Capitalism can be brutal. Sometimes, the businesses you think are foolproof end up getting rapidly disrupted. Consider the case of Walt Disney (DIS -0.04%). Many investors thought it was a foolproof stock. The company has dominated the media industry for decades with its family-friendly brands and through smart acquisitions like Pixar and Marvel.
But now, this dominance is being threatened. Disney is getting attacked competitively by internet platforms for consumers' time. It's also getting squeezed by content providers, like the sports leagues, and is running into disputes with its cable distribution platforms. The ugly headlines have seemed relentless, sending shares of Disney down 60% from all-time highs.
As we sit here today, the stock has only provided a total return of 46% in the last 10 years vs. a 220% return for the S&P 500. Could there be more pain coming for Disney shareholders or is now a buying opportunity?
A changing sports landscape
Disney owns ESPN, the leading sports TV network in the United States. Traditionally, this was a major cash cow for the company -- distributed through the cable bundle, which had over 100 million subscribing households in the U.S. With the majority of sports rights and a ton of die-hard fans, ESPN had tremendous pricing power when deciding its monthly fee to the cable companies.
ESPN and its affiliate channels are by far the most expensive sports network for the cable TV package. Cable companies were forced to pay this high price as ESPN was the only option for popular sports content such as the NFL and NBA.
But that game has now changed in a few ways, threatening ESPN's dominance. First, cable companies aren't making much money from the TV bundle anymore as most of their profits come from broadband internet. That has allowed them to push back in negotiations.
This came to a head in recent weeks when Charter Communications (CHTR -1.73%) decided to take ESPN's content off of its Spectrum TV service. The timing couldn't have been worse for Disney with the college and professional football seasons beginning. Charter is willing to stand tall in negotiations because it can point its subscribers to virtual cable packages such as YouTubeTV, which also carries the ESPN channels.
However, the two companies have agreed to a deal -- and with a lot of the points in Charter's favor. The advertising versions of ESPN+ and Disney+ will now be available free of charge to Spectrum video customers, as well as the upcoming comprehensive ESPN streaming service that will host all of its sports content (ESPN+ only carries a small portion).
Investors reacted accordingly, with Charter shares up 4% on the announcement while Disney stock was up less than 1%.
There are also new competitors bidding for sports rights, and they all have much larger pocketbooks than Disney. The big three in this regard are Apple, Amazon, and Alphabet (owner of YouTube), which have all dipped their toes into sports content in recent years. When the sports leagues come back to the negotiating table, Disney may face high competing bids from these technology giants with tens of billions of dollars on their balance sheets.
Can streaming video make money?
Things may never be the same for ESPN. But the saving grace for Disney's media business may be building its own content bundle that includes ESPN.
The company has a successful in-house streaming service called Disney+ that houses family-favorite content from Pixar, Star Wars, Marvel, and Disney's own legacy brands. It has 46 million subscribers in North America. It also has a majority stake in Hulu, which has 44 million subscribers, along with ESPN+, which is currently at 25.2 million subs.
The problem with these direct-to-consumer (DTC) offerings is that Disney entered the market at unprofitably low prices in order to drive up subscriber numbers. Management is now looking to fix this issue, raising prices for these streaming services by significant amounts this summer and investing heavily into advertising to juice average revenue per user (ARPU).
The base Disney+ plan with no advertisements now costs $14 a month, while the bundle of all three streaming services costs $25 a month. If all of Disney's content is eventually only accessible through these services, it will be a pretty compelling offering for households, especially sports fans in the U.S. Shareholders need to hope a lot of people will pay up to access this content.
Over the last nine months, Disney's DTC revenue grew by just 16% to $16 billion and lost $2.2 billion in operating income. In order to pivot this business to profitability, management needs to thread the needle by raising prices and increasing advertising revenue, but not so much that tons of people start canceling their subscriptions.
If they can do this through the Disney bundle, ESPN and the media business may be saved. However, the segment is still a long way away from profitability. The next few years will be crucial.
Is the stock a buy?
DIS Operating Income (TTM) data by YCharts.
Disney is facing a lot of turmoil with its media segment, but the business is still profitable. Through the first nine months of this fiscal year, the combined traditional and DTC media segment generated $2.2 billion in operating income. Things are moving in the wrong direction, with profits down 46% from a year ago, but as I outlined above, management has a plan to get the business back on the right track.
The opposite could be said for Disney's theme park business, which seems to be humming along just fine. Through the first nine months of this year, revenue at the parks business grew 17% year over year to just under $25 billion and generated $7.6 billion in operating profits, up 20% year over year. This is a huge advantage for Disney vs. its competitors outside of big tech, and can help it manage the transition to streaming for its media operations.
Over the last 12 months, Disney has generated roughly $7.45 billion in operating income, mainly from its theme park business. Today, its market capitalization sits at $150 billion, or roughly 20 times operating earnings, even with the media segment in the doldrums.
If you're pessimistic about the end state of the streaming transition, it's best to avoid Disney stock, even at these depressed levels. Yes, the path to profitability in streaming looks difficult, but if you believe there's a light at the end of the tunnel in streaming video, Disney could be a buy at today's prices.
