Disney (NYSE:DIS) reported a quiet Q2 earlier in the month. There wasn't much action from the Twenty-First Century side of the company as that acquisition just recently closed and contributed just about nothing to the Mouse (we're talking $25 million in profit all-in). There wasn't any Avengers action, because the quarter closed on March 30.
Basically, the company issued a promissory note: it's going to be in a much more meaningful position about a year from now when we start to see subscriber trends in the new Disney+ direct-to-consumer product. That's the main thing on the minds of those on Wall Street.
Main Street investors, however, might want to think about Twenty-First's movie studios and assorted content on television, because there is excitement to be had from that portfolio as it concerns value generation. One can only assume CEO Robert Iger intends on making the most of the last big purchase of his executive tenure's shopping spree, specifically so he can cash out at the end a very happy (i.e., wealthy) individual.
Revenues increased 3% to $14.9 billion for the second quarter and increased 1% for the six-month frame to $30.2 billion. Adjusted net income for the quarter was $1.61 per share, a 13% decrease. For the last six months, net income was $3.45 per share, a decline of 8%.
Get ready for more drops. Operational cash flow backed down 13% to $3.9 billion and free cash flow, the big measure we all like to look at, retreated over 20% to $2.7 billion in Q2. Over the first two quarters of the new fiscal year, operational cash flow was down 11% to $6 billion and free cash flow was worse by 23%, recorded as $3.6 billion.
Aside from the parks, segment operating income also suffered. While parks (which also includes consumer products) increased profit 15% to $1.5 billion (for Q2) and issued a 12% increase to $3.7 billion for the six months, the movie studio decreased 39% to $534 million and 50% to $843 million for the three-month and six-month periods, respectively. Media networks profit decreased 3% to almost $2.2 billion in Q2 and was flat at $3.5 billion for the six months. The latter comprises ABC and the various cable investments, including ESPN. The direct-to-consumer segment saw widening losses, which is a completely expected piece of information that matters little at this time. Revenues in that segment, however, were up 15% and 6% for the three-month and six-month respective time frames.
I tend to think of the studio portion of Disney first when contemplating the overall business model of the company. That tends to be the part of the company that gets my attention (and perhaps most of the company's consumer base) considering how it has made multi-multibillion-dollar acquisitions to build up that segment. Obviously, this quarter saw a disappointing performance from the division. That disappointment was sourced to difficult comparisons based on product that was out last year at this time... a Star Wars picture and Marvel's Black Panther.
While most pundits would probably leave it at that, I have a comment to make regarding difficult comparisons: management now has little excuse to continue on with a variable-earnings scenario for the studio. I'm not so naïve as to believe that there will never be difficult comps ever again (and as many tend to point out, it's a cool problem to have), but management at the very least should program that mindset into their heads. Bob Iger would be wise to at least send a memorandum to the troops over at the studios and instruct them to, whenever feasible, avoid gaps in the release schedule. The goal should be to at least have flat revenues/earnings each quarter from the movie division now that Fox's slate is onboard. I'm on record as saying that I believe the company will eventually have one potential blockbuster released each month, maybe more, and that this should form part of a qualitative thesis on the stock. Besides IP that Fox already has in its portfolio, that part of the company will presumably begin to experiment with the creation of new franchises. Another concern to consider is that, as mentioned in the earnings release, the upcoming streaming plans are shifting the sales model in ancillary channels for the studio, so there was an offset in terms of free television sales experiencing a decline. We'll see more of that, as many articles seem to indicate (i.e., the whole cannibalization argument in which Disney focuses on exclusivity to drive subscription signups for its streaming services).
Media networks is also probably not immune from cannibalization, particularly on the broadcast side. The release indicated a 2% decline in broadcasting revenues, which were recorded at $1.8 billion. Operating income plunged just under 30% to just under $250 million. A few problems plagued broadcasting, which is driven by ABC: expensive programming costs, challenges in moving advertising inventory, and a lower activity level of rights sales for programming in which the company has an interest. Thankfully, the dual revenue stream of advertising and carriage fees is employed here, and the latter helped to provide some comfort. The cable-network side of the media segment had a decent quarter, with increases of 2% in both revenues and operating profit at $3.7 billion and $1.8 billion, respectively. Management stated that ESPN could be thanked for this performance, and that's good news, as shareholders are counting on further strength from the cable brand in the coming months after the company launches its streaming blitz full-on. I still wish Disney had considered getting out of sports broadcasting, or maybe even sold off some of its ownership in the network (I'd rather Disney own 20% and Hearst 80% instead of the other way around!), but it is what it is, and I'm simply behind the structure at this point and do trust that management will see strength from ESPN in the next several years.
One note I'll make about media networks is that I hope Disney will examine all its cable assets in light of the Fox-IP acquisition. In particular, I'm thinking of Freeform. That's always been an odd channel with an interesting history. It previously was owned by Fox and Saban Entertainment (who gave us the Power Rangers) under the name Fox Family, and previous to that it was an outlet for religious content (it still had to give up some time for that pursuant to details of the transfer of ownership). Fox Family eventually became ABC Family, then recently it was rechristened as Freeform in an effort to totally change its brand entity (although some real estate on the channel remains devoted to the previous owners before Fox). Former Disney chief Michael Eisner praised the buy way back when, but it seemed clear to analysts that the company overpaid for the asset. The reasoning for the purchase, that of repurposing programming on ABC and other Disney platforms to amortize costs, has pretty much become obsolete in an era where each channel must use original series to differentiate itself. Considering, too, that the channel really can't be utilized to its fullest because of paid-advertising slots, I'd say this might be something Disney could sell for purposes of reducing debt. Anything else Disney could sell would be welcome, as Disney also needs to be a good seller as well as a good acquirer, in my opinion.
As mentioned, parks is doing well. The core of the Disney empire is probably stronger than ever before. Not only are there so many movie hits available from which the company can create rides, but there simply is a huge catalyst on the near horizon: the attractions based on Star Wars. Disneyland in California will open its Wars section at the end of this month, while the Florida resort is looking to the end of August for its own opening. Not only will ticket sales/attendance very (very) likely increase (I'm surprised, actually, Disney isn't charging a separate admission fee for the first month or so to Wars), but I have to presume this will help sell a lot of merchandise tied to the brand. Consumer products is now bundled with the parks segment, so it would make sense that Disney might be looking at the new attraction as a way of boosting Wars merchandise revenue, which has taken a bit of a hit at times over the last couple years.
Speaking of consumer products, Disney's forays into the video-game business have seen poor reception from the public over the years, to the point that the company dropped directly investing in the sector and is instead relying on a licensing model to expose itself to such economic activity. Makes sense, as the returns on capital invested here objectively did not justify the deployment. In fact, the release mentions that consumer products benefited from a rights-sale to an owned video-game (wish the company mentioned which one it was) and the big success of Kingdom Hearts III, which has earned a good amount of royalties. Recently, Disney has been placing games on different platforms via licensing. Steam and Gog are now selling Hercules and Maui Mallard in Cold Shadow, two games that were out on earlier-generation consoles in the later 1990s. AtGames, the seller of dedicated units that come pre-loaded with software from Atari and other classic systems, signed a licensing deal to bring back Disney games such as Tron and titles based on Wars from Lucasfilm. According to the 10-Q, revenue for consumer products in Q2 was basically flat at a little over $1 billion, but profit rose 17% to $416 million. The Disney Stores part of the company was stated to have experienced a decline in comps, so that area could use some help (the addition of Fox IP should help the entire products section going forward).
The direct-to-consumer segment is what shareholders are anticipating the most; this is the true Disney story right now, for better or worse (I think it will be the former). It's running at a loss currently, which is to be expected as the company allocates money to the model to build it out and to get it ready for the launch of Disney+ in November. There are going to be three main components: D+, ESPN+, and Hulu. There is a fourth component as well, Hotstar, but whereas that is more of an international play (based in India), I believe most investors here will focus on what is more familiar (although please let it be known that Hotstar is a very strong asset, as mentioned by SA contributor Nicholas Ward; according to the company's recent investor presentation, the service has hundreds of millions of active users). D+, E+, and Hulu will require billions of investment dollars, and the company will have to watch its debt load, which currently stands at almost $38 billion. Interest expense increased 15% to just under $200 million (on a net basis, it was flat at a little over $140 million). Certainly very manageable, but over time, I anticipate it is possible the debt will increase if Disney finds it necessary to make more content and to continue acquiring businesses, even if that is only on a smaller scale. As it is now, Disney is not buying back stock (a smart move for the time being as it bets big on its future), and I would imagine dividend increases will be small for the next few years (perhaps even nonexistent, which might be the better move). I also wonder if Disney, which appears to be looking to reduce ancillary deal-making with its content as it seeks exclusivity for streaming, will aggressively license older product that might not give D+/Hulu much help gaining subscribers. Older Touchstone/Hollywood Pictures movies (e.g., Pretty Woman, Splash, Judge Dredd) presumably don't hold the same appeal to the 18-49 streaming crowd as does a Marvel picture starring Robert Downey, Jr. Utilizing parts of the company's library to raise funds is something I also imagined for AT&T (T) in a recent article. Streaming is always going to be most dependent on newer content that is of the time, so I am very interested in how media companies treat their library assets going forward. (Disney tried to monetize older vault product at one time on The Disney Channel and on its current Disney Family Movies subscription product, the latter of which may become irrelevant once D+ is launched.)
Given all this, it is interesting to note that Disney is buying back Comcast's (CMCSA) stake in Hulu in a somewhat complex agreement. The bottom line is that Disney will buy Comcast's ownership for a minimum $5.8 billion, which would be for a 21% stake (a drop from the current 33% ownership Comcast has now assuming the cable company chooses not to continue funding its share of capital-investment requirements) of a $27.5 billion valuation. Comcast will get more than the $5.8 billion if it continues to invest in Hulu and if the fair value goes higher (based on an independent assessment). Not a bad deal for Comcast, especially considering the company can at least hope for an increase in valuation over the next few years and get a bit more money. (I own shares of Comcast and, quite frankly, wouldn't have minded if the company held its stake for a longer term.) With this deal, Disney receives full decision power, so it is now free to steer the company as it sees fit. That aspect represents, certainly, a very useful outcome.
Disney had one bad thing to report considering its acquisitive nature: its Vice investment, which in an alternate universe might have turned into something Disney would have acquired outright, has been written down to basically no value at all. The once-promising multimedia news/video company has found it difficult to manage and monetize its multi-platform approach that at one time was thought to be a profoundly sound way of reaching millennials. Not a big deal, but it does remind us, as Bob Iger's tenure begins its wind-down, that not every acquisition on the smaller scale has worked out. Maker Studios, video-game development companies, Club Penguin were some missteps. The next CEO will inherit a company that may need to make more smaller investments as well as some larger ones. By then, the streaming services will hopefully be scaling higher and generating firm profits (by 2024, Disney projects the services will bear a surplus).
Fair warning, I'm about to repeat myself on the issue of valuation: it simply doesn't matter right now. Disney's stock will be evaluated later on when the subscriber counts start rolling in and we can make comparisons quarter-to-quarter. It will be like this for the next few earnings reports. However, let me say anyway that the stock currently has a P/E ratio based on forward non-GAAP estimates of 20.67. That is rated by SA as a C+ standing. Given the rise in the shares, and the (relatively speaking) lackluster dividend yield of 1.3%, one might say the shares are expensive.
I don't think they are. The other side of the valuation coin is that Disney is hopefully entering a new growth phase with its streaming model and the shares are beginning to break out into a new trading range. Let's look at the chart:
The right side of the above chart tells the tale: the stock got a bid after the company's investor presentation on its streaming plans. Some on Wall Street are obviously positioning themselves for what they believe to be a successful launch for the direct-to-consumer segment. The stock, I would imagine, will see quite a bit of support at these levels.
Disney is getting bigger and more ambitious, and with that comes risk. With every new acquisition, everything else has a more difficult time of catalyzing the stock. Even something like the Avengers, which should generate hundreds of millions of ultimate profit, can only have so much effect at this point. We have to look at the big drivers, and from this point out, those drivers will be linked to subscriber counts for the multiple streaming services the company is backing. I am bullish on the overall story at this time, and believe the stock continues to be a long-term bet.
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Disclosure: I am/we are long CMCSA, DIS, T. 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.