The Walt Disney Company (DIS) commands a strong brand and stable growth but expectations for next year may be just fantasy. The company is one of the most widely favored in the market and the risk to the downside does not justify limited upside potential. Investors may want to take some profits and look to more attractively-priced competitors like the Six Flags Entertainment Corporation (SIX).
Overwhelming support after years of solid gains
Five years into the bull market, you need to start worrying about valuations. We may not see a major correction next year or in 2015 and hopefully we will never see another one like the last, but it will happen. A bear market will hit everyone's portfolio but there are some names that are so widely held and so favored by analysts that the selling may hit even harder. With so much love for the shares now, they could get hit harder as everyone heads for the exits and the bottom drops out.
Few stocks are so favored by investors and analysts as the six below. To screen for the most loved names, I looked for stocks with a 5-star rating by Standard & Poor's as well as positive or buy recommendations from Thomson Reuters, Market Edge and the average consensus estimate. The six below have outperformed the S&P500 over the last year and have less than 5% of their available shares shorted in the market.
Of the six, The Walt Disney Company caught my eye as especially favored and relatively over-valued. The shares trade at almost a 29% premium to their 5-year average price-to-earnings. The company has a strong brand and may deserve a premium on the industry value as well as its own 5-year average but it may also be a signal of heightened expectations. The shares are up almost 30% over the last year and more than 300% over the last five years. Expectations for both earnings and revenue growth are well above current trends and missing these estimates may take some of the momentum out of the stock.
Diversification in revenue but risks to big losses
The company owns a large collection of recreation and media assets which help to diversify risks to any single group. The media network contributes a little more than half of the company's operating profit. The ESPN group of channels contributes 75% of cable network sales and is able to command fairly strong affiliate fees from providers. Disney's own channel carries a strong brand but against stronger competition from Viacom (VIA) channels like Nickelodeon. Disney faces regular challenges with service providers and risks interruptions in fee growth. The company reached a last-minute deal with Dish Network (DISH) earlier this month to avoid a blackout that would have affected millions of viewers.
Disney has seen some large losses in its movie segment over the last several years. The company may lose up to $190 million on The Lone Ranger and has ended its deal with Jerry Bruckheimer to produce the next Pirates of the Caribbean. The loss on the Lone Ranger follows an even bigger flop, John Carter, which lost the company $200 million in 2012. Even with the company's successful movie franchises like Toy Story and Pirates of the Caribbean, DVD sales are facing strong competition from rental alternatives like Netflix (NFLX).
Longer-term there is potential from a joint venture in China for the Shanghai Disney theme park, which is projected to open in late-2015. The park should enjoy some initial strength but may run into competition as the Dalian Wanda Group opens its own park in 2016.
Seeking Alpha contributor Jacob Steinberg defended the shares recently on a larger share repurchase program and stronger profitability across some segments. I agree that a share reduction around 6% would be supportive but just do not think that earnings will justify the high expectations.
Wishing upon a star will not help meet lofty expectations
For the current quarter, analysts expect $0.75 per share on $11.4 billion in sales. This represents growth of 6% in sales from the year ago quarter and a 12% net margin. These expectations may not be too far off compared to an average 6% sales growth and 13% net margin on a quarter-over-quarter basis over the last four periods.
The problem is with expectations for next year and what management might say at the earnings report on November 7th. Estimates for 2014 are for a 16% increase in earnings to $3.92 per share on a 7% increase in sales to $47.85 billion. To achieve this, the company would have to boost its net margin to 14.6% on top of strong sales growth.
First, the company just announced that it would offer full-time jobs and benefits to some employees to qualify for company benefits under the Affordable Care Act. While the current offer to 427 part-time workers is just under 2% of the company's total part-time staff, there is the possibility that the company could extend the offer and drive costs up further.
Second, to achieve sales growth above the longer-term trend, the company would probably have to increase its marketing spend which would make it difficult to increase margins as well.
The near-term risk in the shares is a more realistic outlook given by management in the fourth quarter report that causes analysts to downgrade their expectations. Over the next year, my estimate for $3.58 per share in earnings off of $47.4 billion in sales would justify a price of $62.72 per share if we assume sentiment falls to 17.5 times earnings. This means a loss of 4% from the current price.
The outlook is even more bleak if the shares trade at the industry multiple of 16.2 times earnings, a strong possibility after weaker-than-expected earnings and on several highly-public movie flops. At the industry multiple and on $3.58 in trailing earnings, the shares could fall to $58.00 or 11% lower than the current price.
Adding to Short-term Alpha Portfolio
I am using the possible weakness to pair Disney with a company in the same space that could do relatively well. Shares of Six Flags Entertainment Corporation have moved in lock-step with Disney for most of the last year but have broken down since August.
Expectations for revenue growth at Six Flags next year are much more conservative with estimates for 4.5% growth to $1.16 billion after growth of 3.7% this year and 5.6% last year. Expectations for earnings growth are 20% higher next year to $1.43 per share which would necessitate the company increasing its own net margin to 12% from 10% this year. The stock currently carries a 3-star rating (neutral) from Standard & Poor's and just over 8% of the available shares are shorted in the market. The company has recently announced its 2014 ride additions to its 13 parks, including a wood-steel hybrid coaster in Illinois that may be a contender for the best new coaster of 2014.
It may be tough for Six Flags to meet its expectations as well but the low price multiple and investor sentiment tells me that the market might not be as disappointed as when Disney misses its expectations.
I am adding a short position in Disney and a long position in Six Flags to my Short-term Alpha Portfolio. This follows my long position in Darden Restaurants (DRI) and short in Wendy's (WEN) Corporation on September 25th.
The idea of the long-short trade is to take advantage of mispricing in a specific company without taking too much sector or market risk. By buying one stock and selling a related company, you are potentially removing a lot of the external drivers that affect both stocks. If the over-priced stock comes down to earth while the under-valued name gains, you win on both sides.