The Walt Disney Company (NYSE:DIS) has tried to grow its direct-to-consumer offerings, which has been good for its top-line growth but bad for its profit and debt. Disney stock needs to change this quickly and make streaming pay for itself quickly, which takes work.
I’m looking for companies with strong positions in their industry and may have some upside potential in the medium to long term.
Since Disney is the world’s largest media conglomerate and has one of the most valuable brands, it fits this description perfectly. Now is a good time to look at its investment case again to see if its shares are worth buying for long-term investors.
About Walt Disney
The Walt Disney Company is a multi-billion-dollar entertainment conglomerate. Its businesses include media networks, studio entertainment, theme parks, consumer goods, direct-to-consumer services, and interactive media. Interbrand says that Disney has some of the media industry’s most valuable assets and franchises. It also has one of the most valuable brands in the world, which is worth about $50 billion.
Disney has been around for a long time. It was founded in 1924 and has been traded on the New York Stock Exchange since 1940. It is worth about $168 billion on the stock market.
Its business is split into two main areas: Disney Parks, Experiences, and Products, and Disney Media and Entertainment Distribution. The total amount of money Disney made in its last fiscal year (FY 2022), which ended on October 1, was close to $84 billion. By revenue, Disney Media was the most important segment, weighing about 66%. Disney Parks was the second most important segment, with a weight of about 34%. During the last fiscal year, the DTC offerings in the Disney Media segment brought in about 23% of the total revenue, or $19.5 billion.
Even though its total revenue went from about $55 billion in FY 2017 to $83.7 billion last year, this company’s profile has mostly stayed the same since then. Still, Disney had a lot riding on its parks and resorts segment, which made up about 30% of the company’s total revenue in 2017. This means that COVID-19 had a significant impact on the company, since its theme parks, resorts, and cruises were closed during the pandemic, which hurt the company’s revenue and earnings over the past three fiscal years.
On the other hand, Disney’s direct-to-consumer (DTC) offerings became a much bigger part of its total revenue and are now its main growth engine. In fact, DTC’s revenue grew by 20% YoY in the last fiscal year, while Disney Media’s overall revenue grew by 8% YoY. This is because Linear Networks’ revenue grew by only 1% YoY, while content sales and licencing grew by 11% YoY. Its Disney Parks, Experiences, and Products segment had revenue growth of 73% year-over-year in FY 2022. However, the previous year’s revenue was low because of the pandemic ($16.5 billion vs. $26.2 billion in FY 2019), so growth rates should return to normal in the next few quarters.
Even though Disney has many different kinds of businesses, cable networks, especially ESPN, are still one of its most important assets. In the last fiscal year, linear networks brought in $28.3 billion in revenue, which was 34% of the total. This is one of the most profitable parts of the company, with an operating margin of about 30% (compared to 14.5% for Disney as a whole). But this business segment is still in structural decline, so it’s not surprising that Disney’s growth strategy has shifted to direct-to-consumer offerings in the last few years.
Plan for Growth
ESPN was one of the company’s most valuable assets, but it was losing subscribers because the media industry was changing. More people switched from cable to streaming services, so ESPN lost subscribers. This put much pressure on Disney’s business model because the company couldn’t compete with other streaming services, especially since it had a deal with Netflix to send movies to Netflix (NASDAQ:NFLX).
But the company knew its position as the leader in the media industry was in danger. It decided to take some risks by starting its own direct-to-consumer services and ending its output deal with Netflix, which cost it about $300 million in annual revenue.
Then, Disney changed its growth strategy to launch its own online ESPN service in April 2018 (called ESPN+). This showed that Disney was adapting to the changing media industry, which has a lot more competition than it did a few years ago because consumers are leaving traditional distribution platforms quickly.
The Disney+ DTC service came out at the end of 2019, first in the U.S., Canada, and the Netherlands, but it quickly spread worldwide. Disney+ is a success story because the streaming service has an excellent history of subscriber growth. By October 1, 2022, it will have 164 million subscribers, which is a lot. Disney also has about 24 million ESPN+ subscribers and about 47.2 million Hulu subscribers on top of its Disney+ subscribers. This means that about 235 million people have signed up for Disney’s direct-to-consumer (DTC) services, which is a little more than the number of people who have signed up for Netflix.
This is a great accomplishment in a very short amount of time. The pandemic, which increased demand for these types of services, may also be to blame. Still, it shows that Disney’s plan to start its own direct-to-consumer (DTC) services was the right one, as its famous brands and franchises were a solid competitive advantage to get a strong position in the streaming industry. Netflix took a lot longer to reach the same number of customers. This shows that Disney’s growth strategy was very successful in getting the company to a big size and bringing in a lot of money.
But Disney’s lower prices than its competitors, seen in its average revenue per user, are also part of the reason for this fast growth (ARPU). While Disney+’s average revenue per user (ARPU) is only $3.91 and has been only $6.10 in North America since the end of 2019, Netflix’s average revenue per user (ARPU) in North America was more than $16 in Q3 2022.
This strategy of lower prices shows that Disney was more interested in growth than in making money, which was good for its top line but bad for its bottom line. In FY 2022, Disney’s operating margin in linear networks was 30%, but in direct-to-consumer (DTC), it lost more than $4 billion. Worse, since the end of 2019, its direct-to-consumer (DTC) business has lost more than $8.6 billion, which is a big deal when you consider that Netflix makes money.
This means that Disney’s DTC segment losses are a result of both betting on growth and bad management. Most of these losses can be explained by the fact that operating costs went up without sales going up at the same rate. This trend has only gotten worse over the past year. In fact, Disney has run promotions that have lowered ARPU to keep positive subscriber growth rates. At the same time, operating costs have gone up by 32% YoY to more than $17.4 billion during FY 2022. Also, selling, general, and administrative costs went up by 30% YoY to more than $5.7 billion, leading to a much bigger operating loss in FY 2022 ($4 billion vs. $1.7 billion in FY 2021) because revenues only went up by 20% YoY.
Since Disney now has the same number of subscribers as Netflix and probably won’t be able to grow in a way that makes money, it’s clear that the company needs to cut costs and raise prices. Before 2022, investors didn’t worry much about losses, but the current equity bear market and the slowing subscriber growth rate in the streaming industry have changed their minds. Now, investors are more worried about how to make money instead of how to grow.
This explains why Disney recently got a new CEO and changed its strategy and just recently started offering a free tier of Disney+ in the U.S. that is supported by ads. The price with ads is $7.99 per month, while the service without ads went up to $10.99 per month. Note that Netflix has also changed its strategy. For many years, it said its platform would never have ads, but it has just started offering a “basic with ads” plan for $6.99 per month, aimed directly at Disney+.
This is a good step for Disney to make its DTC business more profitable, but it makes it harder for the company to reach its goal of 230–260 Disney+ subscribers around the world by the end of fiscal year 2024. (vs. 164 million in October). But I think the new management should scrap this goal since getting more subscribers shouldn’t be the top priority. Instead, the company should aim to break even the following few years and make money from streaming in the medium to long term.
Also, there is a lot of competition in the streaming industry, which will likely stay the same in the next few years. This means that subscribers are likely to leave in the next few quarters, both because of the worsening of Netflix’s prices and the global economy. So, Disney may report a drop in subscribers in the next few quarters. However, investors should focus more on the company’s profitability and see if Disney is moving in the right direction to make DTC services profitable long-term.
Disney’s Balance Sheet and Valuation
Another problem related to Disney’s push into streaming, which led to big investments and higher costs, is the company’s debt. Since my last look at this in 2017, when the company had a conservative financial leverage profile, this has changed significantly. The company’s net debt-to-EBITDA ratio is 3.25x (vs. 1.29 in FY 2017). This is a relatively high level of financial leverage (Netflix, for example, has a ratio of 1.7x), and it’s not in line with Disney’s credit rating. If Disney doesn’t reduce its debt over the next few years, its credit rating will likely decline.
This also means that Disney can’t give dividends or buy back its own shares for the time being. This is another reason why investing in Disney is not a good idea. The company is mature and profitable, so it should at least pay dividends to its shareholders.
Regarding its valuation, Disney stock is currently trading at about 21.7x forward earnings, which is lower than its average over the past five years. However, this number will be much higher by 2020/21, when lower earnings and a higher share price will have caused Disney’s valuation to skyrocket. This has changed a little bit in the last few months, but Disney is still overpriced right now, given all the major problems it needs to fix.
Before the pandemic, Disney traded in a range of 10-15x forward earnings, which is more appropriate for a cyclical company. Even if you take the top of its previous range, which was about 15x forward earnings, its fair value would be about $63 per share, which is 30% less than what it is worth now.
Bottom Line
Disney was able to quickly grow the number of people who subscribed to its direct-to-consumer (DTC) services, but this cost the company money, and this needs to change soon. Disney should focus on making money instead of growing and get its debt down to a better level.
Since the streaming business needs to keep making big investments in content, it takes work to reach breakeven in its direct-to-consumer (DTC) segment, which doesn’t look good for its finances in the coming years. Also, its shares don’t seem to be very cheap, so you should avoid Disney stock right now.
Featured Image – Pexels © Magda Ehlers
