Disney: An Undervalued, Wide-Moat Stock

Disney (DIS) is an undervalued wide-moat stock, and we'd get even more enthusiastic if the price dips back to the mid-$30s again. Disney's cable networks, mainly ESPN and Disney Channel, contribute more than half of the company's annual cash flow, so monitoring the competitive position of this business is crucial to our opinion on the stock. Rising TV sports programming costs were a constant theme in 2011, and we think this trend is likely to continue. Despite these costs, we maintain that ESPN is well-positioned as it has pricing power and remains dominant in live sports, which we view as essential for the pay-TV business as time-shifted viewing increases.

NFL Rights Expensive, but Vital
Let's be clear: Given its dominant position and pricing power, the National Football League's moat is wider than ESPN's, Disney's, and most publicly traded stocks. The NFL is the most popular sport in the United States, and we don't expect this to change anytime soon. The short list of reasons for its popularity, in no particular order:

• Great TV sport: High-definition makes the hard-hitting action better than attending in person.
• Competitive balance: Thanks to the salary cap, all teams are on a level playing field.
• Convenience: Games are played one day a weekend (with a few exceptions).
• Gambling: Proliferation of ways to have "action" on games (point spreads, fantasy leagues, office pools).

In September, Disney and the NFL announced a long-term contract that extends ESPN's rights for Monday Night Football through the 2021-22 season. Various media sources peg the average annual cost at $1.9 billion per year, up from the estimated $1.2 billion per year (costs for additional rights added to the $1.1 billion announced in 2007) for the agreement that runs through the 2013 season. This drives the headline increase of roughly 60%, but we think it's more informative to view this figure on an annual cost-growth basis. We estimate that the average annual cost increase is roughly 6%, and we believe ESPN can obtain average affiliate fee increases at or above this level over the next decade.

While the headline cost increase is significant, we think the NFL deal is crucial for ESPN, especially given the sport's popularity and the year-round nature of programming that makes ESPN the most valuable channel for pay-TV distributors. These NFL rights contracts typically have escalators, so the new deal will start well below $1.9 billion. We estimate that ESPN will be paying about $1.3 billion per season when the 2013-14 contract ends. Disney has indicated that the annual increase in rights will be roughly 4% following a steep initial step-up.

In December, the NFL announced deals with its three broadcast network partners--CBS (CBS), Fox, and NBC--that reportedly will average at least $1 billion annually (a more than 65% increase). The current deals expire in 2013; the new ones run through 2022. We estimate that the headline increase is a similar percentage to what the NFL received from ESPN. For broadcasters, NFL programming is a major negotiating lever used to obtain retransmission fees, which are payments from distributors for the rights to include local broadcast stations in basic cable packages.

Live sports programming drives audience ratings and is a crucial offering in pay-TV packages. ESPN's Monday Night Football was cable's most watched series for the sixth straight year and according to Sports Business Journal, Sunday Night Football on NBC was the highest-rated series on broadcast TV. According to Nielsen Co., 24.5 million people watched the NBC Sunday night game between the Cowboys and Giants on Dec. 11, 2011, a much larger audience than for the week's most popular nonfootball program, CBS' "Two and a Half Men," which had 15.2 million viewers. Advertisers realize that sporting events are watched live more than other programming and are the best way to reach male viewers. Even NFL pregame shows can attract audience ratings on par with top prime-time shows.

Included in the new ESPN deal were more than 500 new hours of NFL-branded programming per season (which started in 2011), expanded highlights for its portfolio of networks like ESPN2, and digital rights for ESPN.com. The digital rights include the ability for paid cable subscribers to watch games on tablets and other mobile devices, which bolsters the company's authentication offering for cable providers. NFL-related programming has become year-round and is the most popular sporting event on ESPN, so we think the incremental value of generating a year-round audience makes the high price tag easily digestible for Disney. We believe authentication as a key initiative for the pay-TV industry during the next several years and the extended digital rights in this NFL deal should allow ESPN to remain ahead of the pack in allowing subscribers to stream content.

Competitors Remain in "Catch-Up" Mode
We think ESPN is dominant in national sports programming, but there are a few media conglomerates looking to gain a larger share of the national sports media pie as league-owned networks attempt to capture the economics of live sports channels.

• News Corp/Fox Sports: The News Corp-owned division's strength is in its regional sports networks (RSNs), which show sporting events in local markets. This is a much different business model than ESPN, as the RSNs do not offer 24-hour programming. We view Fox Sports as more of a direct competitor to ESPN in college football with its 50% stake in the Big Ten Network, as well as its deals with the Pac-12 and Big 12 conferences. ESPN has a huge distribution edge in sports with ESPN, ESPN2, ABC (weekends), and ESPNU as major national channels, while Fox has its broadcast network and FX.
• Comcast/Versus/NBC Sports: We will be watching this one closely, as Versus was rebranded as NBC Sports on Jan. 2, 2012, and we assume the Comcast-owned channel wants to become more of a player in national sports programming. As we highlighted earlier, however, there is not much available in terms of sports rights. The just-signed NFL deal will allow NBC Sports to air a two-hour pregame NFL show on Sundays in addition to its 75-minute pregame show before the broadcasted Sunday night game.
• NFL Network: This network was launched in 2003, and we think its primary purpose was to place a floor on programming rights. Obviously, bypassing ESPN and its broadcast partners would allow the NFL owners to reap all of the profits from showing games on television. However, getting NFL Network fully distributed on cable systems has been a challenge, with it usually being offered on sports packages or other premium tiers. The network's main leverage with distributors is the Thursday night game package shown in the second half of the season. According to Sports Business Journal, NFL Network reaches more than 57 million households, up from 37 million in 2006. ESPN and ESPN2 are fully distributed to 99 million pay-TV households.
• MLB Network: Of all the league-run cable networks, we think MLB Network, owned by Major League Baseball, is ESPN's most formidable competitor. With 30 teams each playing 162 games, MLB Network shows a much higher proportion of games than NFL Network. On most weeknights during the season, the network shows games or runs a studio show that starts in the early evening and breaks into live games throughout the night, providing commentary from a host of former major league players. In our view, which may veer from conventional thinking, baseball needs ESPN in order to keep the sport on the mainstream radar along with the NFL and NBA. ESPN is great way for baseball to attract the casual fan who is not excited enough about the game to seek out MLB Network.

We Expect ESPN to Maintain Its Impressive Profitability
The company has been disciplined in its bidding on sports rights. ESPN knows its strengths, and the company has not paid for deals that don't fit its economic model. The company does not pay for NHL games, as the price tag does not justify the poor ratings generated by hockey's small, yet avid, following in the U.S. The company participated in the bidding but did not get the Olympics rights recently "won" by Comcast/NBC Universal. While the Olympics are a major global event every four years, the event does not justify the cost; ESPN has been smart to focus on the U.S. market, where it has a great competitive advantage. ESPN also passed on sharing rights to the NCAA Basketball package held by CBS, which eventually partnered with Time Warner to share the cost of the programming. ESPN is the dominant provider of regular-season college basketball games, and the company did not view the three weeks of tournament games as an economical purchase at the price paid by CBS and Time Warner.

Obviously, changes in the advertising market can affect sales and profitability in the near term, but the closest look at ESPN's margins are at the cable network level (we assume about 75% comes from the ESPN family of networks). On a trailing 12-month basis, profitability has remained steady during the last few years.

Disney's Sum-of-the-Parts Valuation Is Attractive
On a sum-of-the-parts valuation, Disney's stock remains undervalued despite its recent move from $30 (when we thought it was dirt cheap) to above $38 per share. We believe our assumptions for 2012 earnings before interest, taxes, depreciation, and amortization (EBITDA) and assigned multiples are reasonable based on prevailing valuations for each segment's direct competitors. When we think about Disney's wide moat, we break the business into two parts: (1) cable networks, which also include the ABC broadcast network and (2) Disney-branded businesses, which include the parks, filmed entertainment, and consumer products segments. Both "halves" of the business exhibit strong pricing power.

We think the shares are worth $45 applying conservative multiples to our 2012 segment EBITDA estimates, including a 10 times multiple for Disney's cable networks, 7 times for broadcast networks and stations, 6 times for parks and resorts, 6 times for filmed entertainment, and 12 times for consumer products.