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S&P says the media and entertainment giant has several catalysts for growth and a solid balance sheet, and rates the shares a strong buy
From Standard & Poor's Equity ResearchWith a collection of strong media and entertainment brands, we expect Walt Disney (DIS; recent price, $36) to further benefit from continued underlying momentum in its core businesses.
In our view, the major catalysts will include continued healthy attendance and guest spending at its theme parks and resorts; improved profitability at the ABC network reflecting an impressive ratings turnaround in the past two years; continued strong performance of the ESPN cable networks; steadier financial contributions from the filmed entertainment segment, aided by the Pixar acquisition; and rapidly growing digital revenues, as management aggressively seeks opportunities to monetize its vast content base across newer media platforms.
We believe Disney has one of the strongest balance sheets in the entire media and entertainment industry—with its solid financial profile likely to be further enhanced by a pending divestiture of its noncore ABC Radio business. This should enable management to maintain what we view as an aggressive pace of stock buybacks, and potentially allow for further increases in the recurring modest annual dividends. We believe the shares offer compelling value at their present levels, and rank them 5 STARS (strong buy).
Disney's business strategy feeds a virtuous cycle of content creation that, with relatively minimal incremental costs, allows it to leverage its premier media and entertainment franchises across multiple platforms.
Disney is organized into four operating segments. Representing arguably the company's best-known assets, the Theme Parks and Resorts segment (29% of fiscal 2006—Sept.—revenues) includes the Disney World and Disneyland parks in Orlando and Anaheim, Calif., respectively; Disney Cruise Line; Euro Disney, Paris (39% owned); and Hong Kong Disneyland (43% owned). This segment also includes Tokyo Disney Resort (for which the company earns royalties), Walt Disney Imagineering, and ESPN Zone (sports-themed dining).
Aided by new attractions on the heels of well-received promotions, Disney's worldwide theme parks and resorts have also seen a sustained improvement in attendance at the flagship U.S. destinations, which should further drive operating leverage in the high fixed-cost business. We are encouraged by signs of improved trends at Euro Disney in Paris, although there have been some operating challenges at the newly opened Hong Kong Disneyland.
Production and Syndication
The Media Networks segment (43% of revenues) includes broadcast properties such as the ABC TV network, ESPN Radio Network, Radio Disney Network, and 10 TV stations. The cable networks include ESPN (80% owned)—with spin-offs and brand extensions such as ESPN2, ESPN Classic, ESPNEWS, ESPN Deportes, ESPNU, ESPN HD, ESPN Radio, and ESPN The Magazine. Other cable networks include The Disney Channel (U.S. and International), ABC Family, Toon Disney, SOAPnet, Lifetime (50%) and A&E (37.5%).
This segment also includes TV production and syndication businesses (branded Buena Vista, Touchstone, and Walt Disney TV), as well as Internet and mobile properties including ABC.com, ABCNews.com, Disney.com, ESPN.com, ESPN360, and Mobile ESPN. In February, Disney agreed to merge its ABC Radio business, consisting of 22 radio stations and the ABC Radio Network, with Citadel Broadcasting (CDL).
With continued strong ratings, we expect the company to further benefit from its leading array of cyclical advertising-dependent Media Networks brands such as ABC, which has recently spawned several hit shows with potentially significant medium-term upside, and ESPN, which has secured a steady base of dual-stream affiliate fees through long-term carriage deals with multichannel video distributors.
And Pixar, Too
We expect near-term results to benefit from continued strong advertising revenues at the ESPN and increasingly profitable ABC networks, and worldwide affiliate growth at the ESPN and Disney Channel networks—despite potentially higher programming costs on ESPN's professional sports contract with the NFL. We also see a continued ramp-up of worldwide TV licensing and syndication revenues, on the strength of hit prime-time shows such as Desperate Housewives, Grey's Anatomy, and Lost.
The Studio Entertainment segment (21% of revenues) includes the motion-picture studios (branded Walt Disney Pictures, Touchstone Pictures, Miramax), home entertainment businesses, as well as TV distribution businesses (Walt Disney, Buena Vista). In May, 2006, Disney acquired Pixar Animation, a maker of computer-generated imaging (CGI) films, now also a part of this segment, which also includes the Buena Vista Music and Buena Vista Theatrical groups.
With a stellar track record in feature film animation—most recently with Cars—the Pixar acquisition should provide a longer-term boost to Disney's filmed entertainment division, which increasingly should reap the benefits of a major restructuring initiative, in our view. Meanwhile, the live-action film slate has been anchored by record box-office performance and DVD shipments of the Pirates of the Caribbean franchise, the third installment of which is set for theatrical release this spring.
Reaping Restructuring Benefits
We expect the Studio Entertainment division to further benefit from solid DVD shipments of Cars and The Little Mermaid, and perhaps most notably, the second installment of the Pirates of the Caribbean franchise, which recently broke several box-office records. On top of this spring's third Pirates installment, we also see a healthy slate of upcoming theatrical releases—including family-oriented titles such as Pixar's Ratatouille and Toy Story 3, and Disney's Meet the Robinsons—which will likely spawn healthy merchandise licensing.
In addition, we believe the studio should also increasingly reap the potential benefits of a recent major restructuring initiative, which resulted in head-count reductions and a dramatically reduced slate of annual releases in favor of Disney-branded films. However, we expect continued investments in video game development and online, mobile and other new media platforms to weigh somewhat on the company's overall results.
Finally, the Consumer Products segment (7% of revenues) includes the worldwide merchandise licensing and children's book publishing businesses, and about 103 Disney retail stores, mainly in Europe. This segment also includes Buena Vista Games, and DisneyShopping.com. In November, 2004, the company sold to Children's Place its Disney store chain in North America, now operated under a licensing arrangement, as are the Disney stores in Japan.
More New Media
Over the medium to longer term, continued selective investments in video game development should also boost the high-margin consumer licensing business. Under Chief Executive Robert Iger, Disney also has been aggressive in exploring avenues to monetize its vast array of branded content across new media platforms, such as Apple's (AAPL) iTunes, Disney Mobile, Disney.com, and ABC.com.
We estimate that total revenues will rise about 8% in fiscal 2007 to approximately $36.9 billion, and, factoring in potentially difficult comparisons for the theme parks and studio segment, a relatively modest 4% in fiscal 2008, to more than $38.4 billion. With a continued ramp-up of new media investments, the company expects to generate approximately $700 million in digital revenues in fiscal 2007, which would represent a 40% year-to-year gain; we see further growth of 30% in fiscal 2008.
We expect Disney to generate consolidated operating income of approximately $6.9 billion in fiscal 2007, and $7.4 billion in fiscal 2008. Consistent with management's guidance of continued double-digit EPS growth, we forecast EPS of $1.83 and $2.06 in fiscal 2007 and fiscal 2008, respectively (each including about 10 cents of option expense).
Road to Repurchasing
In recent years, Disney significantly enhanced its financial flexibility through a sustained debt paydown, which resulted in a stronger investment-grade credit rating. As of Dec. 31, 2006, Disney had a total debt balance of about $12.4 billion, with cash and equivalents of about $2.4 billion. With capital expenditures for the theme parks expected to revert to normalized levels, we project the company to generate more than $9 billion of free cash flow combined over the next two fiscal years.
Disney recently boosted its stock buyback authorization to 400 million shares, and we believe management is well on track to repurchasing, in the near future, all of the nearly 300 million shares issued in connection with the May, 2006, Pixar transaction. We note that about $1.4 billion to $1.65 billion of partial proceeds are expected from the pending divestiture of the company's ABC Radio assets. We believe Disney's improved financial flexibility could also support further increases of over $500 million for the recurring annual dividend.
After adjusting for several off-balance-sheet assets, as well as the ESPN minority interests, our sum-of-the-parts valuation model derives an intrinsic value of $42 based on our fiscal 2007 estimates, and $48 based on fiscal 2008. Our 12-month target price of $45 lies at the midpoint of those two values, suggesting attractive upside at the stock's current level.
After what we view as a meaningful overhaul in recent years, we view Disney's corporate governance practices as generally satisfactory relative to its peers, and to comparably sized broader market constituents—based on key criteria such as board issues, audit practices, takeover defenses, and compensation/ownership. The board is currently composed of 12 directors, with a majority of independent directors as defined under the New York Stock Exchange (NYX) regulations, and four standing committees, namely audit, compensation governance and nominating, and executive. The board is presided over by nonexecutive Chairman John Pepper (since January, 2007), while Iger assumed the CEO position relinquished by Michael Eisner in October, 2005.
In April, 2007, amid a government inquiry into certain options grants made to Pixar executives, Disney disclosed that it could have to pay about $33.5 million to rectify improper backdating of options valued at $323 million. The options were granted by Pixar since 1997, but before the acquisition of Pixar by the company.
However, the company earlier said its probe found that no one currently associated with the company—including current Disney director/largest shareholder and former Pixar CEO Steve Jobs—had engaged in deliberate misconduct. We view the financial impact of this disclosure as relatively immaterial, and do not believe the company otherwise faces further regulatory scrutiny as a result of this development.
We see a number of risks to our investment recommendation and target price. First, with a relatively significant exposure to advertising-dependent businesses, the company could be adversely affected by a cyclical economic downturn, or by a ratings decline at ABC or ESPN. In addition, a sharp drop in consumer confidence and discretionary spending will likely adversely affect attendance levels at the worldwide theme parks, as would heightened geopolitical anxieties and terrorist attacks.
Further, the company's earnings and free cash flow could also fluctuate with the inherent volatility of studio entertainment results. As a content-oriented company, a lack of vertical integration could also make the company somewhat vulnerable in long-term carriage negotiations with highly consolidated multichannel video distributors.
We also see potential risk factors related to corporate governance issues, including, but not limited to, stock options practices. Finally, some of the media-networks businesses may also be exposed to adverse regulatory developments.