Stay Away From Disney, Even After It Dips Tomorrow

| About: The Walt (DIS)
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Summary

ESPN's subscriber losses may actually be smaller than projected tomorrow.

However, ESPN remains a major headwind to Disney's stock.

The rate of subscriber decline is far in excess of what bulls are incorporating into their models.

There is also reason to question whether the improvement in ESPN's numbers the last two months is real.

Disney (NYSE:DIS) is reporting its quarterly numbers today after the close, and I wanted to respond to some of the arguments that have been made that investors should treat it as an opportunity to buy any dip. In my opinion, Disney remains overvalued, and I would avoid it.

The Other Side

I have been on the bear side of Disney since before my piece last August about a potential looming plunge in ESPN subscriber numbers, stemming from Sling TV's offering of what comes very close to an a la carte offering for ESPN and other Disney properties.

However, Disney remains popular with many, including L&F Capital Management, which characterizes Disney as "short-term bearish, long-term bullish" and sees an expected dip in shares as an opportunity to buy.

The report was generally met in the comments, at least last I checked, with either agreement that Disney was facing only a short-term blip or even some suggestions that the stock won't dip at all. This is essentially a buy-in to the bullishness of Goldman Sachs and Jim Cramer, who both say that the market has already priced in a 2% annual decline in ESPN subscriptions. The argument is that this leaves the upside from the Studio and Parks segments to push the stock further upward.

A Few Things To Remember

I agree with L&F that the report is likely to cause a sell-off, and obviously, I'm not nearly so keen on buying the dip since I think the stock has further to fall. I won't rehash the whole Disney debate here. But I did want to call out a few potential misconceptions I spotted in what's been said the last few days. First, L&F may have actually overestimated subscriber losses for the winter quarter. Second, however, even on their own terms bulls have just admitted they are, in fact, not fully pricing in ESPN's recent subscriber woes, even if they are smaller. Third, Nielsen's more optimistic subscriber counts from the last two months may not even be reliable. And fourth, any strength ESPN is showing is likely to be temporary. I will give a quick explanation of each of these.

Projecting Subscriber Losses

I thought L&F did a good job, and I recommend their article to readers, like I do a lot of their work. But I think, respectfully, there may have been a bit of a miscount here. L&F is projecting around a 2 million subscriber fall last quarter. While Disney has indeed lost 2 million subscribers since September, those losses are actually spread over four months, not three. According to Nielsen's most recent report, Disney lost more than half a million subscribers in December and January combined. The January losses obviously will not be reflected in this report. Combining the 216,000 losses in December only with the larger losses reported in October and November should yield a subscriber loss closer to 1.5 million, give or take.

I think the problem may have been not with L&F, but with Disney. Their last quarterly filing listed 90 million subscribers, and with December end being just above 88 million that would come to almost 2 million. But Disney was actually rounding up Nielsen's number, which had already dropped below 90 million. And December's was actually above 88 million.

At $90 per subscriber per year, as I calculated last year, that puts about a $180 million annual hole in ESPN's revenues, $45 million this past quarter. Not such a big hit, but as I've said before, what makes ESPN's shortfalls so dangerous is that their variable cost of subscribers is so much lower and their fixed cost is so much higher, owing to the nature of sports TV contracts compared to other prime time programming. The hit to Disney's profits from that lost revenue could be almost as high, say $40 million, a not so inconsequential piece of Disney's profit stream. Especially considering the likely shortfalls in Disney's other segments, which L&F already pointed out.

The Market Pricing Is Still Off

Regardless, Disney bulls should take no comfort in a slightly smaller subscriber hit. While that is a much slower rate of loss than October and November, when they were losing half a million each month, even the smaller number represents well over the decline rate that Goldman says the market has priced in. The 326,000 loss last month alone represents a 4% annual decline rate. Twice what the market is supposedly projecting.

Nor is that the worst of it. January and December, when the losses supposedly slowed - more on the "supposedly" below - are ESPN's two strongest months, historically. They are when football is moving into the heart of the playoff chase and then the resulting playoffs themselves. That will be less of a factor going forward. The decline rate of October and November, if it returns, represents an 8% annual rate of decline, four times what the bulls are pricing.

I said in May that Disney's TTM net income needed to be discounted by at least $1.5 billion to account for weakness in ESPN going forward. At almost $110 at close yesterday, Disney is already fairly valued at a 19 P/E. Deducting the $1.5 billion would cut its net income by one-sixth, producing a fair price of below $92. But even that may be conservative. At $40 million per quarter, $160 million per year, compounding, the losses will hit $2 billion in annual profit in three years. That would put Disney's fair price back at the $86 low it touched last summer. And the market may begin to price this in very quickly over the next few months.

Does Nielsen's New Method Even Work?

There is also some question for some of us about whether that deceleration in subscriber losses ever happened at all.

Nielsen has just begun, with the January numbers (covering December, the January estimates just published are the "February numbers," confusing I know) to incorporate broadband households - those using DIRECTV Now, Sling, Vue or some other streaming service - into these estimates.

While they plan to ramp up their position in the sample very rapidly over the next six months, they were severely underrepresented in these two surveys, and questions have been raised about small sample size corrupting the data. The deceleration correlates exactly with the incorporation of these numbers.

While one would expect ESPN to be in at least some broadband-only homes, the absence of any decently-sized broadband-home sample makes it difficult to trust their early numbers for this customer group. And it seems more likely than not that if Nielsen had stayed consistent in only counting traditional TV homes, ESPN's losses would not have decelerated so.

Seasonal Timing

The last thing to remember as well, as I've already touched on, is that even if ESPN has bounced back, it probably won't stay that way. While the quarter ended in December, CEO Bob Iger will have the benefit of the February count when he takes the microphone on the call tomorrow, and doubtless the strongest months of the year will give him the opportunity to call out any stabilization that may have occurred. Either during the quarter or even after.

But that still might not be a good reason to buy the stock. Given the fact that we are now heading into the weaker part of the year for ESPN, any bounce the stock gets from "stabilizing" ESPN losses may well be reversed when the March and June quarters come in. This could potentially set any stock bounce that occurs following tomorrow's dip up for a retrenchment.

If there is a time to buy Disney - and I'm not sure there is - I would consider it to be in the late summer or fall, when football season is about to start up again and ESPN is most likely to have good news to report. Right now, the next six months for ESPN are likely to remain very choppy.

Conclusion

I agree with L&F that Disney may be due for a dip tomorrow, but I would be cautious about considering that an opportunity to buy. The market has yet to fully come to grips with the depths of ESPN's woes, in my opinion. I would avoid Disney's stock.

Disclosure: I am/we are short 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.