Disney (DIS) shares are trading down about -3% on a big up day for the market after reporting 2Q21 results.  Despite reporting results ahead of expectations on financial metrics and seeing estimates for revenue, operating income, and EPS rise, the shares are falling due to a shortfall in growth for Disney+ subscribers and management guidance that subscriber growth will remain subdued through the second half of the company’s fiscal year.

About half of Northlake’s valuation target for DIS comes from the company’s DTC services which include Disney+, Hulu, and ESPN+.  Disney+ is by far the largest factor among the DTC services.  Thus, it is not surprising that a shortfall in subscriber additions is leading to selling of the shares.  Management noted that since its last subscriber update in early March, net adds have picked up.  Nonetheless, several issues are leading to the 2H21 slowdown.  First, the horrible COVID situation in India has led to the suspension of the largest annual cricket tournament.  Second, management has decided to delay the rollout of DTC services in Latin America by a few months in order to be able to use a huge lineup of sports rights to promote the service.  Finally, domestic subs have slowed due to a similar pull forward effect that impacted Netflix.  Management reaffirmed its 2024 Disney+ subscriber guidance and noted that churn is well below management expectations, indicating the service is being very well received.

We have a few other takeaways from the quarter and conference call.  On the downside, management was reluctant to affirm guidance beyond the Disney+ 2024 subcriber figure.  An update could be coming, especially after much time on the call was devoted to discussing new sports rights at ESPN and ESPN+.  Perhaps the company is investing in sports rights in order to drive ESPN+ subscribers above prior guidance and also support Hulu and LatAm where sports are integrated into the entertainment service unlike Disney+ in the US.  Also interesting was the disclosure that Hulu is much more profitable than previously thought.  This cuts both ways since it establishes a much higher valuation for Hulu but also suggests profitability for Disney+ and ESPN+ could be further off than we previously expected.  On the positive side, the domestic theme parks are finally open and demand has been fantastic against capacity restrictions that are being steadily relaxed.

We suspect DIS shares will continue to consolidate until the subscriber outlook at Disney+ in FY22 is positive.  Beyond net additions, ARPU trends need to improve as India comes back from COVID and price increases in the US and Europe take place.  Fortunately for DIS, the company’s traditional businesses are poised for a huge rebound over the next several quarters as the global economy fully reopens.  Theme parks, movies, and advertising-supported networks are already showing green shoots and should accelerate dramatically.  These businesses provide a bridge to the other side of the (hopefully) temporary slowdown in Disney+ subcriber growth.  Northlake believes this is the scenario that will play out and is sticking with a $225 target for DIS shares.

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