Is Disney Stock a Buy?

Disney's (DIS -0.45%) stock recently rallied to its highest levels in nearly four months following its third-quarter earnings report. Its revenue rose 26% year over year to $21.5 billion, beating analysts' estimates by $490 million. Its adjusted net income rose 53% to $1.4 billion, or $1.09 per share, which also topped the consensus forecast by a dime.

Those headline numbers were strong, but is Disney's stock finally worth buying again after underperforming the S&P 500 in recent years? Let's review its growth rates, challenges, and valuations to decide.

Image source: Disney.

Why did Disney underperform the market?

Disney struggled with three major headwinds over the past few years. First, its cable TV networks lost subscribers to streaming video challengers like Netflix. That secular disruption forced Disney to pour billions of dollars into expanding its own streaming ecosystem with Disney+, Hulu, and ESPN+, but those higher costs squeezed its operating margins.

Second, the COVID-19 pandemic curbed the growth of its theme parks and resorts while disrupting its theatrical movie releases. Sluggish ad sales throughout the crisis also hurt its broadcast TV business. As a result, Disney's revenue growth cooled off as its streaming costs surged.

Lastly, new macroeconomic challenges -- including inflation and a potential recession -- are casting dark clouds over Disney's post-lockdown recovery. Furthermore, some investors still aren't fully confident that Disney's CEO Bob Chapek, who succeeded Bob Iger in early 2020, is right for the job.

Disney's revenue growth is stabilizing

Disney's revenue declined 6% to $65.4 billion in fiscal 2020, which ended in October of the calendar year, as the pandemic disrupted its core businesses. Its adjusted earnings per share (EPS) plunged 65% as it expanded its streaming ecosystem and racked up higher COVID-related expenses.

In fiscal 2021, Disney's revenue rose just 3% to $67.4 billion, as the sluggish recovery of its theme parks and resorts partly offset its stabilizing media revenues. Its adjusted EPS increased 13%.

During that year, the company generated 75% of its revenue from the Disney Media and Distribution (DMED) division, which houses its cable, broadcast, streaming, and theatrical divisions. The other 25% came from the Disney Parks, Experiences, and Products (DPEP) division, which handles its parks, resorts, and cruises, as well as its merchandise licenses and sales.

Here's how those two core businesses fared in the first three quarters of fiscal 2022:

Data source: Disney. YOY = Year over year.

Disney's DMED business stabilized this year as more people returned to theaters and it expanded its streaming platforms. It ended the third quarter with 221 million subscribers across all its streaming services, which matches Netflix's latest subscriber count and represents 27% growth from a year earlier.

Its flagship service, Disney+, grew its subscribers 31% year over year to 152 million. At this rate, Disney could overtake Netflix in subscribers by the end of the year. 

The DPEP segment grew rapidly as COVID-related lockdowns were broadly eased across the world. All Disney theme parks have been open since the fourth quarter of fiscal 2021, and it gradually eased their capacity restrictions over the past three quarters.

Those tailwinds should persist for the foreseeable future, and analysts expect Disney's revenue to rise 25% to $84.7 billion for the full year and grow another 11% to $94 billion in fiscal 2023.

Its operating margins are rising again

Disney's operating margin plunged from 21.3% in fiscal 2019 to 12.4% in fiscal 2020 and then dropped again to 11.5% in fiscal 2021. That compression was mainly caused by its streaming investments and COVID-era expenses and challenged the bullish notion that Disney could offset its streaming losses with the growth of its higher-margin theme park and movie businesses.

But in the first nine months of fiscal 2022, Disney's operating margin expanded 390 basis points year over year to 16.5%. Its DMED operating margin still dropped from 16.8% to 9.8% as it ramped up its streaming investments, but its DPEP operating margin jumped from negative 1.5% to a positive 30% and easily offset that decline. That recovery indicates that Disney can still leverage the strength of its higher-margin DPEP unit to expand its lower-margin streaming business.

Analysts expect Disney's operating margin to rise to 14.9% for the full year and then continue expanding to 16.8% in fiscal 2023. They expect its adjusted EPS to increase 68% this year and grow another 40% in fiscal 2023.

It's reasonably valued and poised to recover

At around $120 a share, Disney trades at 31 times next year's adjusted earnings forecast. That price-to-earnings ratio might seem a bit high, but it could cool off as Disney's profit growth stabilizes again. In terms of revenue, it still looks cheap at less than three times next year's sales.

Disney could face unpredictable headwinds if a full-blown recession starts, but it's also bounced back from plenty of economic downturns before. Therefore, I believe it's still a great evergreen stock to buy -- and that it will outperform the market again once its revenue growth and operating margins stabilize.