Disney Droop: Cost-Cutting Won't Save 2009, 2010

No amount of Magic Kingdom fairy dust can save Walt Disney Co. from the same recession pain as its peers, despite its brilliant, lucrative management of its branded assets against cyclical headwinds during the past three years.

That is the conclusion of a comprehensive analysis of film studio, theme parks and television network factors that contributed to Disney's past profit surge but will not be reoccurring. The most recent fiscal fourth quarter marked the first time that Disney missed consensus EPS estimates during Bob Iger's tenure as CEO, which has otherwise been "a habitual upward earnings revision machine," notes Bernstein Research analyst Michael Nathanson.

From fiscal 2005 to 2008, Disney generated an average 20% growth in segment operating profit. Disney's consolidated cable networks increased an average 15%, and accounted for 35% of overall segment growth. The remaining 65% of Disney's operating profit growth was generated by other assets, whose vigor from cost reductions, entertainment popularity and other temporary factors is beginning to wane. The more moderate continuing gains at Disney's cable networks will not be sufficient to make up the difference for these cyclical downturns, or to keep overall operating profits bolstered double-digits.

For instance, the syndication profits from its hit prime-time series "Desperate Housewives," "Grey's Anatomy" and "Lost" are winding down. The three series boosted ABC TV broadcast network operating profits from $245 million in fiscal 2004 to $655 million in fiscal 2008. ABC's two most valuable franchises--"Housewives" and "Grey's Anatomy"--are down 17% and 25%, respectively, in the current ratings season. ABC has no new breakout series at a time when its overall 16% decline in prime-time ratings is the steepest of any broadcast network. It must now rebuild its prime-time schedule in a devastating advertising slump. Nathanson estimates that ABC's broadcast operating profits will fall 61% to $257 million in fiscal 2009. Robert Coen, Magna's director of forecasting and veteran industry guru, said Monday that he does not expect a recovery until 2010. He predicts that overall spot TV advertising will be down 11% and the four broadcast networks' advertising will be down 7.5% in 2009.

Filmed entertainment operating profits have grown by $880 million--or an average 74%--since fiscal year 2005 as a result of lower film output, which reduced total segment costs by more than $1 billion. With most of the cost savings realized, future financial results will more closely track the idiosyncratic performance of each year's release schedule, Nathanson said.

The studio's four-year reorganization included reduced live-action and streamlined animation production at Pixar and Miramax writedowns. Disney's filmed entertainment operations, barely profitable for most of fiscal 2005, posted a 12-month operating profit that peaked at $1.3 billion by mid-2007--and has stayed within $200 million of that range. "The studio cannot continue to cost-cut its way to higher profits," Nathanson said.

As for its theme parks, Nathanson is forecasting a 5% decline in revenues to $8.7 billion and a 22% decline in profits to almost $1.4 billion in fiscal 2009 on declining attendance that directly corresponds to negative GDP. Historically, theme park profits have declined as much as 66% and declined an average 17% during recessionary times of lower attendance, he said. Past theme park resilience was attributed to new gates, increased ticket prices and international expansion. Those profits will not be sustainable in this deeply protracted recession.

ESPN and other Disney cable networks, like others among their industry peers, have realized structural gains in ad dollars and viewers at the expense of the broadcast networks. However, Disney recently reported the first ad decline in three years for its cable networks, which are expected to see ad revenues decline 5% in fiscal 2009. Even anchor network ESPN is vulnerable; it derives 15% of its ad revenues from automotives and another 14% from the insurance and real estate industries.

ESPN's fiscal fourth-quarter ad revenues declined by $41 million, or nearly 10%, as result of the collapse of the auto industry and competition from NBC's Olympic telecasts. That said, Disney's cable network operating profits could achieve a modest 5% gain in fiscal 2009 driven by 10% growth in affiliate fees. Only 18% of Disney's revenues are generated by relatively economic-resistant cable network affiliate fees, which are a rare source of earnings stability and growth. The weakening of its other core businesses would boost Disney's dependence on cable networks to close to 60% of its overall operating income.

As a result, Nathanson has reduced his fiscal year 2009 and 2010 earnings-per-share estimates for the company to 3% below market consensus. Disney's share price is not expected to rise much beyond its current $22-a-share level. It is the only media conglomerate to outperform (by 9%) the S&P 500, which is down 41% year-to-date. All of its media conglomerate peers have underperformed the S&P--the worst being CBS, by 37%.

Although Disney recently launched aggressive promotions to lure theme park patrons, analysts say such moves will, at best, stem losses rather than stimulate growth returns. The $930 million in digital revenues that Disney generated last fiscal year also will help offset balance-sheet losses in traditional businesses. Iger and his management team have been notably forthright about what's to come. "Even the best product out there is feeling the effect," Iger said during the company's most recent earnings call. "No two recessions or downturns are the same, and we're not the same company today."

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