Fool on Call: Disney's Magical Distribution Model

To understand the magic of Disney's (NYSE:DIS) operations, its use of a multiplatform model to distribute silver screen content cannot be overlooked. Even in a quarter where Disney's top line inched forward only marginally, it's in the profit margins where we see the family-entertainment empire's business strategy at work.

The discussion between Disney management and Wall Street analysts in the company's latest quarterly call revolved around its content-distribution model, particularly its success in home video. In this edition of "Fool on Call," we will take a closer look at this dialogue to gain a better view of what lies ahead for Disney in the coming year.

From DVD to iTunes to VOD
My colleague Rick Aristotle Munarriz described Disney's latest quarterly as a home run, despite only 1% revenue growth. His enthusiasm for the company's performance is based on its gains in operating profits. There are a variety of factors we might identify to explain its profitability successes in recent quarters, not the least of which is its multiplatform content-distribution model.

DVDs remain a major hit for Disney. It was revealed in the question-and-answer session of the call that in the second quarter, DVD unit sales of 60 million-plus were on pace with the comparable period from a year ago. That strength isn't expected to subside any time soon. In his prepared remarks, CEO Bob Iger was excited about the upcoming release of the second installment of Pirates of the Caribbean, due out on Blu-ray this month. The second Pirates should provide a boost to the third quarter, but it is worth noting the tough comparisons the company faces against the third quarter last year, when The Chronicles of Narnia, Disney's best-selling DVD title in fiscal 2006, was released.

While we're on the topic of DVDs, there is a wrestling match under way between Sony's (NYSE:SNE) Blu-ray and Toshiba's HD-DVD, as the formats struggle for dominance in the next generation of DVDs. As one would expect, the presence of two major formats has made some consumers hesitant to make any switch at all from the current format. That uncertainty made Iger's remarks on the current health of the DVD industry an interesting one: "As more blockbusters are released on Blu-ray and the price of hardware decreases, we expect the format to grow nicely."

You get the sense from Iger that not only is Disney playing a major part in helping Blu-ray become the accepted format -- as it releases yet another blockbuster in the second Pirates -- but its contributions may also signal the eventual demise of HD-DVD. This sentiment was later reaffirmed in the Q&A session, when one analyst queried whether Disney would consider adopting the HD-DVD format. Iger's response provides useful insight into the state of the formats war.

"What we are seeing lately is that sales of Blu-ray discs are outpacing HD discs by at least 2-to-1," Iger said. He added, "As more quality Blu-ray product comes on the market, which it is going to do, notably with Pirates on May 22, we actually believe that the difference, or the advantage, of Blu-ray is only going to widen."

While Blu-ray continues to outmuscle HD-DVD, we can expect to see next-generation DVD players come "down in price nicely, particularly by Christmas season." Iger also points out that while Blu-ray gains the upper hand and as hardware prices drop, retailers such as Best Buy (NYSE:BBY) and Circuit City (NYSE:CC) will also start to weigh in by choosing Blu-ray, because they have only a "limited amount of shelf space" and will have to make a decision. "And once that happens," Iger asserts, "the advantage is going to go even more in Blu-ray's direction."

Iger also revealed that the only place experiencing a format war is the United States. In other markets, Iger observed, Blu-ray is "winning, and substantially." No doubt this provides little comfort to consumers who just dropped big bucks on a shiny new HD-DVD player.

Blu-ray's dominance and the expected acceleration in next generation-DVD sales is very good news for Disney shareholders. We learned from the company's last quarterly conference call that its amortization method leads to big-time profits, especially for the older Disney classics that have been translated from one video format to another over the years. Not surprisingly, soon after Iger's remarks on the format war, the discussion quickly turned to profit margins.

CFO Tom Staggs reiterated that the "robust home video market" is playing a major role in the company's earnings success, with DVDs contributing a significant part to its multi-platform distribution model. Yet in terms of additional distribution venues, VOD (video on demand) and iTunes are increasing in importance.

In regard to iTunes, Disney is dominating in the video realm. Consumers are primarily flocking to new titles, and Iger indicated that Disney is the only major studio making available new video content to iTunes. "We pretty much have the market to ourselves on iTunes," he concluded. Additionally, the company's agreement with Apple (NASDAQ:AAPL) is designed in such a way that Disney is able to obtain the same level of profitability from iTunes content as it does from DVD material.

As for VOD, Iger indicated that Disney is working with a few broadband-cable operators in select markets on a test basis to see what kind of reception Disney films will receive from consumers through this medium. Although the testing is very limited, Iger noted that the results have been "extremely, extremely strong." He later commented, "I think it's safe to assume that the VOD business is likely to grow."

It looks as though we can add yet another platform that Disney can harness to drive growth and profits.

Fewer titles, bigger profits
The company's multiplatform content-distribution model, which includes DVD, iTunes, and now VOD, provides a variety of avenues for Disney to reach out to the consumer. But multiplatform options are only as useful as the content that drives them. That's why the most illuminating part of the whole call was when Iger indicated that this multiplatform model is being coupled together with a strategy to invest in select Disney movies (versus non-Disney ones) with a greater emphasis on franchise titles. It's believed that focusing on fewer big hits that bear the Disney name, and then making them available through the various distribution channels, is the best way to achieve higher margins.

It's hard to argue with Disney's success using this approach. And with Ratatouille and the third Pirates installment hitting the silver screen in the coming days, Disney will have a few more major hits that it can run through its distribution machine in the quarters ahead, as it continues cranking out strong profits.

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Fool contributor Jeremy MacNealy has no financial interest in any company mentioned. The Motley Fool has a disclosure policy.