Over the last three years, its operating income has stagnated at around $14 billion per year. With cord-cutting gaining momentum, Disney's cable and broadcast offerings (ESPN, Disney Channel, ABC Television Network, etc.) are facing subscriber declines. During the fiscal year 2018, these businesses, grouped under the "Media Networks" reporting segment, still represented approximately 42% of the revenue and operating income.
So far, higher advertising rates have partly mitigated the lower average viewership. But the strategy of raising fees to offset a declining business is not sustainable. Management is taking steps to transform the weakening legacy Media Networks activities into a growth story. The company plans to launch Disney+, its direct-to-consumer streaming offering, the end of 2019.
Content Is Key
Management hasn't provided many details about the Disney+ platform. But we already know it will offer Disney, Pixar, Marvel and Lucasfilm movies released theatrically after calendar 2018. Also, the company will exploit its content libraries and propose extra exclusive original series and movies. Considering the decades of successful content creation and the results of the recent franchises, Disney will offer exceptional content. The recent impressive opening weekend of Captain Marvel is another illustration of Disney's capacity to capitalize on its popular franchises.
And the merger with Twenty-First Century Fox (FOX) will strengthen content inventory and increase Disney's interest in Hulu to 60%. In addition, Disney is also developing its sports offering into a DTC business. ESPN+, the DTC version of ESPN, was launched in April 2018 and already accumulated 2 million subscribers at the end of fiscal Q1 2019.
Synergies With Existing Businesses
Besides the content assets, the company can rely on its other businesses to support the ramp-up of the DTC offerings.
Despite the decline of the cable businesses, Disney still reported 89 million and 225 million, respectively, estimated subscribers for the domestic and international Disney Channels, during the fiscal year 2018. Other channels like ESPN and Freeform also represent tens of millions of subscribers.
And, of course, the parks, hotels and merchandising businesses contribute to brand awareness and provide synergies for the marketing activities around the launch of Disney+. From an operational perspective, the synergies exist as well, as the company will use the same platform for ESPN+, Hulu and Disney+.
Besides the operational synergies, these legacy businesses still generated about $9 billion of annual free cash flow in fiscal 2018. This financial mattress provides Disney with the resources to develop its DTC offerings.
In the short term, the transformation comes at a cost, though. The company reported a fiscal 2018 loss of $738 million for the Direct-to-Consumer and International segment. Also, management anticipates foregoing about $150 million of operating income during fiscal 2019 to ramp up the exclusive content for the DTC services. And the $71.3 billion cash-and-stock deal to purchase Fox assets will increase the debt by about $35.7 billion. Disney will get $15 billion of cash from the sale of Fox's 39% stake in Sky, but the short-term impact on its financial leverage is still important.
At $115 per share, the market capitalization amounts to about $171 billion, which corresponds to approximately 19x the fiscal 2018 free cash flow. Considering the quality of the assets, the market valuation is fair. But the merger with Fox and the ramp-up of the DTC business can disturb the short-term results.
A drop in the stock price over the next few quarters due to these short-term challenges will not change the long-term potential. Thus, I will wait for the stock price to drop below $100, at a multiple of about 16x the free cash flow, to become a shareholder.
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