Disney (DIS) and ESPN: a lesson in analyzing conglomerates

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.

How so?

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.

More tomorrow.

 

Disney (DIS): the valuation issue

Long-time readers may recall that I became interested in DIS in late 2009, the company acquired Marvel Entertainment, a stock I held, for stock and cash.

corporate structure

I hadn’t looked at DIS for years before that.  I quickly learned that DIS was a conglomerate, that is, a type of company where the most useful analysis comes taking the sum of its constituent parts.

I knew the company’s movie business had been struggling for some time and the theme parks were being hit hard by recession.  Still, I was more than mildly surprised that ESPN (plus other media that we can safely ignore) made up somewhere between 2/3 and 3/4 of DIS’s operating earnings.  Why did they still call it Disney?

multiples

Given that the parks are a highly cyclical business and movies moderately so–meaning the PE applied to those earnings should be relatively low–and that ESPN was showing all the characteristics of a secular growth business–meaning high PE–I thought that ESPN represented at least 80% of the market capitalization of DIS.  (That’s despite the fact that the market would apply a higher than normal multiple to cyclically depressed results).

So DIS was basically ESPN with bells and whistles.

ESPN’s turning point

In 2012, ESPN made a major effort to enter the UK sports entertainment market.  To my mind, this wasn’t a particularly good sign, since it implied ESPN believed the domestic market was maturing.  Worse, ESPN lost the bidding, closing out its path to growth through geographic expansion.

It seemed to me that DIS management, which I regard as excellent, understood clearly what was happening.  It began to redirect corporate cash flow away from ESPN and toward the movie and theme park business, which had better growth prospects, and where it has since had unusually good success.

2014-16 results

Over the past two fiscal years (DIS’s accounting year ends in September), the company’s line of business results look like this:

ESPN +        revenues up by +11.9%, operating earnings by +6%

parks           revenues up by +12%, op earnings  +24%

movies        revenues up by +30%, op earnings +74%

merchandise   revenues up by +4.6%, op earnings +33%.

the valuation issue

ESPN has gone ex growth.  This implies these earnings no longer deserve a premium PE multiple.  To me, the fact that ESPN now treats WWE as a sport (!!) just underlines its troubles.

The other businesses are booming.  But they’re also cyclical.  So while improving efficiency implies multiple expansion, earnings approaching a cyclical high note implies at least some multiple contraction.

Because the two businesses are so different, I think Wall Street is making a mistake in treating earnings from the two as more or less equal.

calculating…

DIS will most likely earn $6 a share or so this fiscal year.  That will be something like $3 from ESPN and $3 from the rest.

Take the parks… first.  Let’s say I’d be willing to pay 18x earnings for their earnings.  If that’s the right number, then these businesses make up $54 a share in DIS value.

Now ESPN.  If we assume that the worst is over for ESPN in terms of subscriber and revenue-per-subscriber losses, we can argue that the future earnings stream looks like a bond’s.  If we think that ESPN should yield, say, 5% (a 20x earnings multiple), that would mean ESPN is worth $60 of DIS’s market cap.  If we’d still on the downslope, that figure could be a lot too high.

$54 + $60 = $114.  Current stock price:  $109.

my bottom line

My back of the envelope calculation for the parks… segment may be a bit too low.  I could also be persuaded that my figure for ESPN is too rich, but it would take a lot to make me want to move the needle higher for it.

Yes, most of DIS’s earnings are US-sourced, so the company could be a big winner from domestic income tax reform.

But if I were to be holding a fully valued stock on the idea of a tax reform boost, I’d prefer one with more solid underpinnings.  At $90, maybe the stock is interesting.  But I think ESPN–the multiple as much as the future earnings–remains a significant risk.

 

 

 

 

3Q2016 earnings for Tesla (TSLA): still a “dream” stock

TSLA reported 3Q16 results yesterday after the New York close. The numbers were better than admittedly modest expectations:  the company sold a record number of cars: it had profits; cash flow was strongly positive–although flattered by better management of working capital and sale of pollution tax credits.  Still, a plus.  And the stock is up by about 4% in pre-market trading as I’m writing this.  (I should mention that other members of my family and I hold small positions in TSLA.)

The fact that a $30+ billion market cap company earned $22 million in a quarter would scarcely be considered good news under most circumstances.  Annualizing and rounding up to $100 million for a full year would imply a PE of 300x for the company’s stock!  However, TSLA is still to a considerable degree a “dream” or “concept” stock.

 

The prototypcial “dream” stock is a firm that starts up with the intention of prospecting for gold.  It makes what it thinks/says is a significant strike.  While the company creates the mine and associated processing facilities, speculation about the quality and extent of the orebody runs rampant.  After all, there’s no factual information to contradict any rumors that may float about.

Then the mine opens.  There are now facts available about ore quality and mining costs.  So there’s no more dream–only brass-tacks reality.  The stock typically peaks the day the mine opens.

TSLA’s case is an unusual one.  Auto production has been under way for some time.  Yet the stock hasn’t reverted to trading on actual results.  To some degree the dream has been dented–I find it hard to imagine TSLA could repeat today its 2014 convertible bond offering, whose conversion price was set at $350.  But Elon Musk has expanded and reset his aspirations for TSLA  often enough during its short life as a public company that at least some version of the dream remains alive.  Unless/until TSLA disappoints severely in its results, I’d think the stock will continue to trade without a strong connection to earnings for some time to come.

 

 

 

earnings growth: velocity vs. acceleration

velocity vs. acceleration

For investors, earnings velocity is the rate of change of earnings.

Earnings acceleration is the rate of change of velocity.

Examples:

If a company is growing earnings per share at a steady +10% annual rate, it has earnings velocity of +10% and acceleration of 0.

To have earnings acceleration, the rate of earnings growth has to increase.  The growth rate pattern has to be something like:  +10%, +12%, +15%…

Both velocity and acceleration can be negative as well as positive.  If velocity is negative, earnings are shrinking.  If acceleration is negative, the rate of earnings growth is slowing down.  For growth investors, both are bad signs.

as applies to growth investing

Having any earnings per share growth is better than having none.  Having eps growth that’s fast, and faster than that of the average stock, is an important characteristic of attractive growth stocks.

Having eps acceleration is also important.  Its presence typically creates the largest price earnings multiple expansion.

Acceleration is a two-edged sword, however.  Securities analysts looks for signs of earnings growth deceleration as an early warning sign that a company’s period of superior growth–and therefore of its attraction to investors–is coming to an end.  So it’s often the case that the PE will begin to contract, even though absolute growth is high, because that growth is starting to decelerate.

why this can be important:  performance implications

This can create an odd situation between the performance of two stocks, A and B.

Annual growth of A’s earnings: +20%, +35%, +45%, +25%.

Growth of B’s earnings:  +10%, +12%, +15%, +18%.

In the first two years,  Stock A most likely has outperformed Stock B.  By year 4, B is most likely outperforming A, even though the rate of growth of A’s earnings is continually better than B’s.  That’s because A’s earnings are beginning to decelerate, while B’s are not.

 

 

 

 

 

 

 

reason six why analysts mis-estimate company earnings

reason #6

In my post from yesterday, I titled this reason “making dumb mistakes.”  I’m not sure what else to call it.  Let me illustrate with two examples of recent huge misses by analysts who should have known better.  They’re the June quarter results from two high-profile companies with plenty of Wall Street coverage, WYNN and AAPL.

Let’s take WYNN first.

WYNN’s 1Q2011

In 1Q2011, WYNN earned $173.8 million, or $1.39 per fully-diluted share.  Look one line higher on the income statement, and you see that the $173.8 million figure is after deducting $52.5 million in “income attributable to non-controlling interests.”  That’s minority interest.  It’s income that belongs to the 27.7% of Wynn Macau that WYNN doesn’t own.  (Wynn prepares its financials as if it owned 100% of Wynn Macau, and then subtracts out the minority interest at the end.)

From the minority interest figure and the magic of long division, you can calculate ($52.5 /.277) that Wynn Macau’s total net income was $190 million. WYNN’s share was $137 million.  Therefore, WYNN, ex its interest in Wynn Macau, earned $36.8 million for the quarter.

One unusual feature of 1Q11:  gamblers at the WYNN tables in Las Vegas had bad luck by historic standards during the quarter.  They lost a bit over 30% of what they wagered vs. historical loss experience of 21%-24%.

Any analyst who follows the company could have found all this out in five minutes of studying the 1Q11 income statement.  Given that the analysts’ consensus for 1Q11 was wildly low at $.73, you’d assume they’d do so to try to figure out where they went so wrong.

turning to 2Q11

In 1Q11, 80% of WYNN’s income came from fast-growing Macau, 20% from slowly-recovering Las Vegas.

From figures the Macau government posts monthly on its Gambling Coordination and Inspection Bureau website, we knew on July 1st that gambling revenue for the market as a whole was 12% higher in 2Q11 than in 1Q11.  If we assume that Wynn Macau grew in line with the market, and that a 12% increase in revenues produced an 18% jump in income (basically, adjusting for normal operating leverage and the fact that Wynn Macau “adds” gambling capacity by raising table stakes), then Wynn Macau would have earned about $225 million in 2Q11.  Of that, WYNN’s share would be about $165 million.  That translates into around $1.35 a share for WYNN in eps during the quarter.

What about Las Vegas?  It chipped in $.25 a share to first quarter earnings.  “Luck” at table games returning to historical norms would probably push that figure back to zero.  On the other hand, room rates at both Wynn and the Encore are gradually rising, so zero might be too low.  But let’s stick with zero from Las Vegas is the most reasonable guess.

In other words, a sensible back-of-the-envelope guess for WYNN’s eps in 2Q11 would be $1.35 + $.00  =  $1.35.  This isn’t necessarily the most conservative forecast, but it is one based on factual data about the Macau gambling market and the assumption that nothing much goes wrong (or right) in Las Vegas.

What did the professional analysts say?

The median estimate was $1.01.  The highest was $1.25; one analyst had the dubious distinction of saying eps would be $.69.  For this last estimate to have come true, WYNN would have had to break even in Las Vegas (it earned about $.25/share) and to have revenues in Macau drop by 25% quarter on quarter, while the market was growing at 12%.

Given that WYNN’s results are so strongly influenced by Macau, even the median was predicting a relative disaster for the company there.  What were they thinking?

(True, they might have been assuming a disaster in Las Vegas, not Macau.  And, I’ll admit, I thought WYNN has done surprisingly well in Las Vegas so far this year.  But Las Vegas isn’t big enough to move the eps needle down to $1.  And the situation is a little more complicated than I sketched out above:  Wynn Macau pays a large management and royalty fee to the parent, almost $40 million in 2Q, so the better Macau does, the better ex Macau looks.)

APPLE

AAPL’s 2Q11 (ended in March)

During 2Q11, AAPL earned a profit of $6.40 a share.  Its business broke out as follows:

Macs     3.76 million units     $4.98 billion in revenue

iPod      9.02 million units     $3.23 billion (includes iTunes)

iPhone     18.6 million units     $12.3 billion

iPad     4.7 million units     $2.84 billion

Other                                         $1.3 billion

Total                   $24.7 billion

turning to 3Q11

Let’s try a back-of-the-envelope forecast for AAPL’s 3Q11.  To make things ultra-simple, we’ll ignore operating leverage, which will bias our estimate to the low side.

Macs  growing, but slowly in a developing world where overall PC sales are flattish.  Let’s say $5 billion in sales.

iPod  flat, $3.2 billion in sales

iPhone     industrywide smartphone unit sales are growing at 80% year on year.  All the growth is coming from half the market, Android and iPhone, with Android growing faster; Nokia and RIM are taking on water and sinking fast.  Let’s pencil in 19 million units at $660 each = $12.5 billion.

iPad  this is the tricky one.  We know that AAPL is capacity constrained, is adding manufacturing capacity as fast as it can, and sold 4.7 million units in 2Q11.  Let’s put in 6 million units at $600 each, the average price from 2Q11.   That’s $3.6 billion.

Other Leave it flat at $1.3 billion.

Add all these numbers up, and we get $25.6 billion.  If we assume constant margins–i.e., no operating leverage (which a really terrible example to set–working with margins instead of unit costs, but I’ll do it anyway), then earnings will come in at $6.60-$6.75 a share for the quarter.

As events turned out, my guess is way too low.    …oh well!   AAPL reported eps of $7.79.  The big difference?  The iPad sold 9.2 million units and brought in $6 billion in revenue.  That alone adds more than $.60 a share in earnings.  The rest is bits and pieces.

So I missed badly.  That’s not really the point.  The real question is how my ten-minute approach stacks up against the work of the 45 professional analysts who follow the company for a living–and for whom AAPL is probably their most important stock.  Check them out and I’m starting to look pretty good.

the analysts

The median estimate of the 45 was $5.82 a share.  The low was $5.10, the high $6.58.

How could they consensus be projecting an almost 10% quarter on quarter drop in earnings?

APPL’s main business, smartphones, which accounts for 50% of total company revenue, and a higher proportion of profit, is exploding. The category is growing by 80%.  Rivals NOK and RIMM are not only going nowhere, they’re getting worse by the day.   In fact, NOK’s smartphone sales in the June quarter fell year on year–probably by a third. So AAPL’s continually taking market share from them.  Quarter on quarter sales were likely up.

We don’t know what 2Q11 iPad revenues could have been, only that they flew off the shelves as fast as AAPL put them on.  So product sales had to be up, maybe substantially, in 3Q11.

If both iPhone and iPad were flat, quarter on quarter, the only way to get company results to be down 10% would be if Mac sales, which represent about a fifth of the company’s business, were cut in half.  Hard to fathom, given that the PC industry is growing, if only slightly, and Macs have been gaining significant market share from Windows-based PCs.

what did I do differently?

I think everybody ignored AAPL’s “guidance” of $5.03.  WYNN doesn’t give guidance.

I did five things:

I gathered industry information from the internet.

I read the prior-quarter results carefully.

I used a line of business table to make (very primitive) quarter on quarter projections.

I ignored macroeconomic forecasts of slow growth for the US, since both firms target the affluent here–AAPL more so than WYNN, I think.

I didn’t worry about missing on the high side.  I didn’t want an estimate that was deliberately too conservative.

What didn’t the analysts do?

I only have guesses.

It’s possible that they were influenced by downbeat general economic news.  Even so, I don’t see how you could have gotten to the consensus figures for either APPL or WYNN if you did a line of business table.  But that’s one of the first lessons in Security Analysis 101.  Maybe the analysts in question were out that day.

What is an earnings “surprise”?

When the consensus is wrong

The basic idea behind growth stock investing is to find a company where earnings will be growing faster than the consensus expects for longer than the consensus expects.

For instance…

An example:  Let’s assume a stock is trading at $20 a share.  It had earnings of $1/share last year and is expected to grow by 15% each of the next few years.  This means that, on consensus expectations, it is trading on 20x historic earnings, 17.4x this year’s earnings, and 15.1x next year’s earnings.  As a crude rule of thumb, one might say that fair value for a stock is to have the price earnings ratio equal to the growth rate on next year’s earnings.  On that measure, the stock is fairly valued.

Let’s say the true earnings growth rate is 40%.  That would mean that our stock is trading at 14x this year’s earnings and 10x next year’s.  That’s about a quarter of what our rule of thumb would imply. Apple is a recent instance of this phenomenon.

How does the market adjust its expectations upward?   Continue reading