September 23, 1998

An Investment Opinion
by Louis Corrigan

Disney: A Mickey Mouse Operation?

Shortly before major U.S. stock indexes peaked in July, Loews (NYSE: LTR) Chair and CEO Laurence A. Tisch looked like an idiot. The man many blame for fumbling the ball at the CBS television network was apparently at it again -- shorting U.S. equities and making bets against the S&P 500 index by buying put options. Such bearishness had produced stunning trading losses amounting to $1.5 billion over the fifteen-month period ending March 31, including a $533 million loss during the March quarter alone.

Today, Tisch looks a little smarter, and one of his smartest moves was betting against Disney (NYSE: DIS), the world's second-largest entertainment company with well-known theme parks, filmed entertainment, and broadcasting (ABC, ESPN, A&E) operations. During the June quarter, Tisch purchased Disney put options giving him the right to sell at a fixed price some 5.55 million shares. Though he hedged this bet with call options giving him the right to buy 2.25 million shares at a fixed price, Tisch clearly expected Disney's stock would fall.

And it did. During the June period, Disney traded between the mid-$30s and an all-time high of $42 3/8 hit in early May. At its recent low of $23 1/4, the stock had plunged 45% from its 52-week high, making Disney nearly the biggest loser in the Dow Jones Industrial Average (DJIA) of late. Even after rebounding to $26 13/16 today, Disney's shares (not including dividends) have badly underperformed the market, returning just 14.2% annually over the last three years and zilch over the last twelve months.

Known for delivering double-digit earnings growth, Disney has started to look more like a Mickey Mouse operation --and not in a good way. As the company announced September 11, earnings per share for FY98 are now expected to be a flattish $0.88 to $0.89 per share, excluding one-time charges, versus $0.86 per share last year. Fourth quarter earnings will miss Wall Street's previous consensus estimate of $0.21 per share, coming in at $0.15 or $0.16 per share versus $0.19 a year ago. The company blamed Asian-related weakness in its consumer products business, lower theatrical and international home video revenues, and increased expenses related to new initiatives.

Disney's empire may now be on sale, and there's no getting around the fact that the company has been hit from every angle. It's confronting increased competition in each of its core businesses and suffering from the international economic slowdown that's having a disproportional impact on branded multinational consumer companies. While banking on its eventual recovery may be a no-brainer, the competitive challenges seem likely to get worse, leaving Disney in the short term looking like a bet on Japan's recovery. And who wants to bet on Japan, which has now moved from stagnation to recession?

The creative content segment (films, television programming, video sales, the Disney Store) is the company's largest on a revenue basis. Despite recent hit films such as Armageddon, production and marketing costs have exploded, leading the company to combine the operations of its Walt Disney Pictures, Touchstone Pictures, and Hollywood Pictures. While Mulan performed respectably and should eventually enjoy strong video sales, the fourth quarter will look weak given the robust box office results last year from George of the Jungle and video sales of Sleeping Beauty.

Also, DreamWorks' computer-animated Antz, featuring the voices of Woody Allen and Sharon Stone, will debut October 8, beating Disney's A Bug's Life to the theatres by two months in a move that has Steve Jobs, Chair of Disney collaborator Pixar (Nasdaq: PIXR), in a hissy. DreamWorks also hopes to make a splash with an animated story of the life of Moses called Prince of Egypt set for a December release. Last year saw 20th Century Fox release Anastasia, its first in-house animated feature. While Disney's animation business still appears strong (I personally loved Mulan), it is now just the leading brand in an increasingly crowded field. Given that creative content fuels merchandising and theme park revenues, that's something to worry about.

Another curveball comes from the Financial Accounting Standards Board, which just tentatively approved new rules that could affect reported earnings of filmmakers beginning in 2000. Hollywood's accounting has always been suspect, offering plenty of room for creative license. The proposed rules would clamp down on some questionable practices. While marketing and advertising costs for a film can now be spread over several years, the new rules require expenses to be declared within the first three months of a movie's release. Similarly, film production expenses will have to be written off over 10 years rather than 20 years. Even as such costs hit the income statement faster, revenues from syndicating movie rights to television would have to be spread out over the term of the contract rather than booked when the deal is signed. These and other changes will affect all the film entertainment companies and create a little more uncertainty about at least the reported earnings (though the real economic impact should be minimal).

Looking at Disney's broadcasting segment, operating results for FY98 are expected to be down in the fourth quarter and flat for the year, despite surging profits earlier in FY98 from World Cup soccer and solid gains in advertising rates and subscriber growth at the cable networks. ESPN has become increasingly valuable even as wannabes like Fox Sports gain ground. But ABC, now #3 among broadcast TV networks, has seen its ratings slide. Even the once dominant ABC News is stuck in the muck. Meanwhile, the cost of programming has gone up with ABC and ESPN having to pay a staggering $9 billion to win eight-year rights to NFL football.

Finally, Disney's high-margin theme park and resorts business saw revenues jump 8% and operating profit increase 14% for the first nine months of FY98. This segment accounted for 23.8% of revenues but 30.2% of operating income thanks to 24.6% operating margins. Management singled it out as a fourth quarter bright spot due to increased attendance and guest spending. Yet on Monday, an article in the Wall Street Journal raised questions about even the health of this division.

The Orlando market is looking saturated, with Disney's new Animal Kingdom cannibalizing more of Disney World's customers than expected (and disappointing some visitors) and Universal Studios Florida expected to make a major push to promote its new $2 billion Islands of Adventure theme park. Meanwhile, Asian tourists reportedly account for 8% of visitors to Disneyland in southern California, where attendance was apparently flat to down slightly for the summer. Occupancy rates do remain at around 90% at Disney World. However, higher profits have come from boosting prices at the theme parks, a trend that may not go over well in a world where all other prices seem to be dropping and where demand appears to be slackening due to an international economic slowdown.

Of course, Disney is Disney, a consummate marketer with some of the strongest franchises and brands in the world. The company has also made recent moves to beef up its Internet presence. In June, it took a 43% stake in search engine/portal company Infoseek (Nasdaq: SEEK) with warrants that could give it majority control. Disney will soon relaunch Infoseek's portal service as Go Network ( and market the service via ABC and ESPN. The arrangement has the added benefit of keeping some of Disney's Internet losses off its income statement. Still, such a burgeoning empire requires skilled managers, and the company continues to see high profile defections. While none seems likely to bite the company back as badly as Dreamworks' Jeffrey Katzenberg has, Disney CEO Michael Eisner certainly faces some challenges.