Revisiting The 80/20 Rule - Disney and 21st Century Fox

GuruFocus.com
0

- By The Science of Hitting

I wrote an article back in 2013 titled, "The 80/20 Rule - Disney & Microsoft." The meat of the article was built around this comment from Bill Nygren (Trades, Portfolio) of the Oakmark Funds:



"A situation we like is when we think investors are applying the 80-20 rule inaccurately; 80% of their attention is on 20% of the business value. And that was a situation that we saw at Disney (DIS) where theme park attendance had been down a little bit, and almost everything that was written about the company was about the outlook for theme parks and how that was likely to change over upcoming years.

When we looked at business value, the cable networks that the company owned - ESPN and the Disney Channel along with some other lesser networks - we thought they were at least 80% of the value of the company. We believe the price we were paying was less than the cable networks alone, and with that focus we didn't have to spend that much time worrying about whether next year's traffic at the theme parks was going to be up or down a little bit."



A lot has changed since then. Today, the theme park business (Parks & Resorts) that people were concerned about is booming. On the other hand, investor worries have shifted to the Media Networks business (and specifically ESPN). At first glance, it seems reasonable that the investment community is now focused on the larger piece of the pie (as Nygren suggested they should be). However, I think they may have narrowed their sights too far - and missed some key developments in the story.

First off, Media Networks isn't nearly as important to Disney's bottom line as it used to be. Between 2009 and 2012, Media Networks consistently accounted for 75-80% of Disney's operating income. But that has changed in a big way as of late, largely due to significant earnings growth for the Studio Entertainment segment (roughly tripled since 2012) and the Parks & Resorts segment (roughly doubled since 2012). As a result, the Media Networks segment accounted for less than half of Disney's operating profits in fiscal 2017. This number took another step lower in the most recent quarter (to roughly 30% of profits). Clearly the business mix has shifted in a big way.

Second, I think the market is largely overlooking the future impact of a lower tax rate on Disney's bottom line. Over the past five years, Disney has consistently paid an all-in effective tax rate of 35% or more. As noted by CFO Christine McCarthy, that will meaningfully change going forward:

"As I mentioned earlier, our applicable federal statutory tax rate is 24.5% for fiscal 2018. For future years, the federal tax rate will be 21%. In recent years, our effective tax rate has closely mirrored the statutory rate, and we continue to expect that to be the case going forward."

If you believe Disney will retain the vast majority of the ongoing benefit from the lower effective tax rate (as I do), the only argument that makes sense for the lackluster stock price is that Mr. Market became much more negative about Disney's future prospects over the past three to six months. If that's the case, I'm not sure why; personally, I haven't seen much to support that conclusion.

Finally, I think the 21st Century Fox (FOXA) deal, among other recent decisions, suggests Disney is back on offense. If approved, this deal will significantly enhance the company's ability to go direct to consumer (DTC). It's less certain how this will impact financial results in the short-term (the next few years), but I think this is a sound strategic decision for the long-term (you could probably argue that some market participants are worried about the short-term impact to earnings per share of decisions like ramping investments at Hulu, even if it's beneficial to the long-term value of the business).

Conclusion

By my math, EPS should increase by 20% or so in fiscal 2018, approaching $7 per share. As noted above, that's with an effective tax rate of 24.5%. We should see another 5% bump in fiscal 2019 as the tax rate falls to around 21% (that assumes no improvement in the underlying results). Without any heroic assumptions, I think earnings per share for fiscal 2018 will end up around $7.50 to $8.00 per share (that's a rough estimate). By the way, the company is buying back stock hand over fist, with the number of outstanding shares falling more than 5% in the first quarter of fiscal 2018.

Here's another way of looking at this: Disney traded at more than 20x forward earnings when it was approaching $120 in July 2015. Today, at $106 per share, the stock trades for roughly 15x forward earnings. That significant multiple compression has happened in the middle of a surging bull market (the S&P 500 is up 30% since July 2015, compared to a negative 10% return for DIS).

Much like Bill Nygren (Trades, Portfolio) did back in 2012, let's try to look at the question differently.

Forget about ESPN and the Media Networks segment for a minute. What is Parks & Resorts worth? Segment earnings were $3.8 billion last year and increased 21% in the first quarter of fiscal 2018. After looking at the past decade's financial results and thinking about what's included in here, does this business segment really deserve to trade at a meaningful discount to the market?

Same question for the company's Studio Entertainment business, which reported $7 billion in cumulative segment profits over the past three years. What's the long-term value of Lucasfilm, Marvel and Pixar? If recent results are any indication, these brands are as valuable as they've ever been; they're producing high-quality content that is highly sought by millions of consumers (and, as a result, dominating the box office). The early results suggest that "Black Panther" (out in a few weeks) will continue this trend: Ticket presales are outpacing every other superhero movie ever made.

If you go through that exercise for the other segments, I think you'll see that Mr. Market has been slow to update his views of the company. He's too focused on just one slice of the pie (ESPN in particular). I think that's a mistake - and an attractive opportunity for long-term investors.

My preferred route to Disney (so far) has been through ownership of shares in 21st Century Fox. Assuming the deal goes through, you will receive 0.2745 shares of Disney for each share of Fox that you own. At the current stock price of $106 per share, that's $29 per share of market value (I think the intrinsic value is a few dollars higher). The stub you're left with - "New Fox" - should generate more than $1 per share of FCF. With Fox at $37 per share, that stub is effectively trading at 7x or 8x free cash flow. Based on the quality of the assets, I don't think that valuation makes sense.

I expect an investment directly in Disney or indirectly through Fox to work out well over time.

Disclosure: Long MSFT and FOXA.

This article first appeared on GuruFocus.


Advertisement

Recommended Stories