Disney Earnings Fall on Fox-Related Growing Pains and Weakness in Domestic Parks

Walt Disney (DIS -0.25%) reported its fiscal third-quarter 2019 results after the market closed on Tuesday. The entertainment behemoth's revenue jumped 33%, while its adjusted earnings per share (EPS) fell 28% year over year.

Both the top-line increase and bottom-line decline were largely driven by the company's massive acquisition of Twenty-First Century Fox assets, which closed in late March. As expected, profits were hurt by integration costs, but they were also negatively impacted by weak performances by the Fox movie studio and Disney's domestic parks.  

Shares were down in the 3% to 4% range during much of Tuesday's after-hours trading session. We can attribute the market's initial reaction mainly to earnings coming in significantly lighter than many investors were probably expecting. 

Image source: Disney.

Disney's key numbers

Data source: Disney. GAAP = generally accepted accounting principles. EPS = earnings per share.

The company used $1.75 billion of cash in operations, versus generating $3.68 billion in cash from operations in the year-ago period. Free cash flow was negative $2.93 billion, versus $2.46 billion in the third quarter of last fiscal year.

The combined Fox assets didn't perform up to Disney management's projections. Last quarter, management said that it expected the Fox acquisition to have a negative impact on earnings of about $0.35 per share, whereas the actual impact was about negative $0.60 per share, CFO Christine McCarthy said on the earnings call. She added that there were two main drivers behind this underperformance: the Fox film studio and Star India.

Disney doesn't provide guidance. For some context (though long-term investors shouldn't place too much importance on Wall Street's near-term estimates), analysts were looking for adjusted EPS of $1.75 on revenue of $21.48 billion. So the House of Mouse fell short of both expectations.

Media networks: Operating margin declined 

Data source: Disney.

Here's how the two businesses within this segment performed: 

• Cable networks revenue jumped 24% year over year to $4.47 billion, and operating income rose 15% to $1.64 billion.
• Broadcasting revenue increased 16% to $2.25 billion, and operating income fell 17% to $307 million. (Segment operating income also received a boost of $192 million from equity in the income of investees, down 3% from the year-ago quarter.) 

Cable's higher operating income was due to the inclusion of the Fox businesses (primarily the FX and National Geographic networks) and an increase at ESPN, partially offset by a decrease at Freeform. As has been the case for some time, the increase at ESPN was driven by higher affiliate revenue from rate increases, partially offset by a decline in the number of subscribers. Broadcasting's "lower operating income was due to decreases in ABC Studios program sales and network advertising revenue," according to the earnings release.

Parks, experiences, and consumer products: A rare stumble for domestic parks 

Data source: Disney.

The good news for this segment was that the consumer products business performed well from a profit standpoint, thanks to strength in the merchandise licensing operation -- driven by items based on Toy Story -- and the retail business. Another bright spot was Disneyland Paris (Vive la France!), which contributed to operating income growth. 

The bad news was that Disney's legendary domestic parks and resorts business had a rare stumble, with operating income declining year over year, despite getting a tailwind from the shift in the timing of the Easter holiday. (The reported quarter included both weeks of the holiday, whereas only one week was included in the year-ago period.) The culprit was the combination of higher costs -- in part because of expenses associated with Star Wars: Galaxy's Edge, which opened at Disneyland on May 31 -- and lower attendance. The number of visitors to domestic parks declined 3% year over year, though per capita spending rose a whopping 10% because of increased spending on tickets, food and beverage, and merchandise, McCarthy said on the earnings call.

She added that the company was managing ticket demand at Disneyland for a few weeks following the opening of Galaxy's Edge "in order to maintain a high-level of guest satisfaction," which had the effect of slightly suppressing attendance. She also said that company survey results suggest that some folks are delaying their Disney World visits until after the opening of the new Star Wars attraction. In other words, both reasons for the decline seem to be temporary.

Image source: Getty Images.

Studio entertainment: Results dragged down by Fox studio's poor performance

Data source: Disney.

As I wrote in my earnings preview, "During the fiscal third quarter, Disney released six movies: Penguins, Avengers: Endgame, Aladdin, and Toy Story 4 from its studios, and Tolkien and Dark Phoenix from the Fox studios. Marvel's latest Avengers film, which has shattered numerous major box office records, has raked in nearly $2.8 billion in theatrical receipts, as of Sunday morning. Aladdin and Pixar's Toy Story 4 have also performed very well, with ticket sales tallying just over $1 billion and about $959 million, respectively."

Indeed, thanks to the powerful combined performance of the above noted trio along with theatrical carryover from Captain Marvel, which was released at the end of the fiscal second quarter, studio entertainment's results compared favorably to the year-ago period's results, which featured a mighty roster comprised of Avengers: Infinity War, Pixar's The Incredibles 2, and carryover from Black Panther. 

Disney's legacy studio business performed even better than the segment's results suggest, as overall results were dragged down by the underwhelming performance of Fox studio's releases. On the earnings call, McCarthy said that the Fox studio had an operating loss of about $170 million.

DTC and international: Loss widens on increased streaming business spending  

Data source: Disney.

This segment's loss widened mainly because Disney has been investing in its relatively new direct-to-consumer (DTC) streaming businesses. It continues to invest in ESPN+, which went live in April 2018, and is incurring costs associated with the impending launch of its broader streaming service, Disney+, which is scheduled for Nov. 12.

The underperformance of Fox's Star India also contributed to the profit decline. On the earnings call, McCarthy said that this TV property had an operating loss of about $60 million in the quarter, largely because of a big step-up in rights costs for the Indian Premier League (cricket) and the Quadrennial Cricket World Cup. 

In addition, the segment incurred a loss from the consolidation of Hulu following the Fox acquisition. Once Hulu became majority owned by Disney, 100% of its operating results were reported in this segment's results. Previously, Disney's ownership share of Hulu results was reported as equity in the loss of investees.

Looking ahead

Granted, Disney had a quarter that likely disappointed many investors. But long-term investors know that one quarter is just one quarter and that the key reasons behind the company's earnings decline should prove temporary.

It will likely take some time to integrate the Fox businesses into the fold, but once completed, the combined company should have an absolute stranglehold on the global movie industry. And successful movies are central to Disney's business model in that characters and other intellectual property from its movies make their way into attractions at the company's parks and into a plethora of consumer products.

Two upcoming potentially major catalysts for growth are the opening of Star Wars: Galaxy's Edge at Disney World on Aug. 29 and -- the biggie -- the launch of Disney+, slated for Nov. 12.