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November 13, 2006

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.

Posted by Steve Birenberg at November 13, 2006 03:31 PM in DIS