Disney: A Trilogy Of Problems

Summary

• Disney's stock is trading at the high end of the spectrum which most investors see as justified given the strong subscriber growth on its DTC platforms.
• However, going forward Disney stock is at risk of deteriorating operating profitability due to a number of risk factors occurring at the same time.
• The extremely high box office market share is also at risk which could be yet another hit on Disney's profitability and free cash flow.
• Although Disney's acquisitions over the past decade have been mostly successful, M&A addiction might just make the matters worse.

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Source: variety.com

Disney trading at the very high end of the spectrum

On a historical basis Disney (NYSE:DIS) is expensive, which of course might seem justified to many as the company has reinvigorated its growth profile mostly through acquisitions.

Source: author's calculations based on data from Walt Disney's annual reports and data from Yahoo!Finance

On a free cash flow basis Disney now trades at a 5.0% FCF yield after adjusting for gains on acquisitions and dispositions and the abnormal tax expense associated with TFCF acquisition.

Source: author's calculations based on data from Walt Disney's annual reports and data from Yahoo!Finance

Since 2006, FCF yield has been lower only in 2014/15 period. Not surprisingly that period was followed by an 8% decrease in Disney stock during 2016.

Assuming Disney stock stays flat during the course of 2020, the FCF yield would likely compress further as:

• Capital Expenditure is expected to increase

We expect consolidated CapEx in fiscal 2020 to be $500 million higher than in the prior-year. The increase in CapEx is primarily due to increases at DTCI and Corporate.

• Operating Losses associated with DTC will increase as the segment expands
• Production costs of studio entertainment would likely increase and Disney might also struggle to sustain its all time high box office market share after the very successful 2019, but more on that below.

Relative to peers Disney is also expensive. The company trades at a very high P/B multiple when compared to its peers if we also account for the operating profitability.

Source: author's calculations based on data from Annual Reports and data from Yahoo!Finance

On top of the high price tag that the Disney stock trades at, the company is also facing three significant challenges that investors should be aware of.

Problem 1 - declining operating profitability

It matters for stock price

As we all know, there's usually a strong relationship between return on equity and P/B ratios and Disney is no exception.

Source: author's calculations based on data from Walt Disney's annual reports and data from Yahoo!Finance

In Disney's case asset turnover and leverage ratios have been relatively stable over time and more importantly are not seen as major drivers in profitability for a large media company. That's why operating margin is by far the most important component of return on equity for P/B ratio that Disney trades at.

Source: author's calculations based on data from Walt Disney's annual reports and data from Yahoo!Finance

From the data above, 2019 was at odds with all other years under review. Therefore, going forward we should either see Disney's operating profitability improve thus closing the gap with the trend line or P/B multiple should contract.

This is important going forward for Disney as most people seem to be concerned only with customer growth on Disney's DTC platforms and don't really care about the company's profitability. A dangerous approach in my opinion.

Higher production costs

Disney is heading towards a period of transformation and with that the company's profitability is also likely to be transformed or to witness a period of transition.

For starters, the company will put a lot of effort and funds towards creating a number of TV series exclusive for its DTC platforms. As the CEO said on the last conference call:

Star Wars has three television series, there are in varying forms of production and more in development for Disney+ and Marvel has many more so, while in the Star Wars case, Star Wars 9 which comes out this December will be the last of the Skywalker Saga, and we'll go into a hiatus for a few years before the next Star Wars feature there'll be a lot of creative activity in the interim.

,and also

Additionally, FX will produce original series exclusively for FX on Hulu, starting with four new series in 2020; Devs from Alex Garland, Mrs. America starring Cate Blanchett, A Teacher starring Kate Mara, and The Old Man starring Jeff Bridges and John Lithgow. This is a great way to expand the FX brand and an important step for Hulu as it adds original content to compete more aggressively with new and legacy DTC platforms.

A lot of intellectual property that has been leveraged through the theatrical segment in recent years will now be adapted for TV series, which in turn will be used to attract subscribers for Disney's loss making DTC platforms.

We are already seeing this with Disney's latest series - the Mandalorian. The series have a hefty estimated price tag of around $15 million per episode and there are estimates that the upcoming Marvel based series would cost even more per episode. With intensified competition from deep pocket peers such Apple and Amazon and the high stakes to build customer base for its DTC platforms, Disney must make sure that all these upcoming series are a top notch and this of course would come at the expense of operating profitability.

Disney will also need to convince its shareholders that such an investment will be worth and that it is taking the right approach to its DTC platforms, all three of which are expected to reach profitability around 4 years from now. That's a very long period given the pressure already exerted on operating profitability.

Source: Disney’s Investor Day 2019 presentation

On top of that, operating profitability of the recently acquired Fox assets have historically been lower than the comparable Disney's segments.

Source: author's calculations based on data from Fox and Walt Disney annual reports

In a nutshell, Disney faces a number of risks for its operating profitability - intensified competition, higher production costs, necessity to invest in loss making future platforms and on top of that the need of successful integration of Fox's assets. As operating margin has historically been the key driver of Disney's high premium to book value, the management needs to not only execute flawlessly on its strategy but it also needs to convince existing shareholders that giving up profitability for subscribers growth is going to be worthwhile.

Problem 2 - box office market share also at risk

Even before the acquisition of Fox assets, Disney reached the highest market share in the Domestic Box Office since the 1990s.

Source: prospect.org

The reason why this is so important is that the intellectual property promoted through the studio entertainment segment is then also monetized through the theme parks, merchandise and media networks. That's why box office market share is crucial.

During last couple of years this high market share was generated almost entirely due to IP squeezed from recent acquisitions of Marvel and Lucasfilm, which although being largely successful for now poses a risk for the years ahead as customers likely start to experience fatigue.

Source: The Numbers - Movie Market Summary for Year 2019

Disney's high box office market share seems to be largely dependent on remakes and sequels. Out of the 10 highest grossing movies for 2019 so far, the ones made by Disney were:

• The Lion King - a remake of one of Disney's most popular animations of all time
• Toy Story 4 - yes, that's fourth movie
• Aladdin - another remake of a best selling animation
• Frozen 2 - we are still at second sequel
• and the rest of the movies being from the Marvel Universe

I guess one could argue here that there is nothing wrong with squeezing old IP as long as you do it successfully. I do agree that so far Disney has done a great job on that front.

However, it is important to keep in mind that creativity in the Media space is crucial, and squeezing an old IP with sequels, prequels etc. has its limits and sooner or later audiences get tired of seeing the same characters over and over again.

The situation in 2018 was not very different from that in 2019:

Source: the-numbers.com

Putting all this together and it should come as no surprise that Disney's box office market share is a key driver of the company's total revenue generated with R-squared of 0.84.

Source: author's calculations based on data from Walt Disney's annual reports and data from prospect.org

And of course a key driver of Free Cash Flow.

Source: author's calculations based on data from Walt Disney's annual reports and data from prospect.org

To sum up, as the already very high box office market share is priced in DIS stock, any deterioration in the former cause a divergence between Disney's fundamentals and the stock price. To make matters worse, we should also factor in the expected decline in operating profitability and the higher expected capital expenditure in FY2020.

Problem 3 - growth through acquisitions is risky

Expansion through acquisitions poses a much higher risk than one based on organic sales growth , especially in a highly intangible and creative business such as media entertainment where business value is mostly created through artistic IP and brands.

Source: wsj.com

Although the acquisition of Marvel Studios and perhaps that of Lucasfilm could be deemed to have been a huge success for Disney, the price paid for Fox assets will be harder to justify. Disney paid a hefty price after a bidding war with Comcast for assets that have been evaluated solely through the prism of a future DTC model:

As I've said, our acquisition of 21st Century Fox was largely driven by the value it brought to our overall DTC strategy, adding a number of critical elements including control of Hulu, which opens numerous growth opportunities domestically and internationally.

The main rationale for the acquisition was very different from that applied for the previous two large deals. Also the disruption within the sector and the entrance of deep pocket competitors like Amazon and Apple in combination with all time low interest rates and borrowing costs has probably justified the acquisition at any price.

Conclusion - putting it all together

The narrative for investing in Disney is changing rapidly. From a highly profitable and cash flow generating company, Disney is becoming a more growth oriented enterprise where increase in subscriber numbers is more important than margins. Although the company has already reinvigorated its growth potential without sacrificing profitability through the successful acquisitions such as Pixar, Marvel and Lucasfilm, the last deal for Fox's assets was made for a very different reason - amassing content for DTC platforms.

In doing so Disney has been very busy in convincing investors that any amount spent on developing its DTC platforms is worth, even if that meant paying $71bn for Fox's assets. The PR around the DTC platforms is huge with headlines such as "Disney+ averaging almost a million new subscribers a day" making the headlines.

Even though it might be the future of Media, competition in the DTC segment is likely to be fierce with Disney competing not only against its traditional peers now part of AT&T and Comcast or merged together (CBS and Viacom), but also with new deep pocked entrants such as Amazon and Apple.

In that process of all that hype around Disney+, Hulu and ESPN+, the Disney stock has become one of the most popular among retail investors on Robinhood. At the same time fund managers such as Seth Klarman, Joel Greenblatt, Michael Burry and George Soros have all recently either sold off or significantly reduced their DIS holdings.

Last but not least, all the hype around the DTC platforms is taking away the attention from issues such as margins deterioration and box office market share being at risk. Both of which metrics have historically been the main drivers of Disney's high valuation.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within 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.