Disney(DIS)/ESPN: from growth to value

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?

worst case

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.

 

 

 

revisiting (again) value investing

As regular readers will know, I’m a growth stock investor.  That’s even though I spent my first six years as an analyst/portfolio manager using value techniques almost exclusively–and then worked side by side with a motley crew of value investors for a ten-year period after that.

One way of describing the difference between growth and value is that:

–growth investors know when potentially price-moving news will happen (that is, when quarterly earnings are announced) but are less sure what that news will be

–value investors know what the news will be (if they’ve done their job right, they’re holding stocks where the market has already priced in every possible thing that could go wrong.  All they need is one thing to go right).  However, they may have little idea when good news will occur.

 

Each style has an inherent problem:

–for growth, it’s hard to find rising earnings during an economic downturn

–for value, it’s possible that a long time (say, two years) may pass before any of a portfolio’s diamonds in the rough are discovered by the market.  In that case, the manager will likely be fired before the portfolio pays off.  His/her successor will either reap the rewards of the predecessor or will dismantle the portfolio before any good stuff can occur.

 

At times, I do buy what I conceive of a value stocks.  Intel when it was $19, trading at 8x – 9x earnings and yielding almost 4% (I’ve since sold most of what I own) is an example.  But deep value investors would scoff at the notion that this is truly value.

 

For some time, I’ve been maintaining that value investing has lost its appeal in the 21th century.  Two reasons:

–the stronger one is that the shelf life of physical plant, traditional distribution networks and brand names is no longer “forever” in a globalized, Internet-driven world.  So buying companies that are rich in such assets but not making money is much, much riskier today than it used to be.  Such assets can erode in the twinkling of an eye.

–a weaker claim would be that while there are still value names, it’s hard/impossible to fill out a portfolio of, say, 100 of them, which is the traditional value portfolio structure, in today’s world.

 

I’m rehashing the growth/value debate here because I’m thinking the stronger position isn’t as unassailable as I’ve believed.

More tomorrow.

 

why Apple (AAPL) is a growth stock anomoly

Although AAPL is one of the most important growth stocks of the past decade, its price action doesn’t fit my description of “typical” growth stock behavior.

Although AAPL’s earnings per share rose by 500% between 2009 and 2012, the price earnings ratio of AAPL, which experience says should have expanded a lot during this period, actually contracted.  More than that, it shrank during a period when the PE of the overall S&P 500 was expanding.  So, relatively speaking, its PE behavior was considerably worse than appears at first glance.

In addition, by 2013-14, there was, in my view, ample evidence that the best days for the iPhone would soon begin to be visible only in the rear view mirror.  Yet, after a slump in 2013, the shares recovered their upward momentum in 2014 and carried on their strong performance through most of 2015.  In other words, there wasn’t, as I read the stock price, the usual performance falloff in anticipation of the end to super-normal growth.

How did these things occur?

no PE expansion

On the first point, I don’t have a great answer.  As I wrote while this was happening (or, actually, not happening), I’d never seen this behavior elsewhere in 20+ years of buying growth stocks in the US and around the rest of the world (I was a value investor early in my career).

The only thing I can come up with is that AAPL changed from a very conservative method of accounting for its iPhone profits to a more aggressive one in late 2009.  The change added between 50% and 100% to near-term reported profits.

Professionals typically applaud companies whose accounting is conservative, and disapprove of those who sail closer to the wind.  In AAPL’s case the more flattering figures had been routinely included in notes to the financial statements, where anyone who cared could look at them. So although the move may have been calculated by AAPL management to give the stock a boost, the change didn’t provide any new positive information.  It only created the impression that AAPL was more concerned with flashy optics than operations.

(The issue was how to account for sales of iPhones by AT&T on two-year contracts where AAPL shared in the revenues AT&T collected over the contract life.  AAPL’s initial stance was to recognize the revenue over the two years.  The change was to credit everything up front, at the time of sale.)

no anticipation, no PE contraction

This is a lot easier.  The main factors:

The PE never went up in the way the multiple of growth stocks typically does.

As is the case with many successful growth stocks, AAPL started out with a retail investment base.  Then came hedge funds.  Traditional long only professionals bet against AAPL early on, in my view, and came to the party only after suffering considerable underperformance, either from not owning the name at all or from owning a less-than-market-weight position.  AAPL’s earnings growth was so powerful and so long-lasting that the safest position for skeptics became to establish, kicking and screaming, a market-weight position.  That allowed them to forget about AAPL and look for outperformance elsewhere.  In a sense, the stock’s upward momentum fed on itself.  But it also meant steady accumulation of the name.

In 2013 Carl Icahn convinced AAPL to begin using financial engineering–borrowing to fund large scale stock buybacks and dividend increases–to boost the stock price.  Maybe he didn’t put it quite that way, but between the end of the company’s fiscal 2012 and its fiscal 2015, AAPL shrank the number of its outstanding shares by 15%, despite issuance of new stock to employees.  That’s enough to change the psychology of buyers, as well as to relieve potential selling pressure and give a mild boost to eps.

Mr. Icahn has recently announced the sale of his AAPL holding.  Given that and recent negative earnings news, the stock has declined and the PE has contracted a bit.  However, the shares are now trading at about 2/3 the multiple of the typical US stock–mostly because the market PE has expanded while AAPL’s hasn’t.  All the damage has been in the relative PE, not the absolute.  At such a low relative PE today, I find it hard to argue that damage to the absolute PE multiple is in the cards.

Apple (AAPL) as a growth stock

Apple is among the most successful growth companies of the past ten years.  However, AAPL has had a most peculiar trajectory as a growth stock.  To my mind, it has barely followed any part of the typical growth stock pattern I outlined yesterday.

How so?

For one thing, the peak price earnings multiple and the peak stock price didn’t coincide from AAPL.  Yes, the company did switch to a much less conservative method of accounting for iPhone profits early in that product’s life, but I don’t mean that.  Even after the switch, the PE didn’t expand while the company was piling up quarter after quarter of spectacular, continually surprisingly strong, earnings performance .  The multiple contracted slightly instead.

For another, it was clear by, let’s say 2012, that the smartphone market was becoming saturated.  AAPL was also facing increasing competition from the Android operating system and from Samsung as a manufacturer of mobile devices.  So we had to think that pretty soon the iPhone profit dynamo would begin to lose momentum.

What about another reinvention?  The issue here has always been:

–Reinvention #1, the iPod, doubled the size of a small company.  Reinvention #2, the iPhone, more than doubled the size of a now-large company.  To repeat the same quantum leap, Reinvention #3 would have to be twice the size of the smartphone.  What would that product be?  Would such a product be possible?  (my answer: probably not)  Is such a product likely?  (not likely at all)

(AAPL has had two subsequent innovations, the iPad and the iWatch.  Neither has created anything like the response needed to be Reinvention #3)

In a nutshell, the elevator speech was starting to give a sell sign–based both on earnings momentum for the company as currently constituted and another possible reinvention.

 

Yet, the stock continued to go up, and to outperform the S&P, until about a year ago.

Why?

More on Monday.

 

the traditional growth stock model…

…meaning for the past thirty years or so that I’ve been in the business.

 

What makes a growth stock is faster than expected expansion of earnings per share, that carries on for longer than expected.

Let’s say a stock is now trading for $20 a share.  It earned $.90 a share last year; the consensus of Wall Street analysts is that eps will grow by 11% to $1.00 this year.  Under these assumptions, the stock appears overvalued–one would be paying 20x expected earnings for 11% growth.

Assume, however, that our careful securities analysis, based, say, on the introduction of a badly understood but potentially transformational new product, reveals that eps will grow by 35% (and maybe more) this year–and beyond.  If we’re right, the stock is trading at 15x expected earnings for 35% growth.  It’s  a steal.

Stage 1.  eps acceleration.

a.  The company reports 20% year on year eps growth in 1Q16, vs. expectations of 10%.  The stock goes up, for two reasons:

–stock rises by, say, 20% because beliefs about the level of current earning power are revised up, and

–the stock’s PE ratio expands, meaning the stock rises by another, say, 5% – 10%, on the idea that a permanent upward change in the firm’s earning power may be under way.

b.  The process repeats itself in following quarters as long as expectations lag company performance.

Stage 2.  plateauing

In my experience, plateauing almost always results from a negative change in the qualitative story that’s driving the stock.  Earnings per share still look fine.  But there are indications that the force propelling them is looking long in the tooth.  Let’s say a retailer’s results have been going up for several years, both because of increasing same store sales growth and geographical expansion into new markets.  But now sales in the oldest stores are starting to flatten out, maybe even beginning to decline–and the firm has just entered the last 10% of its potential expansion program.

Typically, this is also the time when the stock’s PE ratio has expanded to crazy-high levels.  So, too, consensus expectations for earnings growth.

 

This is also usually the time when the first portfolio investors in are beginning to make their way to the exit.

Time can be another indicator.  Stages 1 and 2 together tend to play themselves out over five years or so.

Stage 3.  weakening comparisons

a.  The company reports earnings that no longer surprise on the upside.  They may be perfectly fine and in line with company guidance, but they’re less than investors expect.  The realization begins to dawn on holders that the peak of profit growth may have passed.

Now, the stock goes down for two reasons:

–current earnings growth expectations are revised down, and

–beliefs about long-term earnings power come down as well, meaning the PE contracts.

b.  This process continues.

Notes:

–The best growth companies are able to reinvent themselves, sometimes more than once, thereby prolonging their five-year growth cycle.

Microsoft, Cisco, Amazon, Apple are all instances.  In Apple’s case, the company was first the plucky PC company come back from near death.  Then it was the iPod company.  Then it became the iPhone maker.  Each reinvention triggered another growth cycle.

–The fall from grace in Stage 3 is often quite ugly and can last for a long time.  The potential buyers of a fallen angel are predominantly value investors, who are typically only avid purchasers at a discount to some notion of intrinsic value.

More tomorrow.