Investing in Disney

Published on 05/20/22 | Saurav Sen | 3,284 Words

The BuyGist:

  • Disney needs no introduction. It’s been a childhood staple – globally – for decades. However, betting on Disney means betting on a successful transition – from a Parks & Movies business to a Streaming-dominant business. 
  • We make a definitive call on what the business will look like in 5 years. Then we make a decision on whether to invest (or not) accordingly. 
  • This thesis (and all our other theses) connects qualitative factors about the company’s business to specific effects on each important cash flow variable – from Revenue down to Operating Costs, and all the way to Free Cash Flow.
  • This investment thesis is for subscribers only. However, below you can see a preview of the thesis – what our subscribers get.
  • The thesis estimates “what we need to believe” to buy or hold the stock for a decent return, followed by a decision on whether to buy, hold, or sell.
  • That decision depends on the “soft” stuff that matters – competitive advantage, economic moat, management strategy etc.  Ultimately, it’s a qualitative decision.
  • Subscribers have full access to the investment thesis and our decision. 
  • If you haven’t joined The Buylyst for clarity in investing, we encourage you to check out our Reasonable Pricing Plans here.

Table of Contents & Ground Rules

The point of this investment thesis is to have clarity on whether to invest in the Disney transition, and why. Too many people “invest” by just punting based on spurious factors such as recent price movements, superficial valuation multiples, or hearsay from talking heads in media. Ultimately, it’s about decomposing the stock price into EXPECTATIONS that are baked in, and then answering the question “are these baked-in-expectations too optimistic or too pessimistic?”

Digging in – to the expectations that are baked into stock prices – takes time and effort. Most people don’t have the time or patience for this. But we love it!

Let us do the heavy lifting, so you don’t have to.

Here are the contents of the investment thesis:

  1. Thesis Summary
  2. Latest Earnings Report
  3. Ok! What needs to happen?
  4. Comfortable Business?
    • Competitive Advantage & Moat
    • Management Strategy
    • Growth Drivers
    • Key Risk
    • Financial Model Risk
  5. Revenue: Moving Parts
  6. Revenue we can believe
  7. Sanity Check: DTC Subscribers
  8. Sanity Check: DTC ARPU
  9. Sanity Check: Legacy Businesses
  10. Sanity Check: Gross Margin
  11. Fixed Costs Expectations
  12. Cash Flow Summary
  13. Cash Flow Details

Ground Rules:

  1. Our minimum return requirement is: 50% in less than 5 years. 
  2. Based on this return requirement, we ask ourselves, “What do we need to believe about the fundamentals of the business to achieve our return requirement (or more)?”
  3. Then we answer the important question: "do we believe it?"

Before we dig in, here’s a free snippet from one of the sections below. We believe that if this scenario comes to pass (or if the market believes it will), there is significant upside in Disney’s stock. Do you believe this is possible? Probable?


Thesis Summary

Betting on Disney is hinged on 8 key assumptions: 

Betting on Disney is hinged on 8 key assumptions: 

  1. The company will be increasingly centered around Disney DTC (Disney+, ESPN+, Hulu, Hotstar etc.)
  2. Disney DTC subscriptions and pricing will increase significantly.
  3. The Parks, Experiences & Products business (PEP) will remain a steady revenue base. 
  4. Linear TV (normal cable TV) revenue will decrease significantly.
  5. Studio Revenue (theatrical movie releases and licensing) will decrease significantly. 
  6. Put together, we need to believe that Disney’s revenue will grow by about 4.8% annualized over the next 5 years.
  7. Gross Profit Margins will improve over the next few years, getting closer to pre-pandemic levels but never reaching it.
  8. Disney’s brand value will remain as strong as ever.

Here’s what we expect:


We believe this is possible; even probable. Disney will remain one of our core bets at 5% of our portfolio. We’ll spend the rest of this investment thesis deconstructing the chart above. Is this a reasonable expectation? 

Latest Earnings Report

Disney reports off-cycle, so their last earning report on May 11, 2022, was their FY 2022 Q2 report. It was generally positive. Disney DTC subscriptions growth outdid management and analyst expectations. The Parks business is now close to normal (barring closures in China). Linear TV (normal TV) revenue grew year-on-year, surprisingly! And their theatrical revenue is inching closer to “normal” with a year-on-year increase. 

We won’t bore you with the stats because you can get them from the source, but there were a couple of points that stood out:

  1. Disney will launch its Ads-supported Disney+ tier. With the Hulu acquisition, they claim they have a successful blueprint to execute this. In contrast, Netflix will need to build this engine from scratch.
  2. About half of their subscriber growth came from India – Hotstar is hot in India!
  3. Management still expects Disney DTC to reach profitability by 2024.
  4. Management expects margins to keep improving now that most of the world is open. The Parks business in US and Europe is getting back to normal.

OK! What needs to happen?

What needs to happen for us to keep holding DIS? Let’s get into cash flows right away – this is what the business should look like in 5 years for us to keep holding DIS: 

We believe this is plausible, even probable. The key assumptions – over a 5-year timeframe – in this chart are:

  1. Disney DTC subscriber count will grow to around 400 million globally.
  2. Disney DTC ARPU (global average) will be around $10/month.
  3. Parks, Experiences & Products (PEP) revenue will be around $30 billion annually.
  4. Studio/Content Licensing revenue will be around $5 billion annually.
  5. Linear TV revenue will decline by more than 50% to around $14 billion annually.
  6. Gross margin will rise back up to 40%. 
  7. Selling, General & Admin costs will increase by 5% per year.
  8. We assume the same level of cash interest costs
  9. We assume an exit multiple of 20X Free Cash Flow.

We’ll put these assumptions in proper context in the sections below. But first, let’s look at the business. Ultimately, we’re evaluating whether we should be partial owners of the business, not the stock. Numbers are meaningless without the story.

Comfortable Business?

This section follows our standard format that gives you (and us) some quick notes of the qualitative factors about the business, which affect cash flows. Cash flows determine valuation over the long term. We can play around with the numbers all we want, but ultimately the company needs to have a competitive advantage that it can defend over the long-term. Otherwise, all valuation exercises are moot. 

“If the choice is between a questionable business at a comfortable price or a comfortable business at a questionable price, we much prefer the latter.” – Warren Buffett

We realized that this section is a bit long. But we’ve tried to be as succinct as possible. Here’s what we’ll cover:

Positives: 

  1. Competitive Advantage & Moat
  2. Management Strategy
  3. Growth Drivers

Negatives:

  1. Competition
  2. Financial Model Risk


Positive: Competitive Advantage & Moat

We doubt we need to spend much time explaining Disney’s competitive advantage and moat. Their content and intellectual property is top-notch. They’ve got the legacy Disney characters, Pixar, the Marvel universe, 20th Century Fox assets like Star Wars, ESPN, Hulu…this may be the most enviable library of content in the world. They can keep milking these franchises for years, even decades. The Disney bundle – Disney+, ESPN, Hulu, Hotstar – is probably the best streaming option out there.

By becoming a primarily streaming company, Disney’s ability to milk these evergreen franchises (and create new ones) will become so much easier. We believe the Moat will widen because distribution is easier.


Positive: Management Strategy

It’s all about Disney DTC. But in the last couple of earnings calls, Management has stressed that they are open to all types of subscription plans – bundles, ads-supported etc. – depending on what consumers want. Disney has the ability to slice and dice subscription packages that would (theoretically) maximize profitability. 

The veneer of streaming economics took a beating with the last Netflix earnings call. Suddenly the market is questioning growth in video streaming. But Disney’s management is confident that they will reach 230-260 million subscribers by 2024. Currently, Disney DTC’s count is 205 million. So, their target seems comfortably achievable. We expect to get to 400 million subscribers by 2027.

The only way to get to 400 million is by growing in non-US markets. Fortunately, Management knows this. In the last earnings call, they said that Disney has about 500 original international (local language) movies or shows in the production pipeline (to be released over the next few years on DTC): 

  1. 140 in Southeast Asia
  2. 150 in EMEA
  3. 100 in India
  4. 200 in Latin America

Management wants to make Disney DTC the company’s global flagship product, but we estimate that about half the revenue will come from legacy businesses. More on this in the sections below. The big strategic goal is to make Disney DTC (will be called DTC henceforth) and the Parks businesses to amplify each other – families watch shows on Disney+ and the kids want to experience the characters in parks, and vice versa. This is something no other competitor can offer. We expect Management to capitalize on this massive differentiator.


Positive: Growth Drivers

There are 2 main drivers: 

  1. Continued migration from Linear TV to Streaming, globally
  2. Average Revenue per User

To be clear, we don’t really look at Disney as a growth story. Both these “growth variables” here are tempered by opposing forces. Yes, we expect the DTC subscriber count to double in 5 years to 400 million (more on this below). But remember that we expect most of that difference to be filled by the migration from Disney’s Linear business to DTC. So, revenue increase from DTC will be partially offset by revenue decrease from Linear.

We’ve assumed that Disney will have some pricing power – that it can raise its DTC prices to arrive at approximately $10 per month. We assumed the same for Netflix. We believe this is the extent of “pricing power” the big 3 (Netflix, Disney and Amazon) will have. This is an average global number. 


Negative: Competition

We believe the video streaming market will be dominated by 3-4 players: Disney, Netflix, Amazon, HBO/Warner. The comfort and convenience of “time-shifted” content on streaming, meaning you can watch whatever you want whenever you want, is too hard to pass up. Linear TV will still have its purpose – like sports or news – but almost everything else will be primarily viewed on Streaming. So, it is a growth driver, but…

In Disney’s case, the migration from Linear to Streaming might actually hurt profitability. Linear TV has a very high ARPU (average revenue per user). In Streaming, there is a ceiling because of formidable competition. In the scenario we’ve painted in this thesis, we assume that gross margins won’t come back to pre-covid levels when Disney was primary a Parks & Linear TV company. The flip side of this is that Disney is relatively hedged – they have all the avenues to deliver content, so they’re not completely dependent on the big migration.


Negative: Financial Model Risk

There are 2 variables that have more uncertainty about them:

  1. ARPU
  2. Gross Margin

We had to take a stand. We made the call that ARPU from DTC will increase to around $10 per month. And the overall company gross margin will increase to 40%, which is still lower than pre-pandemic levels. More on these variables in the sections below.

Revenue: Moving Parts

Now that we have some qualitative context, let’s zoom right into the main moving parts of Disney’s cash flows before we do sanity checks.

Revenue Growth we can believe

It turns out that we need less than 5% annualized revenue growth for a 50% upside in less than 5 years. Given the historical context, that seems like a very reasonable expectation. 


Usually, we do a revenue matrix in which we dial up and down 2 variables simultaneously. It helps us zoom into the most reasonable combination of those variables, which are usually variants of price & volume. In Disney’s case, we put down definitive markers based on what we deemed reasonable. Here are the revenue variables we took a stand on:

  1. DTC subscriber base reaches 400 million in 5 years. 
  2. DTC ARPU reaches $10 per month in 5 years.
  3. PEP revenue stabilizes at $30 billion.
  4. Linear TV revenue declines by 50% to $12 billion per year.
  5. Content/Studio revenue declines significantly to $5 billion per year.

Do these estimates make sense? Time for sanity checks.

Sanity Check: DTC Subscribers

We’re using the same rudimentary math for DTC as we did for Netflix. We expect both these companies to corner a significant portion of the global market. Inherent in that statement is the assumption that video streaming is a scale game. The big ones will thrive because they have the volume and quality. Smaller competitors that don’t have a critical mass of content won’t thrive. 


Sanity Check: DTC ARPU

We did assume an increase in ARPU. We believe that, so far, Disney has been “buying” market share by offering low monthly (still introductory?) prices. However, they’re pumping in billions of dollars (just $8-9 billion per year on Disney+ alone) to finally have a library of content that has something for everybody. We expect prices will increase to that psychological barrier of about $10 per month. We thought it might be an aggressive assumption, but it looks realistic. That’s represents a 4.2% annual increase over a 5-year period. Not too crazy.


Sanity Check: Legacy Businesses

How much will this decline? There are 3 legacy businesses:

  1. Parks, Experiences & Products (PEP)
  2. Linear TV
  3. Content Licensing & Other (included Theatrical releases)

We expect PEP to remain steadfast. This will be one of Disney’s main businesses – a unique experience that now has the benefit of being reinforced by the company’s other product (DTC). We expect traffic to come back to pre-pandemic levels by next year. In fact, it’s almost there – PEP revenue over the last 12 months was $23.6 billion compared to the 2019 number of $26.2 billion. In 5 years, we believe $30 billion is a realistic assumption.

Linear TV will decline. Almost everybody expects that. However, Disney’s Management makes the case that there are people who like Linear TV and don’t mind the ads. They believe there is a market for it. In fact, we were surprised to see that Linear TV revenue grew every year for the past 4 years! We don’t expect that to continue. We expect Linear TV revenue to decline by 50% in the next 5 years.

It’s no mystery that Disney will, at some point, stop licensing content to competitors. That revenue stream will dry up. In addition, the number of theatrical releases will slow down. We expect that revenue from theatrical releases will also decline by 50%. There will be a residual market for it, but it will be smaller.

Here’s how Disney’s revenue segments stack up: 


Gross Margin Expectations

Within Disney’s historical context, our assumption of 40% seems benign. However, we must admit we’re shooting in the dark here. We do know that – qualitatively – gross margins in Linear TV and Parks is higher than Streaming. However, as DTC scales, its margins will improve. We just don’t know how much. So, we looked at Netflix – Disney DTC’s biggest competitor. It turns out 40% seems reasonable. 


Fixed Costs Expectations

No drastic assumptions here. Disney doesn’t report an R&D line item. So, all we have is Selling, General & Admin costs. We assumed a 5% annual growth rate for 5 years. The key assumption behind this is that Disney has already ratcheted up its SG&A bills due to the Disney+ launch. Going forward, the main cost increases will be in content spend, which is reported at the Cost of Goods Sold level (baked into our Gross Margin expectations).

Cash Flow Summary: What we can believe


So, this is what it all comes down to. This is the scenario we need to believe to remain invested in Disney. We’ve given our reasons why we believe this is a reasonable expectation. And we’ve given some historical and competitive context around these expectations.  

We normally attach a 20X multiple of Free Cash Flow (representing a 5% equity risk premium into perpetuity). That gives us a share price of about $161, which is a roughly 57% premium from DIS’s last close.

Cash Flow Details

Cash Flow Notes


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