🐭 Disney: Creative Destruction

Disruption is good — unless you're disrupting your own business

App Economy Insights

Nov 11, 2022

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The Walt Disney Company (DIS) recently reported its Q4 FY22 earnings report (ending September 2022).

Today, we’ll cover the following:

Austrian economist Joseph Schumpeter coined the concept of creative destruction:

“The process of industrial mutation that incessantly revolutionizes the economic structure from within, incessantly destroying the old one, incessantly creating a new one.”

The secular shift from linear TV to streaming is a textbook example of creative destruction. I discussed in my Netflix article how streaming took over cable as the leading share of US TV time in September 2022.

While a company like Netflix is benefiting from this trend, legacy entertainment giants like Disney have to deal with a zero-sum shift from a declining segment (linear TV) to a growing one (direct-to-consumer, or DTC for short).

The headlines often tout the rise of the DTC segment, but we cannot look at it in a vacuum. DTC's success comes at the expense of other legacy segments that still represent the lion's share of the company’s revenue and profit.

It’s essential to look at Disney’s acquisitions in the past decade to put the company’s performance in context:

2012: Lucasfilm (Star Wars) $4.1 billion.
2014: Maker Studios $0.5 billion.
2016: BAM (streaming technology) $2.6 billion.
2019: 21st Century Fox $71.3 billion

Disney’s acquisition of 21st Century Fox included:

The 20th Century Fox film and television studios.
International operations of Fox Networks Group.
Indian television broadcaster Star India.
73% stake in National Geographic.
30% stake in Hulu.

Before we start, let’s discuss how Disney makes money.

Revenue has two main components:
1. Media & Entertainment (~63% of overall revenue).
  - 📺 Linear TV (legacy networks).
  - 📱 DTC (streaming apps).
  - 🍿 Content (theatrical releases, licensing, DVDs, live shows).
2. Parks, Experiences, and Products (~37% of overall revenue).
  - 🎢 Parks & Experiences (theme parks, cruise line, vacation clubs).
  - 🧸 Consumer Products (toys, collectibles, merchandise).

Costs and expenses include:
- Cost of services: Programming, production, and technology costs.
- Cost of products: Cost of merchandise, food, and beverages sold.
- Selling, general & administrative expenses (including marketing costs).
- Depreciation (theme parks) and amortization (intangible assets).
Margins:
- The operating margin used to be above 20% of revenue. But it has compressed in the low teens after the integration of 20th Century Fox and the transition to DTC. In addition, since the global pandemic, margins have turned negative to close to breakeven.

Let’s look at the most recent quarter!

1. Disney Q4 FY22

Income statement:

Here is a bird’s-eye view of the income statement.

Segment operating profit is an adjusted metric to show profitability by business unit.

Main highlights:

Revenue grew +9% Y/Y to $20.1 billion ($1.3 billion miss).
- Media & Entertainment declined by 3% to $12.7 billion
  - 📺 Linear Networks declined by 5% to $6.3 billion.
  - 📱 Direct-to-consumer grew +8% to $4.9 billion.
  - 🍿 Content Sales Licensing declined by 15% to $1.7 billion.
- Parks, Experiences & Products grew +36% to $7.4 billion.
  - 🎢 Park & Experiences grew +46% to $6.1 billion.
  - 🧸 Consumer Products grew +4% to 1.3 billion.
Operating margin was 2% (+0.3pp Y/Y, -8pp Q/Q).
- Parks, Experiences & Products had a stable 20% adjusted margin.
- Media & Entertainment had a razor-thin 1% adjusted margin.
EPS (non-GAAP) was $0.30 ($0.26 miss).

Cash flow:

Operating cash flow was $2.5 billion (13% margin, -1pp Y/Y).
Free cash flow was $1.4 billion (7% margin, -1pp Y/Y).

Balance sheet:

Cash, cash equivalent: $11.6 billion.
Long-term debt: $57.8 billion.

Q1 FY23 Guidance:

DTC's operating results are expected to improve by $200 million.
Disney+ is expected to achieve profitability by FY24, thanks to price hikes and a new ad-supported tier.
FY23 revenue and adjusted operating profit are expected to grow at a high single-digit percentage.

So what to make of all this?

It was not a good quarter. Disney missed the top and bottom-line consensus.
The creative destruction is visible. DTC growth is more than offset by the decay in other media segments.
DTC subscriber additions were strong. Disney+ added 12.1 million subscribers, above expectations for 9.3 million net additions. Across all three apps, the company added 14.6 million subscribers.
DTC reached “peak operating losses” of $1.5 billion on an adjusted basis, offsetting the profit from the Linear Networks segment, illustrating the zero-sum impact of the transition.
The ARPU (Average Revenue per User) declined. The company continued to offer aggressive discounts and bundles. Half of the decline was due to currency headwinds. A lower per-per-view at ESPN+ was also to blame due to different UFC match schedules.
Parks & Experiences rebounded with favorable COVID comps. However, if we compare Parks, Experiences, and Products to Q4 FY19 (pre-COVID), it grew only +12% Y/3Y. So that’s a 4% CAGR (compound annual growth rate) in the past three years, not even keeping up with inflation.
FY23 guidance is a mixed bag. It implies continued strong demand for parks but a slowdown in DTC growth due to tough comparisons and the price hike.

Is the business sustainable?

Disney has a relatively weak balance sheet. But it has maintained positive free cash flow through its transition to direct-to-consumer (so far).

Capital expenditures are expected to increase from $5 billion in FY22 to $6.7 billion in FY23. As a result, free cash flow could compress further toward a breakeven point.

While the sustainability of the business is not at risk, the company has been on a better financial footing in the past.

2. Recent business highlights.

Let’s zoom in on DTC, the most important strategic initiative.

Direct-to-consumer subscribers in Q4 FY22:

Disney+: 164 million (+39% Y/Y).
Hulu: 47 million (+8% Y/Y).
ESPN+: 24 million (+42% Y/Y).

The headline might say that Disney has more subscribers than Netflix, but it’s misguiding. Disney’s numbers do not adjust for subscriber overlap brought on by the Disney Bundle (all three services for $13.99/month in the US).

While the subscriber growth is impressive, an often overlooked aspect is the average revenue per subscription.

Disney+ numbers include:

Disney+ Core: 103 million subscribers at $6/month.
Disney+ Hotstar (India): 61 million subscribers at $0.58/month.

For comparison, Netflix has a $12/month average revenue per membership.

3. Key quotes from the earnings call

CEO Bob Chapek explained:

“We reached peak DTC operating losses, which we expect to decline going forward. That expectation is based on three factors: first, the benefit of both price increases and the launch of the Disney+ ad tier next month; second, a realignment of our cost, including meaningful rationalization of our marketing spend; and third, leveraging our learnings and experience in direct-to-consumer to optimize our content slate and distribution approach to deliver a steady state of high-impact releases that efficiently drive engagement and subscriber acquisition.”

He added on the ad-supported tier:

“We are exactly 1 month from the U.S. launch of Disney+’s ad-supported subscription offering, which is a win for audiences, advertisers and shareholders. The launch will bring fans a new slate of subscription plans across Disney+, Hulu, ESPN+ and the Disney bundle giving viewers flexibility in choosing an option that suits their needs.
The offering also adds a key component to our total company advertising portfolio and advertiser interest has been strong. […] Disney+ has secured more than 100 advertisers for our domestic launch window, spanning a wide range of categories and our company has over 8,000 existing relationships with advertisers who will have the opportunity to advertise on Disney+.”

The company signed a deal with The Trade Desk (TTD) for targeted automated ads across Disney properties.

Senior VP and CFO Christine McCarthy added some color on the near-term impact:

“We do not expect the launch of the advertising-supported tier of Disney+ in December to provide a more meaningful financial impact until later this fiscal year.”

DTC subscriber net additions won’t be linear, starting in Q1 FY23:

“We expect core Disney+ subscribers to increase only slightly in the quarter, reflecting tougher comparisons against Disney+ Day performance. As we’ve mentioned before, subscriber growth will not be linear each and every quarter, and the trend is driven by several factors, including content releases and promotions.”

The parks seem unaffected by the current challenging environment:

“Looking towards fiscal 2023, while we continue to monitor our booking trends for any macroeconomic impacts, we are still seeing robust demand at our domestic parks and are anticipating a strong holiday season in Q1.”

On the overall picture for FY23:

“We currently expect total company’s fiscal 2023 revenue and segment operating income to both grow at a high single-digit percentage rate versus fiscal 2022.”

4. What to watch looking forward

Acquisition, retention, and monetization

On December 8:

Disney+ Basic (ad-supported plan) will launch in the U.S. for $7.99/month.
Disney+ Premium (no ads) will increase from $6.99 today to $10.99/month.

The big question will be around user retention.

Do the bundles and discounts artificially inflate the subscriber numbers?

Chapek shared previously:

“We believe our churn implications of taking up the price […] will be negligible.”

If Disney follows in the footsteps of Netflix, churn might only be a temporary issue. But we’ll have to see.

Competition

As explained by Netflix management in the Q3 FY22 shareholder letter:

"As it’s become clear that streaming is the future of entertainment, our competitors – including media companies and tech players – are investing billions of dollars to scale their new services. But it's hard to build a large and profitable streaming business – our best estimate is that all of these competitors are losing money on streaming, with aggregate annual direct operating losses this year alone that could be well in excess of $10 billion, compared with our +$5-$6 billion of annual operating profit. For incumbent entertainment companies, this high level of investment is understandable given the accelerating decline of linear TV, which currently generates the bulk of their profit."

A quick look at the performance of other media companies transitioning to DTC shows the same story, from Warner Bros. Discovery (WBD) to Paramount (PARA).