Published by Nicholas McCullum on April 24th, 2017
Disney (DIS) is the world’s largest entertainment company with a market capitalization of ~$183 billion. The company is famous for its well-known characters like Mickey Mouse & Donald Duck, as well as the Star Wars and Marvel cinematic franchises.
Disney also owns ESPN, the predominant television channel for professional sports. Lately, Disney’s Media Networks segment (which houses ESPN) has been under pressure because of declining subscriber numbers.
The consumer trend of cord-cutting (reducing or eliminating cable subscriptions to save money) has impacted ESPN and resulted in some interesting headlines:
- Barron’s: Is It Time for Disney to Wave Goodbye to ESPN?
- Forbes: Disney Acquisition of Netflix Imperative as ESPN Viewership Continues to Decline
However, the decline in ESPN’s subscriber numbers is unlikely to be material to Disney’s long-term investment prospects.
This article will describe in detail why concerns surrounding ESPN are overblown, and why Disney still has robust growth prospects moving forward.
Business Overview & ESPN Concerns
Disney is divided into four operating segments:
- Media Networks
- Parks and Resorts
- Studio Entertainment
- Consumer Products & Interactive Media
A breakdown of each Disney segment by revenues and operating income can be seen below.
Source: Disney 2016 Annual Report, page 31
2016 was a strong year for the aggregate House of Mouse, although the company did see a slight revenue decline in the Consumer Products & Interactive Media segment. Studio Entertainment in particular had a phenomenal year on the back of blockbuster movies like Finding Dory and Captain America: Civil War.
2016 also saw continued decline in ESPN subscriber numbers. However, the sports broadcasting network still has a substantial following.
The following excerpt from Disney’s 2016 Annual Report shows that there are currently ~90 million subscribers to the ESPN channel, with additional subscribers to ESPN2, ESPNU, ESPNEWS, and the SEC Network.
Source: Disney 2016 Annual Report, page 2
ESPN is losing roughly 300k subscribers per month – or approximately 0.3% of its 90 million subscriber base. The reason behind this decline is well understood by Disney’s management and investors alike.
ESPN is a premium channel and charges cable providers accordingly. By offering bundles that exclude the expensive ESPN network (known as ‘skinny bundles’), cable providers can reduce their monthly charges and appease consumers who might otherwise resort to more affordable sources of entertainment.
These declining subscription numbers are unlikely to impact Disney in the long-term.
In the long-run, Disney will likely continue to perform well even if cable television goes away completely. This is because Disney is the leader in premier content, and the value of this content is recognized by non-cable third party content providers.
Netflix (NFLX), Amazon (AMZN), or some other streaming content provider would be happy to provide sports content in lieu of Disney’s current cable television arrangements. Consumers will enjoy watching ESPN (and Disney’s other content) regardless of the medium that delivers it to them.
There have also been a number of more dramatic solutions presented by Disney’s shareholders and the overall analyst community. One of the more notable is a potential sale of ESPN, either as a spinoff into a separate publicly-traded entity or to a third-party buyer such as Comcast (CMCSA). For context, ESPN is valued at more than $50 billion according to Forbes.
Another is for Disney to acquire Netflix. Netflix currently has the largest subscriber base of any Subscription Video on Demand (SVOD) company, currently at 98 million. Disney could scale its impressive content through Netflix’s distribution network to replace revenue lost from cable television.
Regardless of the eventual outcome, I am confident in that Disney is capable of navigating through the waters of declining ESPN subscribers. The demand for Disney’s premium content continues to exist (though delivery preferences are changing) and anchors Disney’s long-term business prospects.
Disney’s growth prospects are robust and vary by segment.
In Media Networks, revenues will be boosted once Disney either restores growth to ESPN subscriber numbers or finds an alternative distribution method (through acquisition or otherwise).
In Parks and Resorts, Disney will continue to benefit from the recently-opened Shanghai Disney Resort, which was opened last summer and is 43% owned by the Walt Disney Company (with the remaining ownership held by the Shanghai Shendi Group). This represented a key push by Disney into the substantial Chinese market and will be a driver of growth (both financially and through increasing brand awareness) moving forward.
Disney’s Studio Entertainment has an impressive set of movies set to come out in the near future, including:
- Pirates of the Caribbean: Dead Men Tell No Tales (May 2017)
- Cars 3 (June 2017)
- Thor: Ragnarok (November 2017)
- Star Wars: The Last Jedi (December 2017)
Studio Entertainment is set to have another fantastic year in 2017, and its longer-term performance will be anchored by the company’s popular brands and unique characters.
Lastly, Disney’s Consumer Products & Interactive Media segment will grow organically as the popularity of Disney’s characters increases through new movie releases and theme park attractions.
Altogether, Disney’s growth prospects appear strong even in light of the impact of cost-cutting on the ESPN subscriber count.
Competitive Advantage and Recession Performance
Disney competitive advantage comes from its impressive intellectual property portfolio. There is no company that excels at creating ‘must watch’ content as much as Disney.
According to Forbes, Disney has the world’s 13th most valuable brand with an estimated value of $18 billion. The company also ranks 8th in terms of consumer perception.
However, the company tends to be vulnerable during recessions. Consumers will cut spending at resorts and on studio entertainment when money is tight. This was reflected in Disney’s financial performance during the Great Recession of 2008-2009:
- 2007 adjusted earnings-per-share: $1.92
- 2008 adjusted earnings-per-share: $2.26 (18% increase)
- 2009 adjusted earnings-per-share: $1.82 (19% decrease)
- 2010 adjusted earnings-per-share: $2.07 (14% increase)
- 2011 adjusted earnings-per-share: $2.54 (23% increase)
Disney’s earnings fell 19% during the worst of the Great Recession and it took two fiscal years to pass the high water mark.
Accordingly, investors should look to buy Disney shares on the cheap when the next recession occurs.
Valuation, Dividends, and Expected Total Returns
Future returns for Disney shareholders will come from valuation changes, current dividend yield, and earnings-per-share growth.
Disney reported adjusted earnings-per-share of $5.72 for fiscal 2016. The company’s current stock price of $114.44 represents a 20.0x multiple of 2016’s earnings.
The following diagram compares Disney’s current valuation to its historical valuation since 2000.
Source: Value Line
Over the past decade, Disney has traded at an average price-to-earnings ratio of 16.3. The current price-to-earnings ratio of 20.0 is well above that level. Right now is not the most opportune time to buy stock in Disney based on fundamental metrics, though the company is trading at a discount to the S&P 500’s price-to-earnings ratio of ~25.
Buying opportunities will likely occur for prospective Disney shareholders during the next economic downturn. The company’s stock tends to decline more than the market during recessions.
Dividend payments will only make up a small portion of Disney’s future returns since it is a low yield dividend stock. Further, the company pays semi-annual dividends, which is unlike the quarterly payment schedule that most companies follow. The company’s current $0.78 per share semi-annual dividend payment equates to a forward dividend yield of 1.4%.
For these reasons, Disney will likely not appeal to investors who need current portfolio income. The company’s yield is dwarfed by the S&P 500’s dividend yield of 2.0%.
Disney has a great dividend history but an unusual dividend policy. The company has paid steady or rising dividends for 60 years, but the company’s dividend increases have been inconsistent. Disney has often raised dividends by double-digits, only to halt dividend increases for a few years afterward.
With that said, Disney is still exceptionally shareholder-friendly. The company repurchased $1.47 billion of stock in the first quarter of 2017 alone, which is equivalent to 0.8% of the company’s current market capitalization.
If this quarterly decay rate remains relatively constant, the company will reduce its shares outstanding by approximately ~3% per year, which will, in turn, improve the company’s per-share financial metrics. Share repurchases will be a strong contributor to Disney’s future returns.
The remainder of Disney’s shareholder returns will be driven by earnings-per-share growth. The company’s bottom line trend since 2000 can be seen below.
Source: Value Line
Disney has compounded its adjusted earnings-per-share by 12.3% per year since 2000. The company’s future growth will likely be slower. Over full economic cycles, I believe this media giant is capable of delivering 8%-10% annual earnings growth.
To conclude, Disney’s future total returns will be composed of:
- 1.4% dividend yield
- 8%-10% earnings-per-share growth
For expected total returns in the range of 9.4%-11.4%, which may be negatively impacted by contraction in the company’s current valuation. Investors can improve potential total returns by purchasing Disney stock on a pullback.
Disney is an exceptionally high-quality business. The current decline in ESPN subscriber numbers is not indicative of a decline in the overall House of Mouse.
The company’s long-term growth prospects appear strong, but its valuation is well above long-term historical levels. Investors looking to initiate a position in Disney might be better off waiting until the stock returns to a more attractive level. For existing Disney shareholders, the company remains a strong hold because of its unique brand, consumer loyalty, and shareholder-friendly management.