Walt Disney: Struggles Continue
Contributor since 2011 / 26115 Followers
Summary:
- The Walt Disney Company’s stock has been stuck for a decade, driven by competitive pressures, resulting margin pressure, poor cash flow conversion, and high debt levels.
- Despite its improved results so far this year, Disney’s profitability remains below past levels, with uncertainty surrounding margin recovery.
- Disney’s recent financial performance shows signs of improvement, with earnings and cash flows on the rise, but challenges remain in the near term, as overall valuations look largely fair.
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In May 2023, I was wondering if wonderland would return to the case of The Walt Disney Company (NYSE:DIS). Margin pressure was widespread, with lower earnings, poor cash flow conversion and high debt levels making me cautious on the stock, with few triggers in sight.
By now, the company has returned to (margin) growth, but the company is still performing far below past profitability metrics here. While the risk-reward seems more compelling here than we have seen for a while, amidst reasonable earnings multiples at current levels, the question is if and how far margins can really recover in the new reality.
A Long-Term Success Story Gone Bad
Walt Disney has been a leading US success story, with a strong and diversified business model, yet a couple of wrong turns, the rise of streaming services, and Covid-19 put real pressure on the business.
Trying to fend off competition from Netflix (NFLX), the company resorted to buying Twenty-First Century Fox in a near $70 billion deal in 2019. This added a lot of debt, while the deal did not bring the anticipated benefits, and the pandemic was around the corner.
After an initial scare reaction following the pandemic, shares rose to the $200 mark in 2021, but were back to the $100 mark in 2022, as shares have traded in an $80-$120 range ever since. With shares moving towards the lower end of the range, investors have not seen any capital gains over the past decade.
Before the pandemic, everything was still largely fine. The company posted sales of around $70 billion with parks and media networks each contributing about $25 billion in stales, and studio entrainment and direct-to-consumer business each responsible for about $10 billion in sales. Operating profits of $14 billion were solid, with net earnings of $10 billion coming in at $6 per share.
While revenues recovered to $83 billion in 2022, aided by inflationary pressures and a reopening of the economy post the pandemic, adjusted earnings fell way short towards $3.50 per share. This was due to a $4 billion loss reported by the direct-to-consumer segment, mostly Hulu and Disney+.
While the company posted solid top-line sales in the first half of fiscal 2023, the same could not be said for margins. This was attributed to continued losses at direct-to-consumer activities, yet margin pressure was felt in media, entertainment, and linear networks as well.
With net debt posted at $38 billion, with earnings likely trending close to $3 per share, I was cautious with a prevailing share price in the nineties. Modest earnings power, poor cash flow conversion made me cautious, amidst a competitive field, and self-inflicted wounds with its woke policies.
Stuck
After trading in the nineties in the spring of 2023, shares actually rallied to a high in the $120s in April of this year, after which a relentless and continued decline sent shares back to $86 per share.
In November of last year, Disney reported its fiscal 2023 results, a year in which sales were up 7% to nearly $89 billion. While segment earnings improved by 6% to nearly $13 billion, GAAP operating profits were down a tenth to $4.8 billion. This resulted in GAAP earnings down 26% to a mere $1.29 per share, with adjusted earnings up seven percent to $3.76 per share.
Following a reorganization of the reporting segments, Disney relies heavily on its $40 billion entertainment business, with margins posted at 3% and change. Declining sales and profitability of linear networks was in part offset by higher revenues at the direct-to-consumer business, which saw losses come down.
The cash cow of Disney is the $32 billion experiences business, posting margins in the high-twenties. The park’s business did alright amidst inflationary pressures and re-opening in China. Sport revenues were dead flat at $17 billion, a segment dominated by ESPN, which has put pressure on margins.
Net debt was posted at $29 billion and change, still mostly related to the Fox deal. On the corporate front, many things happened as well, with Disney announcing its willingness to buy out the stake of Hulu from Comcast (CMCSA), and the company entering into an information sharing arrangement with ValueAct at the start of the year.
Some Improvements
While the shares have been lagging, Disney has been posting improved results so far this year. While first quarter sales were dead flat at $23.5 billion, adjusted earnings were up 23% to $1.22 per share, with cash flows improving as well. Second quarter sales were up 2% to $22.1 billion, with adjusted earnings per share up 30% to $1.21 per share.
Early in August, third quarter sales were reported up 4% to $23.2 billion, driven by growth across all these business units. Accelerating growth is driven by the direct-to-consumer segment and the parks. Adjusted earnings rose by 35% this time, to $1.35 per share, with adjusted earnings so far totaling $3.83 per share, making a $5 run rate within sight for this year.
Net debt actually ticked up to $37 billion. With EBITDA trending around $17 billion per annum here, leverage ratios have risen to the low 2s.
What Now?
Trading at $86, the company is trading around 17 times earnings, based on an earnings number of around $5 per share. In fact, the company updated the full year adjusted earnings per share guidance alongside the third quarter earnings release, seeing earnings up by 30%.
At this 30% profit growth guidance, earnings are seen around $4.89 per share, suggesting a midpoint of $1.06 per share for the fourth quarter, which would compare to a $0.82 per share number in the fourth quarter in 2023. Moreover, this would be a lower earnings number than we have seen recently.
Part of the slower earnings growth is attributed to slower than expected demand in the key experiences segment in the near term. Operating income at this segment is seen down in the fourth quarter, due to the impact of the Olympics on Disneyland Paris, as well as softening in attendance and guest spending, both domestically and in China. Spending might be impacted by a worsening consumer economic environment, as Disney might have taken prices up too far in recent times as well.
Moreover, net debt is substantial as there could be some near term headwinds in this as well, with Disney being in arbitration to pay Comcast/NBC Universal more for its stake in Hulu. Another potential headwind is that the company will incur more expenses related to its cruise ships.
Amidst all this, the only positive is that the pressure is still on the business to perform with ValueAct on boards, badly needed as Disney as still not out of the woods. Given the improved earnings and cash flow performance to date, with shares down to the lows, appeal has increased.
Currently, I am cautious as to the lack of long-term performance of the business. Unlike previous occasions in the $80s, recently Disney has improved earnings power (mostly as the direct-to-consumer business has become profitable), which is quite an achievement in a fierce competitive environment.
While Disney has taken on some debt, this seems manageable for now. However, the real issue for The Walt Disney Company is that of lack of structural earnings growth (as sales doubled over the past decade), stricter cost control, and frankly a better performance of the business, including the creative processes and employment of anti-politic strategies.
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