Has Walt Disney turned a corner?

This Stock in Focus newsletter has been running for roughly six months now and in all that time I have managed to restrain myself from writing about Walt Disney.

This is partly in respect to the fact that I probably talk about the company a bit too much. Indeed, Ed received some feedback last week which suggested I should “let Disney go”. But it’s also partly because I have been in denial about the state of my personal stake in the company. I bought Disney in late 2022 at $97 per share, just before Bob Iger returned to the company in an attempt to steady the ship. For about a year, his efforts failed to bear any fruit, Walt Disney’s share price slumped to a trough of $85 and I stopped talking about the company (or at least, talked about it less).

In that time I have retained my conviction that this is a quality company with the capacity to get through a difficult period. But with my ‘long term investor’ hat on, I have found it easier to stick to my guns by burying my head in the sand and pretending the poor performance wasn’t happening.

This is not the right strategy. In his 2015 book, The Art of Execution, Lee Freeman-Shor says that when it comes to handling losing investments, fund managers tend to fall into one of three camps. The assassins, who deal promptly with any failures by cutting their losses and moving on; the hunters, who analyse and buy more when the time is right; and the rabbits, who do nothing. Rabbits tend to have the worst performance. And that is the approach I have taken with Disney.

Now, things have worked out ok. The share price has started to turn and I’m now up 20%. I am glad I didn’t quickly cut my losses - that isn’t the type of investor I am. But I should have bought more when the share price slumped. I had done an excessive amount of research prior to buying the stock in the first place and saw the $97 price tag as a decent value opportunity. Thus, $85 should have been even more attractive.

The type of research conducted by Mr Freeman-Shor is useful for private investors. Studies like this can help us all set rules to ensure our portfolios stay healthy and to help us take advantage of buying opportunities which can emerge following deep research efforts. Here at Stockopedia, we’ve been building our suite of portfolio management content in the Academy to help you benefit from these lessons. Check it out here.

The reason I’ve looked at Walt Disney now is because it’s the end of the tax year and I have been writing quite a lot about the importance of assessing the health of your portfolio when you think about the best way to deploy your new allowance. And with that in mind, I have decided to have a closer look at my favourite holding. So has the Walt Disney investment case changed since I first bought the shares?

The fundamental business case

At the time of writing, Disney reports revenues from three distinct divisions: entertainment, sports and experiences. That’s already a bit of a departure from the structure when I bought my shares when Disney’s sales came from two operating segments: media & entertainment and parks & experiences.

But the shift makes sense. The nature of the media business has been changed by the arrival of Disney’s direct to consumer streaming service, Disney+. When Walt Disney first bought ESPN in 1996, it made sense to house all of its television channels under one media branch. Today, the television division absorbs very different costs to the sports side of the company. Aside from the technical investment in the platform, Disney+ is reliant on the same sort of content investment as the studios business.

Sales growth at the three divisions has been mixed in the last few years. Revenues in the experiences business (which houses the company’s theme parks, cruise ships and consumer products) have been flattered by comparisons with the pandemic. But growth remains uninspiring and disgruntled investors (more on them later) have pointed to the exorbitant price of park tickets, which has priced out many families, especially during a cost of living crisis. Growth has also been relatively sporadic in the media division, despite the fast start of Disney+ which launched just as the world was going into lockdown. And the sports division was the only one to falter in 2023, with annual revenues flat at $17bn.

But overall, sales are not the most troubling aspect of the Walt Disney investment case. In the last fives years, revenues have risen at a compound annual rate of just under 9% and, despite the fluctuations of the individual divisions, seem to be continuing on a decent trajectory. By contrast, operating and net profits which stood at $15bn and $11bn respectively in 2019 (to give respectable margins of 20% and 16%) have faltered to $5.0bn and $2.3bn. Two of the key metrics that I look for in quality stocks (high operating margins and a decent return on capital employed) have been cannibalised by the exorbitant costs associated with Disney+, film making and park investment.

But one aspect of the Walt Disney quality investment case which has held firm is the company’s ability to convert its profits to cash. Operating cash flows have continued to exceed operating profits, meaning the company has been able to continue to invest without having to raise more money from debt or equity. Leverage was increased by the acquisition of 21st Century Fox in 2019, but the net debt position has been creeping down since then.

The quality figures might not have recovered as much as I would have hoped in the last couple of years, but they’re no worse than when I bought the shares.

Beyond the numbers

But that hasn’t been enough to silence some of the louder voiced doubters. Activist investors at Trian Partners and Blackwell Capital have amassed large stakes in Walt Disney and this week attempted to gain board seats as part of their bid to oust Bob Iger and set out their own strategy for recovery.

They have pointed to the fact that the streaming division has amassed losses of more than $11bn since its launch in 2019 and isn’t expected to be profitable until the end of the year, while a series of expensive films have ended in box office flops. The $7.5bn cost-cutting exercise of the last year hasn’t gone far enough according to the activists, who have suggested that Disney would be better off split into its three constituent parts, all of which with its own stock market listing.

But these attempts to garner board positions fell flat at this weeks AGM, where only 31% of shareholders voted for the activists to be given seats on the board. The company’s largest investors, including BlackRock and Vanguard backed the existing team, while the stronghold of individual investors (who account for about a third of Disney’s shareholder register) voted for Disney’s own board nominees.

The AGM marks the end of a tumultuous battle between Disney and its activists, who first expressed disapproval for the way the company was being run in January 2023. Their disapproval has hinged on the sprawling nature of the Disney empire and the costs associated with that. But that criticism misses a key point in the company’s favour, a point which is hard to define by looking at the numbers alone: Walt Disney has a remarkable catalogue of intellectual property and a phenomenal ability to squeeze profits from it.

In its quest to silence the doubters, management recently published a presentation which attempted to put numbers on the return on investment from franchises like Toy Story, Star Wars and Frozen (5.5x, 2.9x and 9.9x, respectively). These numbers drew some degree of criticism from activists and the media alike. How can the company confidently come to these figures? What was the original investment in Toy Story from the $7.4bn acquisition of Pixar? How can the company say what the total returns have been from a franchise like Star Wars, which spans many films, television series, toys and games? These are all fair questions, but I think they miss the point. The return on investment from winning franchises like these is so hard to calculate because it is so enormous.

Take Groot as an example. Groot was a long forgotten character from the Marvel library, gathering dust in the archives when Walt Disney spent $4bn to acquire Marvel in 2009. Five years later, Groot was given a starring role in Guardians of the Galaxy which generated $774m at the US box office. After sacrificing his adult form to save his friends in the first film, Groot took on a new persona in Guardians of the Galaxy 2. Baby Groot became a plush cuddly toy, a Lego model and he’s since grown through his teenage years to become a hulking adult who has appeared in six phenomenally high grossing films and now a ride in two of Disney’s theme parks.

And this is the power of the Walt Disney business model. Characters from films can become toys, rides and now, thanks to Disney+, television series. Assets which weren’t massive investments to start off with can be used for marketing, or retail, or to build the brand. And success in one division can fuel growth in another. Together, the company’s divisions are worth more than the sum of their parts.