Sell Disney - It Is Too Expensive

Mar. 4.14 | About: The Walt (DIS)

There is an old adage that good companies don't always make wise investments. This is because purchase price is a critical factor in investment returns. Sometimes, investors are so enthusiastic about a company's prospects they push the share price way too high and make it a bad stock. There are a plethora of examples of good tech companies who were terrible investment choices in 1999. When evaluating a stock, it is important to look at both operating fundamentals and valuation. If both factors are not attractive, long term investors are best served staying on the sidelines and waiting for a pullback. At roughly $80, I believe the Walt Disney Company (NYSE:DIS) is a prime example of a great company that is no longer a great stock.

I want to be clear about Disney. I believe the company is fantastic and have been bullish on the stock, recommending shares when they were trading below $70. However as the following chart shows, shares have run quite a bit and are sitting at fresh all-time highs. By virtually every metric, Disney shares look fully valued after this rally, and it is time to take some money off the table and wait for a pullback (which the crisis in the Ukraine may very well bring us).

Disney is performing well as the most recent quarter shows (all financial and operating data are available here). The company grew EPS 32% annually and sales 9%. It is well diversified across many businesses that also provide solid synergy. ESPN is the most valuable cable asset in the country, and sports are increasingly more valuable to advertisers. Unlike other shows, sports have to be watched live unless you are able to stay off social media and the internet. As a consequence, more viewers watch in real time when they have to watch advertisements as well.

Strength at ESPN has offset weakness at ABC. While cable income jumped 34% thanks to strong ratings and higher transmission fees, ABC continues to face declines as content costs rise and ratings are somewhat lackluster. If there is one unit at Disney that is not performing well at Disney, it is ABC. I expect ABC to continue to be problematic in 2014. While ESPN faces more competition from the likes of NBC Sports Network and Fox Sports 1, it has a strong brand and should offset any weakness at ABC.

The main driver of Disney is its film studio. When its films do well, it can offer new attractions at its park, which increases pricing power, sell more merchandise, and make money at the box office. Over the past five years, we have seen the success of CEO Bob Iger's effort to build more stable franchises. The Marvel universes led by Iron Man has become a major driver while Pixar remains the premiere animation studio. Its acquisition of LucasFilm fits with its franchise strategy as well. Its success has bled into Disney Animation with Frozen making a billion dollars at the box office (box office data can be found here). Disney's studio has become the leading studio in Hollywood thanks to strong franchises.

However, investors must note that 2014 is a transition year. Box office results are product driven, and it just so happens that Disney's major films are going to be released in 2015. For the first time in several years, Pixar will not release a movie in a calendar years, which will weigh on results. Similarly, Marvel's two films, Captain America 2 and Guardians of the Galaxy, will likely be smaller than 2013's Iron Man 3 and Thor 2. Conversely, Disney has a potentially record breaking slate in 2015 with The Avengers 2, Star Wars 7, and two Pixar films. Disney is really a 2015 not 2014 play.

Given that, investors need to be aware that 2014 growth may be a bit slower, though it will be relatively fast in 2015 as there are calendar issues. Given this timing issue, I do think investors should be willing to pay a premium multiple off 2014 numbers because we should see 13-18% earnings growth in 2015 and 2016. In 2014, I am looking for about $4.00 on $48 billion in revenue. Disney is now trading at about 20x 2014 earnings and free cash flow. That's an extremely rich multiple even for a company with strong growth prospects. With about $4.60 in 2015 earnings power, shares are trading a still expensive 17.4x those numbers. Basically, Disney is fully pricing in its growth prospects. $80 is a pretty full valuation for next year's earnings, let alone this year's.

At current prices, I would certainly not buy shares of Disney. If you are an investor with a very large capital gain, I understand holding shares and riding out a near term dip to avoid a significant tax liability. Otherwise, I would be a seller of shares. Given its strong franchises and solid growth prospects, I would be interested in buying shares at around $70, or 17.5x this year's earnings. At current prices, Disney is very fully valued and is a great company but a weak stock. The best risk/reward trade is to short Disney, and when the valuation becomes reasonable again, I would buy back into this solid company.

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.