Valuing Quality

As industry specialists, our analysts make key assumptions when we value a company, which are based on our in-depth research of a company’s future prospects. One of the most important assumptions we make is the multiple applied to future earnings to derive the terminal value of a company at the end of our explicit forecast period. The terminal multiple is a critical assumption because it typically accounts for a significant portion of our overall value and it captures a host of assumptions about the quality of the firm such as return on capital and future growth prospects.

The Walt Disney Co. (DIS) is an example of a company that, in our opinion, deserves a higher terminal multiple because of its strong competitive positioning and its ability to invest large amounts of capital into projects that earn high rates of return. We believe Disney’s unique position within the entertainment industry and its multi-platform global distribution network provides strong pricing power and excellent long-term growth prospects.

Strong Pricing Power:

  • Disney’s media business generates revenues from two main sources: ESPN and Disney channel affiliate fees collected from the cable companies (Comcast, Direct TV, etc.) and ESPN advertising revenue. The nature of sports programming and ESPN’s unique high quality content gives Disney significant negotiating power. For example, ESPN affiliate fees are quite high at approximately $5.50 per subscriber per month. These high affiliate fees in turn allow Disney to bid more for important sports rights and lock up content with multi-year agreements, creating a virtuous cycle. Better content leads to stronger pricing power, which again leads to the ability to bid more for quality content. A similar dynamic exists with advertising on ESPN. Higher quality and important live sports content leads to higher and more engaged viewership, driving demand for advertising on ESPN and resulting in higher advertising revenue per ad slot. Once again, this enables Disney to bid more for quality content.
  • Disney theme parks also enjoy strong pricing power. Disney owns a vast portfolio of important animation characters which it leverages by creating exclusive attractions in its theme parks all over the world. As a result of its cumulative investment in parks and exclusive attractions, Disney benefits from high traffic volumes and utilization rates. This scale and the company’s strong brand image act as high barriers to entry and limit competitors from replicating the Disney experience. Kids who watch Disney movies and TV content want to visit Disney’s theme parks, increasing a parent’s willingness to pay. As a result, Disney’s theme parks have been able to raise prices even in challenging economic times, and we believe this trend will continue.

Excellent Long-Term Growth Prospects:

The breadth and interrelated nature of Disney’s business segments gives it the unique advantage of monetizing its media properties across various distribution platforms – films, TV, theme parks, and consumer products.

  • Over the years, Disney has become an expert at creating new characters through its creative studios as well as acquiring new characters through acquisitions. These characters are then monetized through theatrical films, TV programs, attractions/rides in theme parks, and licensed consumer products (toys). This was the strategic rationale behind the Marvel Entertainment and Lucas Films acquisitions. Marvel owns approximately 5,000 animation characters, which are more valuable within Disney than on a stand-alone basis due to Disney’s ability to monetize Marvel’s characters globally via its various business segments. Early results are encouraging, indicating Disney’s efficiency in integrating these acquisitions. Movies such as Avengers and Iron Man 3 have been box office blockbusters. Disney now plans to add its first Marvel themed attraction, The Iron Man Experience, in its Hong Kong theme park by the end of 2016. Very recently, Disney also announced that it plans to create four serialized programs featuring Marvel’s characters which will be distributed exclusively with Netflix starting in 2015.
  • Disney recently increased its capital spending in the theme parks segment which we believe will lead to significant revenue and profit growth over time. The company added a separate park called ‘Cars Land’ next to Disney California Adventure in Los Angeles, introduced several new attractions to its Hong Kong theme park, added two new Disney branded cruise ships, and added a resort in Hawaii. The company is also planning to add an Avatar-themed area to The Walt Disney World’s Animal Kingdom in Orlando. However, the planned theme park in Shanghai, a joint venture with the Chinese government, is perhaps the most meaningful and important to Disney’s future. The Chinese government is contributing approximately half the capital for this park. Once operational, Disney will receive approximately half of the profits from the park plus a management fee. The combination of low capital commitments along with a share in the profits and a management fee will result in high returns on invested capital for Disney.

In summary, we place special emphasis on our key assumptions, especially the terminal multiple. We believe Disney has a unique combination of pricing power and favorable secular growth opportunities which will allow the company to continue to deploy large amounts of capital at attractive rates of return over a long time frame. These attributes coupled with an exceptional management team, a good capital allocation track record, and a conservative balance sheet, are quite rare in the consumer discretionary sector. In our opinion, companies such as Disney that possess the key attributes of a quality business deserve a higher terminal multiple resulting in a higher intrinsic value.

The views expressed are those of the analyst as of November 2013, are subject to change, and may differ from the views of other portfolio managers or the firm as a whole. These opinions are not intended to be a forecast of future events, a guarantee of future results, or investment advice.

© Diamond Hill Investments

© Diamond Hill Capital Management

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