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.

 

 

 

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.

 

 

 

 

Disney (DIS) from 30,000 feet

I’d only followed DIS from afar until the company acquired Marvel Entertainment, which I held in my portfolio, for a combination of stock and cash in late 2009.  I kept the shares I acquired and also bought more while DIS was depressed by critics doubting the wisdom of its move. I’m tempted to write about how wrong that view was, but that’s for another day (not soon).

As I studied DIS’s financials, I found that ESPN accounted for about 75% of the firm’s overall operating profit.  The movie studio, run by a former monorail driver at the theme parks, was a mess.  Income from the parks was depressed by recession.  The Disney brand was also almost completely dependent on female characters, making Disney attractions less appealing to half the adolescent population.  ESPN, on the other hand, was/is the dominant sports cable franchise in the US and was going from strength to strength.  For a moment–until I realized the marketing advantages of having the Disney name in the public eye–I wondered why the company didn’t just rename itself ESPN.

In addition, the simple percentage of earnings seemed to me to understate the importance of ESPN to DIS.  The movie business is typically a hit-or-miss affair and therefore doesn’t merit a premium multiple.  Same with the hotels/theme parks, because they have a lot of operating leverage and are highly sensitive to the business cycle.  So I concluded the key to the DIS story was the progression of its secular powerhouse–and its one high-multiple business–ESPN.  Nothing else mattered that much.  (Of course, I didn’t understand the full power of Marvel, or the turnaround in the Disney studio, or the subsequent acquisition of the Star Wars franchise, but that’s a separate issue.)

In 2012, ESPN began an effort to expand its business in a major way into the EU by bidding large amounts for broadcast rights to major soccer games in the UK.  Incumbent broadcasters, however, realized (correctly) that no matter what the cost it would be cheaper to keep ESPN out of their market than to deal with it once it had a foothold.  So they bid crazy-high prices for the rights. ESPN withdrew.

ESPN’s failure was disappointing in two ways.  A new avenue of growth was closed off.  At the same time, the attempt itself signaled that ESPN believed its existing Americas business was nearing, or entering, maturity.  That’s when I began easing toward the door.

The issues for ESPN–cord-cutting and the high fees ESPN charges–are very clear today.  What I find most surprising is that it took the market three years, and an announcement of subscriber losses by DIS, for the stock market to focus on them.  So much for Wall Street’s ability to anticipate/discount future events, even for a major company.

I don’t think ESPN is helping its long-term future by seeking to boost ratings by having personalities shout at each other in faux debates.  Nor does covering WWE as if it were a real sport.  I think they’re further signs of decay.  My sports-fan sensibilities aside, the real issue is about price.

Suppose every cable subscriber pays $4 a month to get ESPN, but only 15% actually watch sports–or would pay for ESPN if it weren’t part of the basic package.  If so, the real cost per user is closer to $30 a month, most of which is being unwittingly subsidized by non-users.  There’s only one way to find out if current users would be willing to pay $30 for ESPN, which is by removing the service from the bundle everyone must buy, reducing the basic cable charge by $4 a month, and offering ESPN separately.  That’s what the cable companies want–and what ESPN is looking to avoid.

We’re nowhere near the end of this story.  I don’t think the final chapter will be pretty for ESPN.

On the other hand, as I see it, just after the UK rebuffed ESPN, DIS began to direct its ESPN cash flows away from cable and toward building up its film and theme park businesses.  For me, this was the sensible thing to do.  And it confirmed my analysis of the situation with ESPN.

My bottom line:  for four years ESPN has been the cash cow that’s funding DIS’s expansion elsewhere.  Wall Street only realized this twelve months ago.   But DIS’s reinvention of itself is still a work in progress.  Until the market begins to view DIS as an entertainment company that happens to own ESPN rather than ESPN-with-bells-and-whistles the stock will continue to struggle.

 

 

results from Disney (DIS): a lesson in how the market works nowadays

DIS and ESPN

A relative in the movie business called my attention to Marvel Entertainment a few years ago.  When it was acquired by DIS in late 2009, I held onto the stock I got and added more in the mid-$20 range Marvel, of course, has been pure gold for DIS, even though DIS initially went down on fears that DIS had overpaid.  Naturally I sold the stock way too early, in the mid-$60s–acting more like a value investor than a growth stock fan.

My first thought on reading the DIS 10-K, as I acquainted myself with the company,was that the company really should have been named ESPN, since at that time the cable sports network accounted for 2/3 of DIS’s overall operating profit and virtually all of its earnings growth.

red flags about ESPN

Over the past several years, a number of key warning signs have popped up about ESPN, however:

–ESPN decided to expand into the UK, signalling to me that it considered its US franchise on the cusp of maturity

–but ESPN was outbid for soccer rights by locals and effectively terminated its international expansion ideas–not good, either

–DIS began to shift cash flow away from ESPN and toward the movie and theme park business, which I took to be a sign of corporate worries about ESPN’s growth potential, rather than simply diversification for diversification’s sake

–serious discussion has begun over the past year about the demise of cable system bundled pricing, which likely benefits ESPN substantially (I suspect we’ll find out how substantially sooner rather than later)

–since ESPN.com’s recent format change, I find myself almost exclusively using Time Warner’s Bleacher Report for sports information

–personally, although this isn’t the most crucial part of my analysis, I think the progressive dumbing-down of ESPN coverage, in imitation of sports talk radio, to gain a wider audience will backfire.

To sum up,, there has been an increasing collection of evidence that ESPN probably won’t be the same growth engine for DIS that it has been in the past.

Yet…

…DIS shares were down by about 10% in Wednesday trading (in an up market) on the first signs in the earnings report of the factors I’ve just listed.

discounting?

Where was the market’s discounting mechanism, which in the past has been continuously evaluating corporate strategy and factoring worries like the long list I’ve mentioned above into the stock price?

…only on the earnings report, not before

To my mind, DIS trading yesterday is another indicator that information isn’t flowing on Wall Street as fast as it once did.  That’s neither good nor bad;  it’s just the way the game is being played in today’s world.  What we as investors have got to figure out is how to adjust our own behavior to fit altered circumstances.

My initial thought is that it may be riskier than it has been to dabble in down-and-out industries like mining or oil until the final bad news has hit income statements.

 

the fading of Bloomberg Radio

first ESPN…

Over the Thanksgiving holiday my older son pointed out to me that family friend, John Koblin, had written a critical article for Deadspin on how ESPN has gradually lost its journalistic way as it chases television ratings.

The example John focusses on is the network’s apparent obsession with New York Jets football player, Tim Tebow–a legendary college football figure who appears to be the latest in the parade of Heisman Trophy quarterbacks not quite good enough to make it in the NFL.

How is Tebow a continuing story?  ESPN2’s unsuccessful morning show First Take switched format in late 2011.  The new look:  …a staged debate between two cartoonish figures who duel in vintage WWF fashion over some item of sports news.  Their favorite topic:  Tebow.

ESPN discovered that the new First Take was surprisingly popular, even taking audience share away from its mainline morning show, Sportscenter.  It reacted in two ways:

–more phony debates all over the network, complete with loud voices, exaggerated gestures and bombast, and

–Tim Tebow all the time, no matter what the ostensible topic of a given show.

I’m of two minds about this ESPN development.  As a holder of DIS shares I guess I should approve.  As a sports fan, I’ve got to find other sources of sports information and analysis.

…now Bloomberg

Yesterday I was on my way in the car to Delaware and turned on the Bloomberg Radio morning broadcast for the first time in a while.  Five years ago I used to listen every day, either live or through podcasts of important segments.  No longer.  As Bloomberg dialed down the information content and dialed up the reporter self-congratulation I began to look elsewhere.

Anyway, I caught the last part of The First Word, with Ken Prewitt, who strikes me as the only savvy professional journalist left on Bloomberg.  Then came Bloomberg Surveillance, which appears to have had a format tweaking since the last time I listened.  Mr. Prewitt is gone (…or maybe he was just taking a day off from the insanity).  What remains is a veritable First Take of loud voices and self-congratulatory glorification of trivia.

To my mind, this can’t be an accident.  The radio personalities must have been trained, à la ESPN, to speak louder, create fake “debate” and constantly tell the audience how important the topics–and the radio hosts themselves–are.

And, as with First Take, the quest for higher ratings is the most likely explanation, with Fox News and CNBC as the models.  It’s probably also cheaper to simply act as if you’re conveying relevant information rather than to do the research and analysis needed to create it.

The written Bloomberg news appears not to have been infected by this broadcast tendency.  I figure the investment professionals who pay $30,000 a year or more for Bloomberg terminals wouldn’t put up with the stuff that’s now on Bloomberg Radio.

Where is the real financial news today?  It’s in newspapers like the Financial Times  and the Wall Street Journal.  And, like sports, it’s in the blogosphere.

We may mourn the loss of Bloomberg Radio as an information source, and the fact that the search for relevant stock market information is somewhat more difficult without it.  But this also means that insights we may develop are that much more valuable–because they are less likely to have been fully disseminated into the market at the time we figure them out.

ESPN’s role in DIS

Still no internet/TV.  Still no sign of Comcast trucks.  Nor is Comcast willing to say how much longer the outage will last–today is Day 17.  The whole neighborhood is switching to FIOS.  

This is, of course, a trivial issue when compared with the devastation in low-lying areas of Long Island or with the low-income housing in NYC that still has no power (but whose residents are still being charged full rent–rebates to come in January???).  

This post is prompted by a reader’s question about ESPN.  It also addresses some assumptions I’m making about ESPN in saying I think DIS will be a good relative performer over the coming year.

limits to what I know

I’m very comfortable as an investor that I know more than I really need to about how the Disney part of DIS works.  I think I know enough about ESPN, too.

This is an important distinction, however.  In my mind–if nowhere else–there’s an unresolved question about the long-term growth prospects for ESPN.  I don’t think this is a near-term issue.  I don’t think it’s primarily about competition, either.  In its simplest form, it’s how long can ESPN continue to grow revenues at twice the rate of nominal GDP, as it is currently.  When does growth slow down?

ESPN’s importance to DIS

Today, ESPN accounts for 2/3 of DIS’s profits.  What happens if ESPN stops growing at 15% a year and slows down to 10%?  What does the rest of the business have to do to take up the slack? The answer: rev up growth to +25%/year.  Is that possible??  Possible, yes; probable, no–in my opinion.  Therefore, if ESPN slows down, Wall Street revises down its estimates of DIS’s long-term growth rate–and the stock adjusts downward.

ESPN doesn’t have to speed up for DIS to be a good stock.  But it can’t slow down either, in my view.

sports programming

What’s unique about sports programming–and what makes ESPN so attractive–is that it’s the only type of mass media where consumers are regularly willing to pay higher prices for pictures of events in cutting-edge resolution, and for tons of expert (or even not so expert) commentary.

This is not only true in the US, where there’s a mad rush to buy the latest model TV set just before the Super Bowl (the Big Game, to those unwilling to pay to use the SB moniker).  It’s the same in every country whose stock market I’ve ever been involved in.

programming rights

Not everyone can broadcast a sporting event.  Most sports teams/leagues periodically auction off to the highest bidder exclusive rights to broadcast their games.  For many profession teams (and icons like Notre Dame), these broadcasting rights can be their single most important asset, running into the hundreds of millions of dollars in value.

Many organizations break the rights down into a number of pieces to make them more affordable, and therefore encourage more spirited bidding.  The NFL, for example, has separate packages for Sunday Night Football, Monday Night Football, Thursday Night Football, NFC Football and AFC Football–broadcast by NBC, ESPN, the NFL Network, Fox and CBS, respectively.

where ESPN fits in

ESPN is by a mile the dominant sports broadcasting distribution network in the US.  It broadcasts all the major sports.  It also fills a bunch of channels, in both English and Spanish, with 24/7 commentary and analysis.  Over the years it has been consistently innovative, so it possesses an unparalleled internet presence as well–only commentary but fantasy league and broadcasting, too.

network effects

ESPN’s is a business where the rich get richer and the poor get poorer.  As a distribution network gets larger and if a distributor can raise prices (which so far ESPN has been able to), the distributor generates more money to spend on content, including broadcasting rights.  This gives it a huge, and growing advantage over smaller rivals.    At some point, the amount of capital needed to enter the market, or even to maintain a presence, becomes prohibitively high and the weak links drop out.

For market leaders like ESPN, this is a great business.

a sign of maturity?

About two years ago, ESPN decided to make a major move into soccer.  Two reasons:  this would be the leading edge of ESPN’s expansion into Europe; and ESPN could become the leading distributor to a small but growing fan base in the US.

The heavy investment ESPN began to make implied to me that management saw this as the company’s most attractive long-term expansion opportunity.  (Otherwise, it would have focused on something else.)

ESPN, however, lost out in the bidding for Premier League soccer rights in Europe to incumbents who recognized the threat ESPN posed.  It was worth losing money to them just to keep ESPN out.  Not a great solution to the threat of ESPN, but probably the best alternative available.

So, for now anyway, the geographical expansion is off the table.

spending up on the Disney side

Since then, DIS has agreed to buy Lucasfilms for $4 billion.  It has added Cars Land to Disneyland and is overhauling Fantasyland at Disneyworld.  It’s also installing new reservations/guest interface software at the parks.

…a coincidence that Disney capital spending is rising just after ESPN’s need for capital has decreased?  Maybe.  Another interpretation, though, is that DIS’s capital is going into the highest return projects–and that none are in ESPN.

my take

It’s not necessarily a bad thing if ESPN sees no new big untapped markets to enter.  In fact, DIS’s generally conservative accounting philosophy implies ESPN’s near-term profits will likely be higher because the expenses of European soccer rights and of expanding its soccer coverage won’t be there.

But DIS’s shifting capital allocation priorities do bring up the issue that ESPN won’t continue to grow at the current rate indefinitely.

The only practical conclusion I’m drawing is that if what I’ve just said is right, I’ve got to be careful to set a price target ($55?) and remember to sell.