Disney: Losing The Magic?

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About: The Walt Disney Company (DIS)
by: The Value Investor
Summary

Walt Disney has officially acknowledged unbundling and Netflix as big threats.

The company will set up its own platform, creating a drag on earnings (visibility) and potentially confusing the consumer.

Uncertainty in Disney's profit engine has the potential to weigh on the stock a bit further, although I would be an eager buyer in the $80-90 range.

Walt Disney (NYSE:DIS) has officially reset its expectations for the near to medium term as it announced the rollout of a direct-to-consumer service for its content. In essence, Disney has issued a profit warning for 2018-2019 in an effort to halt the impact of the unbundling of its networks business, as the core profit engine, the Media Networks segment, again posted very soft quarterly results.

The issue is that pressure on earnings and cash flow uncertainty will increase in the coming years. On the other hand, investors have seen stagnation in shares for 2 years so far, albeit after a great run in the years before. Even if earnings power gets reduced from a current $6 per share towards the $4.50-5.00 per share region, Disney remains very profitable and well capitalized.

A market valuation multiple, great diversification and stable business should provide support and appeal if shares dip to the $80-90 mark.

Growth Has Come To A Standstill, Margins Under Pressure

Disney has long been a favourite stock among investors in recent years, as they were impressed with the movies of the business, which in their turn were the result of savvy acquisitions. Other key attractions were the strong park results, driven by the anticipation and opening of the park in Shanghai as well as the fact that the operational performance has been good and vast sums of shares have been bought back.

The combination of all of this has perhaps pulled demand for Disney shares forward after they have long traded in a $20-40 range. That changed in 2012 as the stock started to rise in a very steady fashion, only to hit a high of $120 in 2015. While part of this was driven by a strong operating performance, sound deals and share buybacks, valuation multiples have been on the increase as well. At the same time, Disney is facing some emerging challenges, particular in its media business, in which it feels the impact of unbundling and more time being spent on other forms of entertainment.

Additions to the movie business, steady growth in the cable network and growth of the park business allowed Disney to grow sales from $35 billion in 2007 to $55 billion on a trailing basis, for growth of 4-5% per annum on average. This growth has been accompanied by 23% of the shares having been bought back over the same time span, allowing earnings per share to double over this time period, accompanied by modest margin expansion on top of that.

This process is now coming to a standstill, as revenues were flat in Q3 of the current year and are flat so far this year. This is driven by flattish results at the media networks business, double-digit growth at park & resorts, offset by a combined double-digit decline in studio entertainment and the consumer product segment. While the flattish results on the top line are bad enough, earnings are now starting to come under pressure with third-quarter operating earnings being down 10%, marking a clear reversal from past trends.

Current Struggles Expected To Last For A While

Disney reports its results across 4 major categories, and two of them are under pressure. The media networks business generated $23.7 billion in revenues in 2016, or 43% of total revenues. Its segment earnings of 32.8% are very impressive, especially as segment earnings closely resemble overall operating margins.

Revenues have fallen by 1% in the third quarter, driven by a 3% decline in cable network revenues, only partially offset by a 4% increase in lower-margin broadcasting revenues. At the same time, NBA programming costs were up, causing quarterly operating earnings of the entire media networks business to fall by 22% to $1.84 billion, pressuring margins in a big way.

Parks & resorts grew sales to $17 billion last year, equivalent to 30% of total sales. Although margins are quite a bit lower at levels just below 20%, these kinds of segment margins remain very respectable. Third-quarter revenues were up 12%, accompanied by solid sales leverage. Results were flattish in the home market, as growth has been driven by Shanghai and by the 25-year anniversary of Disneyland Paris to a lesser extent.

The studio entertainment business posted revenues of $9.4 billion in 2016, making up 17% of total revenues, accompanied by margins of +28%. These very strong results were driven by strong movie titles and acquisitions being made in recent years. Third-quarter sales are now down 16%, accompanied by a similar decline in operating earnings on the back of difficult comparables and lack of successes in the most recent quarter. The company had a daunting and impossible task to create similar successes compared to Captain America and Finding Dory, two titles which boosted last year's results.

The consumer products & interactive media business is a $5.5 billion business representing 10% of total revenues. While it is the smallest segment in terms of sales, it is highly lucrative, as segment margins exceed 35% of total sales. The lack of blockbusters meant that revenues at consumer product were down 5% as well, although the already impressive margins were improved even further.

Strong Past Performance, Some Uncertainty To Come

The truth of the matter is that Walt Disney has a very strong position versus its peers. The legacy of very strong historical titles is leveraged through products sales, networks and park & resorts in a uniquely integrated business model. Regular growth, capital returns and smart acquisitions, which include the purchase of purchase of Lucasfilm and Pixar in particular, have paid off handsomely for investors.

The reality is that the company is struggling a bit as of late, as is really visible in the results so far this year. Adjusted earnings per share were down 2% in the last quarter and are flattish so far this year, seen around $6 per share.

This makes that Disney trades at market-equivalent multiples at current levels of around $100 per share, for a 6% earnings yield. The company has been increasing net debt levels a bit over time, with net debt currently standing at $18 billion. While this is a large sum in absolute terms, remember that Disney has rather sizeable and predictable cash flows, for a leverage ratio of roughly 1 times. That number excludes the purchase of another 42% stake in BAMTech, as discussed below, as well as a combined $5.2 billion underfunded status of pension and post-retirement medical plans.

To monetize its own content better, Disney is now considering cutting its distribution to platforms like Netflix as it starts its own subscription service, following the acquisition of another substantial portion of the shares of BAMTech. Disney pays nearly $1.6 billion to boost its stake from 33% to 75%. This transition into offering its own skinny bundle will probably involve a lot of investments, as it will be uncertain how consumers will react, given handling such a transition is risky and very important for the company. Remember that media networks made up 43% of total revenues and even 50% of segment earnings in 2016!

The key is that the content produced by Disney is probably not broad enough to offer a one-stop solution which can compete with Netflix, which implies that content needs to be acquired from third parties, while the company will miss out on the transmission fees to Netflix as well (if it decides to cut the distribution to this platform).

Having enough content is probably key for Disney, as consumers are likely to be confused and are financially not better off if they need to subscribe to many channels, especially as the company itself already wants to offer a sport and Disney/Pixar channel. If this trend continues, I see a future in which consumers might even want to have cable again! It should furthermore be said that both Netflix and Amazon (NASDAQ:AMZN) are offering content at appealing prices, as unbundling might actually cost Disney quite a bit of revenue over time.

The increased confusion and decentralization might even drive younger-age cohorts away from this kind of content into social media. While additional investments into content and IP might hurt earnings, they will certainly hurt cash flows in the near term of this experimentation stage, and management is still in the process of figuring out by how much.

Final Thoughts

Current earnings power of close to $6 per share might not be sustainable, as the core media networks business, which accounts for 50% of earnings, is facing real pressure.

The investments into a streaming business will be substantial, as the overall implications for revenues and earnings might be substantial as well. Remember that operating margins have risen from 20% a decade ago towards 25% as of now, thanks to pricing power and sales leveraging, as stagnation and challenges in the core segment, combined with difficult comparables for the movies business, might put pressure on these margins.

If margins were to retreat to 20% and sales remain flat at $55 billion a year, operating earnings drop to $11 billion a year, a number which is similar to reported operating earnings in the first nine months of this year. That implies that earnings power could fall from $6 per share towards levels around $4.50 per share.

If that becomes a reality, the current reasonable multiple of 17 times earnings would jump to 22 times earnings. Worse, EBITDA would fall to $14 billion, which, combined with the current net debt, acquisition of BAMTech and inclusion of pension liabilities, results in a leverage ratio of nearly 2 times - still very manageable.

Using my $4.50 per share number as a sort of bear case in this uncertain short-to-medium term future, and applying a market multiple plus a small premium for the brand and integrated business model, I end up with compelling value in the $80-90 region. While we have not seen these levels since 2014, investors have to realize that Disney has some challenges ahead, as the outcome of the content strategy is still highly uncertain and valuation multiples have generally been on the increase in recent years.

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.