Evaluation of

Disney •
Pixar
Acquisition

Pixar is
Undervalued
Strategic Alternatives
Reengineering Disney Animation: Too Costly In-House
Disney should not reengineer Disney Animation to better compete with Pixar. This computer animation
studio has experienced great box office success because of its core capabilities in superior computer
animation technology. Pixar has “10 years of proprietary software systems that you cannot buy anything
close to in the marketplace. You have to build it yourself.” It has protected its competitive advantage with
patents, making Disney's attempt to compete by developing their own technologies a costly venture. In
fact, Pixar sold one of its earliest software, RenderMan, to Disney. Given that its technology has "enabled
Pixar to make animated films at a fraction of the cost of its competitors and at a faster pace," Disney
would potentially overextend its human capital as well as the financial resources to pay the engineers and
animators' salaries. Simultaneously, these employees pursuing this task would experience intense
pressure, which could potentially lead to negative morale and reduced productivity. Though animated
films generate the highest returns of all movie genres, Pixar's emergence has made competition
increasingly fierce. As a result, an attempt to compete against Pixar would require Disney to increase its
resources and capabilities through a strategic partnership or acquisition with a company like Vanguard.

Work with Another Studio: Pixar is Ideal

By striking a deal with another animation studio, Disney does not meet its objective of increasing its
animation capabilities, but instead becomes merely a distributor. Pixar's closest comparable is
DreamWorks, and naturally a potential partner for Disney. However, Disney and DreamWorks differ in
their focus. Disney seeks to create content that addresses the child in each individual while DreamWorks
seeks to address the adult in each individual. Furthermore, despite DreamWork being well-established, it
is led by Jeffrey Katzenberg, former Chairman of the Studios,who sought to "lure away some of Disney's
best animators." Nevertheless, Orphanage, Wild Brain Inc. and CritterPix Inc are all seeking to become
the next Pixar, and serve as potential partners. However, the 3D images and backgrounds produced by
these firms are not as advanced that by Pixar. Disney demand for cutting-edge technology and industry
leadership make Pixar the most fitting choice.

Renegotiating The Distribution Deal: Pixar Has Other Options

Disney would not be able to negotiate a new advantageous distribution deal with Pixar, because they have
no leverage. If financially feasible, acquiring Pixar would be most strategic. With the current distribution
deal, Pixar earns 40% of the film’s total profits while Disney earns more than 60%. Pixar currently pays
Disney a distribution of 12.5% of the box office earnings. Similar to Lucas/Fox, Pixar could engage in a
distribution deal with another firm requiring only a 7% fee. Given that Sony, Warner Brothers, and
Twentieth-Century Fox all could serve as willing potential distributors, Pixar has options beside Disney.
Furthermore, Disney is currently paying Pixar much less to show films on its TV network, than it paid for
Harry Potter or what Fox paid for Spider-Man. If Disney were to negotiate a new distribution deal, Pixar
would likely demand full-ownership and exploitation rights, and control over the production of each film.
This distribution-only deal may be financially advantageous, but given Disney’ objective to develop its
animation capabilities, this deal would only make Disney a distributor—not an animator.

The Need for An Acquisition: Pixar

In order to achieve its objective, Disney must acquire Pixar. Though Disney was one of the first
animation studios, the industry has evolved and is now dependent on computer-generated animation,
making technological innovation crucial to success. Disney must gain the resources and capabilities to
remain competitive in this fast-growing industry. The fastest way to do so is by acquiring the leading
animation studio: Pixar. While Disney would experience a period of integrating the two cultures, the
resulting benefits would be worthwhile. Disney would benefit from increased animation capabilities,
while Pixar would gain the financial backing of a large media company, required to fund projects to
produce new films and develop new technologies to remain competitive against emerging competitors.
The Financial Impact of The Acquisition
In order to better understand Disney's options, we must consider the potential outcomes (Table 7). If
Disney does not acquire the company, it would forgo not only the profits from Pixar's movies, but also the
rights to merchandise and market its characters. In fact, if we assume an annual operating profit growth
rate of 6%, Disney would recoup its $7.5 B purchase price from only after 15 films. Of course that is only
looking at the profit generated from ticket sales. If we include DVD sales and retail distribution, Disney
would realize a profit on its investment much faster.

But it is important to note that acquiring Pixar would take place through an exchange of stock at 2.3 : 1
Disney to Pixar share exchange ratio. Subsequently, there will be an increase in the number of Disney
shares, but reducing the value of each individual share, and thereby diluting Disney's stocks. This may
cause dissent among Disney's current majority shareholders, because they will experience less power.
However, given the strategic implications of the acquisition, these shareholders will support the decision.

The Impact of the Acquisition

Disney's roots lie in animation, but in this evolved industry, Disney's relevance is questioned. The
acquisition of Pixar would increase Disney's legitimacy as the leader of animation. It would also restore
Disney's brand image, no longer just capable of producing of traditional animated films like Cinderella
and Peter Pan, but well-equipped with technology to produce films with quality graphics and modern
storylines for a 21st century audience. The technological capabilities and fresh outlook Pixar offer will
drive continued growth into the future. The value Pixar will add in combination with Disney's
commitment to producing family-friendly films will catapult Disney back on top of animation, and
reestablish the studio as a competitive animator for a modern audience.

Motives & Potential Benefits

The first film under the 1991 Disney-Pixar agreement, Toy Story, was a huge success and generated
nearly $360 million in worldwide revenues, implying the potential benefits of future partnerships.
Although some believed that Disney buying Pixar was priced a bit higher than expected, the acquisition
was a smart strategic move which could result in positive intermediate-term financial returns for Disney.
The timing was also perfect as Disney’s own animation films had failed one after another. Its first full
computer animation film Chicken Little (November 2005), fared only marginally well. This acquisition
combines Pixar's creative and technological resources with Disney's portfolio of world-class family
entertainment, characters, theme parks and other franchises, resulting in vast potential for new output and
innovation that can fuel future growth across Disney's businesses.

From Pixar's perspective, the acquisition would allow it to fully develop and expand its creative assets,
such as movie characters from its library developed by Pixar previously with the resources of Disney. It
would also gain from Disney's global brand, marketing and promotion program and numerous distribution
channels, including theme parks and television outlets. Furthermore, Pixar will no longer need to pay a
distribution fee to Disney. Pixar's shareholders can also benefit from the acquisition as they will have the
benefits of Disney’s large, diversified earning stream and an integrated portfolio of entertainment assets
by avoiding some of the potential risks from Pixar by concentrating on a single line of business.
Additionally, shareholders will no longer bear the risks attendant to Pixar’s ongoing search for a new
distribution partner by combining with Disney. Since Pixar has an estimated enterprise value between
$6.5 billion and $7.4 billion dollars according to Pixar’s Market Cap, Disney will have to pay $7.5 billion
with premium to buy Pixar, making it a beneficial acquisition deal to Pixar's shareholders.
Critique of Credit Suisse's Valuation
In calculating the multiples in Exhibit 11, Credit Suisse had to make assumptions about Pixar's
comparables, growth rate and discount rate. This section will prove that Credit Suisse chose the wrong
comps and undervalued Pixar's growth rate.
Comparables: Credit Suisse's chosen comps were not fair, because of:
  They were not appropriate companies
 Pixar should be treated as a Best-of-breed.
Pixar is a pure play CG Company. But all of the comps, except Dreamworks, chosen by Credit Suisse
were conglomerate companies. As shown in Table 4, many of the comps had a significant portion of their
revenues coming from outside of the animation industry. Even looking at the P/E ratios between Pixar
and the most similar companies (Table 4), Pixar had a significantly higher P/E ratio than the others.
Clearly, Pixar was not comparable to any of the chosen companies. But how should it be treated?
Pixar should be given a Best-of-breed multiple. In table 5, we compare Pixar's revenue to its best comp,
Dreamworks. Pixar earned on average 45%-70% more per movie than Dreamworks. Because of this
significant difference, Credit Suisse should have included a Best-of-breed premium.

Growth Rate: Credit Suisse's growth rate was not fair. For Credit Suisse's growth rate, they made two
assumptions:
 Growth rates would eventually be constant
 5%-6% is the appropriate growth rate
In Table 3, you can see that Pixar's growth rate is clearly not normal, nor constant. While, Credit Suisse
could assert that Pixar's growth rate would eventually become normal, Disney's operating income (Exhibit
2a) clearly shows that it will not. In the animation industry, a company's operating income is highly
dependent on whether the company releases a movie during that year. Since Pixar does not have a set
movie release schedule, it would be impossible to ever determine their constant growth rate.
But even if you did assume that Pixar's growth rate was normal, 5%-6% is still much too low. From Table
4, we calculated both Pixar's Geometric and Arithmetic growth averages. As you can see, both average
growth rates were much higher than 6%. The table shows the geometric average growth rates from (1995-
2004) and (2002-2004) were both significantly higher than 6% at 81% and 71% respectively. In fact, even
if Pixar was to slow down significantly, Credit Suisse should still assume a higher growth rate.

Discount Rate: Unfortunately, Credit Suisse did not say what assumptions they made when calculating
the Discount Rate. Normally, companies would use the required rate of return for that particular
department. Sadly, we cannot judge the fairness of the discount rate because we are not given this
information.

Conclusion: Clearly, Credit Suisse valued Pixar unfairly. It was clearly UNDERvalued, since they used
the wrong comps (should have added a best-of-breed premium) and severely underestimated Pixar's
growth rate.