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Morningstar | DTC and Fox Occupy Center Stage at Disney; Strong Start to Important Transitional Year

Disney began fiscal 2019 with a strong first quarter that provided insight into the direct-to-consumer business, which we found encouraging. The disclosed projected impact from not licensing its movies reinforces our belief that Disney is much better served by reserving its content for its DTC effort than by arming its competitors. The Fox media assets and the DTC efforts will continue to be the focus as Disney works through an important transitional year. We are maintaining both our wide moat rating and our fair value estimate of $130.

Revenue for the first quarter were flat year over year at $15.3 billion. The reorganized media networks segment grew revenue 7% due to growth at both cable networks and the broadcasting segment. Affiliate fee revenue was up 7% in the quarter as higher rates offset the 1% decline in subscribers. The rate of subscriber losses has decreased for six consecutive quarters, driven by the continued consumer uptake of the OTT TV services. Ad revenue at broadcast networks was up 6% as higher pricing and local political ad spending offset lower impressions due to ratings. ABC continued to see strong ad pricing growth in the current quarter, with scatter pricing running 40% above the upfront levels.

The new parks, experiences & consumer products segment posted 5% growth, as the park and resort business continues to report strong results. Domestic attendance was flat but per capita spending grew by 7% and per room spending improved by 5%. The increased admission pricing does not appear to have negatively impacted attendance or dampened in-park spending. Revenue at the studio fell 27% due to a weak theatrical slate and a difficult comp. Given the record-breaking 2018 box office performance, the studio business will face difficult comps throughout 2019. Segment operating margin for the firm fell by about 210 basis points to 23.9% as the revenue growth was more than offset by the increased programming costs and weaker studio results.

While the firm’s DTC efforts are still in the early innings, the strong start at ESPN+ is a positive sign for management’s bet on the future of Disney. ESPN+ has reached over 2 million paid subscribers, doubling over the last five months. The recent launch of UFC Fight Night on ESPN+ Plus drove almost 600,000 signups. Despite the strong subscriber growth, there have been some issues with streaming quality on the BAMtech platform, particularly during the first UFC event in January. While these issues are troubling as the same technology will underpin the more important Disney+ service, we expect that the issues will be mostly ironed out by the launch. One of the reasons for launching ESPN+ well in advance of Disney+ was to use the sports streaming service as a test platform for the underlying BAMTech technology in order to catch and solve issues like this one.

While management continues to squirrel away most of the details about Disney+ for its investor day on April 11, the firm did disclose the operating income impact of foregoing output licensing would be $150 million for fiscal 2019. While this number appears low, that loss seems to be tied only to the movie output deal with Netflix for the pay-one television window. As we discussed in our October 2018 Ad-Hoc, “Netflix Needs to Chill: The Director's Cut,” Disney’s deal with Netflix only covered movies released in theaters between January 2016 and December 2018. The firm’s first film to fall outside that window will be Captain Marvel which will be released on March 8. Given the six to nine-month lag between theatrical release and the opening of the pay-one television window, only two (Captain Marvel and Dumbo) of the movies scheduled to be released in fiscal 2019 would fall inside this timeframe. We would expect that the operating income impact will be much higher in fiscal 2020 as the movies with forgone output licensing revenue would include Avengers: Endgame (April 2019), Aladdin (May 2019), Toy Story 4 (June 2019), The Lion King (July 2019), Frozen 2 (Nov. 2019) and Star Wars IX (December 2019). Despite the potentially large loss of revenue and operating income from forgoing output licensing for these movies, the strength of that lineup is one of the major reasons that we remain positive about management’s large bet on DTC.