Disney: And Yet Severely Undervalued
Summary
- COVID-19 damages are estimated to be as much as $1.4 billion, and the pain will likely last over Q3 as well.
- Q2 damage is real, but the growth of the business should not be underestimated. Moreover, parks are starting to reopen, and sports events will eventually resume.
- Disney is still generating high levels of cash, and its balance sheet is well-positioned despite the pandemic losses. Even if the pandemic lasts longer, costs will decrease.
- Digital growth has significantly accelerated during the pandemic, and at current prices (under $100), Disney stock is very cheap.
Introduction
Second-quarter earnings are painting the picture of a new Disney (NYSE:DIS), based primarily on digital content. COVID-19 damages are estimated to be as much as $1.4 billion, and the pain will likely last over Q3 results as well. In response to this business environment, the stock price crumbled and the company lost over a third of its value (-35%). Despite harsh business conditions, I believe Disney remains undervalued as the market fails to take into account the benefits of the business transformation.
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The Q2 Damage
COVID-19 affected Disney since late January in Asia, and since March in Europe and America, when theme parks and retail stores were forced to shut down. COVID-19 infected what is the main business of the company - "Parks, Experiences and Products" - that at YE19 constituted 37% of total revenue:
(Figure 1 - Source: Author calculations from Disney Q2 FY2020 earnings data)
For the Parks, Experiences and Products segment, the revenue cut due to closures was approximately $1.0 billion, with a 58% decrease in operating income for the segment. However, the segment revenue decreased by only 10%, while costs continued to increase (+5%).
Repairing In the Works - Costs Reduction
“Costs for the quarter were higher compared to the prior-year quarter due to an increase at our domestic parks and experiences driven by expenses for new guest offerings, which included Star Wars: Galaxy’s Edge, the net cost of pay to employees who were not performing services as a result of actions taken in response to COVID-19, and inflation.”
Source: Disney Q2 FY2020 earnings data
As business was shut down abruptly, expenses for the new guest offerings were not offset by the expected ROI revenue. As parks stay closed for longer periods, these kinds of expenses will keep decreasing until the reopening approaches.
Moreover, the company committed to paying its cast members until April 18th. After that date, stopping payments for 100,000 workers is saving Disney around $500 million a month.
Lastly, CFO announced that Disney will forgo H1 dividend payment, saving the company around $1.6 billion in cash. Certainly a move that won’t make dividend investors happy, but a predictable and understandable choice from a risk management point of view.
An element of concern is the change in accounting guidance that seems to partly shift expenses from H1 to H2. This change should heavily impact the company's balance sheet later in the year, should the business conditions remain poor.
How deep is the wound?
It is obvious that the company has incurred significant problems, but its long-term health is secured. Despite a 30% decrease, free cash flow remained positive at $1.9 billion. Liquidity is also higher at $14 billion, up $6.8 billion since the beginning of the period. This was possible due to the $6 billion debt offering issued by Disney with notes maturing between 2025 and 2050 at a 3.5-4.7% interest rate. Excluding financing activities, over the period cash and cash equivalents increased by $2 billion (29%), showing that the company is not bleeding cash despite the harsh environment.
Strength During Crisis - Revenue up 21%
The real positive of Q2 numbers is a revenue increase of 21% despite parks closures. This highlights that the business transformation of the company is succeeding. Media Networks segment revenue was up 27% over the prior-year quarter, and the Direct to Customer (e.g., Disney+, ESPN) segment increased revenue of almost $3 billion (260%) (Figure 2). Disney+ only launched in Europe on March 23rd, and since the lockdown days are not currently over, we should see significant growth in Q3 as well (Figure 3).
(Figure 2 - Source: Author calculations from Disney Q2 FY2020 earnings data)
The company has announced to have surpassed 50 million Disney+ subscribers. At current margins, this would translate into a 49% increase from Q2, more than 800 million in revenue for Disney+ in Q3 alone, and around $3.4 billion in yearly revenue.
(Figure 3 - Source: Author calculations from Disney Q2 FY2020 earnings data)
The Aftermath - Parks will reopen, Guests will spend
The reopening timeline for most parks is still yet to be decided, but realistically, all parks will at least partly reopen by the end of Q3. Disney's Shanghai is set to reopen May 11th with precautions, at 30% capacity. If the same timeline were to be experienced globally, we should see all parks partly reopened by August. These cautious limits will likely stay in place in all parks until 2021, significantly eating into the company’s profit.
Despite the capacity restraints, the customers more eager to come back to the parks should be the ones more willing to spend. The higher guest spending trend was already strong pre-pandemic, and it should intensify as people regain their freedom. Before the park closures, guest spending was higher compared to the prior-year quarter, and at YE19, YoY revenue growth was at 19%, driven by Hulu consolidation and higher guest spending at parks.
Risks and Challenges
Although parks are reopening, Disney is still particularly exposed to COVID-19. Particularly concerning to the company’s business is a possible second wave of COVID-19 infection. Hints come from China, where areas that re-opened too soon were later forced to re-establish restrictions after observing rising new infections. Intermitting opening and closing parks would incur in significantly higher costs than one long closure until the end of the pandemic. Should new lockdowns measures be required, Disney’s Parks, Experiences and Product segment will experience even more severe losses. Moreover, it is also possible that recurring death waves could push consumers to avoid crowded places despite eased restrictions, creating a situation of full operational costs with little revenue.
A positive hint on this risk can be obtained from China. According to McKinsey’s latest survey, Chinese consumers are gradually regaining their confidence, suggesting the majority will resume higher levels of spending over the coming months. If the same trends were to be seen around the world, Disney parks should see a gradually growing influx of people as they reopen.
On the digital side of the business, easing lockdown measures will result in customer retention challenges. Therefore, the challenge will shift on the competition on content, and although Disney seems to be well-positioned, production delays could lead to increased levels of paused memberships.
Appropriate Valuation
Disney should be priced accordingly, i.e., considering its business transformation as a digital company. Despite the pandemic losses, the company maintained free cash flow at almost $2 billion. For comparison, Netflix (NFLX) is forecasting a 2020 free cash flow deficit of approximately $1 billion.
Production shutdowns due to the coronavirus pandemic helped Netflix save approximately $1.5 billion in costs. In the event the pandemic lasts longer, decreasing costs will materialise for Disney as well.
Disney achieved a 50 million subscriber milestone that took Netflix years to achieve. Considered the different consumer target for the two companies, first-mover advantage does not apply, and Netflix seems to have paved the road for Disney to enter the market. The pandemic and relative lockdown have also saved both companies millions in customer acquisition costs.
Disney P/E stands at 17, while Netflix's is 91, or 5.35 times Disney’s. Price-to-Sales shows the same differences, with Disney at 2.49 and Netflix at 8.59, or 3.5 times Disney’s. With similar growth trajectories and similar revenue, one company maintains a $2 billion free cash flow, while the other posts a $1 billion deficit.
Since the start of the pandemic (mid-February), Disney stock price lost 35%. On the other hand, Netflix rose 10%. Disney's main business is battered, but still profitable. Its digital business growth seems to be ignored, now that the company trades at even lower prices than before the Fox acquisition and the Disney+ launch. At current prices of 99$ per share, I consider Disney a clear bargain.
(Figure 4 - Source: Yahoo Finance)
Conclusion
Q2 damage is real, but the growth of the business should not be underestimated. Parks are starting to reopen, and sports events will eventually resume. The company is still generating high levels of cash, and its balance sheet is well-positioned despite the pandemic losses. Even if the pandemic lasts longer, the suspension of content (both parks and streaming) production costs will stabilize losses. Digital growth has significantly accelerated during the pandemic, and at current prices (under $100) at a 35% discount, Disney stock is rated a Buy.
This article was written by
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.
I am not a financial advisor. All articles are my opinion - they are not suggestions to buy or sell any securities. Perform your own due diligence and consult a financial professional before investing or trading.
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