Debugging The Disney Misconceptions

| About: The Walt (DIS)

Summary

Misconception #1: Buying Netflix could be Disney's only hope.

Misconception #2: Disney has failed to succeed at replicating Neflix's ability to get content directly to consumers" and that they need Hastings to succeed.

Misconception #3: A Netflix's acquisition would create long-term shareholder value and is the needed catalyst to the stock's appreciation.

The Misconceptions

  • One major misconception is that the ESPN viewership decline is the end of Disney (DIS) and that "buying Netflix... Could be Disney's only hope."

These arguments are taken from a Fortune article entitled, "The Case For Why Disney Should Buy Netflix." The article quotes Richard Greenfield whose suggestions for a Disney-Netflix merger has been quoted all over the web in the past week.

"Netflix is already a great friend of Disney, in fact, Iger has repeatedly acknowledged how they are in part responsible for Netflix's success. Disney continues to sell more and more content to Netflix spanning movies and television series, while at the same time struggling to get their own direct-to-consumer content business off-the-ground in the UK," Greenfield wrote. "Buying Netflix is an awfully expensive acquire, but it could be Disney's only hope." - Quote from BTIG analyst Richard Greenfield

To start with, the comment that "it could be Disney's only hope" suggests that Disney is dying as a company.

But as we showed in the previous article entitled, "Disney Is In Good hands," the notion that Disney is dying is far from the truth. First and foremost, we showed that all five segments of Disney have been growing revenues at an average of 22% y/y in the last five years alone. Disney is a ~$160 billion company that has been growing dividends at an average of 27% in the last 10 years and its stock price has appreciated by ~250% in the last decade compared to 58% for the S&P 500. These are not metrics of a dying or stagnant company.

Besides that, recent analyst coverage from Piper Jaffray upgraded Disney on March 3rd, 2016 from Neutral to Overweight. On April 8th, 2016, RBC Capital Markets initiated their coverage on the stock with a sector perform. In addition to that, a survey of 29 brokers by Thomson puts the mean price target for Disney at $108/share or ~10% upside - which we think is very modest.

In addition, according to Walt Disney's CEO Bob Iger during the Deutsche Bank conference on March 8th of 2016, the decline in ESPN subscribers was not different from what the company anticipated. As a result, ESPN took initiatives to strengthen their competitive advantage while anticipating a decline in its pricing ability.

"Let me first of all -- I think putting it in perspective a little bit, what we're seeing in the marketplace today is not that different than what we anticipated.... ESPN is always priced robustly -- our pricing would moderate, meaning we'd be able to take increases, but not at the rate that we were getting them before. And with that in mind it's actually one of the reasons why we thought about diversifying the company more...So what we thought we would do is strengthen our competitive position in the marketplace and we did that by licensing great sports for long-term periods of time, investing in our content, original and live sports, and investing in digital, which is -- essentially means not only giving ESPN subscribers an opportunity to watch ESPN on mobile platforms, but giving us more touch points with the consumer." Bob Iger at the Deutsche Bank 2016 Media, Internet & Telecom Conference on March 8, 2016.

Walt Disney's decisions to sue Verizon so that they can create a basic bundle that includes ESPN and launching DisneyLife soon after the ESPN incident, are decisions that show that they already created plans to mitigate losses from the decrease in ESPN viewership.

Besides, the engine of revenue growth for ESPN is not viewership but advertisers. If advertisers decide to advertise elsewhere because ESPN viewership declined, then that would be a huge problem for Disney. But this is not likely to be the case.

"We also believe that there is still great value in live sports, this value in ESPN to advertisers, to customers, and to distributors. Let's not forget that distributors sell local avails in ESPN and they bring in more revenue from ESPN in terms of local avails than any other channel that's out there."

Therefore, as long as the ESPN value proposition remains compelling to advertisers, the decline in ESPN viewership will have less impact on Disney's top and bottom line.

Furthermore, ESPN is not going away anytime soon.

"In 2015, 95% of all people who had multi-channel service watched sports in some form or another...ESPN was accessed in some form by 200 million different Americans - not just the channel, but all platforms."

Implying that the decline in ESPN numbers is not because Americans or the rest of the world suddenly developed a hatred for sports. Part of this decline is due to basic skinny bundles such as the FiOS Custom TV, which did not include sports programming. But after Disney sued Verizon (NYSE:VZ), Verizon decided to offer two low-cost basic TV packages: one with sports and the other one without. We believe that because of the new basic alternatives, Disney should be able to recover a good chunk of the lost ESPN viewership.

Consequently, Disney is not a company whose fate rests in acquiring Netflix and the ESPN viewership decline is a setback for the company but it will not destroy the company.

  • Another big misconception is that "Disney has failed to succeed at replicating Neflix's ability to get content directly to consumers" and that they need Reed Hastings to succeed.

Another article here on Seeking Alpha entitled "Is Netflix Next For Disney" Part I" makes similar suggestions as the aforementioned article from Fortune. The article states that "Disney has failed to succeed at replicating Neflix's ability to get content directly to consumers" and that "Netflix's Reed Hastings could be a particularly needed executive for Disney."

In our recent aforementioned article "Disney Is In Good Hands," we outlined why and how the leaders of Disney's various segments and its CFO are very capable executives who should put the CEO bearish sentiments to rest.

First, Reed would probably be a good candidate but acquiring Netflix would be such an expensive price to pay to hire someone you are not even sure that would be a great fit to Disney's culture.

Second, We cannot, at this point, claim that Disney's direct-to-consumer strategy with DisneyLife is a failure. But the issue is deeper than that. DisneyLife is not yet part of Disney's revenues. Meaning that any extra revenues from DisneyLife will help increase Disney's top line. It will be a win-win situation for Disney.

Lastly, Disney has not "failed to succeed at replicating Neflix's ability to get content directly to consumers." Disney owns a 33% stake in Hulu LLC as of FY end 2015. Therefore, they have indirectly being able to get content directly to consumers. In addition to the 33% Hulu stake, Disney launched DisneyLife late last year. DisneyLife is a direct-to-consumer subscription-based streaming service and app in the United Kingdom. This means that the assertions that "Disney has failed to succeed at replicating Neflix's ability to get content directly to consumers" are simply not true.

More so, the assertions that "Disney... is struggling to get their own direct-to-consumer content business off-the-ground in the UK" are premature at this point. DisneyLife has been in operation for less than six months in one country and Disney has never given any official numbers on it.

"We launched a direct-to-consumer service in the UK called DisneyLife, just for those who may not have heard of it, and it is movies, windowed television shows, thousands of episodes, music, books, we're a big publisher of non-educational children's books, and some games. It's still early. I won't give numbers, won't even characterize how well it's done or not, except that we have learned a lot about it." - Bob Iger - Chairman and Chief Executive Officer, The Walt Disney Company on March 8th, 2016.

Meaning that characterizing the service as a failure is not accurate. Disney has managed to get content directly to consumers through Hulu and now through DisneyLife.

  • The last misconception is that a Netflix acquisition would create long-term shareholder value.

First, we need to consider what kind of a deal that would look like. Because Netflix has a rich valuation (EV of $47 billion, $2.31 billion in total cash as of the MRQ & $6.78 billion in revenues) which makes Disney's cash reserves (total cash as of the MRQ of $4.30 billion) insignificant. Because of Disney's lack of cash reserves for such an acquisition, the deal could only make sense as a leveraged buyout ("LBO").

Currently, Disney has a total debt of $18.92 billion against $4.30 billion in cash and $54.32 billion in revenues. Currently Disney's debt is not a problem but if such a LBO occurred, it could make Disney too leveraged to be an attractive investment. The risks could include:

  • It could increase Disney's credit risk resulting in credit downgrades. This is because Netflix is a successful company and it cannot sell unless the premium is attractive from its current market capitalization of $46.94 billion. Meaning that Disney would have to double or triple its current debt. A move that would bring credit risk into the picture.
  • It could cripple Disney's ability to borrow money to acquire any new Intellectual Properties ("IP") such as Pixar or Marvel acquisitions. Acquisitions have helped very well for Disney and thus distorting its ability to make such acquisitions would diminish long-term shareholder value.
  • The acquisition could make Disney an inefficient conglomerate because it currently has too many moving parts and adding something as big as Netflix could make it inefficient, hard to handle and most importantly dwindle valuations. It is always hard to value companies with too many moving parts. Besides, conglomerates with too many moving parts are more susceptible to headline risks.

Conclusion

First, we believe that the new skinny bundles, which include ESPN should enable Disney to gain back its lost viewers. Second, Disney is in great hands and has a strong balance sheet to enable it to expand its IP portfolio via both organic and inorganic growth. Third, ESPN is well positioned to continue generating considerable income from advertisers. Fourth, the acquisition would make Disney too highly leveraged. Fifth, there is a premium market opportunity for DisneyLife beyond the United Kingdom. This is why we think there is a great potential for a surge in Disney's stock price moving forward.

Disclosure: I/we 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.