The Walt Disney Company (NYSE:DIS) is not a simple operation. The company shows its movies all over the world, operates theme parks on three continents, runs TV networks over cables and through satellite, and has a small navy of cruise ships. That being said, I often find that reducing an investment thesis to its bare essentials aids in determining what needs to go write for the investment to work.
I strongly believe in the old value investing equation, Profit = Intrinsic Value - Price. Since the price of a company is determined by the market and known in advance, the only thing an investor needs to determine is the intrinsic value of the company. For a microcap company, that is often a fairly straightforward task, since it often has simple businesses with defensible niches. That is the primary reason I focus on small stocks for my research service. For a globe spanning leviathan like Disney, things are more complicated.
But I think a useful investing heuristic is to distill the drivers for a company down to the things that really matter. For most businesses, making only a few predictions about the future can be enough to perform some scenario analysis on the intrinsic value of the company. That is useful, because it allows one to drill into what has to happen for the investment thesis to turn out.
For Disney, the biggest brick in its "wall of worry" its shares would need to climb to advance is ESPN subscriber losses. ESPN is the backbone of the company's Media Networks division, which is the largest segment of the company. The company reports both broadcast results (primarily the ABC network) as well as cable networks. The broadcasting business has earned almost exactly a billion dollars the previous two years, and should be reasonably stable at this point. The company may have some additional upside from additional re-transmission fees for cable/satellite providers, as well as increasing online (Netflix (NASDAQ:NFLX), etc.) revenue for previous television shows. Nonetheless, I'll value ABC at 15X its recent earnings, which is slightly below the multiple on comparable CBS, which has better ratings performance and so deserves a slightly higher valuation. That makes the broadcast division worth $15 billion.
The bulk of the value is in the cable networks, and the company owns 80% of the granddaddy of all cable networks, ESPN. Although it has other assets, I'm going to assume its revenue across the cable networks is proportional to its ESPN subscriber base. That isn't perfect, as advertising will be more closely tied to ratings, but it is reasonable, and I'm looking at the biggest drivers here. The graph below shows the operating profits the company has been earning from the cable networks, as well as the domestic ESPN subscribers.
The obvious conclusion one can draw from this graph of its results for the last eight years is that its earnings were growing dramatically even when subscribers were flat, and that earnings are now only flat even though subscriber counts are declining. The primary reason for this is that ESPN has continued to push through price increases per subscriber. The company was more bullish around ESPN on its recent conference call, noting that it is picking up subscribers from digital services such as Sling and AT&T Direct (NYSE:T).
Therefore, I am going to suggest that the key factor affecting ESPN is the pace of subscriber losses. Those have been running a little over 3% per year, so I'll run a 1% case assuming digital initiatives turn that around, a 2% intermediate case, and a 3% case. I'll also run cases on DIS's ability to continue raising prices, with my assumptions of 5%, 7% and 9% annual pricing growth. I'm also using the same 5%, 7% and 9% growth rates on its costs, as I would expect sports rights prices to continue inflating. As this analysis results in a decreasing cash flow stream, I have done a discounted cash flow analysis on the ESPN business. I used a 5% discount rate, as I feel that approximates its cost of capital. I'd be happy to provide the model upon request if you'd like to run sensitivities on discount rate. It is less impactful than any of the other variables. The values in the table are the value of the cable business in billions.
I spent quite a bit of time running different options, and thinking about how the business is likely to bear out. I think a conservative valuation of the ESPN business requires using the 3% decline in subscribers. I do think the company will be able to raise prices slightly faster than its costs go up. Simply because I expect it to raise its prices at the same rate sports rights go up, but I expect its other costs to be more under control. Thus, for my valuation of the entire company I'll use a case not in the table, a 3% subscriber decline, a 6% price increases, and a 5% cost increases. That worked out to a $73.1 billion value on the cable business.
Parks and Resorts
The next most impactful division for the company is the Parks and Resorts division, which includes the famous theme parks and associated hotels, the cruise line, and the vacation club. This is by far the most capital-intensive division of the company, as it has real assets. As an example, while its 23,000 hotel rooms at Walt Disney World are a very profitable venture, they would not have been cheap to build, and require ongoing maintenance capital to maintain them to a modern standard. Of course, the theme parks themselves are also capital intensive. It has recently built an entirely new park in Shanghai, and adding new attractions across its portfolio. (Star Wars land at Disneyland, Pandora - A World of Avatar at Animal Kingdom, Toy Story Land at Disney Hollywood Studios). There are further expansions planned across the division, including to its cruise line.
The parks and resorts business has been growing its earnings dramatically, and the unit earned $3.3 billion dollars in fiscal 2016. That is a 14.1% return on the property, plant and equipment invested in that business, which is a very strong return on assets, especially considering the long-term nature of this business makes debt leverage appropriate. If you consider this analogous to a hospitality REIT (and given the ROA and moat, it would be at the top of the list), then a cap rate valuation would be appropriate. I would, however, suggest that a theme park and associated hotels are likely to require maintenance capex, so I propose to add back half of their depreciation and amortization before applying a capitalization rate. That takes my estimate of a real-estate style NOI to $4.15 billion. I've included a table below that shows the value of the parks properties at different cap rates. I've also included a row that adds back no depreciation, and one that adds back all the depreciation, as is common when analyzing real estate.
A case could certainly be made that Disneyland et al are comparable quality assets to gateway market office properties, which trade at 4.5% or so capitalization rates. However, I'll go up to 9%, which would be comparable to low quality limited service hotels, to account for the economic sensitivity of the parks business.
Figuring that a "middle-of-the-road" 7% cap rate is conservative for high-quality assets, and adding back half the depreciation is reasonable, I come to a $59 billion valuation for the parks and resorts business. This is slightly higher than the $50 billion in gross capital spending it has done over the years in this business, but is not outrageously so.
I would also note that a backwards looking capitalization rate analysis places no value on investments that have already been made but are not yet providing earnings, such as the Shanghai resort. The company estimated that resort would break even in fiscal 2017, and ramp earnings from there. The park has real value, but will not be included here, so can be considered an upside option.
The Studio Entertainment division is the historical touchstone of the company, as it was the founding division. It is also generally the source of the intellectual property that the theme parks, and consumer products division rests upon, as well as being the original source of the 'Disney Magic.' This is an interesting division to analyze, as the company does announce its movie slate a year or two in advance. That being said, for a long-term analysis, it is very difficult to predict how many "hits" the company will have from year to year. Thus, I believe the most reasonable methodology to take is to take a rolling average of the company's studio entertainment division profits. That being said, the company has made significant acquisitions in recent years, acquiring Pixar in 2006, Marvel in 2009, and Lucasfilm in 2012. Those acquisitions have added significant capacity to produce tentpole films, and existing intellectual property that dramatically improves the chances of those films being a commercial success.
It has been argued that the company's film slate should be subject to mean reversion, especially around margins. The company's margins on its studio division are key, as its revenue has been relatively stable for an extremely long time, although it has turned up recently as seen below.
Source: Disney Annual Reports, Author's Analysis
I think that is unlikely to be the case for a few reasons. The first is the avalanche of IP the company has recently acquired. If the company has a poor year on the superhero movie front with its Marvel IP, it is unlikely that Pixar, Disney Animation, and Lucasfilm will also have a poor year. This diversification should provide some smoothing effects to the company's studio entertainment results. I also believe the company's margins will be sustainable at a higher amount than they were previously for a few reasons. The first is that DIS has moved its business to focus more on big tentpole films, where the opening weekend is a higher percentage of the total take. That is important to its margins, as it receives a higher percentage share of ticket revenues from the theaters from big films, especially on their opening weekends.
An example of the durability of DIS's acquired IP is the recent opening of Dr. Strange. The film is the 14th consecutive Marvel film to open at #1, and it wasn't based on top tier Marvel IP. It held the number one spot domestically for two weekends in a row. I would suggest the company's ability to monetize decidedly second tier Marvel IP successfully bodes well for the next few years of Star Wars releases, as it has the top tier characters from that universe to develop (Young Han Solo, Boba Fett, etc).
The shift to digital distribution has also boosted margins, as films can now be sent to theaters on a reusable digital hard drive as opposed to as expensively printed and not-reusable film.
The studio entertainment division has had a 10-year average revenue of $7 billion, and over that period, it has converted 15.4% of its revenue to operating earnings. However, that has been dramatically higher more recently, with operating margins of 28.6% in the most recent year. The sensitivity chart below shows studio entertainment's value at different revenue and margin performances, and multiples on the earnings. I've started both the revenue and operating margins at the 10-year average, and gone up in stair steps to values slightly above the current ones. For earnings multiples, I used the average S&P 500 P/E over time as the low (15X) and the current S&P 500 P/E as the high (25X). I strongly believe the Disney movie studio with its IP and history is at least as high quality a business as the average company in the S&P 500. The values in the table are the value of the business in billions.
Source: Disney Annual Reports, Author's Analysis
Choosing values for revenue and operating margins of slightly below current figures and the middle-of-the-road P/E ($9 billion, 25%, and 20X) suggests the studio entertainment division is worth $45 billion to the company. Investors who disagree with my estimates of these key variables can use the table to come to their own valuation.
Consumer Products and Interactive
The company put these two divisions together recently, presumably to hide the poor results in the interactive division with the always excellent results of consumer products. The company's consumer products division is probably the best business it has, as much of it is simply licensing corporate IP to others in exchange for royalties. That could be the greatest business in the world, as it has low costs and strong competitive advantages. The business also has pricing power, or at least I think it does based on how much the Buzz Lightyear toy my son is getting for Christmas this year costs. This division is stable, even including the relatively poor interactive results, with earnings growing a few percent per year. I spent a significant amount of time thinking about the key drivers here, and I've concluded the business is of such high quality it would be hard to kill. It will rise more with public acceptance of new characters, but at this point, the library of merchandise is so significant that I think even in a poor year for new merchandise, it should be flat to up. So I'm going to value this division at 20X the most recent year earnings of $1.97 billion, or $39.4 billion.
Valuation and Entry Point
Taking the sum of the valuations for the divisions above and removing 20X DIS's corporate G&A of $12.8 billion as well as its net debt of $16.5 billion I come to a total valuation of $201 billion or $125 per share. That is more than the current share price of $98, which is why I am currently long. As the company increases the size of its theme parks and resorts division with continued capital spending, and increases the size of its movie vault, the earnings should naturally increase over time, which means this is a reasonable entry point. There is, however, the chance for the shares to retrench after Q1 results are reported. On DIS's recent conference call it pre-announced poor fiscal Q1 2017 results, for a couple of reasons. The first was a couple days of having Walt Disney World shut down due to Hurricane Matthew, and the second is having a portion of the Christmas/New Year's holiday in Q2 this year, which will push high revenue/profit days at the parks and hotels into the second quarter. Additionally, the first new Star Wars movie was released in Q1 2016, which means the studio has a tough comparable quarter. That being said, Q2 should be a good quarter for the parks, as it will have a week of the Christmas/New Year's holiday in the current year comping against not having one the prior year, and the Shanghai park will be open for Chinese New Year compared to not being open at all the prior year. Also, due to when the quarter ends some of the college football bowl games will be pushed into Q2, which represents significant advertising revenue to ESPN that will be reported one quarter later.
Disclosure: I am/we are long DIS.
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.