Disney (DIS +7.60%) recently reported its third-quarter earnings, and the numbers didn't impress investors. The company's revenue rose 7% year over year to $15.23 billion, but missed estimates by $110 million. Adjusted earnings per share rose 18% to $1.87, but also missed expectations by eight cents.
Most investors focused on Disney's media unit, where cord-cutting pressure drove a 1% decline in the segment's operating income -- even though its revenue rose 5%. They also wondered if Disney's upcoming streaming platforms and its planned takeover of Fox's (FOX +0.00%) (FOXA +0.00%) media assets would get growth back on track.
Image source: Disney.
However, fewer investors noticed that Disney's weakest unit during the quarter was actually its Consumer Products & Interactive Media (DCPI) business, which sells and licenses products like toys, T-shirts, books, and games. Let's take a closer look at this business, which generated 7% of Disney's sales and 8% of its operating income last quarter.
How does DCPI make money?
DCPI generates its revenue from four main businesses:
- Licensing, which licenses the rights to Disney's products to other companies.
- Retail, which includes Disney's brick-and-mortar and e-commerce stores.
- Games and Apps, which includes internally developed, co-developed, and licensed software for mobile devices and consoles.
- Content, which publishes books, magazines, and digital media.
When reporting revenue from these units, Disney lumps together its licensing, publishing, and games units in one sub-category, and its Retail and "Other" units into the other. Here's how those businesses fared during the first three quarters of fiscal 2018.
| Year-over-Year Revenue Growth | |||
|---|---|---|---|
|
Category |
Q1 2018 |
Q2 2018 |
Q3 2018 |
|
Licensing, Publishing, and Games |
(3%) |
1% |
(10%) |
|
Retail and Other |
1% |
5% |
(4%) |
|
Total |
(2%) |
2% |
(8%) |
Source: Disney quarterly filings.
Disney doesn't break down the two categories' operating income separately, but the full DCPI unit's operating income has been falling steadily in recent quarters.
|
Q1 2018 |
Q2 2018 |
Q3 2018 | |
|---|---|---|---|
|
DCPI Operating Income Growth |
(4%) |
(4%) |
(10%) |
Source: Disney quarterly filings.
Why is the DCPI unit struggling?
In the first quarter of fiscal 2018, Disney blamed lower licensing revenue from Frozen and Finding Dory, the "unfavorable timing" of minimum guarantee shortfalls from its licensees, and currency headwinds hurting its retail business. It noted that stronger game sales, led by Electronic Arts' Star Wars Battlefront II, partly offset those declines.
Image source: EA.
In the second quarter, Disney attributed its slightly better results to higher licensing revenue (aided by higher minimum guarantee shortfalls) and higher sponsorship revenue, which was partly offset by lower merchandise and gaming revenues.
In its latest quarter, Disney claimed that lower licensing revenue, declining comps at its retail stores, and lower income from licensed Spider-Man and Cars products all throttled the unit's growth. However, it noted that rising licensing fees for Avengers products partly offset those declines.
Will the situation improve?
The growth of the DCPI unit is highly cyclical. Big hits like Frozen produce tough year-over-year comparisons that can't be satisfied by other franchises. DCPI also relies heavily on the ability of its licensees -- like EA and Hasbro -- to produce popular games and toys.
Disney once produced more toys and games internally, but over time it shuttered many of those businesses -- including the entire first-party game publishing unit in 2016 -- to cut costs, pivot toward a higher-margin licensing model, and focus more heavily on its media, film studio, and theme park businesses.
Therefore, I wouldn't be surprised if Disney shuts down or sells more parts of its DCPI business over the next few years. Investors should probably expect the business to continue shrinking as Disney turns its attention toward integrating Fox's assets, expanding its streaming platforms, and nurturing the growth of its top movie franchises.
