🏰 Disney: The Magic Kingdom's Dilemma
What to think of Disney with its stock at an 8-year low?
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The Walt Disney Company (DIS) reported its Q2 FY23 earnings (ending in March).
Today, we’ll cover the following:
Disney Q2 FY23.
Recent business highlights.
Key quotes from the earnings call.
What to watch looking forward.
In a world where content is king and engagement is queen, streaming services are the new frontier. Disney has enchanted generations with fairy tales, and now it finds itself in an epic saga of its own, facing one of its most significant disruptions yet with the transition from linear TV to streaming.
The company is navigating the tumultuous sea of digital transformation, its treasure trove of timeless content held in one hand and an innovator's compass in the other.
Let’s dive in!
1. Disney Q2 FY23
Here is a bird’s-eye view of the income statement.
Segment operating profit is an adjusted metric to show profitability by business unit.
Overall revenue grew +13% Y/Y to $21.8 billion (in-line).
Media & Entertainment grew 3% Y/Y to $14.0 billion.
📺 Linear Networks declined by 7% Y/Y to $6.6 billion.
📱 Direct-to-consumer grew +12% Y/Y to $5.5 billion.
🍿 Content Sales Licensing grew +18% Y/Y to $2.2 billion.
Parks, Experiences & Products grew +17% Y/Y to $7.8 billion.
🎢 Park & Experiences grew +23% Y/Y to $6.8 billion.
🧸 Consumer Products declined by -14% Y/Y to 1.0 billion.
Segment margin was 15% (-3pp Y/Y, +2pp Q/Q).
Parks, Experiences & Products had a 28% adjusted margin (+1pp Y/Y).
Media & Entertainment had an 8% adjusted margin (-6pp Y/Y).
Operating margin was 10% (+4pp Y/Y).
EPS (non-GAAP) was $0.93 ($0.01 miss).
Operating cash flow was $3.2 billion (15% margin, +5pp Y/Y).
Free cash flow was $2.0 billion (9% margin, +5pp Y/Y).
Cash, cash equivalent: $10.4 billion.
Long-term debt: $58.3 billion.
Q3 FY23 Guidance:
More softness in Disney+ net ads is expected in Q3, but management expects a rebound in Q4.
DTC's operating loss to widen by $100 million sequentially due to a shift in marketing cost from Q2 to Q3.
Content Sales Licensing operating loss to widen by $150 to $200 million Y/Y.
Parks, Experience, and Products profitability to improve slightly Y/Y.
So what to make of all this?
It was another challenging quarter. Disney just met the top-line consensus, with a slight miss on the bottom line.
The creative destruction is once again visible. The decay in linear networks almost entirely offsets DTC growth.
DTC subscriber trends were concerning. Disney+ lost 4 million subscribers during the quarter due to Disney+ Hotstar (more than in a minute). Even Disney+ Core had relatively weak numbers, with only 0.6 million paid subscribers added sequentially.
DTC reached “peak operating losses” of $1.5 billion on an adjusted basis in Q4 FY22 (ending September 2022), followed by a $1.1 billion adjusted loss in Q1 FY23. So the loss of $0.7 billion in Q2 FY23 was another step in the right direction. But it was artificially inflated by a delay in marketing spend.
The ARPU (Average Revenue per User) grew 20% in the US after a price increase. The price hikes temporarily increased churn, but these headwinds tend to be short-lived (at least, they have been for Netflix). That’s why management expects a rebound in Q4 FY23.
Parks & Experiences, and Products (PEP) have rebounded from the pandemic lows, but we need to zoom out. If we compare PEP to Q2 FY19 (pre-COVID), the segment grew only +10% Y/4Y. So that’s below 3% CAGR (compound annual growth rate) in the past four years, not even keeping up with inflation. Shanghai showed a strong bounce back after being closed during the pandemic, but it remains to be seen how long the bounce will last.
The quarter included a $150 million restructuring charge.
It will get worse before it gets better. Of course, that’s a theme Disney shareholders are familiar with since the stock has been flat in the past eight years.
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 $5.6 billion in FY23 (less than the previous $6 billion announced). Not enough to put free cash flow in negative territory, though. Management has been focused on improving cost efficiencies, starting with DTC.
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
DTC additions (or lack thereof)
Direct-to-consumer subscribers in Q2 FY23:
🔵 Disney+: 158 million (-2% Q/Q).
🟢 Hulu: 48 million (flat Q/Q).
🔴 ESPN+: 25 million (+2% Q/Q).
The subscriber growth has normalized, with the size of the audience crossing 100 million for Disney+ Core. From the beginning, management has presented numbers, including Disney+ Hotstar. However, these subscribers have a limited impact on the revenue, with an ARPU of only $0.59 per month.
Disney+ Hotstar just lost access to the Indian Cricket Premier League (to Viacom18, a joint venture between competitor Paramount and India's Reliance Industries), which was the reason behind the loss of millions of subscribers. In addition, at the end of Q2 FY23, the platform is losing HBO content, which will maintain pressure and generate more subscriber losses.
As a reminder, Disney’s numbers do not adjust for subscriber overlap brought on by the Disney Bundle (all three services for $19.99/month in the US, or $12.99 with ads).
Disney+ numbers include:
Disney+ Core: 105 million subscribers at $6.5/month.
Disney+ Hotstar (India): 53 million subscribers at $0.6/month.
For comparison, streaming market leader Netflix has a $12/month average revenue per membership.
I would expect Disney to catch up and apply regular price increases. Netflix has demonstrated pricing power over time, and we’ll have to see if Disney+ has a comparable moat.
Disney CEO Bob Iger had this to say about the recent price increase:
“We were pleasantly surprised that the loss of subs due to what was a substantial increase in pricing for the non-ad supported Disney+ product was de minimis. It was some loss, but it was relatively small. That leads us to believe that we, in fact, have pricing elasticity.”
As discussed in our recent review of the latest quarter from Netflix, the ad-supported tier already has a higher ARPU than paid plans. If the same logic applies to Disney, advertising is the most significant untapped potential for the DTC segment.
The next move for ESPN
Recently, the Wall Street Journal unveiled new details on ESPN's plan to launch a standalone streaming service. In its current format, ESPN+ only offers select programs, with premium content still reserved for cable viewers. The new approach aims to bring the entire ESPN content portfolio to streaming.
This shift seems inevitable but also marks a potential turning point for cable television. Live sports are one of the primary reasons many customers haven't yet cut the cord.
While this change poses a considerable challenge for the traditional linear networks segment, the real question remains: will DTC fully compensate for the anticipated shortfall in revenue and profit?
3. Key quotes from the earnings call
CEO Bob Iger (who returned six months ago) on recent business highlights:
“A few recent highlights include Marvel Studios Guardians of the Galaxy Volume 3, which topped the global box office in its opening weekend with $289 million. The first round of the NBA playoffs was the most watched ever across Disney networks, and we've been averaging 5 million viewers throughout the first 22 games, up 15% versus the comparable point in last year's playoffs.”
On the new organization since he came back to the corner office:
“Our new organizational structure is returning authority and accountability to our creative leaders, as well as allowing for a more efficient, coordinated, and streamlined approach to our operations.
The cost-cutting initiatives I announced last quarter are well underway, and we're on track to meet or exceed our target of $5.5 billion.”
One of Bob Iger’s first moves since he returned was to put power back in the hands of the creatives. He set creativity as the “number one priority” for Disney.
On the new bundle:
“We will soon begin offering a one-app experience domestically that incorporates our Hulu content via Disney+. And while we continue to offer Disney+, Hulu and ESPN+ as standalone options, this is a logical progression of our DTC offerings that will provide greater opportunities for advertisers while giving bundles of subscribers access to more robust and streamlined content, resulting in greater audience engagement and ultimately leading to a more unified streaming experience. We will begin to roll out this one-app offering by the end of the calendar year.”
On programmatic advertising:
“We've added more than 1,000 advertisers over the past year, and now have 5,000 advertisers across our streaming platforms, with over a third buying advertising programmatically today.”
Disney plans to launch the ad tier for Disney+ in Europe by year-end.
“We see this business as a key growth driver for the company.”
Even inflation beat the PEP (Parks, Experiences & Products) revenue growth compared to pre-COVID levels four years ago, so the track record is not so good when we zoom out.
On marketing re-alignment:
“As we've been looking at the structure of the company these past several months, what's become clear is that there is an enormous opportunity to harness our full potential by increasing alignment and coordination in marketing across our businesses. That's why I named Asad Ayaz our first ever Chief Brand Officer in addition to his role as President of Marketing for our studios. For years, our businesses have been incredibly successful in marketing our content, experiences, and products. And now with greater integration of our touch points with consumers, especially streaming, we're able to be more efficient and more successful in reaching the right audiences with the right offerings from across our businesses.”
CFO Christine McCarthy on streaming content cuts:
“We will be removing certain content from our streaming platforms and currently expect to take an impairment charge of approximately $1.5 million to $1.8 billion. [..] And going forward, we intend to produce lower volumes of content in alignment with this strategic shift.”
It’s safe to assume the attention to the bottom line will shift to subscriber growth (or lack thereof). Cutting content and raising prices is not a good recipe for user retention in a highly competitive environment.
4. What to watch looking forward
Nielsen measures US TV time market share and has documented the steady rise of streaming in the past few years.
Steaming was 34% of US TV time in April 2023, with Hulu at 3.3% market share and Disney+ at 1.8%. It should be clear why Bob Iger is interested in getting 100% of Hulu based on these numbers. With its general entertainment content, Hulu is, in fact, the most essential part of the bundle, almost 2X Disney+ in TV time.
Gaining market share remains critical for Disney because the share of Broadcast and Cable will continue to shrink. Disney must gain market share from other streaming platforms to regain a growth profile for its Media arm.
The Magic Kingdom’s Dilemma
The challenge Disney faces is a classic example of the innovator's dilemma.
This concept, introduced by Clayton M. Christensen in his book "The Innovator's Dilemma: When New Technologies Cause Great Firms to Fail," refers to the difficult choice that successful companies often face when they have to choose between holding onto an existing market by doing the same thing a bit better or capturing new markets by embracing new technologies and adopting new business models.
In Disney's case, the shift from linear TV (a successful, established business model) to streaming (a new, disruptive technology) is an instance of the innovator's dilemma. By embracing streaming, Disney risks cannibalizing its existing linear TV business. However, if they don't embrace streaming, they risk being outpaced by competitors who do.
While the right choice in the long-term might be to embrace the new technology or business model, in the short term, this can lead to losses, upset customers used to the old way of doing things, and internal resistance within the company. Hence, it's a tough but necessary decision to navigate for companies to stay relevant and competitive in the long run.
The implications of this transition are significant: Disney's operating profit in the past 12 months was 42% less than in 2015, and the company's stock has been stagnant for the past eight years.
Disney is not the only company facing this dilemma. A quick look at the performance of other legacy media companies transitioning to DTC shows the same story, from Warner Bros. Discovery (WBD) to Paramount (PARA). Their profitable ‘linear networks’ segments are dwindling, while their nascent and struggling DTC segments are taking over.
Disney has a multi-year challenge ahead, with significant investments in Direct-to-Consumer (DTC) platforms happening alongside the steady decay of legacy linear TV. Nevertheless, linear networks still account for most of the company’s operating income.
Given this dynamic, Disney finds itself caught in an operational dilemma for the foreseeable future: the 'rock' of linear TV in a secular decline and fated for obsolescence, contrasted with the 'hard place' of a currently unprofitable DTC business.
The silver lining here is Disney's robust portfolio of intellectual properties, which are evergreen and have the potential to engage audiences across generations. This multi-generation time horizon might just be what the company needs as it navigates one of the most significant transitions in entertainment history.
That’s it for today!
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Disclosure: I am long NFLX in the App Economy Portfolio. I share my ratings (BUY, SELL, or HOLD) with App Economy Portfolio members here.
Author's Note (Bertrand here 👋🏼): The views and opinions expressed in this newsletter are solely my own and should not be considered financial advice or any other organization's views.