Disney (NYSE: DIS) - Magic Kingdom 2.0 - Part 1 Thesis and Qualitative Analysis
New (Adventure) Story - Transition and Execution
First, I’d like to welcome new readers Games Companies Play investment research service and publication. So glad to have you join us! GCP mission is to analyze businesses and strategies/plays they make to better understand and find value, as well as share ideas and have open discussions with others.
Lets see if we can find value in Disney at current prices. This Equity Research Report is split in 2 parts:
Part 1 - focus on quality aspects of the company and industry dynamics
Part 2 - will cover risks and valuation.
Disney Investment Analysis - Part 1: Story and Path to Successful Transition
One of the ways that I believe is prudent to make money in public stocks is to find undervalued companies when their stocks fall but fundamentals are still positive. This means they have the long-term potential and prospect is visible and realistic to be achieved. First place to look is, again in my opinion, a place with the highest probability for strong fundamentals - top quality companies; usually members of an index (SP100, SP500), already proven, with a long history and familiar products/services with wide adoption.
An important part is that we can understand them and have enough data to track KPIs, build models and assumptions, and equally important understand risks and why such businesses possess opportunities, if any.
We can never know all the risks, but the more the better so we can build a more fundamental base to support us in terms of greater volatility.
One such company is Disney, of course. I don’t know anyone who didn’t hear about Disney. But, that can be good and/or bad thing for investors. Key point however is that while many are familiar with products/services (and I am sure not with all things Disney is providing), not many understand the business model and here might be an opportunity for long play (or short).
After the recent Disney stock pull, I started diving deep into the company to see if there is some value to be found. As mentioned, Disney is a great example of fishing big fish that are at some point close to your web and the question is should you go for it and invest your resources, or move along.
Many blue chip stocks recording strong gains, but DIS is one of the rare outsiders that’s down 20%+ last 5y (down 30% last 12m).
Why?
A couple of things I see:
Competition is getting more fierce in streaming.
Media legacy business is declining as people move to streaming.
Heavy losses in streaming occurred and investors are now focused on profitability, in this new age of higher rates (we will see how long this will last. Do not be surprised if it takes longer - 4-5 years even).
The dividend was cut and still no signs of return.
Change of CEO, a lot of smoke and fire behind the scene.
Also, disputes with Florida state.
This list might also explain why this opportunity exists (if analysis find that fundamentals are actually solid and positioned to prosper long-term vs price in the market).
So, let’s dive into the magic world of fundamental analysis.
Investment Thesis
What is the key that will unlock the treasury box in Disney World?
A thesis should establish key assumptions to track over time and revert to it in order for one to stay focused and adjust accordingly investment positions and actions as business dynamics and market shifts.
Disney is in the middle of a broader industry transition from linear/cable TV to streaming and SVOD. More people are cutting linear TV and moving to streaming. Disrupter (Netflix) gain first mover advantage and became powerhouse, using perfectly age of low rates to finance its content creation and distribution scale, getting huge number of subs which provides economies of scale - key competitive advantage - and taking market share from legacy TV media. Disney as legacy player is facing huge risks to lose its profitability and become less important player in distribution, and consequently losing scale and profitability level enjoyed for decades. Still, fundamentals might still be strong enough to support Disney emerging to be one of the winners of this transition. Execution will be the key for this. Needs to be fast and fully focused. Moreover, all things point that they are ready and focused on this.
I always try to push myself to write thesis in one or two sentences (problem/issue and my take on ability/prospects). Let me try:
Disney stock price is under pressure as the company faces heavy competition in securing distribution and profitability position/prospect amid media transition from linear to streaming, and while risks are tangible, I believe company has enough fundamental power to stay relevant in this game and improve its value longer term.
Blue ocean scenario would be: Disney is not just surviving, but using its current weaknesses (or lesser position vs competition) to transform itself into more powerful player, emerging as a top winner (assuming winners are all that survive and improve its competitive position to build upon) and unlock more value along the way.
Streaming wars and business model
Streaming dynamics and change in consumers behavior for consuming movies and shows is not existential treat, but it’s a huge risk since if Disney lose distribution, it would be left with content production and become a supplier, while distributors will be able to install power plays. Why? Because distributor has a touchpoint with consumers, is able to control demand and attention, which is the key is this business of subs. With demand control and scale, you are able to lower cost of content per sub, and thus invest more and gather more users and lower churn, reinforcing (kind of) network effects with content production and scale (users) and in the end become dominant place for everybody to watch and stream. Key question that is still not fully answered is - does the winner takes all in this game or not?
Probably, there will be few winners. But, only a few, and many are fighting for this. This industry, as video games distribution offers us great excitement of completions and strategy. If there is no competition, Disney would have an easy way. Now, things are very much different vs old age where company dominated and created huge value. This is the challenge for them, as well as for us, investors to understand and see if they have solid chance to be one of the winners.
In the end, investing is a game of probabilities. Each investor should understand business drivers and see for himself or herself what are the odds for company - Disney - to come as a winner vs risks.
How Disney makes money?
Disney is a huge company. It’s not just movies and characters, that most people are familiar with. It is a complex holding that gathers many different functions, people and operates in different industries and markets.
However, all things should be simplified as possible in order to better comprehend them, understand drivers and future prospects so that we can create model and keep track of it, and if possible profit alongside a business as its owners.
Put simply, Disney has a diversified model. It generates revenue from 3 different drivers. This is somewhat diff vs how company disclose info, but I want to understand key pillars and drivers of value.
Media – linear TV and streaming. This segment further derives value from fees, subscriptions and advertising.
Studios - Content production and licensing. A core creative segment that generates and build franchises/IP that are monetized through box office, but also other DIS segments as well as merchandising/licensing.
Theme Parks/Experiences - parks, hotels, cruises. This is where people can get physical experience with Disney IP world.
Media segment is the one that is under big transition, alongside studios (since they are very much interconnected), from linear TV to streaming. Key for successful transition will be execution to switch to D2C and build even stronger connection with users.
Linear TV - this part operates by selling the content to distributors (cable operators…) that make bundles and sell to households. Due to large reach, advertising is/was another revenue stream, very important actually. Then, famous DIS flywheel model came alive, as company, due its huge reach and successful production of movie hits managed to monetize even further those IP via theme parks and licensing.
D2C operates a little bit differently. Direct sales to subscribers enable touch points with users, more data, and more options for monetization, but the problem is that it costs a lot to build such tech and to build scale. Scale you need to get many users to justify large costs of production with pricing that people are able/used to pay. You need to manage your subs your way with your resources (in basic approach), to always offer new things to keep them attached to service, to lower churn and have steady income to plan further. Now, that consumers have more options vs TV age, it is much harder to get them. Thus, one need to manage pricing, content while building scale to secure its position to control supply and demand. On top of all, without scale, company also loses advertising revenue that was regular and big inflow in legacy TV business.
There are a lot of KPIs to track, but 2 key factors for now are:
1. Number of users/subs
2. ARPU – avg. revenue per user
Other would be ad revenue per user, engagement (hours watched, etc..).
Current situation (and the problem)
Linear TV is declining, as people want video on demand. For those who still have doubts, this will become standard. One of the ways (mental model) to understand and see if some new thing/change really makes sense is to try imaging the world with this new service/product and then see if people can get back to previous model/service.
Obviously, no way.
So, one thing needs to be understood. Nothing will be the same. It will be either better or worse. I bet it will be better, for consumers and Disney.
DIS is facing long term cord cutting in very profitable legacy media business, while its direct to consumer, streaming business is under heavy competition and is loss making as company invest into acquiring users to secure its position among distributors in long run. All of this amid increased pressure of higher rates, and investors focus on profitability.
COVID affected parks, another profitable segment, but on the other side, helped faster development of D2C. Parks returned to normal even improved economics and provide great support. But parks are not enough for such a huge company.
Flywheel so famously used to describe DIS success is still in play, though. I don’t believe this is separate categorical competitive advantage on its own (like brand or scale), but it helps company to improve operational efficiency. DIS is leveraging its content production and distribution with theme parks to improve experience with users and increase monetization.
So, DIS still has a chance to stay a key company within media/entertainment industry, to utilize its advantages and expand its value, but needs to control demand/distribution and its own user base. For this, it must change linear networks with D2C, preserving and increasing the scale. If successful, I believe DIS will be even stronger than before. It will have more options for cross-selling and can create whole ecosystem (with parks as well), expanding offers and services beyond current flywheel. This is the ultimate blue ocean scenario.
Can Disney pull this transition?
In order to see if DIS is capable to successfully navigate market shift and emerge as a winner, we need to first define key factors that influence this industry dynamic. After researching different sectors, companies and similar industry transitions, all factors can be summed in 5 aspects, in my opinion:
Brand and IP
Production quality
Financial strength
Distribution and scale
Focus and execution
Let’s examine DIS position in each of those aspects/drivers:
Brand and IP
In this transition battle among distributors and content creators, brand can be very important. People love Disney. This advantage is actualized in huge awareness. Also, Disney as a name reflects quality, evokes emotions, great experience and people will try Disney products. This actually enabled DIS (among other things) to create fast growth of DIS+ platform in its first wave of development.
IP - all those great shows, characters and experiences helped company built its brand, so it represents its integral part. Strong IP lure users in. However, this needs to be managed carefully in order to control supply and demand, otherwise you can ruin it and makes people boring.
Production quality
Disney possess great quality and scale in studios and it is reasonable to expect company will continue to create highest quality content. DIS is able to manage and improve many franchises and create new ones. Its success can be used as a case story on how to create spin offs and new franchises from existing ones; from deep storytelling to expanding worlds and serious characters build, providing consumers with more touch points adding to pleasure/emotions and reinforcing IP with careful timing. All this leads to improving brand equity.
Chart below shows how DIS compares with other major studios and we can and quantify this difference/advantage (I used period pre Covid to out any distortions due to pandemic, but the situation is not much different afterwards). This graph also showcase power of DIS brand.
Average domestic box office per movie (in $m)
Source: The-numbers.com, Goldman Sachs Investment Research, company data
In the table below, you can see the capabilities of all major studios in terms of production space and location.
Source: Online media reports, company data
Content library is a key selling story alongside pricing for consumers to be lured in. Additional benefit is that it represents high barriers to entry into D2C, and that’s why Amazon bought MGM studio – paying $8.45bn for it.
While I believe companies from now be much prudent on spending and content production, and people will focus their limited attention to watching best shows, streamers need to have strong back catalog - high quality content and diverse to lure users and minimize churn keeping people engaged as much as possible. I don’t think that just large library will do the trick, but high quality, convenience and fast discovery will be key for satisfying user experience that will keep them attached.
Additional factor here is sport, live sport mostly. News - I don’t believe it will be factor anymore, like in linear TV, since consumers already can consume news via social media. But, high quality movies, TV shows, and live sports events are not easy to find on social media.
Financial strength
This is a tricky one. When you look at DIS statements, there is strength. Debt is huge but very manageable. It is one of the rarest companies in the world that is able to issue 100y bonds and it will have demand for it. In addition, 11bn in cash. To me, it looks they have more power vs other MEDIA peers and that is most important. Parks are cash generation machine, legacy media still produce inflow, so the company is able to invest into D2C. This means investing into content production, content licensing (from other producers), but also in distribution, users’ acquisitions, tech…
4. Scale
This is very important part. Netflix managed to create a powerhouse without big brands, without previous production. They had financing, but get debt for it, although it was in much suitable environment. Everything was/is based on distribution. DIS managed to acquire solid number of users, came little late in my opinion to the race, but improved drastically since then. Also, introduced some new things, like ads, live program, plus it has ESPN to create bundle. Now they are doing this and it looks like logical and most reasonable thing to do. Users like variety and ad optionality. Internationally, it has strong position and can leverage this.
5. Execution.
In addition to all of this, key in next 1-2y will be execution. Disney managed to do some things very good, but it still did not make up for being late to the race and that is why it now needs to be more focused and decisive. It needs to move fast and spend, properly but wisely.
Disney - The essence
If we have to take one key thing about the company, one advantage/differentiator for it to build upon, what would that be? What is the key in this industry where DIS competes?
Experience and sport clubs
As I was thinking how DIS can survive this transition to D2C and what’s its key advantage, differentiator vs peers, this thing pops up always. However you look, experience is actually the key point for all users. Experience and emotions developed watching shows, visiting parks, traveling, playing video games… This is the entertainment industry and experiences are drivers to value creation.
Young generations are more open to searching and spending for experiences than saving, staying home and building piles of money. They are moving. That is why I think long-term parks will be a huge and valuable asset, not just for DIS, but overall as an industry. However, I am modeling still 2.6% 7y CAGR for Parks until 2030, just to be more conservative in a base case.
Let me explain a little more.
Looks like users will have 4-5 SVOD services, max. I think two will be more like generic - Apple and Amazon, with bundling their other services. This leaves space for three platforms to succeed; one is Netflix, so DIS has a chance. It can also create its own special unique bundle with theme parks and provide additional value to users. The risk here is M&A. If Apple, Amazon, or WDB buy more content and other studios, then those platforms alongside Netflix might just provide enough so people don’t need three or four streamers.
Here again, power of IP and brand is showing its importance. DIS would still be offering unique experience. Nowhere else people can watch and enjoy first hand high quality stories of Marvel, Starwars, and adventures of many DIS unique characters. Plus, they are able to physically experience some of those stories and worlds in theme parks. Get in touch with actors, characters.
DIS is a great place where AR/VR will help expand users experience and enhance it. Open new things for monetization and storytelling. Reinforce its franchises. So, even if people have a lot of content to digest from other platforms (and good one, worth their time), many will still pay for unique things and experiences.
The same is true for sports and live games. That’s why sport is so valuable as well. I believe DIS reached the status of famous globally accepted entertainment asset that people just consume as a normal, use as a benchmark to evaluate other options and want to be a part of it. People got in touch with Disney became fans. People are emotionally connected to many of characters under DIS IP - from Starwars, to Marvel to Mickey and company. Like football or basketball clubs.
Demand last generations and is usually transferred to kids, just like rooting for the club. In addition, on the other side, supply is limited. That’s why clubs are unique and so valuable assets. There are only a handful of top clubs that play in major leagues. And there are other important aspects. Time and emotions (which are very much interconnected).
You can build a new club, you can create new Galaxy wars, new IP, but to bring awareness level to reach a major league, to last generations and win many awards that create global fandom, this takes time. Years and a lot of money. However, time is more important here, as its much more limited resource vs capital. Even if you get the money and invest, its still very uncertain and risky process, since people are already committed to their clubs. Emotionally. Even if you win league, many might hate you, just because they are fans of competitors. They might don’t like the way you win. Plus, of course, it has never been easier to boost global opinions and hurt someone else’s success with rumors and speculations. That’s how basic emotions works and this is in play here with masses of fans. It takes a lot of time, money, and nerves to compete in such environment and its very uncertain path. That’s why many will just rather buy already established big club.
It is hard to quantify such assets, brand equity value. That’s why the most often approach used is relative valuation and benchmark vs similar transactions. Similar, as there are no same two reputable clubs. Each is unique with its own pedigree and traits.
Stay hungry.