The Long and Short

Value in the belly of the DIS curve

| October 20, 2023

This document is intended for institutional investors and is not subject to all of the independence and disclosure standards applicable to debt research reports prepared for retail investors. This material does not constitute research.

While the debt of Walt Disney Company (DIS: A2/A-(p)/A-) largely trades at tighter spreads than peer Comcast Corp (CMCSA: A3/A-/A-) across the curve, there are certain DIS bonds below the $300 million minimum size for the investment grade index that trade at similar levels to CMCSA. Those bonds happen to be in the belly of curve where buy-and-hold investors can pick up around 20 bp for the lack of eligibility relative to index-eligible DIS bonds. Furthermore, these bonds trade roughly on top of CMCSA bonds with similar maturities. DIS maintains a higher rating at Moody’s while also having a positive outlook at S&P, both of which could provide a catalyst for spread tightening should DIS continue to reduce leverage closer to historical levels.

DIS 6.75% 2038 bonds are one clear example of an issue too small for the index that trades wide to DIS issues that do quality. For buy-and-hold investors that do not need the liquidity of an index-eligible issue, these bonds offer good relative value.

Exhibit 1. Single-A Media Curve (7yr-30yr)

Source: Bloomberg TRACE; Santander US Capital Markets

Strategic review addressing secular pressures

While it is no secret that the media industry has been under secular pressure, DIS has been looking to address these pressures by re-evaluating their suite of broadcast and /cable networks, given the rise in cord cutting which has stemmed from the growth of streaming services. DIS may look to sell certain non-core networks, with proceeds used to help strategic investments in both its Parks business and well as direct-to-consumer (DTC) offerings. Disney+ in on a path to profitability in fiscal 2024 despite domestic net losses as average revenue per user (ARPU) improves. DIS noted that over 40% of gross customer additions opted for the ad tier which improved Disney+ ARPU by eleven cents on a sequential basis.

Furthermore, DIS is considering strategic partnerships for the ESPN flagship channels as they look to take them DTC. DIS is considering partners to aid in both the content side, given the sharp increase in sports programming, as well as distribution, technology and marketing. Despite the potential for partnerships, DIS plans to retain control of ESPN.

Free cash flow growth driven by cost cutting initiatives

DIS embarked on a comprehensive cost reduction program which is expected to garner over $5.5 billion in annual cost savings. The cost savings will help to drive both EBITDA and free cash flow growth, which is expected to improve leverage while strengthening its cash position. Cash currently stands at $11.5 billion and consensus estimates put free cash flow at approximately $4.6 billion for fiscal 2023 (which ends 9/30/23) and $6.6 billion in fiscal 2024. That would represent cash flow growth of 328% from fiscal 2022 and 43% from fiscal 2023.

EBITDA margins will also benefit from the cost reductions which should help to bring DIS’ DTC offering margins more in line with peers. Management noted that their steaming business is relatively new when compared with Netflix Inc. (NFLX – Baa3 (p)/BBB+), as the service was only launched in November 2019. DIS has more wood to chop with respect to balancing programming investments with pricing strategies that provide for both subscriber and advertising revenue growth. Management will look for ways to combat password sharing while getting proper technology in place to improve customer engagement (such as betting services). DIS is forecast to end fiscal 2023 and fiscal 2024 with EBITDA margins of 17.2% and 19.3%, respectively.

Exhibit 2. DIS Financials (FY19-FYE24)

Source: Company Reports; Bloomberg; SanCap

Hulu put should be resolved soon

Back in May 2019, DIS entered into a put-call agreement with CMCSA that will provide DIS with full operational control of Hulu. The agreement allowed for CMCSA to require DIS to purchase its 33% interest in Hulu and for DIS to require CMCSA to sell its Hulu interest beginning in January 2024. The start date of the put-call agreement was recently moved up by three months, to September 30, 2023. The floor value of the stake is worth $9.2 billion, which was the fair value of Hulu when the agreement was struck (33% of $27.5 billion). The final valuation of the Hulu stake could be higher as both parties need to come to an agreement on valuation of the stake.

Management has explicitly stated and noted that they remain committed to returning to leverage in line with a mid-‘A’ rating, which equates to leverage below 2.5x. That said, DIS is likely to finance the put-call with a combination of debt and cash on hand. Management has noted that they were very comfortable with their currently liquidity position which includes the aforementioned cash balance of $11.5 billion coupled with untapped revolvers totaling $12.25 billion. Obviously, the more cash used to fund the transaction the better for the company’s gross leverage ratio.

S&P’s positive outlook reflects improving leverage

S&P changed DIS’ outlook to positive when it upgraded the ratings to ‘A-‘ in June of this year. The agency noted that the positive outlook reflects expectations that leverage could decline to under 2.5x in fiscal 2024. DIS ended its most recent quarter with S&P adjusted leverage of 3.1x, which was down roughly two ticks sequentially. The agency notes that the resolution of the outlook will largely depend on the financing of the Hulu put-call, but the agency anticipates that the company will rely on its large cash balance to help fund the transaction.

S&P has noted that DIS’ board of directors and senior management team are committed to restoring leverage below 2.5x. That said, shareholder rewards have been put on hold as the company suspended the dividend during the pandemic and has not repurchased shares since fiscal 2018. While DIS does not report earnings until November 8, 2023, estimates put free cash flow for the quarter at roughly $3.2 billion, which will only lend to the company’s strong cash position. Furthermore, any sale of non-core assets will further strengthen the balance sheet and provide funding for reinvestment in the business.

Value relative to CMCSA

While DIS’ leverage is currently about a half a turn higher than that of CMCSA, DIS’ focus on debt reduction and the balance sheet should have its leverage metric declining in fiscal 2024 to a level similar to, in if not lower, than its peer. CMCSA has largely been focused on shareholder rewards, having spent $18.1 billion on shareholder remuneration in fiscal 2022 relative to free cash flow generation of $15.8 billion. On a LTM basis, CMCSA’s shareholder rewards are outpacing free cash flow generation once again. CMCA’s shareholder focus will keep S&P adjusted leverage in the 2.6x-2.7x range over the foreseeable future, where DIS’ leverage could fall below 2.5x in the next 12 months. Additionally, CMCSA has more than $13 billion of debt maturing in 2024-2025, relative to $7 billion at DIS. DIS’ plans for further debt reduction translates to less refinancing and new issue concession risk relative to CMCSA.

Meredith Contente
1 (646) 776-7753

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