To complete its acquisition of the entertainment assets of Twenty-First Century Fox Inc (NASDAQ:FOXA), Walt Disney Co (NYSE:DIS) is assuming $13.7 billion in net debt in addition to issuing approximately 515 million shares in Walt Disney stock.
The pros and cons of doing this deal are obvious.
Disney becomes the preeminent producer of film and television content, something that’s necessary if it wants to go up against Netflix, Inc. (NASDAQ:NFLX) for streaming supremacy.
As InvestorPlace contributor Luke Lango wrote:
“DIS stock is building a war chest full of the best content in the world. Through acquiring Pixar in 2006, Marvel in 2009 and LucasArts in 2012, Disney has already amassed the most-watched content portfolio in the world. Adding 20th Century Fox films into the fold only further strengthens Disney’s content pipeline.”
Disney is planning to launch two streaming services in the next two years: First, ESPN Plus this spring, and then one for movies and TV shows in the second half of 2019.
Having killer content is critical to the success of both services, and the Fox deal is a no-brainer from that perspective.
Here, I see three possible problems for Walt Disney stock.
The first is dilution.
As mentioned earlier, the company will issue 515 million shares of Walt Disney stock to pay for the assets. To offset some of this dilution, it will repurchase $10 billion between today and the transaction’s closing in 12-18 months, and another $10 billion within 24 months of the deal’s closing.
Let’s assume Walt Disney stock appreciates by 20% a year over the next three years to $192 from $111 currently. Let’s also assume an average purchase price of $152 on the stock it buys back. That’s 131.6 million shares or 26% of the total number of shares issued to pay for Fox.
Disney currently has 1.5 billion shares outstanding. After the repurchases, it will have 1.9 billion shares outstanding. That’s a cash outlay of $20 billion while adding 27% more shares.
The second problem is the deal adds almost $14 billion in net debt, doubling this to $28.8 billion upon the closing of the transaction. That ups its net debt-to-assets ratio from 15.8% to 19.1%. It might not seem like a lot, but if you factor in the dilutive effect of the shares issuance, rising interest rates could make it a problem in the future.
The third issue is that the acquisition is anything but a done deal with regulators. Critics suggest that the immense amount of power held by Disney after buying the Fox assets could prompt the Justice Department to request a sale of one or more assets just like what’s happening with AT&T Inc. (NYSE:T) and Time Warner Inc (NYSE:TWX).
“Imagine the local market power Disney would command in a market such as New York,” BTIG Research analyst Richard Greenfield recently wrote. “Disney would control the ABC affiliate that has the NBA finals and the Oscars, the YES Network, and ESPN/ESPN2, etc.”
Now’s the Time to Revisit ESPN Spinoff
ESPN’s value today isn’t nearly as high as it was 24 or even 12 months ago. It continues to go through a very rough patch in its storied history as America’s leader in sports broadcasting.
On Dec. 18, John Skipper resigned as ESPN’s president after admitting that he needed to step away from the sports world to take care of a long-time substance abuse problem. Good for him for getting healthy.
This makes this an ideal time for Disney to revisit the ESPN spinoff.
First, Disney has got to go out and find a new leader anyway, so why not find someone who has experience running a public company and preferably one that understands or intersects with sports programming.
Secondly, estimates put the value of Fox’s regional sports networks at $23 billion. Add that to ESPN at $40 billion — Wunderlich Securities valued it at $51 billion in 2014, but it’s lost some of its value since then — and you’ve got a pretty attractive IPO in the making once the Fox deal’s been given the go-ahead or the sale of ESPN and its other sports assets are a condition of that approval.
Third, it could generate some much-needed cash to pay for share repurchases, debt repayment, etc.
Bottom Line on Walt Disney Stock
Although it probably seems like I’m against this purchase by Disney, I think it makes sense given the changing landscape in the entertainment industry.
However, investors need to understand that every acquisition has a downside. In this case, it’s the reality that this doesn’t solve Disney’s ESPN problem even with the addition of 22 regional networks.
Spinning off ESPN after the closing of the Fox deal would create lots of interest in both Disney stock and the future ESPN stock.
It kills two birds with one stone.
As of this writing, Will Ashworth did not hold a position in any of the aforementioned securities.