MouseCo: An Investment for the long term

I was recently asked about the type of company I’d be happy to own for long term (>10yrs). Having spent my early career investing in public companies and more recent years investing in early stage private companies, I reflected on the market dynamics, unfair advantages and company leadership that caused some companies to be long term winners.

One organization that has been a long term winner and I expect to be a long term winner going forward is The Walt Disney Company’s core family entertainment assets, which I’ll collectively refer to as “MouseCo.”

Walt Disney Company Background:

Established in 1923, The Walt Disney Company (“Disney”), is a global entertainment company. The company’s operations can be divided into 4 key segments: (1) Parks & Resorts, (2) Studio Entertainment, (3) Consumer Products and (4) Cable & Broadcasting.

Parks & Resorts refers to the company’s theme parks, hotels and cruise ships in the US & Int’l markets. Segment revenue is driven by admissions to theme parks, concessions, room nights at hotels, etc. Walt Disney World (Florida) and Disney Land (California) have historically driven results, but the new Chinese park (June ’16 opening) will be an added catalyst going forward.

Studio Entertainment produces and acquires live-action and animated motion pictures, direct-to-video content, live stage plays, etc. Segment revenue is driven by the distribution of films in the theatrical, home entertainment and television markets. In addition to Disney banner, other key banners include: Pixar, Marvel, Lucasfilm and Touchstone.

Consumer Products licenses Disney characters to third parties, publishes books & magazines, and sells merchandise through Disney stores & ecommerce.

Cable & Broadcasting includes cable and tv networks, tv production & distribution, and tv & radio stations. Revenue is driven by affiliate fees, ad sales and tv programming sales. Key networks are ABC and ESPN.

MouseCo refers to the company’s Parks & Resorts, Studio Entertainment and Consumer Products divisions.

My rationale for investing in MouseCo is driven by:

1. Leadership — Bob Iger has been a highly effective CEO since taking the reins in October 2005. During his tenure both EPS & the stock quadrupled (adding $120B in market cap); this stock performance outperformed the S&P by 4x during that span. Prior to Mr Iger, the core MouseCo business was stagnating as management focused on building a media conglomerate and underinvested in the core MouseCo, leading to few new hits and aging franchises. Mr Iger streamlined the sprawling conglomerate by divesting non-core assets and reinvigorated growth by investing in the core MouseCo studio and acquiring complimentary studios (Pixar, Marvel, Lucasfilm) to add valuable franchises, creative talent and tech. The acquisitions were controversial at the time, but served to turn around the company by accelerating the “flywheel” (see #5) with new franchises.

Mr. Iger (65yrs old) is set to retire in mid 2018 but there is speculation he may stay longer if no suitable replacement is found near-term. While I would expect the company’s capable board will locate a capable replacement, I would identify succession as the biggest risk for the organization.

2. Unique content — Disney’s has been producing feature length films since 1937 and has built a unique brand & a massive content library — key competitive moats. The films are primarily family friendly & can resonate among multiple generations of a family.

The company owns a collection of Disney hits (e.g. Fantasia, Beauty and the Beast, Frozen) plus acquired franchises like Star Wars, Toy Story, Iron Man etc. In recent years, most of the company’s family friendly films have been box office hits, allowing Disney to take large slices of the industry box office (32% in YTD16). The release schedule (thru ’19) looks strong (and de-risked) as most are sequels to established franchises — Star Wars, Cars, Avengers, Toy Story, Incredibles, Indiana Jones.

3. M&A prowess — In the last 10yrs MouseCo has acquired Pixar, Marvel and Lucasfilm (for a total of $15B). These acquisitions added tech (e.g. computer animation, visual effects), creative talent, and franchises (e.g. Toy Story, Cars, Iron Man, Star Wars) under the Disney umbrella, reinvigorating the “flywheel.” Many of the most popular characters in the parks (e.g. Cars, Nemo, Star Wars) are from acquisitions & are driving attendance.

The acquired companies continue to run as structurally separate entities, allowing them to maintain their own identity; this has allowed the acquired businesses to retain talent, a key risk with M&A. Since the acquisition of Pixar in Jan ’06, MouseCo revenue increased from $19B to $28B, with EBIT expanding from $2B to $7B; in ’05 the company had declining revenue & probability.

4. Licensing machine — Disney does an excellent job of exploiting its content via licensing. In ’15, the Consumer Products division generated $4.5B in revenue & $1.8B in EBIT, making it the company’s highest margin division. Revenue has doubled & EBIT increased by >3x since ’05 as MouseCo has been able to exploit both its own hits (e.g. Frozen) plus a treasure trove of characters from the acquired Pixar, Marvel and LucasFilm franchises.

5. Flywheel effect — Disney produces & distributes films that drive the sale of consumer products (toys, games, clothing) and trips to the company’s theme parks. These trips (138M in ’15 attendance) then in turn drive more merchandise sales & the consumption of more Disney film content. This powerful “flywheel” is far more impactful than traditional horizontal or vertical integration; no other entertainment company has a flywheel with comparable size or scope. Walt Disney sketched this flywheel in 1957.

6. Low disruption risk — MouseCo’s various business lines have a low risk of being disrupted in the next decade. Despite the growth of non-linear TV and home theatres, high quality family friendly films continue to perform well in theatres as parents & children are both looking for entertainment experiences out of the home. Sales of merchandise and visits to theme parks are again unlikely to be disrupted by tech (even the the evolution of VR). Disney has historically taken advantage of tech innovations, such as the ’13 rollout of RFID-enabled wristbands to pay for merchandise in the park.

7. Real estate moat — Florida’s Walt Disney World, which includes Magic Kingdom, Epcot, Hollywood Studios and Animal Kingdom, etc sits on 27K acres of owned land in Orlando. The land was purchased in the 60’s for a mere $5M ($185/acre) when it was swampland and Orlando was a small town. Amassing a similar size parcel in a temperate climate, near viable transportation infrastructure & a large population center at an economic price seems highly unlikely; throw in the unique flywheel Disney posses, and recreating Walt Disney World would be impossible. The company’s other theme parks in California, Paris, Tokyo, Hong Kong and China would all be difficult to recreate, but not to the same extent as the core Florida property.

8. Pricing power — MouseCo has demonstrated strong pricing power, as evidenced by single day ticket prices to DisneyWorld increasing at an 8% CAGR (= 3x GDP) since the park opened in 1971. Industrywide, movie ticket prices (3.8% CAGR since ’71) have also well exceeded GDP. Lastly, rising EBIT margins in the company’s consumer products division (now at all-time high of 39%) suggest the company has pricing power there as well. I would expect these trends to continue going forward.

9. High ROIC & clean B/S– Disney is an effective capital allocator and has a clean balance sheet. As a company (inclusive of Cable & Broadcasting), Disney’s ROIC has improved from 6.8% in ’05 to 15.3% in ’15 driven by new characters driving the MouseCo flywheel and growth at ESPN coupled with operating leverage. Producing movies and operating theme park (as well as running cable networks are what I’d consider businesses with high operating leverage, so incremental revenue (from ticket sales to movies/parks or add’l subscribers) come at very high incremental margins as few variable costs are involved. The company’s 15.3% ROIC places it in the top decile of NYSE companies (using CapIQ data).

Disney has a very conservative balance sheet, as evidenced by 1.4x Debt/EBITDA and 12% Debt/EV. The company is solidly in investment grade territory (A2/A) suggesting low credit risk.

10. China strategy — The emerging Chinese middle class is a key macro theme and MouseCo will be a big beneficiary. Disney opened its first theme park (Shanghai Disneyland) in mainland China in June. The $5.5B theme park is almost 1K acres, or 3x the size of the Hong Kong park and is projected to draw 17M visitors annually (vs ~20M at Florida’s Magic Kingdom). The resort is a JV with a Chinese gov’t entity and will be the beneficiary of massive growth within China’s upper & middle classes (63M households by ’22 per McKinsey).

Valuation — As a company, Disney trades at 17x LTM EPS and 16x FY17e EPS. I would be comfortable paying those multiples for a high quality business like MouseCo that (using sellside segment projections) should be able to grow earnings at a low double digit CAGR for the next few years.