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May 09, 2007

Another Good Quarter For Disney

Disney (DIS) reported very good 2Q07 results driven by strong margin performance across all five operating segments. Better profitability allowed EPS to easily exceed consensus estimates coming in at 44 cents, up 19%, vs. expectations of 38 cents, up 3%. Revenues fell very slightly short of estimates at $8.07 billion, $60 million short of estimates. The revenue shortfall was concentrated in the Broadcasting and Studio Entertainment segments but was offset by better than expected revenue for Theme Parks and Consumer Products.

Despite the big beat on EPS, DIS shares immediately traded about 1.5-2% lower following the report. I suspect it is just a sell the news reaction as I really don’t see any problems at all unless you consider a $60 million revenue miss on over $8 billion in revenues a big deal. I don’t, especially when operating income exceed estimates in four of five segments and was $200-300 million ahead of the street.

The upcoming 3Q represents DIS's toughest comparison of the year. Presently, EPS are projected to be flat at 53 cents. For the first six months adjusted EPS are up 31%, so earnings momentum looks set to slack. The major issue for 3Q is that last year DIS released The Chronicles of Narnia DVD which sold extremely well. No comparable release exists this year. I'd guess that alone could cost the company in excess of $100 million in operating profits over the balance of the fiscal year, with most of the shortfall coming in 3Q. On a base of $2 billion in operating income this represents a serious challenge to overall corporate growth.

Offsetting the tough Studio comparison is the fact that for two consecutive quarters DIS's margins have expanded sharply. If overall corporate profitability has taken a full step higher then DIS earnings power is greater than currently anticipated. While some of the margin expansion can surely be linked to outstanding content performance, I think there is some permanent flow through, particularly at the Studio and Theme Parks. Strong scatter pricing at ABC and a recent ratings surge should also boost 3Q....

The 2Q report and management comments about the balance of the year suggests that 2007 estimates of $1.81 are headed higher, probably to north of $1.90. Prior to the report, growth in 2008 was projected at 12%. Maintaining 12% growth brings 2008 to $2.10 to $2.15 vs. current consensus of $2.03. At today's opening level of $36, DIS shares are not richly valued at 19 times 2007 and 17 times 2008 EPS estimates.

The shares had risen 4% into the report putting them at an all-time high. I think the strength of the report will limit any sell the news damage and with any help from the market, DIS can still attain my 2007 target of $40. I plan to hold the position I have in Northlake client portfolios.

Here are some brief segment comments:

Broadcasting: Revenues fell 7% due to less sports programming but profits were up sharply (33%) since sports rights went bye bye. Scatter pricing was up low single digits and is rising similarly this quarter. ABC's ratings have been coming on strong which sets up the upfront very nicely. No detail was provided on losses at the Disney branded mobile phone service. Some analysts may complain about non-sports revenue trends in 2Q.

Cable: ESPN is kicking butt. Profitability in the entire segment including The Disney Channel and international channels was ahead of estimates. The boost from eliminating losses on the ESPN wireless service was not quantified but certainly helped the quarter. Ratings trends at ESPN are solid and deferred revenues will flow in 2H07.

Theme Parks: Overcoming tough comparisons, theme park attendance was quite good, rising 7% in Florida and up slightly in California. Margin expansion continued driven this quarter by solid results in Paris. Hong Kong is still struggling. The margin expansion story at the domestic parks remains on track as margins are up 100 basis points in the first half. Timing issues held back margins this quarter. Attendance, occupancy, and per capita spending trends all look good for the rest of the year. Theme Parks has proven to be a nice positive surprise this year against very cautious estimates.

Studio Entertainment: Despite a $100 million shortfall in revenue, operating income exceeded estimates. Management noted lower distribution expenses due to fewer films and double digit gains in music. Spillover form Cars and Pirates 2 DVDs was not as large as expected. Put it all together and the cost cutting at the studio seems to be very well in place. The Narnia DVD sets up a tough comparison on profitability but Pirates 3 box office will mostly in 3Q this year vs. 4Q a year ago. The bigger challenge will be calendar 2008 when no Pirates film or DVD is scheduled.

Consumer Products: Revenues and operating income surprised to the upside. Royalties on very strong sales of Cars merchandise offset falling minimum guarantees and higher video game spending. Management noted that Cars merchandise sales are still growing. This is a reminder that DIS has many ways to make money on its content, especially the high quality content coming from Pixar. That will be handy to keep in mind as the inevitable hand wringing over Ratatouille begins.

Posted by Steve Birenberg at May 9, 2007 10:08 AM in DIS