Debunking the M&A Tidal Wave – Part II: Reviewing the Narratives

(Check out my first post analyzing the M&A landscape here.)

If you think we’re about to ride a wave of deal making, then grab your corporate strategy surfboard and let’s hit the entertainment and media waters!

Tortured analogy aside, if you saw the chart from yesterday, you know one thing…

MA PPT Chart…if you want to do M&A you should already be in the water.

If anything, the tide has been rising on M&A for years now. Deal making went from around $33 billion in 2009 (one report had it as low as $6 billion in 2008 in the depths of the Great Recession) to a frothy $200 billion in 2016. Since deal making takes time, if you waited until a judge in D.C. approved the AT&T-Time Warner merger, you’re probably too late. (And I don’t think most executives were waiting.)

Yet, the narrative after the decision was one courtroom decision will “unleash a torrent of deal-making”. Why does everyone think that?

My theory: because it is hard to look back and observe trends, as opposed to respond to events. Court cases make for exciting events. Single events get a lot of coverage. Long term trends get one or two articles a year, maybe.

So as I collected my thoughts around M&A in entertainment & media, I reviewed a lot of the articles on M&A in Hollywood. Frankly, the idea that one court case cleared the way for M&A activity isn’t the only bad narrative in this story. The idea that “disruption” is “forcing” large cable companies to merge also doesn’t hold up, to me. And that narrative even influenced the judge in the AT&T-Time Warner case.

Today, I’m going to review all the potential causes for the rise in M&A activity we see in the chart above. Then I’ll put those explanations in context of the AT&T decision. Then next week I’ll review the data to make my final prediction.

Reviewing the Traditional Narrative

Let’s start by making the case of why mergers are more frequent after the AT&T decision. From what I read, it would go something like this:

1. The entrance of tech giants (Netflix, Amazon, Apple, Google, Facebook) is disrupting traditional business models.
2. This increases the need for industry consolidation to survive.
3. But anti-trust regulators have looked skeptically at past mergers.
4. With this deal approved, companies can merge as much as they want!

I saw two major pieces of evidence marshaled for the conclusions above. First, people would use the “Disney – 21st Century Fox – Comcast” love triangle as evidence. But if anything, all the decision did was allow Comcast to bid, which it could have done anyways, and raise the price. The rate of mergers would have stayed the same. Same thing with using Shari Redstone trying to merge Viacom-CBS, which is a deal already in progress.

Second, people love to just throw out names of companies and say, “Could they merge?” If the proposed deals don’t have sources, they’re just blind speculation. Even with sources, they’re mostly talk.

Separating the Good Reasons for the Bad

Instead of crafting a narrative to suit our prediction, let’s look at all the possible reasons  for M&A activity, from the broadest reason to the most minute and ask some questions to assess their impact:

– Was this factor present in the past 10 years? 20 years? 40 years?
– Would this factor have continued regardless of the ruling?
– How important is this factor?

Industry consolidation

As I’ve mentioned before, industry has been consolidating for forty years under a lax anti-trust regime in the Justice department and in the courts. I don’t mean the media and entertainment industry, I mean all industry from healthcare to finance to retail to beverages to airlines to you name it. If every industry is consolidating (sometimes massively) then predicting future consolidation in entertainment is less bold.

I did, though, get sucked down a rabbit hole looking at consolidation in entertainment and media specifically. Consolidation is happening in every single part of entertainment from broadcast channels to cable channels to movie studios to radio stations. Even technology. So…

– Was this factor present in the past 10 years? 20 years? 40 years?
Yes, going back 40 years.
– Would this factor have continued regardless of the ruling?
Yes, the Justice Department easily blessed the Disney-21st Century Fox deal. Donald Trump’s administration and FCC chairman Ajit Pai love industry consolidation.
– How important is this factor?
Very important. As a Hollywood Reporter article said, entertainment companies have been merging since the 1940s, going through waves in the 1940s, 1980s, 1990s and the current one.

It’s a good business environment for mergers and acquisitions.

The evidence for this explanation—which specifically refutes an argument later about “tech disruption”—is that the entire M&A market is looking good right now across the economy. Indeed this is true, as this New York Times article pointed out (using Thomson Reuters data!) and Kevin Drum clarified with inflation adjusted numbers. This differs from the above explanation in that it is really about the consolidation numbers for the current economic climate.

It boils down to a few things, summarized in the New York Times piece: the tax break provides higher profits, interest rates have stayed low and the stock market is booming so firms need other ways to drive growth (and high share prices can increase capital available for M&A). So our questions:

– Was this factor present in the past 10 years? 20 years? 40 years?
It is cyclical, but has been building since the recession in 2008.
– Would this factor have continued regardless of the ruling?
Yes, that tax break isn’t going anywhere…unless a recession hits. But the ruling didn’t effect that either way.
– How important is this factor?
In my mind, nearly as big as the industry consolidation.

Technology firms are entering the media and entertainment business.

Notice, I’m not saying that tech firms are “disrupting” traditional business models. This explanation is simpler: technology firms like the FAANGs have huge amounts of cash on hand and/or huge market capitalization’s, so they are on a buying spree. This increases the likelihood of mergers not because entertainment companies need mergers to survive (they consolidate because of the above reasons), but because entertainment firms want to avoid being acquired.

– Was this factor present in the past 10 years? 20 years? 40 years?
Yes, going back 10 years.
– Would this factor have continued regardless of the ruling?
Yes, the Justice Department isn’t taking on tech giants either. Except for Jeff Bezos.
– How important is this factor?
It depends. So far, the major tech companies haven’t actually saddled themselves with a legacy content company, but built their own platforms (Netflix, Youtube and Amazon) or bought other technology companies (SnapChat, Twitch, What’sApp, Instagram). So we’ll see.

Tech companies are disrupting traditional business models.

This is the ever pervasive idea that streaming is disrupting pay and broadcast TV and music buying and radio and everything else. Oh and advertising is being disrupted too.

I look most skeptically at this explanation. The fairest way to describe this—and I’m trying to be fair—is that the new business models are cutting profit margins of traditional firms, so companies need to bulk up to maintain their profit margins. And it really is true that new entrants like Netflix offer much cheaper alternatives then traditional models, though, Netflix is less profitable in cash terms.

Like I said above, this is the explanation I value the least. Not that it doesn’t have an impact, but it has the biggest “hype to reality” ratio. Industry consolidation allows firms to increase their profit margins, which they do regardless of new entrants. Since this is happening across all industries, it seems like an explanation fitted to the data, not the true driver.

– Was this factor present in the past 10 years? 20 years? 40 years?
It is the one new factor of the last ten years.
– Would this factor have continued regardless of the ruling?
Yes. Netflix is still scary.
– How important is this factor?
It is mainly important for the mentality. It scares executives so they want to bulk up to ward it off.

Anti-trust regulators and the FCC plan to prevent further consolidation.

If you think the Trump administration had/has a plan to prevent consolidation in industry, could you please point it out to me?

Let’s be honest, the government under Trump and Republican leadership really doesn’t care about industry consolidation. Trump actually praised his friend Rupert Murdoch for making such a good deal with Bob Iger. He called it “great for job creation”. Under a Democratic President, maybe the FCC and Justice Department look skeptically at consolidation, but for all their efforts, the Obama administration only stopped three mega-mergers (Comcast/Time Warner Cable, Sprint/T-Mobile round 1, and AT&T/T-Mobile), and it only delayed the consolidation not stopped it.

So when it comes to the question, “What if the judge had ruled against AT&T?”, would that have encouraged the Justice Department to go on a spree of trust busting? I doubt it. Would they have stopped additional deals? Probably not. I think most of AT&T law suit was more about CNN then it was about the size of the deal. Consider, T-Mobile and Sprint merged before the final judgement. They weren’t worried about anti-trust. So the questions:

– Was this factor present in the past 10 years? 20 years? 40 years?
No. The government tried to stop the Comcast-NBCU merger and successfully dissuaded Comcast from the Time Warner Cable merger. But in the last 18 months? Yeah it hasn’t been a thing.
– Would this factor have continued regardless of the ruling?
Yes, it would have. Even when Obama tried to stop some mergers, over time the Justice Department was worn down. So AT&T bought DirecTV, Charter bought Time Warner Cable, and now cellular providers are merging. Again, that was all before the decision.
– How important is this factor?
Not important since it really didn’t effect the behavior of companies.

Mergers and Acquisitions are good for CEOs individually

Here’s the simplest, most human, most “economic” (or Freakonomics?) explanation for the frequency of M&A activity.

CEOs make bank off mergers and acquisitions.

In other words, if humans are self-interested, sometimes they pursue goals and outcomes that don’t align with the incentives of their company or firm. Making better products is hard. Cutting costs in painful. Merging with another company? Relatively easier and more profitable.

The trades are reporting that after a successful merger—meaning it goes through, not that it makes money—Jeff Bewkes made $50 million dollars last year, some of which was driven by Time Warner’s merger-inflated stock price. AT&T CEO Randall Stephenson can now demand a higher salary with his larger company to run. In the short term, M&A activity is rewarded by share price increases, even if the deal bombs, as happens about 50% of the time.

– Was this factor present in the past 10 years? 20 years? 40 years?
Yes.
– Would this factor have continued regardless of the ruling?
Yes, it would have. And honestly, the economy is set up to allow it to continue.
– How important is this factor?
Very. These are the self-interested decision-makers running the system. They’ll make deals to make money, and convince themselves it’s a good thing.

Playing Devil’s Advocate: Why could M&A decrease?

To summarize, the traditional narrative says M&A activity—the rate—will increase. I think it will still grow, but at the same historical rates. At worst, I’ve set a floor of “M&A activity will stay flat”, meaning it has zero growth. So at worst it will maintain its value of $140 billion in deal value per year with 16-18 mega-deals.

But could we make arguments in the opposite direction? That M&A activity will actually slow down? Sure. And if we’re building a 90% confidence interval for the future, we absolutely should give this more weight. What could stall M&A activity?

An economic slowdown

This is what stopped the last wave of consolidation. Basically, the 2008 housing crisis and Great Recession. When no one wants to lend, and share prices fall, and you don’t have profits on hand, then it freezes the market. This would slow or stop consolidation temporarily (and as I saw first hand motivate a lot of investment bankers to go to business school).

Tech continues to build not buy.

I actually don’t hate this strategy and the Bloomberg link at the top makes this case too. Amazon, Netflix and Youtube have all created businesses from scratch. Why buy a legacy company with lots of infrastructure when you can build it yourself? You potentially save a lot of money and, in some cases, it’s unclear what value traditional firms bring to the table.

But they do have some value. Disney doesn’t have its tremendous licensing and merchandising and theme parks businesses without some know how. They’ve kept these characters relevant and popular for decades. The question is: do you have to buy that company or buy those people, which is what Netflix is doing? So what tech firms collectively decide will impact the number of deals.

The number of potential partners dwindles.

This is actually the most persuasive reason for me: if everyone keeps consolidating, after a certain point there is no one left to partner with. This would easily impact the number of “mega-deals”. That said, we have a bit to go until we have complete consolidation, especially counting vertical mergers.

The market turns against conglomerates.

When I built a table to help me analyze M&A activity (collecting the data myself), I had to come up with a term for the big six movie studios. Honestly, “movie studio” sells it short and “conglomerate” makes more sense. It’s the best way to describe a company with television networks, a movie studio, TV production, gaming, theme parks and whatever else the “big 6” studios own.

Yet, in the 1980s, it meant companies like General Electric, which bought broadcast networks and made everything from industrial equipment to microwaves to Cheers. Then the market turned against conglomerates because most of the time big companies didn’t run all their different business units that well, and the market assumed that splitting conglomerates into their individual pieces would have better value.

Tech firms defy this logic. Maybe it is because the wise leadership of Jobs/Cook, Bezos, Zuckerberg, Hastings/Sarandos and Brin/Page truly does turn everything they touch to management gold. Or, they have such huge valuations being “tech” that they can enter any industry and it doesn’t matter. I’m not saying they won’t continue to be valued incredibly highly, but this state of affairs could end sooner then you think.

The political winds change

I want to put this out on Twitter, but wouldn’t the best political campaign for Democrats in the fall be to micro-target cities that have seen huge cable bill increases post-Comcast merger and post DirecTV merger? Just hit Republicans on the issue like this:

Republicans like Mitch McConnell and Donald Trump (and his lackey Ajit Pai) want to increase you cable bill to make their billionaire friends rich.

I’m not a pollster, so I don’t know. But does anything make people more angry than cable bills? Democrats use this! Either way, if a Democrat takes power in 2020, they could restart FCC scrutiny on issues related to anti-trust and merger scrutiny. It might slow the rate of mergers, but like Obama probably not stop it altogether.

We still don’t have a prediction yet

And yet we have 2,800 words on top of the words yesterday. But now that we have the explanations, on Monday, we can dig deeper into the numbers, beyond what the top line data said from Tuesday’s post.

 

Debunking the M&A Tidal Wave – Part I: Setting the Terms

After the Justice Department lost their anti-trust lawsuit against AT&T–which allowed the merger with Time Warner to go through–a consensus emerged in the entertainment press that I would summarize like this:

“The approval of this merger will start a wave of acquisitions and mergers in entertainment.”

This isn’t a straw man argument: I saw this in the Hollywood Reporter, Variety, The Washington Post, Deadline and Bloomberg. (And probably more I just didn’t capture in link form.)

Natural skeptic that I am, in my initial reaction that week I wondered, is this true?

And if we’re asking if it’s true—and we don’t know because it will take place in the future—that means it’s a prediction. And if you agree with the above sentiment—meaning you find it true—you’re predicting the future too.

Predicting the future is hard.

Let’s play a game. It’s the prediction game. Many writers made the prediction above. Many analysts echoed those in stock price moves or recommendations. And you likely agree with it. So answer this: If mergers and acquisitions are increasing, what do you think the percentage increase in mergers and acquisitions in entertainment will be in 2018? 2019? For the next five years?

Write it down if you can. Or lock it in your head. We’ll return to it at the end.

Once I started thinking about this question, I started scouring the internet for data on M&A activity. Then I started writing. Then the article kept going. And going. All of which is to say, I’m going to dive deep into this topic and hopefully return over time. The merger of AT&T and Warner Media Group is probably the first or second most important news story of the year, so we should understand it.

Making a prediction about the future is a good way to understand it. However, my prediction will be quantified and written down on this website by Monday. But we have some work to do to get there.

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Most Important Story of the Week and Other Good Reads – 6 July 2018

Happy 4th of July week! If you’re like me a holiday in the middle of the week just crushes my schedule. But that doesn’t mean we don’t have time for some updates on (what I consider) the most important story of the week and some other good reads.

The Most Important Story of the Week – Sony gives an ultimatum to movie studio head

I’ll give credit to the Ankler/Richard Rushfield for this story. (I hadn’t seen it otherwise.) From the June 28th letter, we found out that Sony has let new-ish boss Tony Vinciquerra and movie head Tom Rothman know that they have three years to get a better return on equity before they sell the studio. As Rushfield, ably points out, their movie pipeline is essentially already built out, so how much better could they make things run?

So why is this the most important story? Well, it encapsulates the history of Hollywood in one movie studio. Or two that merged together. In a way, Sony was the “Amazon” of the 1980s: a huge new firm in a burgeoning industry. This time, electronics instead of technology. And like Amazon or Apple or Facebook or Youtube, the company saw “synergies” in owning content, so it bought a movie studio. Then, the new owner could never figure out how to apply the lessons that helped it dominate another industry to Hollywood. Film-making defies other business logic. Sony could also never quite find the right person to run its new operation and ultimately, had a huge write down for entering this business.

The question is: will the tech companies make the same mistake(s) as Sony? Will the tech companies pay too much for content? Remember–and most deal analysis forgets this–no matter how much of a strategic advantage something is, if you pay too much for something you still lose money. You can absolutely destroy shareholder and customer value by overpaying for an asset.

Other Contenders for Most Important Story

US officially enacts tariffs on China.

The ongoing impact of trade tariffs will be a story to monitor. So far, technology and entertainment have been left out of the fray. That said, a lot of the genesis for why the Trump administration feels hostility for tariffs–China steals IP; China bans foreign ownership–is acutely felt by internet firms. American companies want to do business in China and given the easy ability for tech firms to enter new markets, this stings especially bad. (Though if you’ve ever wondered why Sony doesn’t own a TV network, the US bans foreign ownership of broadcast and cable channels. Imagine a world where Rupert Murdoch never received US citizenship.) Now, I’m still looking more to Europe to see if they will target US media or entertainment or tech companies, but I do think the China tariffs news signals Trump’s resolve to plow ahead with a trade war.

Netflix wins challenge against Fox on lawsuit on executive compensation.

This article popped up in my “Twitter thinks you’d like this” feed. I’m not sure I love that feature, but in this case, yeah I’m interested in that. This is a legal issue that I haven’t read up on–the THR summary is pretty good–but anything that could end a common employment practice (fixed-term employment contracts) that is currently standard feels important. I will add that on initial read, the Fox employment contracts sound very one-sided, which in a rapidly consolidating industry, is both awful and predictable.

An Update to an Old idea

We love crafting narratives. Especially when it comes to our favorite intellectual property. So if the next Star Wars films bombs, it will be blamed on The Last Jedi or Solo: A Star Wars Story or both. Or it will be some combination of critical acclaim and customer feedback.

Or, as Scott Mendelson writes, it could just be because the November/December of 2019 will literally be crazy filled with BIG movies. We could try to assemble a complicated narrative for why Episode 9 will under-perform, or we could just understand it has huge headwinds going against it. Money quote:

November alone will see Warner Bros./Time Warner Inc.’s Wonder Woman 1984, Paramount/Viacom Inc.’s Sonic the Hedgehog, Annapurna’s James Bond 25, Paramount’s Terminator reboot and Walt Disney’s Frozen 2. And then December will have Walt Disney’s Star Wars 9, Fox’s Death on the Nile, Universal’s Wicked and Sony’s Jumanji 3 all likely/possibly opening on or around Episode 9’s Dec. 20 release.

Listen of the Week

So last week I was fairly complimentary of the “listen of the week”, an episode of NPR’s Planet Money’s The Indicator (that’s what I call it) about MoviePass, a company I can’t stop reading about. This week, I’m recommending an episode of “Money Talks”, an Economist Radio podcast. (I subscribe to their podcast feed for all their episodes.)

It’s about Netflix.

Unlike MoviePass, I avoid reading about Netflix. Most articles cover the same spin, and you’ve heard this all before: Netflix is changing the game in content production by spending huge amounts of money. The Economist calls this Netflixonomics.

To their credit, the podcast does ask Reed Hastings on exactly how much money Netflix is losing. The fascinating part, to me, is that Hasting’s answers come across as “disruptive” but are as old as Hollywood. He mentions that costs in TV production are front loaded. Okay, that’s true for blockbusters and big TV series for everyone. He also mentions that one hit can help a network/streaming platform for years. Okay, that’s also true for everyone. Earlier, the podcast mentioned that Netflix is producing shows for a global audience. Okay, that’s true for every studio. (Ask HBO is they’re selling Game of Thrones globally.)

So again, keep a skeptical eye out when you read/listen to entertainment news.

Disney-Lucasfilm Deal Part VI – Television Revenue

(This is Part VI of a multi-part series answering the question: “How Much Money Did Disney Make on the Lucasfilm deal?” Previous and future sections are here:

Part I: Introduction & “The Time Value of Money Explained”
Appendix: Feature Film Finances Explained!
Part II: Star Wars Movie Revenue So Far
Part III: The Economics of Blockbusters
Part IV: Movie Revenue – Modeling the Scenarios
Part V: The Analysis! Implications, Takeaways and Cautions about Projected Revenue
Part VI: The Television!
Part VII: Licensing (Merchandise, Like Toys, Books, Comics, Video Games and Stuff)
Part VIII: The Theme Parks Make The Rest of the Money)

So film is dead. TV reigns supreme. We know this.

Except, it’s not?

I mean, we just calculated that Disney made back 63% of their initial investment on Star Wars with four movies, and has many more in the future. At its peak, nothing can challenge the feature film.

Though some gigantic TV shows have come close. Game of Thrones is a juggernaut in ratings, home entertainment purchases and merchandise sales. The top TV shows can command sales figures in the billions of dollars years after their initial broadcast. I’m thinking of Friends or Seinfeld. And not just in America, but overseas, like The Simpsons, which travels well because it is animated.

Of course, now seems like the time to mention that the future of TV isn’t in international sales, but streaming. (That’s semi-sarcastic.) Streaming will play a key role in Disney’s future and, as Disney CEO Bob Iger has put out, new Star Wars series will be a centerpiece of that.

So let’s value two more pillars of Disney’s empire today: adult and children’s television.

TV – Adult

Being frank, this is much more complicated than calculating projected revenue for films. With movies, we know how well they did at the box office and roughly in home entertainment, so we can assume a lot of the other windows. We can also use box office data sets to gauge ranges of outcomes.

We don’t have that luxury with TV anymore. Subscription services like Netflix, Amazon, HBO and Hulu can hide online ratings. They don’t release the costs of the shows. Other windows are more complex than film: Netflix won’t release in DVD if it doesn’t have to, Amazon hasn’t decided, and HBO will release its shows on DVD, merchandise and even sell to other networks. Even Nielsen data is available, but expensive. (I don’t have it since I’m not in a corporate setting.)

I don’t know what Disney will decide, which makes calculating the value for television series so difficult. Given the variability in the rest of the model, I’ve had to make some simplifying assumptions.

To start, how many series will Disney make? I’m going to assume that since Disney has said they are working on a “few TV series” this will mean three series released per year from 2019 (when the service launches) to 2021. And we’ll give each a three year run. Likely, some will do better, some will do worse. (Better meaning 5+ seasons, worse meaning one season. In between is 3 seasons.) Since they’ll keep making TV series, my model has two new series premiering after that through 2028.

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The Economics Behind Not Making More “A Star Wars Story” Films

I love Han Solo.

To put out my Star Wars bonafides—as if proving I’m a hardcore nerd makes me cooler—I’m the type of Star Wars fan who read the both the Han Solo trilogies, one from the 1980s and the other from the 1990s. Don’t believe me? Here’s my collection of just Han Solo books dating from again 1980 to 2015:

IMG_3549

So it isn’t a coincidence that I chose the Disney-Lucasfilm acquisition for my first “analysis article”. And it’s partly why I can’t stop writing about the disappointment of Solo: A Star Wars Story at the box office. As a hardcore Han Solo fan who loves the business of entertainment, sort of combines two loves into a just overall intriguing topic.

Today’s article is a response—in as near real time as I get—to the Star Wars issue of the day: the future of Lucasfilm’ business slate. First, Collider revealed that Lucasfilm was putting spinoff films on hold. Then The Hollywood Reporter clarified that Lucasfilm was just being careful with future development. Then other outlets jumped in to comment or repeat the news.

I’m not a traditional journalist so I don’t have those inside sources. But I do have expertise in the business ramifications of these decisions. And having spent the last four months analyzing all of Lucasfilm’s finances, I have a complicated model on how their movies perform. This model will allow me to answer some questions about why Disney is slowing the pace of production for Star Wars.

Questions sound like a good way to go. So I’m going to set this up as a fictional Q&A:

Question: Can you explain in one chart why Disney/Lucasfilm are slowing development?

Sure. Here’s the “hockey stick” shape of box office performance from my article on the economics of blockbustersslide-17-e1529621369496.jpgThe take away is pretty simple: the spin-off movies are doing about half as well as the “episode” films. If you look at this chart, you’re tempted to say, “Hey, we should just make Episode films only, and not make spin-offs.”

Question: Do you buy this explanation?

Not really. We’re in the realm of small sample sizes. Ten movies, to be exact. So just assuming that calling something an “Episode” film will make it perform better doesn’t make sense. We need a deeper explanation of the underlying forces.

Question: What are the underlying forces?

Well, as I tried to model, the “economics of franchise blockbusters”. I created a comparable films data set of 75 films, but then trimmed it down to answer specific questions. I modified it in four different ways: Star Wars films since the beginning, Star Wars films since 1999, all blockbuster franchises since 2008 and finally any franchises that showed “fatigue” since 2008. Again, I used adjusted US gross to even these out. Here are those four categories:Slide 28The takeaway of this is that Star Wars does really well. In just the films since 1999, 43% have been “super-hits” (over $700 million in US adjusted box office). But franchises that start to show fatigue didn’t have any super-hits. So we can see that keeping box office performance strong can have a tremendous upside.

Question: Can we quantify what the upside is?

Yeah, I can. Here’s the financial models I made for my “comparables” at each level:Slide 23As you can see, a super-hit isn’t worth just a bit more, it’s worth over four times as much as just a “median” blockbuster hit. (And flops cost you $40 million or so dollars.) In other words, you can attempt nearly 20 franchise blockbusters to try to get a hit.

(One note, the comparable numbers are lifetime numbers. In my model I condensed revenue to a four year period, but the point is Disney, with the blockbuster that is The Force Awakens will make money off of it for decades with resales, DVD sales, or putting it on its own SVOD platform. My numbers seem high, but for a film with a huge box office you make money off of it for years.)

Question: So can we combine the performance and comparables models?

Absolutely, and we get the “expected value” per film. In other words, if you make a franchise blockbuster, what is the expected value? Here is the a combination of the two charts, with the expected value.Slide 38Calculating “expected value” is easy, just multiply the probability of the various performance by the net profit. Once you do that, you see that if Star Wars can sustain at it’s historic level, it’s worth $731 million per film, whereas if it decays into franchise fatigue, that’s only $284 million per film.

(Side Question: Does this expected value apply to all blockbusters?

No! My franchise blockbusters are films in an already established franchise. Attempts at new franchises (which is what most blockbusters are nowadays) can differ in two ways. First, when they lose money, it isn’t just $40 million dollars. Even Solo had a gross of $375 million. And it is lumped in for sales with other Star Wars films. Flops like John Carter from Mars or The Lone Ranger can be in more of the $280 million dollar range. I was going to put The Mummy from last year in this, but it still did $400 million in total box office globally, with only $80 million in the U.S.

The other factor is the new blockbusters have a naturally lower hit rate then established franchises. These two factors make blockbusters riskier than established franchises, but less risky then lower budget films. This table is why, though, I said that Legendary could be doing “moneyball” with movies. They have seen this math, so their key was getting enough capital (billions) to back large movies like this to see the return. Back to the questions.)

Question: So Lucasfilm can’t lose money on these movies? Is that what you’re saying?

In the aggregate, yes. If you make enough films, and your movies perform according to the historical pattern, yes you won’t lose money. Of course, once “franchise fatigue” sets in, a film studio will chose not to keep making as many movies. And if it were on a true, sustained downward trajectory, then the value could drop further. Moreover, all these expected values are just one input into a model with a lot of uncertainty. If you deliberately made a lot of bad movies, yeah Lucasfilm could figure out how to lose money.

Question: So knowing this, how many Star Wars films should Disney make?

To answer that, I really need to go back to my model. (I explained how I got these numbers here, here or here.) To figure out how much money Disney will make on Lucasfilm, I needed to model the expected value over the next ten years. This needed to account for different production issues and different box office performance. Put it all together and I got 8 scenarios. This chart is new, though, and only calculates what Disney could make on Lucasfilm movies over the next ten years, discounted back to 2018 dollars.

Pic 7.jpegWhy discounting to 2018? Well, we’re looking forward so unlike my analysis that is partially backwards looking, we’re evaluating the value of Lucasfilm into the future. Since 2018 is the year Disney/Lucasfilm has to make the decisions about new films, that’s when we need to time our dollars.

(Question: Does the above chart include Episode 9 or Indiana Jones 5?

No included them in my overall analysis of the deal, but not here since I am assuming Disney is already committed to them. They’re sunk costs so don’t effect the planning for the rest of the future Star Wars films.)

Question: Okay, that’s a lot of numbers, any takeaways?

Yeah, first Disney doesn’t lose money in any scenario going forward. In the one scenario where they could—making a ton of films as fatigue set in—they would pull the plug on that course of action, as they are contemplating right now.

But the biggest takeaway is that sustaining the “Star Wars is Star Wars” scenario is more valuable than any production decisions. Accelerating to “MCU style” definitely has higher up side, but if you can’t hold onto the audience, then you lose 40-66% of the value. Even a troubled production slate (“Issues”) achieves a higher return than going to MCU-style if you can keep “Star Wars is Star Wars” at the box office.

(So if you’re a Star Wars fan who’s disappointed in Disney for making too many Star Wars films, here’s you counter-argument to show to Disney execs. Say, “See, Disney if you make fewer films you can make more money.”)

Question: Do you buy this?

It all hinges on is correlation. Is the number of films causing the franchise fatigue, or is it unrelated? The model I have here shouldn’t be interpreted to say that franchise fatigue is caused by increased film output. I consider these two things independent in the scenarios.

That said, as I wrote in the Solo: A Star Wars Story post, yeah, I do think they are related. There is a reason why only one franchise has been able to release multiple films per year and not decay, and that’s Marvel. (And that reason is Kevin Feige.) Otherwise multiple films in a year or even more than every three years tends to yield a decline at the box office eventually. In short, hardly any film franchises can sustain sky high box office if they release a film every year.

Question: You just said that franchise fatigue is both related and not related to the number of films. So which is it?

The better way to say it is franchise fatigue is related to film quality. To go back to the Marvel example, the films keep being excellent. Dr. Strange is the worst reviewed movie in 18 months, and was still well-received. Before that you’d have to go back to Ant-Man. So when Marvel says we can do more movies and keep them great, then franchise fatigue doesn’t set it.

The last two Star Wars films both had mixed customer or critical reactions. That’s what causes low box office more than anything. Increasing the number of films increases the odds of more bad films, which causes fatigue. Very, very few franchises can keep the quality sustained at a high rate for that long, besides Marvel (and again Kevin Feige).

Question: Any other concerns with the model?

Well, the “Star Wars is Star Wars” version is a very small data set. Only 10 films so far. And it is a franchise that is unique in that there were two large gaps between initial films and the prequels (15 years) and the new films (10 years). This built up massive enthusiasm. This is why I don’t model another hit the size of The Force Awakens. I think Disney knows meteoric hits are rare, and as dependent on quality as they ever were.

Question: So after all that, why is Disney making this decision from a business perspective?

Disney is slowing to one film per year, roughly, to keep the quality high. It will also avoid risking bad films and hence franchise fatigue. At the same time, decreasing below that rate leaves money on the table, as our expected value chart and scenarios show. So expect Disney to keep one film per year.

Question: Do you have any other concerns?

Well, the worries about fatigue will only amplify is Lucasfilm releases one or multiple TV series aimed at adults on Disney’s new streaming platform. Even dialing back the movie releases won’t mean Star Wars isn’t in the culture. If the TV series aren’t good or the marketing machines over hype the new series, cutting back on the number of films may not matter.

Also, the TV shows bring up another issue I haven’t really addressed yet, which is the other lines of business. Keeping Star Wars relevant impacts the toy sales, the streaming service, the kids TV and the theme parks. That’s another reason to focus on quality movies.

Question: What is the biggest assumption in this analysis?

The big assumption, and I assume Disney believes this to be true, is that development executives at Lucasfilm can indeed improve quality by slowing down production. Of course, that assumes that development execs are skilled at development and can indeed make better movies, they just might have been spread to thin.

I actually don’t believe this. Assuming that you can simply make better films with the executives you have by trying harder…isn’t really a data-based position. I have a ton of thoughts on how to improve development—most of which Hollywood doesn’t do—but not enough time in this article. Keep reading this site and I’ll get to it.

Question: Do you have any creative concerns?

I do, but this is me putting on my “development executive” hat.

As I was researching Solo I read that Rian Johnson’s new trilogy due in the 2000s will close out Rey and Finn’s arcs. While critics praised The Last Jedi, they tended to gloss over the larger plot: the Resistance lost. I mean, the Resistance is basically 20 people on a ship and the First Order took over the galaxy. With such a deep hole, and knowing that Rian Johnson is making three more films to close out the story, the key question for Episode 9 is this:

Will the good guys win?

If they don’t, and it ends on another “cliffhanger” a la Empire Strikes Back, I think you could see another negative fan reaction. Or at least, it will have to be a pyrrhic victory, where the good guys win, but the First Order is still in charge.The fans want closure to this arc; if they don’t get that, it could impact future box office. This is one of those creative decisions that could impact the business, but is super hard to model.

Question: Fine, just for fun, what would you do if you were Lucasfilm?

Make a Tales of Mos Eisley TV show. It’s still in the core world, but exploring possibly the best short story collection in the larger Star Wars universe. Which is to say, spinoffs shouldn’t be dead quite yet.

Weekly News Round Up – 29 June 2018

Welcome back to another week of my read on the most important story of the week and some other reads or listens to keep you informed on the business of entertainment.

Most Important Story of the Week – Box Office is Strong in 2018

As I wrote after the Solo: A Star Wars Story opening, I don’t follow weekly box office updates too closely. Or more precisely, I don’t consider them the “most important story of the week” most weeks since there is a lot of noise. Instead, I recommend waiting to judge the box office until we have a large enough sample size to draw a conclusion.

Which we had this week in this Variety article analyzing the box office of the first six months. Yeah, six months is a good time to sit back and observe the trends. So far, driven a lot by the surprise monster hit of Black Panther, the unsurprising Avengers: Infinity War performance and solid openings for Deadpool 2, Incredibles 2 and Jurassic World: Fallen Kingdom, box office is up.

The one question, which I’ll reference in a few seconds, is the “MoviePass” of it all. Is MoviePass bumping up attendance by offering artificially lower prices? As the podcast below says, MoviePass claims to sell 5% of all box office tickets in the US. If the MoviePass effect disappears–if it is real and does disappear–could that hurt box office?

Other Contenders for Most Important Story

First, the Justice Department signed off on the Disney-Fox merger if Disney spins off Fox’ Regional Sports Networks. Again, we’ve covered this deal before, but this step does make the merger immensely more likely. (And as the above article on box office highlights, combined the movie studio would have 48.5% of box office this year, which seems…high.)

Second, another social media platform launched more original video. This time Instagram. I want to shrug mainly because everyone making original TV and we don’t have any real metrics to judge success. Which is a topic for a future article. But this does mean more potential capital flowing into Hollywood.

Listen of the Week

Take a listen to The Indicator discussing the implications of MoviePass’ business model. I think MoviePass is one of the more fascinating stories out there, but it remains to see how big of an impact will it have. (Consider this the fill-in for AMC announcing their own subscription service.)

In addition to a business consultant, the good folks at The Indicator interviewed the CEO of MoviePass, Mitch Lowe. This isn’t necessarily a bad thing–CEOs obviously have a ton of knowledge about the company they’re talking about–but it is a red flag on reliability. CEOs and PR folks are well trained in phrasing everything to pass SEC scrutiny, but presenting the best possible case about their company. So you have to have your eagle eyes to spot misleading data.

And I found one glaring one. The CEO of Movie Pass happily passes along this tidbit: the average MoviePass attendee only sees 1.7 movies per month. As a result, MoviePass is confident they can make money with some additional revenue by the end of the year.

But can we take even that “1.7 movies per month” number at face value? Is that the median or mean average? Wait, which month is it from? Is it a rolling average or the number from last month? Or–and this is where it gets potentially shady–was it from a month selected because it looks the best?

He also said at some point that they are “fast approaching 3 million” subscribers. Again, you could take that a lot of ways from they have 3 million currently paying subscribers or they have huge customer churn (or will) when all the annual subscriptions end.

The lesson? Listen to CEOs, but try to hear what they’re leaving out.

An Update to an Old idea

In my first article, I wrote a sentence that critics have bemoaned the number of franchises, sequels and blockbusters going back to when I first started reading the newspaper. But I couldn’t find a lot of historical examples since the internet isn’t great about searching the pre-internet age.

But Sean Fennessey helped me out with this article in The Ringer laying out the sheer volume of sequels coming out. This headline in particular captures the feeling of so many critics: “The Summer of Sequels No One Asked for (or Even Thought Possible)”. He later said,

“It is the first in a series of movies arriving in coming months appearing out of no evident desire, without the breathless anticipation that the studios have churned out for bigger, louder franchises. They’re crypto-franchises, ginned up without anything better to do.

Disney-Lucasfilm Deal Part V: Movie Revenue – The Analysis! Performance, Implications and Cautions

(This is Part V of a multi-part series answering the question: “How Much Money Did Disney Make on the Lucasfilm deal?” Previous sections are here:

Part I: Introduction & “The Time Value of Money Explained”
Appendix: Feature Film Finances Explained!
Part II: Star Wars Movie Revenue So Far
Part III: The Economics of Blockbusters
Part IV: Movie Revenue – Modeling the Scenarios
Part V: The Analysis! Performance, Implications, and Cautions)

Have you ever been on a long hike? Your friends tell you, “Let’s go on this beautiful four mile hike to the top of a mountain with a scenic overview.” So you say yes. You go. It’s long, but you keep trudging.

Midway, you start to count your steps, anything to avoid thinking about the burning in your legs. You imagine the joys of finishing. It just keeps going.

Finally, mercifully, you finish and you’re at the top of the hill. Man, the view is worth it.

Gorgeous.

Then it hits you: you have another four miles to get back down.

It was four miles each way.

That’s a test of fortitude. I bring this up because this article just keeps going. Every time I think I’m finished, well I find another fascinating principle to explain. The “movies” portion alone has kept me busy for four parts and a bonus appendix. (And maybe a bonus article next week on this topic.)

Last time, I explained how I built 8 scenarios forecasting the future of Lucasfilm’s film slate. Previously, I explained how feature film economics work, explained my financial estimates for the first four Star Wars, and explained the economics of blockbusters, which developed a set of “comps” for franchise blockbusters. I brought them together in my 8 scenarios. Today, we’re bringing it home to analyze the results of my model. (See the links at the top.)

Really, this is the fun part. The hard work was building the model and getting some good data to make it accurate. That was the hike up the hill. Let’s gaze out at that gorgeous view, to drive the above analogy firmly into the ground.

Overall Performance

The best way to summarize our 8 scenarios is to calculate the net profits for each outcome. (In my model so far, gross profits are revenues minus costs, and net profits then subtract talent participation.) I’ve discounted them all back to 2012 acquisition dollars since that is when Disney first acquired Lucasfilm:Slide 33Those are a lot of big numbers, so another way to look at it is in percentage terms of the acquisition price ($4.05 billion with a “b”). Here’s that:Slide 34Wow. So in 5 scenarios, Disney makes all its money back with just this line of business alone. Further, even if they only achieve “Blockbuster Average” at the box office, they can even have production issues and still get 94% of the initial price. At worst, with production issues and a franchise fatigue, they still make back 82% of the initial deal price ($3.3 billion in adjusted dollars).

Still, I can hear you, “Entertainment Strategy Guy, just give us a single number! Tell us the average!”

In scenario modeling, the “expected value” is the closest thing you get to an overall “average”. To give that to you, though, I need some probabilities. These scenarios aren’t equally likely. It’s more likely that Lucasfilm has production issues then it is they ramp up to 14 films per year. It’s also more unlikely that “Star Wars is Star Wars” at the box office, as opposed to franchise fatigue or just general underperformance.

So here is how I would rate the probabilities of each scenario. And to simplify things, I gave each scenario it’s own name to make it easier to refer to. And it’s more fun. So how likely are each scenario?Slide 35Here’s the thing: I don’t have great rationale for the production side of the equation. I had started with MCU-style at 20%, but given the vague post-Solo rumors, Lucasfilm put the spin-off movies on hold. That makes me think they will strive for the one film per year rate. For the performance, I think the odds that franchise fatigue truly sets in is about as likely the high case where Star Wars defies box office gravity forever, especially if Lucasfilm determinedly releases 1 film per year. (Remember, before this, Lucasfilm had a 15 and then 10 year gap in films.)

I used my judgment for these probabilities, but I could tweak them if I found better data to make the forecasts. So with the probabilities of our two inputs, we could calculate the probability of each scenario.

Slide 36

The odds of “Gangbusters”, the scenario where “Star Wars is Star Wars” at the box office while moving to two films per year is only 2%. That makes sense; each is unlikely. On the other hand, the idea that franchise fatigue sets in and they have production issues (“Worst Case”) is 5%, which feels right.

In the downside, in “Burn Out” or “Sub-Optimal” Disney doesn’t make their money back. On the other hand, Lucasfilm makes money in the “Base Case”, “Make Money”, “Make More Money” and really cashes in with “Gangbusters”. They also make money in “Missed Opportunity”, though it contains a good lesson that production issues can really leave money on the table.

With our probabilities and the returns, we can now calculate the “expected value” of Star Wars movie revenue going forward. To take this all the way back to the introduction from yesterday, I can’t tell I “know” how well the films will perform from here on out. (Again, that quote.) But I can tell you this is what I expect just the movie portion of the deal to be worth, in financial terms: $4.3 billion in 2012 dollars from 2015-2028. In other words, I expect the movie net profits, after costs and talent participation, just the movie revenue, without toy merchandise sales either, to account for 106.8% of the value of this deal through 2028. In just one line of business, Disney made its money back.

Slide 37

It does strike me that my “base case” scenario is fairly close to the expected value (only off by about $40 million, or less than 1%. So was it a waste to build all the scenarios? No. Those numbers represent two different things, though it does give me confidence in using the base case in an “average total model” when I finish all the lines of business.

Implications

Overall performance isn’t the only thing we can learn from this model. The great thing about a scenario model like this is we can learn some things from it (assuming our math is right, the data is accurate and representative and our assumptions are reliable):

“Franchise blockbusters” have a low downside.

This was a conclusion from “Part III”, but bears repeating. Blockbusters based off preexisting movie series can usually put up something of an opening weekend and make some money. This doesn’t apply to brand new blockbusters, who can lose a whole lot more when they completely flop (I’m looking at you, John Carter of Mars and The Lone Ranger. I wonder what studio made those?)

For franchises—movies in a series based off preexisting IP, for lack of a better definition—the downside really is limited. For Lucasfilm, you can see why they’ll keep making Star Wars films: it’s a low downside risk. (If you’re a Star Wars fan upset at Disney making so many films, well this is your explanation.)

We can quantify this per film with our “expected value” chart as well. Here is the net profits from the green light model per comparable level. Now we can multiple these by expected probabilities:Slide 38For a franchise blockbuster, like Star Wars or Marvel or Harry Potter, the studio can expect $392 million in expected revenue if it performs like past films. Now they will hardly ever get exactly that, but in a portfolio of films this is what they can expect to earn. (For Star Wars fans who think Disney is driving the franchise into the ground, this is your financial explanation of why.)

2020 is a big year for the model

I put most of Star Wars: Episodes 9’s revenue in this year because it will come out in December of 2019, so Disney won’t collect the cash until 2020. Combined with an Indiana Jones 5—if it stays on track—then the total revenue in 2020 is $2.7 billion. That’s a big year. Combined with a 2019 or 2020 release of a new TV series and Lucasfilm has a lot going on.

The time value of money starts to have a strong effect.

The time value of money has a real effect. Take the $2.7 billion in 2020 dollars. Well, discounted back to 2012 dollars, it’s only worth $1.6 billion.

Assuming Rian Johnson’s first new Star Wars movie comes out in 2021 (the year after Indiana Jones or the Christmas of 2020), if you booked all the profit and loss the next year (2022), well you would only earn $0.50 on every dollar in 2012 dollar terms. Again, not that Disney wouldn’t collect each dollar, but if you’re evaluating the deal in 2012 terms, ten years down the line a dollar is only worth half in 2022 what it was worth in 2012 when discounted at 8%. The easiest way to understand the time value of money (for me) is to multiply the money earned by the discounted rate, as shown here:

Slide 39That’s why literally more than half the value of this deal in terms of movie revenue was baked in when the first four films came out, again when evaluating in 2012 terms. Essentially, huge box office returns from the first three films locked in 63% of the adjusted price. A huge Episode 9 and big Indiana Jones 5 (which I assume in half of the scenarios) yields another 23% of the initial price. By 2028, if the series performs on blockbuster average, the last seven movies only make 20% of the initial price of the deal. Here is how that looks by scenario:

Slide 40In terms of our initial question, it basically says that Disney would have to do a lot wrong with the franchise to NOT make money at this point. It’s possible, just much less likely.

Cautions & Criticisms

I’m not perfect, so naturally I can look at my model and give some critiques. Let’s keep these in mind so we don’t take this model as 100% gospel truth.

Be ready to update your priors…especially with small sample size.

If it seems like everyone is over-reacting to Solo’s disappointing box office, well I disagree. Essentially, I think Solo: A Star Wars Story caused a lot of people, myself included to “adjust their priors” to use Bayesian/Nate Silver-ish talk. We assumed Star Wars films didn’t have flop potential when they clearly did. Solo: A Star Wars Story changed my preconceived floor of box office performance for this franchise. I changed my whole model based off that event. That’s worth the conversation.

And it should provide a warning. Do I have other prior assumptions I haven’t captured in this model? I tried to call out as much as possible, but it’s always the concern. Off the top of my head, a big potential swing in value is the probabilities assigned to each scenario. If instead of my probabilities you just assigned an equal likelihood, then Disney would earn $4.6 billion, or 115% of the initial price.

(Of course, there is always the fact that my model might not match the actual performance. I did a little searching for research on other projections of Star Wars revenue/profits and I’ve found a range of numbers. So again, I went with my best judgement.)

This current expected value isn’t the expected value at the time this deal was signed.

Don’t mistake the current estimate of value ($4.3 billion in 2012 dollars, 106% of initial price) for the expected value at the time this deal was closed.

In 2012, at the time Disney signed this deal, a new trilogy could make over $5 billion in total box office, or it could have made “only” a billion dollars. Or somewhere in between. That’s immensely reasonable. Now, Lucasfilm and Kathleen Kennedy hired the right director for The Force Awakens and that didn’t happen.

Evaluating the deal midstream, we get to look back with hindsight and look forward with our forecasts. But that doesn’t mean the performance for the last five years was guaranteed by any means.

Is “franchise blockbusters” the right data set?

This is the toughest part of the process and I’ve seen really smart people make really big mistakes when it comes to finding the right data set of movies. So I could see quibbles with my data set of “franchise blockbusters”. The worry is I biased the data set positively for Star Wars.

As I wrote before, my notable omissions were Jurassic Park, Star Trek, Fast and Furious, and James Bond. The last two I have no qualms leaving out since they don’t have the kid appeal of Star Wars or Marvel. Same with Star Trek overall. The toughest was Jurassic Park, which would mean Jurassic World, so it’s one movie, but a “super-hit”. Again, I’m fine with this, but I’m monitoring those franchises for future data analysis. (If you’re curious, if we had added all the omitted franchises, it would have pulled down the average for hits and super-hits.)

There is no “terminal value”.

In other words, why did I stop modeling at 2028? Short answer: uncertainty. After ten years, models lose almost all their predictive value.

But won’t these films keep being made on into the future? Don’t I need to account for that? Yes. And I will, when I put it all together. I plan to do that for this deal, but not until the last step when I do it for all the business lines at one time.

Final Questions

Please, can I see the unadjusted gross profits?

Sure, since you asked nicely. Again, I don’t think we should lead with this because they are misleading. The raw numbers just look better because they look bigger. (I’m losing clicks I know by not leading with this in the headline. But fine, here they are: First, the total revenue from 2013-2028, unadjusted:Slide 41Do you learn as much? Again, I don’t think so because I think our brains translate that money into current price/value and not the true scaled price. But again it looks huge.

What is the current value of Star Wars movie revenue?

That’s a good question. First, I’m going to give you the unadjusted revenue for the next ten years. To show you how it can mislead you:

Slide 42

I put the expected value below it. So you could look at this and say, “Look, Lucasfilm is still worth $4.2 billion! In just movies!” But again, let’s discount for the time value of money. But instead of discounting to 2012, we need to discount it to the current value.

Slide 43

In this case, we see the revenue is “only” worth $2.5 billion for the next ten years. Still really not bad, but not as well as the initial deal did. Again, a lot of that is drive by the fact that most scenarios only have one or two “super-hits” whereas Disney came out and delivered three of those in a row.

Where do we go from here?

Back to the analogy. We just finished admiring a gorgeous view of financial prosperity. And we learned some things. But now we need to walk back down the hill.

The movies portion has long been the centerpiece of this deal from a financial standpoint. At least, that’s what I expected when I started on the model and remain convinced by after all this work.

But Disney is so much more than just movies. Toys. TV. Theme parks. Our walk down this hill to arrive at our final conclusion needs to analyze each of those lines of business. And I’ll do that next.

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