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Is Disney's Relationship With China a Bigger Risk Than COVID-19 for Disney Stock?

By Will Healy - Oct 22, 2020 at 11:20AM

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Open theme parks and theaters are critical for Disney, as is the China market.

COVID-19 is arguably the worst thing to happen to Disney ( DIS 1.68% ) in decades. Disney and its stock have suffered as theme parks and theaters have had to operate at reduced capacity (if they can open at all). 

On top of that major headwind, the increasingly strained relationship between the U.S. and Chinese governments has brought uncertainty to a key growth region for the company, creating another challenge for management. The question some investors are asking now is whether U.S. issues with China poses a greater threat to this media stock than COVID-19?

Let's look at both matters more closely and see if we can find an answer.

The effects of COVID-19

There is nothing Mickey Mouse about the devastation inflicted upon Disney by COVID-19. In the latest quarter, revenue fell by 42% from year-ago levels. The company's net income also turned negative as it reported a loss of $2.61 in diluted earnings per share. This led to the suspension of the $1.76 per share annual dividend in May.

An illustration shows Cinderella's castle at Disney's Magic Kingdom

Image source: Disney.

Most of the revenue pain came from two of Disney's four divisions. Parks, experiences, and products, which operates the theme parks and Disney vacations, experienced an 85% decline in earnings. Revenue also fell by 55% for studio entertainment, which depends heavily on movie theater attendance.

Still, although this caused profound devastation for the company's earnings, the recovery had begun. Nearly all of the theme parks have reopened at least partially. Also, some movie theaters have allowed a reduced capacity of customers to return.

A recent spike in coronavirus cases could either reverse this recovery or at least put it on hold. Nonetheless, for all of the disruptions caused by the coronavirus, its effects are deeper but probably shorter term. Either the contagion will run its course, or science will find a treatment that allows society to return to normal.

Possible effects of Disney's push into China

Conversely, the problems stemming from Disney's relationship with China will probably be much less dramatic. So far, it has not prevented Disney's Asia revenue from growing.

Officially, Disney has downplayed any China-related issues. China only received scant mention in last year's annual report, and none in the most recent earnings call.

Nonetheless, Disney's conciliatory relationship with the People's Republic of China is front and center. It has earned condemnation from Attorney General William Barr. Disney also faced a backlash as it filmed Mulan in the Chinese territory of Xinjiang, a site of alleged human rights abuses. ESPN management has come under fire in the past for discouraging staff from publicly discussing the NBA's strained relationship with China stemming from comments about Hong Kong.

This could become problematic as Disney has looked to China for much of its future growth. Asia made up only about 11% of revenue in 2019. Still, China is home to two Disney resorts. Moreover, promoting Disney's movies and television content to the country's 1.4 billion people could fuel growth for years to come.

Disney already serves 165 countries with its programming, taking the company toward a saturation point in much of the world. Hence, if it cannot keep expanding in China, it is unclear where it would find comparable growth opportunities.

Also, the volatile state of the U.S. government's relationship with Beijing could potentially affect Disney's businesses in China. This is especially uncertain due to the upcoming presidential election.

President Donald Trump has taken a harder line with the Chinese government than previous administrations. He began and has since intensified the trade war with China.

If Biden wins the election, some speculate that he would follow the lead of former President Barack Obama, who referred to the U.S. and China as the "most important bilateral relationship of the 21st century."

Nonetheless, China faces human rights issues that did not exist eight years ago. That could force Biden to take a tougher stance on China than Obama. Regardless of the results of the election, Disney investors need to keep one eye on the state of U.S.-China relations.

Which is the greater danger?

Investors cannot wholly discount a possible death by a thousand cuts should Disney experience further backlash from its relationship with China. Moreover, if China's relationship with the U.S. government becomes irretrievably damaged, it could curtail or even end Disney's presence in the Chinese market.

Nonetheless, the clear and present danger of COVID-19 appears more damaging. Coronavirus cases have spiked higher in recent weeks. This means the partial lockdowns will probably continue well into 2021, leading to billions more in lost revenue for the media giant.

Moreover, for all of the challenges Disney stock faces with COVID-19, it still trades at a forward P/E ratio of 50. Earnings grew by about 10% between 2017 and 2019. Such growth may not be enough to sustain its valuation, especially if the company further delays reopenings.

Although Disney will probably have to deal with China-related issues for a longer period, the pandemic remains a much larger challenge.

This article represents the opinion of the writer, who may disagree with the “official” recommendation position of a Motley Fool premium advisory service. We’re motley! Questioning an investing thesis – even one of our own – helps us all think critically about investing and make decisions that help us become smarter, happier, and richer.

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