Disney's Q1: Boring, For Now

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About: The Walt Disney Company (DIS)
by: Steven Mallas
Summary

Disney issued a Q1 that was mostly a dull affair.

Studio, in particular, was down but that simply illustrates the tendency of variable performance for filmed-entertainment. Theme parks performed well.

Cash flow declined, driven by revenue/earnings results.

The consistent theme as of late: Streaming is the ultimate catalyst to come. Disney has a lot of opportunity with this initiative (so long as Iger uses his imagination).

Disney isn't super-cheap, but it's not expensive; it's difficult to value the stock until it integrates Twenty-First Century Fox and begins competing directly with Netflix.

Introduction

Disney (DIS) reported results for the fiscal first quarter. I will discuss the performance, using the press release, earnings-call transcript, and this SA news item as sources.

It was a deadly-dull affair. There were declines in segment operating income and cash flow. The stock didn't do much in reaction to the news after it was reported, as one might expect (it did go up slightly, however, which is better than going down).

For long-term holders, the Q1 stats don't matter much. Even the next few quarters may not matter much. Everyone is waiting for the latter part of the year when the company's streaming service is expected to make its debut. Even then, shareholders will have to wait for news flow on subscriber counts to fully evaluate the company's/stock's future. I personally believe this is a stock to hold, even through what may be some boring months ahead.

The First Quarter

Disney saw its top-line stagnate year-over-year, reporting the same $15.3 billion (technically, the previous year's sales line was very slightly larger, I point out with disappointment). Segment operating income dipped by 8% to about $3.7 billion. Adjusted diluted earnings per share retreated 3% to $1.84. That apparently was a big beat in terms of expectations, a significant $0.30 margin.

For me, though, the earnings beat wasn't really the story. I'm not sure it means that Disney's management somehow claimed a great victory in terms of intellectual stewardship of the company so much as it might imply that analysts just weren't sure where the company was going to land. In any case, what's more important is where we go from here in terms of strategy. Disney could beat or miss the next several quarters, and I personally wouldn't care too much since I want to know more about the ultimate strategy going forward. That, of course, means I am placing emphasis on streaming and the completion of the Twenty-First Century Fox (FOX) (FOXA) purchase.

Before we get to that, let me go through a few more numbers. I always like to check up on the statement of cash flows, as Disney has a reputation for generating robust cash from its theme parks and IP-synergies. Well, operational cash declined 6% to a little over $2 billion. Free cash flow was down 28% to roughly $900 million (that's correct, under a billion!).

As for the individual segments themselves, I'll start with theme parks and consumer products (remember, consumer products is now in this part of the conglomerate). This division increased revenue by 5% to $6.8 billion. Income jumped 10% to $2.1 billion. You can usually count on such performance from parks, considering all the news about large crowds and price increases needed to control the crowds (i.e., ensure that Disney doesn't get too many people lest it can't adequately distribute enough premium-quality customer service among its guests).

Media networks did well in Q1. It increased both sales and profits by 7% each, to $5.9 billion and $1.3 billion, respectively. This is always good to see because everyone is aware of the challenges facing the traditional broadcasting industry in general and of the specific issues regarding ESPN. However, profit at the segment devoted to cable networks (which includes ESPN) dipped 6%, so even though media networks as a whole did fine business, investors should nevertheless be aware of this deeper metric. It was stated that higher programming costs impacted ESPN. Management also said that contractual increases for carriage fees, as well as a better advertising environment for the sports network, helped to balance out the negative pull of content expenses. The cable channel Freeform was also highlighted as a drag for cable. Here, lower ratings led to lower advertising success, and if I'm correctly reading between the lines, the company seemed to have ramped down production/development activities in response. Lower ancillary sales from Freeform's content portfolio also exerted an effect. Going back to ESPN, it's interesting to note how important subscribers are to the channel because advertising alone cannot be counted on to generate a good ROI on those high sports costs. The quarterly report said that a loss of subscribers acted in part as an offset to the increase in affiliate revenues, which is a big reason why Disney is going over-the-top with its content in a big way this year.

The studio segment fell off a cliff in Q1. Revenues declined 27% to $1.8 billion while profit sank 63% to just under $310 million. The reason is simple: tough comparisons with the film slates from this year and last year. Remember that Disney bombed with its holiday release The Nutcracker and the Four Realms. Also, there was no Star Wars picture in December. Also remember, too, that even though one expects variability in performance for the studio segment from quarter to quarter, there is a beacon of hope coming in the form of the Twenty-First Century Fox integration. That $70+ billion transaction should allow the company to smooth out studio performance (if that doesn't happen, then one would be justified to question the true value of the deal). Studio still continues to be an important part of Disney's overall strategy. The content it produces will help to promote the adoption of the streaming service.

Speaking of streaming (again), the company reported losses related to investments in Hulu, ESPN+, and Disney+. Not an unexpected line item, as shareholders have been conditioned to allow for content spending and technological upgrades as the tickets needed to produce a viable direct-to-consumer offering for the marketplace at large. When you've got to contend with Netflix (NFLX), you've got to be ready to make some serious capital-investment deposits.

I'd also like to touch on something from the earnings call concerning the company's investment in video games. As most readers probably know, Disney essentially failed to ever properly leverage this particular technological trend. It's a shame because gaming is an important industry in the popular culture, and it is one with which Disney should have found it easy to cross-promote its brand equity. The company now acts as a licensor instead of an investor, which was always the prudent way to approach this industry, but when CEO Bob Iger was acquiring development studios, I had hopes that, even though I disagreed with the investment, the company would surprise me and make a go of it. Let me pull a long quote from the transcript in response to a question from analyst Todd Juenger (this is Iger speaking):

And on the video game business, we're obviously mindful of the size of that business. But over the years, as you know, we've tried our hand in self-publishing. We've bought companies. We've sold companies. We've bought developers. We've closed developers.

And we found over the years that we haven't been particularly good at the self-publishing side, but we've been great at the licensing side, which obviously doesn't require that much allocation of capital. And since we're allocating capital in other directions, even though we certainly have the ability to allocate more capital, we've just decided that the best place for us to be in that space is licensing and not publishing.

And we've had good relationships with some of those we're licensing to, notably EA and the relationship on the Star Wars properties. And we're probably going to continue - we're going to continue to stay in that side of the business and put our capital elsewhere."

Fair enough. Of course, it's always puzzled me why the company didn't simply make platform games of minimal complexity that reflected the 2D sensibilities of the 16-bit era (I assume that wouldn't have been expensive to do) as a way of self-publishing games based on its IP, but it was nevertheless important for Iger to cut his losses (e.g., Infinity toy-to-life) and move on to better capital opportunities, as he put it. I point this interesting exchange out to highlight for shareholders that there is always a risk to whatever Disney invests in, even under Iger. Had video games worked, the consumer products/interactive division would have been a great driver of value. Now, though, licensing strategies will be Disney's preferred method of investment (too bad the company didn't save its money years ago by avoiding acquisition activity in this area).

Streaming will be risky, but I think it is a risk that comes with the opportunity for high reward.

Streaming Services

Disney's direct-to-consumer business will be comprised of ESPN+, Disney+, and Hulu. I'm sure there may be other offerings in the future and certainly, there will be different tiers within each offering, even different from what is available today.

My big hope with streaming is that Bob Iger won't be boring about it. Experimentation should be constant to keep a competitive edge. In particular, I would love to see a test of day-and-date strategies or perhaps more palatable to the multiplex industry, near day-and-date, which would be releasing a movie not long after to streaming after it debuts in theaters. Iger is on record as saying he will not mess with three-month theatrical windows. I honestly have no idea how staunch he is about that, but as time goes on, it's getting harder to believe that some media conglomerate out there won't break the window. I am speaking, to be clear, about tentpole movies, not smaller, independent features that already have day-and-date release patterns (i.e., in theaters and on-demand simultaneously).

The opportunity here would be for Disney (or any streaming product, really, that is attached to a large media concern) to promote its service, gather long-term subscribers and exploit what could be essentially another form of pay-per-view, one at a higher price point. Consider that renting a film on some pay-per-view systems currently costs $5.99. I've read different estimates on what Disney+ will cost initially, but Iger has said the service will cost less than Netflix and that it will have a smaller volume in terms of content. Some have interpreted that to mean it will be between $5 and $7. Remember, though, we're talking initial pricing; as time goes on, one assumes the pricing will trend toward $10. Given that, let's say a new Marvel movie is out in theaters during the summer, and it grosses close to a billion dollars worldwide after the fourth weekend. It is then ported over to the service. Let us further imagine that some consumers sign up for the service purely to watch the movie and nothing else. In that case, it still is of value because Disney could end up getting more from a consumer than it would have under a typical $5.99 pay-per-view transaction... plus, it gets it directly from the consumer, no middle actor. The issue of the free trial, of course, comes up; what I would do to counteract that is not to allow access to the Marvel project under the trial period. The point of this thought experiment is that Disney can use its content to power the streaming service by figuring out a new window structure for distribution. There was a great essay on this subject back in 2017 at The Hollywood Reporter.

Beyond that, shareholders must consider that streaming will transform the company. I believe it is overall positive. Disney has the content which allows it to be competitive with Netflix, and it has the cash. Granted, Disney felt it needed a lot more content/scale, thus the recent transaction with Rupert Murdoch. That was a lot of value transferred from the Mouse to the Fox, and it served as an illustration of Netflix's long head start. It's interesting if you really ponder it: every pundit gushed over Bob Iger's acquisition spree and christened Disney as the King of Content... yet, as time goes on, there always seems to be a need for more IP scale, doesn't it? What will the next acquisition be and will it be big or small? My thinking is at some point Disney tries to buy Sony's (SNE) filmed-entertainment assets (Spider-Man, of course), probably once the next CEO arrives. I bring all this up because you'll note on the earnings report there was no stock-repurchase activity in the statement of cash flows. This was completely expected, and because Disney will probably be doing significant capital investment/acquisitions in the near future, in my opinion, I am bracing myself for lower buybacks and smaller dividend growth. The math just lines up that way.

Valuation/Conclusion

How does one value a company that is on the precipice of change? Well, we can at least note the main metric of P/E. The stock has a forward-P/E of 15.7 at the time of this writing. Also, the dividend yield is roughly 1.6%. The S&P 500 P/E is around 20.7 at the moment. The stock price is about $111 per share or near the middle of the 52-week range. Overall, I wouldn't say Disney is deep-value, but it's also not expensive given its future shareholder-value-growth potential.

Disney is biding its time until it puts its streaming strategy in motion. It's almost here. That, and the Twenty-First Century Fox purchase, should act as catalysts for the stock. Obviously, there is a risk of execution failure. I see no reason at the moment to doubt management's plans. I continue to hold the stock and consider it a long-term investment. Perform your own research to compare your conclusion with mine.

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.