Investment Activity Review - May 2016

The play in 2016 has been about interest rates staying low which would logically see the US$ get weaker. Toward the end of the month that narrative was in question as the talking heads at Club Fed started musing that rates may go up again in June if the “numbers” hold up. That concept caused me to make a few moves in the month.

Sold position Gold ETF (Ticker: CGL)

Building on the premise that interest rates actually do rise, this would imply that the US$ would increase in value relative to the Canadian dollar. Following this mind map, a rising US dollar could put downward pressure on commodity prices like oil and gold as there tends to be an inverse relationship between commodity prices and the US dollar. The point of holding gold was to hedge any depreciation of the US$ which would impair my US stock holdings. A rising US dollar would make it unnecessary to hedge any position, so I decided to sell my gold ETF positions.

Added to short position in S&P500 via Ticker: HSD

With the Fed signalling up until now that they may back off hiking interest rates in the near future, stock prices have been rising again. Not good for my ongoing short position. Yet again and like a broken record, I used the pop in the S&P 500 to continue to average down my short position. I still maintain that asset prices are inflated and subject to a major pullback at some point. Again I have no idea when.

Added to position in Nordstrom (Ticker: JWN)

At one point I had been up nicely on the position but then that came to an end when the company reported a bad quarter and forecast and like all luxury retailers, they got taken down a notch.  I used the pullback as an opportunity to average down the position using a stronger Cdn$ to do some cross-border shopping.

Added to position in Tiffany (Ticker: TIF)

The first time I bought into Tiffany, I bought the shares ($60.87 US) costed me about $894 for 10 shares. When I bought in May another 10 shares, it costed me $889 and this is with the share price at US$71.10. So even with share price up 13-14% in USD terms, I was able to get the shares at the original purchase price.  And they say currency doesn’t mean anything.  If I was going to live for 500 years sure, but my time horizons are much shorter (i.e. 10-20 years) and any blip makes it hard to take a mulligan.

Opened position in Disney Corp (Ticker: DIS)

Disney is one company I’ve had on my List for what has been ages. I’ve never been able to buy it especially over the last year as the stock just has kept going up and every time I think it’s expensive it moves even more.  It has up until now been a darling of Wall Street and it is has taken a bit of a hit recently and as you probably know by now, stocks of well known, best of breed companies that take a hit, will always get my attention. So I decided to dive into Disney. I also thought it would be interesting as about 5 years ago when I was completing my MBA, some colleagues and I wrote an analysis of Disney’s strategy and I thought it would be interesting to see how much of our MBA’esque thoughts have actually panned out. Let’s take a look. As always my analysis involves answering those important 8 questions.

Q1: What do they sell?

Here’s the corporate definition per Reuters,  Disney “is a diversified international family entertainment and media enterprise with five business segments: media networks, parks and resorts, studio entertainment, consumer products and interactive media. Media Networks comprise an array of broadcast, cable, radio, publishing and digital businesses across two divisions the Disney/ABC Television Group and ESPN Inc. Walt Disney Parks and Resorts (WDP&R) is a provider of family travel and leisure experiences. The Walt Disney Studio brings movies, music and stage plays to consumers throughout the world. Disney Consumer Products (DCP) delivers product experiences across thousands of categories from toys and apparel to books and fine art. Disney Interactive is a creator of interactive entertainment across all current and emerging digital media platforms. “

Disney is simply an entertainment company.  I would not put it on my core investing pillars as I’ve said that when it comes to life necessities that entertainment is something we could potentially live without.  That being said, Disney is still a business and one of the great brands and icons in the world. It can’t be ignored.

Disney has been always the House of Mouse. It still remains the company’s primary ambassador. However over the years, the company has consciously made an effort to broaden and modernize its brand. Mickey Mouse and Donald Duck have been replaced by Elsa, BB8, Nemo, and SportsCenter. In fact when you really look at it, the company is more ESPN than it is Mickey Mouse. It didn’t happen by accident.  In the last 10 years Disney has made significant investments in Intellectual Property paying almost $15.5 billion to acquire, Pixar, Marvel Inc, and LucasArts which contain the most iconic characters and stories in the entertainment industry.  At the heart of Disney strategy is creating some of the most prolific and durable content and build an infrastructure and supply chain to ensure that content gets out there in various products and formats. This isn’t something new. It has been embedded into the DNA by Walt Disney himself. He even mapped it out to show all the relationships how they must all work together rather than in stovepipes. It’s an incredible image.

Mr. Disney's vision

Mr. Disney's vision

Q2: Who do they compete with?

Disney competes with other entertainment conglomerates such as Time Warner, CBS Corp, Comcast Corporation. Like Disney, these companies contain numerous enterprises that cater to the development and distribution of entertainment content through a variety of media channels.

Q3: Who buys their products and services?

My kids buy their products. My friend’s kids buys their products. If you like sports, you will watching be any major chamipionship level sports through ESPN. If you’re all about the new or old Star Wars, you are now a Disney customer.  What was once a kiddy company now has a mass-market appeal to various demographics.

Q4: Will they buy their product over and over again?

Apparently one cannot have enough Frozen dresses and Chewbacca masks. The key to their strategy of developing and multi-channel selling their franchises is to generate repeat business and loyalty to the characters and be relentless at doing it. Their proficiency to do this is quite incredible.

Q5: Do they make money?

Source: Valuentum Securities

Source: Valuentum Securities

The company is generating returns on invested capital in the 10-12 percent range that are slightly greater than its cost of capital which comes in around 9 percent. Not a huge margin, but when you are dealing with large conglomerates like Disney even low margins can still generate significant Economic Profit.

A big chunk of their revenues comes from the cable side, especially ESPN. They have had incredible pricing power and have been able to command among the highest cable fees in the industry, fees that are predictable and consistent. Investors like that.

The company paid $4 billion for Lucas Films and from what reports I’ve seen they estimate that they will make that investment back in another 2 years (i.e. by the time the latest trilogy has run its course). After that it’s all gravy.   2 years! That’s insane.

Q6: What do they own and who do they owe money to?

As to be expected when you are dealing with a company that revolves around content, intellectual property, branding, and character franchises, Disney carries a fair bit of Goodwill and Intangible Assets, mainly as a result of its strategic purchases of franchises such as Marvel Comics and the portfolio of characters as well as the recent Start Wars franchise. Despite this, intangible assets represent only 25% of total assets. I thought it would have been higher. Its debt level is manageable with a debt/equity ratio of 0.25. This tells me that they have been able to organically fund a good chunk of their acquisitions.

Q7: How risky is their business?

Entertainment is a show-me now business. As much as you can keep pushing the Mickey Mouse/Disneyworld motif consumers want more and something different. Up until the last 10-15 years, Disney was heavily dependent on the mouse pipeline and it made the company stale. It woke up and realize it had to start being more than that and hence the shopping spree to modernize their portfolio.  Consumers are fickle and it’s hard to know what will work and what won’t.  Not every movie will be a Frozen. Disney has had their share of disasters as well (rememberJohn Carter, Lone Ranger, and Tomorrowland?) One mindset the company has developed is when a movie doesn’t pan out, it’s buried right away never to be spoken again. Failure and long memories never linger at Disney.

Distribution: A new paradigm…eventually

The company has also made some strategic distribution moves that in the short to medium term put it at a bit of disadvantage. The big one is the arrangement they agreed with Netflix in 2012 to allow Netflix exclusive rights to stream Disney content until 2020. the majority of Disney’s direct-to-video content would be exclusive to Netflix starting in 2013, as well as much of its extensive back catalogue. And in 2016, the service would also become the exclusive over-the-top home of the entire Disney library, including all films made between 2012 and 2016, as well as any released through 2019 or 2020. Disney is making only $300 million per year out of this (0.5% of 2015 revenue). A lot of observers panned the deal. If you want to know how Netflix became a juggernaut, this deal had a lot to do with it.

So Disney from a distribution perspective has painted itself into a corner. The good news is that they didn’t sign some ridiculous 50 year deal. There is daylight in that when the deal expires in 2020, the company can do whatever it wants. Given the way technology and streaming work now, the environment is there for Disney to create its own echosystem much in the way Walt Disney envisioned it more than 80 years ago. According to the Redef  group they could see Disney evolve in the following manner:

“When the Netflix deal ends, I’d bet that the entire Disney catalogue will instantly move to a new Disney O&O service. The fact that it was all contained, used and watched in one place not only creates a stronger ecosystem around Disney content, it gives the audience a single point of transition. All of a sudden – and nearly a decade and half after Netflix, Amazon Video and Hulu launched – we’ll have a massively scaled Disney subscription service. And contrary to popular belief, insiders suggest it will include Disney’s Netflix series, too.

But this Disney subscription service will likely go far beyond just video content. It will also bundle in access to all Disney comics, books, apps, digital games and albums (Frozen!), as well as Disney’s network television portfolio. In addition, subscribers will benefit from discounted theme park passes and merchandise promotions, and in time, the ability to purchase ‘day & date’ theatrical content, too. The groundwork for this, though modest, already exists in Disney’s children-focused UK service Disney Life. While we’ll likely see individualized subscriptions at lower prices (i.e. everything Star Wars, everything Marvel), the core of the offering will be, in effect, Disney as a Service2 (“DaaS”). With new multi-media content released daily.

By creating a consolidated offering, Disney can diversify its business away from individual title/product successes and with it, the rollercoaster nature of a hit-based business. Instead, the company’s focus will be on the whole Disney offering – every additional unit of content contributes to the consumer experience instead of driving its own end-to-end P&L3. Similarly, direct distribution will enable the company to better ensure the “Disney Magic” by reducing its reliance on 3rd parties, and to grow Disney’s share of Disney IP-driven revenues. And if Disney’s platform filmmaking strategy works, there should be significant value arbitrage in bringing all content in house versus licensing individual content categories to independent services, such as Starz or Netflix.

Walt detailed an expansive vision for Disney – one where every segment of the business worked in concert. They would develop shared IP, foster shared creative talent and use shared managerial, promotional and financial infrastructure to tell stories that would define generations. Despite the success of this model, Disney was still in the business of selling content: an hour, an episode, a book, a movie, a joke. It couldn’t deliver a sustained experience, establish true direct-to-consumer experiences or escape the tyranny of product and segment P&Ls.

The shift to Disney as a Service will be so significant because it will allow Disney to transform from a company about products, titles and characters to one that sells entertainment ecosystems. Instead of “hiring” Disney for 90 minutes or 30 pages, audiences will hire the company to tell them stories year round and across a multitude of different mediums and formats. This is uniquely possible today”

The future will be about having direct control over content. No more middlemen to distribute. Technology allow you control it and charge a premium for it.

Cutting the cord to their own middle men

The cash cow for Disney has been the ESPN/ABC family of cable channels. Having predictable cashflows coming and the pricing power to charge a premium for it has been the golden goose for Disney. Again technology is threatening this paradigm as more people are seeking alternative forms of accessing content and cutting the cord to their cable package is becoming a more compelling argument. What was once a niche fringe is getting some traction. Recent earnings reports show subscriptions to ESPN dropping which is unheard of, despite the channel owning broadcast right to some of the most watched live sports content around. The stock market is worried about this. People love ESPN. They just don’t want to pay what there asking. Again here is where a potential opportunity is available for Disney to do their own cord cutting and just distribute the content directly themselves. HBO is doing it now and other networks are sure to follow.

Q8: Is the stock cheap?

Source: Valuentum Securities

Source: Valuentum Securities

On a relative basis the stock is fairly pricy at 20 times forward earnings, but is below the peer median multiple.  As I said at the onset, Disney has always been a pricey stock. On a discounted cash flow basis the intrinsic value for Disney comes in at between $93-114, up until recently the stock has been fairly priced. After the latest iteration of Star Wars, I thought this stock was untouchable, yet in the last month the stock has been down 6 percent year-to-date but has almost tripled in last 5 years.  Analysts appear more worried about the ESPN subscriber drop and fear it may get worse. The recent Start Wars success was almost meh to them

Disney is an expensive stock but it is a quality company with some of most endearing loyal entertainment brands on the planet. It now has a vast portfolio of quality and durable assets that appeals to a vast cross section of society. Even more importantly it has this incredible strategic competency that has been engrained by its patriarch to nurture, develop, and ultimately monetize these assets over and over again for a long period of time.

As with quality companies, you sometimes have to pay a premium for them. . The stock is out of favour by the analysts and so it wouldn’t surprise me to see the stock track even lower than the current $98 range. If it does, I have no problem adding and averaging down the position.  I opened a position at $98.32.

About that MBA report

In 2010 my MBA project team wrote an evaluation of Disney’s corporate strategy and we had to provide recommendations on what they should do.  Below is our core recommendations. When I analyzed Disney in my MBA days circa 2011. Here’s what we wrote in terms of their strategy. My comments in BOLD.

Continue Investments in Media
WDC (Walt Disney Company) needs to monitor the upcoming trends in media and distribution.  WDC is losing its reach, power and management over all facets of distribution.  The market is deciding what is going to be a delivery mechanism.  YouTube for example grew on its own and without any ‘old media’ support and Zynga’s Farmville for Facebook is another example of what in the past would’ve been a deep WDC integration – now has tens of millions of users with no WDC exposure.  WDC will have to monitor and invest heavily in these areas.  The authors recommend a small business analysis unit that focuses on monitoring and establishing investment criterion, and recommending joint ventures, partnerships and outright purchases as needed.  This unit would reside in the corporate office and would become subject matter experts in the marketplace, and the conglomerates’ inane skills and abilities – thus providing efficient and holistic approaches to market opportunities.

A lot has changed in only 5 years. Netflix was around but they were mailing DVD rentals.  It appears they tried to address this however the result was that partnership with Netflix and a distribution deal that gives them limited control and flexibility.                                                                                                         

Limit Exposure to Future Capital Expenditure Outlays
The authors are concerned about the continued large outlays of capital for the international theme parks.  Euro Disney continues to be a challenge and the Hong Kong build-out poses a significant financial and brand risk.  As there are new branding and market approaches being developed within the new media area, the authors feel that a better overall return on investment will be recognized if WDC limits future large capital investments in new properties.  This would allow the capital resources to be allocated to new product placement opportunities, or the creation of whole new brand/segments, such as Hello Kitty.

We also said this,

“No longer can Disney rely solely on the Mickey Mouse brand to carry the company.  WDC acknowledges that they must appeal to broader yet more vertical market segments. WDC is constantly challenged to be at the cutting edge for technology, storylines and appeal for various consumer segments.  Recently, WDC has made focused changes to their Studio Entertainment strategy to ensure films are released each year to appeal to one or more of each of the four quadrant tent poles of younger males, younger females, older males and older females (The Walt Disney Company).”

Enter LucasFilms, and Marvel Comics which expanded their demographic reach quite nicely. A home run like Frozen also helped.