I. Background

Disney for much of the last two decades has been a firm run by Michael Eisner and for Michael Eisner. The board that he hand-picked has gone along with all of his major decisions ranging from buying Capital Cities/ABC to entering new businesses. Some of these decisions have clearly been good ones, and some not, but the absence of shareholder oversight over management is troubling.

II. Marginal Investor and Hurdle Rates

Disney is a firm where insitutional investors clearly are dominant, with more than 70% of the outstanding stock held by instiutions and less than 10% held by insiders. (Source: Yahoo! Finance) The largest investor in the firm is a mutual fund - Investment Company of America - and sixteen of the top seventeen investors are institutions. I would expect the marginal investor in Disney to be a well-diversified institutional investor.

Since the marginal investor is well diverisifed, I would look at only market risk while estimating the cost of equity, and I have measured this market risk with a market beta. Since the regression beta had a large standard error (0.27 on a beta estimate of 1.40), I have used a bottom-up beta estimate, breaking Disney down into the following businesses:

Business	Estimated Value	Comparable Firms	Unlevered Beta	Division Weight	Weight*Beta
Creative Content	$ 22,167	Motion Picture and TV program producers	1.25	35.71%	0.4464
Retailing	$ 2,217	High End Specialty Retailers	1.5	3.57%	0.0536
Broadcasting	$ 18,842	TV Broadcasting companies	0.9	30.36%	0.2732
Theme Parks	$ 16,625	Theme Park and Entertainment Complexes	1.1	26.79%	0.2946
Real Estate	$ 2,217	REITs specializing in hotel and vacation properties	0.7	3.57%	0.0250
Firm	$ 62,068			100.00%	1.0929

Source: 10-K, Weights are based upon operating income from each business

Using Disney's current market values of equity ($50.88 billion) and debt ($11.18 billion), we estimate a bottom-up levered beta of 1.25 for Disney. Using a treasury bond rate of 6.08% and a risk premium of 6% yields a cost of equity of 13.85%:

Cost of Equity= 7% + 1.25 (5.5%) = 13.85%

In conjunction with Disney's after-tax cost of borrowing of 7.5%, estimated based upon their rating of AA , we estimate a cost of capital for Disney as a firm of 12.22%

Cost of Capital = 13.85% (0.82) + 4.80% (0.18) = 12.22%

We used a 36% marginal tax rate to compute the after-tax cost of debt.

III. Investment Analysis and Stock Price Performance

Where Disney stands...

Disney's typical project varies by division from very long term, capital intensive investments in theme parks to short-term investments in movies and TV programs. While we do not have the breakdown of Disney's project returns by division, we can measure Disney's return on capital as a firm. In 1996, Disney earned $5,559 million as pre-tax operating income on a book value of capital invested of $19,031 (estimated as the book value of debt and equtiy at the beginning of 1996). The after-tax return on capital based upon these numbers is 18.69%.

Return on Capital = EBIT (1-t)/ Average BV of Capital from 1995 to 1996 = $5,559 (1-.36)/ (19,031) = 18.69%

Relative to the cost of capital of 12.22%, Disney seems to be earning excess returns of 6.47% and a positive EVA.

EVA = (.1869 - .1222) ( 19,031 million) = $1,232 million

This may also help explain why Disney's stock was a good investment between 1992 and 1996, when it earned 1.81% more than expected each year. (This was estimated using the intercept from the return regression for the period, and was compared to the riskfree rate (1-beta))

What Disney needs to do..

What might account for Disney's excess returns? The firm clearly has signficant competitive advantages in the theme park and the creative content business (especially Disney studios) in the form of a brand name that will be difficult, if not impossible, to replicate. The theme park business is also capital intensive and there are competitors who can match its experience or expertise (Universal Studios is closest...) To maintain its excess returns, Disney should do the following:
1. Build on the businesses where its brand name is most potent - products for children. Computer softward, DVDs of old Disney movies, child-oriented resorts etc. The recent Disney venture into cruise lines seems to be a logical outgrowth of this strategy.
2. Establish clear brand name advantages in businesses where there is no clear advantage currently. Neither Touchstone Studios nor Capital Cities/ABC has been able to establish a clear competitive advantage, though "Who wants to be a millionaire?" has given a temporary lift to the latter. Focusing Capital Cities/ABC on more family oriented fare might be one way in which Disney could build on its reputation elsewhere.

III. Capital Structure

Where Disney stands..

As noted above, Disney's current financing mix is 18% debt and 82% equity. Its debt is a mix of long and short term debt, with a weighted maturity of 3 years. About 10% of the debt is floating rating debt, and about 5% is foreign currency debt. Looking at the factors in the trade off on borrowing:

Factor	Disney
Tax Benefit	Disney has a marginal tax rate of about 40%. It has an effective tax rate of 43.58%.
Added Discipline of Debt	Disney is a widely held firm. While institutional stockholders own a significant percentage of the firm, no individual stockholder or institution is large enough to have much say in management. The firm has significant cash flows and should gain from the use of debt.
Bankruptcy Risk	Some of Disney’s earnings are volatile, but a significant portion of the cash flows are stable (especially cash flows from theme parks). The bankruptcy risk should be low, given this factor and the size of the company
Agency Costs	The agency costs are likely to be large for borrowings by the creative content and broadcasting divisions, where it is difficult to track the funds. It is likely to be smaller in the real estate, retailing and theme park divisions.
Future Flexibility	The need for financing flexibility is increasing as the media business changes technologically and becomes more global.

 

What Disney needs to do...

While Disney's existing capital structure is 18% debt and 82% equity (see cost of capital above), its cost of capital is minimized at a 40% debt to capital ratio.

Debt Ratio	Cost of Equity	AT Cost of Debt	Cost of Capital
0.00%	13.00%	4.61%	13.00%
10.00%	13.43%	4.61%	12.55%
20.00%	13.96%	4.99%	12.17%
30.00%	14.65%	5.28%	11.84%
40.00%	15.56%	5.76%	11.64%
50.00%	16.85%	6.56%	11.70%
60.00%	18.77%	7.68%	12.11%
70.00%	21.97%	7.68%	11.97%
80.00%	28.95%	7.97%	12.17%
90.00%	52.14%	9.42%	13.69%

If Disney moves to a 40% debt ratio, with a 11.64% cost of capital, its value as a firm can be expected to increase by about $8.5 billion and its stock price by $12.55. (This is based upon the assumption that the savings from moving to the optimal will increase 7.13% in perpetuity.

At this debt ratio, however, Disney's rating drops below BBB and it can be vulnerable to a drop in operating income.We would argue that Disney's constrained optimal debt ratio of 30% (based upon the rating constraing of BBB) still suggests that the firm has significant excess debt capacity. We do not believe that Disney is a potential takeover target, because of its market capitalization (>$60 billion) and its positive stock price performance (Positive Jensen's alpha). Given the quality of its projects (as evidenced by the EVA estimated in the last section), we would recommend that Disney use its debt capacity to invest in new projects and expand its businesses.

We would recommend different types of financing for Disney's five businesses:
Creative Content: Short-term, dollar-denominated debt, with coupons tied to movie box-office receipts
Retailing: Operating leases ; if possible, tie lease payments to foot traffic in store
Broadcasting: Network rating-sensitive dollar-denominated bonds; Ratings whose coupons are tied to network ratings
Theme Parks: Long term, floating-rate debt (in a mix of currencies, reflecting mix of tourists)
Real Estate: Mortgage Bonds

IV. Dividend Policy

Where Disney stands..

Disney paid dividends every quarter between 1992 and 1996. Its dividends are modest, measured by dividend yield or payout:

	Disney	Entertainment Companies
Dividend Yield	0.67%	0.59%
Dividend Payout	19.73%	35.84%

Disney also has bought back stock at irregular intervals. Between 1992 and 1996, Disney returned about $217 million less than it could have, when dividends are compared to free cash flows to equity:

Year	FCFE	Dividends + Stock Buybacks
1992	$563	$105
1993	$722	$160
1994	$1,139	$724
1995	$1,261	$529
1996	$278	$733
Average	$793	$450

What Disney needs to do...

To make a judgment on how much we would trust Disney’s management to use this cash wisely, and how willing stockholders would be to allow this policy of paying less in dividends than is available in free cash flow to equity, to continue, we scored incumbent management on three dimensions, each of which we have analyzed earlier in this report. The first dimension is corporate governance, where we look at whether incumbent management has been willing to listen to stockholders and put their interests above their own. On this test, Disney’s top management fails the test. The second dimension is stock price performance, where we look at the performance of Disney stock, relative to its peer group and the market, after adjusting for risk. On this measure, Disney has delivered excess returns of about 1.81% a year between 1992 and 1996 to its stockholders and has earned itself some leeway on dividend policy. The final dimension is investment policy, where we analyze whether the investments Disney has made historically have measured up in terms of delivering returns to equity investors that exceed the required rate of return. Again, as our earlier analysis of return on capital and EVA shows, Disney passes the test with a return spread of 6.47% and an EVA of $1,232 million.

In summary, Disney has earned itself some flexibility on dividend policy as a result of its strong stock price performance and returns on its projects. The perception on the part of stockholders that incumbent management is not responsive to their needs, and Disney’s recent acquisition of Capital Cities (which at $ 18.5 billion dwarfs all other investments that Disney has made), suggest that Disney will operate on a short leash. A year or two of disappointing earnings and stock price performance could very well make a restive group of stockholders into a rebellious group, demanding more stock buybacks and dividends.

	High Growth Phase	Transition Phase	Stable Growth Phase
Length of Period	5 years	5 years	Forever after 10 years
Revenues	Current Revenues: $ 18,739; Expected to grow at same rate a operating earnings	Continues to grow at same rate as operating earnings	Grows at stable growth rate
Pre-tax Operating Margin	29.67% of revenues, based upon 1996 EBIT of $ 5,559 million.	Increases gradually to 32% of revenues, due to economies of scale.	Stable margin is assumed to be 32%.
Tax Rate	36%	36%	36%
Return on Capital	20% (approximately 1996 level)	Declines linearly to 16%	Stable ROC of 16%
Working Capital	5% of Revenues	5% of Revenues	5% of Revenues
Reinvestment Rate (Net Cap Ex + Working Capital Investments/EBIT)	50% of after-tax operating income; Depreciation in 1996 is $ 1,134 million, and is assumed to grow at same rate as earnings	Declines to 31.25% as ROC and growth rates drop: Reinvestment Rate = g/ROC	31.25% of after-tax operating income; this is estimated from the growth rate of 5% Reinvestment rate = g/ROC
Expected Growth Rate in EBIT	ROC * Reinvestment Rate = 20% * .5 = 10%	Linear decline to Stable Growth Rate	5%, based upon overall nominal economic growth
Debt/Capital Ratio	18%	Increases linearly to 30%	Stable debt ratio of 30%
Risk Parameters	Beta = 1.25, ke = 13.88% Cost of Debt = 7.5% (Long Term Bond Rate = 7%)	Beta decreases linearly to 1.00; Cost of debt stays at 7.5%	Stable beta is 1.00. Cost of debt stays at 7.5%