Entertainment giant Disney (DIS - Get Report) is preparing to square off against streaming media juggernaut Netflix (NFLX - Get Report) later this year. In this piece, I compare the two companies' stocks and demonstrate why Disney is unquestionably the safer bet.
A Scripted Battle
Tech companies -- and investors -- have become infatuated with scripted content. Many well-financed companies are giving it a shot and attempting to carve out market share in 2019. For example, Apple (AAPL - Get Report) formally announced its ambitions to enter the space last month at its big "It's Show Time" event, and AT&T (T - Get Report) plans to launch its own streaming service later this year. And there's also obviously Amazon (AMZN - Get Report) Video.
This Thursday after the market closes, Disney has its Investor Day where it will discuss its highly anticipated strategy for its direct-to-consumer streaming service, Disney+, which is expected to launch this fall.
For now, investors remain unsure whether Disney will succeed, and as such, have largely remained on the sidelines. Although Disney has a strong portfolio of well-known and loved brands, Disney has to play catch-up and has not yet got a fully operational platform.
CEO Robert Iger has attempted to assuage investor concern by highlighting that during peak streaming consumption, its fully owned BAMTech platform has succeeded in showing strong stability and reliability.
Netflix, on the other hand, continues to see its subscriber numbers increase, although a large portion of its subscriber growth is now coming from International markets, which generate roughly a third of the revenue compared to its U.S. subscribers.
While it may be oversimplifying a bit, one could argue that Netflix has subscribers but is fighting to acquire content, while Disney has content but very few subscribers currently.
Where's The Money Coming From?
For Netflix to keep growing, it must continue to finance its operations via fickle credit markets. It's never a great foundation for a business to be at the mercy of creditors.
Hence, at the end of Q4 2018, Netflix's balance sheet carried an unamortized net debt position of $10 billion plus approximately $20 billion in content obligations. Moreover, Netflix is highly likely to be free cash flow negative for the next several years.
Disney's own financial position is a far cry from being perfect, but it is still vastly superior to Netflix's. Disney finished Q1 2019 with a net debt position of approximately $16.5 billion. However, the huge advantage that Disney has when compared to Netflix is that Disney's revenue is well diversified.
In fact, Disney's Parks, Experiences & Consumer Products not only add an element of diversification to the company's revenue stream, but actually account for more than half its operating income at roughly $8 billion when annualized.
Valuation - Disney Is the Clear Victor!
Disney's valuation has uncertainty hanging over it, as investors remain unsure just how much of a drag its direct-to-consumer platform is likely to have on cash flows. As such, investors presently remain unwilling to pay more than 22x trailing free cash flow and less than 3x its revenue. At the same time, Disney's cash flows are well diversified and at present, there does not appear to be any "pricing in" for the potential of Disney+.
Netflix, on the other hand, has no free cash flow to show. All that analysts and investors have at present to guide them is an accounting profit, which is being estimated after most of Netflix's costs are capitalized on its balance sheet. In other words, investors are willing to pay more than 10x its revenue not only for the likelihood that Netflix continues its rapid pace of growth, but that it continues to hold onto its market share and overall dominance in the streaming space. And its up-and-coming competition may have something to say about that.
The Bottom Line
The riskiest aspect of any investment is the assumption that we have any control over or certainty about the future. I believe the best way to account for risk when choosing the most rewarding streaming platform is to appreciate the inherent uncertainty involved in picking the correct stock and demanding a large margin of safety. I argue that Disney presently offers investors the necessary margin of safety.