Media Talk

Disney: ESPN vs Theme Parks and Studio

Disney (DIS) reported first quarter earnings of $1.50, up 10% from a year ago, and ahead of Wall Street estimates of $1.41.  Revenues grew just 3% and operating income just 5% as EPS benefited from a lower than expected tax rate and share repurchases.  DIS shares have reacted negatively to the report, falling -2% to -3%.  Two factors are hurting the stock.  First, media stocks in general are under severe pressure due to a set of March quarter earnings reports that show acceleration in cord cutting and weaker than expected advertising trends.  Second, trends at DIS’s Media Networks, in particular at ESPN, were weaker than expected.

Despite the massive success and scope of DIS films and theme parks, Media Networks still is by far the largest business segment. In the just reported quarter, Media Networks revenues represented 45% of revenues and 56% of segment operating income. Ever since DIS CEO Bob Iger discussed weakening subscriber trends at ESPN in August 2015, analysis of DIS shares has been dominated by the future of ESPN.  The concerns are legitimate given that ESPN is easily DIS’s largest business unit and has a unique economic model.  ESPN pays high rights fees for the best sports content (NFL, MLB, NCAA) under long-term contracts.  Rights fees escalate modestly each year and in recent cycles have stepped up dramatically as each contract is renewed.  Against this high fixed cost base, management must make assumptions about the number of subscribers and advertising revenue.  With subscribers declining and TV ratings and advertising under pressure the last few years, ESPN’s long-term outlook has come into question.

Escalating rights costs against slowing revenue pressures operating income growth and that pressure is peaking this year as ESPN faces a huge rights fee increase in the first year of its new NBA contract.  For example in 2Q17, Media Networks revenue grew 3% but operating income fell -3% as the escalating rights expenses overwhelmed the revenue gain.

Fortunately for DIS investors, Theme Parks and Filmed Entertainment continue to operate at incredibly high levels.  Each division beat estimates in the quarter.  Theme Parks is enjoying success at the new Shanghai park, which is operating profitably ahead of schedule.  Filmed entertainment continues with an unprecedented string of hit films that drives profits not only at the studio but also in Theme Parks and Consumer Products.  Each division appears in good shape looking out the next several quarters, although any one quarter can face challenging comparisons or timing issues on revenues and expenses.  Theme Parks should see continued benefits from Shanghai and the opening of the new Avatar land in Orlando.  Filmed Entertainment has another big success in Guardians of the Galaxy 2 and the upcoming film slate looks great, highlighted by a new Star Wars film this coming December.  Intellectual property at Marvel, Lucasfilm, Pixar, and Disney Animation gives confidence that the long-term outlook for DIS unique ability to drive growth throughout the company remains secure.

We are sticking with DIS despite the challenges at ESPN and investor skepticism.  The rights fee increases moderate significantly after the June quarter and most major sports rights are locked up at modest escalators for three to five years.  At the same time, ESPN’s contracts with MVPDs hit a new renewal cycle next year allowing for a step up in affiliate fees, albeit on lower subscribers.  In addition, although it has yet offset subscribers losses at traditional MVPDs, new OTT products all contain ESPN so far and growing sub counts will eventually stabilize total sub counts.

For Northlake, the bottom line is we view DIS as a blue chip company with a strong balance sheet, unrivaled intellectual property, and shareholder friendly capital allocation.  Management unexpectedly upped the 2017 share buyback by $2B indicating confidence in the intermediate term outlook.  At plus or minus $6.00 in EPS in 2017 and 2018 and against easing comparisons and higher growth in FY18, we think DIS shares can work higher over the balance of 2017.  In the meantime, we are willing to stick with this premier global powerhouse.

DIS is widely held by clients of Northlake Capital Management, LLC, including in Steve Birenberg’s personal accounts.  Steve is sole proprietor of Northlake, a registered investment advisor.  Northlake’s regulatory filings can be found at www.sec.gov. 

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