Following news reports that there is a coming glut of computer-animated
films, we revisited our initial analysis of the Disney purchase
of Pixar, which we felt was highly likely to fail. So far, Disney is
doing just fine. Disney’s stock is up 25% since the deal was announced
in January, while the Dow Jones Industrial Average has risen 12%.

We still believe Disney-Pixar has the potential to be a horror film.
Disney made two of the three mistakes that can cause serious problems
when companies look for synergies. Those mistakes should manifest
themselves over the next year or two.

The first mistake is overpaying. This shows up all the time, apparently because companies that see synergies are willing to pay even more than they would be if they just thought they were buying a stand-alone business. Quaker Oats made this mistake when it bought Snapple for $1.7 billion in 1994. Some analysts said at the time that the price was $1 billion too high, but Quaker convinced itself that its distribution system for Gatorade would make Snapple available more widely and increase sales sharply. Didn’t happen. Quaker sold Snapple 27 months after buying it, for just $300 million.

Disney paid $8.24 billion, or about 60 times the earnings that Pixar was expected to generate in 2006. That ratio is about three times the price-earnings ratio for the average company. (The disparity in P-E ratios isn’t quite as large as it appears. For one thing, Pixar had about $1 billion in cash, reducing the effective price of the deal. For another, Pixar’s profits in 2007 and beyond stood to get a boost because a distribution deal with Disney was to expire this year. Pixar signed the deal when it was an unknown and had little bargaining power. Whatever new distribution deal it reached would have let Pixar keep a much higher share of the profit from distribution. Still, even after you adjust the value of the deal, it’s clear that Disney paid an enormous premium over the normal P-E ratio.)

For Disney to justify the premium, it needs, first of all, to have Pixar keep churning out an uninterrupted string of hits. But nobody does that. (That’s why many analysts said Pixar stock was overvalued before Disney came along and decided to pay an even higher price.) Disney, itself, once seemed to be on an untouchable winning streak, when it came out with The Little Mermaid in 1989 and followed that with Beauty and the Beast, Aladdin, The Lion King, etc. But competition developed, from Dreamworks and others, and Disney ran out of fresh ideas. In recent years, Disney has been releasing duds such as Atlantis and Treasure Planet. The same will likely happen to Pixar. The reports that there are a dozen computer-animated films set to come out by next summer show that Pixar will have plenty of competition, and the reaction to Cars, released this summer, suggests that Pixar’s winning streak could be ending. The film did well at the box office, based on the goodwill that Pixar generated with earlier films, but reviews were mediocre to negative. Another film or two like that, and Pixar films will no longer be must-sees. Treasure Planet, anyone?

Even a continued string of hits wouldn’t justify the price. Is a hit movie every year to year and a half really worth $8.24 billion? Disney also needs to have Pixar contribute in other ways. This is where Disney made its second mistake.

That second mistake—again a common one among those pursuing synergy strategies—was to assume that the two companies will mesh nicely when there is reason to believe they won’t. IBM, for instance, made this mistake in the 1980s even though all those involved desperately wanted to mesh nicely. IBM had made the personal-computer market explode with the introduction of its PC in 1981, creating an environment where start-ups such as Lotus were thriving. Yet IBM was nowhere in terms of a PC software business of its own. IBM decided on a synergy strategy. It bought pieces of numerous small software companies, then announced that it would sell the products through the IBM salesforce. The idea was that the companies’ stock would get a big boost from the IBM relationship, so IBM would immediately generate a large profit, at least on paper. Meanwhile, the entrepreneurial spirit from these smaller companies would transfer to IBM and let it finally get its own PC software business going. Instead, IBM smothered the small companies. IBM ran scores of sales people through the companies for training, meaning that these small outfits had to just about stop everything they were doing so they could deal with all the love IBM was pouring out on them. The companies soon began performing so badly that IBM’s $100 million-plus of investments were rendered almost worthless. For good measure, the entrepreneurial spirit didn’t transfer to IBM. It eventually took some $2 billion of losses on PC software before giving up on the business.

In buying Pixar, Disney is assuming that Pixar will be able to help make Disney’s animated films more successful. But if Pixar could generate two good ideas every year or so, instead of one, it would already have been making more films. And Disney’s animators are unlikely to want help from the upstarts at Pixar. Disney invented animated films and has a wonderfully rich tradition of such films, so Disney’s animators likely feel they can find their own way out of their recent slump. Just wait a bit, and you’ll start seeing stories about the culture clash between Disney and Pixar. Disney is also assuming that introducing Pixar’s characters to its theme parks will be a major attraction, which hardly seems likely. (Disney made a similar claim when it bought Cap Cities/ABC in 1996 for $19 billion, and ABC characters did nothing to enliven the theme parks.)

As often happens in failed synergy plans, the Disney-Pixar deal seems to have been driven more by emotion than economics. In this case, there’s a double dose of emotion. Disney had been beaten up about its animated-film failings and its inability to sign a new distribution deal with Pixar, so the company was desperate to find some way to take the heat off. In addition, Bob Iger, who became chief executive early this year, needed to deflect criticism that he was merely a puppet of his predecessor, Michael Eisner. For instance, an article in Fortune said in the headline that Iger was “unproven as a strategist” and in the text that “little in his past inspires confidence.” After saying the board interviewed only two candidates, Iger and eBay CEO Meg Whitman, Fortune quoted a former Disney director as saying, “Meg Whitman created one of the great companies in the world out of thin air. What has Bob done?” Good question. What better way to answer it than with a bold deal that let Iger articulate a new vision for the company?

If only the deal were a good one.