Description
Disney (Walt), NYSE – DIS, $17.10 (1/25/03)
Disney, while not the typical VIC company, is trading at roughly 60% of value and owns several great franchises, some of which are currently at very depressed levels. Many analysts and “talking heads” think Disney has lost its magic. An 11/4/02 cover story in Barron’s started off “The Magic Kingdom is in disrepair.” What could be better for a value investor? As Warren Buffet has said, "Most people get interested in stocks when everyone else is. The time to get interested is when no one else is."
Business Summary:
Disney operates in four main divisions (Fiscal year is 9/30):
1)Media Networks (38.3% of 2002 revenue, 35% of 2002 operating income)
2)Parks and resorts (25.4% of 2002 revenue, 41.4% of 2002 operating income)
3)Studio Entertainment (26.6% of 2002 revenue, 9.6% of 2002 operating income)
4)Consumer Products (9.6% of 2002 revenue, 14% of 2002 operating income)
Media Networks (38.3% of 2002 revenue, 35% of 2002 operating income)
The media networks division can further be broken up into two segments: Broadcasting and Cable Networks. Broadcasting is the ABC network (owned and operated TV stations, radio stations, TV programming, and TV distribution). Cable Networks consist of ESPN, Disney Channel, Toon Disney and SoapNet as well as a variety of partial stakes in several other networks. This list includes Lifetime (50%), E! Entertainment Television (39.6%), A&E Network (37.5%), The Biography Channel (37.5%), and the History Channel (37.5%).
While the media networks division contributed 36% of 2002 operating income, this came entirely from Cable Networks as Broadcasting had an operating loss of $34 million in 2002 due primarily to poor ratings at ABC and a soft advertising market. ABC’s overall ratings ranked dead last out of the three major networks last year. The advertising market has shown some signs of improving but rebuilding ABC is one of the company’s highest priorities. ABC is facing somewhat of an uphill battle as higher programming costs are expected in 2003. They face $70 million in incremental costs alone for this year’s Super Bowl. Predicting results for ABC is difficult at best, but given the operating leverage of this business any improvement will add significantly to the bottom line. Getting back to peak 2000 profit levels for ABC will take several years but they seem to have already hit the bottom and are improving. The question in my opinion is not will ABC be fixed, but when. It wasn’t that long ago that “Who Wants to Be a Millionaire” had the network on top.
Cable Networks on the other hand, has performed extremely well accounting for 18% of fiscal 2002 revenues and 36% of operating income. This segment has the highest operating margins of any of the company’s businesses at 22% in 2002. ESPN is the key driver for this segment and has roughly 247 million subscribers. Ninety percent of cable affiliates ranked ESPN as the top network in terms of supporting subscriber retention. ESPN is simply a “must-have” for cable operators. Over 50% of ESPN’s revenues are subscription based so it is not as dependent on the advertising market. ESPN will also be affected by higher sports costs, but ESPN has contractual 15% – 20% annual subscriber fee increases that will continue for the next several years. The ESPN brand name has become increasingly more powerful as they have successfully cultivated derivatives of the original network including ESPN2, ESPN Classic, ESPNews, ESPN Magazine, ESPNZone, ESPNRadio, etc. The other cable networks are performing well too and fit in well with Disney’s overall family entertainment strategy. The Disney Channel has 80 million subscribers and has grown from 18 million in 1996. Toon Disney has 34 million and was launched only 2 years ago. Soap Net has 22 million subscribers and great operating leverage as their programming includes shows that have already been produced for ABC so their incremental re-airing costs are very low. Overall, the cable networks division is performing very well and I would expect it to grow the top line at low double digit rates for the foreseeable future.
Studio Entertainment (26.6% of 2002 revenue, 9.6% of 2002 operating income)
Disney’s studio entertainment division produces motion pictures, television animation programs, musical recordings and live stage plays and distributes the same to theaters, television, home video / DVD, etc. The success of these operations is heavily dependent on public taste and as such fluctuates widely from year to year. They distribute their products under the following banners: Walt Disney Pictures, Touchstone Pictures, Miramax and Dimension. They expect to release approximately 55 feature films in fiscal 2003 including a re-release of 1994 hit The Lion King. A major portion of the value in this division is the huge library of titles they already own. As of 9/30/02 there were 940 titles available to the domestic home entertainment marketplace and 1,641 available to the international home entertainment marketplace. This division has been the subject of some sour news in the last few years as Disney has struggled to produce a “blockbuster” since 1994 with The Lion King. The big hits since then have been developed in connection with Pixar whose contract with Disney only includes three more feature films (Disney retains the rights to sequels of the Pixar movies though). The dependence on the ever changing and fickle taste of the public makes projections for this division very difficult. However the large library and the boost they are likely to receive from “re-releasing” their library on DVD as more and more households become DVD users should provide a powerful boost to earnings as the margins on re-releases are huge and almost risk free.
Theme Parks & Resorts (25.4% of 2002 revenue, 41.4% of 2002 operating income)
Included in this division are all five of the top five theme parks in North America and seven of the top 10 theme parks world wide along with resorts and hotels totaling approximately 24,000 rooms. The theme parks and resorts have performed slightly worse than the rest of this industry during the economic downturn and the 9/11 aftermath. This is primarily because Disney is a “destination” park company as opposed to say, Six Flags which has been written up on VIC. They also have a great number of international travelers. The two drivers of revenue growth here are attendance and pricing. Attendance has been down but pricing has remained steady (a tribute to the “irreplaceableness” of the theme park assets). Disney’s most recently built parks are mostly joint venture projects of some sort which are great uses of the company’s capital. These limit the investment risk by Disney, but more importantly provide a more stable, franchise like management fee to Disney. The company has several attractions planned for the next few years to drive revenue growth.
I would be remiss not to discuss the impact a war would have on the theme park division. Obviously it is not positive, but how negative is it? Disney’s attendance fell 4.5% in 1991 during the Gulf War and about 10% after 9/11. Assuming flat pricing levels, I estimate that a 1% decrease in revenue for this division would cut $.01 from the EPS. So the impact could be sizeable, but not earth shattering. I am not (and don’t want to pretend to be) a predictor of short term markets, but I would expect “Mr. Market” to really impact the stock price if something unexpected happens in the near future. However, the value of the business will decrease with an extended war, but not as significantly as one might expect. I believe a short conclusive war is already priced into this stock.
Consumer Products (9.6% of 2002 revenue, 14% of 2002 operating income)
The consumer products division licenses toys, goods and apparel and owns the Disney Stores that sell all of the Disney merchandise. About one half of the operating income comes from licensing the core characters like Winnie the Pooh, Mickey Mouse, etc and another 20 percent from licensing other characters from animated films. The remaining 30% is from publishing and the Disney Stores. This segment has been in the midst of a turnaround for several years after they overly saturated the market and profits stayed flat for some time. The progress has been very slow due to the 12 to 18 month lead time in the licensing cycle. The company believes the restructuring efforts should begin to payoff in 2003.
Sum of the Parts Valuation
I valued the Cable Networks division on a per subscriber basis with each subscriber being valued at $20 except for subscribers to Disney Channel and ESPN which I valued at $35 and $45, respectively. The dominating position and huge moats that these two assets have is worth a premium to most cable assets. I get a rough enterprise value of $24 billion for the cable networks division. The Broadcasting segment was more difficult to value, but I think it is worth roughly $9 billion. While this is somewhat difficult to quantify, I have assumed a steep discount to the other networks based on the poor ratings of late. I value the Media Networks division at $33 billion. I have separately valued the partially owned cable networks using the same metrics.
The Theme Park division, I applied a 12x EBITDA multiple. Again, the theme parks are unique and irreplaceable in my opinion and deserve premiums to most other theme park / resort companies. I get a rough enterprise value of $23.4 billion for the theme parks division. Separately, I have valued the partially owned theme parks using similar metrics
I valued the Studio Entertainment division at roughly $11 billion. I based this on a comparison to precedent transactions (Sony aq. Columbia, Viacom aq. Paramount, Seagram aq. MCA/Universal) and incorporated a premium for the huge library that Disney already owns.
I valued the Consumer Products division at 10x EBITDA, or $5.5 billion. I subtracted $2 billion from EV for corporate expense, etc. I have summarized this in the table below:
SUMMARY
Media Networks 33.0
Studio Entertainment 11.0
Theme Parks & Resorts 23.4
Consumer Products 5.5
Corporate (2.0)
Enterprise Value of Consolidated Assets 70.9
DisneyLand Paris 1.2
Other Partial Cable Stakes 3.3
20% Minority Interest ESPN (1.8)
Total Enterprise Value 73.6
Less: Net Debt (12.0)
Value of Equity 61.6
Shares 2.0
Equity Value Per Share $ 30.80
There is plenty of room for discussion regarding any of the underlying assumptions or multiples I used. I think the company is undervalued at current prices but by how much is debatable.
Why is it down so much?
ABC has been a huge drag on earnings. The Theme Parks were starting to struggle before 9/11 and haven’t really gotten back on track since. Disney has struggled to produce a blockbuster movie of late. The prospect of a war with Iraq has people a little scared about the theme park business. I believe the problems at ABC and the Theme Park are temporary and are likely to be fixed in a year or two. Disney certainly has the ability to produce a blockbuster movie but predicting something like this is a little out of my league. However, they should really begin to reap some benefits from re-releasing films from their library as more and more households become DVD users. I have attempted to provide some perspective as to how depressed current earnings are with the analysis below.
How Depressed are the Recent Results?
Only to provide a little perspective on how depressed recent results are I have provided a brief summary of the best and worst years for each operating division over the last seven years in terms of operating income (millions).
Worst Results Best Results
Broadcasting (34) 1,195
Cable Networks 497 1,166
Studio Entertainment 76 1,079
Theme Parks & Resorts 990 1,619
Consumer Products 394 801
Total Operating Income 1,923 5,860
Now compare this to actual fiscal 2002 operating income of $2,500. Realize too that the best results above are previously achieved in the last seven years, not an unachievable projection or crazy “pro forma”. If the prior best was achieved in all of the divisions it would be an increase in operating income of 234%. Obviously, this is nothing to base a valuation on because improvements are definitely needed in certain areas. It would be outrageous to assume that all of the divisions will meet their prior best performance right away, or all in the same year. However, it does provide some perspective on what is possible if everything is going well and how depressed current earnings may be.
Business, People, Price (In my opinion, the three most important aspects of an investment decision)
Business: Is the business model understandable – yes. Do they have a sustainable competitive advantage – yes (ESPN, the Theme Parks and the film library are irreplaceable; the consumer products are natural extensions of the library and theme parks).
People: Many will argue this point saying Eisner is overpaid and has lost his magic, but is he properly vested – yes. Is he passionate about it – yes. Is he hands-on – yes. Is he committed to fixing ABC – yes. Is he a good capital allocator – yes (his purchase of Disney shares after 9/11 has to be one of the best capital allocation decisions of his career)
Price: Some will argue over the value of the business but no matter how it is valued it has to be worth more than $18.00 and I would venture to say it is worth $30+. Regardless, there is a sizable margin of safety for a business that has huge economic moats.
Risks
1) Another terrorist event
2) Long drawn out war with Iraq. I believe a war is already priced into the stock. A short quick war would be a possible catalyst.
While either of these will almost surely have a negative short term impact on the stock price (and value to the extent the theme park and resort business is affected) the long term value of the whole business will change very little. Will people stop watching paying for ESPN if there’s a terrorist attack? Will little girls stop wanting to be Cinderella (and buy the products)? I think as Warren Buffet has said “volatility is the admission ticket to superior long term results”. Any significant decrease in the stock price will be an opportunity to purchase a great business at an even greater discount to value.
Catalyst
Catalysts
1) Improved ratings for ABC
2) Hardening of the advertising market
3) Improved general economic conditions and improvements in consumer confidence (increased theme park attendance)
4) Short, quick and conclusive war with Iraq.
5) Release of blockbuster movie
6) Valuation