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Disney's Big Character Test

Stocks in this article: DISTWXDISCANWSAMHP

In The Curse, the authors concluded that paying to own talent, international franchises and assets across disparate consumer media platforms is generally a hard to manage and loss-leading strategy. They highlight focused media companies like Discovery Communications (DISCA), efficient operations like McGraw-Hill (MHP) and businesses with a distinct, non-consumer competitive advantage like Bloomberg as far more valuable models.

Ava Seave, a co-author of The Curse and a principal at consultancy Quantum Media is skeptical of Disney's ability to gain added performance from Marvel or Pixar, relative to what either company could get independently. "You want to sell to everybody, whether you own it or not," says Seave, of a movie studios ability to gain pricing power in licensing content competitively to distributors. Still, she concedes that Disney has a record of finding and deploying talent.

Cuneo, the former Marvel CEO, believes Disney's ability to run Marvel and Pixar characters through its assets is its competitive advantage. Citing Disney's interest in bringing Marvel to theme parks, Cuneo says "to do this quickly would require capital that other entertainment companies don't have today." Cuneo doesn't currently own Disney shares.

"Disney's whole is greater than the sum of its parts," says Martin Pyykkonen, an analyst at Wedge Partners, who adds that Disney's broad base of characters gives it more segment-to-segment synergy than any other consumer media company. He expects that CEO Iger could use Marvel characters to bolster Disney's international presence. "It's much more germane to what Disney does."

The notion of synergy cuts against de-consolidation plans underway at Dow Jones Industrial Average giants like Pfizer (PFE), ConocoPhillips (COP) and Kraft Foods (KFT) and a post-crisis shareholder focus on realizing the full value of assets across Corporate America. Still, some investors own Disney for the benefits of its scale.

"We like Disney's stock because of their ability to leverage various platforms to maximize their advertising revenues," says Robert Key, a portfolio manager at CCM Investment Advisers, which houses $2.5 billion in assets under management and held roughly $13 million of Disney shares, as of March 31.

While Pyykkonen and other analysts are confident Disney benefits from being a conglomerate, there's still reason for shareholders to question whether the company's magic will run cold.

Disney's Studio Entertainment unit posted a second quarter operating loss of $84 million in May on it sci-fi epic dud John Carter, which prompted the unit's head Rich Ross to step down. Even counting the success of The Avengers, Miller Tabak analyst David Joyce expects the division to post declining revenue in 2012, on the loss.

Meanwhile, as of fiscal 2011, over 30% of Disney's revenue and 40% of its operating income came from its cable networks, fueled by ESPN sports programming. But with costs to broadcast the NFL's Monday Night Football rising in 2014, among other sports programming price increases, ad rates at ESPN will need to rise just as fast for Disney to maintain margins at its single biggest profit center.

Because of spending for initiatives like Shanghai Disney and the uncertainty of future ESPN margins, Matthew Harrigan, an analyst at Wunderlich Securities says that Disney is expensive on a free cash flow basis. "Are we at peak margins for ESPN?" wonders Pyykkonen of Wedge Partners.

Those spending and future margin concerns underscore just how crucial it is for Disney to be correct in its assumptions on the benefits of owning Pixar and Marvel.

In Disney's May earnings call, Iger highlighted Marvel and emerging market joint ventures as keys to an international push, citing limited inroads for ESPN abroad. " The opportunities for ESPN internationally I think are somewhat limited. That's not to say that they don't exist, but it's never going be a big part of ESPN's business," said Iger.

While Disney may be venturing in unchartered territory for a media conglomerate in proving the benefits integration, there's reason to believe that after replacing former CEO Michael Eisner with tremendous success, Iger could still get hit by the media mogul's curse.

Of the $200 billion in writedowns that media companies took between 2000 and 2009, the first paragraph of The Curse notes that those losses on M&A and spending pushes into new corners of the media world, "reflects the level of desperation among media moguls faced with new competitors, new technologies, and new customer demands."

For now, Disney investors may yet believe in its synergy magic, as they breathe a sigh of relief on a successful opening of Brave, one of Pixar's riskiest plotlines yet.

Meanwhile, Cuneo remains convinced that character-based intellectual property is a durable opportunity in media and entertainment. He and his son recently made a big investment in Valiant Entertainment, a company with 1,500 comic book characters, including Bloodshot, which sold movie rights to Columbia Pictures earlier in 2012.

-- Written by Antoine Gara in New York

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