Disney's Dilemma: Looking for the Missing Magic

Mickey Mouse is still Mickey Mouse, but Disney is no longer the company it once was. The icon of American culture, which in its heyday regularly steamrolled Wall Street's expectations as it churned out top-notch entertainment, is struggling to redefine itself as an evolving society threatens to make its core business less relevant.

This five-part series, which runs through Friday, takes a look at the challenges facing Disney as it tries to reverse its recently flagging fortunes.

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Disney (DIS Quote) is bleeding, and its wounds may run deeper than anyone understands.

In the past year, the House of Mickey Mouse has lost its place as the world's largest entertainment company to cross-country rival Time Warner (TWX Quote). Disney's profits are sliding, and after a long and successful run, its stock has followed.

Even worse, the bad news has come seemingly out of nowhere, and it hasn't touched the rest of the entertainment sector. While Disney skids, its biggest competitors, Time Warner and Viacom (VIA Quote), are steaming ahead. After a long stretch of bottom-line losses, Time Warner is expected to move solidly into the black this year and double its profits in 2000, according to First Call. Viacom's earnings are also surging, with profits expected to nearly double this year.

For Disney, the story is starkly different. After growing an average of better than 13% annually from 1990 to 1997, Disney's profits rose only 4% in fiscal 1998 and will probably fall more than 10% this fiscal year, ending Sept. 30. (Those numbers actually understate the drop in the company's profits in the past two fiscal years, since Disney has repeatedly shuffled its businesses to give itself better year-over-year comparisons.)

It's not just that profits are down. Disney has also lost its once-uncanny ability to manage its earnings. For years, the company practically scripted its profits, guiding financial analysts to a consensus estimate, then posting earnings that were just ahead of that forecast. In mid-1996, for example, analysts were predicting that Disney's profits for fiscal 1997, which hadn't even begun at the time, would total 91 cents a share. Disney's actual fiscal 1997 profit: 92 cents a share.

Those days are over. Since last spring, when analysts first began to notice the strains on the company, estimates of Disney's future profits have come down month after month. In May 1998, analysts figured Disney would make $1.26 per share in fiscal 1999. Today, they're guessing the company will earn 80 cents. Disney has more than 2 billion shares outstanding, so that 45-cent drop translates into more than $950 million in missing profits, or about $1.5 billion in pretax operating profit for the year.

Take a moment to consider that: $1.5 billion, $125 million per month, $4 million per day. Gone.

Something is wrong with Disney's business.

Disney declined to comment on specific financial issues for this series. In a statement discussing the company's fiscal second-quarter earnings, which were released Tuesday, Disney Chairman Michael Eisner said the company is "definitely not satisfied with our current performance. As a result, we are taking a number of steps, including an across-the-board assessment of our cost structure to address the situation. We intend to make our businesses more efficient, increase our cash flow and position ourselves to better capitalize on the long-term growth potential of our brands."

The company earned $226 million, or 11 cents per share, in the quarter, down from $384 million, or 18 cents per share, in the same period last year. After reviewing the earnings report, several analysts cut estimates for Disney's fiscal 1999 earnings per share even further to around 70 cents. That cut translates into an additional $300 million pretax earnings shortfall for the company.

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What makes the falloff even more perplexing is that Disney is widely considered one of the world's best-run companies. For the past two years, the Mouse has found its way onto Fortune magazine's list of America's 10 most-admired corporations, a list that includes Merck (MRK Quote), General Electric (GE Quote) and Microsoft (MSFT Quote). The company's collaborators, from the animated movie studio Pixar (PIXR Quote) to the licensees that make its branded merchandise, say Disney is an highly supportive partner that keeps them well-informed about its plans and encourages them to work with one other. The Mouse is so dedicated to getting details right that it studies the way customers at its theme parks load up on condiments in its fast-food restaurants, then arranges them for ease of use.

Disney also spends far more than its competitors on creative research and development, which it calls Imagineering. The R&D pays off. Last year alone, Disney launched its first cruise ship, opened a new theme park and created the first DisneyQuest, an indoor amusement center heavy on virtual-reality games. All have won strong reviews.

Until last year, the company's results reflected those strengths. Through the 1990s, Disney has been the only consistently profitable U.S. entertainment company. From the beginning of 1990 to the end of 1997, its stock nearly quadrupled, while Time Warner's doubled and Viacom's rose just 44%.

To be sure, Disney has suffered some management turmoil recently, including the loss of highly regarded CFO Richard Nanula and the company's embarrassing decision to oust Michael Ovitz barely a year after hiring him as president. But analysts and investors say the company's management team remains deep and applaud Disney's long-term strategic planning and commitment to extending its reach into new countries and across the Internet. Disney's professional management stands out even more in the entertainment business, which is filled with would-be moguls seemingly more concerned about creating family dynasties than making money for their shareholders.

"Longer term, I think they're in a great position. I think they have an incredible asset mix [and] great brands, great promotional content, very strong management. They have a long-term business plan in many of their businesses, which is the beauty of Disney," says Merrill Lynch analyst Jessica Reif. (Reif rates Disney neutral; Merrill hasn't performed any recent equity underwriting for the company.)

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And oh, that brand.

Along with McDonald's (MCD Quote) and Coca-Cola (KO Quote), Disney is one of the world's most recognized consumer brands. Mickey Mouse decorates watches in Shanghai and plays on VCRs in Moscow. When word of Disney's talks to build a theme park in Hong Kong leaked in February, the news sparked a broad rally in the territory's stock market as local investors bet that the Mouse would single-handedly end Hong Kong's recession. A poll of almost 900 Hong Kong residents showed that some 90% supported the proposed park.

In the U.S., which accounts for four-fifths of Disney's revenue, the company's influence is even more profound. For 70 years, Disney's creations have been cultural touchstones, from Steamboat Willie, the first Mickey Mouse cartoon, to Snow White and the Seven Dwarfs, the first full-length animated movie, to The Lion King, the highest-grossing animated movie ever.

The company's influence can be measured by the assaults it draws from across the political spectrum. Leftists argue that the company promotes mindless consumerism and turns play into a for-profit enterprise, while conservatives increasingly accuse Disney of being politically correct and too friendly to homosexuals. But for most Americans, Disney still represents safe, kid-friendly, family-friendly entertainment. In surveys by Louis Harris & Associates, Disney consistently ranks among the 20 companies that Americans most admire.

"The secret weapon is trust. Disney is the most trusted brand name in the history of marketing. It hooks us when we're little and never lets go, this unshakable faith that Disney is the best at knowing what's best," wrote Carl Hiaasen in Team Rodent: How Disney Devours the World, a satirical, left-leaning critique of the company.

Click here to see Part 2 of this story.