Disney: Bob Iger Is Serious About A Comeback

Summary:

• Disney CEO Robert Iger is motivated to position Disney for the next cycle of the streaming wars.
• The market is optimistic due to solid numbers and potential catalysts.
• Disney should aggressively attack their debt load, but it is nevertheless in good financial shape, with better free-cash-flow prospects.
• Disney’s assets make it a long-term buy, but investors will pay a premium in the short-term for this name; therefore, buy on price dips whenever possible.

Without a doubt, The Walt Disney Company (NYSE:DIS) CEO Robert Iger wanted the company’s shares to see some sort of energetic reaction to Q1 stats reported on February 7, 2024. (Hey, he and I both, as we’re both long the stock.) How else does one explain the lengthy bullet-point list at the beginning of the release? As well as the announcement about the sports-streaming deal with Warner Bros. Discovery (WBD) and Fox (FOX) (FOXA) the day before?

Well, the shares did see a pop of well over 6% at the time in the after-hours followed by an 11.5% rise in the regular session (with a spike in volume, as expected). And there’s good reason for the market to be optimistic…some of the main numbers were more than solid, and there are a couple potential catalysts in the mix.

Last time I wrote about the stock, I considered it a buy for long-term investors; secondarily, I mentioned it as a technical buy for the shorter-term crowd as well. Up until the price surge after earnings, the stock had trailed the S&P 500 by about a percent post that piece (roughly 7% gain for DIS versus 8% for the index). As I write this, DIS is currently beating the market, but I expect some of those gains to be given back as news on the new sports-streaming platform is digested and traders take some profits (and any unexpected negative headlines on a macro basis) over the short term. So before earnings, I was a bit below the index.

However, I still consider Disney a great name for the long term, and I think averaging in will be the best consideration here. Iger is doing some interesting stuff, but I do have some opinions to share on some of his overall strategy. Thankfully, cost-cutting is continuing in earnest. The shares could be considered expensive on some metrics, but projections for growth appear to be part of the story, so consider that a positive offset. Besides the quarterly numbers, I will check out the earnings call as well.

Q1’s Progress

Probably the first thing to notice is the free cash flow. There was a use of cash in 2023’s first quarter, close to $2.2 billion. Pretty bad. This time, the company generated a little under $900 million of available cash. Not bad at all (although the Hollywood strike activity did cause a bit of a benefit).

But I hope Disney can make more. It has guided for $8 billion in total for the rest of the fiscal year. That is based in part on some conservative spending habits implemented by Iger and the team…the company is targeting $7.5 billion in annualized savings initiatives. Disney should go even further than this and get more aggressive than ever on saving and hoarding cash.

But here’s the problem: D+ and theatrical films are expensive. In fact, Iger mentioned that Taylor Swift’s concert film will be coming to the streaming unit…and that is going to set the company back about $75 million for the privilege, according to reports.

The company was said to have outbid Netflix (NFLX) and Comcast (CMCSA) – it’s difficult to say if Disney should have been a participant in this auction. On the one hand, yes, Swift (and this particular project) is absolutely killing it in the marketplace right now…I see the premium value here.

But the other side: Disney wants to save money, cut costs, and do more with less. Subscriber count is no longer the economic-value-added achievement it once was. Instead, it’s the revenue generated by each user to which the company has turned its focus.

This is why I suspect the company may have been willing to transfer a lot of money from its balance sheet to Swift’s – the idea that advertising and a popular product might create attractive incremental value. If the company perhaps loads a higher density of ads on this product as opposed to others in its streaming portfolio, then such an experiment might yield useful data and an actionable conclusion – try to find more hot properties that can be exploited in the streaming window before they inevitably cool down. (And it helps solve for the problem of someone who subscribes for just one product.)

Yes, the whole theory of D+ was to be a showcase for IP that the Mouse owned – synergy, in other words. Disney even purchased Fox IP to expand its portfolio for direct-to-consumer.

But that was based in part on growing subscribers to scale via a non-ad, premium strategy. Today, that strategy has shifted, and perhaps third-party product will increase its presence on the platform.

Advertising will grow in importance because subscriber counts will ebb and flow depending on the seasonality of the quarter. In Q1, D+ core subscribers shed 1.3 million members on a sequential basis while average revenue-per-user increased by fourteen cents, from $6.70 to $6.84, on the same basis. The plan is to use commercials to propel the gains even further over the long term.

Being careful in terms of content costs leads me to the current debt level of $41 billion. Long-term obligations basically remained steady, although I was happy to see it drop slightly from the previous sequential period. Cash and equivalents turned into $7 billion versus $14 billion, which I take to be the result of the payment Disney made to Comcast at the beginning of this past December to fulfill its contract regarding the minimum purchase price (over $8 billion) of the cable giant’s Hulu stake (the final valuation comes later).

The fact that the debt level is stable (right now, anyway) came as a bit of a relief – I was bracing for a significant increase because of the payment. Perhaps it serves as testament to Iger’s resolve to keep the company’s financial improvements on track. (I should point out too that the company plans on significantly investing in parks over several years, so the balance-sheet impact is probably something management should really be studying.)

The market was excited by the increase of the company’s next dividend payment, as well as an announcement of a return to share-repurchase activity.

I was not.

Sure, I like dividends, I like buybacks, and I go back and forth on the issue. I believe it would currently be in the better interest of the company to aggressively deleverage. The amount for the repurchase initiative was set at $3 billion, and I just can’t help but think that $3 billion would be a nice reduction on the borrowings line. Interest expense for the quarter increased to $528 million from $425 million in the year-ago period. Interest income was better (obviously): $282 million against $165 million. Netting those two items out, interest expense decreased to $246 million versus $300 million. I get it: it’s not a crisis. If I annualized that expense by multiplying by four quarters, I get close to a billion dollars…for me, I just see every dollar paid in interest as something to be eliminated. They could be put to better use.

Strategy Going Forward

Disney has been forced to evolve a lot faster than it otherwise would have. How exactly is the company going to create value from this point on? We know that theme parks will be the big, core driver, as linear continues its attempts to find an equilibrium in the marketplace. Movies, too, will be important, but theaters are still absorbing the impact of the virus, and Disney’s momentum in that arena has been stalled (I believe it will come back).

I’ve been a proponent of using content incubated on one platform in a repurposed fashion on other platforms – and not just as an afterthought, or as a response to some other problem.

Let’s consider the example of Only Murders in the Building. It found a spot on ABC because of the effect of the strikes. Sure, we can all understand that.

But what if it wasn’t a strike that caused the placement but a purposeful approach of synergy, and cross-promotion? That’s how management should be thinking about its D+ inventory, its Hulu inventory, its Freeform inventory, and so on. Yes, Disney does do that already at times…but, it should be more of a comprehensive, planned-out, systematic exploitation of the ecosystem.

Remember that there are two forces at work here: should content be licensed out to a competitor or to an owned/operated platform? The answer can be complex. Recall that residuals are now the bane of media conglomerates that hold too much debt and have not seen the kind of valuation for their streaming arms that they thought they would see (this applies to companies not named Netflix).

But also recall that linear ecosystems and broadcasters can help add value to programming by amortizing costs and generating more sampling – if Murders gets a new audience on ABC, perhaps a spin-off could be developed exclusively for ABC, one that could be rebroadcast on Hulu, and then eventually archived on D+. Maybe Freeform shows it as a special run. Perhaps Disney XD might attempt to program a limited nighttime block for adults with the show. The variations are limitless. This is something Iger should be looking at.

I was surprised at the gaming investment announcement. However, after reading some comments from the CEO in the transcript, I’m wondering if this is somewhat of an indirect (maybe even less indirect than one might think) investment in AI without actually buying an expensive AI company.

First, in answer to a question which essentially asked why this strategy now (as opposed to all the other gaming strategies, including the easiest – straight-out licensing), Iger had this to say:

And so, I met with Tim, and Josh and his team started a discussion about what if we create a gigantic Disney World a la Fortnite that could live next to Fortnite and be completely interconnected with it, a world where people could play games that we create, could create their own games, could watch.

You can imagine the creation of short-form videos or may — we may even use the platform to actually distribute some of our content, also the people that could interact with one another, and ultimately, some form of shopping as well and other forms of creation.“

Here’s how I interpret the above: Iger, even if he didn’t say it directly, wants to eventually allow users to create their own content with Disney characters and then make them available to other users, with those views eventually monetized via merchandise, both physical and digital, with the monetization split with the content creators (i.e., the users themselves, to reiterate). Artificial intelligence would obviously drive this. And to speak it plainly in simpler terms: it would be the YouTube model but with Epic’s platform combined with Disney IP.

Would something like that work? Would the $1.5 billion investment in Epic that Disney is making expand into a significant fortune for shareholders? It’s like anything else of this type: these are early days, and many things won’t pan out. I myself like to imagine what can happen, and I think it is valuable for the company to explore this…but it must be hedged by a straight licensing strategy. Disney has lagged, in my opinion, with licensing video games…remember when every movie, every Disney-Channel television show, had a high probability of being adapted into a video game for consoles and handheld units? Things have improved in this area, as Disney has brought back some older games to platforms such as Steam and in collections for physical release on consoles (such as 16-bit games based on The Lion King), but for those who don’t know, there are a lot of video games in Disney’s past that the company could bring back to gamers of today…it would be a difficult project to either remaster them or track down all co-owners of the source code to clear a vast majority of them, but it would be worthwhile in my opinion to create a long-tail business from it. And back to the potential of this platform to use AI to create content via the user base: I believe something like that is coming in the next decade (yes, I might be early, because this stuff is complicated), and I have given as an example previously the idea of Comcast letting users program a Saturday Night Live episode with AI actors from past and present casts, and then uploading that on a dedicated platform. Something like this could happen one day, and media companies would be wise to plan for it.

I will mention very briefly here the ESPN strategy, which is to create a streaming platform that brings together sports content from Warner Bros. Discovery and Fox. Full disclosure: I do not follow the sports industry so I cannot offer too much insight into the specifics of what the company is trying to do here (you can read some here and I’m sure in future articles from other analysts). I can say that my first thought upon hearing this was: Maybe the company should have sold ESPN. It seems to me that the partnership is the equivalent of bending oneself into a pretzel to make something work out; I do, however, see some of the logic: create scale not by acquisition but by forces joining. The problem is, joint ventures can be tricky, and you’ve got two companies – DIS and WBD – that are saddled with disproportionate debt loads relative to their desired capital structures, which probably can make things particularly tricky. I’ll trust management for now that this can offset some of the linear declines. One thing I will say: if Disney can focus on the betting aspect with this venture, and with ESPN in general, and maybe even get into other forms of wagering via the ESPN brand (can ESPN get into the casino business?), then perhaps investing in ventures like this will pay off.

Conclusion/Valuation/Risks

Disney currently rates highly on most of SA’s factor grades: growth, momentum, revisions, and profitability. These stats get updated over time, so be sure to consider these ratings at the time of writing.

However, SA’s factor system doesn’t look too kindly upon the stock’s valuation, giving it a failing grade. Comparisons to the sector median on valuation is where the stock really fails…as one current example goes, EV/EBITDA, forward basis, is roughly 13 for the stock versus 8 for the sector.

Yet, if you compare the five-year average metrics to the current readings, oftentimes they appear more attractive (and I suppose we have the pandemic to account for some of that). For that same EV/EBITDA, the five-year reading is 21, making the 13 not so bad.

The current PEG (adjusted, forward) is currently slightly below the sector median at 1.4. It is significantly below the five-year stat which is currently above 3.

Let’s consider the entire context: the stock is certainly more expensive than it was a couple months ago because of the rise in price, bringing it closer to the 52-week high. The comparisons with the sector median have to be taken into consideration. The fact that Iger still has more work to do to get the company fully back on track also is a concern.

Things working in favor of the valuation: current concerns could represent lagging indicators. We are arguably in a new bull market; sometimes companies with quality assets will look more expensive than they really are, and waiting to buy becomes an overrated concept. Disney is an iconic media company that has recently reinstituted its dividend and plans a share buyback; yes, I expressed my (somewhat) slight disagreement with that, but at the end of the day, management is expressing confidence it can balance out debt obligations against shareholder-friendly moves.

Blending all this, how else can I call the stock nothing short of a buy on pullback for those who are interested in its business model? The brand equity, the parks, the fact that the company’s movie business is already in a downward cycle (i.e., it is ready to ride the cycle back up)…if one patiently builds a position and holds, it should work out.

As always, there are risks. Probably one of the biggest right now is the film slate. After recent disappointments, such as the latest Indiana Jones film from last summer (which only grossed $380 million worldwide, a terrible stat considering what Disney was used to grossing pre-pandemic, more in the $1 billion+ category film after film), shareholders should keep in mind that an unlucky streak at the box office can continue for longer than expected; the company has some strong IP entries coming this year, such as a sequel to Pixar hit Inside Out, another Lion King offering, new Deadpool and Alien features, as well as a from-nowhere decision to turn a Moana D+ series into an actual theatrical project for the Thanksgiving period, but that doesn’t mean a few of them couldn’t fail in an attempt to keep up the negative momentum (sometimes statistics just cluster that way). The Moana decision was interesting because it represents a quick turnaround that will probably turn out to be a solid risk-reducing decision (i.e., spread the cost over streaming and the multiplex) that can add value to this year’s slate while eventually promoting the D+ service itself (I suppose too the strikes may have affected the choice, but again, we don’t need strikes to force such distribution blueprints).

Other risks include cost-cutting not helping out as much as they should, or if they enter a diminishing-returns phase (i.e., they go too far and impact revenue). On that latter parenthetical point, some pundits are concerned that Disney’s top line won’t be as active in the coming years, so count that risk, too.

Perhaps the biggest risk is with D+ and advertising versus subscriber growth – if Disney fails in executing its ad strategy, then Wall Street will probably want more subscriber growth…but I’ve already said that Disney’s plan now is to essentially go for revenue-per-user, so to swing that pendulum back the other way would be a tall fiscal order.

Lastly, the biggest macro risk is simply the Fed and stock-market volatility. We all know how the CPI number went down and what that might imply for rate cuts and so forth…that’s always going to be an overhang for DIS and all equities (until it isn’t).

Taking everything now, growth potential and valuation and risk, I continue to rate DIS as a long-term buy with careful buying. Bob Iger is motivated in his comeback, and he doesn’t have a lot of time (unless he extends his contract, which I am thinking the odds favor at this point). Disney’s assets are valuable, and with a little innovative strategic thinking, the stock will beat the market in the coming years.

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Analyst’s Disclosure: I/we have a beneficial long position in the shares of CMCSA, DIS, NFLX, WBD either through stock ownership, options, or other derivatives. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Besides long-term positions, I also trade these names in a short-term portfolio.

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