Will this Disney (DIS) quarter be the one that will be remembered for hitting the dreaded "delta?"
I am talking about the fourth letter of the Greek alphabet, which stands for change of any changeable commodity and it's a curse word when it comes to the analysts who cover Disney. This is because of the negative rate of change of the fortunes of the honey pot ESPN, and it was invoked loud and clear on last night's conference call. It's why Disney fell in after-hours trading and remains down today.
The delta's usually spoken about in hushed terms, and never right to the face of CEO Bob Iger. But this quarter was different, and it hit you like a two-by-four in the conference call. Sure, this quarter Disney went all into streaming platforms. Yes, we all now know about the big news of the $1 billion paid for one third of the outfit owned by Major League Baseball, known as BAMTech, where sports content currently not on ESPN but bought and paid for by Disney already will soon appear in an à la carte pay-as-you go method. That will give ESPN more monetization, which it apparently so desperately needs to change the delta.
But it's Disney's loud and clear involvement in two large non-traditional cable entities, Hulu and Direct TV, which broke the taboo. And it was Alexia Quadrani from JP Morgan who did the breaking, with this verbatim quote off the call: "first, with two of the bigger kind of streaming platforms launching over the next sort of six or so months, DTV and Hulu, and Disney's presence in both those packages, Bob (CEO Bob Iger) do you think this could become the delta that investors maybe are looking toward, or are worried about (emphasis mine) in terms of creating a more notable shift away from linear TV or the traditional bundle?"
I thought Iger deftly handled the whole exchange, pointing out that when companies have tried to do skinny bundles without ESPN they haven't worked. He made clear that the more places you can get ESPN, the more money that can be made. Call it the "more the merrier" mantra. He followed that up in his interview with CNBC, where he said BAMTech would "jumpstart" ESPN's numbers. As long as Disney is out there with ESPN in many venues, not compromising the deals it offers to major cable companies, venues including skinny Over the Top bundles, Iger believes it's good news for the company, because it is monetizing content that isn't being monetized enough. No cannibalization, just content you haven't seen on ESPN that could be additive to earnings on the key media networks line.
So, in other words, in Iger's world there is no concern about Disney hitting that delta point, where the rate of the change of the decline of traditional subs is so overwhelming that we will pay less for the stock. There's just more opportunity.
The analyst didn't follow up, but the delta question hung there, like some gigantic question mark in a chess game rap. And that holds the key to why the stock is down today, because all of Iger's moves --Hulu, AT&T (T) , BAMTech -- are not perceived to be alleviating the delta.
Why does the delta matter so much?
Because when you sit back and look at this quarter, it was nothing short of magnificent, away from ESPN concerns. Even with a definitive drop again from ESPN on your cable bundle, Disney gave you 12% earnings per share growth, which happens to be the twelfth double-digit earnings per share quarter in a row. That's remarkable.
You had the best box office production ever, with four of the top five films out there being Disney's. The studio made a stunning $766 million in operating profit. With hits like Finding Dory, Captain America, Civil Warm Zootopia, Jungle Book, it has already surpassed fiscal year 2015, and this is only the third quarter of fiscal 2016. Extraordinary.
The parks and resorts numbers are at an all-time high, with an 8% increase in per capita spending and a 400 basis point margin expansion. They are capturing a huge amount of wallet once someone's at the park, an incredible feat of technology and throughput. Disney Shanghai, which just opened, sounds like the smoothest unveiling of any of the major parks and, if anything, it's way ahead of plan. China ahead of anybody's plan's a big deal anymore. And Hong Kong Disney's picking up the pace, a very nice change, especially given that everything else Hong Kong, from Apple (AAPL) phones to gambling, is way, way down year over year.
So what's the deal with the delta then? Why do we care so much? Simple: ESPN is a gigantic part of the Disney pie, and it isn't growing when it comes to new subs; it's shrinking, despite ad revenue from the network being up a nice 5%.
We don't get precise numbers of subs from Disney -- dismaying in itself -- but we sorta, kinda know that we would get them if the delta was changing the right way. It obviously isn't.
The 88.8 million people who we think take ESPN, according to traditional third-party measures (Nielsen data), would seem to be way down from the 100 million ESPN announced back in 2011; that is when they used to announced such things, like the release put out by ESPN MediaZone on the crossing of the millennial sub barrier back on Feb. 1 of that year. Perhaps they wish they had never bothered to celebrate that hundred millionth sub milestone.
Now, we know people can get ESPN in other ways in various streaming services. The new ones, Hulu, DirectTV, and, of course, now BAMTech, can all help increase sub money, or at least obscure a decline if you are cynical about the message. But Nielsen estimates that ESPN lost 3.7 million cable subscribers in the last year, which is quite a hit to the profit line given that, according to SNL Kagan, cable and satellite companies pay Disney $7.21 per monthly sub.
And that's the delta writ large.
Longer term, I think the analysts are looking at the wrong delta. The one I am focused on is the delta that says the media network numbers aren't as important as they were at one point. The problem, though, is the decline in subs is outrunning any efforts away from the traditional bundle to offset it. We are clearly not at my delta yet.
It's all in the numbers in the release. In the quarter just ended, media networks, where ESPN resides, represented $5.9 billion in revenues and $2.3 billion in income. Total revenues are $14.277 billion. So while media networks is a significant piece of the overall revenue pie, it isn't the be-all and end-all of sales.
But profits? A much different and a much more negative story. Media networks were responsible for $2.372 billion of a total of $4.456 billion of segment operating income.
They are the be-all and end-all.
Worse, the media networks' year-over-year numbers are delta-like worrisome, to appropriate the JP Morgan analyst's breaking of the taboo on the conference call. Media networks year over year are up 2% in sales but flat in operating income. Flat equals "ugh".
That means that all of the good news away from media networks -- movies, theme parks -- is still being subsumed by the decline in ESPN subs. So even though Disney has produced 29 films from the acquisitions of Pixar, Marvel Lucas films and Disney Animation houses, 29 films that have each made $800 million, that astonishing amount still can't make a dent on the delta. Theme parks, with their 6% revenue growth and 8% operating income growth, obviously can't obscure the delta either, despite the huge $4.379 billion revenue number. That's because parks and resorts, at $994 million in operating revenue vs. $922 million last year, remains less than half the media network's $2.372 billion in operating income.
Plus, you know these analysts. They are thinking: "is it really possible that Disney can best the 40% increase in movie revenues, from $2.040 billion to $2.847 billion year over year and the year-over -year 62% increase in operating income from $472 million to $766 million in any sustainable fashion? Isn't that slate about as good as it gets? Can the streak of hits possibly continue despite the myriad billion dollar movie franchises? And even if it does, can it ever really offset ESPN cord cutters and alternative vision seekers, given the speed of the decline?"
So, let's put it altogether. The media networks business is still outrageously profitable, stunningly so. It dwarfs the rest of the company. And that's the real issue here. It seems that all of the sound and fury about the over-the-top initiatives and the billion dollar investment in BAM are all about trying somehow, in some way, to make up for the flatness in operating income and the 2% gain in media networks.
Not only can these initiatives not mask the declining sub issue in this quarter; if anything, they shine a light on them in a way that can't take the pressure off a company that's perceived as ESPN plus a bunch of other unimportant line items that most other companies would kill for.
Is that an unfair analysis? Yes if you are Iger, who has worked so hard to diversify from the ESPN pigeon-hole. But we don't care about deserving. We care about empirical evidence of the success of plans to offset the delta, and they aren't there yet.
Now, where do I come out? I am still pretty darned sanguine with another quarter of double-digit profits. I do think there will be a time when the delta will be about the rate of change of analysts recognizing that all of the other divisions do matter as much as ESPN, if not more so.
Nevertheless, I know I am too early to call the bottom in ESPN, even as I know the analysts are too early to call a top in movies and parks. Until the media networks line item sees better than 2% growth in revenues and flat operating income, there will be many an analyst who will say "why should I stick my neck out now and pound the table on a stock where the next quarter may not have the movie schedule that this one has, but the ESPN roll-off will still be relentlessly occurring, maybe at a different pace because of all of the initiatives announced but still not a good one?" As the JP Morgan analyst Quadrani implies: they just call even more attention to the core ESPN problem.
OK, enough bad news. Here's something to think about: you are only paying 16x earnings for Disney's numbers now, down from 20x last year and 20.5x the year before, because of the ESPN drop-off concern.
That's pretty darned reasonable for 12 quarters of double-digit growth.
Yet, here's what the delta people fear: that's about the same price-to-earnings ratio you paid for Disney's stock back when ESPN had 100 million subs less than a half-dozen years ago. How can that PE multiple largesse be justified? It seems too rich to these classic bean counters.
My answer to all this sturm und drang over ESPN: if Disney can monetize more than it currently is, if we will pay more for ESPN on our mobile, if these different over-the-top entities and skinny bundles can even get that media networks revenue line-up even by a couple of percent, then you will wish you bought today.
I think they ultimately can.
But you will have to wait if you buy today because, indeed, there's too much that is operating at full bore and going well that can now slip up and stop obscuring the relatively flat growth from the big kahuna media networks line. The delta will weigh on shares now, and can't be dismissed out of hand. All of that amazing Disney content and intellectual property is no longer king; maybe a rook, or a bishop or even a knight, despite the offense Disney's running.
And sadly, that is still all that matters. At least for now.