Disney: Shift Towards DTC/OTT Comes Into Focus

Disney reported mixed 3Q18 results with theme parks and broadcast TV excelling and cable networks, the film studio, and consumer products lagging.  Revenue and EPS were a little under consensus estimates leading the stock to decline 1-2%.  The shares have been quite strong since March, reaching their highest level since May 2017.  This may have contributed to small decline in the shares since the report as the expectations bar had risen with the stock price.

Interestingly, almost the entire conference call was focused on the company’s launched and upcoming direct to consumer/over the top products (DTC/OTT).  These products include the recently launched ESPN+, the soon to be majority owned Hulu (after the purchase of Fox assets closes), and the late 2019 launch of a Disney-branded service somewhat similar to Netflix and Hulu but focused on Disney’s power brands:  Disney, Marvel, Pixar, and Star Wars.  These power brands will be enhanced by the Fox acquisition when intellectual property like Planet of the Apes, Deadpool, and Kingsman come into the Disney family.

Northlake has been surprised at the strength in DIS shares of late.  The upside accelerated after Comcast backed off bidding for the Fox assets.  However, DIS is still paying a high multiple, above its own, making the deal financially dilutive in the early years.  Investors have looked beyond that to the promise of the company’s DTC products.  Given the rich valuation ascribed to Netflix shares and the brand strength of DIS, the assumption is that success is assured for the Disney OTT service.  This may be the case but it ignores the fact that DIS will not fully control all the historical films and TV shows related to its intellectual property for several years.  Furthermore, while management believes the brands are so strong that the OTT service can thrive with limited content, the success of Netflix and to a certain extent Hulu is based on the very broad something-for-everyone content libraries.  In other words, it is possible that DIS is underestimating the amount of money it must invest in programming.

All this may sound negative but Northlake sees DIS and its brands as having unique value.  The stock has gone nowhere since August 2015 when the company first admitted that ESPN, previously a major driver of the company’s growth, hit headwinds due to cord cutting and subscriber losses.  From that day forward, a pivot to a Netflix-like DTC service seemed inevitable.  Now that DIS is adding Fox film and TV production and intellectual property, it is easier to see a path to success despite the challenges we just outlined.

DIS shares are inexpensive compared to their history trading at 15 times 2019 estimated earnings.  Other media companies less well positioned for a DTC TV world trade at 10 times earnings or less.  DIS has always earned a premium, and the runaway success of the film studio and theme parks and the unique way the brands help all of the businesses deserves a premium.  Northlake sees the current valuation as fair.  A good content lineup from the film studio is coming in 2019, which along with a reduced pace of sub losses at ESPN as vMVPDs grow should support the shares.  Thus, although we see limited upside and perhaps 10-15% downside in the next year, we currently plan to hold the 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.