The Moat around Magic Kingdom

This summer we took a family vacation to Magic Kingdom in Orlando. My experience, (especially the $150 entry pass) re-emphasized the enormous pricing power of Disney.

While there were many other excellent theme parks in the vicinity, suggestions of substitutes went unproposed to my 4- and 8-year old daughters, due to perceived cruelty.

Next summer, we are also going on a Disney cruise with a bunch of extended family. The cruise costs nearly 2.5x as much as its competition.

I always knew that Disney had a strong moat. However, the observation of how powerless someone as cheap and brand-agnostic as me is, in avoiding paying up premium dollars, forced me to look at Disney the business after we got back from the trip. The recent swoon (after earnings) forced me to pen down my thoughts.

Background

Disney has four business segments. In the order of revenue generated in FY 2016,

  • Media Networks (ABC, ESPN, cable channels) – 43%
  • Parks and Resorts – 30%
  • Studio Entertainment (film, TV, home video) – 17%
  • Consumer Products (books, video games, licensing) – 10%

We can think of Disney as two units, Media Networks + Studio Entertainment, which contributes 60% revenues and 65% EBIT, and Parks + Products, which constitutes 40% revenues and 35% EBIT.

DIS is insanely profitable.

It boasts of consistent gross and net margins of approximately 45% and 15%, respectively. The return on equity has been around 15% since forever, and has occasionally breached 20%. The company is generally well managed; its long term debt/capital is about 25-30%. Over the past 10 years, the number of shares outstanding has been shaved by 20%.

Risk Factors and Opportunities

Subscriber Loss at ESPN and pay TV channels

ESPN earns ~$8/month per subscriber in bundled cable plans. People are moving away from bundled cable packages. This will hurt ESPN (and other channels) in the short and medium term.

  • Longer term (10 yrs), new sports contracts will reflect this deterioration, and will probably be priced accordingly.
  • Management will figure out a way to best monetize these assets. The situation may be more serious for other pay TV providers, which lack a franchise or differentiation.
  • The recent “DTC” move while painful in the short run, was inevitable. In the long run, it will probably look smart.

Heightened CapEx at Parks will Subside

Currently, CapEx/Sales at Parks and Resorts is high (25%). If and when it normalizes to the 15% level,  cash will start gushing out of the pike. Credit Suisse estimates that cash-flow will grow from $800m in 2016 to about $2.7B, when that happens.

Valuation

ROE

The long-term ROE is in the vicinity of 15%. If you hold DIS for long enough, your returns should be pulled or pushed towards this number, unless the story changes dramatically.

Multiple

For FY 2017, EPS is estimated to come in at about $6. At $103, DIS is trading at a PE of about 17. Given the quality of the company, it probably deserves to trade at a premium to the market. If we say it deserves a multiple of 20 (arbitrarily for now, will contextualize later), then it is probably worth around $120.

Terminal Model

Let’s use a simplified “terminal” model. Revenues have been growing at 5% or more since a long time. Operating and net income have been growing at 10% CAGR in the past, but let us suppose that this will taper down to 5% (same as revenue growth).

The return on capital has been around 12%, historically, while the cost of capital has been 8-9%. Given Disney’s moat, let us assume that is one of those rare moaty companies which can earn above its cost of capital, and continue to grow, thereby creating value. Note that this implies a reinvestment rate of 5%/12% = 40%.

It is estimated that DIS will earn an EBIT of about ($15.7B) $9.80/share in 2018 (fiscal years end in October).  Thus, the value of its operating business is,

Operating Value = NOPAT(t+1) (1 - growth/ROC)/(COC - growth)

= $9.80 * (1-0.35) *  (1 – 0.05/.12)/(.08 – 0.05) = $124/share. If we subtract the present value of the long term debt (~$13/share) from this, we get an estimate around $110/share for the equity.

Past Relative Valuation

Over the past 5 years, the PE ratio has varied between 15 and 25. Based on current earnings this implies a $90-$150 band. The EV/EBITDA has varied between 8.6 and 14 implying a slightly narrower $88-$140 valuation band. It must be remembered that over the past 5 years the stock has basically doubled.

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