Disney's Turnaround Is Still in Its Early Innings: Is There a Trade Here?

The Mouse is tired of struggling. Tired of taking losses in certain parts of the firm. Tired of seeing still profitable, but ebbing parts of the firm becoming less able to provide the cash flow required to subsidize sales growth across those parts of the firm that are operating at a net loss.

The Mouse fired a CEO that apparently nobody thought was any good, and replaced him with his predecessor, who at the very least, is far more likeable and perceived as quite capable. The Mouse cuts a ten year branding deal with Penn Entertainment (PENN) so that the casino company can rename and relaunch its on-line sportsbook. The Mouse will also raise prices for the second time in about a year for its streaming service customers, even as the direct to consumer business loses (less) dough.

On Wednesday afternoon, the Walt Disney Company (DIS) released the firm's fiscal third quarter financial results. For the three month period ended July 1st, Disney posted an adjusted EPS of $1.03 (GAAP EPS: $-0.25) on revenue of $22.33B. The lion's share of the adjustment made ($1.10 per share) was for restructuring and impairment charges. The balance ($0.18 per share) was for the amortization of Fox and Hulu intangibles, as well as fair value step-ups on film and TV costs.

While the adjusted earnings print did beat Wall Street, the revenue number fell short of expectations, while reflecting year over year growth of 3.9%. Digging deeper into the numbers, while revenue was growing 3.9%, costs and expenses together grew 3.2% to $19.689B. However, and this is where the adjustment comes in... restructuring and impairment charges increased from $42M a year ago to $2.65B from the quarter reported last night.

After factoring for interest and taxes, net income/loss attributable to Disney printed at a loss of $460M down from $1.409B, which is where your $-0.25 (versus $0.77) comes in. That $2.6B hole is a nasty pill to have to swallow. Even adjusted, earnings were down 5.5% year over year.

Segment Performance

All of the above said, total segment operating income still printed at $3.559B, beating expectations, while decreasing just 0.2%. Operating margin dropped to 15.9% from 16.6%, but that was actually far better than "lowered bar" estimates for something sub -15%.

Disney Media and Entertainment Distribution (DMED) generated revenue of $14.004B (-1%), while producing operating income of $1.134B (-18%).

- Linear Networks generated revenue of $6.69B (-7%), while producing operating income of $1.889B (-23%).

a) Domestic generated revenue of $5.494B (-4%), while producing operating income of $1.78B (-14%).

b) International generated revenue of $1.196B (-20%), while producing operating income/loss of $-87M (down from $166M).

- Direct-to-Consumer generated revenue of $5.525B (+9%), while producing operating income/loss of $-512M (up from $-1.061B).

- Content Sales/Licensing & Other generated revenue of $2.082B (-1%), while producing operating income/loss of $-243M (down from $-27M).

Disney Parks, Experiences and Products (DPEP) generated revenue of $8.326B (+13%), while producing operating income of $2.425B (+11%).

On Direct to Consumer

For those new to this business, the acronym ARPU is short for Average Monthly Revenue Per User (paid subscriber).

Disney+

- Disney+ Core ended the period with 105.7M paid subscribers (+1%). ARPU grew 2% to $6.58.

- Domestic (US & Canada) ended the period with 46M paid subscribers (-1%). ARPU grew 2% to $7.31.

- International (excl Disney+ Hotstar) ended the period with 59.7M paid subscribers (+2%). ARPU grew 1% to $6.01.

- Disney+ Hotstar ended the period with 40.4M paid subscribers (-24%). ARPU remained flat at $0.59.

ESPN+ ended the period with 25.2M paid subscribers (down fractionally). ARPU contracted 3% to $5.45.

Hulu

- Total Hulu ended the period with 48.3M paid subscribers (up fractionally).

- SVOD Only ended the period with 44M paid subscribers (+1%). ARPU grew 6% to $12.39.

- Live TV + SVOD ended the period with 4.3M paid subscribers (-2%). ARPU contracted 1% to $91.80.

Price Hikes

As mentioned in the opening, Disney is for the second time in about a year, raising prices for the above streaming services. The firm will be increasing prices for the ad-free versions of both Disney+ and Hulu, and also announced a coming crackdown on password sharing, following the lead of Netflix (NFLX) on that issue.

This move is necessary as Linear TV's decline appears to be accelerating. Those who bundle Disney's streaming services and choose not to see ads will see the Disney+/Hulu bundle rise to $19.99 per month and the Disney+/Hulu/ ESPN+ bundle rise to $24.99 per month.

Guidance

There was no guidance offered in the press release or for most of the call. Well into the presentation, interim CFO Kevin Lansberry said, "We are still expecting full year total company revenue and segment operating income to grow at a high-single digit percentage rate versus the prior year." This is when you saw the stock put in an overnight bottom and start to find support. Consensus view had been for low-single digit growth in operating income.

Lansberry also mentioned that full year content spend should come to about $27B, which is below prior guidance for $30 and that full year CapEx should print at $5B. These reductions are very likely due to both the writers' strike in Hollywood and the movement of various projects from one quarter to another.

Fundamentals

For the quarter, Disney generated operating cash flow of $2.802B (+45.8%). Out of this came investments in parks, resorts and other properties of $1.165B (-32.9%). This left free cash flow of $1.637B (up from $187M).

Turning to the balance sheet, Disney ended the quarter with a cash position of $11.458B and inventories of $1.9B. Current assets were up to $30.174B. Current liabilities add up to $28.234B, including $2.645B in shorter-term debt, but also $6.474B in deferred revenue.

On the surface, Disney's current ratio has improved to 1.07 from an even 1 at the start of the fiscal year. The firm's quick ratio stands at an even 1, which is fine. However, investors must be cognizant of the fact that deferred revenues are liabilities of goods or labor owed, and are not financial liabilities. Sans that entry on the liability side, the current ratio rises to a much more impressive 1.39.

Total assets amount to $203.783B, Goodwill and other intangibles add up to $91.359B. At 44.8% of total assets, this would normally be a bit much, but this is Disney. Obviously there is enormous intangible and difficult to price asset value here. Total liabilities less equity comes to $101.727B. What stands out here is the $45.794B in long-term debt.

Obviously, we would need to see this number brought into better balance with the firm's cash position or at least with liquid assets if we were to see this balance sheet as strong. There is some work to do here, but it is not a disaster.

Wall Street

Since these earnings were released, I have come across seven sell-side analysts that are both rated at three stars or better by TipRanks and have opined on DIS. After allowing for changes, among the seven, there are six "buy" or buy-equivalent ratings and one "market perform" rating, which is considered to be hold-equivalent.

The average target price across the seven is an even $115, with a high of $146 (Steven Cahall of Wells Fargo) and a low of $94 (Doug Creutz of TD Cowen). Excluding these two as potential outliers leaves us with an average target of $113 across the other five.

My Thoughts

Make no mistake. The turnaround at Disney is still in its early innings. That's why Iger recently signed on for an additional two years. Linear TV is in serious decline. The cinema has become difficult. The subscriber losses are not that serious as long as the price increases do not accelerate this erosion.

So far, the majority of subscriber losses have been confined to India where Disney+ Hotstar lost out on the bidding for the very popular Cricket league games in that country. As readers see above, with an ARPU of $0.59, if the service had to lose subscribers, at least it was mostly the ones who were the least financially productive for the company. At least expenditures will be lower as Iger continues to work on his cost reduction program, which is said to be on track to exceed his stated $5.5B goal.

So far, Disney's longer-term descending triangle, which is a bearish pattern, is still intact. Zooming in...

The shares had taken back their 21 day EMA (exponential moving average) earlier this week and are trying to take back their 50 day SMA (simple moving average) today. If that thin blue line is held, the stock could make a run at its 200 day SMA $95.59 or even at filling that mid-May gap. The stock would need $100 to fill that gap.

These are possible short to medium term outcomes. I am long this stock, but I have to wonder, if the firm can not solve its issues in Linear TV and if the US dollar remains strong (suppressing foreign travel to the US parks as well as revenue earned internationally), I would probably become more of a seller from $95 up to $100 if I were to get that lucky.

As for the present, I see no reason to add today. I'm down 2.4% on this position. It's still a long way from triggering my 8% rule for making an exit. That trigger kicks in at the $84 level. If Iger starts selling parts, I would consider adding and taking my target from $100 up to $120.

At the time of publication, Stephen Guilfoyle was Long DIS equity.