Disney's Not Just a Mickey Mouse Investment

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The crown jewel of Disney’s media networks segment is ESPN. It dominates domestic sports television with its 24-hour programming on ESPN, ESPN2, and its growing sister networks. ESPN has exclusive rights with NFL and college football, the premier sports programming rights in the United States. It profits from the highest affiliate fees per subscriber of any cable channel and generates revenue from advertisers interested in reaching adult males ages 18-49, a key advertising demographic that watches less scripted television than other groups. This dual income stream is a significant advantage not shared by the broadcast networks, which rely primarily on ad revenue. The Disney Channel also benefits from attractive economics, as its programming consists of internally generated hits with Disney’s vast library of feature films and animated characters. We expect the unique content on ESPN and Disney Channel will provide the firm with a softer landing than its peers as viewing transfers to an over-the-top world over the next decade.

Disney's other components rely on the world-class Disney brand, sought after by children and trusted by parents. Over the past decade, Disney has demonstrated its ability to monetize its characters and franchises across multiple platforms--movies, home video, merchandising, theme parks, and even musicals. The stable of animated franchises will continue to grow as more popular movies get released by the animated studio and Pixar, which has already generated hits such as Toy Story, Cars, and most recently Frozen. Similar to the animated franchises, Disney arranged the Marvel universe to create a series of interconnected films and product tie-ins. With the acquisition of Lucasfilm, Disney appears to be positioning the Star Wars franchise in the same manner. Disney's theme parks and resorts are almost impossible to replicate, especially considering the tie-ins with its other business lines.

It's a Wide Moat After All Disney's economic moat is wide. Its media networks segment and collection of Disney-branded businesses have demonstrated strong pricing power in the past few years.

The ESPN network is the dominant player in U.S. sports entertainment. Its position and brand strength empower it to charge the highest subscriber fees of any cable network, which in turn generate sustainable profits. ESPN uses these profits to reinforce its position by acquiring long-term sports programming rights, including the NFL, the NBA, and college football and basketball. The ESPN brand has been extended to create sister channels (ESPN2, ESPN Classic, and SEC Network) and the pre-eminent sports news website (ESPN.com).

The media network component also includes the Disney Channel, one of two dominant cable networks for children, which allows Disney to introduce and extend its strong IP and content portfolio. ABC, one of the four major broadcast networks, offers an outlet to reach almost all 116 million households in the U.S. While network viewership has declined over the past decade, it still outpaces cable ratings and provides advertisers with one of the only remaining avenues for reaching a mass audience.

Disney has mastered the process of monetizing its world-renowned characters and franchises across multiple platforms. The company has moved beyond the historical view of a brand that children recognize and parents trust by acquiring and creating new franchises and intellectual property. Recent success with the Pixar and Marvel franchises has helped to create new opportunities with adults who may have outgrown their attraction to the company’s traditional characters. The acquisition of Lucasfilm added another avenue to remain engaged with children and adults. Disney uses the success of its filmed entertainment not only to drive DVD sales, but also to create new experiences at its parks and resorts, merchandising, TV programming, and even Broadway shows. Each new franchise deepens the Disney library, which should continue to generate value over the years.

Turn Away From Pay TV Could Hurt Disney's results could suffer if the company cannot adapt to the changing media landscape. Basic pay-television service rates have continued to increase, which could cause consumers to cancel their subscriptions or reduce their level of service. ESPN garners the highest affiliate fees of any basic cable channel, and a decrease in pay-TV penetration would slow revenue growth. The cost of sports rights may continue to skyrocket, putting pressure on margins. The company's ad-supported broadcast networks, along with the theme parks and consumer products, will suffer if the economy weakens. Making movies is a hit-or-miss business, which could result in big swings in profitability for the filmed entertainment segment.

We believe Disney’s financial health is solid. Debt is a low percentage of total capitalization, and we expect EBITDA to cover interest expense more than 30 times on average during the next five years. We expect future cash flow to be allocated among smaller acquisitions, share repurchases, and dividends.