The 2019 rally in Disney (NYSE:DIS) stock was long-awaited. Before bouncing about 35% in a little over four months, DIS stock had traded sideways for almost four years.
What drove this year’s gains was optimism surrounding the company’s streaming offering, details of which were released in April. What kept a lid on DIS stock before that was fears about the company’s media business, primarily cable network ESPN.
Ahead of the company’s disappointing, if not disastrous, fiscal third-quarter report this month, the market largely had forgotten about that worry. With streaming still years away from being a profit center, the recent reminder could lead Disney stock back to its rangebound ways.
ESPN Still a Problem for Disney Stock
Over the first three quarters of fiscal 2019, Disney’s Media Networks segment has contributed nearly half of the company’s earnings. And that continues to be a risk to DIS stock.
ESPN, in particular, has benefited from receiving over $9 per month per cable subscriber for its package of networks just in affiliate fees. Those fees are over half the segment’s revenue — and are still rising for now. In fact, they increased 20% year-over-year in the third quarter, per the company’s Securities and Exchange Commission Form 10-Q.
But that’s not necessarily good news. Sixteen points of the increase came from the acquisition of Twenty-First Century Fox. Eight points came from rates, with a 2.5% decline in subscribers and a roughly one point loss from accounting changes.
ESPN is raising affiliate fees because its rates are higher. But those higher rates are coming from contracts renegotiated years ago. That’s going to change. The likes of Comcast (NASDAQ:CMCSA) and Charter Communications (NASDAQ:CHTR), facing “cord-cutting” worries of their own, are not going to force subscribers who don’t even watch sports to pay $10 a month for ESPN channels. Verizon (NYSE:VZ) already came close to an ESPN blackout at the end of last year.
Advertising saw a similar trend in the quarter. Revenue rose 12% year-over-year. Growth to the tune of 24% in Cable Networks came from the addition of Fox, higher rates and higher impressions due to “more units delivered.” In other words, Disney networks simply ran more ads. That’s hardly a viable long-term strategy amid a proliferation of ad-free options. Viewership declined, and the numbers came despite two additional (and profitable) NBA Finals games in the quarter.
At ABC, profits declined on the back of a whopping 11% decline in advertising revenue. Licensing sales fell as well.
Other Risks to DIS Stock
The story across the segment is similar. Outside of Fox, the media businesses are showing minimal growth at best — which is driven by strategies not viable over the long term. Affiliate rate increases are going to slow, if not reverse. Subscriber declines will continue. Ad pricing can’t rise in perpetuity. Disney cannot keep taking pricing enough to offset that pressure.
That’s hardly the only concerning aspect of the quarter. Weak visitation to new “Star Wars” properties led to disappointing numbers in the Parks business. Profits still rose 4%, but that was much lower than analysts and management expected.
On the Q3 call, management tried to explain the lower-than-expected visitation. Chief Executive Officer Bob Iger posited that concerns about huge crowding may have dampened visitation. Increased hotel rates in the Anaheim area didn’t help. Chief Financial Officer Christine McCarthy supported that contention by noting that paid attendance rose. It was season passholders to Disneyland who didn’t show up — likely because they figured the park would be packed to, or beyond, capacity.
Those explanations may be correct. But there are still broader concerns about the business. Namely, can Disney keep raising ticket prices as it has for years now? And will a potential recession hit sales and profits in that segment?
Fox, as even management admitted, had an underwhelming quarter. Disney had to raise its offer for Fox amid a bidding war with Comcast. The business’s first full quarter under Disney’s ownership was disappointing. That’s a bad sign given the $71 billion price tag and the fact that Fox actually adds to the company’s exposure to worrisome cord-cutting trends.
Disney+ and the Bull Case
The bullish retort to these concerns likely boils down to, “So what? Disney+ is on the way.” After the pullback in DIS stock, the company has a market cap of just under $245 billion. Netflix (NASDAQ:NFLX) still has an equity value of $130 billion. It doesn’t seem to take a lot of success in streaming for Disney+ to add material value to the Disney stock price.
I get that argument to some extent. As I wrote earlier this year, even a detailed valuation of DIS stock shows that it probably comes down to streaming success.
But I also argued that even an aggressive valuation suggested DIS was worth about $140 per share at most. Both streaming and the Fox deal have to add value. Fox’s slow start raises risk on that front.
And in terms of streaming, there are two concerns. The first is that, as Iger has pointed out repeatedly, it’s going to take time for streaming profits to actually arrive. Disney is losing high-margin licensing revenue in the interim as it pulls back content from services like Netflix and funds losses in recently consolidated Hulu. It will take some time for the subscriber base to build to the point where those revenues are replaced.
The second, related, issue is that it’s not if Disney wasn’t already monetizing its library through Home Entertainment (still a billion-dollar business) and content licensing. Disney+ is not purely incremental to existing profits. Rather, it’s cannibalizing some of those profits.
The direct-to-consumer offering may be more profitable, to be sure. (In fact, it likely will be more profitable.) But it will also lead to declines elsewhere in the business.
The Bottom Line on Disney Stock
And so the risk to DIS stock is that the old worries and the new business combined can cause some hesitation on the part of investors. Media Networks profits are going to start declining. Parks earnings better not have peaked. Streaming will take years to prove itself.
It’s possible at the least that investors, as they did from 2015-2018, will lose patience. It’s also possible, in a worst-case scenario, that Disney’s consolidated earnings are going to head south. The third-quarter report raises the risk on both those fronts — and suggests that patience might be advised.
As of this writing, Vince Martin has no positions in any securities mentioned.