Source: Author’s calculations, press statements
Disney’s Q3 2020 results reported negative 42% top line revenue growth rates. For a company that was reporting strong prospects in the second half of 2019, this is more than a slight step back. That’s quite terrifying.
Having said that, there’s a stock market adage that says that if it’s in the headlines, it’s in the stock price too. What investors are presently focused on is a company that is at the epicenter of the COVID-19 disruption.
Investors have long ago been preparing themselves Q3 2020 results, and we can see below that since the trough of March/April, Disney shares have meaningfully recovered to a large extent:
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And what’s particularly telling about Disney is that, despite its operational havoc, the shares have mostly kept up with Netflix (more on this later).
The main idea to keep at the forefront of our discussions is that a lot of negativity has already been priced in.
Thinking Broader, What Else Can Disney Offer? Economy Flywheel
Presently, investors are weighing up the potential reopening of Parks, the slow resumption of sports, and how long until new films are once more being created. And while that makes sense, this is a superficial analysis of the impact Disney is feeling right now.
This superficial analysis gives no weight to how the company is likely to look over the next couple of years. Furthermore, Disney is much more than Parks and Resorts: it is a strong and vibrant brand.
For instance, consider the following – each time Disney releases a title, assuming it does reasonably well with audiences (a meaningful assumption, of course), the company sets up content for strong merchandise sales (Consumer Products) and strengthening the appeal of its Parks and Resorts.
Source: 2019 Disney Operating Income – not including Direct-to-Consumer or eliminations
In the graphic above, I’ve not included Disney’s Direct-to-Consumer segment, which is a loss leader, nor have I included intersegment eliminations.
Above, we can see how the company’s profits were derived from different sources in 2019. I’ve highlighted this to drive home a message: approximately 60% of Disney’s operating profits are all tied off its great content library.
This is somewhat similar to an economic flywheel, where a strong film produced in 2012 (Avengers) can continue to resonate with an audience nearly a decade later, or how a film like Toy Story can also lead to plenty of downstream opportunities.
Incidentally, it’s worth noting that slightly more than a quarter of Disney’s operating profits accounted for in Parks, Experiences, and Products are derived from its very high-profit margins in its Consumer Products business.
The message here is clear: Disney’s strong brands lead to very strong and positive operating leverage.
Valuation – Reasonable Margin of Safety, Hugely Cheaper Than Netflix
Let’s take a step back and think about this investment.
Many investors lay claim to the fact that Disney is over-leveraged with too little space to maneuver. This strikes me as short-sighted.
The company certainly carries a large amount of debt, at roughly $65 billion. Meanwhile, it offsets its debt balance with more than $23 billion of cash and equivalents (as of the end of June).
Put simply, Disney is clearly not burning through that much free cash flow, where its balance sheet is left too exposed. In fact, during its Q3 period which spanned April to June, the period that was most likely as challenging as it is likely to become, the company’s free cash flow was $454 million.
Source: Q3 2020 Press Statement
On the other hand, naysayers can declare that this was a period where Disney cut back on all possible expenditures and that this is not sustainable. And that would be a valid comment, but investors are not truly expecting the present COVID-19 environment to last forever either.
Moving on, Disney is being priced at roughly $225 billion, while Netflix is being priced at roughly the same valuation. Even assuming that Netflix is the default, must-have streaming platform, I cannot see how Disney is being fully priced.
For both Netflix and Disney, making content is incredibly expensive. And while Netflix has gone for a strategy that favors a high-volume library, Disney favors high quality.
Moreover, the biggest advantage that Disney has, as discussed throughout this article, is its economy flywheel, where great shows become great brands, which drives consumers to its Parks and Resorts, as well as additional merchandise sales.
Source: SA Premium Tools
For all intents and purposes, most investors would agree that Disney’s Q3 2020 was as challenging an environment as it was going to get. That sequentially, the company should be marked by steady and consistent improvement.
For its part, Disney is being priced at just 3x sales. Netflix, on the other hand, is being priced at 9x forward sales. How can this large pricing discrepancy between these two content giants be justified?
Disney has fallen out of favor and out of interest with investors. I contend that investors should look beyond headlines that paint a gloomy picture of the company’s long-term prospects.
There’s no rational reason for Disney to be priced for just 3x forward sales when there is so much pent potential in its operations. As soon as the economy starts to reopen slightly more, investors will return to show their interest in Disney, but by then, Disney is very likely to be closer to fully priced.
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Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.