Description

Long DIS.  DIS has unique assets that can not be replicated, which confer it competitive advantages and customer loyalty, which in turn give it strong margins and pricing power.  DIS is on the cusp of a transition to a more direct to consumer business model that could drive growth for years to come, while putting to rest various concerns about disruption to traditional media distribution channels.

For several years DIS stock has underperformed as cord cutting has been a major concern for investors, particularly due to Media Networks’ reliance on ESPN.  Additionally, there has been concern that investment in the transition to a streaming model would depress earnings. This transition also entails risk associated with cannibalizing existing high margin licensing revenue for a direct to consumer model.

However, over the past couple of years management has also taken action to rectify some past strategic mistakes and the stock market has just begun to appreciate these moves.  DIS has decided to no longer license its film content to third parties. It also laid the groundwork for a proprietary streaming service with the 75% acquisition of BAMtech. And it recently, closed the acquisition of FOX, bolstering its leading position in media content, and distribution bringing its ownership of Hulu to 60%.  And just this past week, management finally provided details on its new highly anticipated streaming service.

The new over the top (OTT) service is called Disney+ and it is not just another streaming service.  As Matthew Ball describes, it is about leveraging all of DIS’s properties and “it allows Disney to transform from a company about products, titles and characters to one that sells sustained entertainment ecosystems.”  It is a new iteration of Walt Disney’s original vision for his brainchild, in which every segment of the company would work cohesively together to develop, share, and promote content. DIS has always done an outstanding job of cross-pollinating its businesses, but the technology previously available meant that its fans always consumed its content in discrete units (a book, a movie, a visit), whereas now it has the opportunity to sell the entire experience as a service.

The details on Disney+ are as follows: monthly pricing will be $6.99, or $69.99 per year, which seems excessively low compared to other offerings and the amount of content that will be available.  Management expects to have 60-90 million subscribers by F2024, at which point it will achieve profitability. â…“ of subs are expected to be domestic with the remaining â…” international. Eventually, the service could have well over 100 million subscribers.  Based on these estimates it is not hard to get to well over $6 billion in revenue in F2024. Management guided cash content costs to be $1 billion in F2020, growing to $2 billion in F2024, in addition to licensing content from other segments of the company for $1.5 billion.  Operating expenses for the division will be another $1 billion in F2020 and will grow slower than revenues.

JPM projections for the Disney+ roll out:

DIS likely has latent pricing power.  DIS is setting the initial price for Disney+ artificially low to drive adoption and market share gains.  It seems likely that compared to other OTT options DIS will have the ability to double prices once it reaches scale, so $6 billion in revenues could become double digit billions with 100% contribution margin from price increases.

Historically, film studios have not always enjoyed rich valuations given the unpredictable and volatile nature of box office results.  With this shift DIS is moving towards a more predictable, recurring business model that will hopefully generate more annuity like returns, which if successful should translate into a higher valuation.

Despite what might appear as a late entry into SVOD, DIS’s intellectual property is strong enough for it to make up lost ground and take market share.  The market itself is also so new and many consumers are interested in having several OTT services, so the entire pie will be growing for the foreseeable future.  In a recent interview, Iger explained why they waited to launch a service like this and why now is the right time for Disney+.  “We wouldn’t have been ready to talk about it. It takes technology. It takes content. It takes the talent to make the content.  It takes the marketplace. You could argue that what Netflix has done has actually been good for us, because they’ve seeded the marketplace to robust over the top content distribution and presentation.”

If content is king, DIS is incredibly well positioned.  Controlling distribution and maintaining the touchpoint to the consumer will only make that content even more valuable.  Having a direct relationship with its end customer will provide DIS with useful data on preferences, hits/flops, etc. Disney+ will enable DIS to even more effectively cross-market and upsell the rest of its assets.  While the monthly price point of Disney+ is easy to track, it will be interesting to see its impact on overall family spend on DIS properties, although harder to discern. Selling movie tickets and packages to theme parks via Disney+ could be just the tip of the iceberg.  Having a more direct relationship with the consumer gives DIS the opportunity to monetize much more effectively, as well as provide a more compelling experience, strengthening its connection with customers. Disney consumers are typically going to movies in theatres, renting and downloading at home, buying consumer products, and visiting parks and taking cruises.  Historically, the customer relationship has been with movie theatres, cable and satellite operators, big box retailers, but now the customer relationship with DIS is strengthening and deepening due to its ability to have direct contact with them.

There is some concern about cannibalization, which is probably not a big risk, since the platform economics should far outweigh the loss of license fees.  On the last earnings call management discussed taking a $150 million hit this year to operating income due to the loss of licensing revenue. Following the investment phase, as the platforms mature, and pricing power is realized, sacrificing wholesale license fees should have been well worth it.  Management stated that they are not changing the theatrical release window, so there should be no impact on this aspect of DIS’s business. Although wholesale home video revenues have been stable over the past couple of years, the outlook bleak for DVDs and the like, so DIS is right to look to the future with streaming.  These wholesale revenues are also roughly $1.3 billion, which might translate into $500 million of gross profit for DIS, so it need not be treated like a sacred cow. Like subscriber declines in linear television, there is not much management can do about the demise of DVDs, so they are better off cannibalizing themselves.

In the same interview cited above, Iger provided a window into his own personal innovator’s dilemma.  This is a long quote, but I thought worthwhile to show the highlights because it deals with issues, we, as long term investors, appreciate, but rarely see from CEOs of public companies with respect to disruption, incentives, and investing for the long-term at the expense of the short-term in order to maximize value:

If you measure against the present, the present doesn’t stay the present for very long.  In fact in today’s world, it’s changing so much, the marketplace has never been this dynamic.  Meaning speed of change is much faster. And that’s technology, that’s consumer behaviour driven by technology, it’s economics, it’s how things are marketed… So, you can’t measure against what it is today.  You have to measure against what you believe it’s going to be tomorrow. And I think one of the reasons why companies fail to innovate is they continue to measure it against today… You’re getting measured by quarterly earnings and annual earnings, and how much you grew… In many cases compensation is tied to near-term versus long-term.  So, it becomes very, very difficult to innovate, again, because you just you’re so tied to the business model that got you where you are… Everything about our world is being disrupted…We’re wedded to creating great content that is branded. That has served us extremely well… No matter how much technology changes how people are told stories or get their stories, we’re still going to be relevant, but only if we enable ourselves to be distributed and purchased by the consumer in more modern ways.  If we stick to the old, that to me is a recipe for extinction.

DIS has decided to keep Disney+, Hulu, and ESPN+ separate.  While maintaining several different streaming options might seem convoluted, it allows DIS to segment its content to appropriate audiences, since part of the reason for unbundling in the first place is consumers not wanting to pay for a lot of channels they are not watching.  Those who prefer to get everything can stick with the cable bundle, but DIS will also be bundling all three OTT options together, as well.

As for its library, DIS owns some of the most valuable IP in the world.  Charlie Munger reportedly described DIS as the equivalent of an oil company that can put the oil back in the ground after it is done drilling, so it can drill it again (I actually have not found the exact quote after a little searching).  For example, DIS released the highest grossing movies of 2015, 2016, 2017, 2018, and most likely again in 2019 with Avengers: Endgame, Star Wars: Episode IX, Frozen 2, and The Lion King.  DIS takes in 25% of annual box office and usually has the majority of any given years top releases, as well as the majority of films to break $1 billion globally (19 out of 35).

Content acquisitions have generated strong ROI and further created value.  The DIS acquisition of Pixar, Marvel and Lucasfilm have added depth and breadth to its content library, but perhaps more importantly has allowed DIS to mine successful franchises for new content (or just repurpose old content) that continually resonates with fans.  Upon closing the FOX acquisition, DIS has unrivaled global scale in the media industry to repeat this playbook.

Other segments should do moderately well in the near term.  Media networks should be able to offset small subscriber declines with price escalators, resulting in modest growth.  Star Wars park expansions should drive incremental attendance. And speaking of pricing power, two decades ago park entrance would have cost you $42, but today for an adult, which DIS defines as anyone 10 or older, it will set you back $116-169/day, while park hopper passes can sell for over $200.  DIS does offer slightly discounted pricing for children under 9. Consumer products should also perform well with Lion King and Frozen releases, among others.

After its recent move, DIS is trading near the high end of its historical valuation ranges.  However, I believe that what we witnessed last week was the market’s fears about cord cutting abating and earnings dilution from technology investments.  investors now seem to be looking through the losses that the SVOD services will incur in the next several years towards a period of renewed growth and strengthened competitive positioning.  On an enterprise value of $255 billion, EBITDA could stabilize around $18 billion annually for the next couple years. Ignoring Hulu and ESPN+, content spending and operating expense on Disney+ alone will be ~$3billion/year.  Offsetting to some extent the investment dilution in OTT will be the $2 billion of synergies from integrating the FOX acquisition. While this investment is huge undertaking, when these platforms begin to reach scale and profitability there should be a massive swing in cash flow with EBITDA potentially approaching $23-24 billion.  EPS will decline through F2020 to the low $6 range, but there will also be about $2/share reduction from this ongoing investment, so as DIS turns the corner on ramping these services, cash earnings power will be closer to $8-10/share.

Of course, transformational change comes with risks.  DIS is making a big bet here and if sub growth comes in below expectations they will have wasted billions and their competitive position will be weakened.  Some of its most valuable content is still under license deals for several more years, which could hurt customer acceptance of Disney+. One could argue that its release slate over the past couple years was so good that it will be hard to follow up on.  

I have never written up a stock making all time highs before (at least as a long), so I know there will be some “you coulda told me last week” tags, and deservedly so, but I do not think new investors are late to the party here.  This is the first step in a multiyear process that should improve growth and competitive positioning, as well as result in rerating of the stock.

Catalyst

roll out of Disney+