For decades, the Walt Disney Co. has displayed business powers so bewitching that the fabled storyteller could have been sporting the spell-spouting hat worn by the Sorcerer in its 1940 hit film Fantasia. In the musical masterpiece, Mickey Mouse dons the chapeau to essay his own tricks, but can’t control them, unleashing a nightmarish flood in the castle basement where he labors. Recently, Disney’s performance has been about as bumbling as its mascot’s phantasmagoric misadventure. The Mouse House admits that it pulled a Mickey—it got too cocky, lost its touch, and flooded the place. But just as its Mickey later rode to animated glory by mastering the pointed blue headgear to douse blazes and hurl fireballs, Mickey’s creator badly needs to follow its own mythology and regain its heroic might. To restore the magic, a returned Bob Iger is recasting the kingdom’s strategy for conquest in a shift just as radical as his charge to galvanize the flagging giant via daring acquisitions after first taking the reins in 2005.
Reviewing all the great companies renowned for providing strong, reliable shareholder returns in recent decades, it’s hard to think of any that have gone from prince to frog as fast as Disney. Indeed the stock now sells at 35% below its level of four years ago, showing that the markets take a dim view of its prospects. The entertainment colossus turned 100 this year, and it’s striving to accomplish what few enterprises save Coca-Cola have achieved: remain a powerhouse into a second century. But make no mistake, though Bob Iger was only gone from the CEO perch for under three years, he’s returned to a new world. Tom Rogers, former president of what’s today NBCUniversal Cable and ex-CEO of TiVo, and now executive chairman of GameSquare, believes that streaming’s low profitability versus cable will restrain Disney’s earnings for a long time to come, and the company’s being less than frank about the true picture. “They’re not putting forward a transparent enough analysis,” Rogers told Fortune. Rogers says that he wouldn’t buy any Big Media stock today, because “nobody’s proved” they make anywhere near the money on streaming that they’ve made on cable.
Still, Disney enjoys innate advantages over its streaming rivals from Old Media. A big one is its highly profitable and consistently growing collection of 12 theme parks, including overseas outposts in Tokyo, Hong Kong, Shanghai, and Paris. Another is Disney’s skill at sustaining powerful movie franchises from Star Wars to Avatar to Pirates of the Caribbean to Indiana Jones, and deploying the names across multiple platforms by creating superhero-themed attractions at the parks and selling branded merchandise. David Trainer, founder and CEO of investment research firm New Constructs, thinks Disney can stage a big comeback. “Disney has more ways to monetize content than any other media company,” he says. “If you’re convinced they can execute, the stock now looks cheap.” Adds Tim Nollen, an analyst at Macquarie Research, “I’ve said many times, the one company in traditional media most likely to succeed in direct-to-consumer is Disney. That’s because of the depth and breadth of the brand. Their numbers are moving in the right direction, and investors will reward the stock when they start to see earnings from streaming.”
Disney holds the best hand in a losing game. But is that enough to return to the double-digit annual returns that used to be as familiar as the turreted Disney World castle?
Three big mistakes caused Disney’s current woes
In its rush to streaming, Disney made three major errors. The first was its acquisition of 21st Century Fox in early 2019. The deal’s rationale was sound: securing giant libraries of “general entertainment” movies and TV shows to give Disney the extra content needed to launch direct-to-consumer at a running start. After divesting regional sports networks as required by the antitrust authorities, Disney paid a net $52 billion for the Fox assets. According to an analysis by private equity firm Trian, which launched a proxy battle versus Disney that it later withdrew, Disney vastly overpaid at over 26 times Ebitda, when comparable transactions were fetching about half that multiple.
In 2022, Disney’s entertainment group, even after subtracting the big streaming losses, earned $6 billion less than in 2018, according to Trian’s numbers, showing that the Fox assets proved a big drain on earnings. As Doug Creutz, an analyst at Cowen & Co., put it, “The Fox deal dramatically lowered Disney’s return on capital.” In a previous story on the Trian campaign, this reporter asked for Disney’s take on the Trian findings; Disney declined to comment.
A second mistake: Disney’s foray into stressing giant subscriber growth at the expense of profitability. At its investor day in April of 2019, then-CEO Iger set a goal of 60 million to 90 million subs for the core Disney+ platform by 2024. But Disney blew through that number in a year, and by the close of 2022 had amassed 164 million customers. Disney joined its rivals in a kind of arms race to rapidly swell its customer base at top speed and all costs, and for a while, the markets cheered, sending Disney shares to an all-time high in early 2021. But Disney spent huge on marketing, in large part to sign unprofitable customers on its Disney+ Hotstar platform in Asia, at fees one-sixth the level of the U.S. It also grew spending on content at four times the projection in 2019, far outpacing even the jackrabbit run for subs. For FY 2022 (ended in September), Disney booked a $4 billion loss in streaming, or one in every five dollars in revenue.
Third, Iger’s successor, Bob Chapek—who became CEO in February of 2020—radically changed his predecessor’s system of giving the content creators full authority over the financial performance of the shows and movies they produced. Instead, Chapek installed a “matrix” structure where a Disney studio, Lucasfilm, or Pixar Animation would reportedly “sell” its productions to a newly created, centralized unit called Disney Media and Entertainment Distribution, or DMED. That group took charge of the revenue side by marketing the creative output and deciding where it should be aired, whether in theaters, on cable TV, or on Disney+. Hence, the studios no longer controlled the full P&L for the entertainment they produced. Reports swirled that the reorg was causing big morale problems. The separation of expenses from revenues also likely lessened the incentive at a Marvel or Lucasfilm or Walt Disney Studios to carefully control the costs of making their shows and movies.
The stumbling streaming debut pounded both profits and the stock
Viewed from a high level, Disney’s poor performance, both in earnings and in stock price, arises from flubbing the most basic value equation in finance: It hugely increased capital, but made a lot less money than before it piled on the new debt and equity. From the close of FY 2018 to FY 2022, Disney increased its book equity base mainly through goodwill added from the Fox deal and retained earnings by $37 billion, while also growing its debt by $26 billion. Yet despite the $63 billion in fresh capital marshaled to support the streaming drive, adjusted net earnings fell from $10 billion to $3.1 billion.
Disney got a lot bigger—its revenues jumped in those four years by almost 40% to $83 billion. But the fall in profits, and stock issuance from the Fox transaction that swelled the share count by 22%, punished the stock. From the end of FY 2018 to mid-April, Disney shares fell 15% to $100 per share, and its total return was just a negative, annualized 3.3%. Over the same period, the S&P 500 gained 9.6% a year, and the S&P Media and Entertainment Index waxed by 6.4%. Even over a 10-year span, Disney has rewarded shareholders just over 6% a year, half the S&P’s record and three points below gains in the Media and Entertainment Index. In the spring of 2020, the pressure to support streaming forced Disney to suspend the dividend it had paid continuously for 64 years.
Iger’s return promises big, positive changes
On Nov. 20, 2022, Chapek departed and Iger returned as CEO. “The return of one of the best managers in the history of the entertainment industry is a major plus for the stock,” notes Trainer. Indeed, Iger lost no time is changing the playbook from an all-in on growth to an intense focus on profitability. On the first-quarter earnings call held Feb. 8, Iger pledged to pare the workforce by 7,000 jobs, or around 3%; lower content spending, excluding sports, by $2.5 billion; and slash $3 billion from overhead, with bloated marketing expenses as the prime target. Iger said he still wants to grow subscribers but at a measured pace, ensuring that the new recruits pay more in fees than the average cost of delivering the streaming platform they choose, Disney+, ESPN+, or Hulu, or a package that combines the services. “In our zeal for subs we got too aggressive in terms of promotion and pricing,” he said on the call. “We will grow only where subs are loyal and we can price effectively.”
The fall in cable TV earnings poses a major challenge
From a peak of around 105 million more in 2011, the cable industry’s roster of domestic subs has fallen by about one-third to around 65 million, and the downbeat goes on. Despite Disney’s success in raising prices, its operating income from linear customers has dropped from $9.0 billion in 2020 to $8.5 billion in FY 2022. Linear remains a sumptuously lucrative segment, clocking 31% margins last year. But both revenues and profitability are destined to keep dropping as more and more customers, especially among the young, cut the cord, and the shows command fewer dollars per minute of ads. “Ebitda margins in the streaming business may never get as high as they were in the linear business historically. But if they can someday get to this year’s expected level of 25%, that will be a big victory,” says Nollen.
Hence, at lower profits per dollar of revenue, Disney’s streaming services attract gigantic audiences, much larger than it ever saw in linear, to drive profits back to the flush days of cable. For shareholders buying in now, the four-year drop in Disney stock lowers the bar for how much it must earn to adequately reward them. Its current cap of $183 billion is only $12 billion higher than in late 2018. Since Disney’s added $37 billion in equity over those four years, the market has written off a staggering $25 billion, essentially as wasted money.
We’ll assume that from this depressed starting point, investors should expect returns of at least 10% a year to buy Disney stock. That means its market cap must double in seven years to $366 billion. We’ll use 2018, the year before the Fox acquisition, to get a bead on Disney’s normal earnings in its great days. In that fiscal year, Disney posted net profits of roughly $10 billion (after adjusting for a big tax benefit), and its P/E was 17.2. Using that multiple, Disney would need to be making $21 billion a decade hence to hand investors those 10% annual gains. By Fortune’s estimates, its required operating earnings, profit before interest and taxes, would be around $33 billion.
Let’s forecast the profits from each segment to determine what streaming must do for Disney to hit the mark. We’ll start with Nollen’s estimates through FY 2025, then use our own numbers for the four out years. By 2025, Nollen expects a fall in linear operating earnings to $6.7 billion. We’ll project they keep sliding at 6% a year from there, getting to $5.3 billion in 2030. Fortunately, growth in the parks should more than offset the shrinkage in cable. Let’s assume parks grow income at 8% a year from Nollen’s 2025 forecast of $10.5 billion, hitting $14.3 billion seven years out. That’s a modest estimate; Macquarie’s estimate for 2022 to 2025 is 10%. The licensing and theatrical distribution segment, a money-loser last year, should recover fast as cinemas recover from COVID—Disney’s new megahit Avatar: The Way of Water is a reminder of its films’ potential at the box office. Plus, Iger suggests he’s willing to license far more of Disney’s library, closely guarded in the past, to other channels in the years ahead. Say licensing and theaters reach $1.5 billion by 2030. All told, those three businesses promise $21 billion in operating profit.
That leaves one heck of a hole, namely $12 billon, to reach the $33 billion in operating profit needed for a 10% annual return starting from today. And it all must come from streaming. Once again, we know that streaming will never offer margins as big as in linear. But it’s potentially a much, much bigger business for Disney and its rivals. That’s because it’s a lot more international, and Disney boasts, partly because of the parks’ success in Asia, the brands with the broadest global appeal. Disney should be able to at least equal Netflix’s current margins of 18%. If so, its bogey would be around $65 billion in streaming revenue by 2025. At a probably feasible 20%, the target drops to $60 billion.
Can Disney possibly grow its streaming business that fast and that profitably? Today, revenues are running at an annual rate of $21 billion, meaning growth of 17% a year is required. Disney’s already showing it has a wide berth to raise prices. In December, it lifted fees for Disney+ from $7.99 to $10.99 a month and lost few subs, while also successfully launching an ad tier. Most of all, just look at the world’s hunger for entertainment, and especially Disney’s. Fortune Business Insights (no relation to Fortune Media) projects that global streaming revenues will explode 3.5-fold to $1.7 trillion by 2029.
Because Disney’s starting from a deep hole of its own making, the revival will start slowly, and take a long time. Investors seeking a sudden upswing from a big, quick profit pop will be disappointed. It may take several years for Disney to show the big momentum, courtesy mainly of a gigantic global market craving both new and classic entertainment, that will reprise those old-time profits. In Fantasia, Mickey dozed off and needed the Sorcerer to cast the right spell and stop the flooding. Disney investors are hoping that Iger brings the touch that once made its stock as sorcerous as its fabled brands.
