Disney Bull's Pen
by Jeff Fischer ([email protected])

Ever since the acquisition-strewn 1980s -- that were fueled by the proliferation of cable television -- media and entertainment companies have been building empires that rely heavily on brand name recognition. Mind share is just as important as market share if a media or entertainment company wishes to succeed in new and increasingly large (and, therefore, risky) initiatives, such as Disney's now-popular Disney Store and recently launched ESPN sports retail store, its soon-to-be launched ESPN Grill restaurant, and ESPN magazine.

Add the Internet to the mix and you now have a world that is -- on every level -- a media and entertainment bonanza full of possibility. To become large in this world, though, it takes much more than just luck. At this point, if a company doesn't already have a strong foothold in this international business, it faces an increasingly difficult battle alone -- or it should hope to be acquired.

Acquisitions over the past ten years have made the media and entertainment world what it is today, and it has also saddled most media companies with debt. Acquisition-inspired debt is quite different from straight debt for media companies, though, because it usually includes a fair amount of goodwill debt. This is the amount that a company pays above an acquisition's appraised value for the assets that it acquires. Goodwill is listed on the balance sheet as an asset but is then expensed off the balance sheet at a set quarterly rate. This debt is still meaningful since interest is paid on it, but the operating losses that most media companies experience must be taken in context with the type of debt that the companies are expensing.

Enough with the media background stuff.

In the case of Walt Disney <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: DIS)") else Response.Write("(NYSE: DIS)") end if %>, the company has been highly profitable, which is far from the norm in this acquire-to-stay-afloat industry. Following the $19 billion acquisition of Capital Cities/ABC in 1996, Disney is the second-largest media company in the world, second only to Time Warner <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: TWX)") else Response.Write("(NYSE: TWX)") end if %>. Even so, Disney has the best brand name in the industry and owns the majority of well-known franchise entertainment names: Mickey and Minnie Mouse, Goofy, Snow White, Cinderella, Pinocchio -- all of which are cash cow entities that can be (and are) leveraged to the hilt in the form of home videos, new and re-released movies, games, musicals, retail products, theme park attractions, and more.

Disney recently reported results for fiscal 1997, and the performance was strong enough to send the stock soaring. For the year Disney shares gained 43%, handily beating the S&P 500's 33% real rate of return. What's cooking at Disney? Everything.

Operating income for 1997 increased 18% to $4.3 billion, while pro forma net income soared 25% to $1.9 billion on a 6% rise in revenue to $22.5 billion. Growth across the spectrum of Disney's businesses (from radio stations, movie productions, and television to theme parks) made the company hit on all cylinders for the year, despite ABC being the number three national TV network (which isn't a horrible position to be in, really).

$10.9 billion in revenue came from creative content (including movies like Scream and Scream 2 -- as Disney owns Miramax, Hollywood Pictures, Touchstone Pictures, and Disney Pictures, among others); $6.5 billion in revenue came from broadcasting, including ABC, ESPN, the Disney Channel (which will have advertising soon), several radio stations, and book publishers; and $5 billion in revenue came from the world's largest theme parks, to which Disney is adding another attraction in 1998 in the form of the Disney Animal Kingdom at Walt Disney World in Florida. For the year, the company had net profit margins of 8.7%. Operating margins were 16% for the creative content department, 19.8% for broadcasting, and 22% for the theme parks.

Being a bull on the second-largest media company in the world isn't difficult, especially as the world becomes increasingly media and entertainment driven. But Mr. Edible is going to attack Disney's valuation with the ferocity of Mike Tyson (it would probably be easy to attack the valuation of any Dow stock that gains over 40% in one year, as Disney's stock did in 1997). So let's look at the valuation and see if Edible, in his bear argument, will just be swinging at air.

First, considering the simplistic price-to-earnings ratio, at the February 3 price of $107 per share, the stock is trading at 37 times trailing earnings, 33 times fiscal 1998 earnings estimates of $3.19 per share, and 28 times fiscal 1999 estimates of $3.78 per share (the fiscal year ends in September). For the next two years analysts expect Disney to grow earnings per share 24% and 18% respectively -- no small feat -- but a feat that would put the projected 28 P/E for next year at only a modest premium to the average growth rate, especially for such a well-known name. Meantime, Disney grew pro forma net income 25% last year, so trading at 37 times trailing earnings is far from a nosebleed valuation. (Note: When this was originally written, Disney was trading at $96, or only 33 times trailing earnings, less of a premium.)

Even if this might be a reasonable valuation for Disney, the price-to-earnings ratio is not the best way to evaluate a media company. Most media companies don't have earnings due in part to the service of their significant debt and goodwill. Disney is a cut above the pack by having such strong earnings. With media companies, though, cash flow is much more important than the price-to-earnings multiple. Most investors value media companies on earnings before interest, taxes, depreciation, and amortization (or EBITDA, or "blah blah blah", or gross cash flow), but that has some weaknesses because it doesn't include interest or taxes. Fools would rather take after-tax earnings, add the non-cash charges against earnings that are represented by amortization and depreciation, and deduct any capital expenditures. This is free cash flow. Simple, really. Free cash flow is the straight and real cash that a company generates. (For more on valuing the media industry as well as 19 other industries, please see the Industry Focus '98 research report.)

Disney had $1.9 billion in after-tax income and nearly $5.0 billion in depreciation and amortization costs, but minus capital expenditures of nearly $7.0 billion, Disney didn't achieve free cash flow in 1997. Investments in movies and creative content were over $5 billion alone last year. A lack of free cash flow isn't unusual for media companies because they typically have so much debt (and expenditures) to service.

Without free cash flow to go on, we'll go by gross cash flow. Disney's gross cash flow from operations was over $7 billion in 1997, putting the stock at 10 times cash flow. This cash flow number has grown 35% annualized over the past five years. The stock has a book value of $26 per share, and if gross cash flow expansion can coincide with the expected earnings growth of about 20%, it puts the cash flow multiple of 10 in a more reasonable context.

All told, this Fool doesn't think that Disney is at a Mickey Mouse price at $107. It's reasonable enough that maybe Fools should be interested in buying shares for their young ones on any opportunity. Can Disney be usurped in the coming decade? Will kids be hugging giant Ted Turner dolls in the year 2008? I doubt it. The market is blooming, and Disney is there to harvest the crop.

Rick? Mr. Bear on an America Icon? Your turn!

Next: The Bear Argument