Chantal Marx
Background and company history
The Walt Disney Company, or Disney, is best known as the premier purveyor of family entertainment globally. It operates via three core business segments: Disney Entertainment, ESPN, and Disney Experiences.
Disney Entertainment includes the company's full portfolio of entertainment media and content businesses globally, including streaming.
ESPN includes ESPN networks, ESPN+, and the company's international sports channels. Disney Experiences is the global hub that brings Disney's stories, characters, and franchises to life through theme parks and resorts, cruise and vacation experiences, and consumer products, which includes everything from toys to apparel, and books to video games.
Entertainment makes up the bulk of revenue, followed by Experiences and ESPN. Operating profit is predominantly made up of Experiences, followed by Entertainment and ESPN. ESPN has been under pressure in the last few years due to higher sport broadcasting rights fees, which coupled with lower cable revenue, has dragged on profitability.
Disney boasts best-in-class underlying intellectual property (IP), supportive of long-term content monetisation
Entertainment and Experiences have a symbiotic relationship through which Disney brings its IP to life. The below graphic shows how a franchise grows, starting with a movie and then building out to include merchandise, toys, video games, TV shows, rides at parks, themed cruises and more. The company will also enter into commercial agreements with other companies to use their IP in their own products. Examples range as wide as Mattel (Frozen Barbie) and Pandora (Charms).
The IP monetisation has a "fat tail" and in some cases "no tail" (like with Micky Mouse). This makes the business fundamentally different to most competitors as Disney does not have to keep making movies to keep making money from a franchise. It also benefits from a margin uplift through the life of the franchise - a theatrical release is quite expensive, and margins can be tight while distributing merchandise at scale is comparatively cheap and margins are higher.
Streaming still holds opportunity, despite number two position
The addressable market for streaming remains compelling, and while Disney has shifted its focus to profitability in lieu of subscriber growth, it will still benefit from overall market growth.
In terms of the number of users, it is projected that the streaming video on demand (SVoD) market will have 1.7 billion users in 2027, up from 1.3 billion users in 2023, representing a compounded annual growth rate of just under 7% per year. Even in this scenario, the user penetration rate, which measures the proportion of the population using video streaming services, is expected to grow from 17% in 2023 to 20.7% in 2027. This means there is still scope for expansion beyond the next few years.
The emerging markets opportunity is there, but there is still scope for growth within developed markets as well where ability and willingness to pay for content is higher. In the US and Canada, user penetration is close to 50% and in other developed markets, penetration is hovering at between 10% and 40%, depending on the market.
A self-help thesis is beginning to play out
Disney has been through a tumultuous few years, starting in 2019 when it acquired 21st Century Fox and invested in the development of Disney +. This resulted in major cash outflows for the financial year. The following year, under new CEO Bob Chapek, Covid-19 lockdowns struck and decimated both its Entertainment and Experiences businesses and while the launch of Disney + helped the revenue line, it was still unprofitable. A slow recovery followed in 2021 as lockdown impacts came into the base, but Covid-19 disruption still lingered, and consumers remained constrained. In 2022, the operational recovery continued but marked softness in its legacy linear networks business (which sells content to cable companies) and continued losses at Disney + dragged. Ultimately, leadership execution was viewed as disappointing and following a boardroom fall-out on the creative direction the company was taking, Chapek was ousted and Bob Iger, who had been CEO from 2005 to February 2020, was reappointed as CEO in November that year. The new strategy centred on four key pillars of execution, along with a continued focus on saving costs and boosting free cash flow.
1. Studios - Quality over Quantity
As an example - there was a time when a new Marvel movie was released every six months. At the start, these movies did well at the box office but over time, the performance tapered off as the franchise was diluted by too many films being pushed to market and production seemingly appearing being rushed. Management has reduced the content slate and is focussed on strong creative execution that generates a sustainable and long-term return on investment.
2. Disney + is on the road to profitability
After an initial "subscriber landgrab" that coincided with the Covid-19 era where most major traditional content houses launched streaming platforms to compete with Netflix, Disney+ and others are now focussing on pricing correctly, and refining content libraries and spending to become more profitable and cash generative. Indeed, streaming execution seems to be improving and tracking ahead of what Netflix experienced when it launched original content. Netflix took about five to six years to turn free cash flow positive.
3. Rethinking the future of ESPN
ESPN is the world's leading sports brand that has struggled to balance rising costs (broadcasting rights) with a decline in its legacy linear networks addressable market. ESPN+, its streaming service, could be a differentiator there as cross sell opportunities abound with its other streaming platforms, specifically Disney +. Fan interactivity is another area of development as is integrated betting, gaming and commerce. This will aide in bringing margins up to more sustainable levels.
4. Experiences growth in the spotlight
In September 2023, the company announced a major investment drive aimed at improving and expanding its domestic and international parks and cruise line capacity. This is a very profitable business area for Disney and return on invested capital is substantial.
Financial overview
Over the last 25 years, Disney has been a consistent financial performer with revenue growth of 5.5% CAGR and earnings growing by 8.4% CAGR on a per share basis. This includes a lingering impact on profitability from the Covid-19 shock along with deep investments in Disney+ where profitability is not yet close to acceptable levels. Indeed, operating profit only recently exceeded 2019 levels and is yet to return to 2018 levels (prior to the 21st Century Fox acquisition). Margins are also yet to come close to pre-2019 levels.
A continued expansion in margins is expected going forward, fuelled by growth in the Experiences business and a sustained effort to curb costs. This is expected to filter into a rebound in free cash flow generation and improved shareholder returns. We can envisage a scenario where the company gets to a point where it again generates returns more like a "compounder" and less like a cyclical entertainment business. That said, it will likely continue to remain vulnerable to large downswings in economic activity as evidenced by not only the Covid-19 shock but the deterioration in returns during the Global Financial Crisis as well.
Summary investment case
Risks
Consensus outlook and valuation
Market consensus is currently positive on the stock, 70% of sell-side analysts have a "Buy" recommendation of the stock, 11% carry a "Hold" recommendation, and only one analyst maintains a "Sell". The 12-month aggregate target price is currently ~$128, which is ~29% above current levels (~$99).
Consensus is positive on the company's potential to achieve sustained mid-single-digit growth, margin expansion, and low-double-digit growth in profitability. This is expected to translate into strong free cashflow generation and decent shareholder returns.
The stock is trading at a discount to its peers while it has historically traded at a premium. Disney is also trading below its 20-year average forward PE rating even when accounting for the "Covid-19 spike".
