DIS - Disney's Intellectual Properties Need Better Economics

2023-12-01 11:59:39 ET

Summary

• Disney is a great long-term buy for patient investors who slowly build a position on pullbacks.
• The company has seen its IP feature-length multiplex business contract in recent years, most likely because of simple maturation of that model.
• As far as quality of content goes, Disney knows how to play that game - what it could learn instead is how to design more shareholder-friendly budgets for film.
• Disney may want to explore the idea of focusing on scripts over casting expensive stars - box-office take may be reduced in some cases, but so would overall risk.
• Risks to the thesis include bad movie slates continuing for longer than expected, future unexpected work stoppages by talent, issues with D+ streaming service, and overall market conditions driven by inflationary concerns.

No matter what anyone might say to the contrary, Disney ( DIS ) will eventually figure out its IP problem. The problem being, of course, some underwhelming box-office stats.

Keep in mind, things come in cycles a lot of the time, and the movie business certainly defines such thinking... one season you've got a hot slate, the next, things have gotten cold in a hurry.

Disney's next corporate iteration is on its way, and CEO Robert Iger (who will probably train an advanced AI system so that it can lead the company until the time of the expansion of the sun) seems motivated to prove that he can not only grow the company by expansion (Pixar purchase, Marvel addition) but also by contraction (rationalization of D+ costs, reduction of filmed-entertainment capital investment).

Speaking of contraction, Disney's multiplex business strategy has taken a hit. I'd like to talk about that here, as well as a few other points as we stand before the new fiscal year for the company.

Firstly, though, my take on the stock is that it remains a strong idea for a long-term portfolio. Averaging your buys over time is the wise move, buying on down days whenever possible.

Technically, at the moment, the stock looks good, as does the rest of the market. After the first of the year? I expect some selling as the Mr. Claus rally perhaps fades away (I just don't think we're out of the bearish woods just yet, especially as headline risk over predicted Fed tendencies begin to pile up in early January).

Valuation could be better, but some metrics are okay. And the company announced a return to paying dividends, declaring thirty cents per share (welcome news, but the dividend is of secondary priority to me over debt reduction).

Overall, it's an improving story... one that still has room for improvement.

IP Has An EP - Economic Problem

Disney has seen better times with its movies. It's not uncommon for a streak of hit films to suddenly go cold... that's just the nature of the beast. And in fact, that's why the content business is so potentially great: one never really knows if a new film, especially one which was designed to incubate a new intellectual property, will cause an inflection point or not; anything could become the next big thing. Best example given for this idea: Marvel, of course.

Just to put a recent example of a number on this story, the company's fourth quarter saw its content sales/licensing segment - which is partially driven by multiplex revenue - drop 3% on the top line to $1.86 billion and generate a loss of $149 million, which looked horrible standing next to the $8 million loss in the comparable period. What happened? The Haunted Mansion happened. It grossed globally less than $120 million; the domestic and international segments each took in well less than $70 million. Disney cited the project as a negative offset. Whatever horrors reside in that mansion, you can bet these stats are scarier.

As time goes on, what worked in the recent past may not work so well in the present... at least, not until an adjustment is made (and, obviously, I will get to some prescribed adjustments). This could be the case with Disney's acquisition strategy: IP acquired over Bob Iger's tenure has essentially matured in the face of competition for mindshare and, maybe even more specifically, timeshare (i.e., competition with social media, video-gaming, so on). To me, it's not entirely a problem of quality of production... the company seems to be doing mostly fine on that front. And it isn't choices necessarily either - as an example on this count, Pixar may have been weak with Lightyear , but it was a solid decision to make that project, as it extended a franchise and created merchandise opportunities, a strategy on which I am consistently, and vigorously, bullish.

Let's look at some box-office statistics to start the perspective.

The latest Ant-Man asset, released in 2023, took in $476 million in global gross theatrical dollars; both international and domestic had a $200-million-handle, with domestic coming in weaker at just over $200 million. The third Guardians of the Galaxy picture , from May 2023, generated a global gross of nearly $850 million, with domestic at nearly $360 million and international at $486 million. The final Indiana Jones with Harrison Ford couldn't even break $400 million worldwide or $200 million domestic... yes, the ultimate tallies actually came in below those already-low benchmark levels, believe it or not. The Little Mermaid , also from May of this year, captured $570 million from worldwide theaters, and was under $300 million of ticket sales for both of the domestic and foreign marketplaces. Recent superhero feature The Marvels is off to a weak start.

As many have observed, there wasn't a billion-dollar-haul among the bunch. Maybe most strangely on that count is Jones - if ever there should have been a billion-dollar film, that would have been it, as there is no question this will be the last iteration with the original lead.

I believe Iger is taking a spreadsheet approach to fixing the problem - in other words, he's being very careful about every new movie he greenlights to make sure it most likely will generate a decent ROI. It's not always possible to make any guarantees with features, but probably the biggest thing he can control is the amount of films he puts into production.

But is that the best way to go about the problem?

In my view, not necessarily; there might be a more optimal procedure to implement.

The more bets the company can make the better, and the best way to do that is by reducing budgetary costs. I've talked often about attempting to get stars to reduce their compensation quotes, but that could be a losing battle, at least in the shorter term; the bottom line is, stars such as Scarlett Johansson and Robert Downey Jr. will always have a certain (very large) number in mind... and if they don't, their team certainly will.

About the only thing Disney (or any major studio) can do is cast cheaper talent, which would equate to lesser-known, or even totally new, talent.

But how would Marvel creative head Kevin Feige feel about such a concept? He probably wouldn't like it, and it's understandable - he would want to control all aspects of production, and he's built up quite the relationships portfolio in Hollywood.

There was an interesting piece over at Fortune that highlighted some of the difficulties he's had in navigating Marvel (such as having too much content of which to keep track), especially in this new pandemic world. On the latter point: I am starting to wonder if some of Disney's problems - and perhaps some of the other studios' as well - could be linked to the idea that the shutdowns forced content consumers, especially younger ones, to shift their individual tastes and redefine in their minds what a blockbuster is these days. Think of it this way: today's blockbuster is a lot different than yesterday's blockbuster, and you can make any comparison you want - I'll suggest comparing Ghostbusters from 1984 with Ghostbusters from 2021... the cinematic genetics have evolved, and they are driven by a natural selection process collectively wielded by each successive generation of viewers. The pandemic may have changed the second derivative of change in this case, but of course, this kind of transformation over time happens every decade, from the time of silent films to the time of social media.

It may not be any more complex than that, and the fact that a lot rests on Kevin Feige's shoulders may be leading to an inflection point where returns diminish and, unlike the SARS virus, he can't mutate fast enough. If the kids prefer Super Mario over Ant-Man and Miles Morales over Ms. Marvel, then the problem isn't necessarily one of lack of addressable market because of contagion (at least with the youth), it may simply be that more time is needed to adjust, and budgets need to come down... now more than ever.

I say the latter - more than ever - because those who have read my articles in this space know I have beat this drum before. But, yeah, more than ever, Disney better rationalize content costs, and in an innovative way that goes beyond what it is doing now (i.e., Iger can't just rely on turning a D+ series whose blueprint originally called for five seasons into a single-season species to conserve capital).

I think one of the only solutions available is to separate the casting process from the storytelling/filmmaking-development process. Casting science is its own special beast, and whereas Feige and other creators (the writers, the directors, et cetera) can fantasize about which famous (read: expensive) thespian they'd like to hang around with during the making of a Marvel film, perhaps it would be more economical to be supplied a cheaper talent that nevertheless is as close to perfect for the role as possible. It would be similar to former Disney CEO Bob Chapek's engine (now disassembled) of separating the powers that make the content from the powers that distribute the content (i.e., one side makes content, the other decides whether it hits multiplexes or D+ or linear).

That met a lot of resistance, and Iger has since given back much of the influence over distribution to Feige and other creative execs (although mostly to Feige, I'm willing to wager). But what if Feige were told he was to use a newcomer in the role of an Iron Man reboot?

Besides causing a disruptive mutiny that would make the Sam Altman drama over at OpenAI look like a nothing event (and obligate Aaron Sorkin to stop working on an Altman script and start working on a Feige script, I would imagine), I honestly think it would reduce costs and allow filmmakers to focus more on story and structural development as opposed to focusing on film as mere vehicles for the investment portfolios of talent.

Yes, some may say that is a naive take in some respects, but Disney has to reduce costs somewhere to align its fiduciary responsibilities of shareholder-value generation with realistic panaceas.

The topic of alignment of interests is, well, interesting, because in this case, there is a large conflict of interest inherent in current compensation structures - being paid participation on box-office grosses. We'll never know the exact formulae used to calculate what star talent such as Tom Cruise or the Russo Brothers (directors of Avengers ) or Downey Jr. take from an overall box-office gross, and even then, I've read that Disney may do it differently, with bonuses given out once certain multiplex milestones are hit (gone are the days of first-dollar gross, of course, where a star could start making money before cash-breakeven, supposedly), but the principle is the same: profit participation on the backend, in addition to contingent payment upfront, can minimize what a studio should be making from any given digital-celluloid asset (I should note here the difference between profit participation and residuals, the latter guaranteed by contract with the unions; these payments cannot be negotiated away by studios, and even the big stars usually receive them).

We all recall the debacle during the height of the pandemic when Johansson complained about her Black Widow project being moved to D+ instead of theaters, arguing that this would minimize box-office potential and thus her profit-sharing checks; Bob Chapek, CEO at the time, countered that she would be properly compensated, and publicly pointed out that she would be generating better than $20 million for herself. This disclosure failed to make Chapek popular with anyone (except perhaps with me, since as a shareholder I would prefer knowing what talent is making as opposed to all the Hollywood secrecy around deal structures), but she was correct in the sense that, yes, streaming would by necessity cannibalize ticket sales. We were in a different time then, but even if we weren't, the principle would remain the same: Disney can maximize its multiplex business by looking at the bottom line instead of trying to always break records at theaters. That can't happen with top talent always driving a project; besides needing to write out big checks for all the star talent, the stars would want the company to spend profligately on marketing... again, a conflict of interest because to a Johansson and her team, the important thing is to maximize box office not only for bonuses, but to increase quotes for these industry players.

Completely understandable, I get that motivation. But just as Wall Street flipped the script on streaming and now demands profitability for D+ at the expense of subscriber growth, box-office grosses should maybe get a little more scrutiny in terms of their exact value - in other words, is beating a record always worth it? I concede that I love it when Disney breaks records... but I would love it even more if those broken records were driven with more clever and innovative casting decisions and/or contract-negotiating tactics. Understand, too, that I do not have any problem per se with current Disney casting choices beyond the issue of cost... any star from any of the recent portfolio of films is fine by me save for the capital investment required.

There is one salient argument counter to my thesis: ultimate multiplex-content profit - that is, once all ancillary channels of value are included, such as Blu-ray, digital sales/rentals, linear syndication, streaming, both on a domestic and international basis - is directly proportional to box-office gross. Yes, the lower a gross is, the lower sales are of physical discs, and so on. It's at least axiomatic if not a full-blown mathematical law.

Yet, the benefits of lower budgets and zero profit participation can be powerful, not only because of profit, but also because of added protection against lawsuits when the company sells content to itself.

Even trade magazines sort-of get the whole point of this. Deadline's take on Wish 's domestic Thanksgiving-weekend opening is not only that its ranking is weak, but its budget complicates things even further. Let me pull a brief quote for emphasis about Disney's new animated product:

Any argued similarities between the $30M opening of Trolls Band Together and Wish can be dashed: The former Uni/DreamWorks Animation movie cost $95M to the latter, which cost double. End point."

Two things: Yes, Wish opened to slightly over $30 million for the five-day period, and less than $20 million - again, less than $20 million - for the three-day Friday/Saturday/Sunday weekend. (Globally, the opening was just under $50 million.) What does this tell us? Well, Deadline theorized about the cartoon's quality factor:

They’ve seen this plug-and-play princess movie before, with the silly sidekicks (a talking goat and puffy star), and they can wait for this.

Also, it’s not clear in the trailers what this movie is about…wishing on stars? Critics observed and smelled this clearly..."

See, I don't think this is the problem. If you go over the concept of the film, and check out the trailer, quite frankly, to me, it seems like, on paper, this should have been a hit. I don't fault the filmmakers here. In fact, I can see Disney doing a cartoon with the subject of paranormal wishes powering it almost as a mandate, a contractual obligation, even. Plug-and-play is not necessarily a bad thing - if you find a solid formula, you want to stick with it; arguably, Disney has had a lot of luck with its formula in past decades. It totally makes sense.

What may not make sense, at least right now, is a $200 million budget. Disney may want to emulate Comcast's Trolls cartoon by figuring out how it can stretch a budgetary dollar as skillfully.

I concede I don't watch much Disney stuff, but seeing what has worked and how trailers present the concepts at hand, it's hard for me to understand how Disney has strayed too far from its base of quality. Yes, Iger has criticized his team for falling behind on that count, but let's say that is the case, let's say it isn't simply a maturing business model that needs more of a financial adjustment as I argue - given that, I would proffer that one of the only solutions available would be to take more control over the product away from expensive talent and focus solely on story and plot (two distinctly different things, keep in mind), visual presentation, marketability of concept, and distribution. Again, at least for now, gone should be the flexibility to spend enormous sums on directors and actors and all of it; when things pick up again, when Disney's luck at the box office improves - and yes, a reminder: at the end of the day, a movie's success or failure can be more about timing over artistic achievement than anything else - the company perhaps can invest again in exorbitant pay packages if the ROI projections justify it. Said another way, the company can once again be risk-on instead of risk-off as far as above-the-line assets are concerned.

Conclusion

Taking it all together, my feeling is that Disney remains a long-term investment idea for patient investors.

I believe the company will once again do well at the box office, because that is the nature of Hollywood - a movie slate is always a variable entity in terms of success and failure.

What Disney can control more directly - and what it could do a better job with - is how much it spends on making feature-length product.

I don't think Disney is doing a subpar job with the quality of its films. I don't see how the company is all-of-a-sudden a poor producer. I think it is more likely that, as time goes on, audience tastes change up and new things are needed, fresh approaches to concept, etc. (And to point something out: if you read between the lines, you'll note there is a nuanced difference between quality and adjusting the kinds of films one makes; think of what a hit zeitgeist-movie from the 1990s looked like then compared to a movie of today, as an example... would the former fare as well economically in today's marketplace?)

Using new talent, besides adjusting the risk of a film, has the potential added benefit of incubating the next generation of actors and giving the audience something it hasn't seen before; and with Disney's linear assets, it arguably has the opportunity to incubate cheaper talent all the time. Actors from shows on Disney Channel and Freeform (and even some D+ series) might be appropriate casting-wise (and appropriate price-wise) and could lead to decent returns, especially if they are used in conjunction with proper distribution models, particularly ones that hedge the bet (e.g., if box office is weaker than expected, use a 45-day multiplex window married with a 45-day Blu-ray/rental window, followed by placement on digital and D+).

Above all (in some sense), lower budgets could lead to more movies instead of less, which would lead to a larger library of content to license to third parties as well as D+.

Stock/Risks

From a valuation standpoint (at time of writing) as detailed by the Seeking Alpha quant system , DIS is more expensive than marketplace peers but many of the metrics are lower when comparing the stock to itself on a five-year-average basis. Add to that a good rating on the forward-PEG metric. Growth rating also looks good, and the stock has technically bounced off a low that begins with a 70-handle.

What does it all mean? To me, it means: don't enter into a position all at once. Given market conditions overall, as well as a probable retracement of the current rally, DIS will be volatile. Spread a purchase out over time, buy on down days, look for short-term support levels to improve buy points, and consider faithfully adding to a long-term position to reduce investment cost. If you have a long-term horizon and really believe in the stock (and aren't trading it), then doing the latter could be a focus as opposed to any technical considerations.

The risks with Disney are actually quite interesting these days; they have evolved over time. At one point, one might say this company was one of the lowest-risk equities out there - arguably, that has changed a bit, although I still consider it lower risk than other stocks (again, if you are willing to hold for a while).

Here's what you need to know vis a vis Hollywood's favorite Mouse:

• Disney's famous purchases of Pixar, Lucasfilm, and Marvel are perhaps maturing faster than expected... this may lead to extended underperformance of content, especially at the multiplex
• Wall Street is arguably currently giving a pass to Disney on subscriber growth of its D+ streaming service... in other words, the market will forgive Disney if it slips in subscriber count (up to a point, anyway) so long as it gets to profitability more quickly. However, that may not always hold, and Wall Street could immediately favor subscriber growth over profitability at any time (or, more frighteningly, it could want both at the same time, and Disney may have a hard time accomplishing the goal).
• Talent costs could rise precipitously over the next several years, especially if new guild contracts are signed, forcing the company to choose between volume of content and cost of content... that's not an easy situation in which to be.
• Linear assets may decline faster than expected.
• Guilds in Hollywood could go on more strikes.
• The market as a whole is still adjusting to the Fed and the battle with inflation.
• The stock once again pays a dividend, but it has been without one for a while, and it will need years to once again produce a solid history of payments.
• Black-swan events such as pandemics have now proved to be more real than we ever imagined.

Even with all those risks, yes, I am long Disney, and yes, I continue to add to my position. I believe streaming profitability will come at the expense of some subscriber growth and that Wall Street will balance that out in favor of the stock. I think the movie slate will come back, and I am counting on Bob Iger to switch around linear assets, either through sales or innovation, in ways that will catalyze DIS and generate value.

There's work to be done - especially on content budgets - but DIS is a buy on opportunistic pullbacks.

For further details see: