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July 16, 2006

Analyzing Disney's Pirates Treasure Chest

The daily box office results for Pirates of the Caribbean: Dead Man's Chest (POTC) continue to be astounding. After its record breaking opening weekend, POTC easily set mid-week daily records, and now has the 6, 7, 8, 9, and 10-day records. The film appears headed toward $400 million domestic and over $900 million worldwide, ahead of initial expectations to match the first film with $300 million domestic and $653 worldwide.

Since most of the stories about the film have focused on box office, I thought I’d take a stab at profits and see how the better than expected box office might impact EPS for Disney (DIS). Please understand that while I think the analysis is accurate and captures how POTC could be impacting DIS shares, it is overly simplistic and probably naive relative to how the film is financed, and the residuals and participations to the talent....

Initially, Wall Street was assuming that POTC domestic box office would be $300 million, worldwide box office would be $650 million, and profits from all windows would be $250 million. Here's the math on the initial profit estimates:

At $650 million in worldwide box office, rentals (the studio's 55% share of the box office) to Disney would be around $355 million. Estimates for production costs for the film range from $200 to $250 million. Prints and advertising add another $150 million to current expenses. Consequently, analysts were probably assuming the box office window would produce a loss up to $50 million.

The next window is home video. Dave Miller of Sanders Morris Harris uses a rule of thumb that home video revenue equals 1 times domestic box office with a revenue split of 75%/25% between sell-through and rental. The margin on sell-through is higher but I think it is fair to say that most models assume the margin on total home video averages around 60%. Therefore, based on the initial $300 million domestic box office estimates, home video would produce $180 million profits.

The next source of profits is sale of TV rights. I've seen models that assume TV rights are sold for 35% of domestic box office, or $100 million in the case of POTC. This seems high but remember that it would include pay TV, cable, and broadcast in the US and abroad. Let's guess an 80% margin on that revenue and you got an additional $80 million in profits.

So before DIS gets any profits on merchandise related to the film, at a $300 million domestic box office, POTC might produce $210 million in profits. I've read that POTC merchandise is selling better than any Disney or Pixar film since Toy Story 2, so initial analyst estimates of profits in the $250 million or higher range seem totally plausible. And don’t forget that Disney also benefits at its theme parks and cable networks.
There is no way of knowing of how Disney financed the film but for sake of argument I am going to assume that financing costs are included in production costs. The last few quarters, DIS has had a tax rate of 36%, which would leave $160 million in after-tax profits from the film. Based on 2 billion shares outstanding, analysts might have 8 cents of earnings just from POTC in their estimates over the next four to six quarters. Current estimates call for FY07 EPS of $1.65, so it is plausible that this one film could have equaled 5% of analyst estimates for DIS' 2007 EPS.

Of course, it now looks like POTC is tracking to generate $400 million in domestic box office and over $900 million worldwide. Compared to initial estimates, an incremental $300 million in worldwide box office turns the theatrical run from a loss of $50 million to a profit of over $100 million. TV rights revenue could now go as high $125 million pushing profits to $100 million. Home video goes to $400 million in revenue and $240 million in profits. So with box office trending above initial expectations, the film could be heading toward total profits of $440 million vs. initial estimates of $250 million.

Applying the same assumptions about taxes and shares outstanding, and POTC is now looking at adding 14
cents to DIS earnings over the next four to six quarters.

DIS is trading at about 20 times earnings so the extra 6 cents should be worth $1.20 to the stock price. Prior to Thursday's downgrade from CIBC, DIS had actually been outperforming the market since POTC was released, so I think the market has been reasonably efficient as it relates to the upside surprise for the film.

As for that downgrade, I think the analyst is going to regret it as DIS has double digit growth for 2007 in the bag with the extra POTC profits, strength in other films from the studio, the continuing gains at ABC, and steady growth at ESPN. Theme parks is the wildcard and geopolitical tensions and a slowdown in consumer spending are definitely risks. It's a risk worth taking though as comps in Florida aren’t that tough and the rest of the companies businesses can take up the slack of anything other than a significant shortfall.

Posted by Steve Birenberg at July 16, 2006 03:34 PM in DIS