Recommendation: SELL Target Price until (06/30/2015): $60.00 1. Reasons for the Recommendation The Walt Disney Company has been an S&P 500 leader representing the entertainment industry around the world with well-known brands that include Mickey Mouse, ESPN, Marvel, and the recently acquired Star Wars brand. Within the past month, Disney s stock price has hit an all time high of $70.17 and a P/E of 20.91. The record valuation multiples are supported by investors and analysts belief that the Disney Company s recent acquisitions, theme park investments, and media brands such as ESPN will continue to return healthy bottom lines in the future. While I concur that the company will also continue to grow in upcoming years, I also believe there are key issues surrounding the company that are underweighted with regard to current valuations of the Disney Company. These include the postponement of key tent-pole movies in 2014, the expansion of the Aereo Company into other major U.S. cities, negative trends in payfor-tv subscriptions, and pushback from cable and satellite companies in contract negotiations. As the Disney Company begins to publicly address these issues in 2014, it is my belief that we will see a market correction that will lead to a drop in the stock price. Therefore it is my recommendation that the Disney Company be removed from the portfolio considering a year-and-half investment horizon. The first sign that the company will be confronting problems in upcoming fiscal year is the delay of key tent-pole movies from 2014 into mid and late 2015. There has been an increasing trend for major studios to rely on what the industry terms tent-pole movies. These movies generate a majority of the studios net profits for the year but also have significantly high production cost. The Disney Company relies on three to four tent-pole movies a year, and recently announced that they would push the release date of Star Wars VII, Pixar s Finding Dori and Pixar s The Good Dinosaur into 2015, leaving only Disney s Pirates of the Caribbean IV and Disney s Maleficent for release in 2014. This would be the first time that the Pixar Brand would not have its annual summer release, and the postponement of Star Wars VII only further delay returns from the Company s most recent acquisition of Lucasfilm for $4.1 billion. While it is difficult to measure how successful a movie might be in the future, it is clear that revenues will be lower in 2014 and there is uncertainty whether Disney s tent-pole strategy will continue to be successful. The studio segment contributes 8% of operating income and is currently projected to grow by 4% next year. Due to recent decisions to postpone major films till the third quarter of 2015, I believe that the studio segment will only grow by 2%. Another issue that is being underweighted by investors is the 1.2% annual decline in pay-for-tv subscriptions. This is most notably due to alternatives in the marketplace in addition to increased costs of cable and satellite subscriptions. The most current threat to the Disney s media segment operating revenues is the Aereo Company. Aereo TV allows individuals to record digital airwaves onto Aereo owned cloud storage and replay television recordings on their personal electronic devices for only $10 a month. The Disney Company has been leading the charge against Aereo in Federal Courts over lost revenue from advertising and retransmission fees. Currently all lower courts have sided with Aereo based on merit, and the case is now awaiting review by the Supreme Court. Over $3 billion dollars a year in industry affiliate fees are threatened and any future success of the Aereo Company will only compound negative trends in pay-for-tv subscriptions. On average the media segment for the Disney Company is responsible for close to 68% of operating revenue and current trends in this industry will have a negative pg. 1
impact on the bottom line and make it more difficult for the company to capitalize on its broadcasting products. Lastly, analysts are underestimating the pushback from cable and satellite companies in contract negotiations. Although the Disney Company secured a 10-year deal with Comcast in 2012, other companies such as the satellite provider Dish Networks are threatening to drop the Disney Company channels due to increasing affiliate and retransmission fees. Contracts between broadcasters and cable/satellite companies usually include yearly increase in affiliate fees; but overall declines in subscriptions have forced television providers to keep prices low as people move towards alternative platforms to consume entertainment. Recent comments by DishTV and Disney CEO s tend to suggest that negotiations are favoring the satellite companies. One of the benefits for the Disney Company is that it owns the majority of sports programing with ESPN networks, and commands significant advertising revenues from customers who are willing to pay for their favorite sports teams wherever the content is located. This revenue might offset some unforeseen negative impacts to the industry, but negative trends in content distribution and contract negotiations will continue to make it difficult for the industry to capitalize on affiliate fees and advertising. Also movies in 2015 could offset declines in yearly growth from the previous year, but it an inherent risk in the movie business that analysts can not guarantee if a movie will be a box office hit or not. The company s decision to push back release dates will put Disney at greater risk if their movies are not the success that everyone rely on them to be. In the best possible case scenario, the company might perform as projected by other analysts, but my analysis incorporates plausible changing trends in the market place that should carry more negative weight by the market. At this time, I believe that the Disney Company is overvalued and will most likely experience a market correction leading to drop in the stock price. Therefore, I conclude by recommending that we sell our position in the Disney Company. pg. 2
2. Company Analysis The Walt Disney Company is a diverse entertainment company that operates under five business segments: media networks, parks and resorts, studio entertainment, consumer products, and interactive gaming. The company relies heavily on the domestic market with 75% of revenues coming from the North American market. Within the last two years, the company s P/E ratio has been holding around the mid teens until most recently. In the past few months it has climbed to an all time high of 20.9. Increases in the valuation of the company have been due to increased dividend payouts and the company s ability to outperform the S&P 500 the past 10 years. Revenues have grown on average 6% YOY but most recently has slowed down to 4% in 2012 and 2013. Although the bottom line will experience another increase from the previous year there is cause for concern that the stock is fully valued and that future earnings will not translate to projected earnings per share. The media network s segment accounts for over 46% of total revenue and 68% of operating income. The company s ability in past years to increase cable and satellite companies retransmission fees has supported a 6% increase in revenues, but there has been a 16% decline in broadcasting operating income in fiscal year 2013. One of the key strengths within the media segment is the ownership of ESPN that commands significant advertising revenues that account for almost half of all the segments operating income. Although the company has most recently been able to squeeze revenues from pay-for-tv providers, the company is experiencing threats from satellite companies in negotiations with regards to affiant fees. Its contract with DishTV is set to renew in January and DirecTV will have contract renewal in 2015. The studio entertainment segment accounts for 13.8% of total revenues and accounted for 7% of operating income. The studio entertainment segment has taken recent hits in the last two years as tentpole movies have failed to meet expectations with the exception of the Avengers movie that became one of the high grossing films of all time. Most recently The Lone Ranger was anticipated to be a success at the box office but flopped. Costs incurred by the film due to high advertising expenditures have led to losses that contributed to an 8% decline in operating income for fiscal year 2013. The studio segment also experienced negative growth rates of -5% in 2011and -8% in 2012. The decision to push the release date of two key 2014 tent-pole films into 2015 will continue negative revenue trends through 2014. Parks and Resorts are the second largest contributor to Walt Disney Company s revenues with 30.6% in 2012 and supported 19% of the total segment operating income. Fiscal year 2013 saw a 17% increase in operating income due to higher attendance at its parks and resorts and increased park spending. Previous investments in parks renovations will continue to support record levels in park attendance and spending but new revenue growth will come from increase in ticket prices and the opening of Disneyland Shanghai 2016. In the fiscal year 2014, we will not see such large percentage increases in operating income, but will see slight year-on-year increases. The Consumer Products segment contributed 7.9% of total company revenues and 10.4% to segment operating income. On average it has seen an annual increase of 6%YOY and this should continue into the coming years as the company just expanded its Disney Stores into Russia for the first time in history and the opening of Disneyland Shanghai should produce increased revenue streams into 2016. Disney should begin to see an increase in the percentage of total operating income as recently acquired companies such as Lucasfilm and Marvel begin to generate profit for this segment after 2016 but operating income percentages would remain under 15% of total operating income. The Interactive segment contributed only 2.4% toward total revenues in fiscal year 2013 and had operating losses of about $87 million. The development of the Infinity gaming system has been the pg. 3
primary reason for higher operating losses in the past but the games release in September 2013 have helped improve segment operating. Reviews of the game are mediocre and the Infinity game is not predicted to outperform its competitors this holiday season. While the final release of the game will possibly help the interactive segment operate in the black for the first time, contributions to operating income will remain under 1%, a negligible amount. 3. Industry Analysis pg. 4
The media networks segment includes many sub-industries under the media networks umbrella. In regards to the Walt Disney Company, television broadcasting and television production are the two main industries in which the company engages. In television production, companies produce television programing that is then licensed and sold to cable and satellite companies. Similarly within the television broadcasting industry companies operate studios and facilities that program and deliver audiovisual content to the public. Revenues for both television broadcasting and television production are generated through advertising and affiliate fees charged to providers such as the cable and satellite companies. The main activities in television production and broadcasting include TV series, made for TV movies, news and event coverage that rely on a whole host of other industries that are usually unionized and provide the talent, equipment, operators and rights to live events. In terms of the media segment as whole, profits generated by the industry stand at $1.6 billion and current revenues of $37.6 billion are projected to see and annualized increase of 1.7% for the next 5 years. (Chiang, 2013) The television broadcasting industry is considered a mature marked where existing broadcasting companies have to compete for more market share. Although the television broadcasting industry is dominated by only a handful of companies new companies are being attracted to the television production. Barriers to entry are decreasing due to new technologies that reduce startup costs, production, and distribution costs. One of the major threats to the media networks industry is the shift from traditional cable services to online media and impending government regulation. (Chiang, 2013) Profits are predicted to decrease by 5.6% over the next five years and reflect the power of the buyer over the media companies, as they will increase spending in an attempt to retain subscribers. Also, proposed legislation by Senator John McCain is threatening cable companies with single-channel consumer purchasing agreements. Customers will be able to subscribe to individual channels and eliminate full subscriptions which will make it harder for companies to up-sell particular services and reduce advertising income. The studio entertainment segment primarily consists of the movie and video production industry. The industry produces and distributes motion pictures and videos. Primary activities include creating a timeline of production for the film, financing, producing, publicizing, and distributing the motion picture and videos. Total revenue for 2013 is projected at $29.3 billion and the industry annual growth rate for the next five years is predicted to be at an annualized 2.5% increase. (Kaczanowska, 2013) The movie and video production in the US is considered a mature market where existing studios have to compete for more market share. Barriers to entry in the studio entertainment segment are high and include acquiring limited resources such as A-list actors and financing. Also vertical integration with producers that have long-term agreements with distribution channels gives larger companies another competitive advantage and reduces the threat of new entrants. Although barriers to entry are high, recent technological improvements to camera technology allows production at the lower end to achieve professional quality film with lesser talent. (Kaczanowska, 2013) The theme parks and resorts industries provide entertainment and lodging around an amusement park that operate mechanical rides, water rides, games, shows and themed exhibits to entertain guests. They also provide refreshment stands and dining services that generate a significant amount of profits besides ticket sales and hotel room occupancy. (Brennan, 2013) Capital intensity and competition are high which become significant barriers to entry for any new major player and set the stage for existing firms to compete for existing market share. Consumers disposable income and transportation costs are key factors in determining the growth rate within the industry. The economic collapse at the end of 2008 greatly affected all major players in the pg. 5
industry and there were significant losses in revenues in 2009. Analysts predict that following 2013 there will be a continued increase in revenues at an annualized rate of 2.2% and will total 16.4 billion over the five years. (Brennan, 2013) These predictions are closely determined by the health of the economy and disposable income of future travelers both domestic and international but recently the US Federal Reserve will be pulling back it bond-buying program that will begin to increase interest rates around the world. Higher travel prices and a more price conscious consumer could impact the domestic economy that contributes 80% to 85% of domestic revenue. The interactive segment consists of the video gaming industry and the social network game platform. Video gaming produces physical games and software, consoles, accessories, and online extensions to the gaming platform. Similar to video gaming, the social network game industry develops, manufactures, produces, and retails gaming software but primarily distributes its products though social media website and small device platforms such as smartphones or I Pads. Total revenue for the social network game development industry in 2012 was at $4.5 billion and $38.2 billion for the video gaming industry. Profits were at $718.6 million and $3.1 billion respectively, and annualized growth for the next 4 years is projected at 22% for social networks game development and 4% for video gaming. (Schmidt, 2012) Low barriers to entry and a high growth market are the most notable factors when assessing the interactive games market. Low startup costs make establishing a new business relatively easy. (Schmidt, 2012) Market dominators are striving to make contracts with social networking sites such as Facebook to separate themselves with their competition. Attaching their product with these types of platforms are signs that the competition will only grow as consumer have greater access to the Internet through personal electronic devices. Because there are so many competitors within the market, both domestic and international, the threat of substitute products is also high. High barriers to entry and a moderate growth market best describe the video gaming industry. Video games produced are capital intensive and a few major gaming companies dominating the market. The consumer products segment for Disney is focused on the intellectual property and licensing industry where copyrighted material is add to products such as clothing and other accessories are and sold by a third party. The intellectual property and licensing industry accounted for $37 billion in revenue and $13.6 billion in profits for 2012. (Edwards, 2013) Annualized growth is expected to be 4.4% over the next 5 years. (Edwards, 2013) Due to the nature of intellectual property and licensing there are very low costs associated with management and profit margins are significantly high, leading to and increase of new licensors and franchisees. Overall barriers to entry and competition are low and will remain low well into the future making it easy for companies that seek these tools to enter and exit the market. Appendix: Inputs into valuation using multiples pg. 6
* Analyst's own calculations. Source of basic data: company's 10-K; Yahoo! Finance pg. 7