After Frozen crossed the $1 billion global box-office sales mark to become the top-grossing animated film in history, investors have turned their attention to the media giant Walt Disney (NYSE:DIS), and pushed its share price to an all-time high.
Notwithstanding the success of Frozen, Disney's stellar financial track record has always won the admiration of its investors. Disney has remained profitable and free cash flow positive in every single year of the past decade. It also grew its revenues and net earnings by 10-year compound annual growth rates of 5.2% and 17.1%, respectively, over the same period.
Prior to the box office success of Frozen, Disney has historically relied on a string of blockbusters every year to deliver huge profits, including classics like Beauty and the Beast (1991), Aladdin (1992), and The Lion King (1994). These three movies generated a minimum of $300 million in box office receipts, adjusted for inflation.
The blockbuster approach works because of the unique economics of media products such as films, books, and music. Movie-making is a business with huge fixed costs for production and advertising where the variability in box office revenues is significantly greater than the disparity in production costs on a project-by-project basis.
A media company incurs little additional cost when an additional movie-goer watches a single movie, so each dollar of ticket revenue literally flows right down to the bottom line after the company splits the revenue with theaters. As a result, Disney leans toward the blockbuster approach as the 80-20 principle applies here with the top movies taking most of the profits in the film industry.
Disney's recent acquisitions of Pixar, Marvel, and Lucasfilm in 2006, 2009, and 2012, respectively, make perfect sense as these companies share Disney's blockbuster approach toward movie production. Pixar is known for spending years to develop a single movie and focusing on no more than a few movies at any one time. Since 1995's Toy Story, Pixar has never released more than one film per year.
Marvel departed from its traditional co-production strategy in which it worked with other studios when it started to independently produce its own movies in 2005. Marvel could do this because it had a seven-year credit facility with Merrill Lynch and a 10-film distribution agreement with Paramount Pictures. Blockbusters like Thor, Iron Man, and Captain America were products of this strategy.
Similarly, Scholastic, the world's largest publisher and distributor of children's books, benefits from the blockbuster model. Making the right bets on best-sellers has been critical to Scholastic's success. It reached its all-time share price high of $54 in March 2002, after record sales of the 'Harry Potter' series of books. Scholastic's share price also rose to a new nine-year high in 2012, when the sales of 'The Hunger Games' books increased sharply in anticipation of the first 'Hunger Games' movie.
Scholastic has seen its share price stagnate recently over concerns about its ability to secure new best-sellers in the vein of Harry Potter and The Hunger Games. In contrast, Disney seemed to have rediscovered its blockbuster magic with Frozen, an unconventional female-centric movie whose popularity grew via word-of-mouth.
Mickey Mouse and other iconic characters
Unlike other companies which generally earn money by selling the same product or providing the same service once, Disney can generate multiple sources of profit from a single character it creates or owns. Since its creation in 1928, Mickey Mouse has appeared on all kinds of licensed merchandise from T-shirts to watches.
Similarly, Disney's recent acquisitions added to its portfolio of iconic brands and characters. Marvel's comic characters such as Spiderman, the X-Men, Buzz Lightyear from Pixar's Toy Story, and the characters from the 'Star Wars' franchise are no less valuable than Mickey Mouse in generating licensing revenues.
Disney's revenue from the consumer products segment grew by 9% and 7% year-over-year in 2013 and 2012, respectively, offsetting some of the volatility associated with blockbuster movies. More importantly, its consumer products segment has the highest profitability of all its businesses with a 31% operating margin, while its theme parks and studio entertainment business have margins of 16% and 11%, respectively. With the recent success of Frozen, Disney is expected to profit significantly from the follow-on merchandise sales.
Another company which has leveraged on its portfolio of brands is Iconix Brand, the world's second-largest licensor after Disney. It counts Peanuts, Material Girl, and Ocean Pacific among other top names in its list of over 30 brands.
The attractive economics of a licensing model work in Iconix Brand's favor as the business generates high free cash flow, given the absence of capital expenditures and inventory risks. Apart from marketing and advertising spending, Iconix Brand doesn't have to incur costs related to sourcing, manufacturing, distribution, and warehousing. As of June 2013, it enjoyed guaranteed royalties in excess of $800 million.
The numbers speak for themselves. Iconix Brand boasts an impressive financial track record comparable to that of Disney. From 2004 to 2013, Iconix Brand has grown its top line and bottom line by compound annual growth rates of 12.7% and 12.8%, respectively. Its free cash flow margins have also been consistently above 45% for the last five years.
Foolish final thoughts
Even though its share price has reached a historical high, Disney remains an attractive investment candidate in my opinion. Disney's blockbuster strategy has received boosts from its recent acquisitions of companies with strong media properties, and recurring income streams from the sales of consumer products based on its characters should continue to drive its growth in the foreseeable future.