The Time To Buy Disney Is Now

Summary

• As it stands, Disney is a reasonably-priced value play.
• The Media business is stagnating. But there is enough growth in the Studio and Parks segments, along with strong cash flow and balance sheet, to warrant a Buy.
• With the acquisition of Twenty-First Century Fox, Disney is now truly the king of content, set up well to take on streaming competitors and become a growth stock.

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The Walt Disney Company (NYSE: NYSE:DIS) offers the rare opportunity of a reasonably-priced value play on the cusp of a potential growth play. Think Microsoft (NYSE: MSFT) pre-Nadella, when the technology giant was stagnating due to its perceived inability to adapt to the cloud. Microsoft has since undergone a successful pivot of sorts and the stock is racing towards the $1T mark. I see a similar shift happening at Disney in the next 2-3 years; however, even as things currently stand, it has enough dominance in the media landscape to warrant a buy.

Leadership

Bob Iger has been a staple in the media business for over 45 years, serving leadership roles with Capital Cities/ABC and then Disney. During his time at Capital Cities/ABC, Iger worked under Tom Murphy, a CEO with Buffett-like mentality when it came to capital allocation. Particularly impressive about Murphy’s tenure at Capital Cities was the list of companies he acquired and successfully integrated into existing operations. For example, Capital Cities’ acquisition of ABC for $3.5 billion in 1985 - not only was this the largest media deal at the time, but ABC was three times the size of Capital Cities in terms of revenue.

However, Murphy’s track record spoke for itself, as he produced a remarkable 19.9% internal rate of return over a period of 29 years at Capital Cities (as compared to 10.1% by the S&P 500).

Upon Disney’s ultimate acquisition of Capital Cities/ABC, Iger assumed his current CEO position in 2005. In a very Murphy-esque style, he has significantly expanded the Disney brand via fearless acquisitions of Pixar, Marvel Entertainment, and Lucasfilm. Some deals faced a fair share of initial objection. When Disney bought Marvel in August 2009, the stock price plunged on the same day, as many analysts criticized the bloated price that Disney agreed to pay - a 29 percent premium on Marvel’s stock that already was trading near a 52-week high. Eight years later, we all know how profitable the Avengers has been for Disney and its franchise.

With Iger at the helm, Disney's stock price has risen by 317.46% compared to 136.12% by the S&P 500. It is important to overlook the current stagnation and think long-term, particularly given the pending acquisition of Twenty-First Century Fox (FOX) (FOXA), which I will discuss later.

(Source: Yahoo Finance)

Besides Iger, many members of the senior leadership are insiders who have been with the company for at least a decade. When Iger is ultimately ready to hang it up, the company can be trusted with a homegrown candidate (for example, the current Chairman of Direct to Consumer and International, Kevin Mayer) to carry forward the Murphy/Iger legacy.

(Any financial data presented from here on can be found on Disney’s annual 10-k reports, which can be accessed here).

Brand Recognition

Disney’s brand name, with characters and stories that continuously find a way to our hearts, is matched only by a few other companies. Quantitatively, this has consistently led to better margins and free cash flow compared to competition.

Over the past 5 years, Disney has actually increased its free cash flow to Sales ratio from 14.5% to 16.7% (averaging 16.5% in that span). Compare this to competition and we see a significant uptick in profitability: Viacom (NASDAQ: VIAB) at 12.4%, Time Warner (NYSE: TWX) at 11.65%, and recent bidding-rival Comcast (NASDAQ: CMCSA) at 12.6%.

I believe free cash flow (FCF) to be a better measure of profitability than Earnings, since it is a more accurate estimate of cash available for any capital allocation strategies. In calculating free cash flow, I adjust both the cash from operations and capital expenditure values as follows:

• Cash from Ops = Reported Cash from Ops (-) equity compensations (equity is a form of compensation; hence, an expense)

• Capital Expenditure = Depreciation (the reported capital expenditure number has both growth and maintenance CAPEX; hence, depreciation is a better estimation of the amount required for maintenance)

On top of profitability, we also see quite a noticeable increase in the Cash Flow Return on Equity in the 5-year span from 14.2% to 20.4%, once again way ahead of competitors.

Disney is able to leverage its brand, characters, and content to produce higher profit margins and returns on equity. Plus, it is hard to see this competitive moat fading overnight, with the upcoming slot of Studio productions, as well as expansion of the theme parks at both the domestic and international locations.

Strong Financials

The Media segment (42.2% of total revenue) has been heavily scrutinized in recent years with the current trend of cord-cutting, loss of subscribers, and increasing costs. Despite the headwind, the core financials remain strong.

The Studio and Parks segments have driven top level sales from $45B to $55B over the last 5 years (CAGR of 4.87%). The bottom line has shown a more impressive growth from $6.1B to $8.9B (CAGR of 9.22%) with the FCF increasing to $9.1K from $6.8k (CAGR of 9.33%).

Total assets hover around $95B, which I argue is undervalued considering the “land” assets is held at cost as per GAAP measures. Furthermore, we see a modest debt to equity ratio of 0.42, with earnings easily covering the quarterly interest and principal payments.

Management has increased debt levels over the last 5 years (55% increase since FY13). This has coincided with a spike in share buybacks. In 2017, Disney repurchased $9.3B worth of its common stock; considering FCF of $9,197, we see a Buyback/FCF ratio of 1.02. Plus, the stock is undervalued at present, with a P/E of around 15 (compared to the historical average of 18.3 and the current S&P of 24.4)*. Management clearly recognizes the favorable price, implementing an aggressive repurchase strategy at the expense of cheap debt. This has most certainly paid off, as seen by the outstanding growth in both EPS (11.9% CAGR) and FCF (11.99% CAGR) over the last 5 years.

With Disney, you have a strong brand at a reasonable price, with top line and bottom line growth, and a management that values cash flow to maximize shareholder returns with buybacks and strategic capital investments. Add in a steady dividend at a yield of about 1.5% and you have quite a margin of safety, especially in the volatile conditions of today. The core media business is definitely a problem, but not so much to justify the stagnant price over the past few years.

*The only other time in the last 10 years Disney’s Buyback/FCF was over 1 was during the heart of the 2011 recession when the company was selling at 13x earnings.

FOX and Streaming

As mentioned, Disney is a Buy even with how things currently stand. However, there is a greater potential for growth with streaming, which will resolve the Media segment’s troubles and then some more. If properly executed, investors will be quick to jump on-board and catapult the stock to the next level. Here is what I foresee.

(Please note that the following section contains my personal speculation. Even if what I have outlined doesn’t pan out, Disney is still growing enough to be a safe bet. However, I trust Disney’s management to execute, given the ability it has shown with previous mergers and strategy shifts).

It is no secret Disney purchased Twenty-First Century Fox to expand its content library for the Netflix competitor it plans to release in 2019. Imagine the slew of content the service will offer: Disney, Pixar, Marvel, Lucasfilm, X-men, Fantastic Four, Avatar, etc. Furthermore, imagine all the future blockbusters with forthcoming Marvel films, as well as potential crossovers (say between the X-men and Marvel) sure to attract massive box offices and subscriptions. Add in the rumoured price less than that of Netflix (NFLX) and you have a mouth-watering potential for double-digit user growth each month.

Furthermore, Disney is working on potential solutions to fix the cash-bleeding ESPN, the first step of which is the recent ESPN+ service just released in conjunction with BamTech (a company that Disney acquired fully over the last year). I believe that ESPN will become a stand-alone live sports streaming service the current subscribing audience will need access to. At the end of the day, ESPN might be struggling, but it is still the leader in sports. They will turn it around.

Finally, add in the 60% majority ownership of Hulu the Fox deal brings and it gives Disney yet another streaming service to compete with Netflix with over 17 million paying customers spread across both its on-demand and live TV services. Perhaps, their standalone service for the more adult-oriented, PG-13/R-rated content?

Netflix is the current media darling that cracked the direct-to-consumer distribution code for which it is being handsomely rewarded by the market. However, it is only a matter of time before Disney pairs a similar distribution strategy with the content powerhouse it has become. At the end of the day, content is king and Disney is truly the king of content.

Analyst’s 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.