The mystery of Disney

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Is Disney cheap now?

A bit less than a year ago we wrote a piece called “Is Disney Cheap?” The answer is now clear: it wasn’t. The stock has fallen 18 per cent since. The gist of that piece, written just as Bob Iger was being brought back to replace Bob Chapek as chief executive, was that the economics of Disney’s video content business were extremely good — before streaming came along and wrecked everything. The theatrical release/DVD/cable TV/broadcast TV/theme park cycle gave Disney multiple ways to turn intellectual property (characters, essentially) into money. Streaming has replaced some of those profits with losses. We expressed scepticism about the ability of streaming revenues to ever fully replace broadcast and pay-TV revenues. 

The story has evolved a bit since then. Nelson Peltz’s Trian Partners officially launched an activist campaign against Disney in January, nominating Peltz for a board seat. In February, after Iger announced organisational changes and $5.5bn in planned cuts to overhead costs, Trian withdrew the Peltz nomination and expressed pleasure at Iger’s plans. The bonhomie did not last. Trian has now added to its Disney stake and Peltz is angling for a seat again. This week it was reported that former Marvel executive Ike Perlmutter has added his large stake in the company, and his support, to Trian’s campaign.

Trian and Perlmutter are in a better position now than they were a year ago, in that the stock is cheaper and as such the pressure on Iger is greater. In this year’s July quarter, losses from the streaming business, at half a billion dollars, were half the size they were a year before. But subscriber growth has been very sluggish and comparison with Netflix remains painful. With about a third more subscribers (depending how you count), Disney’s rival has an operating margin of more than 20 per cent.  

A Trian presentation about Disney’s shortcomings, from January, highlighted assorted past failures. The company mismanaged expectations, overpaid executives, spent too much on acquisitions, had poor succession planning, and so on. But the only substantive, future-facing strategic point was that the economics of Disney’s streaming business compare poorly with Netflix’s. The differences are indeed stark. A Trian slide about 2022 results:

What is missing, however, from both Disney’s communications and Trian’s, is why the difference is so big. The businesses are clearly very different: Disney has a content machine that feeds other distribution channels, while Netflix is single-channel. But how does that play out in terms of the size and timing of profits? Are there cost allocation issues that need to be kept in mind? Are there differences in strategy that multiply costs at Disney?

Trian’s activist investment in Procter & Gamble was backed by a very specific account of why the consumer goods company was underperforming. P&G’s “matrixed” organisational structure, in which functions such as advertising and manufacture were centrally operated independent of individual product lines, increased costs and limited accountability. A similar picture of what is going on inside of Disney’s streaming business is absent, and much needed. Until Disney or Trian can provide it, it will remain hard to say whether Disney is cheap, or if Trian stands to make much money on its investment. 

Volatility and returns

After we wrote recently about the market’s tepid response to strong economic data, Unhedged’s regular correspondent Dec Mullarkey, of SLC Management, wrote to argue that results year to date have been driven more by rates and real estate than by growth or credit risk. He provided this interesting scatter plot of returns and volatility:

Some debt investments have done exceptionally well. Leveraged loans, a floating-rate investment that has not yet been dragged down by rising defaults, have crushed fixed-rate Treasuries. High-yield bonds, with their bigger coupons and therefore shorter duration, have outperformed investment grade. Lower-rated real estate investments have stank it up. What’s most striking in the chart above is how certain credit investments have generated equity-like returns with just a fraction of the volatility.

We were curious to see how Mullarkey’s chart looks broken into this year’s main two trading regimes — before and after the S&P 500 peaked on July 31. We also threw in a few other candidates, like junky tech and Japanese stocks, for comparison. Before the market peak, high-volatility equities generated higher returns than even the best performing fixed-income categories: 

In the two months since the S&P peaked, the opposite — more volatility, worse returns — holds true. Notably, investments like high yield, IG bonds and the 10-year Treasury have suffered only limited losses, perhaps helped by their lower volatility. Taken in total, the relationship is striking in its linearity:

The returns-volatility relationship flips sharply after the market peaks in July. The chart below sums up. Across asset classes, volatility is similar in both regimes but returns do a full reversal:

The most obvious culprit is changing thinking on interest rates. The July market peak roughly coincides with the 10-year yield breaking to new highs, the peak in 2023 fed funds rate expectations, and the peak for positive economic data surprises (as measured by the Citi US economic surprise index). Markets, having briefly seen the light at the end of the rates-cycle tunnel, realised it was an oncoming train.

Here’s a question to ponder. If rates do indeed stay higher for longer, will the relatively low volatility we’re seeing in credit investments persist? For example, might the good risk-adjusted performance of floating rate investments crash up against a real default cycle? Let us know your thoughts. (Wu & Armstrong)

One good read

The Wu affair (no, not that Wu).

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