Marvin Samuel Tolentino Pineda
I bought more Disney (NYSE:DIS) on May 7, when it sold off post its Q2 earnings reveal. By the time this is published, the stock will be up and down, I’m sure, but I thought at the time that the market overdid the punishment for a slight earnings miss.
The story now is cost-cutting. Yes, all shareholders want revenue to grow, but with linear still declining and with the company stating it may have to release fewer films to compensate for contraction in box-office potential, the focus on cost-control and cash flow should be a welcome aspect of the story at this particular time (at other times, I will certainly alter my opinion when appropriate).
I’m going to highlight a few of the numbers and discuss some of the qualitative aspects of Disney’s current state. You can bet I’ll have something to say about fewer films in the marketplace (not necessarily a fan of that approach) and the approach to streaming for D+.
I continue to believe Disney makes for a solid investment idea if you plan to patiently hold it for the next several years (and beyond, if you can). Averaging in is requisite, even if you want to do some shorter-term investing (say, a few months or so). (Besides a long-term position, I do swing-trade this name from time to time in a separate short-term account, as I don’t mind if I get stuck with it because of incorrect timing. Please be advised that swing trading can be extremely risky as compared to buy-and-hold.)
The reason I believe it continues to be a good long-term idea is because the parks division offers significant flexibility for the company…CEO Robert Iger is focusing capital allocation on that division as it delivers excellent ROI and it serves as a core business which drives investment in other areas. The company’s IP will help to balance out the transition out of a reliance on linear, and Disney serves as a master class in how to fully monetize storytelling via rides and screens and consumer products…that’s its edge. Plus, I like motivated management, and with Bob Iger back to finish what he started, my bet is he won’t fool around given that he must feel that his legacy is on the proverbial line. Disney isn’t cheap relative to sector median, but it isn’t too bad relative to its own five-year metrics. It is also thankfully off its 52-week high of $123 (time of writing) for those who may be thinking of initiating a position (or adding to an existing one).
Q2 In Brief
Here are the numbers I find interesting:
- Free cash flow of well over $3 billion (for the six-month frame) versus a use of cash in the previous year
- The company believes it can deliver $8 billion of free cash for the full fiscal year (and I assume it will deliver a little more than that as fiscal discipline continues)
- Linear-network ecosystem continues its slow decline, seeing operating income for the past six months drop roughly $300 million to $2 billion
- Direct-to-consumer generated $47 million in positive income for Q2, and lost roughly $90 million during the last six months against $1.5 billion in the comparable frame
- Debt now stands at $39.5 billion versus a little over $42 billion in the last reported period (get a little more aggressive here, Disney!)
- The cash hoard on the balance sheet dropped from a truncated $14 billion to $6 billion, which presumably helped get the debt down (Iger once said it wasn’t Disney’s intent to hoard cash, but that was a long time ago…I hope to see higher cash levels as we progress further through the fiscal year)
- Core D+ subscribers: 117 million (decent sequential growth); Hulu subscribers: 50 million (not much growth here, and the live-television portion isn’t gaining traction at all)
Overall, I like the stats. Debt is on the correct path, free cash flow is back in vogue, and DTC is reducing long-term losses. Revenue, yes, is stagnant at $22 billion, but as time goes on, and as the economy improves and the company continues its transition from reliance on linear to reliance on DTC, and as management injects more capital into its park assets, I am going to assume the top line will take care of itself.
Anyway, there may be other things to consider…
Thoughts On Disney’s Future (Short-Term, At Least)
Note on this section: As a quick disclaimer, please keep in mind much of the following is my own speculative musing on how the company might use its ecosystem with streaming going forward. As such, none of this is guaranteed to happen, and I do not advance that reporting exists that any of it is currently being considered by management.
Direct-To-Consumer Streaming
One of the reasons many of us call Disney a long-term stock is because it is hard to imagine the company disappearing; it is utterly iconic, it monetizes storytelling very well, and it has a differentiated set of characters upon which to call in the name of shareholder value.
That doesn’t mean everything is straight up, and that Disney won’t at times serve as a trading vehicle or a value play – i.e., it could stay in a range for a while, or could stay low for a while.
It could be said of any stock, perhaps, but in Disney’s case, it behooves us all to remember that just because it owns solid IP franchises and park-gates that are the envy of competitors, it doesn’t mean all the sailing will be smooth.
Let’s first consider DTC. That comprises the streaming services: D+, Hulu, and the sports-centric E+.
The company is doing well with getting to profitability, but the recent announcement that it will team up with Warner Bros. Discovery (WBD) to create a collection of services for potential new subscribers (and as a way to reduce churning customers) makes me think Iger wants to focus on advertising as the main way to increase average-revenue-per-user, since presumably that alliance might cause, depending on the deal structure with WBD, subscriber prices to be a little less attractive in such a model (perhaps no different from the wholesale model of a phone company offering D+ for free depending on the consumer contract).
Advertising is the new buzzword in streaming. That goes for Netflix (NFLX) too. The key things shareholders will need to watch, and management will need to focus on, is maximizing ad load. My anecdotal impression is that streamers don’t currently program as many ads as they should. The hope certainly is that ad loads can be adjusted higher without causing too much resistance. Perhaps artificial intelligence can help determine the ideal approach; actually, if AI truly is the technological savior that speculative prices predict, one assumes it will have a successful role in figuring out optimal practices for advertising.
Besides ad load, I hope Iger considers using the platform for other kinds of commercial content…for example, with Hulu, imagine if a studio paid to place a twenty-minute short film that served as a lead-in to a new movie ready to hit the box-office marketplace. Presumably that could be on no-ad tiers as well, maybe with a disclaimer that it was paid placement (or maybe not, depending on regulations). D+ might take on an animated series from a toy company looking to sell its wares.
Another thing to consider, especially with the Warner Bros. announcement, is that Disney is essentially conceding that the high-volume content strategy, which it sort-of switched to at some point, no longer will work given the losses management is now attempting to fight (and the quarterly numbers indicate that the battle is progressing well so far). Higher volume of content in theory combats churn, but Disney is ready to face churn head-on, as well as, simply put, pure growth challenges in user growth. In other words, Disney will have to push the subscriber count higher via such bundling, whether with partners like WBD or perhaps in concert with linear operators, or even with retail partners (e.g., a brick/mortar chain might offer a service bundled with some other service, such as shipping, as happened in this case), to keep on track for the predicted scale of the D+ service that the company is adhering to: between 215 million and 245 million by the conclusion of this year. That had been adjusted down from the original investor presentation when D+ launched (for the count to exist somewhere between 230 million and 260 million).
To contain costs, content will have to be reduced. Including theatrical content. That’s a problem for D+ and Hulu because content from theaters helps to power the streaming services.
But does it have to be reduced? Before I get into that, let me pull a quote from the earnings call. This centers on Iger explaining how the company will now favor quality over quantity:
I’ve — we’ve been working hard with the studio to reduce output and focus more on quality. That’s particularly true with Marvel. I know you mentioned television shows. Some of what is coming up as a vestige of basically a desire in the past to increase volume, we’re slowly going to decrease volume and go to probably about two TV series a year instead of what had become four and reduce our film output from maybe four a year to two to the maximum three. And we’re working hard on what that path is.”
Well…I don’t necessarily agree with this approach. I get it, certainly, but…
It’s interesting because those who can remember the good old days of VHS and DVD, particularly when what was called rental prices (the higher cost of a tape/disc that video-rental chains and mom/pop locations would pay for rental copies) gave way to sell-thru prices, will recall that industry as a marketplace which served as a nice risk-mitigator for film investment (i.e., a film would stand a decent chance of recouping costs if it failed at theaters). Streaming was supposed to be the modern version of that hedge. And, simultaneously, it would be the beneficiary of all that hedged output (i.e., increased volume of content available to streaming equals increased subscriber count).
But now, content needs to go down. But…does it really need to do that?
Content Budgets Should Be Reduced…Not Content
Consider the following: a movie that doesn’t exist yields exactly zero dollars in profit to a studio. The movie may not exist for a whole host of reasons, but in this case, it’s because Disney is aggressively cutting costs and optimizing ROI…in other words, lately, people aren’t buying as many projected tickets for Lucasfilm/Pixar/Marvel productions. Why is ROI so hard and risky in the movie business? For me, the answer is because top talent costs a lot of money, especially talent on the screen.
If streaming truly is a hedge instrument that needs content to thrive and synergize with the rest of the Disney ecosystem, why not simply make lower-budget Marvel/Pixar/etcetera stuff and sacrifice some theatrical revenue? Put another way: use cheaper talent, great storytelling (those two things are not mutually exclusive, by the way), and an efficient ad campaign (focusing on platforms the company owns) to stack the deck in favor of acceptable ROI. Iger could experiment with such a model and see where it leads…why not? Remember: not much is expected of a movie that doesn’t exist, so one that does, one that might just use a theatrical run as an advertisement for ancillary distribution channels, could turn out to be a hit, one that births a new franchise. Imagine Pixar doing films more quickly, maybe not being as perfectionist, with great stories/concepts voiced by unknown (yet talented) talent that doesn’t yet have high compensation quotes…that might be a useful way of incubating new cartoon franchises and creating a cadence of product that doesn’t break the bank (and still supplies volume to D+/Hulu as well as theaters). Whereas normal tent pole material might cost between $200 million and $300 million, imagine a Star Wars film made for between $50 million and $75 million…yes, it can be done, and arguably has been, on the smaller streaming screen. Adjust the approach a bit to make it more cinematic, and see what happens.
On Linear Depression And Bundling
I think shareholders need to prepare for the idea that D+ isn’t what it was supposed to be in the beginning…either the equal to Netflix (and let’s be honest, if we all remember the excitement over the impending announcement of the service, everyone thought the IP was going to be enough to become the next Netflix) or, at the very least, the closest second-place winner in history.
Now, it’s all about the bundling…whether that be the D+/H/E+ bundle, or the WBD/DIS bundle, or the D+/Hotstar combination, or any other number of configurations going into the future. Netflix doesn’t need to do any of that. So, when I ponder it all, I come to the conclusion that advertising and promotional bundles will be the ultimate driver of success, not necessarily rampant subscriber growth quarter-to-quarter. D+ will increase in scale over time, but there will be moments of scale-backs that will be as scary as a ride in a haunted mansion.
Which brings me to the whole linear issue. Linear is on the decline, famously, and as I watched some CNBC discussion on the topic, I heard an extremely interesting question posed about the problem: paraphrasing to its basic component, what is the ultimate terminal run-rate destiny of linear? Will it ever cease approaching zero?
There was no forthcoming definitive answer, but at the end of the day, linear will still be around in some capacity for a long time with the company. I’ve always found linear to be an important part of the Disney cross-promotional engine, and I think broadcast/cable can serve as instruments of incubation for intellectual properties. It may be that, for the survival of cable and content companies, both will need to aggressively compromise into existence a model that considers the needs of multichannel-video subscribers, programmers, and content suppliers…if economic value is to be generated, and hopefully increased over time, then perhaps fees paid to the suppliers (i.e., from cable companies to media conglomerates) will need to be reduced and the whole question of content production needs to be rethought.
In fact, in this article at a trade publication about cost-control in Hollywood, an anonymous industry insider mentioned a particularly important consideration: commenting on the reduction in star-driven production packages, the person noted that if you think about a show such as Stranger Things, one would consider that a star-maker as opposed to something that needed a star to be successful. Pause to really let the profound implication of that sink in: if companies such as Disney focused on creating star-maker content as opposed to star-dependent content, what would the ROI on the spreadsheet look like then? Going back to artificial intelligence, will AI help in identifying which projects to green-light based on such a requirement? Is the company, even as I write, working on AI models to answer such questions?
I would hope the answer is yes (again, what is AI for but this?), and I would hope AI is around to answer the aforementioned linear-terminal-run-rate problem. The concept of star-maker content is the same thing as which is king: platform or content. Sometimes it’s content when the platform is starting out; then it becomes a platform when scale is reached. Put another way: would Sylvester Stallone rather his reality show be on Paramount Global’s (PARA) streaming service or Netflix? And all of this makes me think that linear – ABC, the cable channels – should think like a streamer and program a lineup that really goes for the edgy quality of the kinds of hits one sees on HBO or Netflix; that could be one of linear’s only hopes for eventual recapture of a thriving business model.
And yet…this idea that linear woes have, broadly speaking, led to Disney now being in a position to rely on streaming so much that it has to join corporate forces with Warner Bros. Discovery to keep up with the ‘Netflixes’ of the world (or, I should say, the Netflix of the world), conjures up another round of contemplation about the IP portfolio…is it enough, or will Disney need to acquire more IP at some point? If Disney can no longer slate four Marvel movies in a calendar year, and if it has pulled back on Wars films after the Solo debacle some time ago, and if Pixar likewise is having issues (issues that have Iger wishing for more sequels from the animation outfit and less risky originals), then it would seem that Disney needs more characters to exploit. It’s been close to twenty years since Iger purchased Pixar…maybe that, and other acquisitions, are maturing?
Well, one thing’s for certain, in my mind: failed recent outing or not, the company better green-light another Indiana Jones feature to start picking up some slack (and none of that nonsense about it not being viable to recast the role)…which is my way of saying that less Marvel and less Lucasfilm create a deficit that needs to be filled. If Disney didn’t acquire Fox IP and didn’t have a lot of debt on its books, one would have to wonder if it would have pulled what Sony/Apollo/David Ellison want to pull – an acquisition of a studio slate/library (Paramount) via buying a conglomerate and selling off the pieces – but with WBD instead, mostly to get at DC. Something like that might only compound superhero fatigue…but then again, maybe it would help.
Licensing – The Superhero Shareholders Need
And then we return to the licensing issue, which Iger has mentioned before. From the call, Iger speaking:
We are already doing some licensing with Netflix and we’re looking selectively at other possibilities. I don’t want to declare that it’s a direction we’ll go more aggressively or not, but we certainly are taking a look at it and being expansive in our thinking about it. We had previously thought that exclusivity, meaning our own product on our own platforms, had huge value. It definitely does have some value. But as you know, we’re also watching as some studios have licensed content to third-party streamers, and that creates more traction, more awareness and in effect it increases not only the value of the content from a financial perspective, but just in terms of traction. So, we’re going to — we’re looking at it with an open mind, but I don’t think you should expect that we’ll do a significant amount of it.”
Memo to the CEO: Go more aggressively on it!
I believe this is a future opportunity for the company in the face of declining linear stats. I detect a change in tone for the better, as licensing can bring in some much-needed revenue as well as do exactly what he said it could do: promote the company’s brands and platforms by being on other platforms. And I want to be clear on what I believe he is talking about (just my opinion), and what I mean in terms of aggressive licensing: once content has been on D+ for a while, or even on Hulu, start selling it to other platforms, whether it be Netflix, Paramount, or Amazon (AMZN). And I mean the big stuff. And I mean non-exclusive basis. If a Wars series seen on D+ is on its fifth season, then the early ones at the very least need to be showing elsewhere. It makes sense (and dollars). We know the company is willing to license content that isn’t differentiated (such as Disney’s Touchstone-label projects from the 1990s) by IP branding, but the big stuff, well, that has remained under lock-and-key. Exclusivity is needed initially…but it probably has a built-in expiration date, a half-life that needs to be acted upon and exploited.
Licensing can go both ways, too – besides selling content produced by the studio, Disney may want to explore increasing its licensing of content from others. And there might be a very specific angle to consider.
There has been some talk that content produced by another party, specifically content that remains owned by an entity other than Disney, may help to decrease costs. When you think about it, if D+ runs an outside-owned series for a year and then lets the license expire, essentially what that says to the producer is you have to amortize the rest of your costs (or generate most of your ROI) by taking that content and selling it to others (or even on physical disc). Disney is not on the hook for the cost-plus model under which D+ would buy out the backend of above-the-line talent for the privilege of owning the content. This isn’t to imply that Disney doesn’t want to own self-funded/self-produced streaming series/films…but D+ could increase the volume of content by leaning more into the traditional linear model of ordering content from outside, independent suppliers. Think about a special such as the Taylor Swift concert…if Disney wanted to buy that out entirely, how much would it have cost for production and backend combined? I would presume a lot more than $75 million. As it is now, D+ can capture some of the halo Swift effect and then allow it to move on to other platforms after the licensing period ends. Besides specials, many producers/suppliers, big and small, probably would be willing to license shows and movies to Disney for fair amounts given it’s one of the two major streaming platforms – going back to my point about content-versus-platform, it’s probably better to be on D+ than P+…and once the new-subscriber-signup return is exhausted from a new piece of content, it makes sense to let it go and count whatever advertising revenue was achieved and call it a day.
Disney will figure all this stuff out eventually. Sooner rather than later would be appreciated by the shareholders. And following that, I’m sure there will be other adjustments needed and other problems to solve as new outside changes/pressures emerge. I think the next five years will see all of this stuff addressed; after that, it will be time to reimagine what Disney will need to do next.
Valuation
Bringing this to a close, let me segue to valuation. Right now, the SA factor-grade system places a very low rating on the price, deeming it expensive to the sector-median stats. Digging deeper, the stock is possibly inexpensive given valuation relative to Disney’s own five-year average. For instance, on cash flow, forward basis, the shares are trading well over 30% better than the ratio’s average over that time period (17 versus 27). And cash flow (as well as the non-GAAP free cash flow) is an evolving story set to improve. The P/E ratio on this basis also seem attractive. However, in both cases, the sector wins out: with P/E forward, it’s 21 versus 13, with the sector median being the latter number; five-year average is over 40. For cash flow, the sector is about half of Disney’s current performance. (All as of this writing.)
One ratio I would like to see improve – and is arguably a reason for buying on pullbacks – is the PEG ratio (forward basis). Right now, it is in line with the sector median: 1.33 versus 1.31. The five-year average is above 3, so by that comparison, things are looking up. Something closer to 1 would be better in this situation as below 1 is considered undervalued for the metric; in Disney’s case, however, one would expect to pay some sort of premium for the quality assets.
EV/EBITDA is another example of good for the company but bad relative to the sector. Currently, that rates as 13 versus 7, in favor of the sector. But DIS stock has seen that metric average over the last five years, well above 20.
How should we interpret all this – specifically, DIS compared to itself versus sector median? My take is that this is an indication that the shares do not represent a deep-value play and still possess risk, but considering the brand and assets, averaging in on down days and aggressively avoiding price surges is the way to go. (Shorter-term traders, or those who really want more ideal prices, would definitely want to wait for price action a bit below $100, assuming we do get there – which we certainly might, given market volatility, Fed pivots, and Treasury rates. However, there is the risk that the stock could go even lower, given the 52-week low is at $80. There could be some negative catalysts, particularly from the Fed’s fight on inflation, that cause financial disruptions and extreme market volatility. Again, keep in mind: short-term trading is very risky.)
Comparison To Competitors
For how Disney compares to other peers, here is a ranking of stocks in the sector of movies/entertainment. At the time I brought up the link, DIS ranked in ninth place. Companies such as IMAX (IMAX) and Netflix have higher quant ratings, as one might expect, and even Lions Gate Entertainment (LGF.A) and Spotify (SPOT) outrank the Mouse. Most of the stocks mentioned have challenged valuation ratings, but score better on momentum and other factors. Keep in mind, though, the following – Disney continues to right its ship, and being ranked not as high as others might be an advantage as the company improves its cost structure. Let’s consider a specific comparison example with a peer: Netflix has a higher current P/E ratio than Disney – 33 versus 21. Yes, one can understand why sentiment is better on that name, but Disney is intent on using its IP judiciously to get as close to Netflix as possible, and it can hedge that bet with parks and content licensing (Netflix has no parks division, or even a real theatrical strategy, remember). Another example: Comcast (CMCSA) does have parks, a broadcast network, a film production/distribution studio, and its own hedge – broadband utility. The cable giant is pretty cheap at a P/E metric currently below 10 and a dividend yield above 3%. I own Comcast and believe it is a buy, but for different reasons – this is a media stock one certainly owns for income and slow growth over time, especially at depressed levels. For investors looking for value and a better growth profile, Disney looks like a better case.
For the most part, investors are now concerned about the content slate and D+ profitability…parks will take care of themselves, and the thinking is on the part of many that Bob Iger will persevere and save the proverbial day.
Risks
There are risks to consider. One of the most prominent is if the company makes a miscalculation on capital allocation to the parks: $60 billion is supposed to be spent over several years, and that assumes that consumers will be strong during the coming decade and willing to buy tickets and book stays. Disney is investing in parks because that division has disproportionate success attached to it (as opposed to the movie studio), and it might end up being mistaken performance-chasing if the segment suddenly falls out of favor for a while. And on the movie studio’s struggles: if film doesn’t synergize well with the parks, that may put Disney World and the other locations at risk for lower-than-expected ROI generation, given that failures at the cinema obviously can’t promote attractions as well as successes. And parks sometimes need all the help it can get, as was seen with the Wars hotel that simply was too expensive to survive.
Other risks include: the film slate taking longer to finally get back on track; declines in linear profits accelerating; streaming returning to losses as opposed to projected profits; churn increasing; debt expanding. And, generally speaking: market volatility, which might take the stock down closer to its 52-week low of below $80.
A Quick Note On The Other Bob
I will wrap this up with a brief thought on Disney’s previous leadership.
Previous CEO Robert Chapek doesn’t appear too popular on Wall Street or Main Street… and by some, perceived to be the source of all of Disney’s current problems. The funny thing to me about this is the fact that the less popular Bob was merely propelling Iger’s original strategy of all-in on streaming and had the unfortunate luck of being at the helm when institutions suddenly demanded that it was Netflix’s world and that subscriber-growth-acquisition-at-any-cost was a multi-hyphenate mantra that no longer applied to the Mouse…there was to be no multiple-premium reward attached for such pursuits. The pandemic pivot was obsolete, and although Chapek arguably wasn’t as aggressive as he should have been – and the streaming losses Disney had previously incurred were scary, to be honest – he was caught in a strategy whose inertia required time to correct. Patience on Wall Street is thin, though, and the internal reorganization he imposed – which took power away from some creatives in the name of spreadsheet efficiency – only helped to catalyze his eventual ouster. So the previous CEO who installed the CEO who was eventually let go because the board wanted said former CEO back to do what the let-go CEO was criticized for doing at times – mainly, adhering to a spreadsheet and its economic edicts. Got all that?
Life is funny sometimes, and that includes these kinds of corporate-succession dramas. Which reminds me – and everyone else – that Bob Iger still hasn’t detailed any succession plans. I think it is more than probable he may stick around for a while longer past 2026. It’s hard to believe he can accomplish all his goals by then. With the new streaming bundling and the reduction in cinematic output, the Disney model is becoming more complex as it adjusts; there may be fatigue for superheroes on the silver screen, but the Mouse’s board may not be tired of their superhero CEO…(yet)…
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