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The Science of Hitting
The Science of Hitting
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Dan Loeb and Disney: Why I Agree and Disagree

Some thoughts on the activist's letter to Disney

October 09, 2020 | About:

On Wednesday, activist investor Dan Loeb of Third Point sent a six-page letter to Bob Chapek, the CEO of The Walt Disney Company (NYSE:DIS). In his letter, Mr. Loeb made four key points.

His first point has to do with the company's dividend:

"To further capitalize on this transformational opportunity, we believe the company should permanently suspend its $3 billion annual dividend and redirect this capital entirely into content production and acquisition for Disney's DTC businesses, centered around Disney+."

As a reminder, the company suspended its dividend in May when the impact of the pandemic, most notably in the Theme Parks and the Studio Entertainment businesses, became apparent. In addition, management commentary on the most recent call suggested that the dividend would not be reinstated anytime soon (at least until the Parks business got back on its feet). So, long story short, I certainly agree with forgoing the dividend at this time (which totaled $2.9 billion in 2019). In addition, I have no problem with the company forgoing the dividend for the foreseeable future.

That said, the payout has always been relatively small (around 25% - 30% of earnings in the past five years), and there's no reason the company could not easily fund it again as the world gets back to normal.

Second, as highlighted in the above quote, Loeb wants Disney to ramp its content investment in the DTC businesses by a few billion dollars. As he notes, this move would "more than double" the Disney+ content budget, which as outlined at the 2019 Investor Day was projected to climb to roughly $4 billion annualized by fiscal 2024, with a roughly even split between original content and licensed payments to the Studio business (for the rights to movies from Marvel, Lucasfilm, Pixar, etc.).

Loeb believes the prize could be industry leadership for Disney:

"With Disney's superior tentpole franchises and production capabilities, we believe that the company can exceed the subscriber base of the industry leader, Netflix, in just a few years."

To put that estimate in context, Disney had more than 100 million paid subs across its portfolio of DTC services in the most recent quarter, compared to the 193 million global paid subs that Netflix (NASDAQ:NFLX) reported.

Much like Loeb's first point, I don't necessarily disagree. That said, I think Disney had already laid out a fairly aggressive plan for content investments in its DTC businesses. In addition, they have shown willingness to accelerate those plans when given the chance to do so – for example, acquiring the rights to Hamilton for $75 million, as well as accelerating the debuts of Frozen 2, Pixar's Onward, Pixar's Soul (which will skip the theaters and be released directly on Disney+ on Christmas Day) and Star Wars: The Rise of Skywalker on the service. From my perspective, while I understand the logic of additional investments, I also think Disney has shown a willingness to take chances and act more aggressively when given the chance to do so (the only counterpoints I can think of to date are making Mulan PVOD and delaying Black Widow).

Third, Loeb wants Disney to consolidate their DTC offerings:

"We also believe that collapsing all of Disney's DTC services into the Disney+ application will simplify the product and be a meaningful enhancement to Disney's offerings. Given that Disney+'s subscriber base is already meaningfully larger than any of your other DTC services, we believe Disney would benefit from a single customer acquisition vehicle led by Disney+. We understand that each of your DTC services – Hulu, ESPN+, and the upcoming Star offering – serve different demographics and may have various value propositions, but these challenges can be easily circumvented through tiered and bundled product offerings at various price points. Importantly, all product offerings should lead with the company's marquee Disney product and brand."

Again, like the first two points, I don't disagree. In fact, this is something I've been usure about since the decision was publicly announced at the Investor Day in April 2019. From my perspective, and something I've personally experienced as a user, it can be a pain point to engage with the offerings within the Disney bundle through multiple apps, websites, etc. I also agree with the concept of housing the various services within the namesake offering (Disney+).

The fourth and final point is where I have some issues with Loeb's letter:

"Finally, we believe Disney should maintain its focus on transitioning to a subscription-led DTC revenue stream and avoid the temptation of maximizing short-term profits through transactional VOD pricing strategies. While it may be tempting to extract short term financial profit from each marquee film and TV series that Disney produces, we are confident that the 'all-you-can-eat' approach is the best way to maximize the longer value of Disney's content and enterprise by accelerating subscriber growth… we have no doubt that your subscription DTC business, once it becomes the primary landing ground for all Disney's content, will surpass any pay-per-film revenue stream… While some pundits have described the Mulan release as a "debacle" due to the $29.99 cost for a VOD download, we see this as a valuable learning experience, expect stumbles on the way to greatness, and believe this will drive a faster decision to make all content available to subscribers for a simple subscription fee… We are confident that Disney can build a DTC business that will meaningfully exceed its current cable TV and box office revenue streams, but only if the company leans into this opportunity and invests more aggressively."

Let's start with some math. The Cable Networks business (which does not include the ABC broadcast network) and the Studio Entertainment business collectively reported nearly $28 billion in revenues in 2019. They are also highly profitable businesses, with nearly $9 billion in collective segment operating income for the year.

Even at $10 a month in per sub revenues, which is more than 100% above the average revenue per user that Disney+ reported in the most recent quarter, Disney would need 233 million subs to replace those businesses. Those aren't exactly small numbers.

In addition, I think the idea of completely collapsing the theatrical window (in particular) misses a few big points. First, I think some of business' most valuable brands – like Marvel and Lucasfilm – benefit from the movie theater business. And I don't just mean that from a financial perspective: the ability to go with a few friends to see these blockbuster films on the big screen is an experience. It's part of what makes their brands widely loved and part of the cultural zeitgeist.

In addition, I think it's mistaken to believe that the value of these offerings is confined to a single window. Said differently, the value of these films (brands) extends beyond their theatrical window. A movie like Black Panther, for example, will be watched by superfans two, three, or even 10 times once it's moved through the theatrical window. In the past, fans met this need by purchasing a VHS, a DVD, or a Blu-Ray. Going forward, they'll do so by subscribing to Disney+.

I think this thought process aligns with how Disney has approached this same "problem" across all of its entertainment / content businesses over the past 15 years. Consider this comment from a LA Times article published in January 2010:

"In another surprise move, Disney home video chief Bob Chapek, who was viewed by some insiders as a midlevel bureaucrat, was made head of all film distribution, from theaters to VOD and home video, clearly with an eye on moving ahead with Iger's cherished idea of shrinking the windows between theatrical release and various home video options."

Here's the point. Former CEO Bob Iger and current CEO Bob Chapek have been thinking about this issue for the past decade, and they recognize how to balance two key objectives: ensuring short-term profitability while maximizing the long-term value of the business. Personally, I think that their track record points to a clear ability to thread this needle (look no further than Disney+, which added more than 60 million subscribers in its first year and exceeded all expectations by a mile).

The answer, in my opinion, is in the middle ground. At the end of the day, we're talking about roughly 10 movies a year from Marvel, Pixar and Lucasfilm (primarily) that have demonstrated the ability to generate $1 billion or more in global box office revenues. In addition, as I noted above, I think there's a cultural component to these tentpole releases that has a halo effect on the brands (and Disney). For those reasons, I do not think Disney should make the rash decision to completely abandon the theatrical window.

Instead, I think they should continue to work towards the objective that Iger and Chapek were focused on in 2010: shrink the windows between theatrical release and various home video options to a month or two. And today, that home video option should be a single outlet: Disney+. In my opinion, this is the solution (compromise) that is best for Disney in the short-term and the long-term.

Disclosure: Long Disney

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About the author:

The Science of Hitting
I desire to own high-quality businesses for the long-term. In the words of Charlie Munger, my preferred approach is "patience followed by pretty aggressive conduct." I run a concentrated portfolio, with the top five positions accounting for the majority of its value. In the eyes of a businessman, I believe this is sufficient diversification.

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Comments

johnbarber
Johnbarber premium member - 3 months ago

Always depresses me that Buffett says that and simply buy an index fund. Most people will do very well with an index fund but a lot of investors will blow themselves up with such high concentration in their portfolios of only owning 5 stocks in their portfolio.

steopia
Steopia - 2 months ago    Report SPAM

Thank you for another sensible post. I completely agree with your analysis. Limited theatrical release creates a short window of opportunity that creates excitement around a release. DVD sales/downloads are much higher from films that have the biggest theatre takings, as fans who have seen the film in person want to enjoy it at home at their leisure.

The real reasons why Mulan went straight to download back up this analysis. Due to COVID, there would not have been a large enough audience going in person to see the film, thus resulting DVD/download sales would have been disappointing in any case. Also, there would have been a backlog of Disney releases piling up, along with releases from other companies all hitting cinemas when adequate in-person attendance resumes.

This is all to say, in normal circumstances shelving a film's theatrical release would be a mistake.

The Science of Hitting
The Science of Hitting - 2 months ago    Report SPAM

Steopia,

I'm glad you enjoyed it! We see the world similiarly :)

Please leave your comment:



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