Falling by 30% in the last five years, The Walt Disney Co.'s (DIS, Financial) stock has performed poorly. In addition, shares have fallen by more than 50% since its peak in early 2021, which raises some questions about why this has happened and whether now is a good opportunity to buy.
Among the factors that catalyzed this fall was its very compressed net profit. In 2019, the entertainment company's net profit was $11 billion and in 2023 it was $2.35 billion, which together with the changes in outlook caused the stock to decline and the multiples to return to a much more reasonable level.
With multiples at more attractive levels, if the company manages to return its profitability to historical levels, it will be possible to see a large generation of shareholder value, but this comes with some challenges.
How Disney is doing
The company's business is divided into three main categories, Entertainment, Experiences and Sports, with various subdivisions within them. Although it has managed to grow revenue at an adequate rate overall, this has come with a series of challenges directly reflected in the structure of the income statement below, with very compressed margins compared to its history.
Source: GuruFocus
Starting with the Entertainment segment, the main recent challenge that has hindered profitability is direct-to-consumer operations. The company only reached a positive operating income level in this last fiscal quarter, having needed a large volume of subscribers (business of scale) together with price hikes to achieve a better maturity of this business. In linear networks, there was a reduction of $0.2 billion in both revenue and operating income last quarter, explained by lower international results, fewer subscribers, rate decreases and non-renewal of carriage by an affiliate on the domestic side.
As if that were not enough to make the outlook complex, Disney has faced a series of flops in the movie market over the last year, delivering million-dollar losses on films such as "The Marvels" and "Indiana Jones and the Dial of Destiny." Although these titles entered their streaming channels later (which may attract new subscribers), it is very difficult to justify a $237 million loss, which was the case with "The Marvels."
On the other hand, Experience remained solid in the second quarter, with growth in revenue and operating income driven by higher ticket prices, cost-saving initiatives and growth at Disney Cruise and Hong Kong Disneyland. This reinforces one of Disney's moats, that even in a less favorable macroeconomic scenario, it has managed to remain relevant in this business, which has more cyclical characteristics and still improves the dynamics of its prices.
Finally, the Sports segment posted mixed results in the second quarter, with slight revenue growth and stable operating income, with the decrease in Star India's operating loss offsetting the lower operating income of ESPN domestic, which was affected by higher costs and lower affiliate revenue.
In short, along with disruptions to its revenue sources and pressure on costs, Disney has faced a challenging scenario in recent quarters. But it is already showing some signs of inflection, such as the improved levels of profitability at DTC and resilience at Experience, which make the outlook for value generation clearer.
Strong moats and good initiative
Although this scenario is not trivial and the outlook is cloudy, Disney is still a business full of moats. These competitive advantages revolve mainly around its iconic brand and its world-renowned intellectual properties. This means its parks and other experiences continue to perform well as resilient tourist destinations even in challenging times. And with practically irreplaceable characters, since even with possible competitors such as Netflix (NLFX) announcing theme parks in the coming years, it still seems unlikely this will significantly impact the flow of Disneyland.
These IPs also facilitate the streaming business, which, despite strong competition, has good prospects as long as the company manages to increase its gains in scale, advancing the number of subscribers and in the efficiency of costs and expenses, apart from pricing power. It's worth mentioning that Disney continues to expect this segment to be one of its growth drivers in the future, as stated by CEO Bob Iger during the second-quarter earnings call.
“We've said all along our path to profitability will not be linear, and while we are anticipating a softer third quarter, due in large part to the seasonality of our India sports offerings, we fully expect streaming to be a growth driver for the company in the future and we have prioritized the steps necessary to achieve this,” Iger said.
This seems achievable to me. I believe some companies will stand out in this streaming market, such as Netflix, which has already reached a very high level of efficiency and a very solid business model. Disney also seems capable of building something resilient, but with a higher degree of differentiation as it targers different audiences and its own franchises, along with other initiatives such as Hulu, Star and ESPN. In the graph below, it is possible to see an excellent evolution, and if this pace is maintained, we will see DTC positively impact earnings per share growth in a few quarters.
Source: Disney second-quarter earnings presentation
The Experiences business also has interesting initiatives, with some events scheduled for the second half of 2024, such as the Disney Treasure cruise, as well as other strategies like Disneyland Forward, which will be the expansion plan for the Disneyland resort that has received preliminary approval from the Anaheim City Council.
Another trigger I find interesting is the artificial intelligence trend. Disney is not an AI company, but it could benefit from the technology since its films are currently very expensive to make. As the software for producing animation, editing, special effects and the like advances, it is possible the company will achieve a better level of productivity, requiring less time and capital to deliver the same level of film production. I see this as an interesting opportunity for the company.
It is true that Disney has made some mistakes (mainly related to films that have generated a significant loss), but it has also has had some successes recently (such as "Inside Out 2"), which together with its strong moats, improve the prospects for a return to profitability in the coming years.
Valuation and return to the mean
Disney's net income margin has fluctuated between -4% and 21.20% over the last decade, with a median of 15.60%. Meanwhile, the 2023 margin was approximately 2.60% and, in the last 12 months, was 1.90%. This is a crucial point for the thesis since to believe in a greater generation of shareholder value, it is necessary to believe this margin will return to a slightly better level. It is worth noting that Disney highlighted in its presentation a second-quarter earnings loss of 1 cent per share, but excluding certain items (amortization of TFCF and Hulu and restructuring and impairment changes), this figure goes to $1.21, indicating greater operational clarity for the result when these items are no longer a problem.
In the last 12 months, consolidated revenue reached $89.20 billion, a very good level for a mature company. If the company returns to a 15% median and keeps revenue stable, it would have a price-earnings ratio of 13.30, but it is impossible to predict precisely when this level will return, if at all.
For the next 12 months, the market sees a price-earnings of 19, coming close to an adjusted net margin of 10%, which would generate a net profit of approximately $8.90 billion. The median ratio for the last 10 years was 20.50, a level close to what the market estimates.
Another important factor is Disney is guiding for $14 billion in cash from operations (while the market expects something slightly lower), which after about $6 billion of investments in parks, resorts and other properties, it has free cash flow guidance of $8 billion for fiscal year 2024. Just considering this amount, we already have a price-to-FCF multiple of 22.
Considering these multiples, Disney's shares seem attractive since there is still pressure on some of its segments, which, as they advance in profitability and gain in scale, can unlock a lot of value for shareholders even on conservative assumptions.
Final thoughts
Disney is far from being a dying business. Its large moats (especially its IPs) set it apart from other media companies. In this way, I interpret the current level of its shares as attractive for those who like the sector and its business model, but a level that also reflects the challenges the company is facing.
This scenario should not last forever and at some point, Disney will be able to resume producing more profitable films (finding its footing again in the market) and possibly make DTC profitable, which, together with a very resilient experiences segment, could unlock even more value.
