Disney Stock: Great Returns Ahead (NYSE:DIS)

Investment Thesis

The Walt Disney Company (NYSE:DIS) is an exceptional business with a long history of profitability and a durable economic moat. The brand name is beyond strong, and the Disney+ streaming aspect of the business is now being discounted by the market as hype is exiting the room on the back of Netflix’s (NFLX) slowing subscriber growth. Parks and cruises are also expected to take a hit, with a new strain of the Omicron coronavirus tamping down demand. Disney’s dividend was also cut during the worst months of the COVID-19 pandemic, but over time this should be reinstated and long-term holders will be rewarded handsomely.

With a return to normalized profit margins in the future, the stock represents at least 70% upside from current levels, if not more. The economic moat is wide, and revenues for the company have been strong over the last six months, showing that growth can continue even in uncertain times. However, the operating margins are the biggest issue for Disney, not revenue growth. With an economic recession just around the corner and a new strain of COVID, nobody knows just how bad things will get. Long-term, a reversion to the mean of around 20% operating margins could make Disney worth almost double what it is currently trading for today.

Dividends: When Will They Return?

Disney cut their dividend during the pandemic as operating expenses mounted and parks/cruise revenues slipped. The reinstating of the dividend will undoubtedly be a bullish catalyst that many are looking forward to. The big question is – when exactly will the dividends for shareholders return?

While market participants hate when dividends are cut, this was actually a smart move by Disney’s management at the time. The big push into streaming required a lot of capital, and Disney was able to use money from cutting the dividend to make a splash in the streaming industry. It is likely that dividends will not be reinstated until after the streaming expansion is concluded, which may take at least one to two years.

Depending on how you feel about dividends, this stock may not be for you. If you are a dividend investor who is interested in a stable blue-chip company, then there are other large alternatives, such as Verizon (VZ). Disney never had the best track record when it comes to paying dividends, and some of the best companies do not pay a dividend at all, reinvesting cash flows back into the businesses and/or buying back shares. This also is beneficial for investors when it comes to paying taxes. Berkshire Hathaway (BRK.A) (BRK.B) is an excellent example of this, as the giant invests in itself instead of paying out to shareholders. I personally see this as a better use of capital, but Disney may decide in the future that the dividend is worth reinstating. When that day comes, I would expect the market to react positively to the news.

The Streaming Wars – Netflix Vs. Disney+

Streaming is an interesting (relatively) new aspect of the Disney empire, which will position the company to maintain a top three spot into the future. Disney has decades and decades of content already, with no need to spend exorbitantly on creating new content. Disney is spending around $2 billion on new content creation, which may seem like a lot. However, compare this to Netflix, which is increasing its spend from $17 billion to $18 billion on new content this year, at the same time that subscriber growth is beginning to slow.

This is causing Netflix to raise prices on subscriptions, and Disney+ has also won analyst approval for an ad-based plan in an effort to further monetize the platform. It is likely that many customers will choose the cheaper, ad-based plan for Disney+ during recessionary times, rather than paying up for Netflix. While Netflix has some compelling content that is making huge cultural impact (Stranger Things, Squid Game, Etc.) the content library at Disney is unmatched, and the company arguably has more intangible assets than any other on the planet.

In the long-term, it is highly likely that there will be a consolidation of the many streaming services that now exist. I see Disney as being a winner of the so-called ‘Streaming Wars’ due to generational trends and the vast content library. Hulu, and services like ESPN, which the company is reportedly no longer planning to spin-off, also add to the domination of the streaming landscape. While Netflix is certainly compelling for a long-term investment at the current prices, Disney is a better value when looking at book value metrics.

Disney trades at 1.6x book value, while Netflix trades at 4.4x. This is simply one metric to look at, and could be somewhat skewed because of Disney’s intangible assets and Netflix’s asset-light business model. However, when looking at Price-to-Sales ratios, Disney also seems cheaper, with a P/S ratio of 2.2 compared with Netflix’s at 2.5. Earnings are a whole other story, and as of now, in my opinion it is too early to tell where Disney’s earnings will end up in the near-term. While EPS has indeed grown substantially over the last six months, the next six months are highly uncertain, which is a huge risk for shareholders that market participants should be aware of.

Disney’s Earnings Power, Margin Expansion

Disney has much upside in the long-term, as the company’s free cash flows and Direct-to-Consumer business can improve. In 2018, Disney had record EPS with free cash flows of over $9 billion. The next year, earnings growth fell by 20% and the merger caused the cash flows to fall substantially. In 2020, when COVID-19 rocked the entire world, cash flows continued to struggle and have not made a meaningful rebound yet.

Revenue growth continued to accelerate, however, and the market is seemingly focusing too much on politics, the virus, and many other short-term headwinds that continue to push Disney’s share price lower. The earnings power of Disney going forward has the potential to become really great, like it once was during the 2010s. With an operating margin expansion back to normalized levels of around 18-23%, the stock could boom once more.

Margins are expected to more than triple from the current 5.4% over the next several years, which means that cash flows could increase by many billions of dollars. This would cause Disney’s free cash flow to somewhat resemble what it was in 2018, and lead to massive earnings growth ahead. Of course, this is a scenario that is not set in stone, as there is much uncertainty in the market right now with growth prospects for parks, cruises, and DTC profitability in question. This is the risk/reward of Disney, and whether it has a place in your portfolio compared with better alternatives.

100 More Years

Disney has been in business nearly 100 years, which is an amazing feat and not many companies in the entire market can compare. I expect that Disney’s superb economic moat can keep it in business for another 100 years, assuming that it becomes the winner of the ‘Streaming Wars’ and that the brand image holds up over the extremely long-term. The company has a long history of profitability, and with cash flows set to rebound, the direct-to-consumer business becoming more profitable over time, and the gradual normalization of COVID-19, the stock is set to soar once again.

While there is a possibility of 70% upside or more in the short-term, there is no telling how much upside there is over a decade long holding period or even multi-decade. Disney is one of the best “buy-and-hold forever” stocks in the market right now, with a durable moat and blue-chip status. Debt is also another risk to keep in mind, but even $50 billion of debt is manageable for the company over the long-term with cash flows rebounding to their former glory. Disney is unfortunately not what I would call a value investment at current prices, considering the debt level, but a drop in share price to the $75 or $80 level would give more of a margin of safety to long-term investors.

At current prices, my opinion is that the stock is a Buy if taking an extremely long-term view. The short-term will be a bumpy ride, but averaging into a position as the stock drops would be advantageous.

Conclusion

Disney represents great value compared to peers, not only on price-to-book value metrics but also price-to-sales metrics. The dividend is something to keep in mind, as when this is reinstated, the market will likely reward shareholders and sentiment will improve. The streaming aspect of the business is compelling and Disney will be a top three, if not the unequivocal winner in the category, as the content library is rich and the company can spend less on new content than counterparts, such as Netflix. Disney’s earnings power is something that is being overlooked by the market, and free cash flow potential as well. With operating margins normalizing over time at around 20%, the stock could really boom coming out of the COVID-19 pandemic, which is currently seeing a resurgence of the new Omicron strain. I currently view Disney as a Buy, but would be cognizant of the risks involved regarding the company’s debt.