Boring, But Beautiful: Disney Has 20%+ Upside

Admittedly a boring idea, but I am recommending Walt Disney with potential upside of 20% over the next 12 months.

The shares have done well, but lagged some other major media and entertainment stocks over the past six months as the company endured a period of slow earnings growth. I believe the current quarter will flip the earnings trajectory and the stock will move higher with earnings and modest multiple expansion.

2013 and 2014 consensus EPS estimates call for $3.44 and $3.88. Looking out to later in 2013, I think the shares can trade at 17 times 2014 estimates or $65, up 20% from current trading levels.

Disney has gone through a period of slower growth as ESPN has faced rapidly rising costs for sports rights, its theme parks have endured a period of heavy investment, the film studio has transitioned to a franchise film only model, and the Interactive division has suffered significant losses. Each of these issues is set to dissipate over the next year and on its latest earnings conference call management confirmed the bullish turn in fundamentals.

Over the past year, ESPN has renegotiated its carriage agreements with 7 of the top ten multichannel TV distributors. Initial step ups in the fees these distributors pay for ESPN should begin to hit in the current quarter. This will allow growth and margins for ESPN’s operating income to pick up over the coming year. ESPN is Disney’s largest and most valuable asset and resumption in its growth should improve investor sentiment and could lead to slight multiple expansion. Think of ESPN as a business that made a large capital investment with a delayed return on capital. The investment phase is over and it is time to reap the benefit for shareholders.

A similar situation is occurring at Disney’s second most important asset, theme parks. Investment in Orlando and Anaheim has been high in the last few years as new attractions, cruise ships, and new gates and rides have consumed capital. Capital investment is now winding down setting the stage for improved margins.

On its most recent earnings call, management indicated that upside is already occurring at its California park. Future investment will occur at the new Shanghai park but the upside opportunity justifies the spending and investors will likely give the company a pass and grow excited as the park nears opening in the middle of this decade.

The final major positive in the Disney story is that the content engine is entering a period of creative upside. Last year’s big hit, The Avengers, has established the Marvel franchise just as Disney gets to 100% ownership of the properties economics. The Lucasfilm acquisition brings Star Wars later this decade, giving Disney two major franchises that it can move through its pipeline of film distribution, home video, theme parks, cable channels, video games, and consumer products. No media company is better set up to exploit popular, franchise content than Disney.

In the near-term, Disney’s recent earnings report and conference call eased investor concerns and firmed up analyst estimates for the year ahead. Disney does not provide explicit guidance but instead offers commentary around key business trends and expenses.

On its latest earnings call, management provided reassuring words on bookings and spending at its theme parks, confirmed the upside coming in ESPN affiliate fees, announced more output from Lucasfilm, and confirmed accretion from Shanghai Disneyland when it opens in 2015/2016.

In addition, after material losses, the Interactive division turned to profitability and looks like it has a better future built around its Infinity initiative (similar to ATVI’s highly successful Skylanders) and CEO Bob Iger confirmed the division would be profitable this year.