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Can Walt Disney Co (DIS) Stock Continue Its Impressive Rally?

Investors have turned bullish on Walt Disney Co (NYSE:DIS) stock once again. Disney stock has gained more than 15% since it reported an earnings miss on November 10th, almost three times the gain of S&P 500 (INDX:SPAL) which is up by 5.8%. In the same period, the number of shares shorted has declined from 30.71 million to 21.36 million, a decline of more than 30%. Jim Cramer, the host of Mad Money believes that the stock still has a long way to go.

But the recent run-up in the stock price has also increased concerns around Disney’s valuation, especially given the turbulence around ESPN subscriber numbers, which have been consistently declining. ESPN contributes a major chunk of media segment’s revenues, which in turn made up around 42% of Disney’s total revenue in 2016. Concern around ESPN franchise has been the main reason why Walt Disney stock underperformed the market in 2016, in spite of strong performance on revenue and earnings front.

Copyright: blanscape / 123RF Stock Photo

Copyright: blanscape / 123RF Stock Photo

ESPN Worries Continue To Linger

Walt Disney Co (NYSE:DIS) stock was recently downgraded by BMO capital (1) analyst Daniel Salmon from market perform to underperform due to continuing decline in ESPN subscribers. BMO also reduced its price target for the stock from $90 to $88, indicating almost 20% downside from Friday’s close. BMO continues to see the number of subscribers declining for next two years, which will be partially offset by online distribution. To quote Daniel Salmon:

“Sentiment and stock performance has turned positive as investors: 1) feel better about ESPN sub trends after positive comments from management on the last earnings call; and 2) look ahead to a robust F2018 film slate. We think this positive turn comes too early and the risk/reward skews negatively (our target is $88, upside scenario $110, downside is $70). We still see more negative data points than positive for ESPN and believe consensus Studio estimates embed better performance per film, which is a key risk, in our opinion.”

The headwinds facing ESPN were one of the causes for a slight decline in Disney’s revenue growth in 2016. Revenue growth of media division declined from 10% in 2015 to 2% in 2016. However, the fact that media division reported a growth in spite of more than 2 million loss in subscriber base was itself a positive news. Disney was able to grow its media segment revenue by 2% due to higher affiliation fees and advertising. However, the headwinds facing ESPN franchise are likely to abate due to “a) stabilization in pay TV subs driven by new virtual MVPD services and/or (b) traction from the launch of the ESPN OTT service.”.

Very High Expectations From Studios

The sentiment around the House of mouse turned positive after CEO Bob Iger, during the Q4 conference call had stated that “the causes of those losses have abated, notably the migration to smaller packages” and felt “bullish about ESPN’s future”. This has led to investors focusing more on the brighter side of the story, namely, the studio and theme park divisions.

2016 was a great year for studio division. Disney released 13 films in fiscal 2016 for total revenue of about $3.7 billion, or $282 million a film, with four films released last year grossing more than $1 billion. The latest film to gross more than $1 billion was “Rogue One”, a spin-off of the Star Wars saga. Considering that, “Rogue One” was just a spin-off, many investors have higher expectations from the Start Wars Episode VIII.

In fact, investors are expecting the House of Mouse to even surpass last year’s record performance in 2018. Investors are now expecting Disney’s 11 films being released in 2018 to average more than $300 million a film. This high expectation is a potential source of risk for Walt Disney stock. A strong 2018 film lineup resulted in a price target upgrade (2) from Goldman analyst Drew Borst who raised his price target for Disney stock from $109 to $134, an upside of more than 22%.

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Growing Revenues And Strong Balance Sheet

Walt Disney Co (NYSE:DIS) has been consistently growing its revenues and earnings and generating strong cash flows. In spite of the headwinds faced by the media segment, Disney was able to report a revenue growth of 6% in FY 2016, mainly due to the strong performance of studios. Net income grew by 12% while EPS grew by 16% in FY 2016. The strong growth in EPS was facilitated by a variety of factors, including share buybacks, the decline in operating expenses as a percentage of sales and lower tax rate. During FY 2016, the effective tax rate declined from 36.2% to 34.2%, contributing 2% to EPS growth. It is worthwhile to note that, in spite of the decline, Disney’s tax rate remains very high, and is likely to be one of the biggest beneficiaries of the proposed tax restructuring of the Donald Trump administration. Disney’s earnings could rise up by as much as 10%.

Another significant factor which contributed to growth in EPS was Disney’s share buyback program. Disney bought back $7.5 billion of stocks last year, which resulted in an EPS boost of more than 4%. Disney is scheduled to continue its stock buyback program in FY 2017, which will continue to drive its EPS growth. In addition to $7.5 billion of common stock repurchases, Disney also paid $2.3 billion in dividends to its shareholders.

Disney can continue to richly reward its shareholders, due to its strong operating cash flows. In FY 2016, Disney generated $13.21 billion in cash from operations, almost 30% growth from 2015. Even the long-term growth in cash flow has remained strong. Operating cash flows have grown from $7.96 billion in 2012 to $13.21 billion in 2016, a CAGR of 13.5%. And with the opening of Shanghai Disneyland, the cash flows are likely to only improve this year.

The strong fundamentals, the opening of Shanghai Disneyland and a strong lineup of movies in 2018 have earned Disney stock many rating upgrades, including from Piper Jaffray’s Stan Meyers who in a recent report said that:

“We are revisiting Disney’s long-term model, raising estimates and our price target to $130 from $115. Based on our analysis of the upcoming projects across Parks and Resorts, the future film slate at the Disney Studio and its impact on Consumer Products, we are raising our average annual growth expectations by 100bps over the next four years.” 

While Walt Disney Co (NYSE:DIS) remains a good long-term bet, the stock may face headwinds in the near term due to the continuing concerns around ESPN franchise and downbeat expectations from 2017. The stock may face near-term corrections. Long-term investors must use any dips to buy DIS stock.

The article Can Walt Disney Co (DIS) Stock Continue Its Impressive Rally? originally appeared on Watch our analysis video on DIS (3). – Watch, Analyze, Invest. Why spend hours putting together numbers you can get in minutes, in one simple video? Our ‘Robo Advisor’ videos give you every number that matters, in 1 minute. Find insightful articles with ideas on investing, top stock picks that outperform the markets, personalized portfolio analysis videos and a whole lot more. – Your Friend On Wall Street.

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