1

Strategic Issues for Disney in the Cable Industry

Andrew Jensen

5/13/16

BUSA 499: Strategic Management

2

Strategic Issues for Disney in the Cable Industry

In order to transition a major portion of its businesses from the declining cable market

into the emerging streaming market, Disney should acquire Netflix. Disney has a market cap of

one hundred and sixty-nine billion dollars with roughly forty billion of that in the cable market,

while Netflix has a market cap of thirty-nine billion. Disney operates in five different market

segments: Media Networks, Parks and Resorts, Walt Disney Studios, Disney Consumer

Products, and Disney Interactive. Current diversification strategies for existing products in

existing markets are to segment the market through acquisitions. For new products in existing

markets Disney plans to expand on related diversification and seeks to further vertically and

horizontally integrate its businesses (Figure 10). Disney has several long standing strategic

alliances, the longest being with Hewlett Packard. When Disney wanted to develop a virtual

attraction called Mission: SPACE, Disney relied on HP's IT architecture, servers and

workstations. They additionally have alliances with Pandora Jewelry, New Balance Running, and

Kimberly-Clark Corporation, owners of Huggies diapers and wipes, Kleenex tissues, and Pull-

Ups training pants.

The entertainment conglomerates main strategic issue is that it has struggled with falling

ESPN viewership. ESPN constitutes the largest division within Disney’s cable operations. The

company lost seven million viewers by the end of 2015, afflicting advertising revenues as online

streaming services continue to slice into cable viewership (Figure 11). Disney is currently the

seventh largest cable operator by revenues with eight channels operating in eight different

markets (Figure 9). Cable television is one of the few services that customers pay for, yet still are

subjected to advertising. This is unlike Netflix, Hulu, or Amazon Video where subscribers pay a

monthly fee and are able to access unlimited amounts of content.

3

Disney has a lucrative history with acquisitions that span more than two decades and

have created significant value for shareholders. Capital Cities/ABC (including ESPN), Saban

Entertainment (owners of the Power Rangers franchise), Pixar Studios, Marvel Entertainment,

and LucasFilm are all firms that have been acquired by Disney in the last twenty years.

Acquiring Netflix would allow Disney to expand on its direct-to-consumer content while

simultaneously giving Netflix access to the cable television market. It would also allow for

Netflix which is currently pursuing ‘original’ shows, those that it creates itself, to use Disney’s

well established film studio. While the acquisition would not come cheaply for Disney, they have

made large investments in the past to grow their cable businesses, like the purchases of ABC and

ESPN. Disney, which has a relatively low debt to equity ratio, would be able to leverage the firm

and garner the capital needed to purchase Netflix (Figure 13). With a credit rating of A+ Disney

is in very good standing with investors and could issue debt at a low rate for the firm. The

current Federal Reserve rates on U.S. treasuries are very low, giving even low to moderate

yielding bonds a more attractive appeal to investors. They are however, not expected to remain

low as the economy continues to stabilize despite a tumultuous global outlook (Exhibit 15). It is

for Disney, an opportune time to borrow money and acquire Netflix.

ESPN is a quality service that millions enjoy, but the way it is currently presented to

them is increasingly unattractive. Using Netflix as a platform to incorporate ESPN into with ad

free content could increase Netflix’s subscription base even further. The standard Netflix

subscription costs ten dollars per month. Including a bonus package that incorporates live sports

and analysis for a twenty dollar premium on top of the ten dollar price would draw in many more

television viewers tired of sitting through advertising and paying upwards of one-hundred dollars

a month for cable. Disney is not blind to the shift in consumer preferences. They have a thirty-

4

two percent vested stake in Hulu which has a subscriber base of nine million-over thirty-nine

million fewer subscribers than Netflix in the U.S market alone (Figure 8). Disney is primarily a

value oriented company afraid of large capital expenses that may change the perceived security

of the stock, however, if they wish to remain a value oriented stock they must make the

necessary shift away from the cable market which consumes one-fourth of its market

capitalization and endangers its future viability.

The acquisition of Netflix would reduce production and distribution costs for Disney

through economies of scale, further forward vertical integration into direct-to-consumer content,

and a reduction of agency costs. Disney has created dozens of successful films and television

shows using its own well established film studios. Disney’s current production costs are spread

out over a much broader array of content, whereas Netflix has only produced a handful of series.

Gaining access to Disney’s studios would give both companies the capacity to produce more

content at lower prices. Acquiring Netflix improves direct-to-consumer content opportunities for

Disney and expands their reach to the 130 countries that Netflix currently operates in. Providing

services on both live television and streaming allots Disney a greater reach to consumers as they

can view from any television or portable device. Disney and Netflix would additionally benefit

from economies of scope in almost every value chain activity. Common inputs, production

activities, distribution, sales and marketing, as well as support and service would all fall under

shared activities for Disney and Netflix.

The structure of both Disney and Netflix would require alteration to accommodate the

acquisition. Marketing, Legal, Accounting, Finance, and the Communication departments of

Netflix could be mostly eliminated and blended with the equivalent Disney departments.

Functions that are more unique to Netflix however, should remain unchanged. Talent, Product

5

Design, and Content Acquisition which have contributed directly to Netflix’s video content are

important for maintaining and not relinquishing Netflix’s identity in the streaming industry. The

integration of Netflix into Disney would cut managerial or agency costs through the benefit of

shared activities in the aforementioned departments.

The acquisition of Netflix and inclusion of an ESPN streaming package would generate a

ten year net present value of 2.819 billion dollars. Netflix has a current projected sales growth

rate of nearly 26% and has seen doubling and quadrupling of its share value in the last three

years (Pro Forma). The cost of sales, acquiring and making video content is roughly 27% of sales

for Netflix; while they additionally benefit from having zero receivables and zero inventories.

Customers pay instantly when they sign up for the service and there are no physical copies of the

video content, eliminating the need for inventory space and contributing to a reduction in overall

costs. Netflix has no current debt and incurs no interest expenses; it is therefore, a very

unleveraged firm. Other financial indicators of Netflix’s growth potential come in its P/E ratio,

which is 336.26 compared with the industry average of 15.78. Indicators such as these show that

Netflix still has unbounded potential in the market, especially considering that its content is only

in English-something they are working on adding to.

Disney would gain a new competitive position with the acquisition of Netflix. The only

other direct competitor in the cable and production market who has invested in a streaming

service is Fox. They have a 36% stake in Hulu compared with Disney’s 32% stake. The

acquisition would place Disney as the entertainment industry leader controlling almost every

piece of their value chain and allowing them to realize significant revenues from growing

subscription bases. They would have differential low cost access to productive inputs in the

production of films and shows relative to their competitors. A firm that has differential low-cost

6

access to factors such as labor, capital, land, or raw materials is likely to have comparatively

lower economic costs.

Disney faces a strategic issue in the near future: How do they adapt to the changing

market place for cable television. The answer based on qualitative and quantitative empirical

study is the acquisition of Netflix in order to shift their cable networks to ad-free streaming and

improve their direct to consumer content, all while achieving economies of scale in video

production, economies of scope in shared activities, and gaining a new competitive advantage

relative to competing entertainment firms. While this would require a great deal of capital, the

project generates a positive NPV in a rapidly growing market segment, and Disney’s low

leverage would allow them to issue the debt needed to make the purchase.

Marketing Summary

Consumers abandon television often because of the barrage of advertising content.

Streaming ESPN eliminates the need to raise advertising revenues since customers will be

paying a monthly subscription fee-much less than what they are used to paying for a cable

subscription. (Exhibit 15) The ad is simple and to the point: “The sports you love without the ads

you don’t.”

Figure 2.

General Environment

SpecificInternationalEvents

- CBS (UPN Network) and Time Warner (WB network) merger in 2006

Technological

Legal/PoliticalConditions

- Opening up Theme Parks in China where the Chinese Government stipulates they must have majority share of the venture.

New Entry Rivalry Suppliers Buyers Substitutes

High/Mod/Low High/Mod/Low

High/Mod/Low High/Mod/Low High/Mod/Low

Barriers to entry (reverse)

- Are Economies of Scale an important part of this industry? Yes

- Do incumbent firms possess substantial brand identification and customer loyalty that potential entrants do not? Yes

- Are there significant cost advantages independent of scale in this industry (Table 2.2)? No

- Do governments regulate this industry? Yes

Modest/Low threat of new entry as having substantial brand identification is very important, and beginner would need a lot of money to compete.

- Are there a large number of competing firms that are roughly similar in size (e.g. industry not dominated by one or a few)? Yes

- Is this industry experiencing slow industry growth? Yes

- Are competing firms unable to significantly differentiate their products in this industry? Yes/no

- Is production capacity added in very large increments (as measured at the industry level)? Yes

- Do firms primarily compete on price? No

4/5 Yes suggests very threat of rivalry. The industry is dominated by a few big players that have been around for a long time competing against each other.

- Is there only a small number of firms supplying this industry? No

-Are the products/ services from suppliers highly differentiated? No

- Are Suppliers to this industry NOT threatened by substitutes? No

- Can suppliers to this industry credibly forward vertically integrate and compete in the industry? No

- Are the firms in this industry NOT important customers of the suppliers? Yes

-Is the number of buyers to this industry small? No

-Are products/services sold to buyers of this industry undifferentiated & standard? No

-Particularly in B2B industries, are products sold to buyers a significant % of final cost of the buyers’ product/service? No

-Are buyers NOT earning significant economic profits in their industry (meaning they are more sensitive to costs)? Yes/no

-Can buyers credibly threaten vertical backward integration? Yes

Moderate Buyer power. More no’s than Yes’s suggests low buyer power

- Are there products (or services) from firms that are not direct rivals that meet similar needs typically satisfied by this industry but in different ways? Yes

If there are products that meet the same needs but in different ways, substitutes do exist. We need to ask the next question to assess the level of this threat.

- Do substitutes place a ceiling on prices more than competitive rivalry? Yes

The threat for substitutes is high due to the growing number of new media outlets and mobile devise. In addition to the threat for losing market shares to cable rivals.

Figure 3. VRIO Analysis

Value Rarity Imitability Organization Competitive Implications

Notes

Lucasfilm-Star Wars Y Y Y Sustained Competitive Advantage

Disney owns Lucasfilm outright and holds the exclusive rights to Star Wars

Hulu N Y Y Competitive Parity

Disney has a 32% stake and competitor Fox, owns a 36% stake

ESPN Y Y Y Temporary Competitive Advantage

Disney owns an 80% stake amounting to roughly $40 billion in an annually declining asset

Mickey Mouse Symbol Y Y Y Sustained Competitive Advantage

Arguably the most recognized cartoon character in the world. Providing brand awareness across many different platforms

14 Worldwide Theme Parks N Y Y Temporary Competitive Advantage

Theme Parks in Paris, Shanghai, and Tokyo help to expand the brand into new and emerging international markets

Differential Low-Cost Access to Inputs (Los Angeles and proximity to many major professional/collegiate teams)

Y Y Y Temporary Competitive Advantage

Policy Choices Y N Y Temporary Competitive Advantage

Policy choices in regards to the acquisitions of Lucasfilm, 32% of Hulu, and Marvel are astute choices focusing towards the future of the company. These are valuable products that have a lot of potential to grow and Disney works to market and sell them.

Rivalry: There are more than 800 cable and satellite delivered TV networks. Despite the high number, their ownership is very concentrated among a fairly small amount of companies. Nearly 226 of those are affiliated with the top five cable operators. So because the industry is dominated by a few, In addition to the slow growth, we conclude with a high threat of rivalry.

New Entry: With the mature/decline industry growth, and all the players that’s been around for so long. We see more of mergers or acquisitions rather than new entrants. Because of the importance of economies of scales and substantial brand identification we conclude that the threat for new entrants is low.

Substitutes: The increase in video streaming or video-on-demand has given the market several options on how to consume video and media content in general. Companies like Netflix, Hulu, HBO, etc. have taken a lot of market share in addition to increase in use of mobile devices such as smart phones and tablets. We therefor say that the threat for substitutes is high and growing.

Figure 4.

Figure 5.

Figure 6:

Figure 7:

Figure 8

Figure 9

Figure 10

Figure 11

Figure 12

Figure 13

Figure 14

Figure 15

Figure 15: Marketing Image