Why we’re still enchanted by Disney

Long-term Ravenscroft Global Blue Chip holding The Walt Disney Company is going through a period of significant change at a time of heightened industry disruption and mounting tension between creatives and their corporate masters. The market is somewhat sceptical Bob Iger’s restructuring plan will be successful let, alone what the long-term future may hold for one of America’s biggest and most successful entertainment businesses. 

In this podcast, Ben Byrom and Sam Corbet discuss the challenges Disney faces and argue that its stock is undervalued, but not without its risks.

1:02 How and why we monitor earnings

2:22 Our journey with Disney

6:40 The shift from linear TV to a DTC service

8:05 The value of Disney

11:3 0 Q3 update & Chartered Communications agreement

15:13 Broadband opportunities & Comcast deal

22:05 Adding value for consumers

Chapters

• 1:02 How and why we monitor earnings
• 2:22 Our journey with Disney
• 6:40 The shift from linear TV to a DTC service
• 8:05 The value of Disney
• 11:26 Q3 update & Chartered Communications agreement
• 15:09 Broadband opportunities & Comcast deal
• 21:57 Adding value for consumers

Transcript

00:00:01 Voiceover

[Intro music]

This is a financial promotion. If you decide to invest, please remember that investment involves risk. Investments can go up and down in value, so you can get back less than what you put in. Past performance is not a reliable indicator of future performance and may not be repeated.

The information within this podcast has not been prepared in accordance with legal requirements designed to promote the independence of investment research and is not subject to any prohibition on dealing ahead of the dissemination of investment research.

This recording is for informational purposes only. Any opinion expressed is that of the individual speaker at the time of recording and should not be taken as investment advice in any way.

00:00:34 Ben Byrom

Hello everybody. Today I'm with one of my analysts, Sam Corbett, and we're going to discuss an important area of our investment process, which is the ongoing monitoring of our companies both in the portfolio but also on our bench list, companies that haven't quite made it into the portfolio, but we're actively watching, see if one day they may be worth including.

So, Sam, just for our listeners, could you just sort of give a bit of background as to what we do and why it's important to keep track of things.

00:01:09 Sam Corbet

Yeah, of course. I mean, in my mind, there's sort of two reasons why we do regular monitoring of the businesses we own. And that's via listening to earnings calls with management teams. The first is that this gives us an insight into the way the management of the business are thinking and how they're performing or their assessment of how they're performing against their strategic objectives. 

So, the second reason that we listen to these earnings calls is that we also gain an insight into how other market participants are thinking about the company in question.

And this can be particularly useful when we're taking a contrarian stance because it allows us to sort of understand what the other market participants are hoping the company is going to achieve before they will reward it with a rerating and an uplift to the share price. So it can give us the conviction we need to stay invested or remain invested when other people are, you know, sort of saying no to things about the business or don't like the direction the company is headed in, if we have an opinion that sort of bucks that trend, understanding what others are looking for is really useful in sort of standing the test of time.

00:02:20 Ben Byrom

So, a great example of that would have been, sort of, I guess our voyage with Disney? 

00:02:20 Sam Corbet

Yeah, exactly.

00:02:26 Ben Byrom

Going back pre pandemic, the company has sort of taken over 21st Century Fox, had saddled the company with quite a significant amount of debt. I think would be fair to say, but it was also under certain element disruption through Netflix and streaming and that was impacting one of his cash cows, the cable network TV division. People were cutting the cord, preferring to go over the top and stream direct.

And that forced to pivot out of Disney and for the best part of two years Iger was talking about their pivot, but it took really until they launched Disney+ for the market to take any notice, but we were well prepared for that right?

00:03:04 Sam Corbet

Yeah. So, we we've been listening to these earnings calls, hearing what Bob Iger and the team have been saying about their plans to launch Disney+, their direct-to-consumer service. We thought that would be a great way of increasing engagement with your consumer and obviously you get, you know, when you're doing the direct-to-consumer service (DTC), you get far greater data on what it is you're underlying customer is using, what it is they're sort of watching on a regular basis, how regularly. You just get a lot more data that is useful for us, well, Disney is a company, but it's also Interesting to us as investors as well.

00:03:43 Ben Byrom

And so sticking with Disney, I mean, when they launched DTC, they gave quite a clear road map to investors as to what they expect in terms of profits and the investments that they're going to have to make both in the technology but also into the continuous content spend in order to be able to compete for people's attention and therefore maintain subscription levels and obviously grow those subscription levels.

00:04:09 Sam Corbet

Yeah, they're spending about $30 billion a year at the moment.

00:04:11 Ben Byrom

Yeah, I mean it's just an incredible amount of money and the market at the time kind of like shrugged its shoulders, didn't really care. They were more after the subscription growth. But now all of a sudden it matters. And as far as we're concerned, you know, Disney has said to us this is what is going to happen. This is what we intend to happen. And so far, that is what is happening. Yet the market has gone, you know what? That now doesn't matter, it's a new paradigm, we've got our cost of capital, we've got, you know, we want cash today, not tomorrow, so we're going to derate your shares and they've fallen from literally almost touching $200.00 now, at the time of recording, to low 80s, right.

So, monitoring Disney right now is as important as ever. But there's nothing really at the moment that unnerves us from what the company is saying.

00:05:06 Sam Corbet

No, I think the sort of ultimate direction of travel was relatively clear to us from the outset of our investment. Obviously, the market sort of changed what it's prioritising in the heydays or you know, a couple of years ago, it was all about the sort of revenue growth and the subscriber numbers sort of surpassed all expectations.

They amassed subscribers far quicker than even management we're anticipating and now obviously you know that money's less easy to come by. You've seen this sort of focus back towards profitability. And I think it was last year, Q3 last year, they announced sort of record losses in their streaming business. So, you saw, what, $1.5 billion loss over the quarter and they said that this was going to be the peak and since then it's gradually come down. So, you've had losses over the last quarter, I think of 500 million.

So, they are getting towards that, it was a 2024 target that they're going to be profitable. They're direct to consumer service will be profitable by the end of 2024. So, I think there's a sort of clear pathway to that.

But yeah, the market is really unhappy at the moment. Obviously, that's coinciding with a period of decline for their linear TV business, which was conventionally the most profitable portion of Disney’s operations and that's declining at a sort of quicker rate than previously expected. 

00:06:30 Ben Byrom

Well, it's declining at such a rate that Iger now wants to get rid of it.

00:06:33 Sam Corbet

Yeah, they’re certainly mulling over whether there's channels that would be of interest to other parties. We were always aware that the ultimate direction of travel would be to a direct consumer service. And you have seen revenues sort of shift from linear to DTC and I think it's only natural that the profitability of the linear TV business would decline in tandem with, you know, diseconomies of scale. So as that business gets smaller the operating profits that you're going to get as a result of that should decrease as well and that's what we're seeing. Operating margins for its linear TV business have fallen from the mid 30% they were at its peak.

00:07:19 Ben Byrom

And it's quite interesting how Disney's business model has changed so much in such a short order of time. I mean, it is effectively disrupting itself with its DTC strategy at the expense of its linear TV business, so the media segment, Media Entertainment, that has declined in its proportion of overall revenue and operating income and Parks and Resources has come right up to the fore. It is the most profitable area of Disney. It's the one that really drives operating income at the moment and it's also, to be fair to Disney, where they're focusing most of their investments right now.

I mean, Iger came out saying over the next 10 years they intend to invest over $60 billion. I mean, that's double the amount that they've invested in that area over the last 10 years.

So interesting times. A lot of money that's going to be spent on a company that's got quite a bit of debt. So, what's the road map out do you think at the moment?

00:08:14 Sam Corbet

Yeah, there's obviously a lot of moving parts with Disney, which is what makes it particularly tough to analyse.

The way we sort of cope with this is we've sort of stripped it back to basics and we said, OK, we've got part of Disney's business, that's in a pretty steady growth phase, that's the Parks and Resorts side of the business, let's put a value on that. So, we do a sum of the parts we say, OK, this part of the business we think we can value using a discounted cash flow approach. The rest of the business it's, I guess it's in limbo at the moment as to what exactly that is going to look like going forward which makes it tough to value.

So, if we park that to one side, what is the value that we get for the remaining part of the business that we can value easily? And we actually think, having done this, you know, very recently we think today's share price is basically discounting any value for the media and entertainment division. And obviously while we don't know what the ultimate profitability of the new business model is going to look like, I think we're all pretty confident that there is some value in the content that Disney is able to create, those media assets.

So as long as you believe that those media assets have some worth the current share price just seems unjustified for, you know, a long-term holder and which presents an interesting opportunity for us, as sort of long term investors.

00:09:35 Ben Byrom

I think this is a classic case of, you know, how we like to operate is that where we see uncertainty, we see potential opportunity.

Now we've been long term holders of Disney. We've done the round trip in various sizes throughout our sort of journey with Disney in the portfolio.

We're now sort of looking at Disney thinking, OK, it's got some hairs, OK, there's a bit of work that Iger needs to sort out. He's recognised that, he's been talking about the problems that he's facing and the solutions he needs to find. He's extended his contract with Disney for another two years because it's going to take a little bit more time than he first thought, but the vast majority of Disney's current share price is underpinned by its best performing sector.

And the rest of the business, the box office, the merchandise sales and the cash of content that it has and then it's going to continue to produce with those fantastic franchises of it, that's effectively valued at zero.

So, you know, in our mind, and it is a speculation because, you know, we don't know what the future will bring, but in our mind, there is value in Disney.

00:10:42 Sam Corbet

I completely agree. And I also think there's real options. I mean, ultimately, we think that direct to consumer strategy is the right strategy for Disney. But if it transpires that Disney is just unable to make this business profitable, they can always pivot and they could relicense that content back to other, you know, people that can make it work, that do make it profitable. Say a Netflix. Now that shouldn't be, we don't think that's going be their primary strategy at all. But the idea that Disney's incredible brands and franchises don't have any value, it seems, a bit far-fetched to us and that gives us confidence to remain invested at a time where its shares are sort of under attack by the media and the analytical communities.

00:11:26 Ben Byrom

So, to tie this back into what we're talking about, why monitoring is important to us as investors, what are we looking for when Disney reports it's Q3?

00:11:34 Sam Corbet

I think we just need to see some confirmation that the green shoots that we're starting to see are growing and panning out. I think one of the things we need to continue to see is obviously, and this is in everybody's mind, is that 2024 profitability target. So that's going to be very, very telling. Is Disney able to achieve that 2024 profitability? I think one of the ways that they're going to be able to do that and we haven't touched on this yet, but this new agreement they've signed with Charter Communications, which is this cable company that had a very public spat with over the last quarter. 

Basically, how the old model used to work is Disney charged affiliate fees to its cable providers to carry its TV channels. Every year, historically, Disney just used to put up the fees and these cable providers would pass that on to their underlying customers. And they did so without resisting in any way because of the value that Disney bought to their cable bundles.

Without having access to ESPN and Disney TV, they weren't able to sell. You know, that was the bigger lure of these cable subscription packages. So, what we've had now is over the last, you know, 10, 15, 20 years what you've had is Disney take a larger and larger portion of the value created at the expense of the cable providers. To the extent where that cable business, which is once a profitable business for someone like Charter Communications, it is profitable, but it's no longer as profitable, which has seen them sort of pivot and focus on other areas of their business that are more profitable. In Charter’s case it's their broadband service.

So, Charter’s cable business is now less important to Charter’s own profitability. So what they're now saying is, OK, Disney, you've pushed your luck, you've been passing on these affiliate fees or you've been putting up these affiliate fees for too long, this is no longer a core part of our business and we're no longer prepared to accept those increases.

And this has shocked Disney because they've never had this happen before and it led to a sort of stalemate where Disney said, OK, well, if you're not prepared to pay us for our TV channels, we're going to remove them from you. And there was a period of a week where Charter TV subscribers didn't have access to Disney's channels.

Now they were able to eventually resolve it, and one of the sticking points for Charter was OK, you've launched your Disney+ direct to consumer service and content that used to appear on, you know, Disney Channel, you've gradually been removing that and putting it behind the Disney+ paywall. So only your Disney+ subscribers can access this content. So you're increasing the affiliate fees at the same time that you're reducing the content available and we just don't think that's fair.

00:14:38 Ben Byrom

Because you're forcing the subscribers to also subscribe to the Disney Channels.

00:14:41 Sam Corbet

Right, you're double dipping. You're making your cable subscribers pay once for their cable subscription service and then again to access Disney+ to get the content that they used to get as part of their cable subscription service. It seemed like a very reasonable request to us.

Anyway, after you know, a period of stalemate, they've now agreed that going forward they will allow Charter’s cable subscribers access to Disney+ included as part of their cable subscription packages.

00:15:09 Ben Byrom

Now Charter didn't have all the leverage in that negotiation, did they?

Because there was a point, or there will become a point, where cable will be dead. They acknowledge that as much. They're focusing on their broadband. It's easy to change broadband providers. So Disney content as a differentiator for a broadband provider is an important thing still, so they couldn't annoy Disney too much.

00:15:32 Sam Corbet

No, if anything, broadband is less sticky than cable TV. It's easy to change your broadband provider, so you need these bolt-ons to reduce churn. But that goes both ways, so it's also beneficial for Disney, because if you're getting, you know, Disney+ included as part of your broadband service, in the eyes of the consumer, they're paying for their broadband service and they're getting Disney+ for free.

You are less likely to cancel something if the perception is you're getting it for free. Irrespective of whether you consume any content on it or not. It's a marriage that should work well if they can recognise the fact that in order to, you know, benefit both businesses going forward it would be better than both to be friends, ‘frenemies’, as opposed to outright, you know, enemies. “We're not paying your fees.”

00:16:23 Ben Byrom

So there's several things here to look out for in the next earnings season, is that how many other broadband providers go down this route with Disney? What the monetization of that route looks like for Disney, because I think that could be an important part as to how we reach a stage of profitability through the DCT strategy, right?

00:16:38 Sam Corbet

Yeah, 100%. I mean, this is the thing that hasn't been really spoken about much, but obviously, whereas before all the Charter subscription fees, the affiliate fees, that Disney got by charging Charter for access to its channels that fell under your linear TV segment in Disney's accounts. Now a portion of the fees they're getting from Charter are going to be classed as DTC revenues. Because a portion of that now goes to Disney+.

So if Spectrum, which is Charter’s cable service, they have 14 million subscribers, and the idea is to sell the Disney+ access to Charter for 3.99 at a wholesale price per month.

So you've got 14 million subscribers being charged 3.99 a month. You know you've got instant uplift in the hundreds of millions of revenue for Disney+. That's going to really help get them towards that 2024 profitability target. And no one's really talking about that.

00:17:35 Ben Byrom

Very interesting. Just moving on then. So, with regards to the monitoring and what we're looking for in Disney, we want to see how that DTC pans out. We also want to see what's going to be happening with the Comcast stake. Comcast had this option, that they could force Disney to buy them out of their joint venture, Hulu. We suspect Hulu is going to be very much part of the DTC strategy within Disney. How do you think that's going to go down?

00:18:03 Sam Corbet

Yeah, I think you could see them sells some linear TV assets to fund that. They're going to require about 10 billion to buy out the remaining stakes. So they are going to need to sell, you know, either raise some cash or sell some assets to fund that.

Bob Iger, was a bit cryptic, as you'd expect. He's basically said all options are on the table.

So, one of the rumours going around is that there's potential that they will offer a swap for ESPN, so Comcast will take the ESPN brand and the sporting rights and Disney will get the remaining stake in Hulu that it doesn't already own.

00:18:38 Ben Byrom

That would be an interesting move, given that Iger came with ABC through Disney's acquisition of ABC and ABC's kind of affiliation with sports. I think Iger’s kind of respectful of the ability to monetize sports, particularly through, you know, advertising revenue. So that would seem sort of counterproductive to what Iger’s was trying to achieve here.

00:19:02 Sam Corbet

I agree. I also think historically if you look at sports, it’s been a massive draw, particularly within a bundle scenario. A lot of people pay or get access to Disney TV because it was included alongside their sports bundle, their sports cable bundles.

So, you're paying for access to ESPN, but you're also getting Disney TV thrown in. So yes, as Disney shifts to a direct-to-consumer model, you're going to have, you know, devout fans that will absolutely want to pay for Disney+ content independently, but I think we may end up in a situation where Disney, and they are, they're doing something called the Disney bundle. So you're going to get access. So if they retain ESPN, they'll be able to bundle ESPN with Disney+ in a similar manner to what the consumer has been used to in the past via their cable subscription.

That is going to help reduce churn at Disney+, helps reduce churn at ESPN. I can see the value in them retaining ESPN.

00:20:00 Ben Byrom

Irrespective of the increase in costs in sports rights?

00:20:04 Sam Corbet

The increase in cost in sports rights is an issue because sports rights are uneconomical versus media content, but there are ways to bring the cost of sports down or there's other content you can sort of append your sports rights with, which will appear on ESPN that doesn't cost anywhere near as much as, say, I don't know, NBA or NFL rights. 

And this is something that ESPN have been doing for years, by the way, but it's also something another one of our portfolio companies does really well, Netflix. You can create sports documentaries which are tangential to the sport, you know, showing Formula One races or Wimbledon or whatever your chosen sport is.

Those rights are expensive. Having a back story like Breakpoint for tennis or Drive To Survive, is it for F1? Those are much, much cheaper to produce, but they still appeal to sports fans in the same manner.

00:21:04 Ben Byrom

It’s almost like a little mini flywheel within a flywheel. You get the back stories of some of the athletes involved in sport, that generates interest in those individuals. Then people are drawn to see how they perform. Then they maybe subscribe to the actual…

00:21:17 Sam Corbet

Well, that's the thing. It appeals to the diehard sports fans, but it also appeals to the me’s of the world, the people that maybe aren't as interested in the sports side but subsequently become interested in the sport as a result of the documentary.

I mean, you know Ben, but the one I've been watching on Disney+ recently is Welcome to Wrexham.  I'm not a football fan by any stretch, but I've really, really got into watching Wrexham as a result of watching the Ryan Reynolds.

00:21:46 Ben Byrom

The next time you’re in Wales, you're popping up to Wrexham?

00:21:47 Sam Corbet

Well, you know, I might wait for them to come do an away game in London or something but yeah, it's exactly that. It broadens the appearl

00:21:56 Ben Byrom

So, what are we looking for? What do you think the market is going to look for in Q3? And do you think Disney is bottoming out? What do you think the market is going to like to hear?

00:22:08 Sam Corbet

We've touched on it, but the big thing is that 2024 target. However, I think anything Iger can do to show that Disney is actively reducing those losses is going to help.

We've been on this 1.5 billion peak loss and now at 500 million. If it comes down every quarter, that's going to please the market. I think if they address these spats they've had with Charter Communications and you know reposition it as an innovative new agreement that's going to be the future of how they're going to partner with their other distributors, I think the market will react favourably there. And just giving more clarity on what it is that they plan to do with the remaining linear TV assets or how they plan to enhance the value to their end consumer.

I actually think that's the key point here, is that in order to capture more value, Disney needs to focus on creating more value. What can Disney do to be of greater value to its consumers, that they are willing to part with a greater share of their wallet, or Disney end up with a greater share of their wallet?

If you just go after the share of the wallet without increasing the value that the customer feels, they're only willing to put up with that for so long, it's not a sustainable way to grow a business.

00:23:31 Ben Byrom

So offering through the bundle, Disney+, people have to go into Disney+. OK, it's free through the subscription of their cable TV, but they still have to go in, they still have to log in. They have to create their own account. All of a sudden, Disney's now got that engagement. It owns that engagement. It's not just going down a pipe for someone to switch on or switch off. Someones having to interact with Disney.

00:23:54 Sam Corbet

You get far better data. You know who's watching it, how long they're watching it for, what trailers they're interested in or what trailers they've been viewing. You can recommend shows to them. You know, I was watching Wrexham last night. finished it and it came up and said, you like watching Wrexham? How about you watch this next? So there's a whole benefit to the direct to consumer relationship in terms of the data point and how you can increase engagement.

00:24:20 Ben Byrom

Because it's the with-ads model, by engaging with that user and keeping them watching that content, that's great for the advertisers.

00:24:29 Sam Corbet

It is. And the fact that Disney knows exactly who is watching the content means they can better target you with ads as well, so the delivery of the ads is going to be better for the advertisers because the conversion rates should be higher because you are being targeted with relevant ads based on Disney's understanding of you as the customer as opposed to just a generic ad being shown on cable and it's an appealing market segment as well. Disney+, ESPN, they appeal to younger...

00:25:00 Ben Byrom

The young and the young at heart, right? 

00:25:03 Sam Corbet

It's an attractive demographic for advertisers.

00:25:04 Ben Byrom

I think we've taken enough time of our listeners. Thank you very much, Sam.

00:25:07 Sam Corbet

Thank you, Ben.

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