Description

Summary:

I am recommending a Walt Disney Company (“DIS”) short position to pair against the long position in FOX which I presented earlier this year on this site. DIS is a well managed company with great assets, but its P/E is ~30% higher than FOX and its TEV/EBITDA is ~40% higher than FOX. Note DIS’s valuation premium is ~50% if FOX’s non-consolidated assets (Hulu, broadcast spectrum, Edemol Shine and Tata Sky) are included. DIS has had a great run and done everything right over the last few years. However, at this point, I believe the market is overvaluing profit streams from DIS’s hit-driven and cyclical businesses and underestimating risks at ESPN. While FY 9/16e should be a very good year at the box office for DIS, over the next couple years (FY 9/17e and FY 9/18e), I estimate DIS will grow operating profits low to mid-single digits annually, while over a similar time frame (FY 6/17e and FY 6/18e), FOX will grow operating profits low-double-digits annually. Given its higher starting valuation and slower prospective growth rate, I believe DIS could underperform FOX by 30-40% over the coming year.

Details:

In case you haven’t heard, DIS’s Star Wars Episode 7 (“SWE7”) is coming to a theatre near you on December 18^th. This is the most widely anticipated movie in several years and is expected to generate well over $2bn globally at the box office. Many commentators are expecting SWE7 to be the highest grossing firm ever. The current record holder is Avatar (released in 2009) which took in $2.8bn global box office receipts. The highest grossing film in 2015 (and #3 all time) is Jurassic World which made $1.7bn globally. My opinion is that anything below $2.5bn global box for SWE7 will be considered a disappointment. I believe enthusiasm for SWE7 has clouded investors’ vision on DIS’s slowing prospective growth rates, leaving the stock poised to disappoint after the “catalyst” of this film release has passed.

SWE7 along with other upcoming movies in FY 9/16e (e.g. sequels for Finding Nemo, Captain America and Alice in Wonderland) have the Studio Entertainment (“Studio”) division poised for another record year of profits in FY 9/16e. The past two fiscal years have been very strong for DIS as each year had 5 films that grossed >$500m global box office and each year had a >$1bn global box office film (Frozen at $1.3bn and The Avengers: Age of Ultron at $1.4bn). DIS has very strong intellectual property assets but is highly exposed to animation and superhero movies. Of the 10 DIS films that generated >$500m in global box office over the last 2 years, 8 of them are in these two genres. Since both of these genres have generated outsized profits, it’s not surprising to see major Hollywood studios investing billions of dollars to make a lot more of these types of films. From 2011-2015, the major Hollywood studios released 5-7 animated films and 3-4 superhero films per year. In 2016-2017, I estimate the major studios are releasing 10 animated films and 7 superhero films per year. Although Hollywood films are certainly not fungible commodities and DIS has a reputation for making better than average movies, I believe the massive increase in capital invested into two film genres increases the risks of box office disappointments.

DIS’s consumer products (“CP”) division helps DIS monetize Studio’s films via licensed sales of toys, apparel, etc. Combined with its interactive division (DIS is collapsing these two segments going forward), CP did $1.88bn in EBIT in FY 9/15. Since DIS has a unique ability to monetize its major film franchises through licensing arrangements, I think it’s instructive to look at profits from the Studio and CP segments together. On a combined basis, these two segments did $3.02bn of EBIT in FY 9/14 (first full year after Lucas acquisition) and $3.86bn of EBIT in FY 9/15 (26% of DIS's total segment operating income).

Consensus estimates are for these two segments to generate $4.42bn of EBIT in FY 9/16e. Bullish investors view this $560m YoY increase in EBIT as conservative and expect SWE7 to drive >$1bn profits YoY for DIS as a whole. To help frame the downside risk from shorting DIS into a SWE7 upside performance, let’s assume that SWE7 drives a $1.2bn YoY increase in EBIT across CP and film divisions (instead of $560m). This results in ~5% upside to consensus EPS expectations for FY 9/16e. Even accounting for DIS’s strong licensing operation, I think $1.2bn of operating profits from SWE7 looks optimistic as FOX’s film segment saw a ~$450m bump in EBIT the fiscal year they released Avatar. I also view a SWE7 blow-out performance as a mixed blessing, as the better the film does the more difficult the profit growth comparisons will be in future years. Whether SWE7 does well or very well, FY 9/16e will likely be a very high base, therefore I think the Studio and CP division profits could struggle to grow in FY 9/17e and FY 9/18e (vs. consensus expectations for mid-single-digit operating profit growth in those years).

In addition, I think investors are too complacent about DIS’s Media Networks (“MN”) division which generated 53% of segment operating profit in FY 6/15. MN is comprised of cable networks (mainly ESPN and Disney Channels) plus the ABC broadcast network. ESPN is by far the most important asset in the segment and I estimate ESPN generates ~70% of MN profits and 35-40% of DIS’s total segment operating profits. While sports are “must have” content that is still watched live in today’s on-demand world, ESPN has already leveraged this position to extract a massive share of the economics in the multichannel video bundle. Industry sources (Kagan) estimate that affiliate fees/sub/mo for ESPN are ~$6/sub/mo. When you add related ESPN channels (such as ESPN2 and EPSN News), the cost is ~$8/sub/mo. This is ~20% of the total ~$40/mo content costs for a multichannel video subscriber. Because ESPN is such a high cost channel and live sports aren’t that important to a large segment of the population, I think ESPN is more subject to cord-cutting / skinny bundle risk that the market appreciates. In DIS’s 10-K, they disclosed that ESPN subscribers fell 7% over the last two years. Though management points out their paid sub declines are less than these industry-reported figures (due to contractual protections), they are unwilling to give the actual numbers. I think one can assume that subscriber losses will continue going forward. Thus, I believe MN revenue growth could slow to low-single-digits going forward. If I am wrong about continued cord cutting causing MN revenue growth to decelerate, then I will likely benefit more on my FOX long. On the cost side, DIS has >$5bn of annual sports rights costs that are fixed and contractually grow at a mid-single-digit rate. DIS also has its NBA contract stepping up in FY 9/17e, which could be an additional $500m increase in costs in that year. I think the combination of moderating top-line growth and growing costs could lead to minimal operating profit growth for MN in FY 9/17e and FY 9/18e.

Finally, DIS’s Parks and Resorts (“Parks”) division generated 21% of segment operating profit in FY 6/15. Let me point out a few facts to illustrate that DIS theme parks are a relatively expensive discretionary spend category that exhibits historical cyclicality. Average per capita spending at a Disney theme park is estimated to be ~$140/person/day (not including lodging and travel). Per capital spending growth at Parks has a 0.7 correlation with hotel industry RevPAR. Parks generated $3.03bn operating profit in FY 6/15 on a margin of 19.0%. Over the last 13 years, Parks' operating margins have averaged 15%, so 19% is an all-time high. During the last recession, Parks' operating profits dropped by ~30%. Meanwhile, consensus estimates are for Parks' operating income to increase to $3.24bn in FY 6/16e, $3.78bn in FY 6/17e and $4.05bn in FY 6/18e. These consensus estimates assume a 10% operating profit CAGR and EBIT margins hitting a new record high of 20%. DIS is opening up a new theme park in Shanghai in the spring of 2016 which is driving the consensus estimates. At this point, I don’t have a highly differentiated view that Parks' earnings will fall short. Thus, I am simply pointing out that there might be cyclical risk to these estimates.

Putting this all together, DIS has 53% of profits coming from MN and 26% of profits coming from Studio + CP, and all three divisions could struggle to grow beyond FY 6/16e. The remaining 21% of profits comes from Parks, which is currently doing very well, but has a history of being cyclical. Thus, I think DIS operating profits as a whole are likely to grow low to mid-single digits annually in FY 9/17e and FY 9/18e. This is a big deceleration from FY 9/11 to FY 9/16e operating income CAGR of 13-14%. I believe that as profit growth slows, DIS’s premium valuation is likely to contract.

Catalyst

Release of SWE7 could be "sell on the news" event

Recognition that profit growth rates could materially slow would result in valuation multiple contraction