[00:02:43] Shawn O’Malley: Disney, or more precisely, the Walt Disney Company, was founded in 1923 by two brothers, Walt Disney and Roy Oliver Disney. Today, over a century later, Walt Disney is seen as the main man behind the company’s success. But that’s only part of the story. Walt Disney was the creative head of the company. He was a dreamer and an innovator in the animation and entertainment industries.

[00:03:03] Shawn O’Malley: He constantly tried new techniques that were little known and barely used at the time. His brother though was the numbers guy. Roy Disney served as CEO of the company and repeatedly saved Disney by sailing it through tough times that were caused by Walt’s tendency to take on excessive risks.

[00:03:19] Shawn O’Malley: Eventually, those risks turned Disney into the company we know today. A company that manages to create new worlds and iconic characters on and off the screen. These iconic characters and the stories they told shaped people’s idea of Disney. What all big brands have in common is that they have something unique and immediately recognizable about their branding.

[00:03:37] Shawn O’Malley: For Coca Cola, it’s the iconic color scheme and the uniquely shaped bottle that we all immediately recognize when we see it. For Disney, this is the first character that Walt ever created for the company, Mickey Mouse. Just like the Coca Cola bottle, one look at the silhouette is enough to recognize it.

[00:03:52] Shawn O’Malley: And the first thing that comes to our mind is Disney. Disney thrives on this recognition value. Every franchise has its own multiple iconic and recognizable characters. Not everyone of them reminds us of the Disney brand though. Many of them just make the connection to the franchise itself, but often that’s enough.

[00:04:07] Shawn O’Malley: Think about Star Wars, for example. It has dozens of characters with very high recognition value. I bet that almost every one of you would recognize Yoda’s voice or have a picture in mind when I mentioned Darth Vader. I personally, though, do not link these characters to Disney, but that doesn’t really matter.

[00:04:22] Shawn O’Malley: The franchises are strong enough to stand on their own. As long as Disney as a brand is known, that’s enough for either fans of the company or fans of the individual franchises to visit Disney’s parks, go to the theater, watch a new movie, or subscribe to its streaming service. Behind all of this, there’s a greater concept that has been well known and taught inside the Disney management teams for decades, but rarely makes its way outside of the company.

[00:04:45] Shawn O’Malley: This concept is called the Disney Flywheel. If you watch this on YouTube, you’ll now see a picture of the Flywheel concept, Walt Disney’s original drawing from the 1950s. Since it’s a little old, some of the mentioned business segments are no longer relevant. Let me just explain the drawing though. In the center, you have the creative talent and theatrical releases.

[00:05:04] Shawn O’Malley: This is the core of Disney’s existence and business. Starting from the center, dozens of arrows go in different directions, and roughly the same number of arrows lead back to the center. The corners of the paper show Disney’s various business segments. Back then, these included TV, music, comic strips, merchandise, Disneyland, and publications like magazines or comic books.

[00:05:23] Shawn O’Malley: And in between, this is where the magic happens. These dozens of arrows that connect every business and the core are what today’s business professors call synergies. Synergies are additional benefits that come from combining firms or their assets, When synergies exist, the whole is larger than the sum of its parts.

[00:05:41] Shawn O’Malley: So the combination of businesses creates value in itself. Walt Disney knew this before any business professor or consultant created a fancy name for that concept. Let me give you an example of how this can look in practice for Disney. Disney might create a new movie through its excellent creative team, which is sort of the backbone of everything that happens there.

[00:05:59] Shawn O’Malley: And this new movie might feature iconic characters and music that sort of define its perception in pop culture. which The characters are then used to sell merchandising or they can be used in part of Disney parks. The music too is also a really powerful way to keep the film and the characters relevant.

[00:06:15] Shawn O’Malley: Almost all of us know some Disney songs that we’ve heard in movies over decades ago, so there really is a stickiness and staying power to the cultural legacy of a lot of the brands that Disney has created. Once Disney creates an iconic brand, it markets and monetizes it in multiple ways. Today, comic strips or books aren’t really a vital part of the business anymore, but this place was taken by new and much more valuable businesses.

[00:06:37] Shawn O’Malley: Disney’s modern flywheel would look something like this. In the center, you still have the creative talent and the theatrical releases for movies. Around that, you have TV, which includes linear TV networks like cable, and you still have licensing, merchandising, Disney theme parks, and music, but also an important new addition, the direct to consumer streaming business that is best known as Disney Another addition that shows fewer synergies than the others, but still has become an important part of Disney is its live sports segment, which primarily revolves around ESPN.

[00:07:08] Shawn O’Malley: While there have been relatively few synergies with other parts of the business yet, new ones could be created when ESPN transitions to being a direct to consumer streaming service. One could also imagine that a bundle with Disney or at least some other content, could offer more value than ESPN or Disney alone.

[00:07:24] Shawn O’Malley: For a long time, Disney used to create its own movies and characters. However, in the last two decades, Disney has focused increasingly on acquiring other companies and their franchises. Here’s a quick list of some of the most important companies Disney bought in the last 20 years. Among them are Pixar, which was bought in 2006 for 7.4 billion, Marvel Entertainment in 2009 for 4.4 billion, Lucasfilm in 2012 for 4 billion, and Netflix in 2013 for 4. 5 And by far the biggest acquisition, 21st Century Fox, which Disney acquired in 2019 for an astonishing 71 billion. Due to its financial impact, we will discuss this acquisition in more detail later.

[00:08:03] Shawn O’Malley: Part of the 21st Century Fox deal was also at stake in Hulu, a streaming service that is now fully integrated into Disney In 2023, Disney also bought the remaining share of Hulu for around 8. 6 billion. These acquisitions are also part of the reason why I, and probably many of you, won’t immediately associate many of the franchises that Disney now owns with the company itself, as is with Star Wars.

[00:08:26] Shawn O’Malley: Disney didn’t create this world or the iconic characters. It was part, and simultaneously the main reason, for Disney’s acquisition of Lucasfilm. Now that we’ve discussed the different businesses, I want to dig a little bit deeper and analyze their impact on Disney today. I’ll begin with the segment that everyone knows best, Disney’s movies.

[00:08:44] Shawn O’Malley: The company reports these as part of the entertainment segment, and more precisely, under the content sales and licensing portion of its financial statements, but they don’t disclose the precise numbers for box office revenues, though I think the estimates for this can be pretty close. In 2023, the box office has generated approximately 4.9 billion dollars in revenue, which is only about 5 to 6 percent of Disney’s total sales. Admittedly, 2023 was one of the weaker years for Disney’s movie releases. Its best year was actually 2019, with 11. 1 billion dollars at the box office. With that success, Disney actually beat its own past record for having the highest grossing box office ever in a single year.

[00:09:23] Shawn O’Malley: The movies that underpinned that success, among others, were Avengers Endgame, The Lion King, Frozen 2, Captain Marvel, and Toy Story 4. So 2019 was really just a breakout year for Disney, and in the years before this outlandish success, Disney averaged around 7 billion in box office releases and always topped every comparison with other movie studios.

[00:09:44] Shawn O’Malley: Taking 7 billion dollars as a benchmark, movie releases only contribute then about 6 9 percent of total revenues, despite gaining the most public attention for Disney. So, again, like I said, the movies are really a small factor in the overall financials for a company like Disney. But still, they create, as we’ve talked about through the flywheel, such an outsized impact on the company’s branding and really its trajectory.

[00:10:09] Shawn O’Malley: So their importance is not to be underestimated. As mentioned, they’re at the heart of Disney’s flywheel. Many movies from the last few years have become attractions at Disney’s theme parks. One of the newest attractions that will be built in various international Disney parks such as Hong Kong, Tokyo, and Paris is inspired by Frozen.

[00:10:27] Shawn O’Malley: A movie that crossed the billion dollar mark in box office revenues and is another great example of how music is also a part of the flywheel and can play its part in marketing a movie. The Frozen songs are viewed billions of times, not millions, but billions of times online and are an integral part of the movie and its characters.

[00:10:44] Shawn O’Malley: Another example is the recently opened Moana attraction, Journey of Water, based on the 2016 film Moana. This franchise is interesting because it shows how Disney can also monetize on brands long term that weren’t the biggest hits in theaters. While the movie performed very well at the box office, generating nearly 650 million, it didn’t reach the billion dollar mark like other recent successes such as Inside Out 2.

[00:11:06] Shawn O’Malley: However, it continued to be one of the most popular movies on Disney In 2023, seven years after its original release, Moana was the most streamed movie in the U. S. with 11. 6 billion minutes watched. In anticipation of Moana 2, which was planned to be released this year, it drove millions of new Disney Plus subscriptions.

[00:11:26] Shawn O’Malley: This all gives a great introduction to the experience segment, which features theme parks and resorts, Disney’s cruise lines, vacation clubs, and merchandise. But before I get to that, let’s discuss the two remaining businesses in the entertainment segment, linear networks, and direct to consumer streaming.

[00:11:43] Shawn O’Malley: The linear network is one of Disney’s legacy businesses. And I’ll just mention that linear network is a fancy name for cable and satellite TV channels. Disney’s U. S. linear network market consists of ABC Television, the Disney Channel, FX Networks, a 73 percent ownership of National Geographic, and several other well-known channels.

[00:12:02] Shawn O’Malley: Internationally, Fox and Star are also part of that portfolio. This segment’s revenues are stable but not growing over recent years. In the last five years, actually, they were 25 to 28 billion. Thus, the linear TV networks represent a revenue share between 30 and 40 percent for Disney, depending on the year.

[00:12:22] Shawn O’Malley: These are really huge numbers, considering that this business segment is already not growing and will likely shrink significantly in the future. However, the reality is not as dark as it might suggest at first, because the revenues that are actually in danger are not 25 to 28 billion. To make this clear to investors, Disney also decided to change the reporting structure of the linear networks to make it more transparent what revenues are actually part of the TV channels and therefore in danger of decline.

[00:12:50] Shawn O’Malley: Prior to 2023, Disney not only reported the channel revenue of the linear networks, but also a broader range of revenue sources not directly linked to those channels. This changed last year, and Disney only reported 11. 7 billion in revenues from linear TV networks. That’s about 13 percent of revenues, and it’s the part of the business that is actually a threat of decline in the future.

[00:13:10] Shawn O’Malley: The last business in the entertainment segment is everything but at risk of decline. I’m talking about the direct to consumer streaming business, which consists of Disney its flagship streaming service that offers a vast library of Disney, Pixar, Marvel, and Star Wars, but also Hulu, a US based streaming service offering a wide variety of TV shows, movies, and original content, as well as ESPN which is Disney’s sports streaming service that provides, well, live sports, but also exclusive originals and premium articles.

[00:13:39] Shawn O’Malley: These are the domestic streaming services in the U. S., and Disney Plus is also the main product in Europe, while other parts of the world get a different offering from Disney. In Europe, Hulu isn’t available as a standalone service, but you can get access to it via a streaming service called Star, which is integrated into Disney Plus in many European regions.

[00:13:57] Shawn O’Malley: India has its own network called Star, which I’ll discuss further shortly, too. ESPN has multiple networks that cover different regions as well. ESPN Latin America covers most of Central and South America. Brazil has its own ESPN network, and in Europe, ESPN is mainly active through sub licensing agreements with local broadcasters like DAZN.

[00:14:17] Shawn O’Malley: The direct to consumer streaming business, and Disney Plus in particular, were launched in 2019 to transition Disney into the modern age of television and reduce its dependency on legacy network businesses. Disney also wanted to prevent Netflix from building a monopoly position in the streaming market.

[00:14:34] Shawn O’Malley: What company, if not Disney, has the power to challenge Netflix? Disney’s content library is the most extensive of all its competitors, and building new businesses based on existing brands is ingrained deeply into Disney’s DNA through its flywheel concept dating back to the 1950s. The launch of the streaming business also came at the perfect time for Disney.

[00:14:53] Shawn O’Malley: The company was hit hard by the pandemic in 2020, and the closure of its parks and theaters really weighed on the business. Its stock lost 30 percent in the COVID crash. However, investors remembered Disney’s new streaming service and its potential, and excitement about that new streaming segment did eventually fuel a pretty quick recovery for Disney stock, and Disney did double, reaching a new all-time high of almost 200 during the pandemic era.

[00:15:18] Shawn O’Malley: But this enthusiasm only lasted for about a year. Investors quickly realized that the streaming market is a costly market to compete in, and Disney’s net income declined from 11 billion in 2019 to negative 2. 8 billion in 2020. A major part of this decline was of course due to COVID, and investors were prepared to look past that and focus on the company’s earnings potential that it would have with its new streaming service and with the hoped comeback of the experiences segment once COVID faded away.

[00:15:46] Shawn O’Malley: However, the expected recovery in the years after fell short of expectations. Disney hit a plateau of net income at only 2 3 billion. The main reason for this failed recovery was the massive cost tied to Disney Plus. In 2021, Disney Plus generated revenues of 16 billion, but experienced an operating loss of 1.7 billion. In the following years, the losses kept growing, and by 2023, they had more than doubled to reach 4 billion. The reason for those losses was Disney’s content and growth strategy. Disney focused on growth at all costs, and this produced a large quantity of content to feed the streaming service and hopefully drive subscriptions.

[00:16:24] Shawn O’Malley: Initially, this strategy seemed to be an absolute home run. Disney was expected to reach somewhere between 60 and 90 million subscribers by 2024. Instead, it really crushed those expectations, and just 16 months after its launch, they had already reached the milestone of 100 million subscribers. The following year, growth continued until Q4 of 2022, and Disney Plus reached its all-time high subscriber count of 164 million.

[00:16:49] Shawn O’Malley: But that is where things started to go south. Disney began to misjudge the growth potential of this sector. After initially underestimating the growth, they now overestimated it significantly. Disney updated its expectations and planned to reach a very ambitious 300 million subscribers by 2024. Instead, in reality, the subscriber count started declining and eventually stabilized at about 150 million.

[00:17:12] Shawn O’Malley: That misjudgment of growth followed a bad strategy for the streaming business. Instead of cutting losses and focusing on the business’s sustainability, making profits, Disney continued to spend billions and release show after show that really didn’t drive new subscribers to the platform. Investors who hoped for a strengthened Disney company after the reopening of the theme parks and theaters were disappointed, to say the least.

[00:17:34] Shawn O’Malley: Disney Plus wasn’t an additional driver of success. Instead, it kept margins and profits low. Disney’s costs of goods sold have more than doubled since the launch of Disney Plus. The realization that Disney wouldn’t manage to return to pre pandemic profit levels made the stock plummet. Interestingly, Disney’s multiples didn’t go way back below historical averages, meaning that investor sentiment wasn’t the main driver for the falling stock.

[00:17:58] Shawn O’Malley: The problem was simply it’s declining financials. The same multiple on lower earnings and cash flows just results in a lower stock price. So, while the narrative was that investors didn’t want to own Disney anymore, part of the truth is that the deteriorating financial results mainly caused the revaluation.

[00:18:15] Shawn O’Malley: Investors were simply unwilling to pay higher multiples in expectation of a recovery. What happened to Disney customers is also a crucial and often overlooked factor in the worsening financial situation and Disney Plus impact on the company. Disney’s original plan with its streaming service was to attract potential customers they hadn’t yet reached through theatrical releases or their experiences segment.

[00:18:35] Shawn O’Malley: So the plan was to acquire new additional types of customers. However, that is just not at all what actually happened. Instead, Disney turned its most profitable customers, those are the ones who were probably most likely to go to the theaters and visit Disney parks or spend money on merch, into paying Disney Plus customers who, as we’ve already discussed, were not only not profitable but were actually driving a loss for the company at the time.

[00:18:59] Shawn O’Malley: This was partly due to the lockdowns, but even after they were lifted, this phenomenon continued because the business itself was just structurally not profitable because so much money was being spent on content. That was a huge dilemma for the company’s management. Suddenly one part of the flywheel seemed to undercut the others instead of benefiting and improving them.

[00:19:17] Shawn O’Malley: It became clear that something had to change. The change came in the form of Bob Iger, a man who has played a major role in Disney’s success in the last few decades since he has already been the CEO of Disney going back from 2005 to 2020. He wanted to tackle Disney’s most severe problems and bring it back on the path of success, both internally and externally.

[00:19:39] Shawn O’Malley: One of the most urgent problems that inspired Iger to come back was to evaluate the just mentioned cost explosion that was caused by Disney Plus. But he also wanted to stop the decline in the value of Disney’s customer base and the inflation of content that has been produced to fuel that streaming machine.

[00:19:56] Shawn O’Malley: The quantity of content also diluted Disney’s quality and brand reputation. Even fan favorites like Star Wars or Marvel couldn’t excite viewers anymore since it seemed like there was a new show or movie every month. This not only lowered the excitement for new releases, but the successive storylines also complicated the viewer experience.

[00:20:14] Shawn O’Malley: If you missed one relatively niche Marvel show on Disney you might have lacked context for the next big Marvel TV show or even the next big movie. The same goes for Star Wars and other franchises. While this problem didn’t immediately show up in the financials, the declining viewers of each new release did indicate that the content strategy was just simply not working out.

[00:20:33] Shawn O’Malley: When Iger came back, he obviously wanted to change that. Regarding the content strategy, one of the first changes he initiated was to call off shows that didn’t perform well, decrease the number of new shows being published, and overall just try and improve quality. To improve Disney’s financial position correspondingly, he implemented severe budget initiatives.

[00:20:51] Shawn O’Malley: He laid off about 3 percent of Disney’s global workforce, increased the prices for Disney and introduced ad supported subscriptions too. The results we’ve seen from Disney so far seem to showcase that Iger held his promises and that the implemented changes have mostly worked out. In 2022, he publicly said he wanted to cut costs by 7.5 billion in 2023 and achieve profitability with Disney Plus by Q4 of 2024. But Disney Plus reached profitability a quarter earlier. The just released Q3 results for this year show a profit of 47 million for the combined streaming business. While this profit is small, it is a huge step in the right direction.

[00:21:31] Shawn O’Malley: Two years ago, in Q4 of 2022, the losses of the combined streaming segment still amounted to 1. 5 billion dollars. Iger also wanted Disney to refocus on the creative side of the business. Not only was the quality of shows supposed to improve, but movie releases also needed to return to past success and quality.

[00:21:49] Shawn O’Malley: To achieve this, he restructured certain management teams, including the direct to customer team for streaming, and he placed longtime studio bosses with extensive experience in Disney’s creative work as new co-chairs for the entertainment segment. Since focusing solely on subscriber growth led Disney into the cost trap and content slump that has plagued it, service’s profitability.

[00:22:13] Shawn O’Malley: ARPU. ARPU is an acronym which stands for Average Revenue Per User, and that word user is actually interchangeable with subscriber as well. For a streaming service to be profitable, this number must be higher than the customer acquisition cost, plus the cost of content production. Netflix currently has a global ARPU of around 11.

[00:22:32] Shawn O’Malley: 70, which I calculated using the company’s latest earnings report. That global ARPU is the weighted average of the domestic ARPU in the U. S., which includes actually the U. S. and Canada, and the international ARPU, which is split between Europe, the Middle East, Africa, as well as Latin America and the Asia Pacific region.

[00:22:50] Shawn O’Malley: The difference between these global and domestic ARPUs stems primarily from the fact that users across the world pay different prices for content, depending on the relative pricing power in their country. Consumers in less developed countries where median incomes are lower also generally pay less in dollar terms for their subscriptions.

[00:23:08] Shawn O’Malley: While Netflix’s domestic ARPU stands at 17. 24, that value is brought down by Netflix’s more than 190 million international subscribers, of which over 100 million are from countries where revenues per subscriber are only half of that of the domestic rates charged in the US. We can see the same effect at Disney too, although it’s a bit more complex in this case because of the different streaming services Disney offers in each region.

[00:23:33] Shawn O’Malley: Disney Plus’s domestic average revenue per subscriber is between 7 and 8 as of 2024. This is significantly higher than in the years 2019 to 2021 when it was in the range of just 5. Disney Plus’s international ARPU is divided between Disney Plus Core, which is basically the normal Disney Plus service, And Disney Plus Hotstar, which is the Indian and South Asian streaming service.

[00:23:56] Shawn O’Malley: The international ARPU for Disney Plus Core stands at 6. 80, and is thus only a dollar below the domestic ARPU. Hotstar, however, shows significantly lower and more volatile average revenues per user. In recent quarters, it ranged from just 70 cents to 1.30. The comparison to Netflix’s average revenue per subscriber in the Asia Pacific region is also not completely fair since Netflix only has an estimated 10 12 million subscribers in India whereas Disney has over 36 million.

[00:24:26] Shawn O’Malley: Since the price in India is among the lowest globally, the average revenue will also be a lot lower. On the flip side, India is a huge and fast growing market and Disney is much better positioned to capture it. Continuing revenue growth in that region will be crucial to Disney’s direct to consumer success.

[00:24:41] Shawn O’Malley: Overall, Netflix is still far ahead of Disney in terms of profitability, both in per subscriber metrics and overall. We have now talked extensively about the direct to consumer streaming segment and Disney Plus in particular, but I think that was important since it has been one of the main drivers of the stock price’s upside and downside since its launch in 2019.

[00:25:01] Shawn O’Malley: Now, let’s talk about one of the segments that has turned Disney into the cash flow machine it used to be. In contrast to its movie releases, Disney’s theme parks are not only an important marketing and branding tool, but also vital to Disney’s financial wellbeing. Disney operates 12 theme parks across 6 resorts worldwide.

[00:25:18] Shawn O’Malley: Two of them are located in the US, Walt Disney World in Florida and Disneyland in California. In Europe, there is Disneyland Paris. And in Asia, there is Disneyland Tokyo, Disneyland Hong Kong, and Disneyland Shanghai. The theme parks are part of Disney’s Experience segment, which also includes hotel and vacation clubs, as well as a fleet of cruise ships.

[00:25:39] Shawn O’Malley: The parks are responsible for over 60 percent of experience revenues, depending on the year, and the experience segment in turn is responsible for a little more than a third of Disney’s overall revenues. However, parks are not only a revenue driver, more important is their role in producing profits and free cash flow.

[00:25:55] Shawn O’Malley: In 2023, the experience segment generated 70 percent of operating income, and since Disney Parks are responsible for roughly 60 percent of the experience segment’s revenues, their role in cash flow generation is immense. However, we cannot calculate the precise numbers since Disney does not disclose the margins of these businesses.

[00:26:14] Shawn O’Malley: After a tough period following the COVID lockdowns, the experience segment recovered quickly and exceeded pre pandemic levels in 2022, less than a year after reopening. The recovery was driven by high demand for experiences after the lockdowns, and people were getting pretty frustrated with being caught up at home, and many people were flush with cash from the government’s stimulus programs during the pandemic.

[00:26:35] Shawn O’Malley: However, the recent quarter shows a slight slowdown in demand for domestic theme parks. This is probably due to a bout of inflation still ongoing from the aftereffects of the pandemic, as well as recession fears, which have accordingly led consumers to cut spending. Disney’s CFO, Hugh Johnston, said on CNBC that customers seem to save a little more aggressively than before and he expects this trend to continue for at least a few quarters, however, he wouldn’t necessarily call it recessionary behavior yet.

[00:27:02] Shawn O’Malley: Also, the experience segment as a whole did see modest revenue growth of 2%, but it’s just that operating income declined by 3%. Looking at the geographic breakdown, the international parks performed about the same as last year actually, so it was really just the domestic parks in the US that caused the decline in operating income.

[00:27:20] Shawn O’Malley: As mentioned, Disney’s management thinks this could continue for a few more quarters. However, Johnston also said to CNBC, quote, Given that people do tend to protect their vacations more than other types of spending, we tend to get hit late, we tend to get hit less, and we tend to improve more quickly than others.

[00:27:36] Shawn O’Malley: While visiting Disney parks has definitely become a sort of luxury for the average person, it’s still one of those things that people would cut only as a last resort. It’s way easier to save on expensive clothing, eating out, or buying organic food than it is to cancel or reschedule a big vacation. In my opinion, the reaction to Disney’s recent results, especially their performance and the experience segment, is probably a bit of an overreaction.

[00:27:58] Shawn O’Malley: I think investors and Wall Street use Disney’s performance more to judge the average consumer and to really try to learn something about the health of the overall economy than it is a judgment of Disney’s business. The slowing growth underscored the narrative of a recession and Disney was sort of a victim of the resulting pessimism.

[00:28:16] Shawn O’Malley: That could be part of the reason why Disney’s CFO emphasized that he does not see recessionary behavior at hand. He also pushed back on the narrative of weakened Chinese consumers and said that the impact on Disney’s parks in Shanghai has been quote, very mild. So we should expect the experience segment to slow down a bit in the following quarters.

[00:28:33] Shawn O’Malley: Now, I want to go to another business in the experience segment that, in my opinion, gets relatively little coverage. This is naturally because Disney’s parks overshadow its remaining businesses, but still, I’d like to talk about Disney’s cruise ships. The idea behind Disney’s Cruise Ships is to extend their theme park magic to the seas, creating a unique vacation experience that combines Disney’s storytelling and entertainment with a transnational vacation.

[00:28:56] Shawn O’Malley: It kind of follows the motto, the journey is the destination. Just like with the theme parks, Disney’s market position is very strong in this segment. Other cruise lines offer similar services like Royal Caribbean, which has a partnership with DreamWorks, and MSC Cruise, which has partnered with Lego.

[00:29:11] Shawn O’Malley: Nevertheless, Disney’s vast franchise library and familiarity with delivering the full experience package makes the Disney Cruise Lines truly unique. For Disney fans, cheaper cruises cannot substitute the Disney experience. Disney currently has a fleet of five ships. They are called Magic, Wonder, Dream, Fantasy, and Wish.

[00:29:29] Shawn O’Malley: Three more ships are in the pipeline too, though. One of them is called Treasure, and it is supposed to set sail in December of this year. While Disney does not disclose the revenues and profits of each business in a business segment, the cruise ships are operated by a London subsidiary. These have filed reports and showed that the five cruise ships generated 2.2 billion in revenue and 180 million in operating profit last year. And while that’s not too much compared to the 32. 5 billion in revenue and almost 9 billion in operating profit that Disney earns as a whole. The market for cruise ships is growing significantly, and Disney’s market share is still relatively small, which leaves plenty of room for expansion.

[00:30:07] Shawn O’Malley: According to JP Morgan, the cruise industry is estimated to capture roughly 3. 8 percent of the 1. 9 trillion global vacation market by something like 2028. This growth is fueled by the acquisition of new and younger first time passengers and the fact that all-inclusive cruise ship tours are often cheaper than online vacations.

[00:30:26] Shawn O’Malley: Considering the sector’s growth, and the fact that Disney only covers 2.8 percent of global cruise passengers and 4.2 percent of total revenue, there is a pretty big opportunity at hand. As mentioned, 3 more ships are currently planned, and this is part of a 60 billion investment project that Disney announced in September 2023.

[00:30:45] Shawn O’Malley: That announcement caused a lot of headlines, however if we break it down, the number might not seem as astronomical. The 60 billion dollars are planned to be invested over a 10 year period, and assuming an equal distribution over those years, that’s 6 billion dollars a year. When the announcement was made, 17 billion dollars of that was already planned for new attractions at Walt Disney theme parks.

[00:31:05] Shawn O’Malley: That leaves us with just 43 billion dollars to allocate still. Two of the three cruise ships that are supposed to be added to the existing fleet were also confirmed at that point. They’re estimated to cost approximately 1. 25 billion dollars. It should also be mentioned that this is more than Disney has historically invested in the past.

[00:31:24] Shawn O’Malley: So, in summary, while I could imagine they might actually follow up on it and spend that remaining 40 billion, I would consider the number itself more of a headline and sort of a publicity stunt. When it was published, Disney stock was struggling, and this announcement was supposed to be a sign for investors to feel more positive about the company’s prospects.

[00:31:41] Shawn O’Malley: Generally, I support investments in the experience segment due to its financial importance for the company and the historically good returns on invested capital this area has had. What I don’t like are large, fixed numbers. They can easily incentivize management to spend just to keep promises. However, after breaking down the 60 billion investment, I think the risk isn’t too high in this case.

[00:32:02] Shawn O’Malley: Now, we’ve discussed all the major parts of Disney’s business except one really important one. Last but not least is Disney’s sports segment. It’s a segment that, especially for people outside of the US, they don’t always necessarily associate with Disney immediately, however this segment has significantly grown in importance for the company over time.

[00:32:21] Shawn O’Malley: Disney’s sports segment is primarily centered around the ESPN brand, of which Disney owns 80%. Domestically, this includes 8 ESPN channels, ESPN on ABC and ESPN which is ESPN’s direct to consumer streaming service. ESPN also has local channels for international audiences too. In addition to the ESPN brand, Disney also owns Star India, which has most of the broadcasting rights for the country’s biggest sport, cricket.

[00:32:46] Shawn O’Malley: Yet 87 percent of the sport segment’s revenues and all of the operating profits come from the domestic ESPN business. ESPN has been a profit machine for Disney for many years. In the challenging years of the COVID pandemic, ESPN was vital for Disney. In 2022, it was responsible for 17. 3 billion of Disney’s revenue and 2.7 billion of its operating profits. That’s about a fifth of overall revenues and over 22 percent of its overall operating profits. A major reason for ESPN’s profitability is the structure of the American linear network market and the contracts that ESPN signed in 2013 with cable TV providers. These contracts include so called carriage fees, or affiliate fees as Disney refers to them in their financial reports.

[00:33:31] Shawn O’Malley: Paid TV providers pay these affiliate fees to TV network owners who carry the network TV owner’s linear channels on the provider’s cable. These fees are negotiated on an individual basis, so the more demand there is for your product, the more pricing power you have. And the value ESPN can provide is much bigger than almost any other TV network.

[00:33:51] Shawn O’Malley: While most other networks receive affiliate fees per subscription of 0.10 to 0.20, ESPN earned a whopping 9. 42 per sub per month. This is by far the number one in the industry. However, with more and more people cutting the cord, this high margin business will eventually slow down further than it already has.

[00:34:10] Shawn O’Malley: This will not happen within a year or two, but as Bob Iger said, it is inevitable. That’s why the long term plan remains to transition ESPN into a direct to consumer streaming service. To implement this plan, Disney is also looking for strategic partners to help with that transition. Possible partners are the four major US professional sports leagues, the National Football League, the National Basketball Association, the National Hockey League, and Major League Baseball, as well as big tech companies that would take a more strategic role in marketing, technology, or content.

[00:34:40] Shawn O’Malley: A possible benefit from a partnership with the major national sports leagues would be that the rising costs of sports rights, which have become a significant problem for the sports media sector, could get cheaper due to a deal with the leagues themselves. Earlier this year, Disney was in talks with the NFL about a possible partnership, however no agreement has yet to be reached, and it’s unclear whether the talks are still ongoing.

[00:35:02] Shawn O’Malley: In contrast to a deal with America’s major domestic sports leagues, a deal with big tech companies like Amazon and Google could reduce the competition in this sector too. Right now, these companies are signing their own deals to get into sports broadcasting. For example, as you may know, for the last three years or so, Amazon has hosted the NFL’s Thursday night football games.

[00:35:21] Shawn O’Malley: This could become an even bigger problem for ESPN than the decline in linear TV networks. Companies like Amazon are not dependent on these ventures to make money. They’re fine with paying more money than these sports events would even bring in short term, if this means more subscriptions and eyeballs on their streaming service, or in Amazon’s case, on Amazon Prime.

[00:35:40] Shawn O’Malley: Amazon Prime is even more powerful than other streaming services, since Prime’s streaming service is only one part of the Prime ecosystem. It just assists Amazon’s main business, and the integrated streaming service’s job is to drive new subscribers to Prime, since Prime’s subscribers are much more profitable for Amazon than the average streaming customer somewhere else.

[00:35:59] Shawn O’Malley: Overpaying for certain streaming rights is just a calculated acquisition cost. Amazon’s main business basically subsidizes the streaming service. So while Disney needs ESPN to sign good and profitable deals, its big tech competitors have much more financial leeway. ESPN’s future success is thus largely dependent on Disney’s management’s decision making and the partnerships they can close.

[00:36:20] Shawn O’Malley: Back in late 2022, there was also a debate by activist investor Dan Loeb about spinning off ESPN. Estimates from the Bank of America valued the business at 24 billion back then. However, Disney and Bob Iger specifically denied these rumors and since then nothing has happened that would suggest otherwise.

[00:36:38] Shawn O’Malley: The long term plan remains to transition ESPN from linear TV to streaming. We’ve talked extensively about Disney’s business, including its financials and the possible future outlooks for its various business segments. What we haven’t done yet is paint an overall picture of Disney’s financials and its valuation.

[00:36:56] Shawn O’Malley: Looking at Disney’s price to earnings ratio of more than 30, you might ask yourself why we are even talking about an investment opportunity here. However, this number is misleading for the following reasons linked to Disney’s income statement. First off, Disney’s earnings have been down significantly due to the factors we’ve already discussed surrounding the drop off in traffic at theme parks during COVID, as well as the surge in costs associated with competing for new customers on Disney Looking at the one year forward price to earnings ratio makes much more sense, and it is currently trading at 17 to 18 times, which is honestly much more attractive.

[00:37:30] Shawn O’Malley: Secondly, like many media giants, Disney is an asset heavy company. Large amounts of depreciation on equipment and amortization of intellectual property are decreasing its net income, therefore free cash flow is a better metric for judging its operations as a business. Just a reminder, free cash flow is an alternative measure of profitability from net income, which depreciation.

[00:37:53] Shawn O’Malley: Free cash flow, instead, is meant to reflect roughly the cash remaining after paying for operating expenses and capital expenditures. And Disney’s free cash flows have been recovering. After dropping from almost 10 billion in 2018 to 1. 7 free cash flows are now back to 8 billion, and now that we are close to the end of Disney’s cash burning cycle thanks to Disney this should be a more sustainable number.

[00:38:17] Shawn O’Malley: Of course, this can change whenever Disney implements large investments in the experience segment again. Besides lower net income in recent years, Disney has also taken on significant debt. In March 2019, Disney closed on the 71 billion dollar deal to acquire 21st Century Fox, which I mentioned briefly earlier.

[00:38:34] Shawn O’Malley: To fund that acquisition though, the company has taken on considerable debt. Some of the major assets owned by 21st Century Fox include X Men, Fantastic Four, The Simpsons, and Deadpool. The recently published movie Deadpool and Wolverine was only possible because Disney now owns the rights to these IPs and includes the two characters in the Marvel Universe.

[00:38:54] Shawn O’Malley: The deal was more expensive than initially thought it would be because Disney had some competition in bidding for 21st Century Fox, Comcast also wanted to acquire 21st Century Fox, and Disney got the deal but ended up paying almost 20 billion dollars more than it originally anticipated. The result of this deal was a significant increase in long term debt from 17B in 2018 to 52B in 2020, a decrease in retained earnings from 83B to 38B, and a dilution of shareholders through roughly 300 million newly issued shares.

[00:39:27] Shawn O’Malley: While Disney has decreased its long term debt to 42B, its balance sheet remains relatively weak, especially because of its cash position, which is only 6B. Considering Disney’s free cash flows, I don’t expect the company to run into any financial trouble, but considering the possibility of significant future investments, it would obviously be ideal to have a more strong balance sheet that’s better positioned to incur those sorts of costs.

[00:39:51] Shawn O’Malley: I want to now sum up what we’ve talked about so far, discuss Disney’s stock and valuation further, and analyze whether its shares offer an attractive opportunity to buy into one of the most successful companies in American history. Disney stock is currently trading around 90, which is about where it was back in 2014.

[00:40:09] Shawn O’Malley: Since then, revenues have grown by almost a hundred percent. However, it’s net income is actually down from 7.5 billion to 4.8 billion, while free cash flows have grown from 6.5 billion to 8 billion. So there has been some growth, but profit margins, at least in terms of net income, have declined as revenues rose.

[00:40:29] Shawn O’Malley: Looking at the numbers and zooming out, you can clearly see where Disney’s strong and reliable growth trend got interrupted. We’ve mentioned it a couple of times today, but one last time to get us all on the same page. It did not happen because of the COVID outbreak and the resulting lockdowns. While this significantly worsened the situation, the financial decline, if one can call it that, had already happened a year before when Disney launched Disney Plus and started investing heavily in the streaming service.

[00:40:54] Shawn O’Malley: But that’s exactly why Disney stock is so interesting right now. In the last quarter, Disney was finally able to make Disney Plus profitable, and Bob Iger is eager to close the margin gap between Disney and Netflix. At the 2024 Morgan Stanley Technology, Media, and Telecom Conference, he said, quote, When we launched Disney Plus in 2019, our goal was to have basically robust video experiences at scale.

[00:41:16] Shawn O’Malley: What we didn’t have was the technology that we needed to basically lower customer acquisition and retention costs, to increase engagement, to essentially grow our margins by reducing marketing expenses. This is key. We have already discussed Disney and Netflix’s average revenue per user, and there was a large discrepancy and Disney needs to narrow that difference.

[00:41:36] Shawn O’Malley: Improvements this year in its streaming segment are arguably the biggest catalyst for Disney stock, but the market has yet to give Disney much credit for reaching profitability on this front. I think investors are cautious about Disney mainly because they fear a recession in which Disney’s most profitable business, the theme parks, would suffer.

[00:41:52] Shawn O’Malley: This might be a drag on the stock for the next couple of quarters, however Disney parks will not suddenly turn into a long term weakness, and it’s businesses that have been weaknesses like the streaming business, have already improved massively. So while Disney’s stock might not break out for a while because of macroeconomic headwinds, I do believe Disney has a stronger position today than at any point since 2019.

[00:42:13] Shawn O’Malley: You might ask why I say 2019 when the stock price rallied in 2021 and 2022. You’re right, but it only did so based on investors’ expectations of Disney The enormous spending was overlooked for a while, and when that changed, the sentiment changed too. However, now we’re at a point where the sentiment is still bad, but the business is stronger than before.

[00:42:33] Shawn O’Malley: My problem with Disney is that its investment plans are difficult to evaluate. If the investment in the experience segment can achieve the double digit returns on invested capital that prior investments have achieved, Disney will have two engines running for them, the streaming segment, which is growing in profitability, and its experience segment, which is creating double digit returns.

[00:42:51] Shawn O’Malley: However, Disney has made questionable management and acquisition decisions in recent years, and while Bob Iger has made many good calls since he returned, He’s also the CEO who initiated and approved the 71 billion dollar deal with 21st Century Fox, a deal that was not only in hindsight but also at the time seen as way too expensive.

[00:43:09] Shawn O’Malley: Another uncertainty is ESPN’s transition. We’ve discussed how profitable the current structure and contracts have been for ESPN with cable television and satellite TV, yet it remains to be seen how much money they can earn and charge customers for a streaming service and whether that can generate the same revenues as under the TV model.

[00:43:28] Shawn O’Malley: ESPN’s new NBA deal might give us an estimate of how large those numbers could be, and still under the new contract ESPN pays 2. 6 billion per year for NBA rights, whereas the old contract costs them 1.4 billion a year. Considering the decline in subscribers, the NBA contract alone would cost roughly 37 per subscriber per year.

[00:43:48] Shawn O’Malley: We arrive at the number by dividing the 2.6 billion per year by the 70 million ESPN subscribers Disney had at the end of 2023. The additional charge on top of the 9.42 payable under the legacy system is because users who currently do not watch any sports but still pay for the TV channel’s bundle will no longer pay when ESPN is just a streaming service.

[00:44:08] Shawn O’Malley: This means that there are essentially no more subsidies paid by users who do not watch any sports to users who do. It’s impossible to estimate the churn this price increase would create, but Disney has to bring in partners to lower that price or increase the value ESPN offers. Due to the above reasons, Disney’s future outlook is highly uncertain, so complex models with many inputs would really just be a guessing game about its future.

[00:44:30] Shawn O’Malley: Instead, I want to use Disney’s earnings per share and its free cash flow estimates to see what we can expect from Disney’s stock in the next few years if they deliver on the estimates and can return to the average multiples that the company has traded at historically. Analysts are currently estimating earnings per share of 2028 using a multiple of 21 times, which has been roughly the historic average.

[00:44:52] Shawn O’Malley: This would give us a share price of 135. That’s slightly below a 50 percent return over a four year period. Now I’ve said that earnings are not as telling for a company like Disney, so let’s do the same using free cash flow. Analysts estimate free cash flow per share of 10.20 in 2028. That’s the equivalent of 11.7 billion dollars in free cash flows. That’s a lot compared to the 8 billion dollars that Disney currently produces. But let’s go with that estimate for now. The average historic multiple of free cash flow has been approximately about 20 times. So using these estimates and assumptions, Disney would be valued at 204 in 2028.

[00:45:29] Shawn O’Malley: That would be a return of about 125 percent over four years. To be conservative, assuming no growth or a decline in free cash flow up until 2028, this would result in a free cash flow of about 4.50 per share. With a multiple of 20, this would give us a stock price of 90. Unsurprisingly, we arrive at today’s price if there’s no growth because investors are already paying its historic average multiple to own the company.

[00:45:55] Shawn O’Malley: As mentioned before, the multiples are not as depressed as Disney’s stock decline would suggest at first. As always, do not focus too much on the numbers. These are really just rough estimates and they’re supposed to give you direction. What I take from this is that Disney’s upside potential at the current price of roughly 90 isn’t yet high enough to offset the uncertainty around the future of its operations.

[00:46:15] Shawn O’Malley: It seems to be roughly fairly valued. However, at a price below 80, Disney becomes a considerably more attractive investment for me. I don’t own any, though it does sit atop my list of stocks that I keep an eye on, and in the range of 75 80 dollars, it would really be particularly interesting. The risk with Disney is that future investments once again lower the free cash flows.

[00:46:37] Shawn O’Malley: If the potential returns from these investments do not inspire investors, they probably won’t pay a higher multiple for the stock, which would really be a headwind for its returns. And then at that point, we’d be in a similar position all over again. Because of its high debt levels, Disney should also use cash flows to pay back debt before it starts large buyback programs of shares or further increases its dividends to investors.

[00:46:57] Shawn O’Malley: Thus, it might take a while for cash flows to shareholders to increase. Overall, I like Disney’s progress in the last year, and I think if they can stay on track, this stock will do very well in the future. However, the uncertainty in the long term due to ESPN’s transition and the large investments into parks and cruises makes it difficult to assess a margin of safety here.

[00:47:16] Shawn O’Malley: One of my favorite sayings to fall back on for a company like Disney comes from Warren Buffett, who reminds us that we should only invest in companies an idiot can run. Without me wanting to insult any Disney CEO, the last time Bob Ivey retired, it didn’t go well. For a company as capital intensive and complex as Disney, you need more than just an idiot to run it well.

[00:47:37] Shawn O’Malley: For now, Iger is back, and he is very capable, but he won’t be around forever. Sooner or later, the CEO question will come up again. Disney has proven to be a company that could get into trouble under the wrong management, and so this is another problem for the future that I would be concerned about. To sum up the last hour in one sentence, Disney has come a long way in recovering from the pandemic and the costs of competing and streaming.

[00:48:00] Shawn O’Malley: However, there are still problems to solve, and Disney seems to be about fairly priced, although maybe on the cheaper end considering how its stock has really underperformed in recent years. With that said, I’d like to leave you with the following quote from Walt Disney himself. Quote, Disneyland will never be completed. It will continue to grow as long as there is imagination left in the world. I hope you enjoyed today’s episode and I’ll see you again next time.

[00:48:25] Outro: Thank you for listening to TIP. Make sure to follow Millennial Investing on your favorite podcast app and never miss out on our episodes to access our show notes, transcripts, or courses, go to theinvestorspodcast.com. This show is for entertainment purposes only before making any decision, consult a professional. This show is copyrighted by The Investor’s Podcast Network. Written permission must be granted before syndication or rebroadcasting.