Disney Has A Stable Of Horses To Ride

By Stephen D. Simpson, CFA | February 05, 2013 AAA

While the quality of global entertainment and media giant Walt Disney (NYSE:DIS) is generally taken as a given, the company has always been a little more erratic in terms of margins, cash flows and returns on capital than most companies of its size and reputation. These variances are largely a byproduct of the nature of the business (particularly hit movies), but they can still create opportunities for investors. Disney seldom gets very cheap, and the company has multiple levers to improve results over the coming years. But investors should keep their eyes open for a chance to pick up shares should the stock stumble on transitory bad news.

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Fiscal First Quarter Results Basically Fine, but More Margin Leverage Would Be Nice
Disney basically did fine for the fiscal first quarter, though sell-side analysts were looking for a bit more margin leverage. As this leverage is a key part of the multi-year bull thesis, it's worth watching in the coming quarters. Revenue rose 5% as reported, good for a very small beat of expectations. Media networks were strong, with revenue up 7% on low single-digit ad revenue growth at both ESPN and the other channels/networks. Park/resort revenue was also strong, with more than 7% growth helped by a 4% increase in domestic attendance and higher per-cap spending (up 6%). Always-volatile studio revenue was down 5% this quarter, while consumer products improved 7%. Last and least, revenue from the interactive business climbed 4%.

As indicated above, Disney was not quite so adept at translating that revenue into profits. Operating income actually declined 3% and missed consensus estimates - making the miss all the worse on the margin line, given the outperformance in revenue. Network income was down 2%, with the much-larger cable segment (down 2%) dragging down the 16% improvement in broadcast. Parks income was up 4% as the company has yet to really leverage its investments, while studio profits plunged 43%. Consumer revenue rose 11%, and interactive profits reversed a year-ago loss.

SEE: How To Decode A Company's Earnings Report

Media Networks - the Content Is Locked up, Now for the Rate Hikes
Disney has been active and aggressive in locking up key content for its ESPN sports empire. Most of its major sports are locked up past 2020, with NASCAR (up in 2014) and NBA (2015/16) the major exceptions, and you could argue whether the declines in NASCAR viewership make it a "major sport" anymore.

However, this process has not come without costs. ESPN's last agreement to extend its deal with the NFL came at the cost of 73% higher fees (more than $1.8 billion a year). Likewise, you can assume that the NBA won't re-up cheaply, and negotiations with the Big East and the new basketball-focused conference of former Big East schools are on the way as well.

While Disney seldom has trouble selling ads for its sports programming, getting paid by its distributors - cable companies like Comcast (Nasdaq:CMCSA) and Time Warner Cable (NYSE:TWC) - is significant as well, and we're coming up to a new renewal cycle. Disney and Comcast are already squared away, but renewal negotiations between networks and cable companies have gotten considerably more dramatic of late.

At a minimum, expect another round of commercials with each side arguing that it's being held hostage for high ransom by the other. In the end, it will likely be just a sideshow - I can't imagine a cable system being brave (or foolish) enough to let ESPN go dark (not to mention ABC, ABC Family and the Disney channels), but the noise could create some turbulence in the stock if it gets serious enough.

Time for the Parks to Contribute
Disney has spent the last couple of years investing considerable amounts of money in its parks and resorts business. The end result has been new revenue-generators like the Aluani resort in Hawaii, the Art of Animation hotel in Orlando, new cruise ships, the Disney California Adventure and further progress with the Shanghai Disney resort - a park due to open in 2015 at three times the size of Hong Kong Disneyland.

SEE: World's Most Expensive Theme Parks

The challenge for Disney will be leveraging these new assets into profitable revenue. Although the parks/resorts business isn't usually the most profitable part of Disney, consistent double-digit margins are nothing to sneeze at, so it is a significant piece of the pie (generally the second-largest profit center after the networks).

This is an economically-sensitive business, as tough economic conditions usually lead people to stay closer to home, sometimes substituting a trip to a Disney destination with a trip to Six Flags Entertainment (NYSE:SIX) or an amusement park operated by Cedar Fair (NYSE:FUN). Still, we're talking about a company that has essentially pioneered the amusement park concept and focuses on the quality of the visitor experience like no one else.

Long term, I have little doubt that Disney's new hotels will be full of guests, and that its cruise ships will have no problem competing with Royal Caribbean Cruises (NYSE:RCL) or Carnival (NYSE:CCL) for passengers. The key is how quickly attendance/utilization ramps up and amortizes the newly-expanded overhead. Here again could be a source of opportunity in the shares. If the margin leverage from parks/resorts is slow to materialize, it could also create some noise in the market and an entry opportunity.

Studios - Forget the Dark Side, Beware of Live Action
Disney still has something to prove in its studio operations. Nobody questions the company's ability to create profitable Pixar movies or successful Marvel features (particularly with director Joss Whedon under contract). The key is whether the company can get past its challenges in non-Marvel live action movies, particularly with the new "Oz" and "Lone Ranger" movies on the way.

Longer term, of course, there is the Star Wars franchise. Disney has certainly captured ample buzz for its deal with Lucasfilm and its commitment to make multiple future Star Wars movies. Now it's time for the execution, but investors really won't have anything to see for a few years in that regard.

Can Interactive do More?
If there's one part of Disney that needs a serious re-think, it's the Interactive section. Given the quality of Disney's intellectual property and the demonstrated in-house studio capability, I don't understand why Disney isn't a major force in video games. As an aside, the same could be said of Lucasfilm - LucasArts was once a great game developer (and not just within the Star Wars and Indiana Jones universes), but the company basically punted after the late 1990s.

I understand that the video game industry has changed dramatically. Companies like Microsoft (Nasdaq:MSFT), Sony (NYSE:SNE) and Electronic Arts (Nasdaq:EA) are now looking at a much more winner-take-all world, where only a select few titles dominate the market and development budgets swell to movie-like proportions. Even so, gamers have shown that they will pay for compelling stories delivered with good gameplay, and I think Disney has under-exploited this market.

The Bottom Line
As is so often the case with the stocks of blue-ribbon companies, Disney shares are not particularly cheap, even with relatively generous growth assumptions. Even if Disney can grow revenue at a faster rate (5 to 6% long term) than it has over the past decade, and even if the company can take margins and free cash flow generation to new levels, a free cash flow rate of even 8 to 10% doesn't really get the job done. At that level, fair value would still seem to be in the low-to-mid $50s.

I wouldn't consider selling Disney just because it looked a little expensive, but neither would I rush to buy with the assumption that it'll just all work out - maybe it will over 10 or more years, but buying the greatest stock at a bad price is still dangerous. As a result, I'd prefer to wait in the hope that Disney trips up somewhere - squabbles with cable companies, less-than-expected leverage in the parks business or a studio flop - and then get the shares a little cheaper.

At the time of writing, Stephen D. Simpson did not own any shares in any company mentioned in this article.

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