Disney (DIS) reported a mixed quarter that was completely overshadowed by its announcement of a new strategy for its media networks.  The shares are trading lower, which in Northlake’s opinion is logical.  Making major investments into digital, over the top distribution of its sports rights and Disney and Pixar content is going to be expensive with an uncertain outcome.  However, as suggested by another very tough quarter for Media Networks/ESPN, the company probably has little choice.  Fortunately, for long-term investors, DIS is in great shape at its Theme Parks and Filmed Entertainment segments.  These divisions can support a premium valuation for the shares as clarity on the new products and services emerges ahead of their launches (sports in 2018 and Disney/Pixar in 2019).  One other positive in the near-term could be a new cycle of affiliate negotiations between ESPN and its traditional cable and satellite distributors.  ESPN should be able to boost its per subscriber fees from current levels and stabilize subscriber losses without incurring any additional costs since expensive sports rights are locked in under deals that extend into next decade.  Therefore, Northlake is sticking with DIS at least until we can better evaluate the financial on long-term growth implications of the dramatic shift in corporate strategy.

Looking back at 3Q17, Theme Parks performed very well, while Media Networks, Consumer Products and Filmed Entertainment underperformed expectations.  We can dismiss the film studio underperformance given it was mostly due to tough comparisons and the upcoming film slate is outstanding through 2018 with two Star Wars, two Avengers, and two Pixar films.  Media Networks saw a steep year-over-year drop in profits as higher NBA rights costs converged with weak ESPN ratings, fewer NBA playoff games, and still material and larger than expected subscriber losses.  While see ESPN pressures easing in 2018 as new affiliate deals are struck, the weak quarter clearly explains the new OTT strategy.  Consumer Products weakness is a little surprising suggesting that the Frozen benefit has finally worn off and Star Wars and Avengers are not as consumer friendly.  EPS surprised to the upside but that was driven by non-operating items.

Building from its $1.5 billion deal to take control of BAMTech, DIS announced two new OTT services –Sports and Kids – to be launched in 2018 and 2019, respectively.   Management did not reveal many details about the new strategy and there are many unanswered questions.  ESPN will launch a new OTT product available to non-cable/satellite subscribers in early 2018.  The new service will offer thousands of games and live sports including MLB, NHL, tennis, and college sports.  ESPN buys rights to entire sports yet the TV networks can only show one game at a time.  Think about college football when Ohio State-Michigan may be on ESPN while ESPN is televising other games in the Big Ten and SEC.  The secondary games can be sold along with a lot of other sports content in the new OTT service.  Current cable and satellite subscribers with access to ESPN will be able to authenticate themselves and watch the televised games in addition.

The consumer OTT service will feature Disney and Pixar content after DIS takes back its rights to those brands from Netflix beginning in 2019.  As of now, Marvel and Lucasfilm (Star Wars) are not included in the new service.  DIS’s goal is to create a family friendly OTT service selling millions of subscriptions.

Each of these services is designed to be a growth vehicle and position DIS to sustain growth as the traditional TV ecosystem fragments due to cord cutting, cord shaving and cord nevering.  TV delivery is changing rapidly and due its kids and sports focus, DIS, perhaps more than any other company, needs to find a way to have a direct link to consumers.

The strategy has a lot of unknowns and risks.  Will DIS have to invest more heavily in content production and sports rights?  Management seems to think so.  Will the new apps work well and appeal to users?  Too soon to tell but we have experienced some frustration with current ESPN digital apps.  What will the new subscriptions cost?  Will an aggressive OTT strategy only service to accelerate this still very large and very profitable traditional TV business?

As noted at the beginning of this note, we are willing to give DIS time and learn more given there are some other positives supporting the shares over the next several quarters.  Near $100, DIS shares look reasonably valued based on current 2018 earnings.  However, the earnings level and P-E ratio for DIS shares is uncertain.  This balances out to a HOLD for now.

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.