Disney's Marvel acquisition: a strategic financial analysis

Abstract

The purpose of this paper is to assess the value and risks of Disney's 2009 $4 billion acquisition of the Marvel Entertainment Group (Marvel) in a case study utilizing the modern Graham and Dodd valuation approach. The paper presents a detailed valuation of Marvel in 2009 drawing on previously published Graham and Dodd methodological materials and Marvel's publicly available financial reports. Disney's $4 billion acquisition price for Marvel contained considerable risks based on certain valuation assumptions, which were identified in the context of our analysis. This acquisition is a useful one for executives to study because it involves a situation many of them could face: evaluating the purchase of a great company that is seemingly a strategic fit and offered at what appears to be a reasonable price. Assessing such opportunities utilizing the modern Graham and Dodd valuation approach facilitates greater levels of insight into key assumptions, value drivers, and risks. This is a methodology that has proved useful to successful value investors over time. Lessons executives in many industries can learn from a Graham and Dodd-based valuation of the 2009 Disney acquisition of Marvel include: better risk assessment, valuation of entertainment property assets and franchise assessment.

On August 31, 2009, Disney announced its acquisition of Marvel Entertainment, Inc. for $4 billion, which was approximately 29 percent greater than Marvel's market value at the time.[1] Coincidently, this journal had recently published an article on lessons that could be learned from Marvel's well publicized 1996 bankruptcy.[2] That article recounted how the company emerged from bankruptcy when a controlling interest, about 37 percent of Marvel, was acquired by its current management for just $238 million in 1998.[3] Now, with Disney's acquisition, the value of that investment grew to $1.5 billion, which equates to an impressive 20.2 percent compounded return.[4], [5] Clearly, Disney's acquisition was a stunning success for Marvel's top shareholder, but will it be a success for Disney?

Currently, acquisitions are generally priced using one of three popular approaches. Each involves significant assumptions:

Discounted cash flow - assumes that reasonable estimates of future cash flows can be made in the present.

Multiple-based valuation - derives a price based on some financial variable such as revenue or book value and assumes that one compound of one variable accurately represents a firm's value.

Comparables - assume that the value of similar firms serves as a reasonable proxy for the value of a firm at interest, and also that the proxy firms were valued appropriately.

Each of these approaches also tends to be divorced from strategy. For example, rarely are specific risks linked to a valuation. Instead, they tend to be embedded in a discount rate estimate. As another example, growth tends to be modeled on very broad assumptions that rarely tie back to specific strategic plans and performance measures. Drawbacks such as these could contribute to the failure of many past deals.[6]

As an alternative approach, the modern Graham and Dodd method, which is employed by outstandingly successful investors like Warren Buffett, considers valuation differently. First, it addresses key assumptions upfront in the valuation. This is significant because many valuation assumptions are strategic in nature and therefore require strategic input to address properly. For example, assumptions regarding intangible assets, earnings sustainability, the existence of a sustainable competitive advantage, and the viability of achieving reinvestment hurdles in growth initiatives are all strategic matters. The Graham and Dodd approach integrates strategic and financial analyses and inputs in one overall, cross-discipline framework.[7] This perhaps explains why it has been so successful in practice, and why it is an ideal method for corporate M&ABox 1 [Figure omitted. See Article Image.].

Background

At Disney, the strategic logic for acquiring Marvel seems to have emerged as its executives were considering how they could best leverage their company's core entertainment-based competency and brand in a fairly dramatic way, which is challenging given the firm's maturity and size.[10] At the time this deal was announced, it was generally viewed by the business press as a strategic fit. However, no analysis was provided by the company to support this conclusion, especially regarding the price Disney paid. Here is how Disney's CEO, Robert A. Iger, presented the cost of acquiring Marvel: "We paid a price that reflects the value [Marvel] created and the value we can create as one company. It's a full price, but a fair price."[11] To assess this comment, this case utilizes the modern Graham and Dodd approach to value Marvel at the time of its acquisition by Disney. Doing so will identify key pricing assumptions, value drivers, financial goals, and risks in a practical way that executives can use prospectively to assess future deals.

Creating value through comic books and motion pictures

Marvel is, first and foremost, a comic-book-publishing company whose proprietary characters - such as Spider-man, X-men, Iron Man, the Incredible Hulk, and others - have become part of popular culture.

Since it emerged from bankruptcy,[12] Marvel has leveraged the earnings power of its characters effectively. For example, it significantly improved the quality of its comic books while successfully capitalizing on its characters in movies, as illustrated in Exhibit 1 [Figure omitted. See Article Image.].

Given the level of success profiled in Exhibit 1 [Figure omitted. See Article Image.], and the seemingly high probability of it continuing, it is reasonable to ask why Marvel shareholders would agree to an acquisition even at "what most analysts think was a generous price."[14] One answer to this question may be that growing amounts of capital are required to produce big ticket movies like Marvel's.[15] An example of movie-capitalization risk can be found in the history of Marvel's chief competitor, DC Comics, which is owned by Warner Brothers. In 1997, Warner Brothers produced the movie "Batman and Robin" that failed financially; however, because it is a big studio, Warner Brothers was able to absorb the loss and regroup, which ultimately resulted in the phenomenally successful Batman Dark Knight movie in 2008 that grossed over $1 billion worldwide.[16] If DC Comics had produced "Batman and Robin" without Warner Brothers it likely would have been very difficult for it to recover as quickly as it did. Similarly, it would have been difficult, but certainly not impossible, for Marvel to recover from a similar loss prior to its acquisition by Disney. As such, this deal seems strategically logical for both Disney and Marvel; but did Disney pay too much?

Valuing Marvel

There are numerous practical insights to be gained from an overview of the valuation of Marvel based on the modern Graham and Dodd approach (see the Appendix for details). Performing this analysis on Marvel resulted in a net-asset value (NAV) of $424 million, which is only slightly more than 10 percent of the $4 billion deal price.

The second level of value along the modern Graham and Dodd value continuum is earnings power value (EPV), which for Marvel amounted to $1.7 billion or four times the NAV. Subtracting its NAV from its EPV gives Marvel a franchise value of $1.3 billion, which indicates the possible existence of a "franchise." The next step is to validate its value.

Marvel's franchise consists of its portfolio of proprietary characters, which generates relatively strong customer attachments and are protected by various intellectual-property laws (such as patent, trademark and copyright).[17] For example, if someone wanted to make a movie about any one of Marvel's characters they must first obtain Marvel's permission to do so, and then pay royalties for the privilege. This combination of customer attachment and legal protections makes Marvel a vigorous and secure franchise. Significantly, this franchise presents a number of strategic synergies when aligned with Disney's extensive media and theme park platforms, and its "unparalleled" ability to leverage those platforms to create value,[18] that justify the $1.3 billion franchise value.

We therefore conclude our valuation by estimating Marvel's growth value, which is the final and least tangible level of value in Graham and Dodd-based valuation, and which amounted to a premium over EPV of $2.3 billion. With this final component in place we can illustrate Marvel's value profile as shown in Exhibit 2 [Figure omitted. See Article Image.].

Based on our valuation, expected growth comprises 57 percent (=$2.3/$4.0 billion) of the acquisition price, which is a considerable amount. Significantly, our growth value implies a reinvestment rate of 21.3 percent (see the Appendix for details), which is an aggressive assumption. To evaluate the sensitivity of this assumption consider Exhibit 3 [Figure omitted. See Article Image.].

Based on that exhibit, Disney's $4 billion acquisition price is highly sensitive to reinvestment rate assumptions, and at a 232 percent premium over EPV it is indeed a "full price" to pay for Marvel. So full, in fact, that it does not contain a margin of safety. As such, $4 billion is too high a price to pay for Marvel, based on our Graham and Dodd valuation.

Identifying M&A pricing risk

To identify the major components of the pricing risk of this deal, see Marvel's "value drivers diagram," which is simply a graphical representation of the most significant drivers and risks at each level of value (see Exhibit 4 [Figure omitted. See Article Image.]).

Intellectual property risks

The value of Marvel's assets and franchise are both influenced by intellectual-property protections, which are potentially at risk. For example, Marvel's copyrights on some of its best known characters are being challenged by the estate of one of their co-creators.[19] If these challenges are successful, and the protections expire,[20] Marvel's NAV and franchise value will have to be reevaluated, as will its EPV.

Earnings power risks

As explained in the Appendix, our EPV is based on an estimated $230 million of operating income that, in turn, is based on Marvel's historical five-year average. The assumption behind this estimate is that it is sustainable over time; however, there are three key risks underlying this assumption. The first is the risk of Marvel's intellectual-property protections expiring.

A second risk arises because some of Marvel's best known characters are contractually obligated to other studios. For example, "Marvel owns Spider-Man, but it has a long-term agreement with Sony Corporation that allows Sony Pictures Entertainment to make movies based on the character, in exchange for royalties. Similarly, News Corporation's Twentieth Century Fox makes the movies starring Marvel's X-Men."[21] The contracts between these studios are likely complex and, as such, prone to misinterpretation and therefore litigation that could impact earnings. To complicate matters, Marvel also contracted some of its characters to non-Disney theme parks (such as Universal) and some of its toy rights to Hasbro, which could complicate Disney's strategic plans.[22]

Third, the earnings power of Marvel's lesser known characters is unknown, and therefore risky.[23] As an example of the risk this poses, consider Marvel's 2007 movie on the lesser known character "Ghost Rider." As Exhibit 1 [Figure omitted. See Article Image.] illustrates, this movie significantly under-performed the other films listed except one (the 1998 movie Blade , another lesser known character). In short, while the earnings power of character-based blockbuster movies may appear logical in retrospect, it can be very difficult to predict prospectively, and thus must be planned and managed very carefully. This dynamic magnifies growth risk by adding pressure to the high reinvestment rate hurdle noted above.

Risk management

Managing post-acquisition risks like these can be accomplished in a number of ways. For example, shorter-term (1-to-2 year) and longer-term (3-to-5 year) strategic plans could be formulated regarding how Marvel's mainline characters might be leveraged across various media such as movies, television, theme-parks, etc. Both sets of plans could include legal reviews of Marvel's existing intellectual property rights and related contracts along with recommendations for managing those rights to maximize value over time.

Strategies for lesser known character development could include:

- Targeted market analysis, as lesser known characters may have different prospects than better known characters.

- Casting-selection criteria; for example, actor Nicholas Cage is a superb actor but he was not able to make the movie Ghost Rider a success.

- Storyline protocols to prevent poor movie plots from "killing off" valuable characters.

- Budgetary controls to ensure the reinvestment hurdle is met over time.

Activities like these could be particularly significant with respect Disney's international strategy. Disney has substantial expertise leveraging character content internationally to create value, which it will obviously leverage for Marvel's popular characters (to the extent it can contractually). However, Disney will likely have a more difficult time doing this with Marvel's lesser known characters if the strategies for those characters are not carefully planned and executed. Failure to do so would generate both a significant marketing cost and a significant opportunity cost generated by the strategic inefficiency.

To manage these risks, measures could be selected to track key value drivers and risks such as those illustrated in Exhibit 4 [Figure omitted. See Article Image.]. For example, Disney could choose to select measures to track goodwill risk and value creation, earnings sustainability, the status of intellectual-property protections, and investment performance. Doing so would establish a powerful linkage between the deal's strategy and pricing, and the subsequent activities undertaken to realize value. A possible benefit of this linkage is that it could provide an early warning of post-acquisition-performance issues which, in turn, could give Disney time to revise its plans and strategically regroup. This could be significant because Disney may have to regroup at some point in time to manage the risks generated by this acquisition to ensure it justifies the "full price" it paid.

In sum, this deal offers executives many lessons because it involves an acquisition that is both a tempting prize and something of a puzzle to evaluate. The purchase of Marvel was attractive because it was seemingly a strategic fit for Disney and was also offered at what appeared to be a reasonable price. Assessing such opportunities using the Graham and Dodd approach facilitates greater levels of insight into key deal assumptions, value drivers, risks, and post acquisition strategies. It does so in a manner that has proved useful to successful investors from Benjamin Graham in the 1930s to Warren Buffett today. And it would have alerted Disney that it was likely paying too much for Marvel.

Appendix. Marvel valuation detail

Our valuation begins with net asset value (NAV), which is derived by adjusting Marvel's balance sheet on a reproduction basis as illustrated in Exhibit 5 [Figure omitted. See Article Image.].

Note (1A) adds bad debt to accounts receivable to arrive at a reproduction value.[24]

Note (2A) pertains to two shorter-term income tax line items that were discounted back to present value at our discount rate for Marvel (one year's duration).

Note (3A) adds depreciation to fixed assets to arrive at a rough estimate of the reproduction value. In practice, this adjustment could be based on licensed appraisals.[25]

Note (5A) pertains to "goodwill," which in a modern Graham and Dodd context refers to a firm's intangible assets such as its product portfolio and customer relationships, which are estimated as a multiple of the selling, general and administrative expense.[26] Given the historical strength of Marvel's goodwill, I estimated its value at three times the firm's SG&A expense of $138,506.[27] This adjustment could also be based on an appraisal.

Note (6A) pertains to longer-term income-tax line items that were discounted back to present value at our discount rate for Marvel (two years' duration).

Notes (7A) to (9A) add various off-balance liabilities back onto the balance sheet. The source of these adjustments is Marvel's 2008 Form 10K.[28]

Subtracting the reproduction value of the liabilities from the reproduction value of the assets gives an estimated NAV of $424,466. We proceed therefore to earnings power value (EPV), shown in Exhibit 6 [Figure omitted. See Article Image.].

Note (1E) is our estimate of Marvel's level of sustainable operating income, which was calculated as a five year operating income average. The assumption of this estimate is that it is sustainable into perpetuity, or that Marvel's operations will generate this level of earnings every year, on average, forever.

Note (2E) pertains to our depreciation and amortization adjustment presented in Exhibit 7 [Figure omitted. See Article Image.]. As EPV does not consider growth, only that portion of depreciation needed to "restore a firm's assets at the end of the year to their level at the start of the year" is added back.[29]

The source for note (3E) is page 28 of Marvel's 2008 Form 10K. Similarly, the source of note (4E) is page F-33 of the Form 10K (as the year-over-year projected benefit obligation change).

Pre-tax earnings, note (5E), is a simple calculation: (1E)+(2E)-(3E)-(4E).

The source of note (6E) is page 29 of Marvel's 2008 Form 10K.

Expected taxes, note (7E), is simply the product of (5E) times (6E).

Earnings, note (8E), are calculated as the difference of (5E) less (7E).

Marvel's discount rate, note (9E), was estimated at 2.5 times the yield of the 10-Year Treasury Note.[30] The earnings multiple, note (10E), is one divided by the discount rate and is conservative (less than the Graham and Dodd multiple threshold of 16).[31]

Earnings power, note (11E), is simply the product of earnings (note (8E)) and the earnings multiple (note (10E)).

Note (12E) is the cash listed on the balance sheet that when added to earnings power equals Marvel's EPV (note (13E)).

Marvel's franchise was assessed above, and we also discussed Marvel's growth value premium above so here we show how we derived the reinvestment rate implied in Disney's price in the context of our valuation. A "reinvestment rate" is the return that Marvel's incremental earnings are expected generate on average forever to grow its value, which we estimated at 21.3 percent per Exhibit 8 [Figure omitted. See Article Image.].

Aggressive growth assumptions like these are why successful Graham and Dodd-based investors generally do not base purchase prices on growth.[33] They will, however, occasionally base margins of safety on growth, which is a topic beyond the scope of this paper.[34]

Footnote

1. Ethan Smith and Lauren Schuker, "Disney nabs Marvel heroes," Wall Street Journal , September 1, 2009, http://online.wsj.com/home-page

2. Joseph Calandro Jr, "Distressed M&A and corporate strategy: lessons from Marvel Entertainment Group's bankruptcy," Strategy & Leadership, Vol. 37, No. 4, 2009, pp. 23-32.

3. Note that management directed Marvel's operations even though they did not completely own it. "Comic book publisher Marvel emerges from bankruptcy," Los Angeles Times , October 2, 1998, p. D-5, http://articles.latimes.com/1998/oct/02/business/fi-28533.

4. James Quinn, "Marvel saviour Ike Perlmutter to net $1.5bn payout from Disney sale," Telegraph.co.uk , September 1, 2009, http://www.telegraph.co.uk/finance/newsbysector/mediatechnologyandtelecoms/media/6123325/Marvel-saviour-Ike-Perlmutter-to-net-1.5bn-payout-from-Disney-sale.html

5. Management's ownership percentage was valued at 37.5 percent at the time of this acquisition. Significantly, $1.5 billion closely tracks with the growth value of $1.6 billion presented in Calandro (2009), op. cit., p. 26.

6. For a detailed study of the causes of strategic failures see, for example, Paul Carroll and Chunka Mui, Billion Dollar Lessons (NY: Portfolio, 2008).

7. On the cross-discipline nature of Graham and Dodd see Seth Klarman, Preface to Benjamin Graham and David Dodd, Security Analysis , 6th ed. (NY: McGraw-Hill, 2009 [1934]), p. xxv.

8. Joseph Calandro, Jr., "The Sears acquisition: a retrospective case study of value detection," Strategy & Leadership , Vol. 36, No. 3, 2008, pp. 26-34.

9. For further information see Bruce Greenwald, Judd Kahn, Paul Sonkin, and Michael van Biema, Value Investing: From Graham to Buffett and Beyond (NY: Wiley, 2001), and Joseph Calandro, Jr, Applied Value Investing (NY: McGraw-Hill, 2009).

10. See, for example, Brooks Barnes and Michael Cieply, "The Hulk and 4,999 other characters for $4 billion," The New York Times , September 1, 2009, http://bx.businessweek.com/ubs/the-hulk-and-4999-other-characters-for-4-billion/372578130622506764918382af2b4fab1873a017a8b67dc9e1b/

11. Ibid.

12. For information on Marvel's bankruptcy, see Dan Raviv, Comic Wars (NY: Broadway, 2002).

13. For illustration purposes only; more detailed levels of analysis could be included here, but it is beyond the scope of this paper.

14. "Walt Disney buys Marvel entertainment: of mouse and X-Men," The Economist , September 5, 2009, p. 71.

15. Barnes and Cieply (2009), op. cit.

16. Source: The Movie Times , http://www.the-movie-times.com/thrsdir/top60dir/top60Search.mv?The%20Dark%20Knight, accessed September 11, 2009.

17. On the strategic implications of customer attachment see Bruce Greenwald and Judd Kahn, Competition Demystified (NY: Portfolio, 2005), p. 207.

18. Known as the "Disney Difference." Jon Fine, "Disney emerges a winner," Business Week , October 16, 2009, http://www.businessweek.com/magazine/content/0843/b4105085926174.htm

19. Michael Cieply and Brooks Barnes, "Disney faces rights issues over Marvel," The New York Times , September 21, 2009, http://www.nytimes.com/

20. For information on comics-related copyright law see the study produced by the "Center for the Study of the Public Domain" at Duke Law: http://www.law.duke.edu/cspd/comics/digital.php

21. Smith and Schuker (2009).

22. Ibid, and Cieply and Barnes (2009).

23. Martin Peers, "With Marvel, Disney attempts a feat of daring," Wall Street Journal , August 21, 2009, http://online.wsj.com/home-page

24. For information on this adjustment, see Greenwald et al. (2001), p. 56.

25. Ibid, p. 37.

26. Ibid, pp. 61-2.

27. 2008 Marvel Entertainment, Inc., Form 10K, p. F-4.

28. Ibid, p. F-30 for operating leases, p. F-33 for the projected benefit obligation, and p. F-25 for the value of options outstanding.

29. Greenwald et al. (2001), pp. 39-40.

30. The average 10-Year Treasury Note yield for 2008 was 3.67%. Data Source: Federal Reserve System, calculation is the author's.

31. Benjamin Graham and David Dodd, Security Analysis (NY: McGraw-Hill, 1934), p. 453.

32. This method assumes that 100% of Marvel's earnings are reinvested. Conducting this form of analysis at different percentages is possible, but more mathematically involved and thus outside the scope of this paper. For more information see Greenwald et al. (2001), pp. 138-145.

33. See for example, Joseph Calandro Jr "Lessons for strategists in Graham & Dodd's Security Analysis , 6th edition," Strategy & Leadership , Vol. 37, No. 2 (2009), pp. 45-49.

34. For more information see Calandro (2009), Chapters 3-4.

Appendix

Corresponding author

Joseph Calandro Jr can be contacted at: [email protected]).

  

Illustration

Exhibit 2: Marvel's value profile

  

Exhibit 4: Marvel's value drivers/risks

  

Exhibit 1: Select Marvel movie revenue

  

Exhibit 3: Sensitivity analysis

  

Exhibit 5: Marvel's NAV

  

Exhibit 6: Marvel's EPV

  

Exhibit 7: Depreciation and amortization

  

Exhibit 8: Implied reinvestment rate of Marvel's growth value

  

Box 1: