving first run movies D2C.