Buy Disney Ahead Of Its Next Wave Of Growth
Summary
- Disney's structural issues are well publicized and already factored into the share price, which is trading at a mere ~14x consensus FY18 earnings.
- However, the company has a superb content library to lay the foundation for a successful launch of its direct-to-consumer video streaming services.
- I expect growth in Theme Parks & Resorts, Studio Entertainment, and ultimately, video streaming to counteract the decline in its Media Networks and Consumer Products & Interactive Media segments.
- Even a moderate uptake of Disney's streaming services should enable Disney to materially outperform the market from its currently depressed levels and would, therefore, recommend Disney as a buy.
Introduction
Disney (NYSE:DIS) reported conspicuous declines in three out of its four business segments in its 2017 reporting period, leading to a stagnation in the share price of the business. Whilst the rest of the market boomed in 2017, Disney flatlined. The market remains extremely skeptical regarding the company's ability to counteract its various structural issues (notably cord cutting and the impact on ESPN), detailed succinctly in this article.
Whilst I do not doubt that the old Media Networks and Consumer Products & Interactive Media segments will continue to struggle and put a drag on Disney's overall growth due to negative structural trends, the notion that profits generated from these businesses will completely fall off a cliff in the near term is greatly exaggerated, in my opinion. Further, the share price of the business is now adequately reflective of these concerns, with Disney currently trading at a FY18 PE ratio of ~14x or an earnings yield in excess of ~7%, which is a substantial discount to the overall market.
Figure 1:
Source: YCharts
Investment Thesis
A number of factors are in favor of Disney's business going forward. The most material factors, which will benefit Disney, include the following:
- Additional profit and free cash flow generation from the Tax Cuts and Jobs Act 2017
- A resurgence in Studio Entertainment revenue and profits due to multiple successful film launches (Star Wars episode 8, Black Panther, and Avengers: Infinity War)
- Management is also expecting sustained growth in Theme Parks and Resorts.
Most analysts seemingly account for these positive trends in their FY18 forecasts for the business, with revenue expected to increase c. $3bn or 6% in FY18, to over $58bn. Further, 24 out of 27 analysts rate Disney as a buy or hold, with only 3 sell recommendations, and a median target share price of $123, which represents ~25% upside excluding the dividend.
However, what makes Disney a high conviction buy for me is less about the aforementioned (existing) considerations, but rather the enormous potential inherent in two "uncertain" elements to the business. These are, in no specific order:
- Disney's proposed acquisition of key Fox (FOX) assets. Whilst expensive, this acquisition will further support its content and hence, value proposition in high growth segments as well as diversify the overall business
- More importantly, Disney's proposed launch of direct-to-consumer video streaming services in 2019, alongside ESPN Plus, which is to be launched in April 2018, is a game changer.
Fox asset acquisition
Comcast (CMCSA) has thrown a major spanner in the works firstly through its attempt to hijack the Fox deal and then secondly through its attempt to acquire Sky (SKY). My view is that the Fox key asset acquisition is either neutral (i.e. it is unable to make the acquisition) or positive, due to the increased value of the combined companies' owned content (see below) and rights, diversification away from Disney's struggling business units into the high-growth segments and the significant (and achievable) cost-saving synergies.
Figure 2:
Source: Walt Disney To Acquire Parts Of 21st Century Fox - Slideshow
The financial metrics of the deal appear to stack up if one factors in the $2bn of synergies, with the purchase price at an effective adjusted EV/EBITDA multiple of around 8.3x (see below).
Figure 3:
Source: Walt Disney To Acquire Parts Of 21st Century Fox - Slideshow
Although the probability of this deal happening is now uncertain, it is in my view net positive on balance. Should the deal be successful, it will undoubtedly support growth for the direct-to-consumer video streaming business as well, which is where upside potential is most prominent and compelling.
Direct-to-Consumer ("DTC")
One of the major pitfalls of the video streaming services available in the market is the lack of quality sport offerings at a relatively low cost. Most offerings consist of bundled options which price above $30 per month once sport is included, such as for instance YouTube TV and Xfinity Instant TV. ESPN Plus, which is due to launch this month, is Disney's attempt to be first to market with an affordable, bespoke service in the space. My sense is that if Disney can get this service off the ground (which I believe is a strong probability), it can arrest the decline in its ESPN business in time.
There is also an attractive opportunity for Disney to target cricket audiences in Asia off the back of its successful CricInfo website and application. There are over 1.5bn people who fanatically watch cricket across India, Pakistan, Bangladesh, and Sri Lanka, with growing popularity in Afghanistan and the UAE. If Disney can successfully penetrate this market, it could provide an enormous tailwind to the business. Imagine 200m cricket-mad supporters signing up to watch the sport off Disney's ESPN Plus app at $4.99 per month? That would be c. $12bn in annuity revenue in growing markets.
I have previously articulated my belief that for Disney to gain sufficient traction for their full DTC streaming service, they should partner with Facebook (FB) to compete with Netflix (NFLX). However, the general view is that Disney does not need Facebook to launch successfully (outside of ordinary advertising). This perception is likely only increased by the recent issues affecting Zuckerberg and team. I am less convinced, without substantial marketing spend (at the expense of short-term profits) to add subscribers rapidly. This is likely to include, for instance, partnering with Smart TV manufacturers like Samsung (OTCPK:SSDIY) and Sony (SNE) to become a default application on the TVs sold, and marketing aggressively via Facebook and Google (GOOG) (GOOGL) products (especially in international markets), which will not be cheap.
I believe this strategy should be employed by the company although it is likely to result in further short-term share price pressure, given the potential. The long-term objective for Disney, as it is for Netflix, would be to have ~500m (or more) subscribers paying an average of $20 per month for DTC video streaming services (including ESPN Plus), thus generating in excess of $120bn in revenue. At that sort of scale, net profit margins would be expected to be in excess of 20% as well, if one reviews the total operating costs for Netflix as a reference point.
Conclusion
With all that said, my sense is Disney is trading too cheaply to be ignored as an opportunity to generate alpha at just ~$98 per share, given that it is expected to achieve ~$7 EPS on the strength of its existing business segments. With over 20 Marvel movies planned beyond this year, the Studio Entertainment segment is likely to rebound and grow over the next few years supported by the highly successful and iconic Theme Park and Resorts business. The kicker, as mentioned previously, is the potential value inherent in the proposed Fox asset acquisition and DTC video streaming services which represent compelling blue-sky potential for shareholders.
To help, Disney is preparing to reorganize its business into different segments, which will make it easier for investors to identify the growth from the DTC business and apply a multiple similar to that afforded to Netflix, which continues to trade >100x forward PE ratio.
The way I view Disney as an investment can be summarized as follows:
Figure 4:
Source: Author diagram
With that in mind, I intend to acquire Disney shares prior 2019 (when it launches its DTC video streaming service). Given the current market volatility and the continued uncertainty regarding the Fox transaction, I am, however, in no rush to make a purchase of Disney shares even at today's depressed levels. I am, therefore, waiting for an entry price of below $94 per share (~13.5x FY18 PE ratio) pulling the trigger.
This article was written by
Analyst’s Disclosure: I/we have no positions in any stocks mentioned, but may initiate a long position in DIS over 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.
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