Throughout the current crisis, I’ve repeatedly advised investors to take the long view. And that advice seemingly makes Disney (NYSE:DIS) stock an easy buy.
After all, Disney remains one of the world’s great businesses, even if it’s facing short-term difficulties. Disney theme parks, for instance, have closed for months. Yet, over time, few businesses have ever had as much pricing power: Ticket prices for Disney World rose by almost 40x in less than 40 years.
Disney movies are a part of almost every American’s childhood. With ownership of Star Wars and 21st Century Fox, the company’s dominance of Hollywood now extends into adulthood.
Disney+ got a late start against Netflix (NASDAQ:NFLX) in streaming. But figures from this month’s fiscal second-quarter report show quickly Disney+ is catching up. Disney has full operating control of Hulu as well.
So if an investor is going to take the long view, DIS stock certainly looks like a winner. That’s particularly true given the stock’s performance. DIS has declined 20% so far in 2020. It’s underperformed both the S&P 500 and the Dow Jones Industrial Average, each of which include Disney as a constituent.
Indeed, I’ve recommended DIS this year — at the right price (under $100). But the seemingly simple bull case ignores a key problem for Disney: its media business. And when considering the long-term impact of this crisis, and the 20%-plus rally in less than two months, the case for DIS stock isn’t as simple, or as foolproof, as it might appear.
The ESPN Problem Continues
As I detailed last month, “cord-cutting” weighed on DIS stock for several years. Despite a rally in the U.S. stock market, Disney shares traded basically sideways from 2015 to 2019.
It wasn’t until the initial launch of Disney+ last April that the stock finally broke to new highs. The service seemed to give Disney a long-awaited offset to cord-cutting pressure on its ESPN, ABC, Freeform and National Geographic properties.
But this current crisis represents a fresh challenge to Disney’s Media Networks segment. Cord-cutting is only going to accelerate.
Consumers facing short-term unemployment will look to save money — and high-priced cable bills will be a logical initial target. Meanwhile, many viewers now have the time to actually research streaming options, pick up a Roku (NASDAQ:ROKU) or Amazon (NASDAQ:AMZN) Fire Stick, and ditch cable.
Indeed, elsewhere in the market, investors are pricing in exactly that pressure. For instance, Comcast (NASDAQ:CMCSA) has badly underperformed fellow cable operator Charter Communications (NASDAQ:CHTR). Why? In large part, because Comcast owns NBCUniversal. Charter has no media assets, but can profit from higher-margin broadband revenue.
Investors are fleeing media stocks right now. And a good chunk of Disney’s value comes from media.
The Profit and Debt Problem
It’s difficult to pin down the precise amount of earnings that will come from the media networks going forward. The acquisition of assets from 21st Century Fox closed last year, which impacts year-over-year comparisons. The Parks and Studio Entertainment businesses collapsed in the most recent quarter.
But in Q1, the most “normal” recent report, Media Networks drove one-third of profit before losses relative to Disney+ and corporate expense. Even that understates the case a bit, however. Disney’s Q1 includes the holiday season, which unsurprisingly drives big growth for its consumer products business.
On a run-rate basis, then, the networks, most notably ESPN, probably generate close to 40% of earnings. And those earnings are in trouble.
In Q2, for instance, ad revenue at ESPN fell 8%. Affiliate revenue — payments to Disney from the likes of Comcast and Charter for carrying ESPN — did grow. But if cord-cutting accelerates, subscriber losses will do the same. And contracted rate increases in those affiliate agreements won’t be enough to offset that pressure
At the same time, ESPN has to pay increased costs each year under its agreements with sports leagues and college conferences. Lower revenue and higher costs combine to drive a sharp decline in earnings.
To top it all off, thanks to the Fox deal Disney now has much more debt. That only amplifies the profit problem in terms of both earnings and the DIS stock price.
The Cautious Case for DIS Stock
To be clear, I don’t think Disney stock is a short. I don’t even believe long-term investors who own DIS need to sell immediately.
This is a great company — for the most part. And it’s worth noting that the same cord-cutting trend hurting ESPN and the other networks should help Disney+.
Indeed, NFLX stock is up 40% so far this year and sits at all-time highs. Disney+ should have, at worst, a solid second-place position in streaming, ahead of launches from Comcast and AT&T (NYSE:T) this year.
But in a market that still has value in a number of sectors, price matters. At $116, DIS stock is starting to price in a return to normalcy.
The problem is that normalcy isn’t returning to ESPN. The company gets roughly $10 per cable subscriber per month. Average revenue per user for the ESPN+ streaming platform in Q2 was just $4.24. That figure actually fell 17% year-over-year due to Disney’s bundle of Disney+, ESPN+ and Hulu.
Again, 35%-40% of earnings are coming from a business in permanent decline. The Fox deal loaded the balance sheet with debt. Those are two key reasons why DIS stock remains so far below past highs. And those are two key reasons why caution is merited, despite the long-term strength in the rest of Disney’s business.
Matthew McCall left Wall Street to actually help investors — by getting them into the world’s biggest, most revolutionary trends BEFORE anyone else. The power of being “first” gave Matt’s readers the chance to bank +2,438% in Stamps.com (STMP), +1,523% in Ulta Beauty (ULTA) and +1,044% in Tesla (TSLA), just to name a few. Click here to see what Matt has up his sleeve now. Matt does not directly own the aforementioned securities.