Out of the Doldrums at Disney, Part 3

Why the stock appears to have significant upside.
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Continued from Part 2

So Disney is cheap.

But is it worth buying?

Murphy and Staggs offer plenty of reasons it might be, brand woes notwithstanding. Here are three: DVD, international and broadband. At present, analysts are simply ignoring the potential profits from all three -- probably because it's still unclear how quickly they might start spewing cash. But the first two could hit Disney's bottom line much sooner than investors realize, while the third is the Mouse's hidden trump card against its online competitors.

First, DVD. Already this video technology has become among the most quickly adopted home electronics products of all time, and by 2002, more than half of all U.S. homes are expected to have a DVD device, including computers equipped with DVD drives, according to

Strategy Analytics

, a British electronics consulting company.

That's great news for Disney. Murphy says the company's research shows even if consumers already own Disney home videos for a VCR, they will often move the VCR to a different television and buy the videos again on DVD. "People

are adding DVDs to their VCRs," he says. "What it does is it enables you to have more places to watch prerecorded material, VHS and DVD."

"There's clearly upside there," Staggs says. How much is impossible to quantify, but the promise is enormous. Home video was the single most powerful earnings driver for Disney during the fat years of the early '90s.

The potential for international growth is easier to measure. Despite Disney's worldwide brand recognition, only one-fifth of the company's revenues came from outside the U.S. last year. In the four most important international markets -- Germany, Japan, the U.K. and France, which combined are bigger than the U.S. -- per-capita sales of Disney-branded merchandise are only 30% to 70% of sales here. Murphy says the gap has little to do with cultural differences and lots to do with Disney's weak organization internationally.

Michael Eisner "is literally the brand manager of the Disney brand here in the U.S, making sure the company is speaking with one voice. ... We never had that one company approach" overseas, Murphy says. "I look at the international thing and say there's huge opportunity to increase consumption of our brand without a lot of incremental cost."

(On Oct. 27, Disney took its first public steps toward revitalizing its international operations, naming six executives who will have responsibility for managing the Disney brand throughout Europe. "Our mission is to bring coordinated leadership to the international activities of the Walt Disney Company in order to achieve the same consistency of voice and cross-divisional strengths we enjoy in the United States," Walt Disney International President Robert Iger said in a statement.)

Finally, the coming explosion in broadband, high-speed Internet service is likely to be enormously positive for Disney. Murphy explains why: "We are a competitive Internet company in the narrowband world. But in the broadband world, we should be a truly unique and differentiated company. ... The evolution to broadband can't happen quickly enough for us. ... Headline news on the Internet is becoming a bit of a commodity. ... If you want the score in the

Mets

game, you can get it. ... But to be able to see the Sam Donaldson interview with Bob Rubin -- that's an incredibly powerful feature that doesn't exist

today, and we can do it uniquely vs. an

AOL

(AOL)

or a

Yahoo!

(YHOO)

."

Culture Shock

None of these changes will happen overnight. In fact, most analysts think Disney's earnings will stay flat in 2000.

But even if it takes a few months for the impact of DVD and international growth to hit Disney's bottom line, investors can already take comfort that something important is already changing. Too many years of success bred a culture of arrogance at the Mouse. As early as 1994, when Eisner told

The Washington Post

that he "expected to be taken around on everyone's shoulders" after proposing a historical theme park in Virginia, the company's overconfidence was evident. (The park was never built, thanks in part to Eisner's comments.)

Even as the company's stock tumbled in the past two years, Disney's hubris worsened. Among the missteps were questionable capital spending, including two sports teams and a couple of $350 million cruise ships, needless disdain for the press and a running battle with the Christian right. The company's hubris peaked this spring, when Eisner refused to back down from an ugly court battle with Jeffrey Katzenberg that Disney eventually was forced to settle anyway.

"Sometimes you become a victim of your own success," Staggs admits.

Now, Staggs and Murphy say, the company has realized it must listen more closely to its critics and work harder to cultivate partners, on Wall Street and everywhere else. The sports teams are on the block, and the company is taking a new look at all its expenses. At age 57, Eisner wants to prove that he is the same manager who grew Disney's stock 30-fold between 1985 and 1998. And Staggs and Murphy, who have both turned down rich potential paydays to stay at Disney, want to prove they've made the right choice.

Turning It Around

A couple of analysts have already taken notice. Last week, in a research note headlined "Encouraging Developments Taking Shape at Disney,"

Salomon Smith Barney

analyst Jill Krutick pointed to a "more Wall Street friendly approach" from the company. (Salomon has underwritten for Disney in the last three years.)

"A long run of success tends to create a couple things -- an aura of invincibility, arrogance, frivolous spending," says Douglas Eby, president of

Robert E. Torray

, a Maryland firm that manages $6 billion in stocks. "And clearly Disney succumbed to that, and the most encouraging thing I see at the company is a focus more on return on capital, which the CFO is instilling."

Torray, which buys stocks it believes can double in five years, has bought 7 million Disney shares so far this year on the belief that Disney has too many strengths to languish for long.

"Our style of investing is to buy superior businesses at fair prices, with the idea of holding them for a long time. ... With Disney, we are confident that the company's assets and brands and content will over the long term continue to be very valuable," Eby says. "We think we understand the issues that are causing the earnings to stall, and we don't view them as a permanent impairment."

Still, most of the Street is locked in a waiting game. That's understandable given how badly Disney has performed over the last two years. In addition, the Viacom/CBS merger has created a new "must-own" entertainment company and stolen the spotlight from the Mouse.

Eby, for one, admits he doesn't expect Disney to turn around overnight. But he says that's not why he's buying the stock. "I see a situation that has limited downside," he explains: "A company that has underperformed for several years and, no matter how you slice it, is cheap to its peers."

And if company's brand proves to be more resilient than critics expect, investors who buy Disney now could be in for a very smooth ride.