AMM Dividend Letter Issue 24: How Long Can You Hold Onto Disney?
This is from the AMM Dividend Letter released November 19, 2015. If you want to see the latest “Dividend Stock in Focus” as soon as it’s released then join our mailing list here.
Would you want to own this stock and its 80% decline?
How about this one? Would you like to own this stock too as it declined 44%?
Trick question. It’s the same stock.
Clearly, this a terrible company reflected by a stock that has suffered at least 2 major declines over 40%. But, what if I told you this stock was Starbucks (SBUX) which recently hit a new all-time high. Those major declines exist within this chart amongst many other declines.
And on a Percent Return basis.
Would you want to own it now? I’m pretty sure the answer is yes.
The harder question is would you have been able to hold onto your shares the entire time? Could you have resisted selling your shares during any one of Starbucks’ declines? Would you have been able to resist selling after initially doubling or tripling your investment to hold for the 19,000%+ return?
With the benefit of our hindsight bias you may say “of course so, Starbucks was and is a high-quality company”. But if you were really honest with yourself you would admit that there was a very likely chance, perhaps > 90%, that you would’ve sold during a decline or too early after an initial gain.
We all want the 10,000%+ returning stock. We all want the next Apple, Microsoft, or Starbucks. Our hindsight bias fools us into thinking that finding them and then holding onto their shares for the incredible long-term returns is easy. It isn’t.
Finding high-quality, high-return businesses and paying a fair price for them is the relatively easy part. It’s basic math. The hardest part is gaining control over our emotions, overruling our instant reaction systems, and engaging our rational thinking system to avoid selling high-quality businesses at the wrong time.
Stocks are the longest duration asset in the investment universe; they can exist for decades and even centuries. The Bank of New York’s (BK) stock was the very first stock traded on the NYSE in 1792 and it still trades today. When you buy shares in a high-quality company time is your ally. They will do the “heavy lifting” of compounding your capital at above average rates. You just need to give them time to do so and not let your short-term emotional decision-making systems get in the way.
Dividend Stock in Focus
The Walt Disney Co. (DIS): $118.14*
*price as of the close November 18, 2015
In 1986, a computer graphics hardware group headed by Ed Catmull left their corporate parent to branch out on their own. Along the way, they picked up a $5 million dollar investment from Steve Jobs and named their group Pixar. Steve Jobs ultimately invested up to $50 million into the company to help keep it afloat as they tried to create a market for their computer hardware product, the Pixar Image Computer.
Before breaking away from their corporate parent, the group that would become Pixar hired John Lasseter a former Disney animator to make animated short films. The plan was to generate demand for Pixar’s hardware by showcasing the power & capabilities of the Pixar Image Computer. The plan failed. What Pixar didn’t expect were John’s animated short films becoming the highlight at SIGGRAPH, the major conference for the computer graphics industry.
Pixar’s hardware business never gained traction and the division was sold. Steve Jobs, the majority equity holder of Pixar, was even thinking about selling the whole company. During the tumult, Pixar’s animation division was blossoming and attracting a lot of attention. John Lasseter won an Oscar for Best Achievement in Animated Short films for Tin Toy. Then Disney came calling. Disney made a $26 million deal with Pixar to produce 3 computer animated films. The first full-length animated movie Pixar made was Toy Story in 1995, an immediate blockbuster. The surprise blockbuster stopped Steve Jobs from selling the company and instead repositioned Pixar for an IPO in 1995.
Then in 2006 Disney, the company that dismissed John Lasseter over his computer animation aspirations, realized the amazing potential of this new medium and bought Pixar for $7.4 billion in an all-stock transaction.
What about Pixar’s former corporate parent? They must be kicking themselves for letting the Pixar group go? Things turned out OK for them too.
Ed Catmull was originally hired by George Lucas and Lucasfilm Ltd. to head the Graphics Group at Industrial Light and Magic, the group that eventually became Pixar. Lucasfilm (Star Wars) was just bought by Disney for $4.05 billion bringing Pixar and Lucasfilm back together again.
Over the last 9 years, Disney has grown their dividend at a compound annual growth rate of 15.7%. Since the year 2000, Disney has paid an annual dividend in December of each year. Starting in 2015 Disney has moved to a semi-annual payment of $0.66 per share, a 14.78% increase over 2014’s annual payment of $1.15 per share.
Catalysts for Dividend Growth and Price Appreciation:
Disney is an extremely large and diversified media company. The long-term strategy under CEO Bob Iger has been building and acquiring “tent poles”, media brands that are their own major attractions. Disney then finds a way to generate more profits and cash flow from each major brand allowing Disney to outbid rivals for other “tent poles” in a virtuous positive feedback loop. It started with Capital Cities/ABC in 1995 and their ESPN Network and has continued with the most recent purchase of Lucasfilm and their Star Wars assets.
Disney bought Marvel for $4 billion in 2009. At the time, Marvel Studios had two hits, The Incredible Hulk and Iron Man. The other Marvel character-based movies were licensed out to other studios, Spider-Man to Sony and X-Men to 21st Century Fox. The purchase was considered a stretch but Disney saw the value in the hundreds of characters in the Marvel universe. Disney implemented a strategy to release a new Marvel movie every year.
Disney also introduced the mega-franchise movie model based on the Superhero ensemble The Avengers. Each character would have their standalone movies that tied into the next upcoming ensemble Avengers movie. The link-ins and tie-ins have made each movie a must see for fans of the Marvel Universe. It also helps that the majority of the movies are very well done. While they’re not winning an Oscar, they provide high-quality family entertainment.
Marvel is entering phase 3 of its movies as the original Avengers Superheros reach the end of their contracts and their current story arcs. We’ll see if the demand for Marvel movies wanes as Disney introduces lesser known Superheros. If Guardians of the Galaxy, one of the least known groups of heroes in the Marvel Universe, can achieve blockbuster status then the future looks bright for the Phase 3 movies.
Toy Story was Pixar’s very first full length animated movie. The initial draw of the movie was the new and unique use of computer animation. The novelty of computer animation initially brought people into the theater. Then as people watched Toy Story they realized the creative team at Pixar is a group of master storytellers whose chosen medium is computer animation. Pixar’s stories captivate the young and the old and it’s easy to see why each Pixar release reaches blockbuster status and why its characters immediately become loved around the world.
Pixar’s upcoming movie releases are a mix of characters both new and old.
“There’s been an awakening. Have you felt it?” – Star Wars VII: The Force Awakens
Glenn sure has; being one of the millions who crashed movie ticket sites nationwide after the premier of the 3rd Star Wars trailer. Don’t worry, Glenn was able to get tickets for opening night.
Star Wars: The Force Awakens is projected to be one of the highest grossing films ever. With how bad the Prequels were, this is a strong statement about the cultural phenomena that is Star Wars and the continued demand for all things Star Wars since 1977. Disney bought Lucasfilm and its Star Wars properties for $4.05 billion in 2012. Disney is using the same play-book it implemented after purchasing Marvel with plans to release a new Star Wars movie, canon or anthology, every year. With Episode VII expected to gross $2+ Billion in revenue, Disney’s purchase of Lucasfilm looks like a tremendous steal.
Besides the movie revenue, Star Wars is a merchandising powerhouse that has been added to an already industry leading merchandising business.
Creating a blockbuster movie is great for one time blasts of revenue and profits. However, Disney’s real strength relies upon its ability to create annuity-like cash flows from the licensing and merchandising of its beloved characters. Disney is the #1 licensor in the world with approximately $45 billion in retail sales last year. #2 Viacom generated $18 billion.
Retailers want to sell Disney owned properties and it allows Disney to negotiate contracts heavily in its favor. This has led to revenue and operating profit growth of 10.4% and 17.4% respectively at Disney’s Consumer Products division. Profit margins have expanded in recent years too.
Disney has 11 franchises earning over $1 Billion in global retail sales. This includes classic characters like Winnie the Pooh and Mickey Mouse as well as new franchises like Frozen and The Avengers. Recently added Star Wars will most likely be the 12th billion dollar franchise.
Star Wars parent Walt Disney Co., toy makers including Hasbro and Lego, and major retailers are gearing up for what could be the biggest licensing event of the year. What’s at stake for them? At least $1 billion in retail toy sales for 2015, according to experts, with all gear tied to the film expected to ring up $3 billion to $5 billion globally.
“This is going to be a $1 billion property” for toys, says Jim Silver, editor-in-chief of toy-focused website TTPM.com. “That’s going to be quadruple what it is in a non-movie year.”
Parks and Resorts
Over the last few years, Disney has spent around $4.6 billion improving and expanding older parks, building Disneyland in Shanghai, adding more cruise ships, and completing construction on Aulani Resort in Hawaii. The years of investment are starting to pay off as total revenue (both domestic & international) from Parks and Resorts grew 7% from last year. Domestic revenue grew at 8% and should continue to grow as the U.S. economy and consumer spending rebounds. Parks and Resorts account for 30% of Disney’s revenue and 20% of its before-tax operating profit. Parks and resorts is the most cyclical part of Disney’s diverse businesses and the most susceptible to downswings in the economy. For now the economy is still on the upswing, especially for the consumer, and Disney is finding ways to get its visitors to pay more per visit.
Disney’s most profitable business segment is it Cable Networks division which includes the Disney Channels,
ABC Family Freeform, A&E Networks, the SEC Network, the ESPN channels, and now an upcoming cable channel for Vice Media.
Disney’s cable networks currently generate 49% of Disney’s before tax operating profits. The Cable Network division generates revenue by selling advertising and charging cable operators like Comcast affiliate fees for carrying their channels. The original ESPN channel alone garners the highest affiliate fee amongst all cable channels at $6.55 per subscriber. The Disney Channel is 4th and ESPN2 is 9th.
Media consumption habits are changing. Viewers are moving away from linear TV towards time-shifted media consumption. People are watching TV shows when it’s convenient to them through DVRs, like TiVo, or through Over The Top Services (OTT), like Netflix and Hulu.
Live sporting events are tough to time-shift. You can do it, but it’s boring. You can’t share the moment with other fans. The demand for live sports is why ESPN can charge the highest affiliate fees. Given the shorter commercial breaks and the coveted demographics that watch sporting events, it is also why ESPN can charge some of the highest advertising rates too. ESPN also has annual 5% affiliate fee increases in its carriage contracts which should help drive revenue and profit growth in the years to come.
Pre-Mortem (Potential Risks to our Thesis):
The biggest risk to Disney’s profitability is its cable networks. More specifically ESPN. We will focus this section entirely on the risk to ESPN.
It was Disney’s earnings call back in August that started the massive sell-off in all media companies. During the call Bob Iger, Disney’s CEO, lowered their growth forecast for their Cable Networks division from high single digits to low single digits. The knee-jerk reaction was to assume that cord-cutting had reached a tipping point and cable subscriber losses would accelerate. This is bad news for all media companies that draw large amounts of revenue and profit from cable affiliate fees and even more so for Disney who charges the highest affiliate fees.
Millenials cutting the cable cord is a real phenomenon. Two of the main drivers are shifting viewing habits and cost. Traditional cable is expensive for people in college and just out of college. Especially when they see they can get their shows through Netflix or Hulu for about $10 per month. We think the expectations for a tipping point in cord cutting were a little overdone. Second quarter net subscriber reports include the end of the school year. There is a spike in cable subscription losses from college students ending leases and heading home for the summer. Also, AT&T and Directv were finishing up their merger and pulled back on promotions during the second quarter reducing subscriber gains. So far in the 3rd quarter cable providers are reporting better than expected cable subscriber retention.
On Thursday, Charter Communications Inc. said it added 12,000 video customers in the period, up from a loss of 9,000 in the year-ago quarter. Time Warner Cable Inc., which is being acquired by Charter pending regulatory approval, lost just 7,000 residential video subscribers compared with 184,000 in the same period last year. Earlier this week, Comcast Corp. reported it had substantially reduced its video subscriber losses.
However, the question remains is this a short-term disruption as the media companies and cable companies adjust to changing viewing habits or is this the start of a secular decline? For the next few years, affiliate fee increases for Disney’s Cable Networks far surpass the expected cable attrition rates but it is a trend we will need to monitor. Will millennials come back to cable as they get older and start families? Will they opt for skinny bundles or the traditional bundle? What happens to their OTT service usage when Netflix and Hulu have to raise subscription rates to remain solvent? What happens when cable companies charge users per data downloaded? There are a lot more questions about the future that we just can’t answer yet and, as always, we will need to monitor industry trends and update our thesis as the facts change.
Rising Sports Costs
The other aspect affecting the profitability of ESPN is the rising cost of sports rights. Recent firings and the non-renewal of contracts with top talent have all been claimed as evidence that sports rights costs are out of control at ESPN. Maybe. It could also just be run of the mill corporate bloat. For the last few years, it seems like ESPN hired every former professional athlete as on-screen talent and every show ended up having at least 5 hosts. The true stars of ESPN are the games, not the talking heads.
Regardless, the cost of acquiring the rights to broadcast sporting events continues to rise and the trend will most likely continue in the near future. If ESPN wrongly forecasts future revenue from cable subscribers while continuing to outbid rivals for rights then Disney’s most profitable segment could become the most operationally challenged.
We like owning companies with valuable and irreplaceable assets. Sometimes those assets are intangible and exists in the hearts and minds of the consumer. Disney owns a large collection of these intangible assets, from Mickey Mouse to Luke Skywalker. Disney’s stewardship and management of these beloved assets have propelled the company into one of the most valuable media companies in the world. We currently value Disney at $130 per share. During the summer when the market overreacted to Disney’s 2nd quarter earnings announcement, we were finally given an opportunity to buy Disney at a discount.
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