(Note: This article was in the newsletter on August 11, 2022.)
Disney (NYSE:DIS) posted a beat which made the market happy. Then again, making the market happy is all about controlling market expectations. Many times, the market reacts to a “beat” or a “miss” that really is not all that material to the long-term picture. In this case, no matter what the market thought, the company recovery from the shutdowns of fiscal year 2020, as well as the aftereffects, ensured a positive earnings comparison. It would have taken a major malfunction for a negative comparison.
But long term, shareholders really want to know how the company will handle the continuing decline of legacy operations combined with new forms of obtaining news and entertainments. Probably the best answer here is that the company, like many, is watching consumers for the answer. Now maybe Mr. Market would like something more definite. But Mr. Market would also run for the exits if that definite answer was incorrect. It is, therefore, just possible, that keeping one’s options open is the best answer at the current time.
The streaming market, in particular, is fairly young without much of a history. So, the future possibilities are wide open. My own opinion is that something like cable that has packages of lots of programming will eventually develop in streaming. I think we are seeing the beginning of that now. But for the time being, traditional television and cable are seen as legacy services that are in decline mode.
Third Quarter Results
With all those considerations in mind, Disney had a nice recovery quarter. Earnings topped considerations. But management noted that cash was still being spent on the ramp-up from the shut-down period. Therefore, there was an implication that free cash flow was nothing close to what it should be. Free cash flow did turn positive (as management defines it). But management is looking for much better numbers in the future.
Still, the cash flow statement revealed that management was beginning to repay debt with the sizable cash balance. That should indicate some confidence in the future that was clearly not there during the shutdown period.
There were a lot of companies that raised the cash balance by raising debt because of the unknowns at the time of the coronavirus demand destruction. Now, some of those companies, like Disney are cautiously beginning to unwind that situation while keeping a wary eye on the future. China is one country that is not done with shutdowns. Therefore, management is being very cautious about returning cash and debt to “normal levels”.
Management noted that the streaming future is looking fairly bright for the company. Some will note that the company lost a considerable amount of money. But then again, this company is getting to where competitors like Netflix (NFLX) are in considerably less time.
Many forget that Netflix reported losses and to this day reports woeful cash flow from streaming.
Notice that free cash flow again practically dried up in the second quarter. There have been hopes that the company would show $1 billion in free cash flow this year. But that is a paltry target for a company with enterprise value that floats considerably above $150 billion. Basically, the free cash flow target was met with the first quarter of the fiscal year. In the future, cash flow is going to have to improve a whole lot.
The same goes for management’s assertion of self-funding. This big company, for the time it has been public, should be generating profits to return to shareholders. Clearly that has yet to happen. Some would argue that it all goes to growth. But supposedly the growth will be about 1 million new subscribers in the third quarter. This whole year has so far been a growth disappointment.
Disney reported far more robust growth figures for its streaming. It also reported a robust loss for the division.
There is a cost to fast growth. Management appears to be dealing with the situation. What some fail to remember is that pioneers like Netflix also had their initial investment in the business as well. The business itself appears to be firmly established enough that management now is comfortable increasing the income. How well that works is another matter. But one of the advantages of following a pioneer into a new business is that a lot of the initial guesswork now has more certainty. Market testing is easier and predictable to an extent it is not when the first company tries that business.
The other thing to consider is that Disney will have the cash generated by other divisions once the ramp-up is complete to help establish the streaming business. An established company like Disney will typically generate billions of free cash flow (note that the last few years were anything but typical) that a company like Netflix does not have.
Also, a factor in the discussion came out in the second quarter management discussion of Warner Bros. Discovery (WBD):
Our objective was not only to be one of the top global streaming companies, but also a media company able to drive financial returns by distributing our content on every platform, and our conviction has not changed.
The quote above from David Zaslav, President and CEO, is a different take on the purpose and strategy for streaming than one often hears. He views streaming as a delivery tool similar to a television set. So as long as a delivery system works, he is flexible enough to want to be one of the top entities for that delivery system. But he is flexible enough to realize that these systems come and go. So, it is better to treat it as one vehicle rather than streaming being “the way to go” for the future so that other possibilities could be ignored until it is too late.
This line of thinking is similar to viewing Amazon (AMZN) as yet another sales channel for the retail group to use along with buildings. It may or may not replace buildings in the future. But the key is to be flexible to use it for maximum benefits along with all the other methods retail uses to sell products (as opposed to internet selling or bust type attitude).
Disney posted essentially a decent recovery quarter. Mr. Market has posted the typical overreaction in a positive direction. So, the very immediate future is likely to show some retracement of the earnings announcement news reaction.
But Disney management clearly intends to do more than just recover from the fiscal year 2020 challenges. Maybe the streaming future of the company has yet to be defined in a way that Warner Brothers Discovery management has defined it. But that can be an advantage in that management has left open some flexibility to deal with a still unfolding future.
Clearly Disney has some legacy businesses that either will not exist in the future or will be present in a very different form. Any business has to constantly evolve to survive. It is also clear that this business has some tremendous assets that form a competitive moat to reduce future risk that other competitors do not have.
Those who believe that the management will continue to deal with the future as the challenges unfold can invest in a company with a storied history that few can match. The CEO is relatively new to the job. For some that would involve a risk that they may consider unacceptable. But Disney management in general has depth and experience that few competitors can match. It will not take much for the current CEO to keep the company on a reasonable growth pathway.