Lone Ranger Can't Ruin Disney's Free Cash Flow

| About: The Walt (DIS)

Media conglomerate Disney (NYSE:DIS) announced slightly disappointing third-quarter results. Revenue fell slightly short of consensus expectations, growing 4% year-over-year to $11.6 billion. Earnings grew a mediocre 2% year-over-year to $1.03 per share (excluding one-time items), which was actually slightly better than consensus estimates. Though headline numbers were weak, free cash flow for the third quarter surged 27% year-over-year to $2.7 billion, equal to 23% of total revenue.

The big disappointment during the third quarter came from Disney's Studio Entertainment business. Revenue declined 2% year-over-year to $1.6 billion, while operating income fell 36% year-over-year to $201 million. This comes as no surprise as The Lone Ranger is already considered a flop. Since we highlighted Disney's blockbuster strategy last month, the outlook hasn't improved. CFO Jay Rasulo said the film's performance would be even worse, saying on the conference call:

"Needless to say we're disappointed with the performance of the Lone Ranger and in light of the film's box office results we expect to incur losses on the film in Q4 of between $160 million and $190 million."

As we previously stated, this is simply the reality of Disney's strategy: bet big on (potentially) billion dollar franchises, or don't bet at all. This is acceptable as long as Disney's other businesses continue to grow, but if growth at its cable properties or theme parks were to slow, we'd rather see the firm focusing on profitable movies rather than making massive bets in hope of finding the next Pirates of the Caribbean.

Image Source: DIS 3Q FY2013 Earnings Release

While 'Studio Entertainment' was weak, Disney's 'Media Networks' segment more than picked up the slack. 'Cable Network' revenue jumped 8% year-over-year to $3.9 billion, driving segment operating income 12% higher to $2.1 billion. If fees from content distributors weren't enough, ESPN remains a low-risk advertising option since it commands a live audience. Rasulo added some very positive commentary on the conference call, noting:

"ESPN cash ad sales were up 9% in the quarter, which is roughly in line with the ad sales pacing we discussed on our Q2 call. ESPN's reported ad revenue was up 3% as a result as the increase in cash ad sales was partially offset by lower ratings. The decline in ratings during the quarter was primarily related to NBA comparability issues. During the quarter, ESPN aired fewer NBA regular season games compared to last year when the lockout created a more back-end loaded schedule. Also, ESPN aired fewer play-off games and those match-ups delivered lower ratings in last year's playoff games. So far this quarter, ESPN's cash ad sales are pacing up 11%."

'Broadcasting' results weren't as strong as ABC received lower ratings and did not have the strong advertising demand from political campaigns. The lack of election-driven revenue will give ABC an even more difficult fourth-quarter comparison, but growth from cable networks should be able to offset any weakness.

In tandem with strong cable operating income growth, the 'Parks and Resorts' segment performed exceptionally well during the third quarter, with revenue up 7% year-over-year to $3.7 billion and operating income up 9% year-over-year to $689 million. During the course of the past two years, Disney has invested heavily in new attractions, and it appears to be paying off with not only stronger attendance, but also stronger spending within the parks.

'Consumer Products' also experienced decent revenue growth of 4% year-over-year, with operating income up 5% year-over-year, to $219 million. We expect this segment to perform well in the future, particularly in light of the new deal Disney signed with Hasbro (NASDAQ:HAS) that all but guarantees a healthy revenue stream.

Valuentum's Take

Though Lone Ranger disappointed, we were pleased with the broader story at work at Disney. Fiscal year 2014 will likely be similarly as strong, but we're really excited to see what impact Star Wars has on the greater business in fiscal year 2015 and beyond. Given the success of seemingly endless comic book movies and Star Wars' enormous fan base, we think Disney could be set up nicely for the rest of the decade in terms of new film launches. If so, Disney might not be making value-destructive gambles on so-so ideas (i.e. John Carter, Lone Ranger).

Ultimately, we'd love to acquire shares of Disney at the right price, but at this time, we believe the company looks fairly valued. Disney has fantastic dividend-growth potential, but its paltry dividend yield (approximately 1.2% at time of writing) keeps us on the sidelines in our Dividend Growth Newsletter portfolio.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: HAS is included in our Dividend Growth portfolio.