In last quarter’s review of Disney (DIS), we noted that “Over the next six months, Disney investors have little to worry about.”  We also discussed how we enjoyed the earnings call because it was mostly about operating fundamentals of the company’s core business with less focus on the upcoming Disney+ launch.  At the time, we said when it comes to current operating businesses, “the news is pretty good.”  Well, well, well.  The latest quarter earnings for the period ending June 30, 2019 encountered some serious shortfalls in the core business.  Specifically, the newly acquired Fox film and TV studio and the company’s theme park division fell well short of estimates.  The company expected these issues to continue through the current quarter with the Fox assets particularly lagging.  Earnings estimates for the next few years fell materially following the news.  Nonetheless, at Northlake, we still think DIS investors have little to worry about.

The company is all-in on its pivot toward internet-delivered services.  A new bundle of Disney+, ESPN+, and Hulu’s ad-supported product was announced costing just $12.99.  This continues Disney’s aggressive pricing first introduced with its $6.99 price for Disney+.  At these prices and given the company’s unparalleled content (Marvel, Pixar, Disney, Star Wars, National Geographic). We expect rapid uptake of Disney+ when it becomes available on November 12^th.  Later in August, Disney plans to launch the largest marketing campaign in the company’s history to support the launch of Disney+.  Think about the saturation marketing for a Star Wars or Avengers film and you get the idea.  We still believe that Disney shares are in the clear until Disney+ is launched even after the June quarter shortfalls.  Should the early subscriber numbers be as large as we expect, the stock will do well and easily recovery the -5% loss post the earnings release.

Getting back to the quarterly earnings miss and reduced guidance, the company noted that a lot of it was due to having taken their eye off the ball in the almost two years the acquisition of the Fox assets were under regulatory review.  This a bit of a weak excuse but we are willing to give the company a pass since the bulk of the miss at Fox was the flop of film Dark Phoenix which was written down by $170mm.  At theme parks, the problems were self-inflicted reflecting the combination of visitors delaying visits ahead of the opening of the new Star Wars attractions in Anaheim and Orlando and the company’s decision to limit lines to enhance customer satisfaction for the new ride at Disneyland.  We see the issues at Fox and theme parks as temporary, although it could turn out that the Fox acquisition is not accretive to Disney as soon as previously expected.

One other issue to keep an eye on is the losses related to the digital transition.  Last quarter marked the first that Hulu was 100% consolidated.  The losses were larger than expected despite Hulu growing its subscriber base rapidly.  Hulu is probably a good problem for Disney given its potential as it scales and the market caps given to Netflix and Roku as comparables.  Also worth noting is that the company incurs large foregone high-margin revenue by no longer selling content from its film and TV productions including ABC.  This foregone profit has always been hard to pin down in dollars and, at least in the June quarter, was higher than expected.  This is a situation where the cost is taken now to build an exclusive library of highly demanded content for a payoff later when subscribers begin to pay for Disney+ and Hulu.

We still think the stock is worth around $150 with a market multiple applied to core earnings and $20-30 for new digital services.  We are sitting tight with Disney and feel the bad news is out and confusion over the exact transition costs is better understood.

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 wvww.sec.gov