- It is like the EV industry – Thank you Tesla – thank you for spending billions and creating a market, now let the big boys make the money!
- Trust me, as a social media provider, content is king!
- Investors should expect returns from Disney between 9% and 14% over the long-term.
- Disney is a great business
- Disney’s current fundamentals
- 21st Century Fox acquisition – putting things into perspective
- Disney vs. Netflix
- Disney investment thesis – 3 scenarios
I look at a lot of stocks during a week as part of my investment research process and most of the week was spent on commodity stocks, mostly zinc miners, but I also like to look at great businesses. I wish to have a list of 30 great businesses to follow so that I can be ready to buy when the rare opportunity comes, to buy a great business at a fair price. One that fits a great business description is certainly Disney (NYSE: DIS), as it is an earnings compounder.
Disney is a great business
Why is Disney a great business? Well, revenues increased 63% over the last 10 years, net income increased 230%, book value increased 86% and cash flows increased 184%, while the number of shares outstanding actually went down by 17%.
Source: Morningstar – DIS key ratios
If Disney does similarly over the next 10 years, you have nothing to worry about your investment in Disney. The key analysis aspect for long term investors is to eliminate short term noise and look at where will Disney be in 10 years and how will its fundamentals evolve. There is a lot to watch as Disney is acquiring parts of 21st Century Fox (FOX) and expanding into direct to consumer (DTC) services, but at the end it is always about the product and the demand for it.
The key factors to look at are:
- The long-term impact of DTC and FOX acquisition
- The margin of safety
- The long term risks
The good thing about Disney is that it is a well-covered and researched stock, so there is nothing really one can add, you only need to systematize the information and look beyond the next few quarters, something few actually do.
Let’s look at what is there now, the current fundamentals and whether those can represent a margin of safety.
Disney’s current fundamentals
The dividend yield isn’t really spectacular at 1.58% but the PE ratio is already interesting as a PE of 15 is better than the market’s average. An earnings yield is of around 6.5% is not really a great return, but we have to think about the future.
Source: Morningstar – DIS quote
The free cash flows are in line with net income, confirming the 6.5% expected yield on the current price. So, let’s talk about what might happen next.
21st Century Fox acquisition – putting things into perspective
There are lots of unknows related to the FOX acquisition but one has to put the exorbitant $71.3 billion headline acquisition into perspective.
- Disney will issue 343 million shares, so that won’t be a cash cost. The dilution covers for $38 billion. $33 billion to go.
- FOX divested its 39% in Sky for $15 billion and the money goes to Disney. $18 billion to go.
The $18 billion plus the $14 billion debt assumption from FOX’s current debt, is by what we have to increase Disney’s debt. Thus, $31 billion. Given the Sky divestiture, Disney might keep its high credit rating and enjoy lower interest rates, especially now that the FED paused with hikes. Disney’s part of the $3.5 billion FOX had in free cash flows, should be well enough to cover for the increased interest payments without considering the increased leverage it might get form the new platforms. If they reach the $2 billion in synergies, no worries about the debt payments.
Source: The Walt Disney Company
We can only assume what will Disney’s increased international footprint look like in a few years, plus the leverage it is going to have on its content. However, an exercise in valuation is always good.
Disney vs. Netflix
Netflix has created the market, but the market will always be dominated by content and I think content is on Disney’s side. Combining ESPN, FOX and Disney Plus will allow the company to leverage its content and grow at a faster pace then Netflix, especially as the international footprint and brand recognition is already there. As most of the costs are already sunk because content creation is Disney’s and FOX’s actual business, the company will not have the huge costs Netflix has for content production and purchase.
Source: Netflix Investor
Over the last 12 months, Netflix spent $13 billion for additions to streaming content assets, $10 billion in 2017, $8.6 billion in 2016. Disney has it all already, therefore, we can expect much better margins once HULU, Disney Plus, ESPN and whatever they are going to present on the conference call in April are launched properly.
I would also argue Disney is better than Netflix as Netflix’s content is based on volume, not on quality. I actually tested it for this purpose and not once did I say wow, I cancelled my subscription immediately.
I must say Hulu just looks more familiar, plus whatever Disney is doing, will be more familiar to all.
Further, Given that Netlix is not cash flow positive, it is a risky story as a contraction is subscriber growth, possible if there are new entrants, and I really don’t see that much potential for stickiness with Netflix, could create funding concerns, limit content investments, all to the benefit of Disney’s big guns.
Disney investment thesis – 3 scenarios
The cosy, pessimistic scenario
If they just reach Netflix’s revenue, I would dare to add $5 billion in free cash flows over the next 5 years, just from DTC. If we add the $2 in synergies, $2 billion FOX already has and the current $10 billion and some growth, we easily get to $20 billion in free cash flow by 2024. At the current free cash flow yield, we could estimate a market cap of around $300 billion, divided by 1.9 billion shares, it should result in a stock price of $157. Add the 2% dividend you will probably get, you have a return of about 9%. Not bad from a great business.
From a business perspective, Disney’s current market cap is $166 billion, i.e. what you would be paying for it if acquired now. When we add the new issued shares, the market cap will be around $200 billion for cash flows of around $12 billion with the combined entity. This again, leads to a current 6% return. However, I think the growth will lead it to a 9% return over time but the key question is the growth. I am sure it is not going to be linear.
The positive scenario
Let’s say that Disney, that has much more diversification and a stronger brand than Netflix, manages to get to 25 billion in revenue over the next 5 years, adds $10 billion in free cash flows from DTC and $5 billion from other things, we are at $25 billion in free cash flows. Multiply that by 15 and we have a market cap of $375 billion for $197 stock price. This already implies a 12% return, 14% if we add the dividend.
From a business perspective, the positive scenario, that I deem most likely, will still be a single digit cash flow yield.
The exuberant scenario
The exuberant market scenario would be one where Disney becomes a growth stock like Netflix, gets a PE ratio of 25 and reaches a capitalization of $625 billion. Given the current market conditions, the willingness Central banks have to keep monetary policy loose, I would now say it is not a possibility.
Disney’s free cash flow with 14% growth over the next 5 years and subsequent 5% growth.
Source: Author’s estimations
I really think Disney is a great business but it doesn’t yet meet one of my investing criteria, or Buffett’s investing criteria, a very attractive price.