Disney: Still Hungover

by The Compound Investor

It has been a very quiet few years for Disney’s (DIS) share price. The stock traded at circa $115 at this point in 2015, falling to around $106.25 as of right now. Add around $4.50 per share worth of dividend cash into the mix, and we come out roughly where we started. The Dow Jones Industrial Average, of which Disney is a constituent, has put on nearly 50% over the same timeframe, just by way of comparison.

So, what’s up with Disney stock? Two things stand out right now. First, we have the inevitable hangover from the good times between 2010 and 2015. Disney’s business and stock looked unstoppable back then, with EPS growing from $2.05 per share to $4.90 per share during that time. The stock basically trebled over the same period.

On-the-ball readers will no doubt notice that these two performances don’t entirely match. I mean, the business doubles its earnings power yet shareholder returns treble? Unless you are dealing with a stock that is ludicrously undervalued, then at some point shareholders will always have to pay the piper for that kind of positive discrepancy. This is where the hangover kicks in.

The second point I’d make regards Disney’s Media Networks segment. This is responsible for around 45% of total operating profit and includes sports broadcaster ESPN as well as ABC. Last year, Media Networks generated $6.9b in operating income. It made $7.8b back in 2015. Now, the issues surrounding subscriber losses and lower advertising revenue are well documented. On top of that, content costs demanded by the NFL, NBA and so on continue to grow. That said, the segment is still a cash cow for Disney with circa 30% operating margins. In addition, the other parts of the business – the parks, the resorts, the movie studios pumping out Star Wars and Avengers titles and so on – have done pretty well. They generated combined operating income of $7.9b last year for the firm. The comparable figure in 2015 was $6.9b.

The Bigger Picture

You will notice that I deliberately divided Disney’s business into two parts there. That is because you have probably read a whole lot of articles covering Netflix and streaming. The theory goes that if folks stop subscribing to cable television, then companies like Disney earn less in affiliate fees – i.e. the cash that cable companies pay per month per subscriber – and less in advertising revenue (fewer eyeballs equals lower advertising dollars). As you can see from above, this looks like it has already had an impact on the Media Networks division.

There is a good case to be made in claiming that these threats are overblown. To illustrate why, let us take fiscal year 2014 as a baseline. I picked that year because ESPN was still riding high with 96m subscribers back then. Disney also made roughly $7.5b in total after-tax profit that year. Now, despite the trouble that linear-TV has had, analysts forecast that Disney will earn around $10.75b this year. That is around 45% higher than four years ago.

The per-share numbers are actually even better due to the cumulative effect of share repurchases. On that basis, Disney will have grown its income by 65% in that time. Suddenly the bigger picture doesn’t look too bad. It is just that the hangover period has seen the valuation slashed from nearly 25x earnings to 15x earnings. What is the net result? Profit has actually grown, but the stock goes nowhere.

Now, even if you were so pessimistic on the future of television that you discounted Media Networks to zero, you can buy Disney shares today for 30x the net income of the other segments. That is the 50% of Disney’s operating profit that is much more resilient to long-term change. It is an economic engine that generates something like $5b in after-tax profit. If the firm is successful in its bid to acquire the lion’s share of Fox, then that will go even higher. In any case, is there enough insurance in Disney’s valuation to wait out the slight Media Networks issue? Considering a total earnings yield of over 6.5%, I am inclined to say yes.

Note

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