Lights, Camera, Compounding

When constructing portfolios, we always remind ourselves to remain true to first principles in identifying stocks for potential inclusion. Specifically, we consider the economics of a business – the existence of pricing power, returns on invested capital, cash flow conversion, investment intensity and profit margin profile – together with the management team’s track record in capital allocation and responsible and ethical governance. We also do a lot of work to understand the future demand profile for a business’ goods or services, as well as the competitive advantage a business enjoys, as we believe it is the only true source of any long-term ability to earn excess returns on capital.

In purchasing Disney for our portfolio in early 2019, we believe we own an outstanding business, composed of high-quality, differentiated and difficult-to-replicate assets, with a pathway to create economic value for investors for a long time to come.

Setting the Scene

Disney is not a company that needs a lot of introduction; founded by brothers Walt and Roy Disney as an animation studio in 1923, it has been synonymous with family friendly entertainment for decades. However, most people associate Disney with box office success, and intuitively have a sense that they must also generate some portion of revenues from its theme parks and merchandising efforts. While true, it does not represent the full picture: the company actually generates most of its revenues and profits from linear cable and broadcast television networks, as can be seen from the chart below. (Some of the shift in weights in FY19 reflect the consolidation of the recently acquired 21st Century Fox assets for roughly half the financial year).

Thus, while the film studio and direct to consumer (DTC) streaming businesses garner most of the headlines, to build an investment case for Disney and get to the root of what we consider its competitive advantage, it is critical to understand the other segments and place them in their proper context – particularly the Media Networks, given their relative contribution to revenues and profits.

A Simplified Recent History of Disney’s Media Networks

The US Media Networks segment is comprised of the Disney, National Geographic, FX and ESPN cable channels, the ABC broadcast network and a 50% investment in the A&E Network. The segment earns revenues from selling airtime to advertisers and charging satellite and cable providers an affiliate fee for the right to show the content produced by Disney to their customers.

The jewel in the crown is undoubtedly the sports-focused ESPN network, which owns the distribution rights to a variety of widely followed sports in the US. Given its popularity and breadth of content, the ESPN family of channels has been able to consistently increase the affiliate fee it asks from the satellite and cable providers for many years. Why? Mainly, because sport remains the most valuable form of live entertainment: completely unscripted drama with an unknown outcome, and most valuable when experienced in the moment as opposed to later, when the result is known. (This contrasts with most scripted entertainment, which can be consumed as the viewers’ schedule allows). As a happy coincidence, live sports are also incredibly well suited to selling advertising airtime, given the natural breaks in the on-field action.

Given the market structure of the US television landscape, ESPN has thus been an incredibly profitable venture for Disney over an extended period of time; of all the channels included in the traditional US cable bundle, ESPN enjoys some of the highest affiliate fees of any content provider.

Not surprisingly, the increasing number of consumers who choose to receive their in-home entertainment exclusively via a streaming service has hurt the traditional linear cable and broadcast companies. From a peak of roughly 102 million households with cable bundles in 2013, the current count stands somewhere between 86 and 87 million households – a steady year-over-year decline for an extended period of time.

The lower cost of internet-based streaming services has been a substantial driver of this shift in consumer behaviour, mainly enabled by the fact that these players (such as Netflix) can cut out a vast swathe of the distribution layer and go directly to the consumer. Some of the decline in cable households has been offset by consumers who choose cheaper digital bundles (featuring less channels) offered by certain distributors, but overall the trend seems clear: the traditional linear cable bundle will continue to see an erosion of subscribers over time in favour of streaming entertainment.

For Disney, this dynamic came to a head on 4 August 2015, during the company’s 3rd financial quarter earnings call. CEO Bob Iger indicated to investors that ESPN had begun to experience ‘modest sub losses’, causing the firm to slightly lower the medium-term guidance for its affiliate revenue growth. Given that live sports was seen by investors as the final holdout to the threat of cord-cutting, it was not well received: most major US media companies sold off substantially on the following day, with Disney itself shedding nearly US$19bn in market value (roughly 9% from the previous closing price) on the news.

The market saw Disney as facing a near impossible-to-solve question: in a world increasingly shifting to streaming, how would the company respond to remain relevant? Any shift to aggressively move into the streaming business would likely come at a substantial cost and undermine its largest and most profitable business in linear television – a classic case of the innovator’s dilemma.

Thankfully, Bob Iger seems like a man who likes a thorny problem and can take the long view.

Laying the Groundwork

Disney started off by purchasing a company called BAMTech – first a minority stake in 2016, then increased to a majority position in late 2017. The technology developed by BAMTech underpinned the streaming offering of Major League Baseball in the US. Disney acquired the company with the intent to use this technology to build its own streaming capability.

During an earnings call in November 2017, Iger announced the intention to launch a sports-focused streaming service called ESPN+ in 2018, and first mentioned the plans to launch a ‘Disney-branded DTC’ service in the latter part of 2019.

Shortly thereafter, in December 2017, Disney announced its intention to acquire the majority of the entertainment assets owned by 21st Century Fox. Given the size of the deal, it took more than a year to finally be completed, but as of 20 March 2019, Disney owns the film and television studios, certain cable networks and sizeable entertainment content library previously held by Fox, substantially expanding its intellectual property war chest for the upcoming launch of its own streaming efforts. As a result of the deal, Disney also owns a leading media asset in India, and now owns the majority of Hulu.

It’s worth expanding modestly on the latter business. Hulu was originally established as a joint venture between various US television networks as an initial foray into the subscription video-on- demand landscape, with content being sourced from all partners to the venture (Disney, Fox, Comcast and Time Warner). Given the competitive nature of the relationship between its co-owners, the business was to some extent never free to fully pursue its full potential. Now under the effective control of Disney, it adds yet a third arrow to Disney’s quiver of streaming offerings, offering a low- cost, ad-supported tier as well as a more expensive ad-free version.

ESPN+ launched in April 2018, giving Disney a foothold in the streaming landscape. It did not (and still does not) feature the most valuable sporting content the company owns – that is still offered through the traditional cable bundle – but gives Disney a destination to which we believe it can over time migrate this content to.

At an investor day in April 2019, Disney finally gave the market the complete roadmap for its future in streaming: a combined offering of family-friendly entertainment in Disney+, sporting content in ESPN+, and general entertainment content via Hulu, with properties from the Fox acquisition supplementing the shows already sourced from Disney’s own studios. Available both individually and as a bundle, it finally gave the company a credible path to transition from the economics of traditional linear media to the streaming landscape, and it positioned Hulu as the venue for more ‘edgy’ content (think The Handmaid’s Tale) relative to the family friendly venue of Disney+.

Investors responded with enthusiasm. The stock had never managed to breach its previous all-time high of nearly $122 set on the day of the August 2015 earnings call; following the investor day this year, it has finally surpassed this level.

Disney+ launched in November 2019, and is currently available to subscribers in the US, Canada, the Netherlands, Australia and New Zealand. The recent rally in the stock has been driven by the announcement that Disney managed to sign up 10 million subscribers in the first few days of availability in these markets, far exceeding investor expectations. The service will launch in several major western European markets by 31 March 2020 and continue rolling out to other countries over the next 18 months. We think that Disney+ will also enjoy substantial pricing power in time.

Beyond the Distribution Channel

While this simplified history hopefully provides some context of the rationale behind the launch of Disney+ (and the roadmap going forward), it still does not address the most fundamental question: why invest in the business? What is the competitive advantage, and why do we think it can it be sustained?

Idle speculation is always fun, but as the adage goes, it’s always difficult to make predictions – especially about the future. In that light, some of the most helpful investment insight can often be gained by flipping the question on its head – what will not change in the next ten years?

One thing we firmly believe will not change is that people will still want to fill an appreciable chunk of their leisure time by watching high-quality entertainment content. Admittedly, the mechanism for distributing this content may change, but we think the demand will still exist – and the players with the best library of content are well positioned to fulfil that need. For a variety of reasons, we think Disney is one of the players at the top of the field.

Firstly, it’s worth taking a step back and briefly considering the other assets Disney owns outside of the Media Networks: the various studios, theme parks and related holiday offerings.

To our thinking, the core of Disney’s ability to differentiate begins with its ability to generate world- class intellectual property within the Studio Entertainment segment. Whether this be animated (Walt Disney Animation, Pixar) or live action (Marvel, Lucasfilm, Walt Disney Studios), well embedded or recently acquired (Twentieth Century Fox, For Searchlight, Blue Sky Studios), the company has a long and storied track record of creating films and shows that delight viewers across the world. In fact, we think the library of characters stretching back many decades puts Disney in a fairly unique position, in that it has true cross-generational appeal. Parents are in the position to share the shows and films they grew up with, with their own children. Given the family-friendly nature of most of the content, this cross-generational appeal also underpins a second important differentiator: while kids love the content, parents trust the content. Given that the purse strings are largely controlled by the parents (well, in theory...) this matters a lot when it comes to allocating the family entertainment budget.

What about the media networks, though? ESPN is about to go through another cycle of renegotiating affiliate fees with cable and satellite providers in the US. In general, we think the business will push for a ‘final’ round of strong price increases, given that the next round (likely in the mid-2020s) will see the world in a far more streaming-oriented landscape, at which point we think the combined DTC streaming offering will have scaled to the point of being able to absorb the initial margin pressure from consumers switching to ESPN+. At the same time, we do think there’s at least a possibility that not all content goes purely streaming-only, and that ‘live’ content – primarily sports and news – may actually work better in a non-streaming environment (where the ability to consume at a time and place of one’s choosing is more important than the ‘live’ nature). Regardless, we believe that there is path to managing the transition to a streaming future, acknowledging there could be some volatility along the way.

Futureproofing isn’t Free

As always, we think we should be intellectually rigorous when analysing any business for potential investment, and if there ever was a narrative-friendly stock, it’s Disney. Where can we be wrong?

Firstly, it’s important to acknowledge that Disney is a cyclically sensitive asset. Should the economic expansion slow (or end), revenue growth would likely go negative for a period of time as it did during the recessions of 2001 and 2009. In the latter case, revenues fell by 4.5%, whilst operating income fell by roughly 20%. This weakness was driven by a reduction in advertising and consumer spend, and magnified through the operating leverage introduced by the high fixed cost base of the various underlying business segments. Given our view of 2020 is that the US consumer remains in reasonably good shape, we do not think this is an imminent risk, but we account for the cyclicality in our discount rate and by modelling the valuation using several scenarios.

Secondly, there is execution risk to the Disney+ transition, particularly as it relates to the legacy Media Networks. The company itself has indicated it only expects to be breakeven on its DTC services by 2023/2024, indicating the level of investment in original streaming content required to build a full-fledged streaming bundle. Moreover, there is a second aspect to consider: if one believes that a part of the attraction of the DTC offerings are that it becomes the exclusive home of Disney content (any other approach would fundamentally undermine the attractiveness of the service, in our view), it follows that Disney will stop licensing this content to other networks, both in the US and abroad. This means Disney will forego a substantial chunk of high-margin licensing revenue whilst at the same time incurring losses as a result of investment in the DTC business. Again, we think the management team is taking the strategically correct and brave decision to bite the bullet and start this transition, but the interplay of the above dynamics mean that ‘success’ may actually look like the company incurring deeper losses in the DTC segment at first. There’s also the unknown cost of rolling out Hulu internationally – something management has indicated they will communicate to markets in early 2020. Given that outside the US, Hulu is a relatively unknown brand, it may require a decent amount of brand building alongside the investment in original content.

Thirdly, it’s also worth noting that the Fox acquisition has substantially increased Disney’s debt load – the company now has roughly US$47bn of gross debt on the balance sheet, and the future obligations for content rights amount to even more (though these latter would form part of the normal course of operations). Disney has stated that it is prioritising the reduction of the debt in its capital allocation plans and has gone so far as to suspend its share repurchase programme until its leverage ratios normalise. All else being equal, the company has more financial risk and less flexibility while the debt levels remain elevated.

Finally, there are a slew of risks around the offering itself: what if audiences tire of Disney’s franchises? Are the studios at peak creative output? What happens if legislation regarding IP protections change? Can one of the tech majors – coming at the entertainment market with different objectives and substantial cash hoards – upset the streaming landscape? Can price increases at the Parks be maintained to the same extent as in the past? And – critically – what happens if cord cutting accelerates? While acknowledging all of these risks, we also point out that they have been around for every year of the last decade. The most financially relevant is likely an acceleration of cord cutting, which would create an air-pocket of profitability right when spending at the DTC businesses ramp. This is a key risk, which we believe requires careful monitoring.

As always, it comes down to the price paid and the portfolio sizing. When buying Disney earlier in 2019, much of the good news around Disney+ was not yet reflected in the price. While it is tempting to value the business using a sum-of-the-parts approach (apply a ‘normal’ P/E multiple to the ‘legacy’ business, and add to that a price/sales or EV/EBITDA derived value for the DTC business), we believe the correct approach is to try and quantify the cash flows, given that Disney will ultimately be spending several billion dollars on growing the exclusive content library for the streaming venture while forgoing licensing profits elsewhere.

At present, Disney is a mid-size position in our fund; ongoing rapid appreciation may see us take some profits, whilst a pullback would hopefully provide opportunities to increase our holding at a reasonable margin of safety. While it’s easy to build the bull case, we have a clear idea of the red flags that would make us re-evaluate our holding.

Conclusion

As we said upfront, we truly believe Disney is a collection of unique and difficult-to-replicate assets. The latter is key: any competitor would literally have to spend years building the same brand affinity for its intellectual property, not to mention be willing to invest many billions of dollars in doing so. By launching Disney+ and taking control of Hulu, the company has built a direct channel to connect with its audience better than ever before, whilst also hedging against the dominance of Netflix in the entertainment landscape. (We do not think Disney+ will necessarily only grow at the expense of Netflix, but that is likely the topic of a future note).

Disney is valuable because of the uniqueness and appeal of its intellectual properties and physical assets reinforce each other. Walt Disney himself realised this back in 1957 and laid out the foundations of the business model with this hand-drawn outline of how the various businesses under one roof serve to enhance the value and appeal of the others.

While much of the distribution landscape has changed and the business has expanded, the core principle remains as strong as ever, and underpins our belief in Disney being a long-term compounder. 

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