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The Science of Hitting
The Science of Hitting
Articles (690) 

The Cost of 'Sweeping, Permanent, Profound Transformation'

Some thoughts on Disney's transformation and why it reminds me of Walmart

April 06, 2020 | About:

I’ve followed Walmart (NYSE:WMT) for years, and previously owned the stock. In particular, I’ve been effusive in my praise for CEO Doug McMillon. He has done as good of a job as anyone could’ve reasonably expected given the hand he was dealt. But as I noted in February 2019, what this would ultimately mean for the long-term owners of the business was still up in the air:

“The first few years under McMillon’s leadership were focused on stabilizing the core (U.S. brick and mortar). The company succeeded on that front. At the same time, they invested to reaccelerate growth in U.S. e-commerce, both through organic investments and M&A… The issue is that these investments are bringing significant operating losses onto the income statement. In addition, it’s not clear when (or even if) those losses will slow…

Walmart continues to aggressively invest in U.S. e-commerce. With the acquisition of Flipkart, it now appears committed to doing the same in India. The question is when we’ll see a return on that investment. I don’t know the answer. What I have learned from watching Walmart over the past five-plus years is that this can – and likely will – take a long time. That may be the right decision for the long-term health of the business – but it’s not the easiest thing to live through…

I give McMillon much credit for what they’ve accomplished. That said, we are in the early innings of a major investment cycle to position the business for the future. With competitors like Amazon and big plans in nascent markets like India, the long-term ROI of this massive investment is uncertain. That's keeping me on the sidelines.”

To quantify what I was getting at above, Walmart recently reported results for fiscal 2020, with full year adjusted earnings per share (EPS) of nearly $5. It might be surprising to learn that this is roughly in-line with what the company earned in fiscal 2013. Said differently, after many years of hard work and investment (which I would personally consider a success), EPS has not grown.

There’s another company that may follow a similar path: The Walt Disney Co. (NYSE:DIS).

Disney, through its collection of unrivaled brands as well as a business strategy that enables monetization of IP through movie theaters, parks and consumer products, has built one of the great companies of the world. Its uniquness has borne fruit: as former CEO Bob Iger once noted, “Looking back, particularly with Marvel and Lucasfilm, we had an ability to monetize those assets better than anyone else. If someone came along, we would have had a competitive advantage.”

However, one of its pillars, the Media Networks business, is facing real headwinds. The number of pay-TV subscribers in the U.S. peaked a few years ago, with the pace of subscriber losses picking up steam in recent quarters. These declines reflect the impact of competition from much cheaper premium video providers like Netflix (NFLX). Importantly, for entertainment programming, subscription video on demand (SVOD) offerings like Netflix are also a much better product than what’s available on linear TV (most notably, there's no advertising on Netflix). The combination of significantly lower prices and a better product has led to surging consumer demand. This is directly impacting the pay-TV world – and Disney was the biggest beneficiary in that ecosystem.

Currently, across its slate of TV networks, Disney receives $15 - $20 per month from MVPD’s. Last year, the pay-TV universe contracted by roughly 3% - 4%. That works out to something like 3 million fewer pay-TV subs, or more than $600 million in lost affiliate fees (those revenues come with high incremental margins as well). That is a trend I expect to continue – and potentially worsen – in 2020.

At the same time that Disney is watching its legacy Media Networks business deal with some headwinds, they are investing significant sums of money in attempt to develop a direct to consumer (DTC) business. (Importantly, the company has had significant success so far, with Disney+ attracting nearly 30 million subscribers in the U.S. within three months of launch.)

While that growth is encouraging, it comes with much less attractive economics for Disney than a linear pay-TV subscriber, much like the early growth in Walmart’s e-commerce business. As an example, consider these numbers from Credit Suisse: the firm’s analysts estimate that Disney’s DTC business will lose $3.6 billion in fiscal 2020, $2.0 billion in fiscal 2021 and $1.2 billion in fiscal 2022.

As a Disney shareholder, you’re looking at sustained declines in a highly profitable business segment, while simultaneously digesting billions in losses associated with DTC investments.

The net result has been a significant decline in earnings expectations for Disney: consensus estimates before the coronavirus impacts were fully appreciated had recently declined to roughly $5 per share, compared to an estimate of roughly $7 to $8 per share a few quarters ago.

To put that number into perspective, Disney earned more than $5 per share in fiscal 2015. Much like we saw at Walmart, where earnings in fiscal 2020 were roughly in-line with what the company had earned seven years earlier, Disney is also living through an extended period of investment that has resulted in minimal earnings per share growth during the transition.

Conclusion

Of course, that’s not the whole story. The fact that per share earnings are being constrained, even for a period of years, should not be the sole consideration for long-term investors. What we need to determine is whether these investments are likely to generate attractive returns over time.

Personally, I have some lingering concerns. To put it bluntly, it’s not clear to me that Disney’s earnings power will benefit as a result of this transition, at least not in the near term. To be clear, it’s not the growth of DTC that I’m unsure about; I think it’s very likely that Disney+, ESPN+ and Hulu will continue to add millions of subscribers over the next few years. My concern is the impact that all of this will have on Disney’s profitability. I think it’s probable that continued growth and promotion of DTC offerings by all of the major media companies will lead to accelerated cord cutting. For Disney, that means the Media Networks business segment – which generated $7.5 billion in operating profits in fiscal 2019 – is likely to face sustained headwinds on the bottom line.

Like Walmart, which was "forced" to digest worse unit economics as the business mix shifted from brick-and-mortar to e-commerce, I think Disney has a few painful years ahead in terms of earnings power as they deal with the mix shift from the legacy pay-TV business towards DTC.

Now, that may work out wonderfully over the long run, but I think these transitions require a lot of time and resources, especially when you’re behind the eight ball and are forced to play catch-up against well-run competitor like Amazon or Netflix. In that situation, it’s probably not realistic to expect much, if any, earnings growth in the short-term.

Some readers may remember a memberable Disney earnings call where former CEO Bob Iger first told investors that the company was seeing “some subscriber losses” at ESPN. What you may be surprised to learn is that call took place in August 2015 – nearly five years ago. For what it’s worth, the stock currently trades at a lower price than it did in August 2015. With hindsight, I think the change in the stock price the day after that call – a decline of nearly 10% - understated the potential impact of that news. Iger’s words were an early sign that meaningful transformation would be necessary – a transformation that would require significant time, money and managerial attention. As investors, I think we can sometimes overlook just how arduous this process can truly be.

I’ll close with something that Bob Iger told Barron’s in January 2019:

“What I posed to my senior team and ultimately to the board was, ‘We can’t sit back and let this happen’… Our ability to endure was going to be solely tied to transforming ourselves, and not pursuing a strategy of, ‘We’re going to get through this, it’s a storm that’s passing overhead, and when it clears, we’ll be fine.’ We have to be different when that storm clears. We can’t be the same. What we really needed was to lock arms and say this period of transformation that will now be more self-inflicted is going to require a reset, including on Wall Street… If you’re investing for the future, and you’re spending to create a new business model whose revenue is going to lag the launch and the expense of the initiative, then your profits are going to go down… If you’re going to look for traditional metrics to measure performance, it’s not going to work.”

That board meeting occurred in 2016. Four years later, I would argue that the transformation is still in its early innings. The market's muted reaction to the company's stellar start in DTC, with the Disney+ numbers blowing out all analyst estimates, points to the reality that it will take years before this early success results in meaningfully higher profitability for Disney.

Now, to the next question: Are these investments likely to work out for Disney?

And as importantly for shareholders, is the stock attractively valued here?

I will be writing an article to address these questions in the next few days.

Disclosure: Long Disney.

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About the author:

The Science of Hitting
I desire to own high-quality businesses for the long-term. In the words of Charlie Munger, my preferred approach is "patience followed by pretty aggressive conduct." I run a concentrated portfolio, with the top five positions accounting for the majority of its value. In the eyes of a businessman, I believe this is sufficient diversification.

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Comments

xzhao10
Xzhao10 - 6 months ago    Report SPAM

Nice write-up, Science. Walmart is competing with Amazon on efficiency, to see who has the lower operating cost. But cutting cost has a limit. So the best Walmart can get is to get even. Disney is different. It is competing with Amazon and Netflix on intangilbe assets. You can find Nemo no where but at Disney. What Disney is doing is to add a distribution channel, since that is the direction the entertainment is going. Just my 2 cents. Best, -Xing

The Science of Hitting
The Science of Hitting - 6 months ago    Report SPAM

Xzhao10 - I think that's a very good point. Thanks for sharing!

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