Disney Cable Networks Post Strong Earnings

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Walt Disney generated strong sales and profitability in its fiscal third quarter. The shares are fairly valued, trading just 17 times our fiscal 2014 earnings per share estimate, as the stock has run from $48 to $65 so far in 2013. The Lone Ranger movie write-down of $160 million-$190 million is getting headlines today, but for investors it just shows the hit-or-miss nature of the film business.

Overall sales increased 4% and segment operating margins declined 80 basis points to 26.9% versus the year-ago quarter, as a drop in profitability at the movie and consumer products segments offset margin expansion at the cable networks. The parks business continued to hum along, with 7% sales growth driven by pricing increases and slight attendance growth. Parks margins reached 18.7%, up 40 basis points. The movie studio suffered a 2% revenue decline as Iron Man 3 generated $1.2 billion at the box office versus $1.5 billion for The Avengers in the year-ago quarter. Most media companies wish they had this problem. The write-down of The Lone Ranger is a disappointment, but given the franchise power that now includes Star Wars, this will be a blip on the screen for investors with a long-term perspective.

Affiliate fee growth at the cable networks was in the high single digits, boosted 2% by a pull-forward of fees from the fourth quarter. Ad sales at ESPN were up only 3%, dragged down by weaker ratings related to fewer NBA games versus the prior year and weaker NBA audience ratings. On a trailing 12-month basis, the cable networks achieved operating margins of 42.6%, a high-water mark even when adjusting for the shift in recognition of affiliate fees pulled ahead from the fourth quarter.

There is chatter in the market about margin pressure at ESPN in 2014 and 2015 based on sports rights fees increasing for NFL, MLB, and college football playoffs. We agree there is potential for some pressure on record-high margins, especially if the roughly 30% of ad revenue at ESPN is soft in any quarter over the next 18 months, but we’d view this as a temporary issue, and any market overreaction would present a chance to buy a great business at a better price.

We are likely to hear a lot of buzz about Fox Sports 1 at the Fox investor day tomorrow, which we will attend. From Disney’s perspective, we believe there is an enormous gap for News Corp. to overcome, as several News Corp. executives have admitted. Most of the key sports rights are locked up into the next decade, with the NBA national package as the main exception–ESPN is sharing these rights with TNT through the 2015 season. There will be competition for these NBA rights, but we believe ESPN is the most equipped to pay up, given its pricing power and huge revenue pool relative to Fox Sports 1.

Initially, Fox Sports 1 will have limited sports programming, which will consist of college football and basketball (mainly Pac-12 and Big 12 games), MLB (games on 26 Saturdays starting in 2014), a limited number of Nascar races, UFC fights, and FIFA/World Cup rights starting in 2015. Clearly, NFL programming is a major hole in this lineup, and with most of the rights unavailable over the next eight years, paying up for a Thursday night package (now shown on NFL Network) is the only way to add NFL games for the foreseeable future.

The pay TV distributors have longed for a second option to carrying ESPN and its sister channels, but we believe Fox Sports 1 will become an additional channel they are “forced” to carry at a rumored price of $1 per subscriber per month. Still, we find it interesting that Disney has renegotiated its affiliate deals without any public resistance (unlike the current situation between CBS and Time Warner Cable) over the past two years, despite the expense monthly cost. Investors believe ESPN will remain the dominant national sports channel in the U.S. and is more than capable of entering a bidding war for key programming if it needs to in the future.

 

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