the maturing of ESPN
In the 2016 DIS fiscal year (ended in October), earnings from the Media Networks segment, which is basically ESPN, decelerated from its fiscal 2015 +6% pace to a slight year-on-year decline.
Two problems: increasing costs for sports rights; and “cord cutting,” that is, consumer reluctance to pay increasing fees for cable service and cancelling instead.
Part of the issue is the proliferation of new sports content generated by individual teams.
Part is the high cost of ESPN programming to consumers: SNL Kagan estimates that by the year after next, ESPN will be charging $9.17 per cable subscriber for its services, up from what I think is around $8 now.
Part is also ESPN’s preferred position in the basic packages offered by cable companies. I’ve read analyses, which I’m not sure are correct, that maintain that although all cable subscribers pay for ESPN, at few as 20% actually use the service regularly. If so, $100 per year per subscriber translates into $500 per year per user.
In addition, as a sports fan I’m offended by the faux debates and shouting matches that ESPN has begun in an attempt to woo viewers. Covering WWE as if it were a real sport …Really?
the move from growth to value
It seems pretty clear to me that ESPN is no longer a growth business. Gathering realization of this by investors is the reason, I think, that DIS has underperformed the S&P over the past two years by about 25%–despite its movie and theme park success.
The important question for investors is how much deceleration at ESPN is factored into today’s DIS quote. Is the worst that can happen already priced in?
I think I understand the worst-case scenario. It’s that pricing for ESPN ultimately shifts from per subscriber to per user. This most likely means a substantial decrease in ESPN revenues. The big question is how much “substantial” is. If it’s correct that only one in five cable subscribers actually uses ESPN, then revenues could be cut in half by the change, even if users are willing to pay double what they are laying out today.
That outcome may be extreme, but it’s certainly not priced into DIS stock, in my view.
I’m not sure what the right calculation is. However, while the outcome of this important issue is so up in the air, I find it hard to imagine DIS outperforming.
DIS shares went on a fabulous run after the company acquired Marvel in late 2009, moving from $26 a share to $120 in early 2015. Since then, however, the stock has been moving sideways to down–despite rising, consensus estimate-beating earnings reports in a stock market that has generally been rising.
What’s going on?
The basic thing to understand about analyzing a conglomerate like DIS is that aggregate earnings and earnings growth matter far less than evaluating each business in the conglomerate by itself and assembling a sum of the parts valuation, including synergies, of course.
In the case of DIS, the company consists of ESPN + television; theme parks; movies; merchandising related mostly to parks and movies; and odds and ends–which analysts typically ignore.
In late 2009, something like 2/3 of the company’s overall earnings and, in my view, 80%+ of the DIS market value came from ESPN.
At that time, ex Pixar, the movie business was hit and miss; the theme parks, always very sensitive to the business cycle, were at their lows; because of this, merchandise sales were similarly in the doldrums. ESPN, on the other hand, was a secular growth business, with expanding reach in the global sports world and, consequently, dependably expanding profits.
ESPN profits not only made up the majority of the DIS conglomerate’s earnings, the market also awarded those profits the highest PE multiple among the DIS businesses.
At the time, I thought that if truth in labeling were an issue, the company should rename itself ESPN–although that would probably have detracted from the value of the remaining, Disney-branded, business lines.
Then 2012 rolled around.
I haven’t been watching publicly traded apparel retailers carefully for years. For me, the issues/problems in picking winners in this area have been legion. There’s the generational shift in spending power from Baby Boomers to Millennials, the move from bricks-and-mortar to online, the lingering effects of recession on spending power and spending habits. And then, of course, there’s the normal movement of retailers in and out of fashion.
I’m not saying that retail isn’t worth following. I just find it too hard to find solid ground to build an investment thesis on. Maybe the pace of change is too rapid for me. Maybe I don’t have a good enough feel for how Millennials regard apparel–or whether retiring Boomers are using their accumulated inventories of fashion clothing rather than adding to them.
Having said that, I’m still surprised–shocked, actually–at how the current quarter for apparel retailers is playing out. It seems like every day a new retailer is reporting quarterly earnings that fall below management guidance, usually the latest in a string of sub-par quarters. That itself isn’t so unusual.
But the stocks react by plummeting.
You’d think that the market would have caught on that Retailland is facing structural headwinds. Or at least, that the retail area that made the careers of so many active managers over the past twenty or thirty years doesn’t exist any more.
Is it robot traders? Is it an effect of continuing buying by index funds? I don’t know. But the continuing inability of investors to factor into stock prices the continuing slump of apparel retailers is certainly odd.
I read a recent comment Warren Buffett made expressing his regret at never having bought AMZN.
As far as I can see–and I’ve never met Mr. Buffett–he’s an urbane, sophisticated, complex individual who chooses a down-home persona to market himself to the world. I don’t regard anything he says that involves the stock market as being a stray, off-the-cuff remark. I wonder what he meant.
the top ten
As of March 31st, Berkshire Hathaway’s top ten holdings are, in order:
IBM (adjusted down for Buffett’s announced intention to pare his holding by 30%)
Source: CNBC (a format that allows easy sorting of the SEC data)
The list comprises 80% of Berkshire’s equities.
Yes, despite Buffett’s well-advertised aversion to tech, there are two IT names in the top ten. But IBM is cutting edge tech circa 1975 and AAPL is a high-end smartphone company looking for a new world to conquer.
the Buffett approach
All these firms do have the signature Buffett look: they have all spent tons of money developing important consumer-facing brand names. While that spending has created an enduring consumer franchise, there is no hint of the existence of this key asset on the balance sheet. Rather, the all-important brand-building expenditure is accounted for as a subtraction from asset value.
The one possible exception to this is Charter, whose cable networks rather than sterling service and extensive advertising give it near-monopoly access to customers. Here again, however, the ability to gradually write off the cost of constructing those networks through depreciation argues that the balance sheet severely understates their true worth.
The formula, in brief: the “hidden” value of extensive well-staffed distribution networks plus iconic brands built through extensive spending on advertising and promotion.
The obvious limitations of this approach are: that while novel in the 1950s, the whole world has since adopted Buffett’s once-pioneering approach; this would be great if there were no internet undermining the value of traditional brand names and distribution networks.
In other words, a software-driven, internet-based firm like AMZN seems to me to be the last thing that would ever be on the Buffett radar. It also seems to me that taking AMZN seriously would mean rethinking the the whole Buffett investment approach–not the valuation discipline, but the idea of the value of traditional intangibles–and recasting it in a much techier way.
why not adapt?
Why not do so anyway, instead of kind of limping to the finish line?
Maybe it’s because that doing so would attack the heart of the intangible brand value of Berkshire Hathaway itself–and that attack would come not just from a nobody but from the brand’s most credible spokesperson, the Sage of Omaha himself.
That’s the day the S&P 500 took a dramatic 2% plunge, with recent market leaders doing considerably worse than that, right after the index had reached a high of 2400.
Despite closing a hair’s breadth above the lows–normally a bad sign–the market reversed course on Thursday and has been steadily climbing since. The prior leadership–globally-oriented secular growth areas like technology–has also reasserted itself.
–generally speaking, the market is proceeding on a post-Trump rally/anti-Trump agenda course. Emphasis is on companies with global reach rather than domestic focus, and secular change beneficiaries rather than winners from potential government action that have little other appeal
–while trying to figure out whether the market is expensive or cheap in absolute terms is extremely difficult–and acting on such thoughts is to be avoided whenever possible–the valuation of the S&P in general looks stretched to me. Tech especially so. This is especially true if corporate tax reform ends up being a non-starter. My best guess is that the market flattens out rather than goes down. But as I wrote a second or two ago absolute direction predictions are fraught with peril
–tech is up by 17.0% this year through last Friday, in a market that’s up 6.4%. Over the past 12 months, tech is up by 35.2% vs. a gain of 16.8% for the S&P. Rotation into second-line names appears to me to be under way, suggesting I’m not alone in my valuation concerns
–currency movements are important to note: the € is up by about 10% this year against the $, other major currencies by about half that amount. Why this is happening is less important, I think, than that it is–because it implies $-oriented investors will continue to favor global names
–the next move? I think it will eventually be back into Trump-motivated issues. For right now, though, it’s probably more important to identify and eliminate faltering tech names among our holdings (on the argument that if they can’t perform in the current environment, when will they?). My biggest worry is that “eventually” may be a long time in coming.
the auditor’s opinion
On my first day of OJT in equity securities analysis, the instructor asked our class what the most important page of a company’s annual report/10k filing is. The correct answer, which escaped most of us, is: the one that contains the auditor’s assessment of the accuracy of the financials and the state of health of the company. The auditor’s report is usually brief and formulaic. Longer = trouble.
Anything less than a clean bill of health is a matter grave concern. The worst situation is one in which the auditor expresses doubt about the firm’s ability to remain a going concern.
a new financial accounting rule
In today’s world, that class would be a little different. Yes, the auditor’s opinion is the single most important thing. But new, post-recession financial accounting rules that go into effect with the 2016 reporting year require the company itself to point out any risks it sees to its ability to remain in business.
the Sears case
That’s what Sears did when it issued its 2016 financials in late March. What’s odd about this trailblazing instance is that while the firm raised the question, its auditors issued an “unqualified” (meaning clean-bill-of-health) opinion.
what’s going on?
Suppliers to retail study their customers’ operations very carefully, with a particular eye on creditworthiness. That’s because trade creditors fall at the absolute back of the line for repayment in the case of a customer bankruptcy. They don’t get unsold merchandise back; the money from their sale will likely go to interests higher up on the repayment food chain–like employee salaries/pensions and secured creditors. So their receivable claims are pretty much toast.
Because of this, at the slightest whiff of trouble, and to limit the damage a bankruptcy might cause them, suppliers begin to shrink the amount and assortment of merchandise, and the terms of payment for them, that they offer to a troubled customer. My reading of the Sears CEO’s recent blog post is that this process has already started there.
It may also be, assuming I’m correct, that the effects are not yet visible in the working capital data from 2016 that an auditor might look at. Hence the unqualified statement. But we’re at the very earliest stage with the new accounting rules, so nothing is 100% clear.
breaking a contract?
Sears has complained in the same blog post about the behavior of one supplier, Hong Kong-based One World, which supplies Craftsman-branded power tools to Sears through its Techtronic subsidiary. Techtronic apparently wants to unilaterally tear up its contract with Sears and stop sending any merchandise.
Obviously, Sears can’t allow this to happen. It’s not only the importance of the Craftsman line. If One World is successful, other suppliers who may have been more sympathetic to Sears will doubtless expect similar treatment.
Developments here are well worth monitoring, not only for Sears, but as a template for how new rules will affect other retailers.