Today I did a quick audio interview with WRKO Radio to discuss Walt Disney Co.
You can check it out here (no paywalls, ads, etc).
But I want to add more here on FATRADER with some additional commentary, because after a short-form interview like that, there are plenty of details I can fill in.
Disney Vs Netflix
Back in September 2018, I warned on my free newsletter that I had concerns about Netflix’s valuation:
“On the other hand, something like Netflix with a price-to-earnings ratio of 150 and a 300% stock price gain in three years is a bit spookier to hold in my opinion at this point. It has about the same market capitalization as Disney, but with a quarter of the revenue and a twelfth of the profits, albeit with faster growth. That kind of valuation gets a lot of scrutiny during economic downturns.”
As luck would have it, we immediately had a sharp market sell-off just a few days after that issue:
As Netflix plunged 36%, Disney stock apparently missed the memo that the market was even having a big sell-off, and mostly just chugged along flat except briefly around the Christmas Eve panic. At the widest gap, Netflix had underperformed Disney by about 30% in a span of two months.
But during the V-shaped recovery, Netflix did recover very quickly, and now the two stocks are basically neck and neck again.
To be clear, I’m not shorting Netflix. I just don’t think it’s a good deal at this valuation; it’s too optimistically priced and leaves no margin of safety.
Netflix is nearly a pure streaming business with little exposure to legacy assets, which makes it a highly-valued FAANG darling. Investors pay 10x TTM revenue for it, and over 100x earnings, although the earnings figure doesn’t mean much because it’s just an accounting profit. In reality, Netflix is producing bigger and bigger free cash flow losses year after year, and issuing junk bonds (BB- rated) to fill the gap.
Until 2014, Netflix was basically free cash flow neutral. Then it started to ramp up content and reported -$841 million in free cash flow in 2015, -$1.5 billion in 2016, -$1.9 billion in 2017, and -$2.7 billion in 2018. To fill this increasing gap of negative free cash flow, the company went from $900 million in debt to $10.3 billion, an increase of 11-fold in five years. It also continues to mildly dilute its equity base.
There is potential light at the end of the tunnel. The optimal scenario for Netflix is that annual content spending eventually levels off while subscriber revenue keeps increasing, so that the company becomes free cash flow positive. But even then, Netflix has to continue to grow subscribers at a fast pace to justify the high valuation and earn serious profits, even as Amazon, Apple, Disney, AT&T, and Hulu ramp up their streaming competition.
Doable? Perhaps. Worth paying 10x TTM revenue for? Not in my opinion.
At 15x earnings and a little over 3x TTM revenue, Disney on the other hand has a lower hurdle to step over for good returns, and is a stock I’d rather own at this stage of the market cycle. I can’t tell you what the price will do in the near term, but I’m happy to hold it for the long-term as a couple percentage points in my overall portfolio. The company owns ESPN, ABC, Disney Channel, stakes in A&E and History Channel and National Geographic, Star India, worldwide theme parks, some of the most profitable film studios on the planet with the strongest media franchises (Disney, Pixar, Fox, Marvel, Star Wars), a profitable merchandise business, 60% of Hulu, and is now in the process of launching new streaming platforms backed by their unrivaled content library.
As of their most recent quarter (which was pre-Fox), Disney had a very strong balance sheet, with a debt/income ratio of less than 1.5x and a well-deserved S&P credit rating of “A”. After the Fox acquisition, Disney has more debt but also more free cash flow, and has announced its plan to halt its share repurchases for a while to reinvest into its streaming business and likely pay down some debt as it digests the acquisition.
Is Disney Late to the Streaming Party?
During my interview, the host understandably expressed his criticism of Disney CEO Bob Iger for not moving into the streaming space faster. There’s certainly a valid argument that Disney should have had streaming services up a few years ago.
Disney’s media networks are cash cows, pulling in billions of dollars of free cash flow per year. But due to cord-cutting, those cash flows are under pressure, and Disney really needs move online now.
However, first mover advantage isn’t everything. Google wasn’t the first search engine. It wasn’t even one of the first ten. But its algorithm was so much better than competitors when it launched that it took market share anyway. When it comes to content, Disney is the king. It just needs to shift that content towards its own streaming platforms. And consumers can easily have multiple streaming subscriptions without breaking the bank.
Disney entered the streaming space indirectly in 2009 by buying its initial stake in Hulu, which now has over 25 million subscribers and is growing its number of subscribers faster than Netflix on a percentage basis. Now that Disney acquired Fox assets, they own a majority 60% of Hulu. Disney also has licensed some of its content to Netflix and Amazon for years, meaning it profited from streaming without spending extra money on it.
In early 2018, Disney launched their streaming sports service, ESPN+, which now has over 2 million subscribers in under a year. And later this year, Disney will launch Disney+, their Disney-branded family-friendly streaming service filled with their signature Disney animated movies, Pixar, Marvel, Star Wars, National Geographic, other content from their vast library, and new original content.
Going forward, streaming is going to be a competitive space, and there is less time pressure on Disney (which is already wildly profitable) than there is on Netflix (which is not). Additionally, AT&T and Disney are beginning to pull content from Netflix to shift it to their own platforms or are charging higher licensing fees for the content that’s left.
When Netflix makes content, they pretty much only benefit from subscriber fees, and right now, they are burning through cash and issuing more and more junk-rated debt to do it. But the goal, as I said, is for the subscriber base to become large enough for this to turn free cash flow positive.
Disney, on the other hand, monetizes its content far more thoroughly. When they make a movie, it often becomes profitable right from the box office. Then if it’s a film for kids or teens, they sell profitable toys and games based on that movie. Then they make more money with the movie by showing it on their existing networks and/or on their upcoming streaming platform. Then they will attract more people to their theme parks with rides based on that content.
They have numerous ways to extract value from the content they make. So, they are building out these new streaming platforms from a foundation of already having an unmatched content library, healthy profits, and an investment grade credit rating.
Disney stock became overvalued in 2015, but has traded sideways for a few years as revenue and income continued growing:
Chart Source: F.A.S.T Graphs (black line = stock price, blue line = average valuation level over time)
Today, Disney stock is more reasonably-priced.
If we have a stock market melt-up at some point, whether due to an announced China deal or just general sentiment, Netflix could certainly outperform Disney for a time. However, during a more volatile market, or based simply on long-term fundamentals and current valuations, I think the risk/reward ratio makes more sense for Disney at current price levels as part of a diversified portfolio.
I'm long DIS.