Merging company

Disney: Super moat, strong cash-generating capacity (NYSE: DIS)

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Investment thesis

The Walt Disney Company (NYSE: DIS) is a diversified global entertainment company with movie franchises, streaming service, theme park and merchandising. Since the creation of Mickey Mouse in the 1920s, Disney has had tremendous success acquiring and expanding into many different businesses. Disney’s share price has fallen since mid-2021 and is now half of its previous level, due to overall market volatility, the collapse of Netflix and struggles in the entertainment industry and of the hotel industry. I think the market is overpricing Disney’s strength and I expect Disney to rally because:

  • Parks and amusement businesses are recovering, and in fact Disney is unable to meet full demand due to labor shortages.
  • Disney has strong cash-generating capacity and a strong balance sheet. Their debt ratio (50%) is much stronger than its competitors Netflix (99%) and Warner Brothers (106%).
  • The streaming service is hitting its peak, and movie theaters are also getting busier. Revenues for the last twelve months have already exceeded their pre-pandemic level.

Resumption of theme parks and entertainment activities

The Park and Entertainment business is recovering and booming. Based on the latest filing, the Disney Parks, Experiences and Merchandise segment more than doubled from a year ago. Management mentioned that this strong performance was due to increased demand and improved personalized customer experience. Spending per capita rose more than 40% from its pre-pandemic level in 2019.

With the recovery in traveler numbers, new rides (e.g. Next-Gen Storytelling and Guardians of the Galaxy), and expanding theme parks (e.g. Disneyland Paris), I expect the Parks and Entertainment business continued its solid performance. Additionally, current Disney theme park capacity was limited by labor shortages, not demand. The demand is actually very strong. Disney is doing everything it can to staff the positions, including offering bigger signing bonuses, and their number of employees is growing. As positions are filled, Disney should be able to meet full customer demand and revenue will increase.

Disney financial statements

Financial statement (SEC filing)

Disney employee numbers

Disney employee numbers (Macro-trends)

Solid financial position and economic moat

One of the main advantages of investing in a blue chip company like Disney is its strong financial position and well-defined economic moat. Even amid the pandemic, Disney generated operating cash flow of $3.7 billion and $3.5 billion in 2020 and 2021, respectively. Unsurprisingly, their balance sheet is much stronger than that of their competitors. Their total debt-to-equity ratio (50%) is almost half that of Netflix (99%) and Warner Brothers (106%). With the Federal Reserve determined to control inflation, even in the face of a recession, this solid financial position should reassure investors.

Plus, Disney has a very well-defined economic divide. Disney owns brands such as Marvel, ESPN, National Geographic, Lucasfilm and Pixar. All together, this forms a composite group of market-leading characters and creates a formidable economic gap. A bearish economic cycle may temporarily affect movie or theme park revenue, but it will only be a short-term impact. Consumers will return to Disney movies, parks and merchandise for the long term.

Disney-owned businesses

Disney-owned businesses (Max Title)

Strong streaming and cinema market

Disney’s streaming service and movie business is also growing. Disney ended the second quarter with over 205 million total subscriptions, and they plan to reach 230-260 million Disney+ subscribers by 2024. Their expansion plan includes 1) growth in international markets , 2) lower cost ad-supported subscriptions, 3) take advantage of blockbuster titles like Star Wars: The Book of Boba Fett and Marvel’s Moon Knight. Given their long history of success in film and broadcasting, I have no doubt that they will achieve their goals.

The cinema market is also recovering. The number of ticket sales has risen sharply since the middle of the pandemic in 2020. The number may not have fully recovered to pre-pandemic levels, but it is definitely trending up. Ticket sales for June in the United States and Canada were approximately $990 million, about 10% lower than 2019. This is a strong increase given that movie attendance was 44% lower in April (compared to 2019) and 26% lower in May. . As we move on from the pandemic, I expect box office numbers to return to pre-pandemic levels soon.

Annual ticket sales in the United States

Annual ticket sales in the United States (Numbers)

Estimation of intrinsic value

I used a DCF model to estimate the intrinsic value of Disney. For the estimate, I used free cash flow ($10.8 billion) and the current WACC of 8.0% as the discount rate. For the base case, I assumed 14% cash flow growth (Seeking Alpha estimate) for the next 5 years and zero growth thereafter (zero terminal growth). For the bullish and very bullish cases, I assumed cash flow growth of 17% and 20%, respectively, for the next 5 years and zero growth thereafter. As their theme parks and movie business continue to recover, 17-20% growth seems achievable.

The estimate revealed that the current share price is up 15-30%. Given their economic moat, recovering theme parks and movie business, and rising streaming revenue, I expect Disney to continue to recover and finally realize that edge.

Price target

Upside down

Base case

$108.72

13%

Bullish case

$121.67

27%

Very bullish case

$135.93

42%

The assumptions and data used for the price target estimation are summarized below:

  • WACC: 8.0%
  • Cash flow growth rate: 14% (base case), 17% (bullish case), 20% (very bullish case)
  • Current EBITDA: $10.8 billion
  • Current stock price: $95.86 (08/07/2022)
  • Tax rate: 20%

Cappuccino Stock Rating

Weighting SAY
Strength of the economic gap 30% 5
Financial solidity 30% 4
Growth rate vs sector 15% 3
Safety margin 15% 5
Sector outlook ten% 4
Globally 4.3

Economic Gap Strength (5/5)

Disney has one of the strongest economic moats. Their iconic characters and brands are part of everyday pop culture. It’s also very impressive that so many different parts of their business (animated films, sports, streaming, TV broadcasting, etc.) have been able to generate tons of money even in the midst of a pandemic.

Financial strength (4/5)

Disney has been a cash-generating machine for the past few decades. Even in the midst of the pandemic and with their theme park business half crippled, they were able to generate over $3 billion in operating cash flow. Their balance sheet is much stronger than that of their competitors.

Growth rate (3/5)

Disney’s growth rate will be exceptional over the next few years as we exit pandemic restrictions and resume pre-pandemic operations. However, the long-term growth rate should stabilize around 5-7% per year, which will be in line with the rest of the industry and competitors.

Safety margin (5/5)

The recent decline in their share price (~40%) has created a great opportunity for investors to grab Disney shares at a discount. A top-notch company like Disney with a strong economic moat is a great way to build long-term wealth if you can grab it at a bargain price.

Sector outlook (4/5)

The entertainment industry will grow with the population and the economy. Part of people’s disposable income will naturally go to the entertainment industry. As a leader in the entertainment industry, Disney will benefit from the industry’s long-term growth.

Risk

The Federal Reserve seems determined to cause a recession to fight inflation. Every time the stock market gains momentum, the Federal Reserve comes out and pours cold water on it by raising interest rates sharply or predicting a dire economic scenario. Therefore, I don’t expect the stock market to gain sustained momentum until inflation drops. In a recession, there will naturally be fewer theme park visits and less movie theater spending, which will hurt Disney’s growth prospects.

Disney is approaching the 2024 deadline to buy an additional 33% stake in Hulu ($27.5 billion). Incorporating Hulu into Disney could limit capital, drain human resources and create conflict by merging two different business models. Since Disney already has a successful Disney+ streaming service, Hulu’s value to Disney has dropped significantly over the past two years. Disney certainly has a lot of experience acquiring and integrating new businesses, so I expect them to come up with an approach to successfully utilizing Hulu’s content and subscriber base. However, investors should closely monitor the progress.

Conclusion

Disney has been a superb investment over the past few decades. With many market-leading brands and characters, I expect them to remain a cash-generating machine for a long time. The resumption of theme parks and cinema activities should provide a growth spurt, followed by stable long-term growth. A potential recession would only be a temporary setback. Overall, I expect a 15-30% increase.

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