Disney: Rejecting ESPN Spin-Off Is Right Move For Investors – Seeking Alpha
Chapek made the right call deciding against ESPN’s spinoff
The Walt Disney Co. (NYSE:NYSE:DIS) CEO Bob Chapek told the FT in an interview Sunday that management plans to keep ESPN under the Disney umbrella, rejecting earlier calls by activist investor Dan Loeb to spin off the sports broadcaster.
The move by Chapek likely preserves shareholder value for the long-term, for two reasons; firstly, it means the company can continue to use free cash flow from ESPN to fund growth avenues like streaming. Secondly, there are enormous growth prospects for sports broadcasting in the future if companies can leverage a global sports rights portfolio to drive advertising revenue. Loeb showed great character by deciding to publicly accept the decision, so investors can breathe easy since there probably won’t be any escalation from activist investors.
In the letter sent by Loeb to Chapek, he cited three reasons why an ESPN spin-off made sense; 1) Disney can unload a lot of its debt on ESPN before spinning it off, essentially deleveraging the company. 2) All synergies between ESPN and broader Disney can be replicated by contractual agreements. 3) It would help change the shareholder base of Disney to more growth-oriented investors.
The investment firm certainly has a point when it comes to the importance of paying-down debt since Disney has a debt to EBITDA ratio of 4.3x. Its interest coverage ratio (using EBIT given depreciation is an important expense for Disney due to its theme parks investment) is 4.7x. Paying down debt would be particularly beneficial to equity holders if the company can maintain its high EV/EBITDA ratio of almost 22 times. Investors can find all that information by calculating them from quarterly fillings, but they can also find all the information available on the Financials and Valuation tabs on Seeking Alpha’s Disney page.
The spin-off suggestion was consistent with the theme of the letter of driving efficiencies and cutting costs. Other notable points like buying out the rest of Hulu and disposing of underperforming assets drove that point further.
While spinning-off ESPN does free-up some cash flow from interest payments and provides Disney with more upfront cash to invest in streaming compared to the amount of cash flow ESPN would have generated, it completely discounts ESPN’s own growth prospects.
Currently, ESPN’s role is simply to produce cash that the company can use to invest in Disney+ or pay down debt. The good news for investors was that management was able to grow profits last quarter in cable despite the chord-cutting trend:
The increase at Cable was due to growth in advertising revenue and to a lesser extent, a decrease in marketing costs and an increase in affiliate revenue. Advertising revenue growth was due to an increase in rates and higher impressions reflecting higher average viewership. Rates and impressions benefited from the timing of the NBA Finals, which aired in the current quarter compared to the fourth quarter of the prior year as a result of a delayed start of the 2021 NBA season due to COVID-19. Higher affiliate revenue was driven by an increase in contractual rates, partially offset by fewer subscribers. Programming and production costs were comparable to the prior-year quarter.
So the management was able to maintain costs while driving higher advertising and affiliate fee revenues. It’s unclear if controlling costs will be a long-term trend given the growth in sports rights, but the growth in advertising and affiliate fees can certainly continue for some time given the importance of sports to the cable bundle.
That in itself isn’t a bad position to be in, given that margins on streaming will improve longer-term and along with theme parks become the main drivers of the company. Chapek, however, told FT that he does have growth plans for ESPN:
We have a plan for it that will restore ESPN to its growth trajectory… when the rest of the world knows what our plans are they will be as confident about that proposition as we are.
So not only can ESPN provide dependable cash flow to Disney, management seems to believe they can grow that cash flow over time.
While Chapek did not share those plans, here’s what CFO of Warner Bros. Discovery, Inc. (WBD) Gunnar Wiedenfels said about sports at a recent investor conference can give some clues to investors:
We have that ability to partner with leagues by bringing to the table our full global footprint here. And we have a very strong established sports viewership in Latin America, very strong viewership in Europe on the back of Eurosport with the various sports verticals that we own in that market and to your point, with Turner in the U.S. as well. So I do think there’s a lot of opportunity.
So there is a belief held by Wiedenfels that having a global audience subscriber base can be a competitive advantage when bidding for sports rights. I share his belief as well. The reason is that, in addition to helping leagues promote their sports, it will increase the reach of league sponsors and drive significant advertising revenue for companies like Disney and WBD.
What streaming really enables for media companies is the globalization of their subscription and advertising revenues. In the past, those media companies rented out their content for channels and shared in advertising revenues as well. That revenue was predominantly in the US given that’s where companies were based and the challenges of creating a global cable business. With streaming, media companies realized that they can generate their affiliate fees globally at (almost) zero marginal cost. And with the addition of ad-tier products, companies now can increase their advertising TAM from $230 billion mainly in the US, to almost $800 billion globally.
Sports will be an important component in driving that revenue as it completes the virtuous cycle for media companies. Streaming can bring in the user base, which means more eyeballs for leagues, which secures sports rights deals, which brings in more users and drives higher advertising revenues, and so on.
While building its streaming service, Disney is simultaneously increasing its global footprint in sports. In addition to the much-publicized cricket deal in India, Disney won cricket rights in Australia and the English Premier League rights in 10 countries. The endgame is probably a bigger streaming user base and higher advertising revenue globally.
ESPN is currently providing Disney with dependable cash flow that is used to pay down debt and invest in streaming. The company can however unleash ESPN globally at some point in the future, focusing on building a global sports rights portfolio that drives high-margin, digital ad revenues.
My previous article on Disney rated the stock a sell given the difficulty in attaining 2024 targets. I did state in that article that Disney remains a great company longer-term. Focusing more on the long-term prospects, I am assigning the stock a hold rating.
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Disclosure: I/we have a beneficial long position in the shares of WBD either through stock ownership, options, or other derivatives. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.