Disney Proving Skeptics Wrong

Disney reported an exceptional quarter. EPS of 63 cents and revenues of $10.45 billion crushed estimates of 52 cents and $10.04 billion. Revenue growth was 9% and operating income gained 15% vs. expectations of 3%. Non-recurring items contributed no more than 2 cents to the EPS number.

On the conference call, management indicated that so far they see no signs of the economy causing a slowdown. Management pointed specifically to the fact that room bookings for the March through September quarters are running modestly ahead of last year. Given the fair argument that families don’t usually cancel vacations once they are booked, it seems that the near-term worries about Disney's theme parks are unwarranted.

In fact, I think a strong argument can be made that FY08 ending in September is pretty much in bag as a decent growth year well ahead of the outlook implied by recent estimate cuts. The debate is now going to shift to FY2009 where comparisons just got tougher and theme parks could come under pressure due to unwilling ness to book vacations based on current economic conditions and headlines.

Disney has incredible creative momentum. Hannah Montana, High School Musical, Cars, Pirates of the Caribbean, new hit shows on ABC, new sports rights at ESPN, the Jonas Brothers, Club Penguin, Enchanted. Each of these properties is driving current revenue. New properties are regularly created and old properties are revived and extended. For example, Toy Story did $400 million n retail merchandise sales in 2007. In 2009, the two original Toy Story films will be re-released in 3-D ahead of the 2010 release of Toy Story 3 and a whole new merchandising push.

Along with the revenue push from creative content, Disney is very tightly managed. Margins were very good in every segment except for the studio which faced an adverse mix shift from DVDs to box office.

Ultimately, the outlook for Disney comes down to a battle between the momentum of creative content and tight cost controls vs. a weakening economy. I think it is clear that at least for the next quarter or two Disney is very well positioned to weather the economic storm. On that basis the shares look modestly undervalued for the short-term and exceptionally undervalued for the long-term assuming the economy recovers in the second half of 2008.

Here are brief segment highlights….

Broadcasting: Revenues and operating income grew 8% and 30% against expectations of 4% and 14%. The writer's strike had no material impact. Strong advertising trends and elimination of mobile losses provided a boost.

Cable Networks: ABC Family and the Disney Channel were highlighted. ESPN grew as well although growth was held back by a higher revenue deferral than a year ago. ESPN ad revs grew by double digits.

Studio Entertainment: DVD sales fell 9% which is actually not bad and better than some estimates based on published sell through data. Box office was flat. Mix shifted in favor of box office which pressured margins. The Ratatouille DVD will not be released internationally until later this quarter. This could provide a nice bump to the March quarter given that over 2/3rds of box office was earned abroad making it the #2 international Pixar film.

Theme Parks: Attendance, spending, hotel occupancy, and margins were all exceptional. As outlined above, no weakness evident yet. The rest of the fiscal year looks good. On the call, management noted that the mix in the domestic theme parks has shifted toward the cruise and vacation club businesses. Cruises are in growth mode and the vacation club is holding up very well. In addition, management noted that it has "considerable leeway" to adjust cost to demand should demand weaken or strengthen. Items pointed include park hours and entertainment offerings.

Consumer Products: Revenues grew 26% and operating income grew 37% against estimates of 12% for both. While legacy content like Cars and Toy Story was very good, this performance can be directly attributed to Hannah Montana and High School Musical in merchandising and video games. In an aside, Bob Iger noted that girls are playing more video games which works to Disney's benefit. The decision to bring video games in house looks like a smart one.

Disney Earnings Preview: Slower Growth But Looking For A Positive Surprise

Disney is expected to report its weakest growth quarter in several years but I do think investors should interpret it as the end of Disney's multiyear run of superior financial results. Tough comparisons and the challenges of a weakening consumer are driving the slower growth but there is a good chance Disney will beat estimates which will remind investors that the company is coping quite well and deserves a higher valuation.

For its fiscal first quarter ending December 31st, Disney is expected to report EPs of 52% on revenues of $10.04 billion. These figures represent EPS growth of 6% and revenue growth of 3%. Operating income which is the most closely watched financial metric at Disney is projected to grow just 3%.

These figures understate the health of Disney's business as 2007 ended because a 20% decline in profits at the company's Studio Entertainment segments is dragging down results. Each of the company's other segments including Broadcasting, Cable Networks, Theme Parks, and Consumer Products should enjoy double digit growth in operating income in the quarter.

A couple of things to keep your eye on in the report and on the call are (1) the pace of share buybacks which have been very aggressive, (2) the outlook for the theme parks given that visibility has shortened, (3) comments on progress building out the internet businesses, and (4) any impact from the writer's strike.

Here is a brief look at the company's business segments....

....Broadcasting: Despite weak overall ratings at ABC a strong market for advertising and good ratings in key time slots, should allow this segment to enjoy revenue growth of 4% and operating income growth of 14%. The shutdown of the Disney Mobile venture will benefit the quarter as well. Comments on the writer's strike especially as it relates to the March quarter will be of interest. Also the timing of political spending at the TV stations will impact guidance.

Cable Networks: This segment is projected to show revenue growth of 14% and operating income growth of 13$. ESPN is benefiting form being DVR proof leading to rising ad demand and prices even as ratings were down a bit this year. The Disney Channel is smoking although since it is not ad supported the flow through may not be quite as large as might be expected. This segment contains the company's recent acquisition of Club Penguin which could impact comparisons. As usual the timing of revenue recognition at ESPN can distort the quarter along with bumps in sports rights fees.

Studio Entertainment: This is the segment that will drag down corporate results. The problem is tough comparisons in the very profitable DVD business. Last year Pirates 2 and Cars sold extremely well. This year Pirates 2 was less popular and Ratatouille was only releases in the US. Ratatouille performed much better at the international box office. Disney did have good depth in the top 20 selling titles during the holiday season which may offset the tough comp to some extent. Disney also had a good quarter at the box office which sets up future DVD sales and also will help offset the tough DVD comp. Overall, analysts are looking for the segment to report a 3% drop in revenues but a 19% drop in operating income.

Theme Parks: Despite lots of concern there was no slowdown at the theme parks in the December quarter. Thanksgiving was the busiest ever at the domestic theme parks and reports on Christmas were robust. A weak dollar is helping. Disney vacations are booked far in advance providing some insulation against the early stages of a consumer slowdown. Thus, the discussion on the call will be about the outlook. Last week management made constructive comments. I expect those to be reiterated and fleshed out against tough questioning from analysts. At the international parks, Hong Kong is struggling while EuroDisney continues its turnaround. For the December quarter, revenues should grow 7% with operating income rising 14%.

Consumer Products: Disney's content generation engine has been on fire which should drive good growth in this segment despite tough comps. Analyst estimates call for 12% growth in revenues and operating income. High School Musical, Hannah Montana, Cars, Pirates, and Ratatouille are key properties. Video games are in this segment which can swing profits either way as the business is still in investment mode but beginning to generate hits.

Routinely Good Quarter for Disney

Disney reported 4Q07 EPS of 42 cents adjusted for a tax benefit compared to consensus of 41 cents. Revenues of $8.93 billion matched the $8.98 million consensus. Comparing the segment numbers to my spreadsheet shows a remarkable closeness. This is actually one the things I like about Disney: the company is very tightly managed and predictable (leaving aside the volatility in movie and TV production). Strong and consistent execution is especially valuable with concerns over consumer spending rising. It is also helpful to valuation of the shares. Disney trades inline with peers News Corporation and Viacom. I think the strength of management and the company's franchises are deserving of a premium valuation.

The quarter and management commentary will not do much to quell the debate over how fast Disney will grow in FY08. In general, management sounded confident about the December quarter with theme park attendance and occupancy trends looking up mid-single digits and scatter market advertising up "strong" double digits at ABC – I'd interpret that as over 20% --- and double digit at ESPN. The company has a good DVD lineup with Pirates 3, Ratatouille, and High School Musical 2.

The only issue I see in the 4Q report is the slight contraction in theme park margins....

....This is the first quarter since 3Q05 where margins did not expand at theme parks. This was the very first question in the conference call Q&A and as I suspected (and hoped), the explanation was the international parks as Hong Kong remains disappointing. Management stated that domestic theme park margins expanded again. To get to double digit growth in 2008, Disney will need theme park margin expansion. Attendance and spending trends in the December quarter provide a good start and I'll be looking to renewed margin expansion this quarter to firm up the outlook. On the conference call there were several questions about theme park visibility indicating that analysts aren't comfortable even though September quarter was good and December bookings are similar. The visibility issue will serve as fodder for Disney bears who will note that attendance could slump quickly and unexpectedly. Foreign visitation and upper middle class Americans who forgo Europe due to currency provide support, however.

I do not mean to be flippant or lazy but if you read my preview of the earnings, virtually all of the commentary on the segments is more or less repeated in the press release. So in brief…

ABC was flattish as weak ratings were offset by big advertising price increases. ESPN was great with underlying growth in advertising greater than 10% after the benefits of recognizing revenue deferrals and the ads in the new NASCAR telecasts. The studio was weak as expected due to Pirates 2 in the year ago 4Q while Pirates 3 this year was in 3Q. Consumer Products continues to benefit from Cars and Pirates merchandising and Hannah Montana and High School Musical. This is offset by increased spending on licensing development and video games. FY08 will see another step up in these spending categories which will be a modest headwind. Theme park comments are largely above but management noted that attendance grew 5%, spending per guest was up 2% and hotel occupancy was just over 90%.

Disney 4Q07 Earnings Preview

Disney is expected to report strong 4Q07 financial performance capping another great year. For 4Q, consensus calls for EPS of 42 cents, up 17%, on revenues of $9 billion, up 2%. Operating income, a key metric for Disney investors, is expected to rise 14%. Estimates are unchanged since the last quarterly report although the tone of commentary about the quarter and 2008 has improved.

Assuming the quarter contain minimal downside surprises, a good assumption in my opinion, the response in Disney shares will be all about the 21008 outlook. Disney is wrapping up its fifth consecutive year of double digit operating income growth. With stiff comparisons against 24% operating income growth in 2007 and Disney's well-chronicled exposure to consumer spending via theme parks and advertising, there is a lot of concern about how quickly growth will decelerate in 2008. Current EPS estimates show an 11% growth expectation in 2008. That is good but probably not enough to drive the shares significantly higher. However, indications form management that 2008 is shaping up better than expected, a real possibility in my opinion, would allow Disney shares to break to new highs if the market is cooperative. I am very comfortable being long heading into the report and expect to remain long for at least another quarter or two.

Here is a look at anticipated segment results for 4Q07 and FY08....

....Broadcasting: For 4Q, revenue is expected to decline 3% due to a tough comparison against strong syndication sales a year ago. Syndication revenue is very profitable so the entire segment is expected to shift from a small gain to a loss of over $30 million. ABC should be flat as weak summer ratings are offset by very strong scatter pricing. Looking to 2008, ABC is off a decent start this TV season leaving some room to the upside to the upside relative to current estimates. Nevertheless, operating income growth in 2008 is unlikely to reach above high single digits.

Cable Networks: This segment should be the driver of 4Q results with revenues rising 20% and operating income gaining 26%. Strong ratings, affiliate fee growth, revenue deferral reversals at ESPN, and the elimination of losses related to ESPN Mobile will be the key contributors to growth. One potential negative to keep an eye on is programming expenses at ABC Family and the Disney Channel. For 2008, the segment will moderate but should grow double digits as ESPN benefits from much more moderate rights fee increases and affiliate fees and advertising continue to grow. Also, upside exists at the Disney Channel form High School Musical.

Theme Parks: Mid single digit revenue growth driven by high occupancy and growing attendance should lead to margin expansion and 10% growth in operating income. Theme parks have a high fixed cost base so as long as revenue drivers are intact, margin expansion is in order. For 2008, concern about consumer spending is holding estimates back to mid to upper single digit growth. Disney may also pick up some costs related to expansion of its cruise line, California park, and time share/vacation club business. These are worthwhile investments, however, as they should lead to a surge in segment growth and margins in 2010 and beyond.

Studio Entertainment: A tough comparison vs. 2006 when Pirates 2 was in theatres suggests a tough quarter for the studio. Revenues are projected to fall 21% with profits dropping 7%. Tight const controls and lower levels of marketing support for film releases are limiting the operating income decline. DVD comps are also tough this quarter. For 2008, lack of a Pirates film sets up a tough comp as does crowded DVD release calendar this holiday season. Mid-single digit growth would be a good outcome, although expectations are low to begin with.

Consumer Products: Benefits from High School Musical and easier comps should offset higher development spending on video games, driving 6% revenue growth and 16% operating income growth in 4Q. In 2008, similar drivers should lead to growth of around 10%.

Pirates, Cars, and Rats

While preparing my fourth quarter box office preview column last week, I came across some interesting and positive data concerning Disney. One of the worries for Disney this year has been the tough comparison at the movie studio due to the phenomenal success last year of Pirates of the Caribbean: Dead man’s Chest and Cars. This year, Disney released Pirates of the Caribbean: At World’s End and Ratatouille. Domestically, both of the 2007 releases significantly trailed their 2007 counterparts. Pirates 2007 matched Pirates 2006 overseas, leaving it $100 million short. This is material difference but given the vagaries of studio accounting and the fact that the two films were made at the same time, I would be shocked if Disney even mentioned any differences in the two films profitability on its upcoming quarterly conference call.

The Cars vs. Ratatouille comparison is trickier. Cars grossed $244 million in the US vs. $203 million for Ratatouille. Overseas, however, Ratatouille looks like it will easily exceed Cars, thanks especially to fantastic grosses in France. In fact, thorough the end of September, Ratatouille had grossed $223 million abroad, $6 million more than Cars. Furthermore, Ratatouille had yet to open in the United Kingdom, Germany, Italy, Greece, or Denmark. These countries produced a combined gross of $67 million for Cars, suggesting that the final worldwide tally for Ratatouille will exceed Cars....

....Despite the global box office success of Ratatouille, analysts are still worried its overall profit contribution will fall short of Cars due to the phenomenal success of merchandise related to Cars. I would never discount the merchandise and licensing teams at Disney but selling cars is a lot easier than a rat and gourmet food.

The bottom line is that the global box office performance of Ratatouille has probably been strong enough to mitigate the concern of analysts and generate more than enough revenue and profits to meet or exceed the conservative estimates in their spreadsheets that were likely influenced by the lagging domestic box office relative to Cars. Disney faces other earnings risks given the jam packed DVD release schedule this holiday season and fears about consumer spending but it appears that one risk feared earlier this year has failed to materialize.

Disney Earnings Growth Continues Unabated

Disney (DIS) reported another strong quarter. EPS of 58 cents exceeded the 55 cent consensus estimate with revenues in line with expectations at $9.05 billion. The upside came from margins with Broadcasting being unusually strong with operating income up 127%. Cable Networks also had higher margins than analysts were expecting. The only shortfall was operating income at Studio Entertainment but this segment has notoriously volatile and difficult to predict financial performance.

Commentary about the fourth quarter and general big picture thoughts about 2008 and beyond was all positive. Between the upside surprise and the confidence expressed by management I think the concerns over DIS's future growth will moderate somewhat. This should allow the shares to resume their leadership among megacap entertainment conglomerates. All you really need to do is juxtapose the earnings reports and conference calls of Disney and Time Warner from yesterday to see why Disney shares remain attractive.

Disney also announced the acquisition of Club Penguin, a social networking site focused on the kids demographic. DIS will make an upfront payment of $350 million with an additional $350 million due if certain incentives are met. The deal should be accretive in year one and accretion will rise if the incentives are met. Club Penguin could have about $50 million in revenue and I would guess pre-tax margins are near 40%. I like the deal for DIS. Promoting Club Penguin across Disney properties should accelerate growth and in the long run the ability to use Club Penguin across the company's other assets seems plausible.

Looking more carefully at the segment level, it was another quarter of solid growth. Revenues were up 7% and operating income again rose double digits, gaining 14%. EPS for the first nine months of the fiscal year have grown by 24%....

Broadcasting had a great quarter with revenues up 9% and operating income up 127%. Programming costs were much lower due to success of ABC's schedule while international and domestic syndication of recent hits on the network drove revenue.

Cable Networks had 5% revenue growth and 9% operating income growth. ESPN and the domestic Disney owned networks led the way. Next quarter will see a big boost in revenue from ESPN deferrals but will also assume much of the NASCAR rights fees. I am not sure how this will balance out relative to expectations but I would guess that analysts knew about the rights fees already and the extra revenue will be incremental.

The volatile Studio Entertainment segment saw revenues decline rise 6% and operating income fall a worse than expected 20%. The entire issue was about a tough comparison in highly profitable DVD sales. Next quarter faces a tough comparison on theatrical box office since Pirates 2 was entirely in the third quarter a year ago and is one of the top grossing movies of all time.

Theme Parks continue to plug along with domestic attendance trends flattish but better than expected against tough comparison. Per capita spending at the parks and hotels is running up strongly helping to drive margins. Management had met its 20% margin goal but commentary on the call suggests they think they can get back towards toward record margins of 23% in the next few years.

Consumer Products remains an underappreciated segment. Revenues rose 23% and operating income was up 12%. Investments in video games and merchandising held back margins but given all the great content DIS has produced in the last few years this investment will pay off down the road. Consumer Products has the potential to surprise to the upside and help sustain growth next year as DIS faces tough comparisons elsewhere.

Disney 3Q07 Earnings Preview

Disney (DIS) faces a tough comparison when it reports its 3Q07. Projected EPS of 55 cents are up just 4% vs. a year ago. Analysts have long expected this to be the toughest comparison so it should not come as a surprise. Given ongoing concerns that DIS' best financial performance is behind it, the report and conference call could be significant to resolving the debate.

DIS has been growing at a double digit rate for several years and the stock price has responded accordingly. Financial performance in all divisions has been excellent and current profitability levels are at all-time highs pretty much across the board. No one argues that DIS' growth will not slow. Rather it is the magnitude of slowing where the debate occurs. I am in the bull camp, believing that double digit growth can continue. The stock is acting like the growth string is near the end. A good report with confident talk about the future – DIS does not provide guidance – should be greeted well but any shortfall or signs that the rest of 2007 will remain sluggish probably means the end of the bull run in DIS shares for the time being.

For 3Q07, DIS is expected to report EPS of 55 cents on revenues of $9.04 billion. Revenue growth is projected at 6%. Operating income is the key metric for DIS and it is projected to grow at or slightly ahead of revenues indicating flat to slightly higher margins.

As with most of the major media stocks, it is segment level results where the action takes place. Here is a brief preview of each segment...

Broadcasting should show revenue growth of 7% and a big 45% increase in operating income. Strong scatter pricing and the strength of ABC's primetime schedule last TV season provide the upside. In addition, costs should be down as the company had less programming development this year. DIS also had a good quarter for TV syndication which is normally highly profitable.

Cable Networks should show double digit revenue growth but just low to mid-single digit operating income growth. Revenue deferrals and somewhat soft ratings at EPSN and a tough comp vs. last year when the High School Musical DVD was shipped will hold back operating income. The Disney Channel should continue its strong growth.

Theme Parks should offer more of the same with mid-single digit revenue growth accompanied by margin expansion driving double digit operating income growth. DIS still faces tough attendance comps at its theme parks due to 2006 promotions but this segment has consistently beat estimates this year despite those tough comps.

Studio Entertainment is projected to show negative comparisons. Box office looks good but the lack of a big selling DVD title against the initial shipments of The Chronicles of Narnia a year ago creates a very difficult hurdle. Furthermore, most of the marketing expenses for Ratatouille will fall in 3Q even though the film was not launched until June 29th, creating an expense-revenue mismatch. One positive to come out of this segment this quarter should be reassuring words about the profitability of Ratatouille and Pirates of the Caribbean: At World's End both of which performed well but under some aggressive estimates.

Consumer Products was a bright spot last quarter and another good quarter is expected. Licensing revenue related to Cars, the Pirates movies, and Ratatouille should continue to grow strongly. Rising expenses as DIS develops its video game division will be a negative offset.

News On Northlake Stocks

Several stocks in the Northlake portfolio have had newsworthy items over the past week. Here is a recap of the latest news, all of which I think is positive.

Disney (DIS) completed the sale of almost all of its radio operations to Citadel Broadcasting (CDL). DIS shareholders received .0768 shares of CDL for each share of DIS they owned. DIS received $1.35 billion in cash from CDL. I plan to hold CDL and will look to add to the small positions if the shares come under pressure as DIS shareholders sell their small holdings. The profile of a DIS and CDL shareholder would seem to have little in common which could lead to lots of selling. Given that the DIS deal about doubles CDL shares outstanding, I think supply-demand imbalances could put some downward pressure on CDL. That was not the case yesterday when CDL rallied on the first day of post-closing trading. CDL has a current yield of over 5% which should limit downside....

Central European Media Enterprises (CETV) announced that it was acquiring 5% of its Romanian operation form its long-time partner and current senior executive Adrian Sarbu. CETV now owns 95% of Romania with Sarbu holdings 5% that has a newly restructured put option. CETV paid $50 million for the 5% stake, placing a value of $1 billion on Romania. I expect Romania to produce about $85 million in EBITDA this year, putting the multiple at 12 times. This actually seems a little cheap to me given that Romania has been growing at 30-40% per year and is projected to sustain a growth rate in excess of 20% for several more years. I suspect that CETV held the upper hand in the negotiations given Sarbu's small minority stake. I am always happy when CETV is able to buy more of its own operations and it is even better when the price is right. I remain a buyer of CETV which has lagged over the last month.

Endeavor Acquisition (EDA) released 2006 and 1Q07 financials for American Apparel and also filed the proxy. These filings indicate the acquisition of American Apparel remains on track for a 3Q07 closing. I have not had a chance to read all the filings but the headlines suggest that everything is on track. Management indicated that same store sales remain strong in 2Q and 1Q EBITDA suggests that the company is on track to meet 2007 guidance. The shares have moved to new highs since the filings. I still think EDA can reach $14-18 assuming American Apparel is able to maintain operating momentum in the first few quarters following the closing of the deal.

Rogers Communications (RG) announced the purchase of five traditional over-the-air TV stations in Canada. All major cities except Montreal were included. It is not a huge deal at $350 million Canadian but based on Canadian press reports it looks like a favorable deal for RG. RG shares remain right at their 52 week high and the prospects for further upside remain as wireless and cable drive mid-teens growth in operating profits and significant free cash flow begins to flow. A price target of at least $45 is realistic.

Disney Radio Sale Set To Close

While Disney (DIS) shareholders digest the box office and stock market reaction to Pirates of the Caribbean: At World's End, the company announced details of the divestiture of most its radio business. According to press release issued Friday, on June 12th, DIS shareholders will receive .0766 shares of Citadel Broadcasting (CDL) for each share of DIS they own as of the close on June 6th. CDL is buying DIS's radio business including radio stations and the ABC Radio Network. DIS will continue to be involved in radio through its ownership of the Radio Disney and ESPN radio networks and a few stations operating with content from these networks.

CDL shares have performed poorly since announcing the acquisition of the DIS radio assets last year. CDL is essentially doubling down on radio as the DIS assets are as large as CDL's current business. CDL is paying an above market price for the DIS even after DIS agreed to a modest renegotiation of the deal terms. Compounding the troubles for CDL has been deteriorating advertising growth for the radio industry as it loses share to online advertising.

While CDL shares have worked steadily lower since mid-February, radio stocks as a group have actually performed fairly well, beating the market's return about 75% of the week's so far this year according to recent data from Credit Suisse. Consequently, I think it is possible that consummation of the DIS deal might allow CDL shares to perform relatively well for a few weeks. On the other hand, the newly issued and distributed CDL shares seem likely to be sold creating a near-term supply-demand imbalance. CDL is issuing approximately 150 million shares to DIS shareholders vs. 100 million currently outstanding. Given the vastly different investment profiles of DIS and CDL, it seems fair to assume that many individual and institutional DIS shareholders will be looking to sell their newly received CDL shares....

The new CDL will be a heavily leveraged company producing significant free cash flow that it intends to sue to pay an annual dividend. Analysts believe the current yield on new CDL shares could be around 5% representing about 50% of projected free cash flow. With station sales, excess free cash flow not paid as dividends, and modestly growing free cash flow, CDL could gradually delever over the next few years. The shares presently trade at around 10 times management's suggested pro forma 2008 EBITDA of $400 million with debt equal to 6 times pro forma EBITDA. This valuation is below the current multiples on other leading radio stocks.

CDL is not without risk given the secular challenges facing the radio industry but the financial leverage looks manageable and that can be a recipe for superior shareholder returns if management has a shareholder bias. CEO Farid Suleman has a good track record from his days at Infinity Broadcasting and owns 5 million shares. Forstmann Little is a controlling shareholder. Suleman and Forstmann Little should share the priorities of most shareholders.

New CDL reminds me a little of Regal Entertainment (RGC), which is also highly levered, pays a substantial dividend that supports the stock price, and has a significant controlling shareholder. I've done well with RGC, earning a total return in excess of 20% since the initial purchase in March 2006. I think new CDL could possibly do as well in the next year so as of now I plan to hold the CDL shares that client accounts will be receiving.

Another Good Quarter For Disney

Disney (DIS) reported very good 2Q07 results driven by strong margin performance across all five operating segments. Better profitability allowed EPS to easily exceed consensus estimates coming in at 44 cents, up 19%, vs. expectations of 38 cents, up 3%. Revenues fell very slightly short of estimates at $8.07 billion, $60 million short of estimates. The revenue shortfall was concentrated in the Broadcasting and Studio Entertainment segments but was offset by better than expected revenue for Theme Parks and Consumer Products.

Despite the big beat on EPS, DIS shares immediately traded about 1.5-2% lower following the report. I suspect it is just a sell the news reaction as I really don’t see any problems at all unless you consider a $60 million revenue miss on over $8 billion in revenues a big deal. I don’t, especially when operating income exceed estimates in four of five segments and was $200-300 million ahead of the street.

The upcoming 3Q represents DIS's toughest comparison of the year. Presently, EPS are projected to be flat at 53 cents. For the first six months adjusted EPS are up 31%, so earnings momentum looks set to slack. The major issue for 3Q is that last year DIS released The Chronicles of Narnia DVD which sold extremely well. No comparable release exists this year. I'd guess that alone could cost the company in excess of $100 million in operating profits over the balance of the fiscal year, with most of the shortfall coming in 3Q. On a base of $2 billion in operating income this represents a serious challenge to overall corporate growth.

Offsetting the tough Studio comparison is the fact that for two consecutive quarters DIS's margins have expanded sharply. If overall corporate profitability has taken a full step higher then DIS earnings power is greater than currently anticipated. While some of the margin expansion can surely be linked to outstanding content performance, I think there is some permanent flow through, particularly at the Studio and Theme Parks. Strong scatter pricing at ABC and a recent ratings surge should also boost 3Q....

The 2Q report and management comments about the balance of the year suggests that 2007 estimates of $1.81 are headed higher, probably to north of $1.90. Prior to the report, growth in 2008 was projected at 12%. Maintaining 12% growth brings 2008 to $2.10 to $2.15 vs. current consensus of $2.03. At today's opening level of $36, DIS shares are not richly valued at 19 times 2007 and 17 times 2008 EPS estimates.

The shares had risen 4% into the report putting them at an all-time high. I think the strength of the report will limit any sell the news damage and with any help from the market, DIS can still attain my 2007 target of $40. I plan to hold the position I have in Northlake client portfolios.

Here are some brief segment comments:

Broadcasting: Revenues fell 7% due to less sports programming but profits were up sharply (33%) since sports rights went bye bye. Scatter pricing was up low single digits and is rising similarly this quarter. ABC's ratings have been coming on strong which sets up the upfront very nicely. No detail was provided on losses at the Disney branded mobile phone service. Some analysts may complain about non-sports revenue trends in 2Q.

Cable: ESPN is kicking butt. Profitability in the entire segment including The Disney Channel and international channels was ahead of estimates. The boost from eliminating losses on the ESPN wireless service was not quantified but certainly helped the quarter. Ratings trends at ESPN are solid and deferred revenues will flow in 2H07.

Theme Parks: Overcoming tough comparisons, theme park attendance was quite good, rising 7% in Florida and up slightly in California. Margin expansion continued driven this quarter by solid results in Paris. Hong Kong is still struggling. The margin expansion story at the domestic parks remains on track as margins are up 100 basis points in the first half. Timing issues held back margins this quarter. Attendance, occupancy, and per capita spending trends all look good for the rest of the year. Theme Parks has proven to be a nice positive surprise this year against very cautious estimates.

Studio Entertainment: Despite a $100 million shortfall in revenue, operating income exceeded estimates. Management noted lower distribution expenses due to fewer films and double digit gains in music. Spillover form Cars and Pirates 2 DVDs was not as large as expected. Put it all together and the cost cutting at the studio seems to be very well in place. The Narnia DVD sets up a tough comparison on profitability but Pirates 3 box office will mostly in 3Q this year vs. 4Q a year ago. The bigger challenge will be calendar 2008 when no Pirates film or DVD is scheduled.

Consumer Products: Revenues and operating income surprised to the upside. Royalties on very strong sales of Cars merchandise offset falling minimum guarantees and higher video game spending. Management noted that Cars merchandise sales are still growing. This is a reminder that DIS has many ways to make money on its content, especially the high quality content coming from Pixar. That will be handy to keep in mind as the inevitable hand wringing over Ratatouille begins.

Disney: Slowing Growth, High Expectations Raise The Bar

Margin expansion should propel Disney (DIS) to another quarter of greater than 10% growth in operating income when it reports 2Q07 results after the close on Tuesday. Revenue and EPS growth are only projected to grow in the low single digits due to tough comparisons. DIS has produced significant positive surprises in each of the last four quarters and estimates have been rising slightly so the expectation bar is high. With 3Q also facing a tough comp and slower growth than in recent quarters, DIS probably needs to report a positive surprise and indicate 3Q is shaping up well for the shares to move higher. An as expected quarter could lead to a sell the news reaction.

DIS is being very tightly and adeptly managed and has great momentum in its content divisions. I think the company will produce a quarter that satisfies investors. I am long and expect to remain long following the quarter looking for an exit closer to the $40 level.

Current consensus estimates call for EPS of 38 cents on revenues of $8.13 billion. A year ago EPS was 37 cents on revenues of $8.02 billion so growth is expected be just 1-2% in the headline numbers. Margin expansion at almost all division will produce better operating income growth which is the key measurement for investors....

Broadcasting will likely show down revenues due the carriage of the Super Bowl a year ago. Excluding the Super Bowl revenues will be up about 5%. Revenues and margins will benefit from the shift of Grey's Anatomy to Thursday night and should overcome generally softer ratings. Scatter market ad pricing has been strong which will also help the quarter. Losses from the Disney branded wireless MVNO will pressure the quarter.

Cable will produce another good quarter driven by the ESPN juggernaught. Revenues should grow about 7% with operating income up about 10%. Elimination of losses from the ESPN branded MVNO will boost profits. Revenue deferrals will again be an issue but will just delay revenue and profit recognition until 2H07 when football and NASCAR programming airs.

Theme Parks face another tough comparison due to the 50th anniversary celebration a year ago in California. Trends in Florida have been strong, however, and should be enough to produce an uptick on the revenue and operating income lines with an assist form cost controls. Parks in Hong Kong and Paris will continue to produce good revenue growth but sizable losses.

Studio Entertainment faces a tough comparison and is expected to see slightly lower revenue than a year ago. A smaller movie slate and cost cutting should lead to margin expansion and a gain in operating income. Last year saw very strong DVD sales and international box office from Chronicles of Narnia. This year's films performed better than expected and it is possible that DVD sales of Cars and Pirates 2 carried over into the March quarter.

Consumer Products is the smallest at DIS and will produce flat results. The winding down of minimum guaranteed revenues will be offset by the start of royalties on formerly owned Disney stores. Higher spending in the video game unit could pressure profits.

Disney's March Quarter Shaping Up Well

As mentioned in my overview of the 2007 Prudential Midwest Media Day, I came away from my meeting with Disney (DIS) with increased confidence in the outlook for March quarter earnings. The March quarter represents 2Q07 for DIS and will be reported after the close on May 8th with a conference beginning at 4:30 EDT.

There are several reasons for increased optimism about the March quarter including (1) strong scatter market pricing at ABC, (2) mid single digit gains in DVD revenue, ( 3) decent performance at the box office from this year's releases relative to what was expected to be a tough comparison, (4) fewer movie releases this year possibly offset by marketing costs for Meet The Robinsons falling in the March quarter against a June quarter theatrical release, (5) flat overall theme park attendance which is trending above conservative analyst estimates, and (6) ratings strength at ESPN and the Disney Channel and the financial benefit of ABC's taking over the #1 spot on Thursday's, the most lucrative night on TV..

The debate over DIS shares continues to revolve around the growth rate in the next 18 months....

A better than expected March quarter would put points on the board for the bulls but still won’t answer the all the questions due to continuing tough comparisons, especially in the June quarter, higher sports expenses for the NFL and NASCAR, and increasing concern about the health of the economy and how that might impact travel to the company's theme parks.

I am sticking with Northlake's long positions in DIS although upside is limited to 10-15% based on my current expectations. If the shares were to move up another couple of dollars without an increase in estimates, I'd probably take profits.

Disney: Strong 1Q07 Earnings Support Higher Target Price

Disney (DIS) reported much better than expected 1Q07 earnings with EPS coming in at 50 cents against a consensus estimate of 39 cents. Revenues were also better than expected at $9.7 billion vs. an estimate of $9.5 billion. I don’t see any unusual items that would impact the 50 cent figure so this looks like a large and clean beat.

At the segment level, revue upside came from Broadcasting and Studio Entertainment with modest upside at Cable Networks. At the operating income level, DIS came in just short of $2 billion, over $300 million ahead of analyst estimates. Cable Networks and Studio Entertainment provided all of the upside.

DIS no longer provides guidance and Q&A on the conference call was a little short because the company is hosting an analyst meeting starting tonight. However, it was clear from the tone of the call that management is very confident in the FY07 outlook. Given the big beat and confident commentary, estimates will definitely be going up by "at least" the amount of the beat. DIS looks poised to produce another year of double digit EPS and operating income growth, something that many on Wall Street, including some bulls were worried might not happen. 1Q07 results provide for a little more upside in DIS shares but maybe as importantly they dramatically reduce the risk that 2007 turns out the be the year that the DIS story ends. The toughest quarterly comps are coming in the next two quarters so reaction in the shares might be limited but DIS is likely to continue beating conservative estimates providing upside momentum to the shares. The $40 level is now clearly within reach.

Here are brief segment comments....

Broadcasting: Performed as expected with ABC doing well and the TV stations getting a boost from political advertising. Of great significance, management noted that current scatter market pricing is 10% above upfront. This should lead to estimate increases in this segment.

Cable Networks: Confounding some skeptics, ESPN continues to rock. Adjusted for a $60 million revenue deferral that has no costs attached, operating income would have risen about 10% despite the huge increase in amortization of the Monday Night Football NFL contract. Management didn’t really change their tune of calling for "average" annual growth of double digits for ESPN but the commentary suggested this would probably be reached in 2007 despite many naysayers. The NASCAR contract starts amortizing in 2007 so keep an eye on the ratings for races.

Theme Parks: Another solid quarter. Against very tough comparisons revenues rose 4% and operating income rose 6%. Attendance trends are very good in Florida driven by domestic visitors. This is another division where estimates have been cautious and the good start to the year should lead to increases in estimates for the remaining quarters.

Studio Entertainment: A huge quarter by any measure driven by DVD sales of Pirates, Cars, and Little Mermaid. Revenue rose 23 %, beating estimates by over $100 million. The flow through to operating income was superb as EBITA rose by over 200%. At $600 million, EBITDA beat estimates by $200 million. Management noted that Little Mermaid is a fully amortized title and sold very well. Also, Pirates and Cars sold at least as many units as hoped and management is not concerned about an unusual level of returns from major retailers. This is probably the last strong comparison for the Studio for several quarters.

Consumer Products: Strong merchandise licensing for Cars and Pirates could not overcome the loss of guaranteed revenue, weak video game sales, and high video game development costs. Revenues fell 8% and EBITDA fell 13%, both coming in below analyst estimates. This is DIS smallest division so the shortfall is not too much of a concern. Comparisons should improve as the year goes on.

Disney Radio Deal and Weekend Box Office

Just before Thanksgiving, Disney (DIS) and Citadel Broadcasting (CDL) announced a restructuring of CDL's deal to buy DIS' radio assets. The total value of the deal has been reduced by $100 million and an additional $200 million of cash due to DIS will now come in the form of CDL shares. Essentially, DIS is trading $300 million in cash for $200 million in CDL shares. It was widely expected the deal was going to be renegotiated since the radio industry has suffered severely since the deal was struck, so this news isn’t much of a surprise. The loss of $100 million in value is minor compared to DIS' market cap of $68 billion. DIS now will temporarily own 57% of CDL instead of 52% but the plan all along has been to pass that ownership on to DIS shareholders. It is still not certain what form the distribution will take. I think this is an acceptable outcome for DIS shareholders and it now looks closing is a near certainty by 2Q07.

In other news, the weekend box office, performed admirably against another tough comparison.....

My thesis that depth of quality product reaching all movie going demographics could limit the year-over-year declines against last year's trio of blockbusters (Harry Potter, King Kong, Narnia) provide correct this weekend. The overall weekend for the top 12 films was flat as the new Bond and Happy Feet were able to match last year's second weekend for the fourth movie in the Potter series. Bond and Happy Feet are showing very good legs and this coming weekend should be another where depth limits the damage. Comparisons then toughen again. I still think investors will look past the tough compass this holiday period leaving renewed positive sentiment toward the box office intact ahead of next May's blockbusters (Spiderman 3, Shrek 3, and Pirates 3). This is good news for major entertainment conglomerates and theatre exhibitors including DIS, News Corp (NWS), Time Warner (TWX), Lionsgate (LGF), Regal Entertainment (RGC), and Carmike Cinemas (CKEC).

Disney's Swing Factors for 2007

4Q06 earnings from Disney (DIS) left open the debate over whether the company 's four year string of double digit operating income growth is about to come to and end. With DIS shares are a premium to other diversified media conglomerates, a premium earned by the company's outstanding performance the last few years, the FY07 growth rates is critical to the performance of DIS shares in the month end.

I have strongly advocated for ownership of DIS partially on the belief that skepticism toward the 2007 growth rate would give way to the realization that DIS would continue to drive industry leading growth. What follows is a rundown of the pluses and minuses at the margin for DIS in 2007. I still think the plusses win out but you can decided for yourself.

Positive Swing Factors

• ABC is off to a great start this TV season. The shift of Grey's Anatomy to Thursday nights, popular new shows, scatter market pricing firmly above upfront, and the elimination of losses on Monday Night Football all suggest upside to the ABC, which has significant operating leverage.
• ABC's owned and operated TV stations will benefit from political advertising in 1Q07 (this quarter).
• ESPN ratings are very strong this season. MNF ratings are above guarantees, likely providing upside in profitability (or reduced losses) on this expensive rights contract. Losses on the ESPN Mobile venture won’t be repeated.
• DVD sales for Pirates , Cars, and a slate of other successful films that were released in FY06 will hit in FY07, mostly in the current quarter. This is very high margin revenue.
• The divested Disney Stores will begin to receive licensing fees.
• Merchandising revenue, again a very high margin stream, will continue to be boosted by Cars and Pirates.
• Domestic theme park attendance has held up well with flat comparisons against very tough comparisons. Revenues are still climbing as per capita spending is rising mid-single digits.
• Margin expansion will continue at the domestic parks, helped along greatly by a sharp drop in pension costs. Admittedly this is a low quality earnings stream.
• EuroDisney and Hong Kong Disneyland will see reduced losses.
• A smaller film slate means incrementally lower marketing costs.
• Cost cutting at the movie studio could save $100 million.

Negative Swing Factors

• DIS continues to invest in its video games unit. Incremental spending will be $30 million.
• Radio will ultimately be divested. Investors will probably look at pro forma growth but this division is worth -5 cents in annual EPS.
• Capital spending is going up due to theme park investment and further spending on digital content initiatives.
• Losses may be higher for the Disney branded mobile phone initiative.
• ESPN won NASCAR rights which will begin to be amortized in calendar 2007.
• Consumer products had minimum guaranteed revenue related to its sale that disappears in 2007.
• The tax rate is going up slightly.
• The Pixar acquisition will be dilutive for a full year.

In my opinion, analyst estimates somewhat favor the negative factors, leaving room for upside if the positive factors come through. Additionally, DIS appears very close to renewing its deal with Comcast (CMCSA/K) for carriage of the ESPN family of cable networks and the Disney Channel.

The deal is rumored to include the sale of DIS' minority stake in E! for over $1 billion. The sale of E!, the divestiture of radio, the acquisition of Pixar, and the investment in video games and digital content, and the continued investment in international parks and distribution signal how DIS hopes to drive growth beyond 2007. Besides what I hope will be rising estimates in 2007, I think DIS has laid out the clearest path to long-term growth with the simplest capital structure among the major entertainment conglomerates. Put those two things together and it should be obvious why I remain bullish on DIS shares.

Disney Numbers Are Good But Sell The News Wins Out

Disney (DIS) reported strong 4Q06 earnings. EPS of 36 cents compared to a rising 33 cent consensus and revenues of $8.8 billion were ahead of the consensus estimate of $8.7 billion. Segment level results were as good as or better than expected across the board with particular strength in Studio Entertainment and Theme Parks.

Despite the better than expected results I think DIS shares may trade slightly lower for two reasons. First, given the strong run-up and rising estimates, a positive surprise was expected. Thus, a sell the news setup is in place. Second, on the conference call, I thought the companies comments on swing factors for FY07 (DIS does not provide guidance) will leave the debate open as to whether the company can extend its string of double digit growth in operating income. I think the commentary gave slightly more ammunition to those who think the streak will be snapped than those who think it will continue (I think it will continue)....

Don’t read that as unusually negative. DIS management was confident and spoke of many opportunities for growth in 2007. Furthermore, the current consensus calls for less than 10% growth.

Coming off this quarter, I still like DIS and think it is one the best positioned large cap media stocks. The stock just might be due for a rest while the growth I expect in 2007 is given a chance to reveal itself.

Cable Networks was a star again as ESPN continues to grind out growth and the Disney Channel continues to monetize its ratings success. Revenues rose 16% and operating income rose 2%. Margins expanded due to the recognition of deferred revenue and lower marketing expenses. Advertising revenue growth appeared to be satisfactory based on comments on the conference call. Looking ahead, the company said that growth would be "generally consitent" with their promise that ESPN would average double digit operating income growth. Tough comparisons await due to increased rights fees for NASCAR and Monday Night Football. Thus, I'd take this comment as being favorable relative to many analysts who fear 2007 will be a loser growth year for ESPN.

Broadcasting revenues rose just 1% with operating income declining 40% off a small base of just $48 million. Management said that ABC performed well but rising costs for the Disney mobile phone service held back margins. For 2007, ABC appears to be in very good shape due to strong ratings, a good upfront and very strong scatter market advertising in response to this year's ratings success. I think Broadcasting represents a positive swing factor relative to current estimates.

Theme Parks had another good quarter, especially in light of very tough attendance comparisons. Revenues rose 8%, while operating income rose 28%. The closely watched margin expansion continued at the domestic parks helped by higher guest spending that offset flat attendance growth at the domestic parks. Operating income also got a boost from a full quarter of operations at Hong Kong Disneyland vs. mostly pre-opening costs a year ago. December quarter attendance trends look flat but that is encouraging performance against record attendance a year ago. I sense that management is more optimistic than the street about Theme Park growth in 2007.

Studio Entertainment easily beat estimates with revenues of $2 billion and operating income of $214 million against estimates of $1.85 billion and $170 million, respectively. The positive surprise emanated from the big success for Pirates and Cars at the box office and better margins for home video due to a favorable mix of titles and reduced marketing expenses. The Studio should perform exceptionally well in 1Q07 when the December quarter gets the Pirates and Cars DVDs. Comparisons toughen starting 4Q07 but the timing of Pirates 3 will help comparisons in 3Q07. Management noted that TV syndication might be down in 2007 vs. a very strong 2006.

Consumer Products did very well in merchandising due to Cars and Pirates but higher spending on developing the video games unit held back margins. Revenues slightly exceeded expectations, rising 9% but operating income grew just 1%. In 2007, these trends should continue with an incremental $30 million in spending at the video games unit offset by Pirates 2, Pirates, Cars, and the next Pixar film, Ratatouille, which is due out next June.

I have a few follow-up questions concerning the swing factors in 2007. I'll post in Market Insight if the answers offer additional insights.

Don’t read that as unusually negative. DIS management was confident and spoke of many opportunities for growth in 2007. Furthermore, the current consensus calls for less than 10% growth.

Coming off this quarter, I still like DIS and think it is one the best positioned large cap media stocks. The stock just might be due for a rest while the growth I expect in 2007 is given a chance to reveal itself.

Cable Networks was a star again as ESPN continues to grind out growth and the Disney Channel continues to monetize its ratings success. Revenues rose 16% and operating income rose 2%. Margins expanded due to the recognition of deferred revenue and lower marketing expenses. Advertising revenue growth appeared to be satisfactory based on comments on the conference call. Looking ahead, the company said that growth would be "generally consitent" with their promise that ESPN would average double digit operating income growth. Tough comparisons await due to increased rights fees for NASCAR and Monday Night Football. Thus, I'd take this comment as being favorable relative to many analysts who fear 2007 will be a loser growth year for ESPN.

Broadcasting revenues rose just 1% with operating income declining 40% off a small base of just $48 million. Management said that ABC performed well but rising costs for the Disney mobile phone service held back margins. For 2007, ABC appears to be in very good shape due to strong ratings, a good upfront and very strong scatter market advertising in response to this year's ratings success. I think Broadcasting represents a positive swing factor relative to current estimates.

Theme Parks had another good quarter, especially in light of very tough attendance comparisons. Revenues rose 8%, while operating income rose 28%. The closely watched margin expansion continued at the domestic parks helped by higher guest spending that offset flat attendance growth at the domestic parks. Operating income also got a boost from a full quarter of operations at Hong Kong Disneyland vs. mostly pre-opening costs a year ago. December quarter attendance trends look flat but that is encouraging performance against record attendance a year ago. I sense that management is more optimistic than the street about Theme Park growth in 2007.

Studio Entertainment easily beat estimates with revenues of $2 billion and operating income of $214 million against estimates of $1.85 billion and $170 million, respectively. The positive surprise emanated from the big success for Pirates and Cars at the box office and better margins for home video due to a favorable mix of titles and reduced marketing expenses. The Studio should perform exceptionally well in 1Q07 when the December quarter gets the Pirates and Cars DVDs. Comparisons toughen starting 4Q07 but the timing of Pirates 3 will help comparisons in 3Q07. Management noted that TV syndication might be down in 2007 vs. a very strong 2006.

Consumer Products did very well in merchandising due to Cars and Pirates but higher spending on developing the video games unit held back margins. Revenues slightly exceeded expectations, rising 9% but operating income grew just 1%. In 2007, these trends should continue with an incremental $30 million in spending at the video games unit offset by Pirates 2, Pirates, Cars, and the next Pixar film, Ratatouille, which is due out next June.

I have a few follow-up questions concerning the swing factors in 2007. I'll post again if the answers offer additional insights.

Another Strong Quarter On Tap For Disney But 07 Is What Matters

Disney (DIS) is expected to report strong 4Q06 earnings to wrap up its fourth consecutive year of double digit EPS growth. EPS are expected at 33 cents on revenues of $8.69 billion. The EPS comparison would represent growth of 43% against an easy comparison a year ago when $300 million in losses were recognized at Miramax.

The big debate over DIS shares concerns whether FY07, which started on 10/1/06, will continue the streak of double digit growth. Tougher comparisons at the movie studio, theme parks, ABC, and ESPN have many investors worried that growth at DIS will moderate. In fact, the current consensus EPS estimate of $1.70 for 2007 represents growth of just 7.6%. Consequently, on the conference call any comments about guidance or indications of how business is pacing for 2007 will be most likely to impact DIS shares in the near-term.

For the current quarter, growth should be broad based with each operating segment growing EBITDA by double digits. Growth at the studio will be strongest given the aforementioned easy comparison and the runaway success of the company's summer film slate led by Pirates of the Caribbean: Dead Man's Chest and Cars. ESPN is also expected to report a strong quarter as timing issues will shift about $85 million in revenues into the quarter. Consumer Products will benefit from spillover of merchandising from the box office success. Theme Parks will be driven by margin expansion as attendance was very strong a year ago in response to an effective marketing campaign built around the 50th Anniversary of Disneyland. Broadcasting should continue its turnaround led by good ratings performance and improved ad pricing at ABC. One thing that could distort results is the shift of Monday Night Football from ABC to ESPN....

Looking ahead of FY07, I remain optimistic that DIS will come through with another year of double digit growth. First, the company will benefit greatly from the December quarter release of DVDs for Pirates and Cars. Second, ABC is off to a great start this TV season which should lead to strengthening advertising sales. Third, ratings for Monday Night Football on ESPN have been very strong, likely above ratings guarantees. This should help offset the big increase in rights fees for the NFL contract and the new NASCAR contract. Fourth, DIS has made major changes at its movie studio, reducing and focusing the release slate and cutting jobs. The benefit in 2007 could be $100 million, or more than 1% of EBITDA growth.

There is no doubt that analysts are expecting these things to happen (of course, I formed my own thinking by learning from them – special props to Kathy Styponias at Prudential). However, estimates for 2007 have not gone up in the last 30 days. Therefore, I think if management signals through its commentary that 2007 is looking good, estimates could move up and DIS shares could make one more burst upward. Keep in mind that DIS has suspended providing specific guidance so the commentary on the call is what will matter.

DIS has reached my targets but since I think estimates are going up I am going to stick around a bit a longer. How much longer will definitely be influenced by what I learn after DIS reports.

Third Quarter Box Office Wrap

Following three straight weekly declines, the box office rose 6.6% vs. a year ago this past weekend. The weekend is actually the first one of the fourth quarter. Consequently, I wanted to look back at the completed numbers for the third quarter.

Despite the weakness exhibited in the final three weeks, the third quarter still held onto a good gain, up 8.2% vs. a year ago. The strength was driven early in the quarter by the massive global success of Pirates of the Caribbean: Dead Man's Chest, while Talladega Nights: The Ballad of Rick Bobby picked up the baton in August (I guess all the Hollywood execs will be looking to greenlight films with semi-colons for next summer!)....

Looking just at films released during the third quarter by the major studios, Disney (DIS) was easily the biggest winner thanks to Pirates which pulled in $420 million of the studio’s total of about $560 million. Not to be overlooked, especially from a profitability standpoint are the companies two other major releases in the quarter, Step Up and Invincible. Adding in Cars, which was the #2 movie of the summer, DIS is poised for a big holiday season for highly profitable DVD sales.

The other winning studio for third quarter releases was Sony (SNE), which had Talladega Nights leading the way to over $350 million in gross receipts. SNY had a lot of success earlier this year and is the leading studio so far in 2006.

Fox, owned by News Corp (NWS) had a weak quarter of releases but enjoyed hits early in the summer with X-Men: The Last Stand (those damn semi-colons again!) and The Devil Wears Prada.

Paramount, owned by Viacom (VIA), enjoyed a good quarter with Jackass: Number Two (there they are again!), World Trade Center, and Barnyard: The Original Party Animals (not again!). Following a long dry period, Paramount's success will come as a relief to VIA shareholders. And don’t forget the Paramount's early summer release of Mission: Impossible 3 (sorry, had to get one more in).

The worst performer among the major studios during the third quarter and the summer was the Warner Brothers division of Time Warner (TWX). The company has a series of flops from a box office and profits standpoint. I suspect this is widely noted by investors at this point, so beyond the possibility of worse than expected 3Q06 results in the Filmed Entertainment segment and another lousy quarter in 4Q when DVD sales will lag, investors are probably looking ahead to 2007 when easy comparisons and a strong release schedule lead by the next films in the Harry Potter and Ocean's Eleven franchises are due to hit theatres. Prior to 2007, Warner Brothers might have a hit on its hands with its animated musical about singing and dancing penguins, Happy Feet. Don’t believe me that penguins might strike Hollywood gold again….watch these trailers.

Finally, there could be some upside relative to consensus for Regal Entertainment (RGC) in the third quarter as the current consensus has year-over-year revenue growth of just 3.3%. I suspect investors are ahead of analysts as RGC shares have rebounded nicely since the swoon following slightly disappointing 2Q06 earnings but a good report might be enough to push RGC shares firmly into the $20s, especially given the 6% current yield against the recent bond market rally.

Near-Term Good News For Disney

Yesterday, in the post immediately below, I mentioned that Disney (DIS), News Corp (NWS, NWS.a), and Time Warner (TWX) were all trading at 52 week highs. Departing from the doom and gloom that Dominates most discussion of media stocks, I laid out some big picture thoughts that might be driving the bullish action in the stocks. However, there are actually some short-term developments that are helping each company. In particular, DIS continues to enjoy a string of good news that has driven the stock for the past couple of years.....

Most recently, DIS announced yesterday that ESPN was shutting down MVNO mobile phone business. Losses have run above expectations as subscriber growth was negligible, marketing plans were re-tuned, and phone subsidies increased. The company was guiding to $100 million in losses form this venture in FY06. I read the closing of this venture, even if it results in a significant write-off as bullish. First, analyst estimates contained anywhere from $50 to $100 million in additional losses from this venture in 2007. Jessica Reif of Merrill Lynch was using $100 million and raised her 2007 earnings estimate by 2 cents after the announcement. The big debate that has dominated the DIS discussion was whether the company could continue its multiyear string of double digit EPS growth in 2007. Elimination of the ESPN MVNO losses is a nice boost for the bulls.

Second, and more importantly, new CEO Bob Iger has promised on the last quarterly conference call that the company would take a hard look at this venture and not losses get out of control. The fact that he was willing to admit a mistake and take his lumps is a sign of real leadership. Iger has gotten high marks since taking over for Michael Eisner, receiving credit for bold moves like the Pixar acquisition and aggressive exploitation of DIS content on developing distribution platforms like the web and iTunes. I’ve always felt stocks of companies with well respected CEOs deserved a higher valuation. IN media, I think that is more the case given that the CEOs are often flamboyant and egotistical. Media CEOs are first name guys – Sumner, Rupert, Mel. I see Iger as deserving of respect for his effectiveness, not his high profile and that helps to support a premium multiple for DIS.

The final piece of recent good news for DIS is a strong start for ABC and ESPN in the fall TV season. ABC won the first full week of the new season as its risky move of Grey’s Anatomy to Thursday night opposite perennial #1 show CSI paid big dividends, with the ABC show easily winning the competition. ABC also won the first Sunday night of the season, meaning that the two most viewed nights of TV both went to the DIS-owned network. Following a lousy summer and less progress that expected last season, these signs of renewed momentum at ABC are a very welcome developments with meaningful financial upside given the high operating leverage in the network TV business model.

ESPN also is seeing early returns on its swap form Sunday night to Monday night football. Ratings for the first few Monday night games have been stellar, up more than 20% vs. Sunday ratings a year ago. ESPN also benefits as pre and post game shows advertising slots are more valuable. Additionally, ABC has much lower costs on Monday. So it looks as though the huge increase in rights fees incurred by the switch to Monday nights might pay off. At worst, it doesn’t appear that ESPN will be taking the bath that some predicted on its new NFL deal.

DIS should enjoy strong earnings growth the next several quarters driven by box office success for Pirates, Cars, and a few other films and the follow up DVD sales at Christmas. I am with the bulls who believe that 2007 will shape up as another strong growth year for DIS, further cementing the company as the premier large cap media stock.

Big Media Stocks Performing Surprisingly Well

Wow! Time Warner (TWX), Disney (DIS), and News Corporation (NWS, NWS.A) all made 52 week highs yesterday.

On the one hand I shouldn’t be surprised because the Dow and S&P 500 are at multiyear highs. On the other hand, media stocks as a group have been pretty poor over the last few years with key sub sectors like radio and newspaper suffering severely eroding fundamentals. Granted, DIS, TWX, and NWS are underrepresented in these areas but they are still exposed to the internet challenge, general advertising trends, competitive pricing in TV distribution, and weakening trends in theatrical films and DVD sales.

I suppose the new highs in these stocks could just be a gift from trading gods since yesterday was my 46th birthday. However, something broader seems at work. If I had to guess I’d point to two factors that might account for the simultaneous strength. First, the big entertainment conglomerates are growth cyclicals in terms of their earnings and cash flow. This makes them beneficiaries of soft landing scenario that is being credited with the market’s current bullish phase. Advertising represents about 20% of revenue for DIS and TWX and 40% of revenue for NWS. DIS gets and other 30% of revenue from its theme parks. Improved investor confidence in future economic growth should be reflected in higher valuations for these economically sensitive revenues. Additionally, word out of Goldman Sachs Commuicopia conference last week was that current broadcast and cable network TV advertising trends were firming. DIS, NWS, and TWX have the bulk of their advertising exposure in these national categories.

Second....

I think investors are starting to see the internet as an opportunity for these companies because they produce a huge amount of video content. Video is the flavor du jour on the internet right now and content production represents 20-25% of revenues for DIS, NWS, and TWX. Initial forays into offering TV shows and movies through iTunes, their own websites, and an YouTube have been successful and it appears that a new high margin revenue stream maybe developing. There might be a parallel to the film to VHS to DVD history. The nice thing about being a content producer is that each technological advance allows you to repackage your library and generate revenues yet again from sunken costs. The big conglomerates are also making some progress on traditional websites with NWS getting lots of credit for its purchase of MySpace and some early sings that AOL’s transition to a free site is going well.

I don’t mean to downplay the challenges faced by media companies, including these entertainment conglomerates. However, with the stocks reaching 52 week highs simultaneously for the first time in years, it reminds me that there are plenty of positives in landscape for media.

I remain long DIS for all Northlake clients and have been looking to buy NWS on a pullback. My thesis on NWS is that it should take the mantle from DIS as the fast growing big media company in 2007, which could provide a bump in its valuation.

Disney Radio Deal In Jeopardy?

Last week saw a flurry of acquisition and divestiture activity in the radio industry including news that the buyer of Disney's radio assets, Citadel Broadcasting, wants to renegotiate to lower the purchase price. News that Citadel wants to renegotiate the terms of its buyout of ABC's radio assets is not surprising and likely led to the 3% fall in DIS shares last week. Radio advertising has been weak since DIS agreed to the deal and valuation on M&A activity throughout media has fallen. Working against Citadel, however, is the fact that last week Entercom Communications agreed to buy 15 radio stations from CBS for same multiple of cash flow that Citadel is paying DIS.

I think most major DIS shareholders were previously aware of the possibility the deal could be renegotiated. As long as the deal does not fall apart, I don't see it as anything more than a near-term trading issue for DIS.

Strong Quarter For Disney But 2007 Concerns Limit Upside - For Now

Disney (DIS) reported much better than expected 3Q06 EPS. EPS of 53 cents easily beat consensus of 44 cents (3Q EPS were aided by 1-2 cent accounting benefit). Revenues were only slightly better than expected so it was operating profit performance that provided the upside. In particular, the Studio, Theme Parks, and Consumer Products provided the upside. Cable Networks also had strong profit performance. The only weak spot was Broadcasting which came in lighter thane expected on revenues and profits.

The shares should respond well to this report although I expect the debate over the 2007 growth rate to continue. Management did not provide any guidance for 2007 but did offer a list of swing factors. On the plus side, the 1-2 punch of Cars and Pirates of the Caribbean: Dead Man’s Chest should drive profits throughout the company through FY07 and FY08. Importantly, these two properties show how DIS is able to leverage successful content throughout all of its divisions. High School Musical on the Disney Channel is another example that is driving current results through TV ratings, album sales, and book sales. Also on the plus side for 2007 is a decent upfront for ABC. If ratings meet guarantees, ABC has plenty of scatter to sell and lots of digital tie-ins to sell.

Potentially holding back growth in 2007 are tough comps at the Theme Parks, the uncertainty of ratings at ABC and ESPN, slower affiliate fee growth at ESPN, the struggling overall ad market, and significant investments in distribution for consumer products. It is also unclear how much investment will occur in the ESPN and Disney mobile telephone ventures.

In the short-term, I think investors will give DIS the benefit of the doubt given the outstanding results the company has achieved over the past several years, especially recently during Bob Iger’s brief reign. DIS is playing offense with a strong lineup. Investors should continue to applaud.

Looking a little more closely at the quarter….

Broadcasting suffered from heavy investment in new pilots and costs assoicatied with the Disney Mobile venture. Radio, which is being divested, was also weak, in line with industry trends. ABC and the stations performed OK otherwise.

Cable Networks saw slightly lower than expected revenues but great margin performance so that profits were at the very high end of expectations. ESPN is performing well and the Disney Channel is benefiting from the multi-platform success of High School Musical.

Theme Parks performed particularly well on margins with revenues at the high end of expectations. I was a little surprised that analysts were assuming flat or even lower margins despite consistent gains over the past few years. Marigns rose almost 200 basis points vs. a year ago. On the call, management expressed confidence in its ability to control costs in the future, providing some defense against the tough comps in theme park attendance. Occupancy in Florida and California is over 90% and per capita spending has been rising in the upper single digits.
The Studio was a blowout in the quarter. Revenues and operating profits beat expectations by at least $100 million. DVD sales for The Chronicles of Narnia. DVD units were up 9% with lower distribution costs and lower returns. This couldbe an indicating that DIS is getting its arms around the changes in the DVD market which have accompanied slower growth. Strong box office from Cars and lower costs at Miramax also helped the quarter. Higher costs for marketing of Cars and Pirates did hold back profits.

Consumer Products was very strong, with profits beating expectations by $20-30 million. Iger opened the call noting that Cars merchandise is incredibly strong with young boys and that Pirates may be the biggest cross platfrom success the company has ever had. Strength here should continue but will be offset by increased investment in distribution channels and video games.

Cheap Is Not A Reason To Own Media Stocks

A new study by McKinsey & Co., highlighted at AdAge.com, does a good job of explaining why television advertising is facing such strong growth headwinds. The key pull quote from the AdAge article is that the study claims that "by 2010, traditional TV advertising will be one-third as effective as it was in 1990."

The article goes on to offer some statistics from the study, noting that it assumes a 15% decrease in buying power driven by cost-per-thousand rate increases; a 23% decline in ads viewed due to switching off; a 9% loss of attention to ads due to increased multitasking and a 37% decrease in message impact due to saturation....

Spending More to Reach Fewer Viewers

While TV is not alone in having its message lost due to saturation, the report does capture the secular challenge faced by TV advertising. The problem is that ad pricing keeps rising while ad viewing keeps falling. This leads to a continual increase in the cost to reach a viewer. The same thing can be said for the cost to reach a radio listener or a newspaper or magazine reader.

Appeal of the Internet Is Ability to Measure

Much of the diverted consumer is going to the Internet, but it is not just lost consumer attention to the Net that is causing advertisers problems. The idea that the Net is more measurable in terms of consumer response also is contributing to the perception that traditional media advertising is losing effectiveness.

Teens Spend 600% More Time Online Than Adults

The study also offers the sobering statistic that teens, the next generation of consumers that advertisers want to reach, spend 600% more time online than adults. In other words, the current trend against traditional media advertising could remain in place for decades.

Traditional Media Stock Valuations Reflect Challenges

Traditional media companies aren't standing still. They are expanding their online operations and changing their selling practices. And their stocks already reflect the challenges to some degree with valuations near or at historical lows for virtually all traditional media sectors.

As Monday's New York Times notes, investors will reward forward-thinking, high-performing media companies, as they have Disney (DIS) and News Corp. (NWS/NWSA) over the past year.

My key takeaway here is that cheap is not a reason to own media. Given the strong secular headwinds, look for multiyear growth acceleration such as we have seen in DIS. Or look beyond the usual suspects to growth in unusual areas like Central European Media Enterprises (CETV).

Disney 3Q06 Earnings Preview

The real excitement surrounding 3Q06 earnings from Disney (DIS) will concern how it impacts the outlook for FY07. Despite strong fundamentals and consistent double-digit growth, DIS shares have stalled over concerns about 2007. Recently, estimates have been falling and now reflect just over 10% EPS growth. Concerns surround tough comps for the theme parks, slowing affiliate fee growth at ESPN, and a plateau for the turnaround at ABC. On the flip side, the Studio is performing very well which is setting up big home video profits, cost cutting at the Studio will be significant, and the outlook for ESPN and Theme Parks is just for modestly lower growth. I remain on the bull side of this debate and expect 3Q06 results and commentary to support my view.

For 3Q, DIS is expected to report EPS of 44 cents on revenues of $8.61 billion. EPS should grow over 10%, revenues over 11%, and operating income about 25%. Operating income is benefiting from favorable timing on revenue recognition at EPSN that has penalized results year-to-date and a huge turn at the Studio which posted a loss a year ago....

Broadcasting is expected to show double digit revenue growth but incur a double digit decline in operating profits. The quarter witnessed good ratings and scatter pricing for ABC but the company spent heavily on pilots for the upcoming season where 10 new shows are on the schedule.

Over 75% of revenue at Cable Networks comes from ESPN. ESPN has enjoyed strong ratings and will recognize an extra $50 million in deferred revenue this quarter. The Disney Channel also could provide a boost this quarter due to the phenomenal success of High School Musical. Look for a 15% gain in revenues and a 25-30% gain in operating income.

Theme Parks are expected to show revenue and operating income growth of 10%. I think there could be some upside to the operating income estimates as margin expansion has been a hallmark of recent parks performance. The big question in Theme Parks is whether the tough comparisons against the 50th Anniversary fueled attendance growth will put a big dent in FY07 growth. The parks in Europe and Hong Kong are expected to at least breakeven this quarter.

The Studio will witness a big turnaround against a year ago when large write-offs for Miramax pushed the segment to a loss. This year the box office comparison is easy while the home video comparison is tough. Revenues are expected to rise 9-10% with operating profits of $100 to $125 million. Studio results can be very volatile relative to current estimates. Marketing spend for Cars and Pirates of the Caribbean: Dead Man’s Chest will hold back the quarter but the December quarter should be enormous when DVDs for both films hit store shelves.

Consumer Products is the smallest division by far but it could produce a big gain as apparently merchandise sales for Cars were among the best ever for a DIS film.

A couple of other things to be looking for on the conference call are the size of the losses for the Disney and ESPN wireless MVNOs, the magnitude and timing of savings on the cost cutting at the Studio, and an update on the sale of the company’s radio operations. With the Emmis Communications deal falling apart, there are probably fears that DIS’ deal to sell radio could be in jeopardy – that would be a definitive negative.

Weekend Box Office Still Looks Good For Disney and Regal

After 17 days in theatres, Pirates of the Caribbean: Dead Man's Chest is the fastest grossing film in history. The movie remains comfortably on track to produce better than expected profits. In fact, benefits to Disney (DIS) relative to current expectations could begin as soon as the September quarter since the film seems likely to more than recoup its production and marketing costs during its global theatrical run.

Most analysts assume that a film will lose money in its theatrical window only to produce profits later in home video and television rights. DIS does face a potential timing issue in its June quarter when the bulk of marketing costs for Pirates and Cars are likely to be booked. Pirates wasn't released until July so this could create a timing mismatch.

Pirates is the fastest film to reach $300 million, in just 16 days. The film is running $21 million ahead of the prior champ in that category: Revenge of the Sith. Weekday and weekend grosses are now both running ahead of Sith, which went on to gross $380 million. The only real question now for Pirates is whether it can catch Shrek 2 and The Phantom Menace to become the #2 grossing movie moving of all-time....

DIS is already set to release the next film in the Pirates franchise next Memorial Day. Given the fact that both films are likely to produce profits in all windows and both DVDs seem likely to fall in DIS' fiscal year ending September 2007, next year is shaping up as an enormous for profits at the company's studio. This should serve to offset some concerns about slowing overall growth for DIS next year.

Looking more broadly at the weekend box office, despite weaker than expected openings for several new films, strength in Pirates and good depth allowed the overall result to return to positive comparisons. The weekend was up about 5%, leaving the year to date gain over 6% and the current quarter running ahead by 15%. These trends remain bullish for Regal Entertainment (RGC).

Disney Pulls Back But Its Not Due To Pirates

Pirates of the Caribbean: Dead Man's Chest (POTC) continues to rule the box office. Nevertheless, Disney (DIS) shares have sold off since the movie was released. I wouldn’t chalk that up to any disappointment over the film, however.

In the early part of last week, before catching a downgrade on Thursday, DIS shares actually outperformed the market. I'd suggest that was the trading action related to the movie. Since then, I think the downgrade (built off the belief that street estimates for DIS EPS growth in 2007 are too high) and geopolitical tensions drove the shares lower. The quick strengthening in the dollar also probably contributed as DIS is sensitive to international travel at its Orlando theme park.

I maintain my view that 2007 results will not disappoint. Continued margin expansion at the theme parks, growth at ESPN, a solid upfront for ABC, and the flow through of profits from DIS very successful winter 2005 thru summer 2006 movie slate provide enough upside to meet consensus estimates. I think this fundamental strength will be evident when the company reports its June quarter. Recent sellers, shorts, and downgraders will regret their positions come the August 9th reporting date. One signal I could be right is that DIS shares finished up yesterday despite a second downgrade. I helped a tiny bit by adding DIS to a new client account.

Going back to the box office....

POTC fell about 54% last weekend from its record setting opening weekend, a performance that gives little guidance to box office observers who are trying to gauge its legs. A drop of 60% plus would have been a reason for concern while a drop of 40% would have put the film in the running for #2 all-time behind Titanic and ahead of Shrek 2. I standby my assumption that the film will gross over $400 million domestically.

Based on early international box office reports, a total of over $500 million abroad seems in the cards. In fact, with the film still only open in about 1/3rd of its foreign markets, Variety speculated the international haul could exceed $600 million making POTC the third ever film to cross $1 billion worldwide (Titanic, $1.8 billion; Return of the King, $1.1 billion).

Despite a solid weekend for POTC and in line openings for the two new films, Little Man and You, Me, and Dupree, total weekend box office fell for the first time in 8 weekends. The decline of 7% is nothing for box office bulls to be alarmed about. Last year, two of the summer's most popular movies, Charlie and the Chocolate Factory and Wedding Crashers both opened. Additionally, not be lost is the fact that the prior weekend was up an astounding $70 million, or 46%, from a year ago, and this past weekend was up 7% from 2004.

Year-to-date box office is up over 6%, implying attendance growth of about 3% this year for the supposedly dying theatre business. That myth will suffer another blow this weekend when I expect comparisons to return to positive territory. This continues to bode well for Regal Entertainment (RGC), whose shares have performed very well relative to the market's decline. I guess I'm not the only one who sees value.

Analyzing Disney's Pirates Treasure Chest

The daily box office results for Pirates of the Caribbean: Dead Man's Chest (POTC) continue to be astounding. After its record breaking opening weekend, POTC easily set mid-week daily records, and now has the 6, 7, 8, 9, and 10-day records. The film appears headed toward $400 million domestic and over $900 million worldwide, ahead of initial expectations to match the first film with $300 million domestic and $653 worldwide.

Since most of the stories about the film have focused on box office, I thought I’d take a stab at profits and see how the better than expected box office might impact EPS for Disney (DIS). Please understand that while I think the analysis is accurate and captures how POTC could be impacting DIS shares, it is overly simplistic and probably naive relative to how the film is financed, and the residuals and participations to the talent....

Initially, Wall Street was assuming that POTC domestic box office would be $300 million, worldwide box office would be $650 million, and profits from all windows would be $250 million. Here's the math on the initial profit estimates:

At $650 million in worldwide box office, rentals (the studio's 55% share of the box office) to Disney would be around $355 million. Estimates for production costs for the film range from $200 to $250 million. Prints and advertising add another $150 million to current expenses. Consequently, analysts were probably assuming the box office window would produce a loss up to $50 million.

The next window is home video. Dave Miller of Sanders Morris Harris uses a rule of thumb that home video revenue equals 1 times domestic box office with a revenue split of 75%/25% between sell-through and rental. The margin on sell-through is higher but I think it is fair to say that most models assume the margin on total home video averages around 60%. Therefore, based on the initial $300 million domestic box office estimates, home video would produce $180 million profits.

The next source of profits is sale of TV rights. I've seen models that assume TV rights are sold for 35% of domestic box office, or $100 million in the case of POTC. This seems high but remember that it would include pay TV, cable, and broadcast in the US and abroad. Let's guess an 80% margin on that revenue and you got an additional $80 million in profits.

So before DIS gets any profits on merchandise related to the film, at a $300 million domestic box office, POTC might produce $210 million in profits. I've read that POTC merchandise is selling better than any Disney or Pixar film since Toy Story 2, so initial analyst estimates of profits in the $250 million or higher range seem totally plausible. And don’t forget that Disney also benefits at its theme parks and cable networks.
There is no way of knowing of how Disney financed the film but for sake of argument I am going to assume that financing costs are included in production costs. The last few quarters, DIS has had a tax rate of 36%, which would leave $160 million in after-tax profits from the film. Based on 2 billion shares outstanding, analysts might have 8 cents of earnings just from POTC in their estimates over the next four to six quarters. Current estimates call for FY07 EPS of $1.65, so it is plausible that this one film could have equaled 5% of analyst estimates for DIS' 2007 EPS.

Of course, it now looks like POTC is tracking to generate $400 million in domestic box office and over $900 million worldwide. Compared to initial estimates, an incremental $300 million in worldwide box office turns the theatrical run from a loss of $50 million to a profit of over $100 million. TV rights revenue could now go as high $125 million pushing profits to $100 million. Home video goes to $400 million in revenue and $240 million in profits. So with box office trending above initial expectations, the film could be heading toward total profits of $440 million vs. initial estimates of $250 million.

Applying the same assumptions about taxes and shares outstanding, and POTC is now looking at adding 14
cents to DIS earnings over the next four to six quarters.

DIS is trading at about 20 times earnings so the extra 6 cents should be worth $1.20 to the stock price. Prior to Thursday's downgrade from CIBC, DIS had actually been outperforming the market since POTC was released, so I think the market has been reasonably efficient as it relates to the upside surprise for the film.

As for that downgrade, I think the analyst is going to regret it as DIS has double digit growth for 2007 in the bag with the extra POTC profits, strength in other films from the studio, the continuing gains at ABC, and steady growth at ESPN. Theme parks is the wildcard and geopolitical tensions and a slowdown in consumer spending are definitely risks. It's a risk worth taking though as comps in Florida aren’t that tough and the rest of the companies businesses can take up the slack of anything other than a significant shortfall.

Disney's Pirates Brings Big Profits

Consumers and investors tend to focus on box office and forget profits when looking at domestic box office numbers. Several analyst reports out today are looking at the profitsfor Pirates and the news is good for Disney (DIS). Analysts must have been playing it safe because several bumped their estimates by a nickel or more for FY07 which is where the profits on the film will reside due to the requirement that marketing and production costs be expensed upfront. Film profits usually come from windows like DVD and sale of TV rights that come six to 18 months after the domestic theatrical opening.

For Pirates, analysts are estimating that production costs were anywhere from $200 million to $250 million. Film advertising and print cost estimates range from $75 million to $150 million. This creates a cost basis ranging from $275 million to $400 million before additional costs related to participations for talent and any financing partners. Consequently, on the assumption that DIS will collect revenues equal to 50% of the global box office, the total worldwide take must be $550 million to $800 million for the film to reach breakeven during the theatrical run which will correlate with DIS’ 3Q and 4Q06. The first film did worldwide box office of $653 million ($305 million domestic, $348 million international). Analyst are estimating the new film to do at least as well as the first film, thus, breakeven is on the horizon. That would be good news as most films are not profitable on their theatrical run.

Analysts project that over the next 18 months, the film will produce profits for DIS form $250 million to $400 million across all windows and including merchandising. Down the road, there is also an immeasurable benefit to the theme parks. This film is the perfect example of how DIS can benefit across its divisions from successful family-oriented films. With Chicken Little, Narnia, Cars, and Pirates all having been successful since the 2005 holiday season, there is a lot of cushion in the DIS numbers over the next 4-6 quarters.

Disney Downgraded at Citigroup

On top of the slightly weaker than expected opening for Cars, Disney caught a downgrade from Citigroup which has the shares down about 3% this morning. However, the downgrade had nothing to do with Cars. Rather it was totally predicated on the analyst’s expectation that theme park revenues and operating income would fall well short of consensus in 2007 leading DIS to miss the current 2007 consensus forecast of $1.64 by 11 cents. Citigroup believes that theme park attendance will fall short due to tough comparisons against 2006 growth that was driven by the 50th anniversary marketing. Additionally, waning consumer confidence correlates with lower them park attendance.

Back to Cars, I quickly browsed through analyst commentary and found that most analysts noted the slight shortfall but few felt it would have any significant impact on profits. Merrill Lynch said that at most over the next two years when DIS is projected to earn over $3.00 combined, the shortfall could cost 3-4 cents, just 1% of EPS. Merrill went on to state that at a presentation it hosted in London last week, the head of Disney's consumer product division said that the Cars launch was the strongest for any Pixar film ever with most of the initial inventory fill selling out. This is an important point as the Pixar acquisition must be analyzed relative to its contributions across all of Disney's businesses, not just eh box office for any single film.

DIS shares have fallen almost 10% from last week’s 52-week high at today’s open. I think that more compensates for the slight shortfall of the Cars opening and Citigroup's concerns over theme park growth in 2007. Sentiment on the shares will now be sour for the short-term but as I wrote earlier today I think near-term earnings will remain very strong and Pirates of the Caribbean and June quarter earnings provide catalysts over the summer.

Cars Not Quite As Good As Expected; Overall Box Office Up Again

Cars opened at the low end of expectations with $63 million failing to provide a catalyst I had been counting on for Disney (DIS). I think the opening will hurt sentiment for DIS stock because it will make it easy for naysayers to get traction with the "they overpaid for Pixar" theme. However, DIS shares fell sharply late last week as expectations for Cars starting to come in so I don’t think there is a lot of downside left relative to the market unless the film drops much more quickly than expected at next weekend's box office or weekday grosses with kids now out of school are weak.

I am staying long DIS for Northlake clients because I think fundamental momentum is excellent with ABC, ESPN, the TV stations, the movie studio, and the theme parks all performing very well. Additionally, the shares could get another pre-opening lift ahead of the release of the summer's most anticipated movie, Pirates of the Caribbean: Dead Man's Chest , due in theatres on July 7th.

The overall box office was healthy again for the weekend, up vs. last year for the fourth straight weekend....

The top 12 films grossed 8% more than last year and all films in release were up 4%. Remember, $63 million is a huge opening and only for a Pixar film is that considered a disappointment. The weekend saw 5 films gross over $10 million with none of the leading films showing unusual declines. The top ten was filled with films appealing to all important demographic groups supporting my contention that if there is decent product the box office can still grow at its historic rate.

Year-to-date the box office is now up about 5%, with the second quarter tracking for a double digit gain. Comparisons remain easy for the next 6 to 10 weeks, so I am also sticking with my long position in Regal Entertainment (RGC). RGC went ex-dividend last week on its 30 cent quarterly payment. The shares are down about 5% before the dividend since I made the initial purchases for Northlake clients. I remain confident that a target in the $23-24 range is realistic as summer box office momentum sticks.

My Expectations for Disney's Cars

Disney (DIS) made a new 52 week high in Monday's abysmal market, likely anticipating this coming weekend’s opening of Cars. I think the Cars hype is also helping Regal Entertainment (RGC) which has performed relatively strongly the last few sessions. Northlake remains long both stocks although DIS is approaching my target for considering a sale.

I think the Cars opening will be very large, easily exceeding the $68 million for the Ice Age sequel earlier this year. One good sign for Cars is the solid legs for Over The Hedge. Although the film will not be a mega hit, its weekend-to-weekend drop-off has been modest. This shows that the market is out there for a film appealing to children. Also working in Cars favor is that young boys love to play with cars and trucks. The young boy demographic can be tough to reach. A final factor I see helping Cars is the appeal it has to the huge NASCAR fan base. NASCAR's fan base is a broad swath of middle America, one that has driven other movies like Passion of the Christ to huge numbers.

I have read a few cautious comments regarding the box office potential on some movie blogs. They are of the variety that Cars is very good but not as good as we have come to expect from Pixar.

Excluding the unusual success of Finding Nemo, the recent Pixar films each did around $250 million domestically (Toy Story 2, Monsters Inc., and The Incredibles). Incredibles and Nemo each opened at $70 million, Monsters started with $62 million, and Toy Story 2 began with $57 million.

My prediction is that Cars will pull in around $250 million for its domestic run with an opening weekend north of $80 million. The larger opening than prior Pixar films with a similar total run respects the front loading that is appearing with increasing frequency of late. Popular films are showing an increasing tendency to burn out more quickly. This is more of an issue for theatres than studios but is something to be aware when analyzing opening weekend trends.

Memorial Day Box Office

My friend and fellow money manager, Doug Kass, is making a good call to short Dreamworks Animation (DWA) on the back of less than stellar box office for Over The Hedge. There are no catalysts for DWA unless the film does surprisingly well this weekend. Short of buyout rumors becoming reality I see little upside and 10% downside.

Doug is also betting the over the weekend box office X-Men: The Last Stand (X3). Again, I think he is right. The opening weekend could be large. From what I gather buzz on the film is good, although early reviews aren’t nearly as favorable as they were for the first two films. The plot seems to advance the series by exploring the mutants more fully which should help keep X-Men a fresh franchise. Also helping is the fact that the last X-Men movie was released in 2003. The disappointing Mission: Impossible 3 had to overcome a six year hiatus from MI2. Finally, teens drive the box office and the fan base for X3 is teens....

X2 opened with $85 million in 3,741 theatres, according to BoxOfficeMojo.com, easily beating X1's opening. X2 opened on the first weekend in May whereas the current installment gets Memorial Day, usually a very good weekend for movies. I have to think that experts will be calling for X3 to match or exceed its predecessor. Remember Sunday is a full weekend day on Memorial Day weekend. I think $100 million for the 4 day weekend is a definite possibility.

For the overall box office, the weekend looks promising with good numbers likely from The Da Vinci Code, which performed strongly on Monday, and Over The Hedge, in addition to the big opening for X3. The comparison is fairly tough, however. Last year on Memorial Day, the final Star Wars movie did $70 million and new releases Madagascar and The Longest Yard did $61 million and $58 million, respectively. If Da Vinci and Over The Hedge drop 30% helped by the long weekend, even a $100 million opening for X3 would leave the top 3 films short of the top 3 from a year ago.

Nevertheless, I think a strong opening for X3 and decent holds for Da Vinci and Over The Hedge will leave box office observers and analysts in a good mood with the Cars opening just two weeks away, followed by Pirates of the Caribbean a month later. I know I've said this often recently but this is a good summer to be long Regal Entertainment (RGC) to play overall box office strength and Disney (DIS) to play what may turnout to be the two most popular movies of the summer.