(Note: This article originally appeared in the August 11, 2022 newsletter.)
Disney (NYSE: DIS) posted a beat that made the market happy. Again, making the market happy is all about controlling market expectations. Often the market reacts to a “beat” or a “failure” that really isn’t all that material to the long term picture. In this case, whatever the market thinks, the company’s recovery from the fiscal 2020 shutdowns, as well as the aftermath, ensured a positive earnings comparison. It would have taken a major malfunction for a negative comparison.
But in the long term, shareholders really want to know how the company will handle the continued decline of legacy operations combined with new forms of obtaining information and entertainment. The best answer here is probably that the company, like many, is watching consumers to find the answer. Now, maybe Mr. Market would like something more specific. But Mr. Market would also run for exits if that definitive answer was incorrect. So it’s entirely possible that keeping your options open is the best answer right now.
The streaming market, in particular, is fairly young without much history. So the future possibilities are wide open. My own opinion is that something like cable that has lots of programming packages will eventually expand into streaming. I think we are seeing the beginning of it now. But right now, traditional TV and cable are considered declining legacy services.
Third quarter results
With all of these considerations in mind, Disney had a strong recovery quarter. Earnings exceeded considerations. But management noted that the money was still being spent on ramping up the shutdown period. Therefore, there was an implication that free cash flow was far from what it should be. Free cash flow has become positive (as defined by management). But management expects much better numbers in the future.
Still, the cash flow statement revealed that management was beginning to pay down debt with the large cash balance. This should indicate some confidence in the future that was clearly not there during the shutdown period.
There were many companies that increased the cash balance by increasing debt due to the unknowns at the time of the coronavirus demand destruction. Now some of these companies, like Disney, are cautiously beginning to unravel this situation while keeping a cautious eye on the future. China is a country that is not done with closures. Therefore, management is very cautious about returning cash and debt to “normal levels”.
Management noted that the future of streaming looks pretty bright for the company. Some will note that the company lost a considerable amount of money. But again, this company is getting where competitors like Netflix (NFLX) are in a lot less time.
Many forget that Netflix reported losses and reports dismal cash flow from streaming to date.
Note that free cash flow practically dried up again in the second quarter. It was hoped the company would post $1 billion in free cash flow this year. But that’s a paltry goal for a company whose enterprise value is well over $150 billion. Basically, the free cash flow target was met in the first quarter of the fiscal year. Going forward, cash flow will have to improve a lot.
The same applies to management’s assertion of its self-financing. This great company, for the time it is listed on the stock exchange, should generate profits to return to shareholders. Obviously, that hasn’t happened yet. Some would say that it all depends on growth. But supposedly the growth will be around 1 million new subscribers in the third quarter. This whole year so far has been a disappointment when it comes to growth.
Disney announced much more robust growth numbers for its streaming. He also reported a robust loss for the division.
There is a cost to rapid growth. Management seems to be coping with the situation. What some don’t remember is that pioneers like Netflix also had their initial investment in the company. The company itself seems to be established enough that management is now comfortable increasing revenue. How it works is another matter. But one of the benefits of following a trailblazer in a new venture is that much of the initial guesswork now has more certainty. Market testing is easier and more predictable to an extent that is not the case when the first company tries this activity.
The other thing to consider is that Disney will have cash generated from other divisions once the ramp-up is complete to help establish the streaming business. An established company like Disney will typically generate billions in free cash flow (note the past few years have been anything but typical) that a company like Netflix does not.
In addition, a factor in the discussion emerged from the discussion of Warner Bros.’ second quarter management. Discovery (WBD):
Our goal was not only to be one of the world’s leading streaming companies, but also a media company capable of generating financial returns by distributing our content across all platforms, and our belief has not changed.
The above quote from David Zaslav, President and CEO, is a different take on the purpose and strategy of streaming that we often hear. He sees streaming as a broadcast tool similar to a TV. So, as long as a delivery system works, it is flexible enough to want to be one of the main entities of that delivery system. But he’s flexible enough to realize that these systems come and go. So it’s best to treat it as a single vehicle rather than streaming as “the way forward” for the future so that other possibilities can be ignored until it’s too late.
This line of thinking amounts to seeing Amazon (AMZN) as another sales channel that the retail group can use with buildings. It may or may not replace buildings in the future. But the key is to be flexible to use it for maximum benefit with all the other methods retail uses to sell products (as opposed to internet selling or bust type attitude) .
Disney basically posted a decent recovery quarter. Mr. Market displayed the typical overreaction in a positive direction. So, the very immediate future should show some retracement in the reaction to the earnings announcement.
But Disney management clearly intends to do more than just recover from the challenges of fiscal 2020. Perhaps the company’s streaming future has yet to be defined in the way that the management of Warner Brothers Discovery defined it. But that can be an advantage in that the management has left some flexibility to deal with a future that is still in the making.
It’s clear that Disney has legacy businesses that either won’t exist in the future or will be present in a very different form. Any business must constantly evolve to survive. It is also clear that this company has considerable assets that form a competitive gap to reduce future risks that other competitors do not have.
Those who believe that management will continue to face the future as challenges arise can invest in a company with a rich history that few can match. The CEO is relatively new to the job. For some, this would involve a risk that they might consider unacceptable. But Disney’s management in general has a depth and experience that few competitors can match. It won’t take much for the current CEO to keep the company on a reasonable growth path.