Image Source: Mike Mozart
Disney’s Quarterly Performance Reignites Fear
On May 10, Disney’s (DIS) shares fell after the company reported lower-than-expected fiscal second-quarter earnings. Investors are concerned with the media and entertainment giant’s weakness in advertising revenue and subscribers in its Media Networks segment, which accounts for more than 60% of the company’s operating income. Was the fiscal second quarter the beginning of a long-term trend for the segment at Disney? As more and more consumers continue to opt away from traditional cable TV, will not only its subscriptions decline, but will demand for advertising space on the networks also fall as fewer consumers are reached through the medium? Investors are fearing the worst.
The development is certainly worth following and materially impacts the long-term thesis of Disney, but not all is bad at the company. Disney reported its 11th consecutive quarter of double-digit adjusted earnings per share growth in the second quarter of fiscal 2016. The firm’s Parks and Resorts segment has been growing at a solid pace thus far in fiscal 2016, and its Studio Entertainment segment has grown operating income 60% through the first six months of its fiscal year thanks to blockbuster hits such as Star Wars: The Force Awakens. The shift in Disney’s business away from the more steady Media Networks business toward the difficult to predict Studio Entertainment business isn’t all that welcome, however. What was once viewed as a reliable revenue stream through a subscription and advertising based revenue model is now shifting to a dependence on being able to consistently produce hit films.
Combatting the Cord-Cutting Trend
Other companies are struggling alongside Disney in the fight against cord cutting by the new age consumer. Comcast (CMCSA) is a prime example of this, and the firm recently purchased DreamWorks Animation (DWA) to augment its position in the kids and family entertainment space through its Universal Filmed Entertainment Group. The deal is yet another indication that traditional network-based entertainment companies are looking for other means by which to expand their revenue base. A main factor in the acquisition was Comcast’s interest in the potential of theme parks and products associated with DreamWorks’ portfolio of films.
Comcast and Disney are both taking the cord-cutting challenge head-on through online entertainment provider Hulu, which is jointly-owned by the two firms and Twenty-First Century Fox (FOX). Hulu is developing a subscription service that would rival traditional pay-TV providers, in addition to its on-demand programming platform. The plan for the developing product is to create a personalized experience through a combination of traditional linear TV and on-demand video. Exposure to such an entity offers the traditional TV giants a bit of a hedge against the trend, but it may not be enough.
Subscriber Trends Still Mixed
Oddly enough, Comcast’s first quarter report showed solid growth in its Cable Communications and Cable Networks segments. A tough comparable period of 2015 impacted growth results in its Broadcast Television segment, but overall the firm bucked industry trends in the period. The company added 53,000 net video customers in the quarter, and advertising revenue also performed well in the period. We’re viewing this with the notion that one quarter does not make a trend in mind – perhaps a welcome view for long-term Disney holders.
AT&T (T), however, reported a net customer loss of 54,000 in the quarter as losses in its U-verse video products outweighed gains in its DirecTV segment. The company expects to end the year with positive net video subscribers due to exclusive NFL package offerings and benefits from wireless and video bundling, but whether or not long-term organic subscriber growth can continue to be realized remains in question. The potential of the firm differs drastically from that of Comcast or Disney due to the inherent ties of its video and wireless operations.
For starters, the future of AT&T largely relies on the integrated services it is beginning to roll out, and the firm’s ability to effectively drive advertisements through those mediums. In an increasingly mobile world, a younger generation is always on or near a mobile device, which is precisely where AT&T’s advantage emerges after the acquisition of DirecTV. The firm added to its mountain of debt to fund the purchase, but it was a bet that it was willing to make to capture demand from an increasingly fickle generation of video consumers who want to consume their entertainment when, where, and however they want it.
Til’ Debt Due Us Part
Telecommunications companies are often required to take on considerable amounts of debt in order to build their extensive networks, and AT&T is no exception. The company finished the March quarter with more than $122 billion in long-term debt and little more than $10 billion in cash and cash equivalents. However, AT&T holds a relatively solid net debt-to-adjusted EBITDA ratio of 2.27x as of the end of the first quarter of 2016. The firm’s free cash flow has been sufficient in covering dividends in recent quarters, but it does not leave much left for maintaining the health of the business. We’re of the opinion that the company’s strongest dividend growth years are behind it, as it continues to prioritize spending to drive product innovation.
Verizon (VZ) is another example of a telecom giant with tons of long-term debt on its balance sheet, sitting well-north of $100 billion, but the firm does have a solid net debt-to-adjusted EBITDA ratio of 2.2x as of the end of the first quarter of 2016. Verizon’s quarter did not have the growth of AT&T’s, but it continued to march steadily higher on both its top and bottom lines. Revenue gained nearly 1% from the year-ago period, and earnings per share advanced nearly 4% on a year-over-year basis. Mobile video is a key focus for the firm and will remain so for the foreseeable future.
In the quarter, Verizon announced its agreement to acquire XO Communications for $1.8 billion, a relatively negligible price when considering the size of Verizon. However, the deal is important for the future of the firm in that Verizon will be leasing XO’s airwaves to test them for the development of 5G networks, which have the potential to offer speeds up to 10 times faster than today’s 4G network speeds. This increase in speed will allow Verizon to take its current smartphone customers, which make up 85% of total wireless customers, to yet another service level, a growth strategy that will become increasingly more important as 95% of all Verizon smartphones are 4G LTE capable.
The increased network speed also ties back to the battle for mobile video usage. The current growth in Verizon’s 4G device adoption is driving increased data and video demand for the firm, and as speed and accessibility continue to improve, the trend of video consumption on the go will only become stronger. As Verizon and AT&T push the limits of their capabilities to draw additional content consumption, traditional pay TV providers will continue to feel a pull on subscriptions and advertising revenue.
Sprint in a Battle for Survival
While Verizon and AT&T continue to fight for the top spot in the telecom industry and keep the focus of their arms race trained on the future, competitor Sprint (S) is busy focusing on the now. The company reported positive annual operating income for the first time in nine years in fiscal 2015, ended March 31. It also reported more net additions than Verizon and AT&T for the first time on record in the fourth quarter of its fiscal year. Adjusted EBITDA leapt 24% on a year-over-year basis in the fourth quarter, and positive momentum was felt throughout its business as the fiscal year came to a close.
Despite the positive news in operating income, Sprint did not turn a profit in the year, and it remains significantly free cash flow negative. The company’s number of net additions will continue to benefit from its repricing initiative, but this is not likely a sustainable growth strategy. Average revenue per user trends have not been favorable, and the surge in additions is likely to subside as Sprint’s competitors expand their offerings. The long-term picture of Sprint is of serious doubt, and we view it as merely a speculative bet, nothing more nothing less. The best-case scenario for the firm may be a buyout of shares, but playing the “buyout” game is often a fool’s errand. We’re on the sidelines.