MI372: Can Disney Bring The Magic Back? Valuing Disney w/ Shawn O'Malley

24:26While this profit is small, it is a huge step in the right direction. Two years ago in Q4 of 2022, the losses of the combined streaming segment still amounted to$1.5 billion. Iger also wanted Disney to refocus on the creative side of the business. Not only was the quality of shows supposed to improve, but movie releases also needed to return to past success and quality. To achieve this, he restructured certain management teams, including the direct-to-customer team for streaming, and he placed longtime studio bosses with extensive experience in Disney's creative work as new co-chairs for the entertainment segment.

25:02Since focusing solely on subscriber growth led Disney into the cost trap and content slump that has plagued it, let's take a look at the most important metric for improving the streaming service's profitability, ARPU. ARPU is an acronym which stands for average revenue per user, and that word user is actually interchangeable with subscriber as well. For a streaming service to be profitable, this number must be higher than the customer acquisition costs plus the cost of content production. Netflix currently has a global ARPU of around$11.70, which I calculated using the company's latest earnings report.

25:36That global ARPU is the weighted average of the domestic ARPU in the US, which includes actually the US and Canada, and the international ARPU, which is split between Europe, the Middle East, Africa, as well as Latin America and the Asia Pacific region. The difference between these global and domestic ARPUs stems primarily from the fact that users across the world pay different prices for content, depending on the relative pricing power in their country. Consumers in less developed countries where median incomes are lower also generally pay less in dollar terms for their subscriptions. While Netflix's domestic ARPU stands at$17.24, that value is brought down by Netflix's more than 190 million international subscribers, of which over 100 million are from countries where revenues per subscriber are only half of that of the domestic rates charged in the US.

26:24We can see the same effect at Disney too, although it's a bit more complex in this case because of the different streaming services Disney offers in each region. Disney Plus's domestic average revenue per subscriber is between$7 and$8 as of 2024. This is significantly higher than in the years 2019 to 2021 when it was in the range of just$5. Disney Plus's International ARPU is divided between Disney Plus Core, which is basically the normal Disney Plus service, and Disney Plus Hotstar, which is the Indian and South Asian streaming service. The International ARPU for Disney Plus Core stands at$6.80 and is only a dollar below the domestic ARPU.

27:03Hotstar, however, shows significantly lower and more volatile average revenues per user. In recent quarters, it ranged from just 70 cents to$1.30. The comparison to Netflix's average revenue per subscriber in the Asia-Pacific region is also not completely fair since Netflix only has an estimated 10 to 12 million subscribers in India, whereas Disney has over 36 million. Since the price in India is among the lowest globally, the average revenue will also be a lot lower. On the flip side, India is a huge and fast growing market, and Disney is in a much better position to capture it. Continuing revenue growth in that region will be crucial to Disney's direct-to-consumer success.

27:41Overall, Netflix is still far ahead of Disney in terms of profitability, both in per-subscriber metrics and overall. We have now talked extensively about the direct-to-consumer streaming segment and Disney Plus in particular, but I think that was important since it has been one of the main drivers of the stock price's upside and downside since its launch in 2019. Now let's talk about one of the segments that has turned Disney into the cash flow machine it used to be. In contrast to its movie releases, Disney's theme parks are not only an important marketing and branding tool, but also vital to Disney's financial well-being.

28:14Disney operates 12 theme parks across six resorts worldwide. Two of them are located in the US, Walt Disney World in Florida and Disneyland in California. In Europe, there is Disneyland Paris, and in Asia, there is Disneyland Tokyo, Disneyland Hong Kong, and Disneyland Shanghai. The theme parks are part of Disney's experience segment, which also includes hotel and vacation clubs, as well as a fleet of cruise ships. The parks are responsible for over 60 % of experience revenues depending on the year, and the experience segment in turn is responsible for a little more than a third of Disney's overall revenues.

28:49However, parks are not only a revenue driver, More important is their role in producing profits and free cash flow. In 2023, the experience segment generated 70 % of operating income, and since Disney parks are responsible for roughly 60 % of the experience segment's revenues, their role in cash flow generation is immense. However, we cannot calculate the precise numbers since Disney does not disclose the margins of these businesses. After a tough period following the COVID lockdowns, the experience segment recovered quickly and exceeded pre-pandemic levels in 2022, less than a year after reopening.

29:22The recovery was driven by high demand for experiences after the lockdowns, and people were getting pretty frustrated with being caught up at home, and many people were flush with cash from the government stimulus programs during the pandemic. However, the recent quarter shows a slight slowdown in demand for domestic theme parks. This is probably due to a bout of inflation still ongoing from the after effects of the pandemic, as well as recession fears, which have accordingly led consumers to cut spending. Disney's CFO Hugh Johnston said on CNBC that customers seem to save a little more aggressively than before, and he expects this trend to continue for at least a few quarters.

29:58However, he wouldn't necessarily call it recessionary behavior yet. Also, the experience segment as a whole did see modest revenue growth of 2%, but it's just that operating income declined by 3%. Looking at the geographic breakdown, the international parks performed about the same as last year, actually. So it was really just the domestic parks in the US that caused the decline in operating income. As mentioned, Disney's management thinks this could continue for a few more quarters. However, Johnston also said to CNBC, quote, given that people do tend to protect their vacations more than other types of spending, we tend to get hit late, we tend to get hit less, and we tend to improve more quickly than others.

30:36While visiting Disney parks has definitely become a sort of luxury for the average person, it's still one of those things that people would cut only as a last resort. It's way easier to save on expensive clothing, eating out, or buying organic food than it is to cancel or reschedule a big vacation. In my opinion, the reaction to Disney's recent results, especially their performance and the experience segment, is probably a bit of an overreaction. I think investors and Wall Street use Disney's performance more to judge the average consumer and to really try to learn something about the health of the overall economy than it is a judgment of Disney's business.

31:08The slowing growth underscored the narrative of a recession, and Disney was sort of a victim of the resulting pessimism. That could be part of the reason why Disney's CFO emphasized that he does not see recessionary behavior at hand. He also pushed back on the narrative of weakened Chinese consumers and said that the impact on Disney's parks in Shanghai has been, quote, very mild. Still, we should expect the experience segment to slow down a bit in the following quarters. Now, I want to go to another business in the experience segment that, in my opinion, gets relatively little coverage. This is naturally because Disney's parks overshadow its remaining businesses, but still, I'd like to talk about Disney's cruise ships.

31:45The idea behind Disney's cruise ships is to extend their theme park magic to the seas, creating a unique vacation experience that combines Disney's storytelling and entertainment with a transnational vacation. It kind of follows the motto, the journey is the destination. Just like with the theme parks, Disney's market position is very strong in this segment. Other cruise lines offer similar services like Royal Caribbean, which has a partnership with DreamWorks and MSC Cruise, which has partnered with Lego. Nevertheless, Disney's vast franchise library and familiarity with delivering the full experience package makes the Disney cruise lines truly unique.

32:19For Disney fans, cheaper cruises cannot substitute the Disney experience. Disney currently has a fleet of five ships. They are called Magic, Wonder, Dream, Fantasy, and Wish. Three more ships are in the pipeline too, though. One of them is called Treasure, and it is supposed to set sail in December of this year. While Disney does not disclose the revenues and profits of each business in a business segment, the cruise ships are operated by a London subsidiary. These have filed reports and showed that the five cruise ships generated $2.2 billion in revenue and$180 million in operating profit last year.

32:51And while that's not too much compared to the$32.5 billion in revenue and almost$9 billion in operating profit that Disney earns as a whole, the market for cruise ships is growing significantly, and Disney's market share is still relatively small, which leaves plenty of room for expansion. According to JP Morgan, the cruise industry is estimated to capture roughly 3.8 % of the$1.9 trillion global vacation market by something like 2028. This growth is fueled by the acquisition of new and younger first-time passengers and the fact that all-inclusive cruise ship tours are often cheaper than online vacations.

33:25Considering the sector's growth and the fact that Disney only covers 2.8 % of global cruise passengers and 4.2 % of total revenue, there is a pretty big opportunity at hand. As mentioned, three more ships are currently planned, and this is part of a$60 billion investment project that Disney announced in September 2023. That announcement caused a lot of headlines. However, if we break it down, the number might not seem as astronomical. The$60 billion are planned to be invested over a 10-year period, and assuming an equal distribution over those years, that's$6 billion a year. When the announcement was made,$17 billion of that was already planned for new attractions at Walt Disney theme parks.

34:04That leaves us with just$43 billion to allocate still. Two of the three cruise ships that are supposed to be added to the existing fleet were also confirmed at that point. They were estimated to cost approximately$1.25 billion. dollars. It should also be mentioned that this is more than Disney has historically invested in the past. So in summary, while I could imagine they might actually follow up on it and spend that remaining$40 billion, I would consider the number itself more of a headline and sort of a publicity stunt. When it was published, Disney stock was struggling and this announcement was supposed to be a sign for investors to feel more positive about the company's prospects.

34:41Generally, I support investments in the experience segment due to its financial importance for the company and the historically good returns on invested capital this area has had, what I don't like are large fixed numbers. They can easily incentivize management to spend just to keep promises. However, after breaking down the$60 billion investment, I think the risk isn't too high in this case. Let's take a quick break and hear from today's sponsors. Hey, it's Sean O'Malley, just popping in with a quick message. If you like this podcast, well, I've got great news for you. We've got a handful of other shows for you to explore, from learning about Bitcoin to embracing a richer, wiser, happier lifestyle.

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38:25All right, back to the show. Now we've discussed all the major parts of Disney's business, except for one really important one. Last but not least is Disney's sports segment. It's a segment that, especially for people outside of the US, they don't always necessarily associate with Disney immediately. However, this segment has significantly grown in importance for the company over time. Disney's sports segment is primarily centered around the ESPN brand, of which Disney owns 80%. Domestically, this includes eight ESPN channels, ESPN on ABC and ESPN Plus, which is ESPN's direct-to-consumer streaming service.

39:01ESPN also has local channels for international audiences too. In addition to the ESPN brand, Disney also owns Star India, which has most of the broadcasting rights for the country's biggest sport, cricket. Yet 87 % of the sports segment's revenues and all of the operating profits come from the domestic ESPN business. ESPN has been a profit machine for Disney for many years. In the challenging years of the COVID pandemic, ESPN was vital for Disney. In 2022, it was responsible for$17.3 billion of Disney's revenue and$2.7 billion of its operating profits. That's about a fifth of overall revenues and over 22 % of its overall operating profits.

39:41A major reason for ESPN's profitability is the structure of the American linear network market and the contracts that ESPN signed in 2013 with cable TV providers. These contracts include so-called carriage fees or affiliate fees as Disney refers to them in their financial reports. Paid TV providers pay these affiliate fees to TV network owners to carry the network TV owners linear channels on the provider's cable. These fees are negotiated on an individual basis. So the more demand there is for your product, the more pricing power you have. And the value ESPN can provide is much bigger than almost any other TV network.

40:17While most other networks receive affiliate fees per subscription of 10 cents to 20 cents, ESPN earned a whopping$9.42 per sub per month. This is by far the number one in the industry. However, with more and more people cutting the cord, this high margin business will eventually slow down further than it already has. This will not happen within a year or two, but as Bob Iger said, it is inevitable. That's why the long-term plan remains to transition ESPN into a direct-to-consumer streaming service. To implement this plan, Disney is also looking for strategic partners to help with that transition.

40:52Possible partners are the four major US professional sports leagues, the National Football League, the National Basketball Association, the National Hockey League, and Major League Baseball, as well as big tech companies that would take a more strategic role in marketing, technology, or content. A possible benefit from a partnership with the major national sports leagues would be that the rising costs of sports rights, which have become a significant problem for the sports media sector, could get cheaper due to a deal with the leagues themselves. Earlier this year, Disney was in talks with the NFL about a possible partnership.

41:23However, no agreement has yet to be reached, and it's unclear whether the talks are still ongoing. In contrast to a deal with America's major domestic sports leagues, A deal with big tech companies like Amazon and Google could reduce the competition in this sector too. Right now, these companies are signing their own deals to get into sports broadcasting. For example, as you may know, for the last three years or so, Amazon has hosted the NFL's Thursday night football games. This could become an even bigger problem for ESPN than the decline in linear TV networks. Companies like Amazon are not dependent on these ventures to make money.

41:56They're fine with paying more money than these sports events would even bring in short term if this means more subscriptions and eyeballs on their streaming service, or in Amazon's case, on Amazon Prime. Amazon Prime is even more powerful than other streaming services since Prime's streaming service is only one part of the Prime ecosystem. It just assists Amazon's main business and the integrated streaming service's job is to drive new subscribers to Prime since Prime subscribers are much more profitable for Amazon than the average streaming customer somewhere else. Overpaying for certain streaming rights is just a calculated acquisition cost.

42:29Amazon's main business basically subsidizes the streaming service. So while Disney needs ESPN to sign good and profitable deals, its big tech competitors have much more financial leeway. ESPN's future success is thus largely dependent on Disney's management's decision-making and the partnerships they can close. Back in late 2022, there was also a debate by activist investor Dan Loeb about spinning off ESPN. Estimates from the Bank of America valued the business at$24 billion back then. However, Disney and Bob Iger specifically denied these rumors, and since then, nothing has happened that would suggest otherwise.

43:03The long-term plan remains to transition ESPN from linear TV to streaming. We've talked extensively about Disney's business, including its financials, and the possible future outlooks for its various business segments. What we haven't done yet is paint an overall picture of Disney's financials and its valuation. Looking at Disney's price-to-earnings ratio of more than 30, you might ask yourself, why we are even talking about an investment opportunity here. However, this number is misleading for the following reasons linked to Disney's income statement. First off, Disney's earnings have been down significantly due to the factors we've already discussed surrounding the drop-off in traffic at theme parks during COVID, as well as the surge in costs associated with competing for new customers on Disney+.

43:46Looking at the one-year forward price to earnings ratio makes much more sense, and it is currently trading at 17 to 18 times, which is honestly much more attractive. Secondly, like many media giants, Disney is an asset heavy company. Large amounts of depreciation on equipment and amortization of intellectual property are decreasing its net income. Therefore, free cash flow is a better metric for judging its operations as a business. Just a reminder, free cash flow is an alternative measure of profitability from net income, which reflects the estimated costs of non-cash items like depreciation.

44:19Free cash flow instead is meant to reflect roughly the cash remaining after paying for operating expenses and capital expenditures. And Disney's free cash flows have been recovering. After dropping from almost$10 billion in 2018 to$1.7 billion in 2019, free cash flows are now back to$8 billion. And now that we are close to the end of Disney's cash burning cycle, thanks to Disney +, this should be a more sustainable number. Of course, this can change whenever Disney implements large investments in the experience segment again. Besides lower net income in recent years, Disney has also taken on significant debt.

44:53In March 2019, Disney closed on the$71 billion deal to acquire 21st Century Fox, which I mentioned briefly earlier. To fund that acquisition though, the company has taken on considerable debt. Some of the major assets owned by 21st Century Fox include X-Men, Fantastic Four, The Simpsons, and Deadpool. The recently published movie Deadpool and Wolverine was only possible because Disney now owns the rights to these IPs and includes the two characters in the Marvel Universe. The deal was more expensive than initially thought it would be because Disney had some competition in bidding for 21st Century Fox.

45:28Comcast also wanted to acquire 21st Century Fox and Disney got the deal but ended up paying almost $20 billion more than it originally anticipated. The result of this deal was a significant increase in long-term debt from$17 billion in 2018 to$52 billion in 2020, a decrease in retained earnings from$83 billion to$38 billion, and a dilution of shareholders through roughly 300 million newly issued shares. While Disney has decreased its long-term debt to$42 billion, its balance sheet remains relatively weak, especially because of its cash position, which is only$6 billion. Considering Disney's free cash flows, I don't expect the company to run into any financial trouble.

46:08But considering the possibility of significant future investments, it would obviously be ideal to have a more strong balance sheet that's better positioned to incur those sorts of costs. I want to now sum up what we've talked about so far, discuss Disney stock and valuation further and analyze whether its shares offer an attractive opportunity to buy into one of the most successful companies in American history. Disney stock is currently trading around$90, which is about where it was back in 2014. Since then, revenues have grown by almost 100%. However, its net income is actually down from$7.5 billion to$4.8 billion, while free cash flows have grown from$6.5 billion to$8 billion.

46:48So there has been some growth, but profit margins, at least in terms of net income, have declined as revenues rose. Looking at the numbers and zooming out, you can clearly see where Disney's strong and reliable growth trend got interrupted. We've mentioned it a couple of times today, but one last time to get us all on the same page, it did not happen because of the COVID outbreak and the resulting lockdowns. While this significantly worsened the situation, the financial decline, if one can call it that, had already happened a year before when Disney launched Disney Plus and started investing heavily in the streaming service.

47:20But that's exactly why Disney stock is so interesting right now. In the last quarter, Disney was finally able to make Disney Plus profitable, and Bob Iger is eager to close the margin gap between Disney and Netflix. At the 2024 Morgan Stanley Technology Media and Telecom Conference, he said, quote, when we launched Disney Plus in 2019, our goal is to have basically robust video experiences at scale. What we didn't have was the technology that we needed to basically lower customer acquisition and retention costs, to increase engagement, to essentially grow our margins by reducing marketing expenses.

47:53This is key. We have already discussed Disney and Netflix's average revenue per user, and there was a large discrepancy and Disney needs to narrow that difference. Improvements this year in its streaming segment are arguably the biggest catalyst for Disney stock, but the market has yet to give Disney much credit for reaching profitability on this front. I think investors are cautious about Disney mainly because they fear a recession in which Disney's most profitable business, the theme parks, would suffer. This might be a drag on the stock for the next couple of quarters. However, Disney parks will not suddenly turned into a long-term weakness, and its businesses that have been weaknesses, like the streaming business, have already improved massively.

48:30So while Disney's stock might not break out for a while because of macroeconomic headwinds, I do believe Disney has a stronger position today than at any point since 2019. You might ask why I say 2019 when the stock price rallied in 2021 and 2022. You're right, but it only did so based on investors' expectations of Disney+. The enormous spending was overlooked for a while, and when that changed, the sentiment change too. However, now we're at a point where the sentiment is still bad, but the business is stronger than before. My problem with Disney is that its investment plans are difficult to evaluate.

49:03If the investment in the experience segment can achieve the double digit returns and invested capital that prior investments have achieved, Disney will have two engines running for them, the streaming segment, which is growing in profitability, and its experience segment, which is creating double digit returns. However, Disney has made questionable management and acquisition decisions in recent years. And while Bob Iger has made many good calls since he returned, he's also the CEO who initiated and approved the$71 billion deal with 21st Century Fox, a deal that was not only in hindsight, but also at the time seen as way too expensive.

49:35Another uncertainty is ESPN's transition. We've discussed how profitable the current structure and contracts have been for ESPN with cable television and satellite TV, yet it remains to be seen how much money they can earn and charge customers for a streaming service and whether that can generate the same revenues as under the TV model. ESPN's new NBA deal might give us an estimate of how large those numbers could be. And still, under the new contract, ESPN pays$2.6 billion per year for NBA rights, whereas the old contract costs them$1.4 billion a year. Considering the decline in subscribers, the NBA contract alone would cost roughly$37 per subscriber per year.

50:14We arrive at the number by dividing the$2.6 billion per year by the 70 million ESPN subscribers Disney had at the end of 2023. The additional charge on top of the$9.42 payable under the legacy system is because users who currently do not watch any sports but still pay for the TV channels bundle will no longer pay when ESPN is just a streaming service. This means that there are essentially no more subsidies paid by users who do not watch any sports to users who do. It's impossible to estimate the churn this price increase would create, but Disney has to bring in partners to lower that price or increase the value ESPN offers.

50:48Due to the above reasons, Disney's future outlook is highly uncertain, so complex models with many inputs would really just be a guessing game about its future. Instead, I want to use Disney's earnings per share and its free cash flow estimates to see what we can expect from Disney's stock in the next few years if they deliver on the estimates and can return to the average multiples that the company has traded at historically. Analysts are currently estimating earnings per share of$6.44 in 2028. Using a multiple of 21 times, which has been roughly the historic average, this would give us a share price of$135.

51:21That's slightly below a 50 % return over a four-year period. Now, I've said that earnings are not as telling for a company like Disney, so let's do the same using free cash flow. Analysts estimate free cash flow per share of$10.20 in 2028. That's the equivalent of$11.7 billion in free cash flows. That's a lot compared to the $8 billion that Disney currently produces. But let's go with that estimate for now. The average historic multiple of free cash flow has been approximately about 20 times. So using these estimates and assumptions, Disney would be valued at$204 in 2028. That would be a return of about 125 % over four years.

51:59To be conservative, assuming no growth or a decline in free cash flow up until 2028. This would result in a free cash flow of about$4.50 per share. With a multiple of 20, this would give us a stock price of$90. Unsurprisingly, we arrive at today's price if there's no growth because investors are already paying its historic average multiple to own the company. As mentioned before, the multiples are not as depressed as Disney's stock decline would suggest at first. As always, do not focus too much on the numbers. These are really just rough estimates and they're supposed to give you direction. What I take from this is that Disney's upside potential at the current price of roughly$90 isn't yet high enough to offset the uncertainty around the future of its operations.

52:41It seems to be roughly fairly valued. However, at a price below$80, Disney becomes a considerably more attractive investment for me. I don't own any, though it does sit atop my list of stocks that I keep an eye on. And in the range of$75 to$80, it would really be particularly interesting. The risk with Disney is that future investments once again lower the free cash flows. If the potential returns from these investments do not inspire investors, they probably won't pay a higher multiple for the stock, which would really be a headwind for its returns. And then at that point, we'd be in a similar position all over again.

53:14Because of its high debt levels, Disney should also use cash flows to pay back debt before it starts large buyback programs of shares or further increases its dividends to investors. Thus, it might take a while for cash flows to shareholders to increase. Overall, I like Disney's progress in the last year, and I think if they can stay on track, the stock will do very well in the future. However, the uncertainty in the long term due to ESPN's transition and the large investments into parks and cruises makes it difficult to assess a margin of safety here. One of my favorite sayings to fall back on for a company like Disney comes from Warren Buffett, who reminds us that we should only invest in companies an idiot can run.

53:50Without me wanting to insult any Disney CEO, the last time Bob Iger retired, it didn't go well. For a company as capital intensive and complex as Disney, you need more than just an idiot to run it well. For now, Iger is back and he is very capable, but he won't be around forever. Sooner or later, the CEO question will come up again. Disney has proven to be a company that could get into trouble under the wrong management, and so this is another problem for the future that I would be concerned about. To sum up the last hour in one sentence, Disney has come a long way in recovering from the pandemic and the cost of competing and streaming.

54:26However, there are still problems to solve, and Disney seems to be about fairly priced, although maybe on the cheaper end considering how its stock has really underperformed in recent years. With that said, I'd like to leave you with the following quote from Walt Disney himself. Quote, Disneyland will never be completed. It will continue to grow as long as there is imagination left in the world. I hope you enjoyed today's episode, and I'll see you again next time. Thank you for listening to TIP. Make sure to follow Millennial Investing on your favorite podcast app and never miss out on our episodes.

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