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Business of Magic
A look at the business of Disney
|Alex Stroup, Editor|
Just as a reminder, we've been looking at The Walt Disney Company's performance for the 3rd quarter of 2000 and also their performance for the last few years, by taking a look at each of Disney's the business units to see how revenue and profit has been growing. Or not growing, as we'll see in a moment.
What we've seen so far is that in the 3rd quarter revenue was up about 10% and profit was up nearly 20%, while the average for the last few years has been the other way around - revenues up but profits pretty much flat. Poking around a bit so far, we've seen a couple of business units that have done very well - we'll call them "The Good" - which are the Theme Park and Resorts unit (WDW, Disneyland, Cruise Ships, etc.) and the Media Networks business units (ABC TV and Radio, ESPN, etc.).
But not all of Disney's business units have done so well. This leads to...
Movie and Studio Content
Can it be true? The heart of The Walt Disney Company - the movie and animation studios and the home video business - is an underperforming business unit? Well, the Q3 results were $1.243 billion in revenue - which is down 2.0% from $1.269 billion in Q3 of 1999. And they also posted an operating loss (yes, a loss!) of $3 million - also down, this time down 200% from a $1 million loss in Q3'99. Frankly, this is poor performance.
Over the longer term, the picture doesn't look much prettier. At first, it appears there was some growth in the 1996 to 1998 period, but since then revenue has dropped off and operating income has been either very small or a loss:
And even this picture is somewhat deceiving. The gray area on the graph is where most of the growth is, but it isn't what it seems. The gray area represents a period of time when Disney Consumer Products (the Disney Stores and all the product licensing) was combined in with what was then called "Studio Entertainment." Unfortunately, there's no way to pull the results of those two groups apart, so we don't know if the movies and videos were doing well and consumer products were doing bad or vice- versa.
Why did Disney do this? Is it kosher, business-wise? Actually, yes, this is a perfectly legitimate practice - and it's a fairly common one as well. The reason that companies reorganize their results in this way is - yes, you guessed it - to make the numbers look better. Now we don't know Disney's reasoning behind this move, or why they split things back up again. But I have a theory.
My guess is that in the mid-1990's, the Movie and Studio Content business was starting to turn down but the Consumer Products unit's financial results were moving up. By putting these two business units together, Consumer Products' growth would hide the weakness in the movies and video. But things may not have gone according to plan. Instead, Consumer Products' results flattened out and studios continue to drop. So rather than Consumer Products pulling the Studios' results up, the Studios were instead dragging Consumer Products down. By breaking the units apart again, at least the Consumer Products group might have a chance to shine.
So we can only really count on the last two years' separated results for the Movie and Studio Content unit to try to find the trend. Revenues are on a slight downward trend, and operating income has averaged only $45 million per quarter over the last two years. Looking at the last 4 quarters, there was actually an operating loss of $71 million. Needless to say, this is not what the shareholders want to see.
For the 4th quarter that ended on September 30th (and whose results Disney should announce on Thursday), I'm guessing that the quarterly revenues will be pretty much flat when compared to Q4 last year. This is because in Q4 1999 Disney had movie hits with Inspector Gadget, most of Tarzan (which opened two weeks before the quarter started), about half of The Sixth Sense.
(Note that Disney only got part of the profits from The Sixth Sense because The Studios were trying to cut their losses by sharing the risk on films they thought would be losers. Joe Roth, the studio chief at the time, apparently thought The Sixth Sense was going to be a loser and signed away half the profits for some quick cash. No wonder Joe is no longer with Disney.)
Anyway, in Q4 2000 Disney had modest hits with Disney's The Kid and Coyote Ugly and a big hit with Scary Movie (and Remember the Titans looks promising, but it opened a day before the quarter ended so it won't have much of an impact). My estimate is that the revenues on those sets of hits are pretty much equal. In addition, movie ticket sales in general were 5% lower this summer. (Alas, I haven't been able to find much detailed information on video sales.)
Meanwhile, I expect operating revenue to go up a little, since the company (through its Disney, Buena Vista and Miramax distribution arms) released few films in Q4 than they did last year: 10 this year vs. 13 last year. Fewer movies released means less money spent on making those movies, and so I think we'll see a small (under $100 million) profit this time around.
Longer-term, I'd say it's anyone's guess where the Movie and Studio Content will go. The current trend is downward and it is possible that this trend will continue - especially is Disney concentrates only on releasing fewer films. On the other hand, if the Studios break their dependence on big-budget special effects extravaganzas with expensive talent (oh, like Mission to Mars and Gone in 60 Seconds) and tries some different things like less expensive and more niche films with less costly stars (like they did when Eisner first came in), they could turn things around quite nicely. Or they could just get lucky and hit a few home runs in a row. I wouldn't want to bet on any of those, though.
The other bad business unit right now is the Consumer Products unit, which includes the Disney Stores and all the Disney licensed products.
Revenues for this group can be deceptively small, since when Mattel sells a plush Pooh that it manufactured under license, Disney only gets to count the license payments (a percentage of the sales) as revenues rather than full retail price. So even though a lot of Disney-licensed merchandise is sold by other companies, Consumer Products' revenue appears small. Other the hand, this is offset by what the Disney Stores sell, which is fully counted as revenue.
Anyway, with that all in mind, Consumer Products had $511 million in revenue in Q3 and $59 of that became operating income. This is down from $577 in revenues and $114 in income the year before, which is a drop of 11.4% in revenue and a fall of 48.2% in profits. Ouch. Again, this is not good financial performance.
Unfortunately, this seems to have been the recent trend for the Consumer Products unit:
Once again, we have the gray area in the middle that shows when the Consumer Products unit was combined with the Movie and Studio Content unit. Since we have no idea what happened in the gray area, it's best to look at just the last two years. Both revenues and operating income are sinking. A lot these problems have been caused by falling sales at Disney Stores. In fact, the Disney Stores only account for about 6% of this unit's profit while licensing profits are more than 11 times larger.
Of course, The Disney Company has seen this trend as well and has been working to turn things around. Hence, the huge revamping of the Disney Stores that was announced last month. They've already redesigned and remodeled a store in Costa Mesa, to be followed by one in Cherry Hill, New Jersey and then 20 more early next year. Eventually, they will spend up to $300 million to remodel 600 stores over the next three years - and close about 100 others. This makes me believe that they expanded too rapidly and built too many Disney Stores, and are now having to shut some of them down.
This revamping also includes changing what the Disney Stores sell. So say goodbye to much of the adult offerings and say hello to more parenting items like cups, plates and sheets. Oh, and they're also adding some trendy fashion apparel like "baby-tees" (small tight T-shirts for adults, not for babies) imprinted with double entendres such as a picture of Snow White and the phrase "Attracts small strange men." (Walt spins!) They also intend to cut the number of different products carried at each store almost in half.
Anyway, it is obvious that these changes will take at least a year to make any significant improvement to either the top line (revenue) or the bottom line (profit). In the meantime, they will be spending lots of money to remodel all those stores. So I expect Q4 to be even worse than Q3 - lower revenues and significantly lower operating income. In fact, I wouldn't be surprised if Consumer Products showed a small loss in this quarter. The next year or so won't be much better, at least until a lot more Disney Stores get remodeled. Beyond that, the remodeling may successfully bring growth back to Consumer Products, but I'm still skeptical. Repositioning a brand like the Disney Stores that consumers already have formed an image of is difficult, expensive and not a guaranteed success. And besides, as one analyst said, how many Mickey Mouse t-shirts can you own?
We're almost done now - there's just one Disney business unit left, and that is...
The final piece of Disney's business is the Internet Business, the Disney Internet Group, formerly known as "Go.com". In the 3rd quarter that ended on June 30th, this unit had revenues of $86 million, which was up 10.4% from 1999's $78 million. For that same period, they had an operating loss of $314 million, which is 13.9% larger than 1999's Q3 loss of $276 million. That's right - this group took in about $80 million and spent nearly $400 million ($78 million + $314 million). This is what I would call one ugly- looking business.
Although actually it isn't quite that bad for Disney as it looks - but not by much. You see, Disney doesn't actually own all of this Internet business. At the height of the Internet craze, they sold off 29% of the business unit (in something called a "tracking stock", which lets them sell stock in part of the company without actually having to separate it from Disney). I gather that Disney's management expected that, like other Internet stocks, this tracking stock would zoom skywards. This would set a large market value on the 71% that Disney still owned, which should then be reflected in the Disney's stock price.
In other words, they would use the stock market's Internet mania to help prop up the Disney's stock price. Although it sounds shifty, it really isn't - if stock market investors are willing to pay a high price for part of Disney's Internet business, then that's its value. And that value should be factored into the part of the unit that Disney still holds. Other companies have done similar things - 3Com's spin-off of it Palm Computing unit while still owning most of the spinoff was a major success.
There's another benefit to this as well - since Go.com is treated for accounting purposes as a separate company that Disney doesn't fully own, it shows up in all the financial documents not as an business unit but as an investment. In other words, it isn't shown as part of operating income! So while the big losses generated by Go are eventually factored in (which is one of the reasons the ultimate "net income" figure was so much lower than the operating income for the last quarter), the losses aren't counted against the operating income of the other units.
And it also means if you don't look carefully at the Disney's quarterly report, you might think this loss was a one-time thing - which it most certainly is not. (Also notice in the quote from the shareholder's letter that was back in Part 1 explicitly excluded Go.com's results from the earnings per share figure. This, of course, makes things look a little better at a quick glance.)
Anyway, this maneuver didn't quite work out the way Disney planned. Go.com's stock went public just under a year ago, and the stock ended its first trading day at $33 per share. But it dropped under $30 within a week and has slowly and steadily worked its way down to $8 now. So it hasn't really helped Disney stock price in the way it was intended. But has helped in another way - since the only own 71% of it, Disney only takes 71% of Go.com's loss. So from the Walt Disney Company's overall financial view, it is really more like revenues of about $55 million and an operating loss of only $220 million. Still, this is a big loss - it eats up a third of the profits made by that the theme parks during the quarter.
The recent past hasn't been much better either:
The Internet Group as it stands today has only been around since late 1999, when Disney completed the purchase of Infoseek and put it together with the existing Buena Vista Internet Group. We have financial information for most of the year before that, thanks to what is called "proforma data", where Disney's accountants go back through historical financial data and recreate how the company would have performed if it had existed as it does today. They need this information for the quarterly financial reports so investors can compare how Go.com unit did in the previous year - just like we're doing now. Which is where I got this data.
This also gives rise to the gray "hole" around Q4 1999 - since the Q4 2000 results haven't been released, they haven't published the proforma Q4 1999 results yet either. But I think we can safely assume that nothing out of the ordinary happened during that quarter.
Anyway, what the graph is showing us is that revenues have always been low but slowly growing, while losses have been large and getting larger. The slight improvement in the operating loss in the last quarter is encouraging, but it is too early to tell whether this is the start of a trend of lower losses. Still, the idea behind Disney's Internet business is not to necessary make a lot of profit right now. Instead it is an investment into this new media that will hopefully pay itself back many times over sometime off in the future.
In the short-term future, I don't see a major change in this unit's performance. In think the revenue will go up a little bit in Q4, as the larger amounts of business being done over the Internet is offset by loss of ad revenue that had been coming from dot-coms that have since failed. And I think the losses will probably flatten out - cost-cutting efforts will be offset by the expense of getting ready to realign and re-launch the web portal once again.
Over the next few years, I don't see this unit turning around spectacularly and making a lot of money. Call me a "dot-com" skeptic - it's just not so easy to make a successful and profitable Internet business. Disney, for all the time and money it has put into the Internet Business unit, still hasn't been able to figure out how they're going to make money off this thing. Maybe when everybody has high-speed broadband connections, Disney can make money using their film and cartoon library. But until then, the losses will keep piling up. This group has effectively lost over $1.7 billion dollars in the last two years and that figure will keep going up until they figure out how to turn a profit. A huge financial sinkhole without a clear exit, to me, is pretty darn ugly.
It's now time to put everything we've learned together and try to answer the questions we discovered back in part one: How come Disney's operating income in Q3 was increasing twice as fast as the revenues, and why has Disney's operating income been pretty much flat over the past few years even though revenues have increasing?
The second question is the easiest to answer. Revenues have grown over the last seven years because first all the business units were growing early in this period and then in last few years when the Studios and Consumer Products faltered, the Media Networks and the Theme Parks and Resorts units continued to grow. The Internet Business unit only came to the party lately, and its' revenue is so small in comparison to the other units that it has made no impact here. On the operating income side, the increasing profits from the Theme Parks and Media Networks have been almost totally offset by the declining profits from the Studios and Consumer Products as well as the loses generated by Go.com.
And now to answer our original question: How did operating income in Q3 increase twice as fast as the revenues? Actually, this pretty straightforward as well - the Theme Parks and Media Networks strong revenue growth was moderated by the revenue declines from the Studio and Movie Content and Consumer Product units. The operating income seems tricky - how could Disney as whole have nearly 20% operating income growth when the Studio's profit was flat and Consumer Products' profit fell? Well, because the profits from the Studio and Movie Content and Consumer Products units were so small (when compared to the other two units) that their changes really didn't have any impact on the total. In other words, since the Theme Parks and Media Networks units accounted for 95% of Disney's operating income, we only see their strong growth. And that's how Q3's results happened!
Well, we've finally made it through the Q3 results! I hoped you enjoyed this not-so-little journey in Corporate Finance and Accounting. But no resting on our laurels here - the Q4 results should be released today. I'll look over them in the next few days, and let you know what I find.
I'm curious to see how close my predictions were...