By Ben Roberts, Integer Investments analyst
Earlier this year, we posted an article focused around the future prospects of The Walt Disney Company (NYSE:DIS), coming to the conclusion that despite the weakness of ESPN, we believe that there is a clear path towards value creation. Disney is currently trading at $98.36 and a 2017 P/E ratio of 17.36 (Gurufocus), this is still cheap compared to the rest of the industry, with analysts still overpricing in the downtrend in Disney’s media networks business. Below, we will discuss Disney’s shift towards direct-to-consumer distribution, outlook for the Parks and Resorts and Studio Entertainment segments and updated reasons as to why we are still optimistic about Disney’s prospects moving forward.
Streaming as a major disrupter
The growth of Netflix (NASDAQ: NFLX) at 20% Y/Y has seen the entertainment market make a significant shift towards direct-to-consumer services as companies look at taking on Netflix’s first mover advantage. We have recently seen the launch of CBS All Access, growth of original programming on Hulu, and continuing seasonal strength of HBO GO. The current market shows Netflix holding around a 75% market share, with the smaller players such as Hulu and CBS Access falling far behind.
The competitive advantage is that direct-to-consumer platforms allow the ability to consume entertainment at a time of your choosing, large content libraries at the relative cost of a cinema ticket and ability to ‘binge watch’ television shows. This shift in consumption preferences shows no signs of slowing down as consumers are wanting quick, easy to watch content constantly at their fingertips. The profitability of the subscription-based model has been proven by Netflix and we see the overall multimedia entertainment market moving in this direction. Media conglomerates need to decide whether to continue licensing their content to third parties such as Netflix and Amazon (NASDAQ: AMZN) or leverage their pre-existing content library and create their own platform. This decision has a large trade off as on one side you have the financial upside that streaming platforms represent and on the other you have the large capital investment and associated costs that are required to launch an in-house direct-to-consumer platform.
In the DIS Q3 earnings call, CEO Bob Iger announced that Disney would be launching direct-to-consumer subscription streaming services for ESPN that will launch in 2018 and Disney, Pixar, Lucasfilm and Marvel that will launch in 2019. With such a large investment and shift in DIS's strategic focus for their profitable albeit declining Media Networks segment, future growth for the company hinges on the success of both platforms.
Disney’s Shift towards Streaming
- Invested a further $1.6 billion into BAMTech, moving from a 33% to 75% equity stake.
- Announcement of ESPN direct-to-consumer streaming service in 2018, Disney streaming service in 2019.
- Ending distribution agreement with Netflix beginning with the 2019 calendar-year theatrical slate.
- Expansion of ‘Movies Anywhere’, DIS digital film service. 20th Century Fox, Warner Bros and Universal Studios now joining the service.
Can Disney succeed in the direct-to-consumer market?
Disney still trades at a discount when compared to similar companies at a TTM P/E of 17.36 and EV/EBIT of 11.97; this represents a great opportunity in our perspective. Looking at the latest trends in the multimedia entertainment market, we see Disney’s shift into direct-to-consumer offering as a major shake-up of the streaming market and a catalyst for future revenue growth. Disney’s prospective 2019 service would aim more towards a younger audience and appeal to a significant portion of Netflix’s present subscriber base. Netflix’s current kid-friendly offering is reliant on licensing agreements and without large investments in original children's programming will be left behind as more companies see greater value in direct distribution rather than licensing.
We feel that the competitive advantage of DIS in the streaming market can be shown through several key areas:
- The strength of Disney’s brand equity. (Ranked 14th most valuable brand by Interbrand)
- Disney’s library of intellectual property. (Disney Animation, Pixar, Star Wars, Marvel)
- Disney’s lasting appeal to children and families. (Majority of Disney content is G/PG rated)
- Leveraging of multiple business segments to drive revenue.
Disney can use its media networks to reserve prime time space to advertise its latest film. Successful films can then drive attendance at theme parks and the increase the value of licensing agreements.
At the recent Q3 earnings call, CEO Bob Iger announced that:
“We'll also be making a substantial investment in original movies, original television series, and short form content for this platform, produced by our studio, Disney Interactive and Disney Channel teams. Subscribers will also have access to a vast collection of films and television content from our library.”
We see huge opportunity in exclusive original programming for Disney’s direct-to-consumer platforms and feel that Disney can successfully monetise the intellectual property, both TV and movies that they currently possess. We see Disney’s brand equity being stronger in international markets than Netflix, Hulu, Amazon Video and that customers may prefer the established Disney brand which adds to our optimism through 2019. As discussed in a previous article in which we entertained a potential acquisition of Netflix, a direct-to-consumer streaming service presents large synergies for Disney and we see similar value in the Disney-branded service from 2019 onwards.
Netflix recently announced that they would increase prices on two of its subscription tiers. The announcement was met with a positive reaction by analysts which resulted in a 5% stock price reaction. We agree with this market sentiment as current subscription pricing is very much inelastic and any further pricing increases up to a $12.99 mark for a basic subscription would have little to no impact on subscriber growth. This presents an opportunity for Disney as it changes the outlook for operating margins for their own service as we feel the Disney-branded service would launch in a similar pricing range of $10.99-$12.99. As a whole, we believe that this adds to the positive outlook for both prospective streaming services.
Parks & Resorts and Studio Entertainment
The strength of DIS Parks and Resorts segment is clear with a dominant market position and growing brand equity. The segment experienced average quarterly operating income growth of 17% through Q3 of FY17. This outpaces the performance of all other segments for Disney. We believe that further growth is possible for the segment, especially in its international operations. Shanghai Disney Resort and Hong Kong Disneyland Resort are both located in China which has seen a growing middle class and rising incomes. This is favourable for Disney as attendance numbers are certain to increase with the Shanghai operation also continuously building up its presence in the region. However, it must be noted that Disney does not hold outright ownership of both the Shanghai (43%) and Hong Kong (47%) (Source: 2016 annual report) resorts so financial results will only marginally reflect each operation's success.
DIS has also recently begun work on numerous expansions and refurbishments of its domestic parks, including the expansion of its core brands (Star Wars, Marvel) into both the Orlando and California operations. A key factor to watch will be if this actually helps to drive growth in attendance numbers and average spending per attendee. Disney’s current strategy for its Parks & Resorts and Studio Entertainment segments includes:
- Expansion and refurbishment of existing domestic parks and resorts (Star Wars Land in Anaheim and Orlando, Animal Kingdom at Walt Disney World Resort and Marvel land at California Adventure).
- Driving operating income growth at international operations in particular Shanghai Disney Resort and Disneyland Paris.
- High quality studio entertainment releases in 2018/2019.
- Leverage strong performance of tentpole studio releases to drive revenue in consumer products (Star Wars and Frozen).
The studio entertainment segment is one of the core drivers of growth for other segments and the company as a whole. With an impressive release schedule across FY18/19, we feel the segment can produce similar growth to FY16. This success revolves around the release of a Star Wars ‘Episode’ which is reflected by revenue growth of 28% Y/Y and operating income growth of 37% Y/Y caused by Star Wars: The Force Awakens in FY16, and with the impending release of Star Wars: The Last Jedi, we see DIS somewhat replicating FY16 results. However, the key driver of longterm growth will still be the release schedule during FY18/19 and we believe these major releases will drive growth for both Consumer Products and Park & Resorts.
DIS FY18/19 Release Schedule:
- Black Panther (Feb 9th)
- Wreck it Ralph 2 (Mar 23rd)
- Avengers: Infinity War (Apr 27th)
- Han Solo Star Wars Film (May 25)
- Incredibles 2 (Jul 13th)
- Mulan (Nov 2nd)
- Avengers 4
- Toy Story 4
- The Lion King
- Frozen 2
- Star Wars IX
The key releases to look at in our view are Frozen 2, Incredibles 2 and Toy Story 4. Past trends have shown the growing demand for animated offerings, and based off historical performance, all three releases should gross upwards of $1.25 billion. This will have a revenue flow on effect to other divisions due to the lucrative nature of the ‘kid friendly’ merchandise market. We are paying particular attention to the ‘Frozen’ brand as while the first Frozen film was released in FY13, licensing revenues increased consistently through FY15 and declined afterwards. This shows the significant financial impact that the release of “Frozen” had on driving merchandise revenues over several financial years.
CEO Bob Iger on Disney’s product offering:
“I'll call it our product cycle. With a slate of Marvel films that goes well into the next decade, and the same with the Star Wars front – on the Star Wars front and probably the strongest slate of Disney films that we've ever had in development, you have to consider the options from a revenue-generating perspective that that provides us in multiple windows, in multiple ways, whether it is licensed to third parties in a variety of forms or whether it's proprietary on our services, meaning subscription, et cetera, and so on.”
We believe that through focus on the core brands of Disney, Marvel and Star Wars and multi-channel distribution, Disney is in a strong position and will continue to create value long after the retirement of Bob Iger in 2019.
We constructed a simple multiples analysis to value Disney, using data supplied from Gurufocus. We used a combination of EV/EBITDA, EV/EBIT and P/E metrics to value the business. These metrics were also weighted equally in calculating the implied price. We also placed more weighting on the larger media conglomerates, as they had similar structure and business models.
The analysis suggests that DIS is trading at a relative discount compared to other media conglomerates. The 19% upside is in line with our outlook for the company. It also must be noted the other financial strengths, the company has a relatively low leverage ratio (23.92% Debt to Assets Ratio), commitment to share buybacks with $20 billion returned to shareholders since early 2015, strong dividend growth rate of 23.70% over the last three years and higher than market 3-year EPS growth rate of 5.66%. In our opinion, the valuation and the other factors mentioned prove that DIS is currently a bargain compared to the rest of the industry and that the implied upside still does not factor in DIS streaming services, strong FY18/19 release schedule or consistent growth of the Parks and Resorts segment. We believe that future growth is possible and stock price upside will not be limited to the $110-$120 range.
Disney has the right strategy with its shift into direct-to-consumer services and coupled with the chance to further monetise its large investment in intellectual property puts it in the perfect position to create further value for shareholders. We believe a strong Q4 release schedule and further growth in the Parks and Resorts segment will offset the weakness of ESPN and lead to a large upside in the share price. We continue to like Disney at current prices (even more at $97.38) and are excited for what the next two years hold for the company.
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Disclosure: I am/we are long DIS, AMZN.
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.