Disney (NYSE: DIS): Short Term Volatility Meets Long Term Growth

Disney theme park stock market investment

The beleaguered company has taken some extensive hits. With the evolving COVID-19 situation doing broad-based damage to global economies in the macro landscape, specifically how bad has Disney been hit? We dive into Disney’s quarterly earnings report and take a look at its 4 major operating segments to find out.

1. Media Networks (Revenue +28% | Operating Income +7%)

This segment consists of:

(1) Cable Networks

The company’s cable network has seen a 17% increase in revenue and 1% increase in operating income primarily due to the consolidation of Twenty-First Century Fox (TFCF) and Nat Geo, which partially offset decreases in revenue from ESPN. ESPN’s revenue decrease was due to increased production costs and lower advertising revenue, attributed to lowered average viewership since COVID-19 effectively drove cancellation of major sporting events beginning mid March (the peak sports season).

(2) Broadcasting

Broadcasting revenues increased 49% to and operating income increased 53%. It has to be noted that the increase has been attributed to the consolidation of TFCF and timing benefit from the new accounting guidance adopted in 2020 which allows amortisation of capitalised costs. In layman terms, the new accounting policies lowered programming and production expenses for 1H20 and will result in higher programming and production expenses in 2H20 instead.

Verdict:

There seems to be no meaningful increase in operating incomes and revenues from a business standpoint since the increase in revenue is credited to the consolidation of TFCF. Moving forward, we are likely to see broadcasting income tumble as the pandemic progresses due to lack of live content such as sports, since broadcasting is largely a derivative of live content supply.

1. Parks, Experiences and Products (Revenue -10% | Operating Income -58%)

Man, this won’t be pretty.

The steep fall in operating income is very obviously due to the closure of Disney resorts, parks and cruise line business. Disney values the impact on segment operating income at USD 1 billion which implies that the company should have projected a 8.8% increase in year on year revenue stemming from higher average revenues per user.

It is clear that there is an exacerbation of losses between revenue and operating income. Costs incurred were drastically increased due to the introduction of new guest offerings at parks and experiences, and this was coupled with remuneration expenses for employees who were not performing services due to COVID-19. The rift between revenue and operating losses are hence a byproduct of increased costs and diminished revenues which created a multiplier effect on operating losses.

Verdict:

Even though the financial impact seems dire, the worse is unfortunately yet to come. The stated financial impact was only due to closures of from mid-March onwards , which is a relatively short lead-up time prior to the earnings report*.

Moving forward, we are likely to see revenue fall to almost zero given weak merchandise sales (weak demand for Mickey and Minnie & Avengers merchandise being only partially offset by higher revenue from Frozen merchandise).

Operating income will nosedive into the negatives due to costs still being accrued from maintaining viability of business lines despite no cash inflow from operations. This will eventually be a major pain-point for Disney’s bottom-line moving forward since this segment typically represents ~45% of Disney’s total operating income.

*A case may be made that Asian parks and resorts have been closed early in the quarter. However the Asian park and resort revenues only account for 12% of overall segment revenue compared to 75% from North America. Consequently, the full scale of closures have not yet been espoused in the latest financial statements.

3. Studio Entertainment (Revenue +18% | Operating Income -8%)

Increases in studio entertainment revenue from the prior year’s quarter were due to significant titles released which performed well at the box office e.g. Frozen 2 and Star Wars: The Rise of Skywalker as compared to Mary Poppins Returns and Dumbo in the prior quarter.

However, film distribution was adversely impacted by COVID-19 in consideration of theater closures beginning mid-March which attributed significantly to the poor box office reception of Onward. Together with bad debt expenses, the twin effect induced segment operating income to head into the negatives.

Verdict:

This segment historically accounts for a sizeable ~18% of Disney’s total operating income. I forecast studio revenues being hit adversely to a large extent this year after factoring both postponements to theatrical releases and potentially muted reception to theatrical returns*.

It definitely does not help that currently stalled productions will defer much of Disney’s studio pipeline. Expect heavily losses from this segment moving forward.

* Surveys by EDO on 6809 US moviegoers yielded results which showed that 45% of respondents would wait a few weeks while 10% stated that they would wait several months

4. Direct-to-Consumer & International(Revenue + >100% | Operating Income – >100%)

Here comes Disney’s (likely) saving grace.

The segment’s operating loss was driven by operating costs by the virtue of Disney+’s launch and consolidation of Hulu. Paid subscriber count has increased exponentially for Disney’s D2C services as shown below:

Figure 1a: Number of paid subscribers for Disney’s D2C services

Disney retains expertise in producing content for D2C channels through acquired subsidiary functions and propagates them to the masses via effective channels such as Disney+, ESPN+ and Hulu.

There has been a darth of new content since studios have paused production. The recent surprise success of Trolls 2 might push Disney to adopt D2C ahead of theatrical releases for postponed movies such as Mulan. If this happens, we can expect Disney to change its business model to remove reliance on studio entertainment in the longer run – but this is a topic for another day.

Recent releases of the 10-episode documentary titled The Last Dance hasinspired significant audiences while setting ratings records for ESPN, pointing to the larger story surrounding burgeoning consumption of on-demand viewing services with implicit demand for new releases. This bodes well for a post-pandemic Disney which can presumably churn out quality content pandering to the needs of their subscribers, effecting increased viewership*.

There has been some mention of how Netflix posses a significant threat to Disney’s operations in this segment. While I do not discount Netflix posing a major hurdle in Disney+’s expansion efforts, I postulate that there could be a false-dichotomy in such comparisons since subscribers have been shown in past surveys done by Deloitte Insights, to own up to 3 streaming services. There is definitely competition by these two firms but I suspect the situation is overblown to some extent especially since demand for shows on individual platforms can be mutually exclusive.

Nonetheless in the short run, Netflix stands to outpace Disney in terms of content creation since Netflix shoots far in advance, with public statements mentioning that their 2020 pipeline is well-stocked and only requires late stage production which can be done remotely. Post-pandemic, I definitely can see Disney having leverage over Netflix accruing from their capabilities in churn out new content via catalysts like live sports. Disney is also a highly diversified conglomerate with many business verticals while Netflix can sometimes appear as a one-trick pony. The abundance of revenue streams in multiple areas capturing post-pandemic demand all point to a higher upside for Disney.

*To clarify, Disney’s current main strategic thrust should be customer acquisition and relevant post-pandemic content strategies should be viewed predominantly as retention strategies

Verdict

By tabulating the estimated monthly revenue derived from paid subscriber count as of March 2020 and utilising average monthly revenue per paid subscriber figures, the estimated revenue per month (assuming subscriptions stay constant) is around USD 793M per month.

Figure 1b: Average Monthly Revenue / Paid Subscriber for Disney’s services
Figure 2: Calculation for estimated monthly revenue for segment

This revenue figure per month has a high probability of increasing over the next few months with subscription growth as Disney+ rolls out to other geographical regions. It has also been proven in numerous surveys that the current stay-home measures have had a positive impact on the average consumer’s propensity to spend on D2C services.

The segment’s operating loss is projected to be mitigated and might turn green by the year’s end since Disney+ has been generally developed and marginal costs incurred in operating the services will not be detrimental as initial implementation.

So… what’s next for investors looking at Disney’s stock?

Out of the 4 key revenue segments, 2 possess significant downside risk (revenues potentially being close to zero and operating profits plummeting to negative values). Furthermore, these two segments account for 54% of revenue and 64% of operating income in 2019.

Out of the remaining segments, positive growth in revenue and operating incomes will only be a possibility for the Direct-to-Consumer & International segment, assuming current adoption rates. It remains to be seen whether operating incomes will turn green, which can only be possible with competitive segment operating margins.

Expect increased financial distress to be reflected Disney’s income statement during the coming months. The recent quarter’s results were rather optimistic since the true effects of COVID-19 were reflected relatively late. Note that Disney does not have robust liquidity to carry its operations through this pandemic and recently raised debt totaling USD 10.92 billion at an A2 rating in May 2020.

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To sum it up…

Short – Mid Term

I would advocate staying out of Disney’s stock and monitoring the situation carefully. The excessive impacts on financial statements could drive stock price lower – to the USD 90s range. The only reason why it might remain in the USD 100s range would be due to long term investors piling up on Disney stock with the view of it being a good long term investment.

Long Term

Disney is an intriguing long term prospect because it possesses a very unique moat and almost insurmountable competitive advantage.

The company has had an irrevocable generational impact and a brand value of $44.4bn, ranking 10th in the world. Its incredibly strong brand equity has been built through concise development of brand stories and acquisitions of subsidiaries in line with their positioning to bolster their capabilities. It is due to these sensible actions made by management which ensure that Disney’s competitive advantage remains uneroded in the dynamic industry they navigate in.

No one has any doubts regarding Disney’s intrinsic allure. The Happiest Place on Earth will remain so when COVID-19 tides over and pent up demand could potentially drive record revenue and earnings growth, provided Disney has infrastructure in place to handle this newfound demand. Until then, investors have learnt over generations – to never bet against the mouse.

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