Walt Disney’s next frontier

How much juice can be squeezed out of a franchise? Or an individual character for that matter? Quite a lot according to the folks at Walt Disney (US: DIS), whose Pixar Animation Studios have just released their fifth film in the Toy Story franchise; an origin story about one of the original film’s lead characters, Buzz Lightyear.

In this ‘prequel’ we get to watch the film which Andy and his peers from 90s animated fiction enjoyed so much that its lead character became one of the world’s top selling toys. It’s a good hook, but it’s perhaps a bit too clever. Real life 90s kids flocked to watch Toy Stories 3 and 4 at the cinema because they wanted to find out what happened to Buzz - the toy that they grew up with having been first introduced to him in 1995. This film introduces a new character (with a new voice). It doesn’t tick the nostalgia boxes that previous sections of the franchise did so expertly.

That is one of the theories currently being circulated to explain Lightyear’s underwhelming domestic box office performance - the film took in $50.6m over its opening weekend, some way short of an expected $85m. Another hypothesis is that Lightyear has been hampered by the success of Disney+, where most of Pixar’s more recent films have landed directly. At the last count the platform had almost 140 million subscribers worldwide, many of whom seem happy to wait to watch Lightyear on the small screen.

But does an underwhelming big screen performance matter?

Certainly not as much as it used to. At its heart Walt Disney is an animation studio, but cinema ticket sales are no longer the core of its business. It has been a long time since the Studio Entertainment division contributed meaningfully to either the top or bottom line. In 2005, Parks & Resorts overtook Studios to become the company’s second largest revenue contributor and in 2021, Disney’s new boss Bob Chapek oversaw the merger of the Studios segment into a broader Media and Entertainment Distribution division.

Walt Disney financials: mixed fortunes

The new structure paints a picture of Chapek’s vision for the next chapter in Walt Disney’s life - he is intent on creating an entertainment business which leverages the company’s sprawling intellectual property and uses it in many different channels. In February he appointed a meta-executive, responsible for overseeing the company’s expansion into "the next great storytelling frontier". Cinema tickets are the past, digital channels are the future.

A challenging beginning

But Chapek’s arrival in the top job at Disney has not been plain sailing. He took the role in early 2020 as the Covid-19 pandemic hit full disruption mode and all of the company’s parks and cruise ships were forced to close. The three months to June 2020 (Q3 2020) saw the low point for the division, with revenue dropping to just $1.07bn and operating losses of $1.88bn. The Media and Entertainment division was a more consistent performer at the top-line and while cinema closures and a lack of sporting events hurt the studios and broadcasting businesses in 2020, the phenomenal success of Disney+ quickly plugged any sales shortfall. But margins here are very weak. Creating 3-hour CGI blockbuster hits like The Avengers is not cheap. Nor is launching a global streaming service and despite the success of Disney+ in attracting a massive audience, it remains loss-making.

The challenges of the last few years have seen the company’s high quality fundamentals falter. Return on capital employed averaged 18% in the five years to 2018, but has dropped dramatically since then. Margins have been hammered and operating cash flow faltered. And the balance sheet is also casting a slight shadow over the investment case. At the last count net debt stood at $35.4bn, equivalent to 43% of equity. The company borrowed heavily when it acquired 21st Century Fox in March 2019 and three years of lower-than-expected cash generation has hampered its ability to chip away at that debt.

Meanwhile, Chapek has had to contend with unwanted political turbulence, especially in Florida - home to the Walt Disney World theme park. The company’s resistance to the controversial Parental Rights in Education bill has drawn the ire of Florida’s Republican governor Ron DeSantis, who has threatened to remove the park’s generous tax status. Meanwhile the shadow of the immensely popular former boss Bob Iger looms large. Iger stepped down from his role as president of the company last year with speculation about a difference of opinion between the two Bob’s rife.

Nervy steps into a tech future

But while the company’s share price held up during the pandemic challenges, the specter of recession is causing more consternation for shareholders. Theme park visits, plush toys and a Disney+ subscription are the types of discretionary spending that can be ditched when consumers have to tighten their belts. Walt Disney’s share price has fallen 40% in the year to date and it has underperformed its market by 38%.

It is tough to know how long it will take for the bottom to be reached. Walt Disney remains a quality operator and a price to earnings ratio of 18.4 times looks tempting, especially compared to recent history. The company also has an attractive PEG ratio of just 0.5, although this should be viewed in the context of the post-Covid earnings recovery.

The digital media space is a new frontier for Walt DIsney where it will be competing with companies whose whole life has been tech-first. But these are the types of business which are now struggling with the saturation of the streaming market and are now unable to keep generating the growth numbers which their investors have become accustomed to. Meanwhile Walt Disney has its intellectual property backed balance sheet and over 100 years of history to fall back on. As Netflix is busy saving costs and cutting staff, opportunities could be opening up for the Disney media mammoth to take its next big leap into the future.