Disney: a "Value" Story Waiting to Be Heard
Warning! GuruFocus has detected 7 Warning Sign with DIS.
I immediately bring Buffett into play, and the stories shared by the Oracle of Omaha, always a cornerstone in my investment style.
First, I'd like to mention that Disney has some of thoseunique and diverse qualitiesrequired to clear the first filter of a value investor, you will grin when I tell you that, at that point, Buffett himself had decided tosell out from DIS ... with regret.
The reasons? The usual ones: unpredictable returns. And in this, his lifelong colleague Munger also finds justification, whose reasoning will help enrich the risk section of this article (we'll see that soon).
Similar to Gayner, known as the mini Buffett, with Markel Gayner Asset Management Corp. Same uncertainties, but two different periods. The first ones, the uncertainty lay in the transition to cable TV with a volatile model. And for today's investors, From cable TV to the new DTC services.
Since 1997, when Buffett was deciding whether to sell or hold DIS, Disney has changed. It is no longer just an entertainment vehicle, but a legacy conglomerate.
From the 10-K we know that about 46% comes from the main segment: entertainment. Then the second source of income is experience (38%), followed by sports (ESPN and similar) at 19.7%.
This is net of intersegment eliminations. 50% of the entertainment segment's revenue comes from DTC, which includes the streaming service. Here, it competes through Disney+, and partly also with Hulu, with around 186 million subscribers, behind the giant Netflix in this regard, which has over 260 million subscribers, not to mention it is also the most expensive platform. Disney holds a 4.6% share of the DCT segment, Netflix 8.5%, YouTube (11.1%).
DIS's financials tell a story, and it's a pleasure to listen to it.
You can feel a rising climate of tension from the statement that started in 2019; you wouldn't want to be in the shoes of the CEOs from that period. If you followed the events, both Bob Iger and Bob Chapek were criticized in turn: First for the acquisition of 21st Century Fox, then for the pandemic, dragged down by closed parks, empty theaters, and Disney+ running at a loss., empty theaters, and Disney+ running at a loss. And if it's true that numbers speak, at the time a value investor would indeed have had reason to be afraid.
But let's bring some order to it.
Here's a TLDR: from 2019 to 2023, revenue and EPS collapsed, and total debt doubled with the FOX acquisition; cash burn increased steadily, and no new cash was being generated. ROIC fell below WACC, weighed down by macro conditions. The market fled from DIS stock.
Now it's worth taking a look at these indicators: Net income grew by 111% in 2024 year-over-year, and TTM results already show a 411% increase. The CFO is breathing again, up 41% YoY, confirming a significant upward trend also in FCF, both levered and unlevered grew by nearly 30%. All three business segments are recovering, but what I liked the most was the strong rebound in the entertainment segment, with income up 171%. A major contributor to this was the reduced loss in the DTC segment.
The DTC segment has reached breakeven; and if it were to maintain its current margins, there would be a potential operating margin of 5.5% (considering $336 million in operating income on $6.118 billion in revenue), even though this projection is not confirmed by the guidance. Considering the negative role it has played in DIS's financials over the past years, in my view a new scenario is opening up for Disney, one that the market may begin to price in.
The operating margin of the DTC segment in the 10-K was 142/22,776, approximately 0.63%; while in the FY2024 10-Q, it stands at 5.5%. And I ask myself: if we extend the time horizon to 10 years, is it really unreasonable to assume that DIS could maintain the FY24 Q1 operating margin? In my view, not at all, especially considering that Netflix operating margin is around 20%.
And this is feasible given that Disney has one of the strongest MOATs in the entertainment landscape: the Disney Characters. Animated characters don't age and don't renegotiate contracts, leveraging a cross-generational appeal that remains valid for decades (natural loyalty), which other platforms don't have. And with the expansion of its IP base through Pixar, Marvel, Lucasfilm, and 20th Century Fox, Disney will be able to keep its MOAT alive over the years, while also reducing competition in other sub-markets (like live-action).
And this translates into the numbers through improved pricing power: it's no coincidence that the increase in prices (ARPU) and advertising revenues have driven the recovery of the DTC segment.
So, what would a 5.5% operating margin contribute to DIS's overall EPS?
Projecting the $6,118 million from the 10-Q across four quarters gives $24,472 million in annual revenue. At a 5.5% margin, that's about $1,346 million in operating income. Assuming only 26% of that becomes net income (as per total estimates), we get $350 million in incremental net profit.
Considering that $4,972 million was reported in 2024, the DTC segment alone would generate a 7% increase in total net income. And this doesn't even factor in potential positive impacts on the other two segments, Experience and ESPN.
But we can take it a step further: the FCF/Net Income ratio is about 1.5x.
So the EPS increase generated by the DTC segment would translate into an incremental FCF of 7% 1.5 = 10.5%. This is the real reason why it might become attractive again to value investors.
Over the past 10 years, FCF growth has been around 5%, but if that's the case, it wouldn't be so far-fetched to imagine it rising to at least 1015%, especially considering that entertainment is Disney's least capex-heavy segment (only 18% of the entertainment segment's FCO went into CAPEX, according to the latest 10-K).
We now have the data to build a solid valuation section: If we assume that the DTC segment continues to contribute positively to FCF, and we apply an FCF/Net Income ratio of 1.5x, the EPS growth rate would reach 10% (i.e., 15% FCF growth 1.5).
With a 10-year time horizon, that results in EPS10Y = 3.06 (1 + 0.10)? = 7.94 dollars. So, the forward P/E at 10 years would be 14x. Attractive.
Using a simple DCF calculator from GuruFocus, I get a margin of safety of 33% with an 8% WACC, based on 10-year adjusted assumptions and an optimistic FCF growth rate of 15% over the next decade.
Keeping the WACC fixed at 8%, which I consider reasonable, but lowering the FCF growth rate to a more conservative 10%, the model still yields a margin of safety of 5.78%.
Would Buffett and Munger see more clarity in today's Disney? And would the mini Buffett be justified in holding it? In my opinion, Munger would disagree. To prove it, I refer to the Discovery case, appreciated by Munger because it lacked live-action content; a component that in theory represents Disney's MOAT.
And that's a problem because it would erode the compounding effect generated by cash flows from the DTC segment, the very engine that supports my thesis.
To quantify the risk, I follow an unorthodox but practical method, the Star Wars method: compared to Star Wars: Episode VII, the average budget for the following two films increased by +29%, while ROI dropped from 8x to 4x (from the reading of box office data).
Film
Budget
WW Box Office
ROI
Episode VII (2015)
$245M
$2.07B
8.4x
Episode VIII (2017)
$317M
$1.33B
4.2x
Episode IX (2019)
$275M
$1.08B
3.9x
This is a pattern not seen in other animated series, like the classic Toy Story, which maintained a ROI close to 5x with more linear budgets.
While I recognize this doesn't depend solely on actor costs, on average, live-action films tend to see production costs increase progressively by around 20% (in line with these figures), and this directly impacts ROI.
What if this cancels out the incremental EPS growth estimated for the DTC segment?
In that case, EPS would grow by only +4.18% over the next 10 years.
As a result, the forward P/E at 10 years would be 25x,which would be excessive, even compared to today's forward P/E distribution.
In essence, the price would become congested. And that's a risk.
I find it fascinating to see how Disney's management has been able to navigate the complications that emerged after 2019. And although the market hasn't fully caught on yet, the financials clearly reflect this recovery, and between the lines, a segment emerges: DTC. This could become the engine for a new level of cash generation and profit.
With the right time horizon, Disney's unmistakable MOAT, which I identify in the Disney Characters, will once again play a decisive role, and in my view, DIS stock prices will have to adjust to these new prospects.
This article first appeared on GuruFocus.
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