Why Disney's Magic Isn't Gone

Walt Disney's magic vision and emphasis on "imagineering" (the blending of creative imagination with technical know-how) took Disney (NYSE: DIS  ) from a bankrupt studio in 1927 to a powerful media empire worth billions. 

But after several decades in the same business, Disney may be in trouble. On its recent earnings call, losses on projects like The Lone Ranger (a writedown of $160-$190 million) got immediate attention from investors and caused the stock to drop slightly. But does this mean that the magic of Disney is gone?

More than movies
Luckily for Disney, the company's business involves more than just movies. Disney owns important media channels like ESPN and Disney Channel. Even better, Disney owns very attractive assets: studios like Marvel and Pixar, a 40% equity stake in Euro Disney, 51% interest in Disneyland Paris, and a 48% stake in Hong Kong Disneyland Resort.

These assets explain why Disney's overall sales still increased 4% after the movie studio saw a 2% decline in revenue. The park business grew 7% due to price increases and attendance growth. Therefore, the decline in share price after the earnings report should only be temporary. Most investors probably see Disney as a movie studio, but time will show that Disney is more than just movies. In the meantime, Disney's current valuation could be an entry point for investors in search of exposure to the entertainment industry. 

Fundamentals are pretty
By owning a great amount of safe, valuable assets (from real estate to media channels), the company has made its cash flow strong and stable. Its media business is the most important segment, generating more than half of the company's operating profit, which is supported by some well-established studios like Pixar, Marvel, and Lucasfilms (acquired in October last year for $4.05 billion). 

This is reflected in Disney's latest earnings figures. Excluding items affecting comparability, the company's third quarter EPS  increased 2% over the prior-year quarter. Media Networks (broadcast, cable, radio, publishing and digital businesses, the Disney/ABC Television Group and ESPN) revenue increased 5%, and operating income increased 8%.

Parks and resorts revenue for the quarter also increased 7% (operating income for this segment was up 9%) due to increased guest spending and attendance at Disney World and Disneyland. The poor performance of the Studio Entertainment business did not influence the other units.

More blockbusters on the way
The Studio Entertainment unit had a tough quarter, but conditions could change. Disney has a strong global brand and a vast library of animated content. It also owns Pixar, and under John Lasseter, Pixar has been able to develop very successful films without using Disney's main characters. 

 Source: Valuentum.

The latest movies produced by Disney include plenty of hits. The Iron Man series, for example, earned more than $2 billion dollars at the box office. With Star Wars films in the pipeline, I expect this business unit to recover in the next two quarters. This would suggest that The Lone Ranger is an exception to the rule of Disney's success.

Comcast  (NASDAQ: CMCSA  ) , the owner of Universal Studios, is excellent at producing big hits. Fast & Furious 6 had the second-biggest opening of the year so far, only behind Disney's Iron Man 3. By the time Disney released The Lone Ranger, Comcast had released Despicable Me 2. Disney only obtained $48.9 million in the first five days after the debut of The Lone Ranger. Despicable Me 2 generated as much as $142 million for Comcast in the same time frame.

The performance of Comcast and Disney are heavily correlated, showing the similarity of their businesses. There are some crucial differences, however. Comcast's earnings have been flat for the past six months. Also, as the biggest cable provider in the United States, Comcast is exposed to a mature market. Cable exposure poses strong limitations to Comcast's revenue growth, as consumers shift to Internet-based video distribution. 

Twenty-First Century Fox (NASDAQ: FOX  )  is very active in distributing animated movies for children, much like Disney. Fox did pretty well with Blue Sky Studios, the production house behind the Ice Age series. Fox distributed its first official Dreamworks animated movie,The Croods, around the time Disney's Pixar studios was preparing for the release of Monsters University.

Fox's film studio, which generates about 20% of its operating profit, also benefits from the company's worldwide distribution. Fox does have its own problems, though, particularly in the television business. Some of its most famous programs, like American Idol, have experienced dramatic decreases in viewership.

That being said, Fox still has investment potential. Fox has one of the lowest price-to-earnings ratios in the industry at 10.4, well below Disney at 18.4. It's also growing fast: Fox's revenue growth (year to year) was, according to the latest earnings call, 15.67%--well above Comcast (6.96%) and Disney. The downside? With a 1.85 debt-to-equity ratio, the company is more leveraged than Disney or Comcast. The upside is that Fox intends to use $4 billion  for stock repurchases. 

However, Fox's high exposure to cable network programming could become a threat in the long run. According to Fox's annual reports, cable network programming provided 27% and 24% of consolidated revenues in fiscal 2012 and 2011, respectively. The company has managed to increase its affiliate and advertisement revenue so far, but strong competition from online streaming video alternatives could offset its future growth potential.

Final Foolish thoughts
Disney had a tough quarter because it had to deal with losses from The Lone Ranger. However, in the long run, the company's ability to generate cash flow from its parks, its global brand, and its television channels (Disney TV, ESPN) remains intact. This may be a good entry point for investors with a long-term time horizon.

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  • Report this Comment On September 05, 2013, at 11:01 PM, AntiochAndy wrote:

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