SUMMARY:
- Disney’s DTC strategy has changed business from a stalwart to a show-me story.
- Disney’s financial performance and financial metrics have seen a dramatic shift that demonstrates the impact of the DTC business.
- While management has a plan for profitability for the DTC business, it is by no means a certainty.
CNBC played passively in the background during Scott Wapner’s ‘Overtime’ segment as I assisted in the construction of a block tower tall enough to impress my son. In the back of my mind, I knew Disney would be reporting fourth quarter and full year results which would be reported on the station.
Disney is one of the first stocks I ever purchased more than 10 years ago. Disney is an iconic company with iconic brands. During his tenure as CEO of Disney, Bob Iger emulated Disney’s values while positioning Disney as a media powerhouse through acquisitions like Pixar, Lucas Films and Marvel. Operating results followed suit with consistent growth, returns on equity and returns on capital positioning Disney has a stalwart.
Between 2012 and 2019, Disney generally traded around 18x earnings with an EV/EBITDA multiple around 11x justified by mid single digit revenue growth, low-mid double digit earnings growth, and consistent cash flows upwards of $9 billion a year. These cash flows funded a relatively consistent dividend (later cut as a result of the pandemic). Returns on equity and returns on invested capital averaged around 18% and 13%, respectively, representing the value that Iger and Disney were creating.
Though criticized for being late to establish a streaming service, Iger’s strategy for Disney+ was aggressive. Under his leadership, Disney acquired 21 Century Fox and consolidated ownership of Hulu offering Disney an incomparable media library and the foundation for Disney+ before his departure in 2020.
The Shift From Stalwart to Show-Me Story
These actions also began the shift from the stalwart that I bought 10 years ago to the show-me story that Disney has become today.
As I watched the earnings release hit the tape on CNBC, I was struck by the uncertainty that I felt and have felt about the company since the birth of Disney+. To be clear, I am not saying that the introduction of a streaming service was the wrong strategy. The deterioration in Disney’s Linear Networks (formerly Media Networks) business justifies a shift in strategy. Instead, the introduction of Disney+ has shifted Disney in a way that they no longer resemble the old company. The metrics of old compared to those today depict this story.
As you can see in the table above, Disney is trading well above its historic multiples, has a less healthy balance sheet, and is creating less value for shareholders with returns on equity and capital in the low single digits. Yes. Some of this can be attributed to the impact of the pandemic and inflation, but it is also a portrayal of the toll the direct-to-consumer (DTC) strategy has taken on Disney.
Disney May Still Also Be Overvalued
Despite the stock falling over 40% year to date, using the full year adjusted EPS figure of $3.53, Disney is still trading at 24x earnings and around 21x management’s guidance for 2023. Though far more reasonable than its valuation over the last two years, these multiples are still well above the market multiple, well above its streaming peers, and are pricing in growth that has yet to materialize in earnings.
Further, these multiples remain high in spite of management’s guidance for “…fiscal 2023 revenue and segment operating income to both grow at a high single digit percentage rate versus fiscal 2022”, in line with Disney’s average growth rates over the last 10 years. It is also worth noting that Disney has not returned to pre-pandemic earnings levels despite trading at or above its pre-pandemic stock price. On an EPS basis, Disney earned $3.53 in 2022 which is 46% below 2019 EPS of $6.64, and nearly 58% below 2018 EPS of $8.40. This speaks to the dramatic decline in Disney’s margins over the past 3 years, and has translated into severe declines in free cash flow to about $1 billion in 2022.
Will Disney Show Us?
Let’s be fair by stating the positives. Disney has shown us to a certain degree. For fiscal year 2022, Disney reported revenue of nearly $83 billion up 9% for the quarter, 23% year over year and well above 2019 levels. DTC revenues have played their part in overall revenue growth rising 20% in 2022. On a subscriber basis, the DTC business has seen success with more than 235 million subscribers across Disney+, Hulu and ESPN+. Further, an argument can be made that in order to scale a new business the likes of Disney+, sacrificing margins for growth is necessary.
This, however, will need to translate to the bottom line before Disney can claim victory and return to creating value for shareholders. At the moment, the economics of streaming are not the same as the old cable and broadcasting businesses. Disney’s historic operating margins in its Linear Networks business were +30% and accounts for +30% of Disney’s revenues while its DTC business is seeing accelerated losses up to nearly $1.5 billion in the most recent quarter and over $4 billion for 2022.
When Will Disney+ Be Profitable?
The answer to this question can only really be answered in time. However, during Disney’s conference call, CEO Bob Chapek made a cautiously optimistic statement about the potential profitability of the DTC business, a step in the right direction.
“…assuming we do not see a meaningful shift in the economic climate, we still expect Disney+ to achieve profitability in fiscal 2024, as losses begin to shrink in the first quarter of fiscal 2023.”
The assumption that we do not see a meaningful shift in the economic climate is quite the caveat to profitability for Disney+. That aside, to get to profitability, the company plans to raise prices next month, offer an ad-supported option for Disney+, realign costs particularly on marketing spending, and learn from mistakes to release more consistent, high quality content.
While management’s plan sounds reasonable, their guidance to match 2022’s cash content spend of $30 billion in 2023 may mean that the increases in average revenue per user (ARPU) will need to drive the path to profitability as opposed to a decrease in spending. This quarter did not drive confidence toward that end as ARPU for Disney+ fell from $4.12 to $3.91. A deterioration in economic conditions or churn caused by price increases for Disney+ could also derail this guidance.
Only a few days after Disney gave this guidance, Yahoo Finance reported that an internal memo sent by Chapek on Friday, November 11th told division leaders that the company has established “a cost structure taskforce” to help Disney+ reach its profitability targets. This will include a review of content and marketing spend could include limiting headcount additions and hiring freezes. While this may be promising news from a near term profitability standpoint, streaming is a competitive business that requires constant content creation to keep subscribers. We are inevitably left with the question – Will spending cuts impact subscriber growth?
Conclusion
The discussion above speaks to the shift in Disney from stalwart to show-me story. As a result, over the past 18 months, I have dramatically reduced my position in Disney. While the company’s performance has begun to be reflected in the stock price, the company is still being given the benefit of the doubt based on its valuation. Disney is a hold at these levels. I will be actively watching for progress on the path to profitability for Disney+. In the near term, this should include smaller losses for Disney+, improvement in ARPU and realization of the company’s announcement for spending cuts.
