Oh, Bother

Disney needs little introduction. The business has a storied, 100-year history, and as a result owns an enviable library of family-friendly intellectual property – from Mickey Mouse to Star Wars and the Marvel franchise; from the Winnie the Pooh to Toy Story.?

In addition, Disney owns ESPN (the premier sport TV network in the US) as well as a stake in Hulu (a US-only streaming venture).?

It goes without saying that the pandemic was an extremely challenging period for Disney, with people around the world being unable to attend theme parks or film theatres. In March 2020, we made the decision to exit our entire position, and have not owned Disney since.

Considering the quality of their intellectual property, we did not take the decision to sell lightly. What was our rationale at the time, and – with the benefit of hindsight – did we make the right call??

Balance Sheet Drama?

As our investors know well, we err on the side of caution when it comes to owning businesses that have a significant amount of debt.?

Coming into 2020, Disney’s then-recent acquisition of 21st Century Fox had seen its gearing (as measured by the net debt/EBITDA ratio) increase to around 2.9x – a level that the business had last been at around 2003. While not in and of itself a cause for concern – especially for a business with the proven ability to monetise intellectual property as well as Disney – it did raise a yellow flag or two. Operationally, we believed that the Fox assets would take time to properly integrate, and that the upcoming launch of Disney+ would require significant investment in content to quickly build an audience.?

Perhaps more pertinently, we have learnt through observation (and hard experience) that once a management team saddles a business with a significant amount of debt, they become at least somewhat beholden to the bankers and other capital providers in the way they manage the business. Decisions tend to be made for the benefit of debtholders, largely leading to suboptimal results for shareholders.??

With the pandemic shutting down meaningful parts of Disney’s business, we knew that EBITDA would decline precipitously. (With the benefit of hindsight, Disney saw its EBITDA drop by a staggering 60% from December 2019 to 2020). As such, with a constrained balance sheet we were 100% certain that Disney would be forced to raise capital to stave off the initial blow from the COVID-driven shutdowns. However, given the dysfunction in bond and equity markets in the first half of March 2020, we were worried that debtholders would not be willing to step in at anything less than extremely punitive terms to Disney, considering that the net debt/EBITDA ratio was about to dramatically spike. We saw the possibility of a highly dilutive equity raise at depressed prices as a very real risk to our investment case, and therefore acted decisively in selling our holding.?

If we had to point to the overriding reason for selling Disney in March 2020, it would essentially come down to this: we could not handicap how long Disney’s parks and theatrical businesses would essentially be shut for due to the lockdown requirements of the pandemic, and we couldn’t be certain that equity owners were not about to be heavily diluted. We exited our full position around $95/share – well off the early 2020 highs of $145, but some ways higher than the eventual bottom around $79.?

As it turned out, the Federal Reserve injected a gargantuan amount of stimulus into markets in the second half of March 2020, which re-opened funding markets. Disney raised approximately $18bn of debt between March and May 2020, pushing its total debt to just over $68bn. Today, Disney’s net debt/EBITDA is still above 2x, having declined post our decision to sell. (For those interested, it peaked in December 2020 around 6.6x).??

We can debate whether the Fed’s massive liquidity injection in March 2020 bailed Disney out until we’re blue in the face, but the scoreboard will show that our worst-case scenario did not eventuate for Disney from a balance sheet perspective.?

Streaming Wars?

The other factor we place an excessive focus on is the management of the companies that we invest in.?

Bob Iger had been the CEO of Disney from 2005 up to February 2020, when he unexpectedly handed the reins to Bob Chapek. Chapek began his career at Disney in 1993, having worked his way up through the ranks over a 27-year period before becoming CEO. The timing of the transition likely couldn’t have been worse, happening mere weeks prior to the global outbreak of COVID-19.?

When the role of CEO changes in any company that we own, we sit up and pay attention. In this case, one Bob (Iger) handing over to another Bob (Chapek) meant that Disney was in all likelihood in very capable hands, with an internal succession being a reasonably low-risk outcome for shareholders. At the time of the management handover, both Bobs’ were seasoned media industry executives that had earned their stripes at Disney.?

However, the winning formula that had proved out in making Disney so successful for decades arguably required a different approach, as the media landscape had shifted dramatically over the preceding years.?

In short, competition for viewership had arrived, with the likes of Netflix, Apple TV+, Paramount and Amazon Prime all well-funded and intent on winning the streaming wars. At the same time, the pandemic was likely the worst thing that could have befallen Disney, since it forced all their media rivals – some who were sceptical of making the transition to the streaming model – to find religion and embracing streaming in short order. While we do not dispute the quality of Disney’s IP, it is also fair to say that Disney management had not operated in such a competitive environment in a long time – if ever.??

Perhaps even more relevant was the fact that the increasing levels of competition among the streaming platforms meant that it was great time to be a high-profile actor, director or screenwriter, since you could essentially name your price to be engaged in any production. The cost of content skyrocketed as all players threw money at increasingly high-profile projects designed to lure subscribers. (For example, Amazon’s new The Lord of Rings series became the most expensive TV show of all time at a cost of $715mn for a single season in 2022). In effect, the excess industry returns were reaped by the creative talent, largely at the expense of the streaming services.??

Simply put, over the past few years one would rather have been Chris Hemsworth than Disney.?

Peak Profitability?

Historically, Disney’s most profitable line of business has been its TV networks, which earned money through selling advertising and charging cable TV providers for the right to include Disney’s TV content in their bundle. ESPN was the crown jewel of this business.?

At the time of Disney buying ESPN in 1996, video was consumed largely at home via cable television. Fast forward more than two decades and both consumer tastes and ways to consume content (i.e. via mobile devices and on demand) have materially changed.?

Through no fault of the management at Disney, there has been a secular change in the market they operate in. As a result, we believe ESPN’s dominant position – and the commensurate level of its profitability - has peaked. Consumers today increasingly spend time consuming content on YouTube, playing video games or watching short videos on TikTok. These alternative forms of entertainment have provided an outlet for both advertisers and consumers alike.?

For these reasons, we would argue that the moat of Disney’s TV networks business – anchored by ESPN – has meaningfully eroded.?

Return of the Bob (Iger)?

Disney’s response to increasing losses in their streaming service and shrinking profits in the cable business was to increase ticket prices at their theme parks, making it increasingly unaffordable for the average consumer during a period of significant cost-of-living increases.?

Disney arguably had very little choice in the matter: being geared (requiring them to make significant ongoing interest payments) while propping up a loss-making streaming service and fighting a rearguard action to preserve profitability in the TV networks placed an enormous strain on its finances. As it happens, the theme parks business is not by nature a capital light enterprise, meaning that while capital expenditure can be delayed periodically, it cannot indefinitely. Consumers demand new and improved experiences each time they visit, which requires investment.?

With the landscape around Disney changing rapidly, the Disney board decided to remove Bob (Chapek) in November 2022, replacing him with… well, Bob (Iger). As outsiders to the business, we are somewhat perplexed as to what concern the board was addressing with this decision. While we acknowledge that Disney was almost uniquely positioned to suffer from an event like the pandemic, which had a meaningful impact on its business, not all of its current challenges are due to mismanagement from 2020.??

With that said, was Bob (Iger) returning to fix the issues that arose during Bob (Chapek’s) less-than-3-year tenure, or were these rather a manifestation of Disney’s eroding moat that began under his own tenure in the years building up to his retirement in 2020? While the jury is still out, we think the latter is more likely.?

Conclusion?

In hindsight, we sold the Fund’s holding in Disney at a time when the price we were offered did not reflect our assessment of the risks to the franchise – rather, it reflected our assessment of risks to the balance sheet, which ultimately did not eventuate. Within a year of our sale, the share price almost doubled off the COVID-lows – arguably, a better exit point.??

That said, at the end of 2023 – now nearly four years on! – Disney’s share price is now ~5% below our March 2020 sale price. The more fundamental issues around its future profitability, declining TV networks business and streaming losses have weighed heavily on the stock, and the business has largely been on the defensive for most of the past three years.??

We take two lessons from this review:??

1. Always be wary of businesses carrying a huge amount of debt, as an unforeseen crisis (such as COVID-19) can materially limit operational flexibility and even introduce fundamental risk. While we were concerned about dilution in March 2020, the?true?long-term risk was the disruption of the traditional media landscape playing out. Arguably, Disney could have been more proactive in addressing this transition, but it has been hamstrung by a mountain of debt since 2019. We believe this fact has materially curtailed its ability to navigate the extremely challenging COVID period.??
2. When an entire industry is throwing huge amounts of money at the same opportunity – which we would argue is what happened in the streaming landscape after the pandemic forced all players to find religion on streaming – the first order effect is for all players to see their profitability being competed away. This is a classic capital cycle, and generally leads to poor returns for shareholders – as has been the case in the streaming media landscape since mid-2020.?

We do not aim to time the market, but holding onto Disney would have incurred a meaningful opportunity cost for the Fund since March 2020, considering that over this period the Fund has returned above our 8-12% per annum targeted range.?

In short, we were almost certainly right to have sold due to our concerns around the absolute debt levels, but how this risk translated to the business was not something we specifically foresaw.?

The Trust Company (RE Services) Limited (ABN 45 003 278 831, AFSL 235150) is the issuer of the product. For general advice only and does not take account the objectives, financial situation or needs of investors. Read the PDS and Target Market Determination (TMD) (available at https://lnkd.in/ghHtnMuf) to see if the product is right for you. All investments contain risk and may lose value.