From one perspective, Disney (NYSE:DIS) looks like one of the best businesses in the market. The company’s Parks business is an obvious cash cow. Star Wars and Marvel Studios add to the company’s long-held intellectual property to create a content powerhouse. That content will only be boosted by the recent acquisition of assets from Fox Corporation (NASDAQ:FOX, NASDAQ:FOXA), which will help drive the company’s streaming service, to be launched later this year.
Looked at another way, however, Disney isn’t quite as attractive. The Disney stock price soared after streaming plans were announced back in April. But for years before that — and months since — DIS has done little but move sideways. Disney’s new streaming service might drive optimism, but it’s a response to cord-cutting causing shrinking profits in the company’s key media businesses. ESPN, in particular, seems at risk in the changing content landscape.
For years, that split perception of Disney kept the Disney stock price largely locked in place. But the new streaming plan has changed the story surrounding DIS stock.
What’s interesting is that the fundamentals seem to reflect that change as well. Looking at the legacy businesses, DIS stock actually looks potentially overvalued. But if an investor believes the Fox acquisition and, more importantly, the streaming plans are worthwhile, the price of Disney stock should have room to climb.
Good News In the Parks Business
There are few businesses in the world better than Disney’s parks. Disney’s pricing power, in particular, appears to be unmatched. Adjusted for inflation, the price of a Disney World ticket has roughly tripled since 1971. Disneyland admission prices have also more than tripled just since 2000, albeit on an unadjusted basis.
Disney’s ability to hike pricing hasn’t slowed down. Pricing increased 7% in the first half of fiscal 2019, according to the company’s 10-Q. And the company continues to tweak its rates based on demand, in an attempt to increase attendance and pricing while keeping the visitor experience reasonably intact.
Meanwhile, new Star Wars areas in both U.S. parks offer yet another reason to visit, and another reason for consumers to pay more. Likewise, the cruise line business is seeing strong demand and higher pricing. The strength of the Disney brand and the Disney experience has driven stunning growth in the parks business: According to Disney filings, operating income increased 14% in fiscal 2017, 19% last year and another 16% in the first half of FY19. There’s little reason, barring a recession, to see that trend changing.
That’s the good news. Outside of the two U.S. parks, however, the news isn’t quite as good. The company’s parks in Shanghai and Hong Kong aren’t wholly owned. In fact, the international business isn’t all that profitable. Trailing twelve-month operating income for the entire international portfolio is $467 million. That’s less than 10% of total profits for the parks business.
Those businesses are growing nicely, reversing from a modest loss in fiscal 2016, and posting 8% growth in the first half. But the parks business remains a U.S. story for the foreseeable future.
Questions In Parks, Experiences and Products
Meanwhile, the Consumer Products business, which now is part of the company’s Parks, Experiences and Products segment, is much weaker than investors might assume. Earnings have trended downward for years, including a 17% decline between fiscal 2016 and fiscal 2018. Profits have risen 3% in the first half, but there’s still a sense that Disney hasn’t quite capitalized on its IP in this space. Notably, the company has given up on its ambitions in video games, instead outsourcing intellectual property to developers like Electronic Arts (NASDAQ:EA).
That weakness isn’t fatal to the bull case for DIS stock. Consumer Products generates barely 10% of total operating income (excluding losses in the direct-to-consumer and international businesses) over the last twelve months. That figure will come down further over the next year as Fox profits hit the books.
But without growth in Consumer Products, PE&P growth remains reliant on the two U.S. parks. And it’s worth wondering if a recession might hit demand … or if there comes a point when ticket prices simply can’t increase any further. Can Disney really charge, say, $200 per day for Disney World admission? Will consumers balk at some point — particularly if the economy isn’t quite as strong as it seems to be at the moment?
It’s worth noting that shares of the two publicly traded U.S. theme park operators have struggled of late. Cedar Fair L.P. (NYSE:FUN) shares hit their lowest level in almost five years last month. Six Flags (NYSE:SIX) is not far from a 30-month low. Investors in the rest of the space are worried.
To be sure, Disney World is not Six Flags or Cedar Fair, in many ways. And, again, the U.S. parks business is attractive even considering cyclical risk. But there are concerns elsewhere in the Parks, Experiences and Products segment. Certainly, there are reasons to believe that growth will at least slow going forward.
Beyond the parks business is where Disney gets interesting — and the debate over the Disney stock price intensifies. The Studio Entertainment segment contains Disney’s film library and its production businesses, including Pixar, Marvel, LucasFilm, Touchstone and Walt Disney Pictures.
At the moment, it would seem to be a great business. Disney’s studios dominate the box office in an unprecedented manner. The company generated nearly 20% of total worldwide box office last year, according to Variety. Its nearly $8 billion haul was the second-best in history, behind only Disney’s 2016 performance. The company is on pace to set a new record this year.
Avengers:Endgame posted unbelievable numbers this spring, and should benefit Disney’s fiscal Q3 results, likely coming in just a few weeks. And the company’s various brands appeal to pretty much every demographic in almost every geography worldwide.
And yet, profit-wise, the Studio business hasn’t been that impressive over the past few years. Operating profit increased less than 9% over the past two fiscal years, with a dip in fiscal 2017 followed by big growth last year. First-half earnings are down by half, though timing is a big factor. Toy Story 4 and Endgame no doubt will boost Q3 and second-half results, but even with all the blockbusters Disney churns out, profit growth isn’t that spectacular.
Part of the problem is that the blockbusters are enormously expensive. CFO Christine McCarthy noted on the Q2 conference call that results even from Endgame would “be tempered somewhat by the cost structure”. Timing is an issue as well: even huge franchises can’t pump out a film every year. The disappointing results from Solo: A Star Wars story earlier this year show that even ardent fans can suffer from fatigue.
Looking forward, the Avengers franchise is taking a pause, and Star Wars will do the same. This is a lumpy business, and with those pauses, it’s a business that some might believe is at or near a peak.
The Studio Entertainment Debate
There is some evidence for the argument that Disney’s production businesses probably are near, or at, peak revenue and earnings. Even with Disney’s help, U.S. box office receipts continue to weaken, dropping 9% so far this year. Receipts in China are off over 2%. Shares of movie theater operators are feeling the pressure: AMC Entertainment (NYSE:AMC) trades at an all-time low following a 2013 IPO, while Cinemark Holdings (NYSE:CNK) has traded sideways for about five years now.
At a certain point, Disney is going to have a hard time driving bigger box office receipts if fewer consumers are going to theaters. In theory, the company could start developing films for its streaming service. But it’s tough to replicate the $1.5 billion in global box office Avengers:Endgame has created in a subscription model.
There’s also the question as to whether tastes will change. How many superhero movies can consumers watch? Dark Phoenix and Hellboy already have disappointed this year (Disney didn’t produce either film, but Dark Phoenix was a Fox picture). The current Hollywood business model of churning out sequels and constantly expanding franchises likely will change at some point. Either customers will get bored, the market will be oversaturated and/or less people will go to the movies.
That said, it may be other, smaller studios that take the hit before Disney. Fox brings new intellectual property — and it has room for margin improvement, as Disney management noted on the Q2 call. And for all the hype about blockbusters, production actually isn’t the biggest revenue driver for the Studio Entertainment.
Even in fiscal 2018, a huge year for Disney in terms of new releases, box office revenue was barely ahead of revenue earned from television and streaming video on demand (SVOD). Another 16% of segment revenue last year came from the company’s still-strong home entertainment business.
Those revenues have higher profit margins, as the cost of existing films is minimal. And so one argument for patience toward Studio Entertainment is that segment is more about the underlying and existing IP than new releases … even if those new releases garner much more of the headlines.
ESPN and the Disney Stock Price
Over the past four quarters, the Studio Entertainment and Parks businesses combined have generated just shy of $7 billion in operating income, according to Disney filings. The Media Networks segment over the same period has contributed $7.35 billion in earnings.
If there’s a short case for DIS stock, this is it. Yes, the parks and studio businesses are attractive. But over half of earnings — admittedly before the acquisition of the assets from Fox, and for now ignoring losses in digital and international — come from the Media Networks segment and the Consumer Products business. Neither appears to be a good business right now.
As I wrote just last month, ESPN is a major problem for Disney. It’s the key reason why the Disney stock price stayed stuck for nearly four years. Profits for the Cable Networks group — of which ESPN is the major profit engine — declined in each of the last three fiscal years. ESPN and ESPN2 have each lost roughly 12 million subscribers since fiscal 2011.
The news has been better so far this year, with profits in the Media Networks segment up year-over-year. But there are still obvious concerns. Notably, Cable Networks earnings declined again in the first half. ESPN is a major profit driver, and clearly it is headed in the wrong direction.
Media Networks On the Whole
Indeed, the risk to Disney’s networks business isn’t limited to just ESPN. The segment as a whole, which includes ABC, Disney Network, Freeform and a 50% stake in A&E network, has worries as well, even after a seemingly strong half. Overall, affiliate fee rates — paid to ESPN and other Disney networks from cable and satellite operators — have risen 7% in the first half. So have advertising rates.
That might seem like good news. It isn’t. Even with those rate increases, profit growth is minimal: Just 0.5% year-over-year through the first six months. And those increases aren’t going to hold forever.
Affiliate fee renegotiations are likely on the way: Credit Suisse (NYSE:CS) estimated last year that 95% of its deals are up for renewal starting in late fiscal 2019. ESPN’s leverage is likely declining. Consumers — many of whom don’t even watch sports — are increasingly aware that they are paying as much as $10 per month to have ESPN, whether they want it or not. Cord-cutting is driven in part by that fact, which contributes to higher prices from the likes of Comcast (NASDAQ:CMCSA) and Charter Communications (NASDAQ:CHTR). Even if ESPN can hold rates reasonably steady — or modestly positive — affiliate fee revenues are going to drop going forward.
Meanwhile, advertisers are targeting live sports in an increasingly fragmented content landscape, but ad rates can’t climb 7% a year forever, either. Here, too, higher rates are being offset by lower views: advertising revenue rose just 0.4% in the first six months.
Admittedly, this isn’t just a Disney problem. Networks of all types are challenged. But elsewhere, investors have priced in those challenges. AMC Networks (NASDAQ:AMCX) trades for less than 7x 2019 EPS estimates. Discovery Communications (NASDAQ:DISCA) sits at 8x, with CBS (NYSE:CBS) modestly higher.
This is a business likely heading for long-term decline. And that significantly colors the bull case for DIS stock.
Valuing the Businesses
Disney’s FY19 segment-level EBITDA should look something like this:
- Media Networks: $7.4 billion
- Parks, Experiences and Products: $9.0 billion
- Studio Entertainment: $3.1 billion
What does that mean for the Disney stock price?
The Media Networks business likely is worth at most $74 billion, assuming a 10x EBITDA multiple. That’s a premium to other networks stocks, with CBS trading at almost exactly 9x at the moment and other networks receiving even lower valuations.
Valuing the Parks, Experiences and Products businesses is more difficult. EBITDA significantly exceeds EBIT (also known as operating profit), given the capital-intensive nature of the parks business. That should reduce the EBITDA multiple somewhat. About a quarter of profit in the segment comes from consumer products, a business that at least of late has been declining. That, too, suggests a lower multiple.
Cedar Fair is valued at a touch under 10x EBITDA. Six Flags garners a multiple near 12x. Disney’s parks unquestionably are more valuable, however. Cedar Fair is targeting 4% EBITDA growth over the next four years. Six Flags’ profit increases of late are in the single digits. Neither holds a candle to Disney’s growth, past or future. Disney’s parks, plus its cruise line business, are more valuable qualitatively and fundamentally; 12x appears to be a reasonable, if somewhat aggressive, multiple. That’s a premium to Six Flags even with the drag from consumer products. That values the PE&P segment at about $108 billion.
For the Studio Entertainment, the exercise is more difficult. No studio is as dominant. No peers exist as a standalone on the public markets (Lionsgate (NYSE:LGF.A,NYSE:LGF.B) owns Starz and has a heavy presence in television production). But we know that Disney paid roughly 11.5x EBITDA for Fox — about the same as AT&T (NYSE:T) did for Time Warner. That multiple would value Disney’s film business at about $35 billion.
Disney also has corporate costs, which run at roughly $900 million a year. Those should be deducted from any sum of the parts analysis. A somewhat arbitrary 8x multiple knocks $7 billion off the total — and implies that these three businesses, combined, are worth right at $210 billion.
What That Means for DIS Stock
Before the Fox deal closed, Disney had about $16 billion in net debt, and 1.49 billion shares outstanding. These calculations would suggest an equity value pre-Fox of about $194 billion, or $130 per share.
With the Disney stock price currently at $140, that doesn’t make DIS stock seem all that attractive. And that’s particularly true since even $130 might be an aggressive estimate; 10x EBITDA for any media company in this environment is potentially high. Move that back to 8-9x and DIS stock drops closer to $120.
Looking at it another way, the overall EBITDA numbers suggest these three businesses, based on debt levels before the Fox deal, could drive less than $8 per share in EPS; $130, in that model, suggests about a 17x P/E multiple. That seems cheap. But, again, over half of these profits — from Media Networks and Consumer Products — are likely in decline. Consolidated growth is likely minimal.
That was the case before Disney’s recent moves, and it explained why the Disney stock price didn’t move over that stretch.
Fundamentally, just looking at the four biggest businesses — parks, consumer products, networks and films — DIS stock looks reasonably valued, and maybe even a bit overvalued. But, of course, DIS stock isn’t based just on those four businesses.
Fox, Streaming and Digital
Disney isn’t just those businesses anymore. It spent about $56 billion in cash and stock — after the proceeds from the sale of Fox’s stake in Sky to Comcast — for the Fox assets. Disney owns a majority stake in digital distributor BAMTech, which underpins the company’s ESPN+ offering. It owns two-thirds of Hulu, with an agreement to take full ownership next decade.
As far as Fox goes, the question is whether the deal creates value for Disney stock. Again, the $120-$130 valuation above is based on the structure of Disney before the deal. If Disney overpaid, that figure comes down — and Disney paid a hefty premium after a bidding war with Comcast.
But Disney also has said it projects as much as $2 billion in cost synergies from the deal — in addition to an expected EBITDA contribution of about $4.7 billion. Should those savings be realized, DIS paid less than 9x EBITDA — a much more attractive multiple.
BAMTech and Hulu both are losing money, but both still have value regardless. Disney has contributed nearly $2 billion for its stake in BAMTech so far. Disney in a filing valued Hulu last November at $9.3 billion, making its stake worth about $6 billion. But its deal with AT&T implied a valuation closer to $14 billion, as does its agreement to pay Comcast at least $5.8 billion for its current 33% ownership. That would make Disney’s stake in the streaming service worth close to $10 billion, or about $6 per share; 10% accretion from Fox (almost $6 billion in value created) adds almost $4 per share to the Disney stock price (based on the post-Fox share count of about 1.8 billion). Hulu is worth about $5 per share. BAMTech is probably worth $1-2 per share.
Add those figures to the $130 valuation of the legacy businesses and fair value for DIS stock gets to $140 — right where it trades at the moment.
Streaming and the Sum of the Parts
Historically, sum of the parts valuations like this tend to be viewed in a skeptical light. Value on paper can’t always be realized in practice. In many of these cases, investors assign a “conglomerate discount” to businesses with disparate operations. General Electric (NYSE:GE), even before its recent troubles, was a prime example. In many cases, the sum of the parts is less than the parts.
But Disney should be different. The whole point of Disney is that each business amplifies the other. The $4 billion acquisition of LucasFilm didn’t just allow Disney to make new Star Wars films. It gave the company the existing library, which it could monetize through its home entertainment division. It added a new source of revenue for the consumer products division. And it allowed for the expansion of Disney World and Disneyland — driving higher revenue and bigger profits in the Parks business.
That’s one of the more attractive aspects of the Disney case. And streaming would seem to be another example of the cross-selling ability that defines Disney. The service will rest on already-developed and/or purchased content, whether its Star Wars, The Simpsons, Toy Story or Mickey Mouse cartoons. Streaming is just a way for Disney to make more money off its existing property, and at the moment, it doesn’t appear priced into DIS stock at all. That suggests upside for Disney stock, right?
Streaming Drives the Case … And That Might Be a Problem
Perhaps. But it’s not quite that simple. Disney is already losing money from its digital pivot, as it funds losses at BAMTech, ESPN+ and now Hulu. It’s going to spend more money as it launches streaming — and it’s going to lose revenue and profits as well.
Most notably, Disney is pulling back content from Netflix (NASDAQ:NFLX), and foregoing hundreds of millions of dollars in high-margin licensing revenue in the process. But it’s also going to lose sales in its Home Entertainment division, which has generated $1.6 billion in revenue over the past year. Consumers aren’t going to buy a Star Wars DVD if they can have access to the entire library — and the rest of Disney’s content — for $5.99 a month.
Between lost revenues and higher spending, Disney is going to see overall earnings decline in the near term, as even CEO Bob Iger has said. Simply shifting content to the service, between lost licensing and home entertainment revenues, likely hits earnings by well over a billion dollars.
But streaming isn’t just a near-term issue. There’s a real question as to whether the digital era is better for a content owner like Disney. It’s not better for ESPN, certainly, which is moving from getting $9+ per month for cable subscribers to just $5 a month for ESPN+ users. Even for the rest of the business, however, there’s a cost to streaming.
And so Disney’s streaming plans have to be successful to move DIS stock higher — and they probably have to be hugely successful. Disney+ has to get millions of subscribers to get to the point where profitability is guaranteed and investors can view the business as a legitimate competitor to Netflix.
It very well might do so. Bulls would argue — and perhaps rightfully so — that no company on Earth has better content. It can target families with the Disney brand and adults with Star Wars, The Simpsons, Marvel and content from ABC. And at some point, Disney no doubt will start raising prices for Disney+, returning some of the profits lost during the digital shift.
But with the gains since the streaming service was announced, there’s not much room for error left in the Disney stock price. Investors are acting as if success is a foregone conclusion. If they’re right, and streaming over time can add a few billion dollars in profits, DIS stock has a path to $200 in the coming years. If streaming stumbles at all, however, even the best of Disney’s businesses likely won’t be able to offset that disappointment.
As of this writing, Vince Martin did not hold a position in any of the aforementioned securities.