Walt Disney’s remake of The Lion King grossed $78.5 USD million on opening day, the biggest single-day gross for anything other than a Star Wars or Marvel movie. Pretty significant, and even more so on the heels of some disappointing second quarter results from Netflix.
The two companies are often pitted against each other, especially now that Disney is launching its own streaming platform, Disney+, this fall. It seems like the luster of Netflix is starting to wear off. This was the first quarter that Netflix lost subscribers in the U.S. and people are rightly starting to worry if throwing money at content to gain new subscribers is sustainable.
We’ve owned Disney for a long time and we’re often asked why. Why not Netflix? Aren’t they the forward-thinking disruptors that managed to get us all from DVDs to streaming in the first place? Isn’t that the wagon you’d rather be hitched to?
The best way to explain why we choose to invest in Disney is to understand what each company sells, how many ways they’re able to sell it, and how many people want to buy it. Understanding these dynamics and how they might evolve over time allows us to forecast profits and gauge the riskiness, sustainability, and uniqueness of the business.
What are they selling?
Netflix is in the content business. They finance that content by selling subscriptions. The problem is that they don’t have enough subscriptions to pay for the content, so they make up for the deficit by borrowing money. Netflix sells you content for less than it costs, and you buy the service because it’s cheap and convenient.
Disney is in the entertainment business. They have the unique ability to make content come to life. Disney turns one hour of watch time into a toy, a costume, a theme park, or a cruise line vacation. Disney can take the experience offline in a way that Netflix can’t. Disney is also the biggest sports entertainment company in the world. If you want to watch a game, odds are Disney owns the broadcasting rights.
Content vs. distribution, who owns what?
A good way to compare these companies is to look at who owns the content and who owns distribution. With their incredibly valuable collection of franchises, it’s safe to say that Disney owns the content.
Netflix is an aggregator of distribution. They ‘own’ the customer relationship, which they earned originally by selling other people’s content. Many argue that it doesn’t matter that Netflix’s content isn’t great because they own distribution, and that the value lies in their ability to reach people directly. Kind of like how Amazon owns the pipeline to people’s homes. If you own the pipeline, you can always build on top of it.
But unlike Amazon who also aggregates distribution, Netflix has not been able to become profitable. Netflix’s problem is that if they make lousy content, and continue to lose distribution rights to existing content, they lose the customer because they don’t have anything else to sell them. Amazon sells millions of items and has many lines of business they can pivot to. Their customers aren’t going anywhere.
While owning distribution is valuable, ultimately the pipeline is worthless if consumers don’t want the content you’re offering.
The problem with Netflix’s business model
Netflix grew rapidly by distributing content in whatever way was most convenient for people to consume it, and for a long time, their stock valuation was reflective of growth rather than profitability.
As it continues to get more expensive to buy content and harder to negotiate terms, Netflix has tried to futureproof themselves by transitioning from licensing other people’s content to creating their own. On revenues of $20 billion, it’s projected that Netflix will spend $15 billion on original content this year alone. By contrast, on revenues of $72 billion, Disney expects to spend $1 billion on original programming for Disney+.
The problem for Netflix is that to keep selling subscriptions they need a lot of new content. It’s expensive to make and not everyone will sell it to them anymore. They recently lost the rights to Friends and The Office, two hugely popular shows that subscribers were sticking around for. Losing access to big franchises puts more pressure on Netflix’s original content to both draw people in and keep them there. Retention is becoming an issue, especially in the U.S. where they lost subscribers this past quarter.
Netflix is a startup. It needs to build its catalogue from the ground up whereas Disney has a stockpile of content going back to the founding of Disney Studios in 1923.
Disney gets into distribution
There’s no company in the world with a better collection of diverse content than Disney. They own the biggest family-friendly franchise of brands including Marvel Studio, Lucasfilm (Star Wars), and all of Pixar’s animated movies. They also own ESPN, Hulu (a Netflix competitor), and 20th Century Fox.
Disney makes an estimated $300 million letting Netflix use its films, but long-term it doesn’t make sense to license their content to a competitor. Letting Netflix continue to build a relationship with their customers would be a mistake. If you’re serious about content, which Disney clearly is, you need to own your distribution platform. You need to get rid of the gatekeepers.
With this platform, Disney will become the most dominant gatekeeper of entertainment content. It’s important to note that Disney spent some of its profits to build and buy pipelines to the customer. Simply put, Netflix’s pipeline is not a unique attribute or a competitive advantage.
Disney has lots of ways to make money
Netflix’s business model is simple, they sell subscriptions. Disney, however, has their hands in all kinds of things and makes money from four different segments.
Disney+ will be one piece of a very large pie. They make money from their media networks, parks and resorts, studio entertainment, and consumer products. Disney can afford to stumble in one segment because of how large its other segments are. This is exactly the kind of diversification you want in a company you’re going to own for a long time.
Another thing to remember is that Disney has an unbelievably passionate fanbase. Until now, their theme parks and cruise line have been the only place they’ve been able to connect directly with their fans. Getting into the distribution business is about more than another income stream—it’s about getting to know exactly who their audience is, what they like, and where they live. It’s about owning the whole customer relationship.
The real value creation is that they’re going to be able to know their customers better, have an ongoing direct relationship with them, and gather data about them more efficiently. That’s going to lead to even stronger brand affinity and more ways to cross-sell between segments. Imagine this: Disney knows you watched the Lion King 10 times last month because your kids are obsessed, so they send you a 20% discount to the theme park and to order the Halloween costume. Netflix can’t do that.
Where the rubber hits the road and the Lion King roars
Let’s wrap this up with the numbers: In the past five years, Disney has free cash flowed a positive $42 billion. Netflix has bled a negative $11 billion. Disney is valued at $320 billion and could pay you $9.5 billion this year if you owned the whole company for a 3% return. Netflix is valued at $154 billion and you would lose $3.5 billion this year if you owned the whole company, with the safe assumption that would happen again next year.
You’ll be hard-pressed to catch up with the King.
Uncommon Sense 