Disney's Hunt for a Happy Ending

Hit movies have boosted earnings. However, from the theme parks to ABC to Pixar, Mouse House problems are stifling the stock

By Ronald Grover

In Finding Nemo, this year's animated blockbuster from Walt Disney, a timid clownfish searching for his son struggles against all odds. Disney (DIS ) can relate. Hammered by falling ratings at its ABC network, a prolonged travel slump that savaged its theme-park business, and an economic slowdown that crimped sales of Mickey and Minnie merchandise, Disney has been looking to sprinkle some magic on its balance sheet. Now, at long last, it appears that Sleeping Beauty might be waking up.

On July 31, Disney reported third-quarter earnings of $400 million, a 9.9% hike from a year earlier and slightly better than a consensus estimate from analysts polled by Thompson First Call. Revenues increased by 6.6%, to $6.18 billion, from $5.8 billion a year earlier.

The results, while impressive, don't give the complete picture, however. Disney's turnaround is still a work in progress. True, the movie studio is hitting on all cylinders, with Finding Nemo swimming past $320 million at the box office and the Jerry Bruckheimer-produced action film Pirates of the Caribbean closing in on $220 million. But Disney is still hampered by lackluster performance at its giant theme-park unit, which, in better times, contributed about half of operating income. To date, theme-park earnings are down 22% on last year.


  Small wonder many analysts continue to keep Disney on their neutral lists, awaiting the improvement of the world economy. Others worry that Disney may be overpriced. Its stock, trading at $21.65 as of Aug. 7's close, has run up 30% in 2003, thanks to prerelease buzz about Nemo and the return of advertisers to ratings-challenged ABC.

However, most analysts don't see any big pickup soon. Merrill Lynch's Jessica Reif Cohen, who has a neutral rating on the stock, figures Disney's shares "have potential to rise to the mid-$20 range." (In its annual report, Merrill says it has done investment banking for Disney in the past.)

J.P. Morgan's Spencer Wang points out that Disney trades at 12 times cash flow, slightly ahead of other media-company valuations, and like a number of other analysts, he urges caution. "We believe the market has already discounted much of the earnings recovery in financial year 2004," Wang wrote recently. "We would look for a more attractive entry point before turning more aggressive." He has a neutral rating on the stock. (In its annual report, J.P. Morgan says it has done investment banking business with Disney.)


  Analysts would like to see the return of free-spending international travelers to Walt Disney World in Orlando, which gets nearly one-third of its visitors from overseas, or to the trio of Disneyland Resort hotels in Anaheim, Calif. Instead, attendance at Disney World this summer has been off by 8%. And while Disneyland -- which relies less heavily on foreign tourists -- saw attendance rise by 7%, many of those visitors hailed from close by. Such patrons tend to spend less on food and lengthy hotel stays, further cutting into the parks' operating earnings.

When will they come back? Disney executives don't sound terribly optimistic. "A dramatic uptick in visitation is unlikely in the near term," admits President Robert Iger. Indeed, SG Cowen analyst Lowell Singer figures it may take until mid-2004 before European travelers return to the U.S. in sufficient numbers to help Disney (see BW Online, 8/8/03, "The Travel Industry's Summer Bummer").

In the meantime, the Mouse House is heavily discounting travel packages and ticket prices to generate what business it can from those markets. Travelers can get seven-day Disney World packages for the price of a four-day trip. And in California, a four-day pass to Disneyland and the adjacent Disney California Adventure in Anaheim is going for 50% off the daily ticket price. By Ronald Grover


  Result? The promotional cost has taken its toll. Theme-park earnings will likely decline to $166 million in the fourth quarter, down 29% from the $235 million in for the year-ago quarter, figures SG Cowen's Singer. While he rates Disney market-perform, Singer has reduced his earnings estimates, in part because of lower theme-park margins.

While Disney awaits the tourists' return, it's struggling on other fronts. Ratings at ABC stubbornly refuse to rise. So, Disney is slashing program costs by relying less on expensive, one-hour dramas and leaning more toward sitcoms, which bring the added benefit of selling better as reruns. Also, the network has reduced what it pays to buy shows from other studios.

Merrill's Cohen estimates that ABC can reduce losses to $420 million in 2004, down from the $540 million it's expected to lose in 2003. She also figures that an advertising upturn will help ABC, its wholly owned and network-affiliated TV stations, and Disney's ESPN cable sports channel, all of which are writing contracts with double-digit price hikes. Overall, Cohen sees earnings at Disney's TV operations rising by 18% this year, to $1.2 billion, and by 30% in 2004, she says.


  Disney is also overhauling some of its less profitable units. It has hired investment bankers to sell off its 500-outlet Disney Store chain, which analysts figure loses about $100 million a year. Also, it has trimmed the number of products it licenses, focusing on higher-end wares and reducing its reliance on movie-driven products that don't sell as well.

Another gambit is beefing up products based on Disney Channel TV shows like Kim Possible and Lizzie McGuire. To improve earnings at its studio operation, CEO Michael Eisner says Disney has cut back on the number of expensive films it produces and is churning out more lower-budget films like the Queen Latifah comedy Bringing Down the House and remakes like the recently opened Freaky Friday.

Disney is locked in negotiations to extend its contract with Pixar Animation Studios, which made such Disney blockbusters as Monsters, Inc., the Toy Story movies, and Nemo. Pixar, controlled by Apple (AAPL ) Chairman Steve Jobs, wants to reduce Disney's 50% stake in films Pixar makes, starting in 2006. The studio wants to finance its own films and give Disney a much lower percentage, perhaps as little as 6%, to distribute its films.


  During a recent conference call with analysts, Eisner refused to answer questions on the talks, saying that Disney would sign a contract with Pixar only "if there is a deal that makes sense for both Disney and Pixar shareholders." Pixar remains under contract to deliver two more films to Disney, The Incredibles next year, and Cars in 2005 or 2006, Eisner added.

Another hot spot: Disney may have to provide funding to its 39%-owned Euro Disney theme park in France. Staggered by a slowdown in European travel, Disney says it has already agreed not to charge royalties and management fees to the separately traded company. On top of that, Disney may be required to take a noncash writedown of its $522 million loan to the park if its management can't restructure debt and violates covenant agreements. Disney CFO Tom Staggs says he's confident Euro Disney can restructure, as its executives have done in the past.

Disney, which long relished its reputation as the Happiest Place on Earth for shareholders, has still plenty of remodeling to do. It could use a lift in worldwide travel, some hits at ABC, and a diplomatic coup that would keep Jobs's Pixar in the family. A turnaround could have more twists and curves than Disneyland's Matterhorn ride -- but it sure won't be as fast.

Grover is Los Angeles bureau chief for BusinessWeek. Follow his weekly Power Lunch column, only on BusinessWeek Online

Edited by Patricia O'Connell

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