Disney’s been in the press lately thanks to Third Point’s letter and their subsequent announced restructuring. A lot of people have weighed in on the topic, and to be honest I really have been somewhat surprised by most of what I’ve read. Nobody seems to want to challenge this activist letter, so I thought I’d take a crack at it as this is a topic near and dear to my heart.
If you have not read Third Points Letter you can find it here. To summarize the thesis, Third Point makes an argument for Disney to go “all in on streaming” and to demonstrate this commitment by cutting their dividend to accelerate content investment in their DTC services. Their thesis is that Disney management is maybe lacking in streaming commitment due to their historical way of managing content distribution (up front profits), and that as far as the stock is concerned this is what stands in the way of Disney’s Media Networks/Studio revenue getting a Netlfix sales multiple. As far as activist letters go, I did not find this to be a compelling argument. But before I get into the details as to why, I think it’s critical to review the historical financial data of Disney which some very smart people have chosen to ignore.
This is what Disney’s biz looked like at the turn of the millennium…
In 2000, Disney Studio division was 23.5% of revenue and at a depressed 4% of operating income (down from 18% two years earlier). This was due to the recent failure of Disney’s tried and true VHS IP Vault model of releasing a treasured title every 5 to 10 years. The arrival of the DVD had really disrupted this model. So, no surprise that at it was right about this time that Disney was making their first major distribution pivot since the dawn of the VHS as they had recently committed to shake things up and go all in on the now rising DVD format. Management decided to stop limiting IP supply and try to cash in on the craze of consumers building their own home DVD libraries. This strategy worked very well.
At the peak of the DVD boom in 2007, Disney’s Studio hit a record $1.2bl in operating income. Amazing right? Well, not really, revenue mix wise not much had changed at the group level with the studio biz now just 21% of total revenue and at 15% of operating income.But this is not to say things were the same. Inside the Studio division the DVD unit had grabbed the lion’s share of revenue with Home Entertainment now outgrossing the box office by 3x.
It would take until 2014 with Frozen and Marvel for Disney to offset the decline in DVD revenue with a $1.5bl operating income year for the Studio division, and it wasn’t until 2016 that they surpassed the studio division’s 2006 peak in revenue.
A lost decade for Disney?
Not exactly, as operating income expanded 150% over the same time period. See here is the rub with Disney, the Studio grabs all the headlines but bottom line wise it’s really just a supporting cast member. In 2014 after Frozen literally “Let It Go”, Studio division operating income was only 11% of group operating income. At pre-reorg/Dis+ Launch/Fox Acq 2018 peak, it was roughly 18%.
So, for the better part of 20 years Disney’s Studio biz has really been a mid-teens slice of operating income and revenue. And on an EBTIDA basis you are probably looking at something that trends closer to the 10% mark or low teens level. But the composition has flipped…
Home entertainment which was once over 50% was now less than 20%, while TV/SVOD has grown organically (Netflix cutting fat checks played a part in that) and box office by means of mkt share and consolidation. Still despite this underlying change in composition the overall group contribution didn’t change much.
So, what about the other 85% of EBITDA?
Parks and Experiences and the ESPN component of Media Networks pretty much dominate the rest of the biz and cash flow, and it’s probably no coincidence there was not much to say there as we are in the midst of a global pandemic. But unfortunately, you can’t ignore how these businesses relate to the rest of the pie when you are giving Disney management advice. In 2000, Disney earned roughly $1.14 a month per for the roughly same domestic subscriber (80ml) base it gets $9 a month from today. More on that later, but first let’s look at the key points Third Point makes in their letter with respect to streaming.
Disney is pre-occupied with upfront profits and not seeing the long-term customer value from shifting to a subscription model. Adobe and Microsoft are cited as notable companies that chose to make a difficult sacrifice in distribution that was subsequently rewarded by the market.( nice huge PE expansions are shown for both names from pre to post cloud)
These tech giants aren’t exactly a good comparison for Disney, but SaaS is gift from God these days so no surprise. Let’s start with the obvious fact that these are software productivity tool providers whose key SaaS transitioning products were core profit centers for these two companies, and whose means of transitioning distribution in fact directly impacted the end user experience.
Basically, if Adobe/Msft competitors started shipping competing productivity products continuously, both companies faced the risk of losing their UTILITY customers to more cloud native products (GSUITE for example) whose features were evolving. That being said the pricing adopted by both allowed for a smooth transition and in the case of Adobe resulted in drastically expanding the addressable userbase. But again, the critical factor for both these companies was a shift to UTILITY COMPUTING and thus the need to be able to support their products and end customers with continuous deployment.
To quote a friend who was softwafe developer and later exec at a software giant that navigated this transition…
“the server business is hard. you have to ship the software like it’s CDroms still, get customers to install updates, have support staff keep track of upgrades, make versions upgrade well, plugins have to work work across lots of versions, etc etc etc etc etc etc etc etc etc etc etc
when i was writing code still at ***** i would issue individual patches for some customers so they could resolve their bug. you can’t scale that.”
However, let’s be clear, I can still buy Office or Acrobat Pro 2020 with a perpetual license if I want.
Still, the point I am making here is Disney’s Studio biz is not exactly the companies cash cow, and what they are selling is not a software productivity tool. And anyone whose followed the company over the last 30 years knows that Disney management isn’t exactly stubborn and incapable of shifting their model as needed.
In 2005 as the box office was stagnating and DVD sales were soaring, Iger floated the idea of releasing DVD’s in the same window as the Theatrical release. This caused quite a storm in Hollywood.
So, why would Disney’s CEO publicly suggest something that would piss off distribution partners?
Because Disney was dominating DVD and Finding Nemo had just done like ¾ of billion dollars in DVD sales, and Disney was starting to think about how much more they could make charging for a same day DVD release. But with the benefit of hindsight I don’t think anyone (actually who knows these days) will argue that Iger wasn’t wise to go in the other direction with the box office and expand his share by acquiring Pixar, Marvel, and Lucas Films over the next few years. Why buy these assets? Well it would appear Iger realized Disney was in the EVENTS EXPERIENCE Business which is a challenge one needs to consider when considering going all in DTC.
This quote from Iger in 2006 recapping the success of the Pirates of the Carribean: Dead Man’s Chest flywheel should be factored into any Disney analysis with respect to Disney’s DTC commitment.
Disney’s Event Biz starts at the box office which is TINY fraction of revenue and profits, and it ends at the theme parks which is one of Disney’s two GIANT cash cows. What shine comes off the brand if grown men are not lining up to watch a Star Wars film or kids hosting their birthday parties at some new MCU tentpole? The classic Disney movie model was box office event and then buy the DVD for the kids to watch that 5x+ at home. Then toys, happy meals, costumes, books, music, plays, games, parks etc. Can u trigger the same enthusiasm if there isn’t an event at the start and the scarcity of box office buzz for opening night for a blockbuster? How many parents have home theaters that can comfortably accommodate 15 kids for a Mulan Bday party? Is Disney still Disney if I can hit pause to finish my homework, play Roblox, or go watch Youtube? Will I get the same buzz and cultural impact with a PVOD launch?
I ask these questions because once upon a time there were compelling arguments made that all Disney needed to do at the box office was recoup their marketing costs and the flywheel would take care of the rest. I have hard time believing that without the box office that Disney’s superhero shine doesn’t start to fade if I can watch the Boys and Umbrella Academy just as easily as a new MCU film. So, with that in mind increasing content spend on DTC actually has costs for an EVENT driven high quality SCARCE IP entertainment biz. Dilution would be the operative finance word that comes to mind as far as risks. And some could argue that to turbocharge Disney+ launch last year that Disney did just that with a massive blitz of prime live action remakes. So, yeah the Msft/ADBE comparison is best dismissed. Onto the next point….
Disney’s recent $30 PVOD Mulan experiment failure (still unclear and arguably unique due to China element on this one during Covid) was short-sighted and management should adopt an all-you-can-eat approach to their content based on how “Spotify and other music streaming peers have built a digital subscription industry that is multiples of the iTunes ‘a-la-carte’ model.”
Ok, this one is a bit wild, but again Third Point seems focused on the multiple expansion from the market (the goal) vs whether or not the analogy makes sense. For $10 a month on Spotify I can consume all the music every created since pretty much the beginning of time. This obvious difference between music streaming and SVOD seems lost on Third Point and so does the fact that the talent in Hollywood still captures a huge chunk of the pie. The same can’t be said for the music industry. Just ask any musician doing the math on what Spotfiy paid Joe Rogan to move his Podcast to their platform. 20bl+ music streams and counting till you are a Mega hit Podcast! Also, Spotify gets better with each song which is kind of the whole thing with music algorithms that is not the same with long form scripted video content. Then there is of course the obvious problem which is that for less than the monthly cost of Netlfix I get everything since the beginning of time. Meanwhile, Disney film/tv DTC gets to compete against live sports, Social, Netflix, Amazon, Apple, HBO, Youtube, video games, podcasts, and Music. So, capturing some box office or transactional event revenue in the same manner a musician does from a live performance is kind of relevant especially if I haven’t yet figured out a way to eliminate the Hollywood performance athlete compensation. Anyway, again it seems the outcome is the driver here, and that is Disney getting Spotify’s multiple on their media revenue recurring vs any logical benefit that might accrue to the entire biz by magically ramping content creation and shifting it all to DTC streaming. Then there is their final point on the box office obsolescence…..
Just this week, Regal Cinemas shuttered all its US operations and physical theaters. While we all share a certain sadness and nostalgia for this eventuality, I am sure that people felt similar emotions about horse-drawn carriages when the automobile was first introduced. Every Hollywood executive has been able to enjoy first run films in the comfort of their home theaters for years. We urge you to democratize this experience and to continue to embrace the future of home entertainment with the utmost urgency in executing the company’s digital transformation.
I really don’t even know what to say here. The theater is not nostalgia when the screen is the 30ft tall and 90ft wide, and the horse-buggy to car analogy is horrible. Technological evolution is not the issue here. Again, I don’t know how many homes have event level movie exhibition space, but that physical space is in fact still part of the challenge seems obvious. Sure, kids are gaming and watching each other on Twitch but this is part of the home experience. We have had VOD for over a decade on cable, and there was nothing technologically stopping Disney from running 9 channels with all their content round the clock on linear. As for studio execs democratizing access, I’ll just quote William Money in Unforgiven “Deserve has got nothing to do with it.”
Really, I think this activist letter could have skipped all this noise and just focused on the one clear point they seem preoccupied with respect to Disney’s biz….
“there is no arguing against the $1,200 per subscriber valuation the market currently ascribes to Netflix. It is even harder to argue against the step change in returns Disney could generate by accelerating content spend (measured in multiples) compared to paying that same capital to shareholders in the form of a dividend (measured in a low single-digit percentage).”
This is essentially the meat of the thesis, and where you need to ask the hard questions as an investor.
The message this Activist wants the market and management to hear is simple: Disney’s has a Netflix sized Film/TV streaming market value buried inside of it that can be unlocked by committing to DTC 1st distribution model. Add that to ESPN/Parks&Experiene and you have a SOTP potential $200bl unlock that might be just a few billion in content spend and a nice PR away.
And what better time to announce all of this than when that prized core is under extreme duress.
Problem is this thesis assumes copying Netlfix makes sense, and that doing so today gets you what the street has been rewarding Netlfix with for sub growth over the last several years. Essentially a free financial arbitrage just sitting there to be exploited by changing distribution strategies (or more specifically expressed commitment to distribution strategy). I think this is wishful thinking at best, and really misses the boat on the relationship between these two media businesses.
Disney and Netlfix’s success over the last decade was in fact highly interconnected and to a degree interdependent.
1) The rise of Netlfix and SVOD from a genre perspective impacted a certain subset of drama/action/indie films as well as traditional TV series disproportionately. This resulted in Disney’s box office share rising as tentpoles took over the theater and ASP’s offset declining traffic.
The data speaks for itself.
Disney’s box office domination was in fact inversely related with the explosion of high quality competing content in every other genre. Their IP in fact appreciated, and the flywheel did great throughout this window.
Literally with hindsight being 2020 would anyone go back and tell Disney to just go right to SVOD if they could do it over? The answer is no. First, because the hypothetical is in fact a bullshit exercise as you couldn’t make cost of capital assumptions like Netlfix or for that matter scrap content deals overnight. But really it would have made no sense brand wise to abandon the event element. Disney would not be Disney without Avengers on IMAX screens and at theme parks. Culturally speaking things would not have played out the same.
1) As Netlfix drove cord cutting, and most TV content went OTT AD FREE what else benefited? Sports.
Now the popular narrative with respect to ESPN is that it’s been losing subscribers over the last decade. And this true….
However, ESPN’s sports junkies were always being subsidized by that part of the basic cable TAM that had zero interest in sports. So, as I mentioned at the start of this article, as live sports share of TV went up ESPN started raising prices. To the tune of about 7% per annum.
Yes, this is not sustainable forever, but the surge in sports gambling/fantasy over the same time period has left ESPN in a pretty good position transition wise if they execute from here based on their league deals. Has this turned into a windfall for them? No, because the sports programming costs have continued to climb as well which is part of the issue in premium content. And there are obvious risks going forward if FANG comes to town for the next league deals. But there is also gambling upside and NFL Sunday ticket potential as well or retransmission fees if Monday Night Football moves to ESPN.
The key takeaway here is that Disney and Netlfix don’t exist in a vacuum, and that these businesses do both compete and some cases complement each other.
“This shit is chess, it ain’t checkers”- Alonzo, Training Day
I’ve also seen some people compare the Disney+ streaming transition to newspapers moving online. Think NYT and WAPO and how they have transitioned away from print. Basically, another nostalgia argument with the glory days of page one being hard to let go of since that was where all the profits came from. I disagree with this take. This is again similar to the MSFT/ADOBE take in that it misses the all important fact that the box office hasn’t been some giant profit engine for the company that the old guard is somehow reluctant to let go of. That issue aside though, Print to Digital is nothing close to what linear to OTT is all about. For example, as I pointed out earlier, Disney could have easily released every single movie on PPV at anytime over the last 40+ years. Cable made that possible. Streaming and cable are both digitally consumed formats and so is the box office (98% digital) these days. What’s changed is the coaxial cable has been replaced by broadband and in the case of an OTT channel the set-top box by streaming app. Now in the case of TV shows whether a season is released all at once or on a weekly basis has been something that Netflix initially changed though as we are seeing lately this is not exactly being uniformly adopted in OTT land. And now with FAST (free ad supported TV) we have linear based ad supported programming OTT. And anyone with cable or fiber has on-demand access to premium channel content. When one major print Newspaper shifts to a real time digital distribution model that is kind of a big deal for the biz model. The internet as we are seeing today combined with social platforms changed the entire news biz. But I don’t think any MCU Fanboy is going to tell you they would have rather watched Avengers End Game for the 1st time on their 70” screen at home let alone on an Ipad instead of on a 90-foot screen with a packed house on opening night.
Why do fans attend sporting events? For the social experience.
See, there are some flawed assumptions at the core of the DTC streaming thesis with respect to Disney as everyone has Netflix multiple blinders on when they talk DTC. It’s like its Field of Dreams, but Bob Chapek is now Ray with a voice in his head on DTC streaming. Except the end game here isn’t the customers/subscribers but rather the Netflix multiple.
“Multiple Expansion will come Bob”
But reality suspension aside…investors need to stay grounded and think through their assumptions….
1) The narrative that has surfaced a lot under COVID that DTC means you can keep 100% of the margin now that cable, international partners and the box office are out of the way is amusing. This is of course a pipe dream. Amazon/Roku/Google etc have been trying to build carriage models around the dongle/OTT-TVOS. And oh yeah on mobile you have the app stores. The Roku Channel wants to be your cable package in the form of billing software. Then you have the TV manufacturers who also want a piece of the CTV ad pie. And let’s not forget the payments companies. So, virtualizing the cable company or changing the distribution does not eliminate the middleman. And the cable guys/telcos need to replace lost revenue with the Internet bill which everyone still needs to consume this content. Yea, those dumb pipes still control the last mile. So, when you consider that Disney may take 60%+ of gross receipts for one of its mega blockbusters, paying 20-30% to Apple, Amazon, OR Roku is not exactly a bargain if the demand is not going to be far greater.
2) DTC is a better economic model. Distribution is king. This is debateable again. Disney isn’t Netflix. It already has a global media content brand. Netflix has had to build one and the only way it could was DTC, and it’s been rewarded handsomely for the GROSS dollar they capture on a subscriber because they started from zero. Disney captures a NET dollar globally that may in fact look the same on an annual basis but is not rewarded the same because it’s been functioning largely like an annuity. If we assume 4-5 OTT services will be the new bundle, well then at global scale maybe everyone looks something like traditional Disney. The rest of the game is really just accounting. Also, remember that OTT has brought Amazon/Apple/Google etc into content. They are super bundlers with infrastructure/distribution economies scale&scope. One could argue (nobody has bothered because its essentially counter trend) that the proliferation of OTT means Disney is in fact in some cases better off being the content partner of all these distributors vs a direct competitor.
I am not particularly good at hammering my point home in a few sentences, but I am not going to wrap up here without tossing out a few things.
We live in a world were founders and executives are now worshipped in a cult like manner that used to be reserved almost exclusively for Berkshire’s annual shareholder meeting. Evangelism has become a big thing in stock investing, and in how public companies present themselves to all stakeholders in growth sectors like SaaS. With that in mind……
Steve Jobs chose Tim Cook, a logistics/operations guy, to succeed him at Apple and not Jon Ives or anyone else on the design/product side.
Bob Iger chose Bob Chapek, head of parks/resorts, and not Kevin Mayer or anyone else on the content side.
I found Iger’s autobiography to be a great read, and up until Covid I don’t think anyone would have criticized him for how he’s navigated the turbulence running the empire that is Disney over the last decade. Personally, I think the MCU crossover strategy Disney put in place for plus if woven well with the box office in a post covid world is still the right strategy. Disney gets more data for the flywheel while still maintaining the event/scarcity element of its IP. The appeal of getting on the ‘accelerating’ bandwagon that is covid investing is not exactly lost on management, but the pandemic will eventually end. And when it does…….
Also, Disney needs to think carefully about its competition. Netflix has become global giant in content the likes of which Disney has not had to contend with before.
And Netflix is coming for Disney….
While these two have complemented each other over the last few years and will no doubt continue to co-exist, it’s pretty clear that Netflix is focused on chipping away at the Disney IP mystique.
Consider that Netflix fought very hard to get the Irishman theatrical window down to 45 days or less. I don’t think they left free Scorsese Box Office $ on the table because they simply wanted $150ml in streaming prestige. You could argue that the whole negotiating process was an exercise to weaken the box office’s PREMIER EVENT status because that and the Theme Parks are what Netflix believes is the moat Disney has and not necessarily the rich IP history. I don’t expect them to admit it publicly but look at what they do vs what they say. Netflix knows production wise Disney is competing with them for talented story tellers and actors. And they believe in the land of abundant high-quality content; Disney’s scarcity model is vulnerable. Netflix’s recent animation studio space leasing and ambitious release schedule of animated films tells you they think Animation is the missing piece they need to crack this.
“Netflix has been extremely busy in the animation space of late; in addition to Glen Keane’s Over the Moon, set for release October 23, the streamer is in various stages of pre-production and production on Jorge Gutierrez’s Maya and the Three, an animated Good Times series from Norman Lear, Zack Snyder’s Army of the Dead prequel anime series, Guillermo del Toro’s stop-motion Pinocchio and CG Trollhunters: Rise of the Titans features, and Captain Fall from Norsemen creators Jon Iver Helgaker and Jonas Torgersen, among others. Four more seasons of Dragon Prince have been ordered, and a number of new series, such as Hoops, Dragon’s Dogma, Midnight Gospel, Wizards: Tales of Arcadia, Kipo and the Age of Wonderbeasts, and Jurassic World Camp Cretaceous have recently premiered. Busy doesn't even begin to describe their animation efforts”.
And maybe Disney will have a new competitor with 200ml+ subs bidding on global Sports rights deals in a few years.
But is Netflix right?
Time will tell. One could counter in that in today’s sea of content Disney’s IP is in fact more valuable than ever and the MCU just proved that. Well, if that is in fact the case, Disney would be a fool to walk away from the connection consumers have with them and the big screen. This would be doing their competition a favor.(box office worth weight in gold)
And you could take this a step further and argue the $2bl+ Netflix is generating in op income without being FCF positive yet on that huge revenue base speaks for itself. So, sure cut the dividend, but invest that money wisely.
If you are in the business of saying nobody can replicate my content and story-telling ability by throwing wads of money at the problem because well I’m an exceptional story-teller/experience creator then I’m going to assume quality over quantity is still something you live buy. At which point, cutting the dividend to create more DTC content maybe isn’t a good long-term plan. Maybe there are costs to the brand if enjoying Disney characters and Netflix characters is something I now completely associate with my living room. That being said there is no denying that Disney can extract valuable data on its consumers from Disney+ that can be leveraged for the benefit of the flywheel, but when you are in the experience business this data is not the End Game.
So, if Disney wants to explore a gambling app (Thanks to Covid-ESPN has a gambling channel on Youtube now & a partnership w Cesars/WilliamHill), or buying Roblox, or launching schools for kids virtual learning as Prof G suggested (That Be Our Guest/ Wear a Mask song spoof was great!). I’m all mouse ears!!! But if you are going to snap your fingers and tell me Pumba now has P/L responsibility for all content distribution (to be fair HBO/NFLX have also used Covid to shake some things up) and that this will get you a Thanos multiple….well….we all know how that ended.
Teri maa ki chooth!