Walt Disney (NYSE:DIS) stock remains rangebound. Disney stock did hit its highest levels in almost three years last month, and briefly spiked to a new three-year high after fiscal Q4 earnings on the 8th. But DIS stock has pulled back — if modestly — and at $112 again sits within a range that has held going back to early 2015.
I had argued heading into earnings that DIS stock had a chance to take a tumble. That didn’t happen immediately — Disney stock gained almost 2% on the Q4 beat — and it’s difficult to tell whether recent weakness is stock-specific or simply a result of a weak broad market.
Still, it’s at least possible that investors digesting the report are reacting to continued weakness at the company’s ESPN unit. For all the optimism toward Disney’s new streaming service, its acquisition of assets from Twenty-First Century Fox (NASDAQ:FOX,FOXA), and its studio and theme parks business, cable TV still is a key profit center here. And ESPN — though its exact contribution isn’t broken out — is clearly the most important part of that segment.
And the business continues to head in the wrong direction, as detailed in the Disney 10-K. This isn’t a new issue: ESPN’s troubles are a key reason why DIS stock has been rangebound for three-plus years. But with little sign of those troubles coming to an end, I still believe the network is a big reason why returns in Disney stock will be equally modest going forward.
ESPN Already Has Hit Disney Stock
Again, the troubles at ESPN aren’t new. But they did continue in fiscal 2018.
Per figures from the 10-K, ESPN had 86 million subscribers at the end of FY18 — down roughly 2 million year-over-year. That drop continues a steady erosion: the network has lost 13 million subscribers in the past five years, according to filings.
The underlying numbers aren’t as bad as the subscriber figures — at least not yet. The Media Networks segment, which includes ESPN, ABC, Disney Channel, and other outlets, still saw revenue rise 4% year-over-year in FY18, after a 1% decline in fiscal 2017. But much of the strength is coming from affiliate fees, or payments from cable carriers like Comcast (NASDAQ:CMCSA) or satellite providers DISH Network (NASDAQ:DISH) or AT&T (NYSE:T) unit DirecTV. Those fees increase annually under contracts negotiated in the past.
At some point, however, those fee increases likely are going to stop. ‘Cord-cutting’ is accelerating in part because many individual subscribers don’t watch sports at all and yet are responsible for roughly $100 per year each in affiliate fees to ESPN. Meanwhile, ratings are down, with segment advertising revenue down 5% in Media Networks and 6% in cable. The lion’s share of that latter decline is coming from ESPN — despite the company running more ads. And while revenue rose last year, earnings continued to decline, in part due to higher costs that will continue going forward.
ESPN simply is heading in the wrong direction and the news likely is going to get worse before it gets better. I wrote that this was a problem last year and it’s not one that’s improved since.
ESPN Could Pressure DIS Stock Going Forward
It’s not an insignificant problem, either. Backing out non-cash charges, the Cable Networks business category generated over one-third of Disney’s segment-level operating income. The majority of those profits come from ESPN (including all of its branded channels). The other networks may not be performing all that well, either: Disney Channel and Freeform (formerly ABC Family) have seen similar subscriber declines domestically.
In addition, the Consumer Products segments generates about 11% of profit. It too is in multi-year decline. Combined, over 40% of Disney earnings are headed in the wrong direction. That figure gets closer to half including ABC.
It’s simply difficult for a company to consistently grow earnings with that type of headwind. And there’s little reason to see a reversal. ESPN still has 86 million subscribers. Some chunk of those viewers would prefer not to pay for ESPN at all — and at some point will no longer do so. Cord-cutting pressures on the smaller networks isn’t going to let up, either.
There is good news when it comes to Disney stock, admittedly. Disney Plus, as the new streaming service is named, will launch next year. Star Wars and Marvel can drive continued growth in the Studio Entertainment segment. The theme park businesses are hugely valuable.
Still, half of profits are declining. And that can offset an awful lot of good news. With tax reform being lapped in fiscal Q2, high-margin revenue from Netflix (NASDAQ:NFLX) disappearing, FY19 earnings growth likely will be limited. Beyond that, it gets even tougher.
Disney stock might look cheap given its growth opportunities. But given the pressures on the same growth, it hardly looks cheap enough.
As of this writing, Vince Martin has no positions in any securities mentioned.