Disney's Massive Cannibalization Opportunity

Disney (DIS 0.16%) laid out its ambitious plans for Disney+, its forthcoming flagship streaming service, at its investor day last month. Management expects to reach between 60 million and 90 million subscribers by 2024, all paying around $7 per month or $70 per year.

CEO Bob Iger has told investors to brace for a negative impact on net income as Disney transitions to more direct-to-consumer distribution. Indeed, the company expects an incremental operating loss of $460 million this quarter as a result of its investments in streaming. A portion of those losses will come from forgoing some licensing revenue from its film and television output, as well as marketing and technology expenses.

But giving up revenue in exchange for establishing a more direct relationship with consumers will ultimately benefit Disney. And it has a massive opportunity to cannibalize itself and quickly grow its subscriber base.

Image source: Disney.

Where Disney+ subscriber budgets will come from

Disney is currently giving up some streaming video on demand (SVOD) licensing revenue to keep its titles for itself. Ultimately, however, SVOD revenue will remain steady as Disney merely licenses streaming content from itself for Disney+ and its other direct-to-consumer services.

Disney+ will spend around $1.5 billion licensing content from Disney's studio entertainment and media networks division. That's about one-fifth of its total SVOD/TV distribution revenue from last year.

The revenue Disney will cannibalize is its home entertainment revenue, which totaled about $1.75 billion last year. Remarkably, Disney's home entertainment sales have remained consistent despite the rise of streaming services over the last decade. Here's how the last six years stack up.

Data sources: Disney's 2018 10-K and 2015 10-K.

Importantly, that revenue is just Disney's take of its home entertainment segment. Distributors typically mark up prices in order to make a profit on each sale. So consumers are spending a lot more than that on Disney every year.

Transitioning from one-time consumers to ongoing subscribers

Let's say Disney keeps about two-thirds of every home video sale. (That's probably generous.) That means consumers are spending $2.6 billion to $3.1 billion per year on Disney content already. That's outside of what's available on streaming services.

If Disney can convince consumers to switch their budgets from one-time DVD purchases to ongoing subscriptions, it'll win over 31 million to 44 million subscribers without requiring consumers to spend anything extra on home entertainment. That's halfway to its goal already.

Granted, it's unlikely Disney will completely cannibalize its home entertainment sales, but the company can exercise at least some control over how consumers access its films at home. Instead of releasing films straight from theaters to DVD and Blu-ray, the company could provide an exclusive window to Disney+.

Disney currently does the exact opposite, creating an exclusive window for DVD sales before films are available for streaming. That may be part of the reason why the company's been able to sustain strong home video sales despite increased streaming video subscriptions. But the economics of Disney+ incentivize the switch.

Disney+ can be more profitable than DVD sales

There are a couple factors that will make Disney+ more profitable than traditional home video sales.

First and foremost, Disney+'s gross margin is likely higher. It keeps all the subscription revenue, or it pays out at most 30% to a digital distribution platform (where the cut likely falls closer to 15% over time). Automatically, it's keeping more of every sale. The marginal cost of each sale is likely lower as well because Disney isn't shipping a physical product.

Second, Disney can see greater marketing efficiency from selling a film on Disney+ than it could from selling the same film on DVD. The lifetime customer value of a Disney+ subscriber is likely higher than that of a DVD buyer.

Consumers might spend billions on Disney videos every year in aggregate, but that doesn't mean each individual consumer is spending more than $70 per year on Disney videos. If Disney can convince them to try Disney+ instead of buying a DVD, it can likely generate incremental revenue over traditional home video sales.

More revenue and higher gross margin is a pretty clear recipe for increased profits. And the transition from home entertainment revenue to direct-to-consumer revenue ought to be relatively smooth, making this a win for Disney and its investors.