UCC - Disney: The Cash Flood Begins

• Disney's movie releases are going to increase free cash flow tremendously, probably beginning with the third quarter.
• Disney probably has a lot of potential blockbusters in the backlog of movies to be released.
• The parks are now operating and will generate a lot of cash as well.
• The streaming business probably adds far more to corporate profitability than GAAP accounting would demonstrate to investors.
• Mr. Market usually provides a buying opportunity before the cash flow rolls in by being overly nervous about future success.

(Note: This article appeared in the newsletter on July 10, 2022.)

The Walt Disney Company ( DIS ) reported negative cash flow from operating activities in the first quarter. Even in the second quarter, investments in various activities still exceeded cash generated by operating activities. This was largely due to a lack of activity during fiscal year 2020 during the coronavirus demand destruction. But the parks are now operating, and the ramp-up requirements are declining. The movie backlog has been largely paid-for, so most of the movie ticket sales that Disney receives will result in cash generation. The next few quarters should see free cash flow climb tremendously.

Disney is about to extend its reach into the cruise ship business. The common theme is, of course, the free time-entertainment part of the consumer's life. Disney has a rather broad definition to extend the brand into new growth areas constantly.

The latest " Tho r" movie appears to be off to a good start . This follows the " Doctor Strange " blockbuster . In between was a movie that did not quite meet market expectations. But that is about the way things go in the movie business. The fact of the matter is that the blockbusters usually generate a significant amount of cash even for a corporation that is the size of Disney. Any movie that is showing in theaters generally has the costs paid for and will now generate a lot of cash.

Disney has a very long history of generating more cash than it needs. Therefore, inroads into other growth areas can continue well into the future. Disney may be a large company, but it also can grow a lot bigger as long as the controls are in place to generate decent cash flow.

The Streaming Business

The common perception is that Disney will grow or not grow based upon the streaming business. But that is really not the case as shown above. Instead, streaming is yet another way to add more customers that other divisions can also sell products to.

So many have reported that streaming has lost money. But investors need to realize that blockbuster movies are paid for in the theater. Accounting rules require an allocation of those movie costs to streaming even though that movie already made a profit before it was ever streamed.

Most of us who are analysts do an incremental cost analysis. That means we report to management only the extra costs that streaming incurs. This shows management whether or not streaming was profitable. There are also "intangible benefits" in that streaming will add customers to other divisions. The obvious answer here is that a streaming customer is worth far more to Disney than accounting reports, as shown above.

It is very likely, depending upon how management calculates all the tangible and intangible benefits of the streaming division, that the division is not losing money in the eyes of management because the benefits result in increasing corporate profitability that far outweighs the reported losses.

It is true that Disney does spend money for streaming original content. That content can later be a television special or sold on DVD's. There may even be a clothing line that benefits from the program or a ride at the parks. So actual profits in the eyes of management is going to be very different from GAAP reporting. Those of us that go through this know that GAAP is only one view of profits. There are several more that shareholders do not see ((EVER)). The other thing that streaming helps with is the occasional movie that results in a loss can generate still more cash flow by streaming.

Movie Backlog

The movie part of the company is ramping up from the nadir of the fiscal year 2020 period. That is a fair amount of cash flow that really has not been present for a couple of years. Some of the cash generated will obviously be used to make more movies. But the well-run movie business usually generates cash far in excess of the cash needed to keep the business going.

The market has really not priced a few successes into the stock price. Instead, the market appears to have focused upon the one disappointment. But Disney has been an expert in extending the lives of its franchise movies. That is very likely to continue (albeit with a misstep here and there). Disney has found a way to make the movie business far less of a gamble than many competitors.

That actually constitutes a competitive moat that could last a very long time.

Third Quarter And The Future

Cash flow is likely to climb sharply in the near future because the parks are again operating, and movies are being released. Longer term, this company has a much more profitable way to make movies than do many competitors.

That should result in a stream of steadily climbing profits. The company is no more dependent upon streaming than it is upon the "Disney Channel" (for example). Should a venture like streaming fail, the company has other possibilities like the Disney ships to enable a bright future.

There is going to be an occasional movie or program flop (or even a new division flop). That happens. But this company is large enough to continue to grow even with that occasional misstep. The market has so far focused on the problems. It has definitely not taken into account what a return to normal for this company will look like. That pessimistic view continues to limit the upside of the stock.

As shown above, the stock price is now where it was at during the fiscal year 2020 coronavirus demand destruction. Yet earnings prospects are far better going forward than was the case back then.

It is not unusual for Mr. Market to have second and third thoughts about the coming success. Mr. Market often overrates the future until the future becomes the next few quarters. Therefore, a stock price dip before the profits roll-in is not uncommon. Instead, it is contrarian investing at its best.

Disney management, through the well-developed Disney brand, and the (for example Marvel) movie franchises has managed to take a lot of risk out of the highly variable entertainment business. Many competitors depend upon finding a new franchise from time to time. Disney can do that while relying on a steady flow of franchise extensions that many competitors can only dream about.

The streaming business simply extends the Disney brand to a new area while giving the company yet another way to attract more customers. Success of the streaming business would be a big help. But if at any time it is deemed a failure, it is such a small part of the company, that the effect on Disney as a whole would not really be all that material. Clearly Mr. Market disagrees. But that is because Mr. Market usually goes with a fair amount of emotions until the numbers appear.

Right now, this stock appears to be a "win-win" for many kinds of investors.

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