Despite increasing earnings this year and opening a park in Shanghai, Walt Disney Co (NYSE:DIS) stock is down 12% year-to-date, mainly due to problems at ESPN, which accounts for a large portion of Disney’s profits.
This year, Disney is the second worst-performing member of the Dow Jones Industrial Average year-to-date, ahead of only Nike Inc (NKE). What shall we conclude? Is Disney headed for long-term decline, or is the market overreacting and Disney stock is now undervalued?
Or, is this a buying opportunity?
Disney Stock: Pros
Strong Brand: Being a household name, Disney is one of the world’s strongest brands. Earlier this year, Disney toppled Lego as the world’s most powerful brand in a survey by Brand Finance. The Global Reptrak 100 2016 ranked Disney behind only Rolex. Another survey named Disney the world’s most authentic brand. A strong brand brings with it many advantages, including higher margins and customer loyalty. And Disney shows no signs of resting on its laurels, buying Pixar in 2006, Marvel in 2009 and Lucasfilm, the maker of Star Wars, in 2012.
DIS Trades at a Discount: Disney stock now trades at 16 times earnings, cheaper than the market. On Oct. 14, the Dow Jones Industrial Average traded at 20.03 times earnings and the S&P 500 Index changed hands at 24.33 times earnings. Given Disney’s world-class brand, does this valuation make sense? Trouble at ESPN pushed down Disney stock, and investors might have overreacted. Morningstar analysts assigned a fair value of $134 to Disney stock earlier this year. Disney has grown its operating margins from 15.92% in 2006 to 25.21% last year. This shows either rising pricing power or operational efficiency. Disney has also grown dividends at a 29% CAGR since 2010. And Disney won’t have debt problems with a debt-to-equity ratio of 0.3.
Movie Sales Rise During Recessions: It has been seven years since the recession ended in the United States, and this year the IMF reduced global growth forecasts because of the Brexit vote. Downside risks, such as terrorism, the election and debt, remain, and could sink the country back into recession. The movie business is not as vulnerable to recessions as one might think. During hard times, people naturally crave distraction, and box office revenue rose in six of the past seven recessions. If the economy slides back into a recession, Disney’s studio entertainment division will keep it afloat.
Disney Stock Cons:
Higher Sports Rights Costs at ESPN: In September, Drexel Hamilton analyst Tony Wible downgraded Disney stock because of rising NBA sports rights costs. Sports rights costs have been rising because of new entrants into sports broadcasting: NBC Sports Network went on the air in 2012, followed by Fox Sports 1 in 2013.
And this may continue, as a Turnkey Sports poll of 2,000 sports industry senior executives found that 54% expect sports media rights to continue rising for the next five years, since Big Tech operators like Alphabet Inc (NASDAQ:GOOG, NASDAQ:GOOGL), Facebook Inc (NASDAQ:FB), Yahoo! Inc (NASDAQ:YHOO) and Twitter show interest in streaming live sports.
ESPN spent $800 million more on its NFL deal in 2014, and $825 million more on the NBA deal this year. Now ESPN will pay the NFL $1.9 billion a year and the NBA $1.4 billion a year. To make up for this, ESPN got cable companies to increase the fee to $6 per subscriber. In return, cable companies could lower ESPN’s penetration from 90% to 80% of households. Now they can offer low-cost cable packages excluding ESPN. This led to ESPN’s second problem, cord-shaving.
Disruption of the Cable Industry: Competitive pressures will force cable networks such as ESPN to rethink their business models. Cable networks accounted for 46% of Disney’s operating profit in 2015, so concerns about ESPN should not be taken lightly. Since 2011, ESPN has lost over 11 million subscribers, bringing the total down from above 100 million down to 88 million subscribers by August 2016. Some viewers choose skinnier bundles that exclude channels such as ESPN (cord-shaving).
Others cancel their cable subscriptions (cord-cutting) and instead use video streaming, from websites such as Hulu and Netflix, or over-the-top internet television — such as Sling TV from Dish Network Corp (NASDAQ:DISH) or PlayStation Vue from Sony Corp (ADR) (NYSE:SNE). And some new households choose not to subscribe to cable or satellite TV (cord-nevers).
Another risk is that sports leagues cut out ESPN, instead offering their own streaming services directly to viewers. MLB introduced a streaming app under its MLB Advanced Media division. BAM inked a deal last year with the NHL to stream NHL hockey games. Wisely, Disney invested $1 billion in BAMtech, the streaming unit of MLB Advanced Media.
Competition in China: The $5.5 billion Shanghai Disney opened in June this year. Disney’s local partner, the Shanghai Shendi Group, projects 10 million to 12 million visitors will visit the park in the first year. China’s richest man, Wang Jianlin of the Dalian Wanda Group, plans to build 15 Wanda City parks across China to compete with Disney.
Wang said that “one tiger is no match for a pack of wolves,” referencing Disney Shanghai and the parks he has planned. In August, however, Wanda’s Wuhan theme park closed for “renovations,” but reports alleged that the park was only getting a few hundred visitors a day. Wanda isn’t Disney’s only competitor in China: a total of 59 theme parks are scheduled to open by 2020. The Wanda Group also invested $3.3 billion in EuropaCity, a complex near Paris that will compete with Disneyland Paris.
Bottom Line on Disney Stock
Don’t count the House of Mouse out just yet. Disney seems to be adapting to a changing environment. Cable networks like ESPN are going through a transition to OTT and streaming, and Disney is building up its digital capabilities.
Television viewers value live sports, news, and prime-time shows, which Disney provides via ESPN and ABC. Streaming faces problems as well, such as data caps. As for China, the tourism industry is worth $610 billion and growing fast, so there will be room for many entrants.
Buy Disney stock while the market undervalues it.
As of writing, Lucas Hahn did not have a position in any of the aforementioned securities.