Here’s What Investors Should Make Of Disney’s New Streaming Service

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Disney (DIS) shook the financial markets when it reported earnings for its third quarter of fiscal 2017 (which ended July 1).

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It wasn’t the company’s financial performance that shocked investors. Rather, Disney announced a significant strategic change that will change the way the House of Mouse does business in the years to come.

Disney is breaking away from Netflix (NFLX) and ESPN’s television network providers and building two separate in-house streaming programs, one for each of original content and live sports.

The markets did not appreciate this news. Disney’s stock is down approximately 5% since making the announcement.

However, there’s actually a lot to like about Disney’s new content strategy. Data suggests the company has the capability to realize significant financial upside and benefit from other ‘soft’ advantages after building out its in-house streaming capabilities.

This article will provide a quick summary of Disney’s third quarter financial performance before discussing the implications of Disney’s new content streaming strategy, particularly as it relates to long-term dividend growth investors.

Financial Performance Summary

Disney’s financial performance was typical of the media giant in recent quarters: stagnant revenue growth and a modest decline in adjusted earnings-per-share.

More specifically, the company’s third quarter adjusted earnings-per-share decreased by 2% from the prior year’s period, coming in at $1.58 (from $1.62 previously).

For the nine-month period, Disney’s adjusted earnings-per-share of $4.63 came in slightly better than 2016’s figure of $4.61.

Additional measures of Disney’s financial performance during the third quarter can be seen below.

Source: The Walt Disney Company Third Quarter Earnings Release

On a segmented basis, Disney’s recent financial performance has varied significantly between its operating units. This is a trend that continued in the third quarter.

Disney’s four reporting segments are:

  • Media Networks (which, importantly, houses ESPN)
  • Parks and Resorts
  • Studio Entertainment
  • Consumer Products and Interactive Media

Each segment exhibits different behavior based on underlying qualitative factors.

The Media Networks segment has experienced declining revenue and operating income because of ESPN subscriber reductions.

The Parks and Resorts segment has experienced a significant expansion as parks are opened in new international locations and additional sections are added to existing locations. More specifically, the Parks and Resorts segment has added a park in Shanghai in 2016 as well as an Avatar section at Disney World. Disney is also adding an important Star Wars section to Disney World in 2019.

The Studio Entertainment segment has a high degree of performance volatility, as it is dependent on the release schedule for Disney’s new movies. However, this segment has the potential to be the company’s strongest performer over the next ~5 years given its remarkable slate of Marvel, Star Wars, and Disney productions set to release during that time period.

Lastly, the Consumer Products & Interactive Media segment is the smallest segment, and has shown top and bottom line shrinkage as of late.

The following table shows Disney’s segmented financial performance for the three- and nine-month period ending July 1, 2017 compared to the prior year’s period. As you can see, there is evidence of each of the trends I explained above.

Disney

Source: The Walt Disney Company Third Quarter Earnings Release

Here’s what the company’s chief financial officer had to say about the company’s quarterly financial performance:

“Our results for the quarter reflect the underlying strength of our brands and franchises, and our continued investment in high-quality content. Our ability to successfully execute on our core strategy, coupled with our plans for new direct-to-consumer offerings, give us continued confidence in our ability to drive shareholder value.” – Christine M. McCarthy, Senior Executive Vice President and Chief Financial Officer, The Walt Disney Company

Altogether, Disney’s third quarter financial performance was in-line with the expectations of the investor community.

It was the company’s new content streaming strategy that really shocked investors.

The New Content Strategy

The new content strategy that Disney has announced is largely centered on bringing the company’s content streaming capabilities in-house.

Following details of the company’s investment in BAMTech (more on that later), here’s Disney’s CEO describing the seismic shift to the company’s strategy:

“Today we announced a strategic shift in the way we distribute our content. The media landscape is increasingly defined by direct relationships between content creators and consumers, and our control of BAMTech’s full array of innovative technology will give us the power to forge those connections, along with the flexibility to quickly adapt to shifts in the market. This acquisition and the launch of our direct-to-consumer services mark an entirely new growth strategy for the Company, one that takes advantage of the incredible opportunity that changing technology provides us to leverage the strength of our great brands.” – Robert A. Iger, Disney’s Chairman and CEO

Beginning in 2019, Disney has announced that it will no longer license its content to Netflix. Instead, Disney will be creating its own subscription-based streaming service for its original content, which the company’s CEO has stated will be ‘unlike anything else in the market’.

The scope of the original content that Disney will pull from Netflix is somewhat unclear. Disney executives have clearly stated that any pure-play Disney content (think Toy Story, Frozen, or The Lion King) will be pulled from Netflix, but the future of content created by Disney’s Studio Entertainment subsidiaries is, as of right now, quite vague.

There are two content categories that the investment community is particularly curious about:

  • LucasFilm content (Star Wars)
  • Marvel content, particularly the Netflix-specific content (The Defenders, Luke Cage, Jessica Jones, Daredevil, and Iron Fist)

On Disney’s third quarter conference call, an analyst inquired about the inclusion of these franchises on Disney’s new streaming service. Here’s the full response from Disney’s CEO:

“The disposition of the Marvel and Lucas or Star Wars films, we have not determined yet. We’ve had a discussion internally about how best to bring them to the consumer. It’s possible we’ll continue to license them to pay-service like Netflix, but it’s premature to say exactly what we will do. We certainly have that opportunity. There’s been talk about launching a proprietary Marvel service and Star Wars service, but we’re mindful of the volume of product that would go into those services, and we want to be careful about that.

We’ve also thought about including Marvel and Star Wars as part of the Disney-branded service, but there where we want to be mindful of the Star Wars fan and the Marvel fan and to what extent those fans are either overlapped with Disney fans or they’re completely basically separate or incremental to Disney fans. So it’s all in discussion. But we will say is that Disney Pixar will definitely part of this and not be part of any other pay window distributor in the United States. And disposition of Marvel and Star Wars we’ll announce at a later date when we’ve determined what to do.”

In addition, Disney will be creating a second in-house streaming service. Instead of being focused on original Disney content, this second streaming service will be focused on sports – those that were traditionally delivered through Disney’s ESPN television network.

While Disney’s original content streaming service will launch in 2019, the ESPN streaming service will start ‘early next year’.

Disney’s CEO Bob Iger has stated that Disney has not yet discussed the new sports streaming service with ESPN’s existing TV distributors, but it is expected to be highly beneficial for consumers. The streaming service has a high likelihood of being more affordable than the existing ESPN package, while Iger anticipates streaming an additional 10,000 sporting events over what is presently available on the existing ESPN service.

So why the sudden, significant change in strategy for the House of Mouse?

Well, these two new streaming services were made possible through Disney’s investment in streaming technology company BAMTech.

Disney already had a stake in BAMTech, but is paying $1.58 billion for an additional 42%. Here’s how Disney’s CEO Bob Iger described the investment on Disney’s third quarter conference call:

“Last year, we acquired a substantial stake in BAMTech to help us scale and monetize our streaming capabilities. Since then, we’ve been increasingly impressed with the platform, the leadership, and the potential to drive growth. So much so that we’re investing an additional $1.6 billion to increase our stake from 33% to 75% and acquire control of the company. This move gives us immediate access to the team and the technology we need to deliver the highest quality direct-to-consumer experience, which ultimately gives us much greater control of our own destiny in a rapidly changing market.”

Previously, BAMTech was owned by MLBAM, the internet company owned by Major League Baseball.

What This Means For Dividend Growth Investors

By and large, we believe that investors should welcome this strategy change from Disney, particularly after considering the potential impact this might have on the company’s ESPN subscriber base.

There is plenty of evidence to suggest that this is a win for Disney’s investors.

First of all, Disney’s existing partnership with Netflix, announced in 2012, is estimated to generate $350 million per year for the House of Mouse.

Once Disney cancels this partnership in early 2019 and begins charging for its own subscription service, it is highly likely that this revenue will be easily replaced. The following chart shows the number of subscribers required to replace Disney’s current Netflix revenue at varying price points for its new streaming service.

Disney

For context, Netflix currently has more than 100 million subscribers.

The opportunity for Disney here is huge. There are approximately 25 million U.S. households with children aged two to 14, which doesn’t account for the possibility of international subscribers. In addition, fellow Seeking Alpha contributor Kevin Fulmer has shown that there are 65 million people who ‘like’ the Disney and Pixar pages on Facebook.

After considering these data, I believe that Disney is easily capable of reaching the 5.8 million subscribers necessary to replace existing Netflix revenue, and any streaming customers beyond that point represents upside for the company.

In addition, Disney will continue to generate revenue from Netflix if it continues to allows Marvel and Star Wars content to be streamed over the Netflix platform. While this would likely result in a lower price point for Disney’s proprietary streaming service (since there is less content associated with it), it also means that less streaming revenue would need to be created to make up for the Netflix opportunity cost.

Aside from direct financial benefits, there are soft advantages to Disney’s new content strategy.

Disney will now have direct access to consumer behavior, allowing the company to best understand what its fans want. Disney can then tailor its new content accordingly.

All of this upside exists without considering the implications of Disney’s new ESPN streaming service. Sports fans are notoriously loyal, and giving them the ability to easily stream live sports on their television, computer, or mobile phone presents tremendous upside for Disney’s business. Disney has indicated that the ESPN streaming platform will be made available through the existing ESPN app, which should help boost adoption rates among existing ESPN consumers.

Altogether, Disney’s new content distribution strategy provides a welcome change for the company and appears to be beneficial for the company’s long-term shareholders.

Final Thoughts

Although the markets may disagree, it appears that Disney’s new content distribution strategy has the potential to be a significant win for the company’s investors.

Even if the company can generate a modest 10 million subscribers on its new service, it will generate significantly more revenue than its existing partnership with Netflix.  Even before the announcement, we preferred an investment in Disney to Netflix.  The same is true now.

Disney will also benefit from the other ‘soft’ advantages of being both the content creator and content distributor. By having a deep, personalized knowledge of consumer behavior, Disney should be capable of tailoring its content creation strategy to best meet the desires of its customers.

So what should investors make of Disney’s price drop?

Remember, this is arguably the strongest media company in the world. Disney has grown its earnings and dividends at 14.0% and 19.0% per year, respectively, over the past decade.

In addition, Disney has many endearing characteristics from a qualitative point of view. The company is well-managed, has one of the strongest brands of any company worldwide, and is well-positioned to grow over the next decade thanks to a strong studio production schedule and its new content distribution schedule.

Disney is trading at a price-to-earnings ratio of 16.9 (using 2017’s expected earnings) after its recent price drop. This is just slightly above its ten-year average of 16.3.

Accordingly, Disney is a potential buy after the announcement of its new content distribution strategy.

Article by Nick McCullum, Sure Dividend

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