First of all, I want to thank all my readers for the overwhelmingly positive response to “Disney: Don’t Bet Against Human Spirit Part I.” As promised, I am back with the second chapter of our research series on Disney (DIS). Today, we will analyze the long-term financial trends of Disney’s business and study its dividend history to predict when Disney should be able to resume its dividend payments. Ultimately, I will illustrate why Disney remains a promising investment notwithstanding its current and near term obstacles.
Since the aforementioned article, Disney has declined by approximately 7% due to fears of a “second wave” of the virus. While these fears may have merit (nobody can say for certain), the statistics strongly lend to the idea that Disney will reopen by July, at least in Florida.
That is, Florida has still only experienced 3,000 deaths due to the virus with a population of at least 22M at any given time. This appears to lend to the idea that the virus does not thrive in very hot and humid environments.
With all of this being said, we are here today to discuss Disney’s long term prospects. The stock market is not looking to what happened last quarter, nor even the quarter immediately in front of us. The stock market is always looking 6-12 months out.
So let’s get straight into it!
Income Statement Analysis
As can be seen above, over the last decade, Disney’s revenues have increased from $38.19 billion to $78.21 billion at CAGR of ~7.43%. While the revenue growth rate is pretty good considering Disney’s size, the recent contraction in gross margins from ~45% to ~35% is worrisome. Lower gross margins can be attributed to Disney’s acquisition of 21st Century Fox in March 2019.
Disney categorizes its revenues in the following business segments:
Parks, Experiences, and Products,
Studio Entertainment, and
Direct-to-Consumer & International
Amongst these segments, the theme park and cruises segment was hit the hardest by the coronavirus pandemic. Let’s look at the revenue breakdown to get a better understanding:
Source: Disney 10-Q
As we discussed in our previous Disney note, an economic reopening would see Disney’s Orlando theme parks serving guests starting mid-July. The long queue for entry at Universal Studios, which opened last week, showed that Disney would also be able to garner ample guests, albeit at a reduced capacity.
Further, the threat of a second wave drove markets lower last week, and Disney’s stock could remain volatile in the short-term. However, long-term investors must look at the current price action as an opportunity to build long positions in a high-quality business, i.e., Disney.
Balance Sheet Analysis
Before Disney completed the levered acquisition of 21st Century Fox in 2019, it had a pristine balance sheet. However, with $55.45 billion in financial debt and just $14.34 billion in cash and short term investments, at the end of March 2020, Disney was forced to suspend its dividend and raise new debt of $11 billion to tide over the upcoming recession.
According to various sources, Disney is losing close to $800-1000 million every month in the theme park segment due to coronavirus enforced closures. Hence, I expect Disney to see more short-term pain in its highest-earning division. However, Disney+ has emerged as a colossal success story, and accelerated growth in other services like ESPN+ & Hulu should help Disney to limit its losses somewhat. In short, I would say that diversification has saved Disney, and its introduction of Disney+ has proven extraordinarily timely.
As of March 2020, Disney had a Debt to EBITDA ratio of 3.84, which is very high for a business like Disney. However, investors were prepared for it as Disney had disclosed during the 21st Century Fox acquisition announcement that the Debt to EBITDA could rise to 4.0x.
What Disney’s management and investors did not prepare for was the coronavirus pandemic. Considering additional debt of $11 billion and a significant drop in earnings, the Debt-to-EBITDA ratio could quickly shoot up from here. Further, the possibility of a credit rating downgrade cannot be ruled out at this moment, and investors must monitor this aspect regularly, as it could portend further financial deterioration for the company, resulting in intrinsic value destruction.
Now, we know that the world is facing an economic crisis, and a fall-off in consumer discretionary spending could have lingering effects on Disney for quite some time.
With this in mind, I ask myself: Will Disney be able to service its debt load and survive this crisis? Let’s investigate further.
As you can see above, Disney’s EBITDA of $13.81 billion is almost ~10x its annual interest expense of $1.31 billion. However, EBITDA is set to decline, while interest expense, on the other hand, is set to rise. The situation is precarious, but Disney investors need not worry as a robust cash position ensures financial stability even if Disney’s business continues to suffer over the next few quarters.
In sum, servicing its debt should be no issue for Disney, and I believe Disney’s balance sheet is strong enough to weather a prolonged economic downturn.
Free Cash Flow Analysis
Disney’s free cash flow generation recently fell off a cliff, as can be seen below. From roughly $10 billion in 2018, TTM free cash flow went into negative territory during the previous quarter. Investors must brace for a worse earnings report for Q2, but I see things improving thereafter.
As we can see in the chart above, the total dividend payout was increasing pre-COVID-19, but Disney has already suspended its first-half dividend for 2020. With an economic downturn driving consumer discretionary spending lower, I do not expect to see free cash flow to return to pre-COVID levels anytime soon. However, Disney could see a strong recovery in 2021, and the success of Disney+ could help free cash flow generation reach all-time highs in the next few years.
Before the ill-timed acquisition of 21st Century Fox, Disney had a conservative cash dividend payout ratio of ~30%. I expect Disney to maintain similar levels of CDPR once the company resumes its dividend.
Historically, Disney has proven itself to be a reliable dividend growth stock, and although Disney cut its dividend, I feel it was a prudent decision as the company will surely need the cash to shore up its balance sheet during this unprecedented crisis for the company. I think Disney’s fresh debt issuance of $11 billion and easing of lockdowns across the globe could mean the company will resume its dividend as early as the second half of 2020.
However, I always advocate conservatism for long-term investors; thus, if you are buying Disney right now, please do not expect the dividends to resume before 2021.
During the last decade, Disney repurchased close to 24% of its outstanding shares at a rate of ~3.32% per year between 2010-2018. In 2019, Disney suspended its stock repurchase program with the 21st Century Fox acquisition in mind.
To complete the humongous ~$85 billion acquisition, Disney issued close to ~300 million shares as part of a cash and stock deal. I am optimistic about Disney resuming its dividend sometime next year; however, I am not sure when the buyback program could be restarted with the gigantic debt load hampering Disney’s financial flexibility.
Valuation and Final Recommendation
One must consider that one year is a blip in the lifetime of a stalwart company such as Disney. What’s more, the value of any asset is the present value of the cash flows it produces throughout its entire lifetime.
With this in mind, Disney’s intrinsic value remains at $163 (more details here). However, we now have an even better buy point at $115 after a ~7% price decline. The total expected price return on a ten-year investment now stands at ~14.64% CAGR. The total expected return with dividends can be seen below:
Total Return Without Reinvestment
Total Return With Reinvestment
Hence, I like Disney even more at $115 and expect the magic to return in mid-July despite fears of a second wave of COVID-19. For long-term investors who want to buy a quality business with a strong “economic moat” below its fair price, Disney is one of my top ideas. I recommend my readers to start a long position now and add to it on any significant dips.
In the next part, I will analyze the short-term effects of coronavirus pandemic on Disney’s earnings and provide an earnings preview for the upcoming quarterly results.
Key Takeaway: I rate Disney a buy at $125 and below.
As always, thanks for reading; remember to follow for more, and happy investing!
Note: “Disney: Don’t Bet Against The Human Spirit” is a five-chapter research series created by L.A. Stevens Investments, LLC. Today’s article was the second chapter of the series. So, stay tuned and click the “Follow” button to get an email notification when the third chapter is released.
Beating the Market: The Time Is Now
There has never been a more important time in stock market history to buy individual stocks at the heart of secular growth trends. Mature market performers/underperformers and index funds simply will not cut it, as we face a decade during which there is absolutely no guarantee the overall markets will rise.
This is why the time is now to discover high-quality businesses with aggressive, visionary management, operating at the heart of secular growth trends.
And these are the stocks that my team and I hunt, discuss, and share with our subscribers!
Disclosure: I am/we are long DIS. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.