Disney: Closing In on an Inflection Point Where Streaming Gains Can Begin to Offset L
Disney: Closing In on an Inflection Point Where Streaming Gains Can Begin to Offset Linear Weakness
After taking a critical look at Disney, we are reducing our fair value estimate to $115 from $145 while maintaining our wide moat rating and revising our Morningstar Capital Allocation Rating to Standard, from Exemplary. We believe the stock remains undervalued, but we think the move away from linear television viewing by consumers will keep Disney’s performance from returning to its past glory.
Disney is managing the evolution of the media industry, most notably the shift from linear television viewing to on-demand streaming services. Disney was perfectly positioned to take advantage of the traditional model, with its ownership of a national broadcast network, in ABC; the top sports network, in ESPN; and a leading children’s network, in the Disney Channel. These remain very valuable assets that give Disney advantages as the industry evolves, but challenges exist, and we don’t think the new media landscape will be as profitable as the prior one.
Disney’s linear networks businesses have been under pressure over the past few years as pay-TV subscriptions continue to decline. Disney is addressing this issue through its nascent direct-to-consumer offerings. As the DTC offerings mature, we expect the recent rockiness—consisting of declining linear revenue and cash burn in the DTC businesses—to stabilize. A wealth of content and the financial capacity to continue creating more should keep Disney+ and Hulu among the more attractive streaming services for consumers. ESPN+ does not yet include core ESPN programming, but we expect it will in the next couple of years. The availability of nearly all linear content on DTC apps will require Disney to manage its contracts with the pay-TV distributors that historically provided the bulk of the firm’s television revenue, but with content that’s in demand, we expect Disney to successfully manage this evolution.
Published on Dec 01, 2023
Disney Is Nearing an Inflection Point Where Streaming Gains Can Begin to Offset Linear Weakness
Business Strategy and Outlook
Disney is managing the evolution of the media industry, most notably the shift from linear television viewing to on-demand, direct-to-consumer, or DTC, streaming services. Disney was perfectly positioned to take advantage of the traditional model, with its ownership of a national broadcast network, in ABC; the top sports network, in ESPN; and a leading children’s network, in the Disney Channel. These remain very valuable assets that give Disney advantages as the industry evolves, but challenges exist, and we don’t think the new media landscape will be as profitable as the prior one.
Disney’s linear networks businesses have been under pressure over the past few years as pay-TV subscriptions continue to decline. Disney is addressing this issue through its nascent DTC offerings. As the DTC offerings mature, we expect the recent rockiness—declining linear revenue and cash burn in the DTC businesses—to stabilize. A wealth of content and the financial capacity to continue creating more should keep Disney+ and Hulu among the more attractive streaming services for consumers. ESPN+ does not yet include core ESPN programming, but we expect it will in the next couple of years. The availability of nearly all linear content on DTC apps will require Disney to manage its contracts with the pay-TV distributors that historically provided the bulk of the firm’s television revenue, but with content that’s in demand, we expect Disney to successfully manage this evolution. We believe Disney will maintain viewership and therefore monetization as DTC matures and the video entertainment industry becomes less bifurcated between linear and streaming subscriptions.
Other critical parts of Disney should continue to thrive. Although we don’t expect attendance at movie theaters to be as high as it once was, the firm’s franchises and top production studios should ensure that the content Disney produces and licenses will be in demand. More important, we expect continuing strength in the experiences business, which consists primarily of Disney’s many theme parks. The ability to marry iconic franchises with vacation destinations gives the firm unique properties that have enduring popularity.
Published on Nov 30, 2023
We are maintaining our wide moat on Disney.
Ultimately, we believe the firm’s ownership of timeless characters and franchises and its ability to continue creating and attracting top-tier content outweigh the near-term challenges it faces related to an evolving media industry. Although we think it’s likely that a media industry not built upon the traditional cable television bundle will keep Disney from returning to the level of economic profitability it routinely achieved in years past, we still expect the firm’s returns on invested capital to comfortably exceed its cost of capital over the next 20 years.
Recent struggles at Disney are related to the shift from the linear television model—where nearly all U.S. households subscribed to a pay-TV service offered by distributors like the cable and satellite providers—to the direct-to-consumer, or DTC, streaming model. The attraction of Disney’s top-tier networks, led by ESPN, ABC, and The Disney Channel,resulted in this package of Disney channels being included in nearly all subscriptions at industry-leading rates. Relatively high levels of television viewership also boosted advertising revenue. Cord-cutting and a decline in linear viewership has dampened both of those revenue streams.
Disney is still in the transition period of moving to the DTC model. Like all DTC platforms, the initial buildup of the service has come with operating losses, and Disney has not yet included all of its content on its streaming platforms, as doing so would hasten the decline of its linear business. We see these challenges as a temporary part of the transition. There are various ways this evolution can play out, with two likely possibilities, including lower fees paid by pay-TV distributors or the inclusion of streaming access as part of a pay-TV bundle. But the most important feature, in our view, is that Disney continues to hold premier content and has the highest likelihood among all competitors of maintaining a pipeline of the highest-quality programming. Over the long term, the ability to generate or attract the best content makes economic profitability highly likely.
The intangible assets that underpin Disney’s moat include the intellectual property behind franchises and characters that have proved enduring across generations, ESPN’s position in the sporting world, and the multiple television and movie production studios Disney has. The interaction among these assets benefits all of the firm’s business lines and makes the whole stronger than the individual parts. Not only would new competitors find it nearly impossible to offer competing entertainment experiences, but we see few—if any—existing companies that can offer anything similar to what Disney can.
Apart from the ABC broadcast network, ESPN is Disney’s premier programming network. It is a leader in sports content and reputation, giving it near-universal carriage in pay-TV bundles at industry-leading fees and making it an attractive outlet for premier talent and sports leagues. Although the exposure ESPN historically provided is less of a differentiator than it once was, Disney still has resources to secure major sports rights, and it remains second to none for the reach it can offer to on-air talent for general, all-day sports programming, as opposed to platforms where sports is not a focus. Disney has thus far resisted offering linear ESPN programming on a streaming service, but we expect that to change within the next couple of years. With a linear subscriber base down more than 25% since the 100 million peak in 2010, we see less and less value in preserving the bundle in its current form while forgoing opportunities with consumers who have cut the cord. ESPN remains synonymous with sports, and we expect it to continue to attract sports fans, whether through DTC or the bundle.
Our view is similar for Disney’s entertainment segment. Linear TV networks, which include the ABC broadcast network and various cable channels, face headwinds from the decline in pay-TV subscribers and linear television viewership, but Disney still has multiple top film and TV production studios and enough unique content to drive successful DTC streaming services. Disney+ and Hulu trail only Netflix in streaming subscribers, and we think the existing size and content pipeline will begin to drive durable DTC profitability by 2025. In our view, a streaming service needs scale to give it the resources to operate in a virtuous cycle, where it can generate enough cash to continue securing a wide enough content library to retain large subscriber bases. We believe Disney has major building blocks already in place. All outlets within the segment also benefit from the strong franchises Disney has created, which give it a durable advantage in creating future movies and continuing to monetize content it has created. Finally, while broadcast networks aren’t as vital to society as they once were, they remain unique properties that attract content and drive advertising, given their reach.
We believe Disney’s experiences segment, which consists mostly of theme parks and other vacation-related revenue streams, has the most durable advantage. Disney characters have proven timeless, and we think it would be nearly impossible for new competitors to offer destinations that are as attractive. Securing and building the infrastructure is one challenge, but even if a competitor undertook that massive project, it wouldn’t have the depth of attractive characters to drive interest at a national or global level. These characters and franchises also drive licensing revenue on consumer products, a high margin source of continuing revenue for Disney. In short, Disney can provide a type of experience that we expect will drive consistent demand, and its offering for that type of experience is unique and best in class.
Rated on , Published on Nov 30, 2023
We’re reducing our fair value estimate for Disney to$ 115 from$ 145 after taking a fresh look at the company and further considering the long-term outlook for its traditional linear television business.
Fair Value and Profit Drivers
Our fair value estimate implies a P/ E multiple of 22 times our 2024 earnings estimate.
We project linear networks revenue, which no longer includes ESPN after the firm changed its reporting segments, to average 1%-2% annual growth over our five-year forecast. We expect growth to be somewhat choppy from year to year, mostly due to advertising revenue. We project a slight annual decline in the affiliate fees Disney receives from pay-TV distributors due to a continuing decline in the number of subscribers to pay-TV services. However, we expect the pace of cord-cutting to slow, and the decline should be largely offset by growth in fees over time.
With a similar view toward ESPN as other linear networks—we also expect linear ESPN revenue to grow 1%-2% annually. However, we project higher growth out of the broader sports segment, driven by subscriber growth on ESPN+, its sports streaming service, and growth in pay-per-view sales. We don’t yet model linear ESPN programming being available on ESPN+. We think that is likely to happen during our forecast period, but we believe it will be initiated either as part of an agreement with the pay-TV distributors or will result in significant decline to the fees pay-TV distributors pay for ESPN. However it plays out, we don’t expect it to result in any sort of incremental windfall for the sports segment, which we project to grow 2%-3% annually.
With its other streaming services, including Disney+, Hulu, and international platforms, we project high-single-digit sales growth annually. We believe there is room to continue adding subscribers—we project over 1 million annually to the domestic platforms and 7 million annually internationally—and we expect average revenue per user to trend up, through periodic price increases and higher advertising revenue. However, we expect a competitive market with multiple streaming services, and we believe Disney will remain sensible with pricing as it focuses on profitability, which is why we don’t project even bigger subscriber gains. In the U.S., we project Disney+ and Hulu to each have around 50 million subscribers by 2028, well below leader Netflix, which currently has nearly 80 million subscribers in the combined U.S. and Canadian markets.
We project the most growth out of the experiences segment, driven by theme parks and the related hospitality services as well as new cruise ships that are due to arrive in 2025 and 2026. However, the recovery in attendance after the pandemic shut down some theme parks into 2022 is now virtually complete, so we don’t expect the double-digit growth of the past few years. We project 4% average annual revenue growth over our five-year forecast.
We project margins to expand and free cash flow to rise significantly, both as a result of the cost-cutting measures Disney initiated in 2022 as well as a rationalization in content spending. We project the firm’s EBITDA margin to rise from about 16% in fiscal 2023 to 23% by 2028, returning to a level not seen since 2019. We project $25 billion in content spending in 2024, in line with the company’s target, which is a significant decline from $30 billion in 2022 and $27 billion in 2023. However, we expect content spending to begin rising again in 2025, as we believe the firm must continue spending to offer attractive programming and retain sports rights. We project a gradual rise back to $29 billion in content spending in 2028. However, cost efficiencies and leverage we expect the firm to get from the growth of its DTC platforms result in free cash flow rising from our projected $8 billion in 2024 to nearly $14 billion by 2028.
Published on Dec 01, 2023
Our Morningstar Uncertainty Rating for Disney is High.
Risk and Uncertainty
The evolution of the media industry that is currently taking place is the main factor behind our assessment.
Outside of its parks and experiences business, Disney historically had three main sources of revenue: fees that it received from pay-TV distributors to carry the Disney bundle of channels, television advertising, and licensing fees for movies and television programming distributed by third parties. Each of these revenue sources are now under pressure. Cord-cutting and diminished linear television viewership have depressed carriage fees and advertising revenue. Shorter runs in movie theaters and an industry shift toward DTC streaming services have depressed licensing revenue.
A successful evolution for Disney would entail its DTC business more than offsetting the declines associated with its traditional business model. Considering the moat Disney has thanks to the value of its content assets, we think this is possible. However, this shift is still in the early stages and the transition has not been smooth—and there remains a real possibility that Disney’s business in this new era will never be as good as it once was.
From an environmental, social, and governance perspective, we believe potential social issues carry the greatest risk. The entertainment industry in general has a history of bad behavior regarding issues like sexual assault and harassment and racial and gender discrimination. Disney has not been immune from lawsuits in the past, and there’s always a risk of additional ones. We doubt any individual one could create a material financial impact, but harm to the firm’s image could bring consequences with consumers and employees that ultimately dent Disney’s business.
Rated on , Published on Nov 30, 2023
We assign Disney a Standard Morningstar Capital Allocation Rating.
Our rating is based primarily on our assessment of Disney’s business investment decisions but also considers the firm’s balance sheet health, and decisions surrounding capital return to shareholders.
Over the course of its history, Disney’s decisions have been exceptional. The characters it created, savvy acquisitions, such as Marvel, and the foresight to create its parks business have made Disney an iconic brand and premier company with a wide economic moat. However, investment decisions over the past decade have been more mixed. The firm spent roughly $70 billion, ultimately with a mixture of cash and stock, to buy 21st Century Fox in 2019. We believe Disney acquired some valuable assets in the deal, but we question whether Disney will receive proper value. Disney acquired many linear television networks, which we think are declining in value, and an additional stake in Hulu, paving the way for the firm’s commitment to buy all of the streaming platform. Disney undoubtedly needed to adjust its vision for the company’s future as the linear television model that had been so successful began to look like a relic. However, we question whether this was the best way to preserve value, and we think focus and capital investment likely would’ve been better suited elsewhere.
Apart from the debatable decision about buying 21st Century Fox and taking on debt to do it, we think Disney has managed its balance sheet well and made the right decisions regarding return of capital to shareholders. Disney found itself in an unthinkable position when the pandemic struck and its parks business shut down almost completely. The firm was in a good enough financial position to survive the shock and come out of it without a balance sheet that impaired the company. Management wisely, in our view, cut the dividend while the firm brought down leverage and invested aggressively in its direct-to-consumer business, which is crucial to the firm’s future. With leverage now back to levels not seen since before the 21st Century Fox acquisition, the firm is beginning to return capital to shareholders again.