Thursday, March 04, 2010

Disney (NYSE:DIS): 2011 In Wonderland; upgrade to Buy - Merrill Lynch/BofA

Merrill Lynch/BofA is making a significant call on Disney (NYSE:DIS) upgrading to name to a Buy from Neutral while raising their price target to $42 (prev. $33), implying 33% upside.

The firm notes they believe accelerating DIS earnings will be driven by five major themes over the coming quarters, including: 1) a broad economic recovery that benefits advertising-driven Media Networks, 2) a falling unemployment rate that helps consumer recovery, benefiting Parks & Resorts and Consumer Products, 3) new expansion projects that bring incremental growth to Parks & Resorts, 4) a new creative cycle that benefits Studio Entertainment and Consumer Products and 5) ABC retrans deals and relaxed political spending rules that boost Media Networks cash flow. Considering the risks and opportunities, Merrill's new Bull Case scenario reflects 3.8x more upside than their Bear Case downside, making DIS one of the most compelling equities in Media and Entertainment in FY11—especially for those seeking consumer exposure.

- Advertising recovery: auto comeback hits home
Following a -13% compression in 2009, the firm believes total U.S. advertiser spend is poised to rebound to the mid single digit range in CY10E, as current economic indicators and non-economic events such as political elections and the Olympics point to higher ad spend. With almost 20% of its revenue derived from advertising, they believe DIS will benefit from the continued rising tide of advertiser spend.

- Consumer recovery: help wanted? gone to Disney World
With unemployment high, consumer confidence low and 30% of total revenue driven by Parks & Resorts (P&R), DIS remains meaningfully geared towards a consumer recovery. Our analysis suggests that declines in unemployment should translate into meaningful top-line improvement at Disney’s P&R businesses in FY11, with positive operating leverage enabling outsized bottom-line benefits. Merrill believes these factors will help drive P&R revenue and EBIT growth of +7% and +18%, respectively, in FY11E.

- New creative cycle: bouncing off the bottom?
Due to the hit nature of the movie business, it is difficult to pinpoint an exact turnaround of Disney’s recent lackluster film performance. However, Merrill believes the combination of several upcoming franchise-type films and recent restructuring activity could set the stage for Studio Entertainment and Consumer Product outperformance in FY11/12E. They currently forecast Studio Entertainment revenue and EBIT of $7.1bn and $765mn in FY11E, respectively, buoyed by the upcoming releases Alice in Wonderland, Toy Story 3, The Sorcerer’s Apprentice, Pirates of the Caribbean 4 and Cars 2. Firm believes Disney’s Studio Entertainment has potential to return to its past success levels in the years 2006-2008 ($730mn-$1.2bn of OI).

- Other considerations: sustainable cable network growth
While Cable Networks have historically represented the largest segment for Disney, their importance has grown in terms of revenue (now 30% of total FY10E) and operating income (just under 60% of FY10E and 66% including Equity in the Income of Investees) with sustained growth and the decline of other less stable segments. In FY09, Cable Networks was the only segment to post revenue and OI growth. Disney Channel and ABC Family continue to build on recent successes, while ESPN is still the largest driver of the segment (estimated at roughly 75% of total Cable Network OI).

With DIS shares currently trading at 13x FY11E EPS, the firm believes DIS’ historical 15% premium to S&P 500 reflecting unique brands, well regarded management, solid earnings performance and strong balance sheet is sustainable considering the number of positive factors potentially influencing the company over the next 12-24 months. On a forward year PEG basis, DIS is currently trading at a discount to the market (0.57 vs. 0.99), clearly not reflecting its higher growth potential (+23% EPS growth vs. the S&P 500’s +13% growth using BofAML Macro Research projections). Merrill believes numerous catalysts exist for upward estimate revisions, including upcoming theatrical releases, retrans consent/reverse comp deal announcements, new cruise ship launches and Park upgrades (in addition to underlying cyclical improvements).

They are increasing their FY10E and FY11E EPS from $1.93 to $2.00 and $2.19 to $2.45 to better reflect their revised outlook and firm's price objective is now $42 (+33% upside), which implies 17x FY11E P/E. Firm's new longer term Bull and Bear case valuations are $51 and $26, respectively, reflecting peak upside of +63% and worst case potential of -16% over the next 12-18 months.

Notablecalls: I like this call a great deal. Merrill's Entertainment team has been cautious-to-neutral on Disney for a while and rightly so. The stock has been a dog for years (well, at least since 05/06) and have gotten their act back together only recently. Disney has so many moving parts yet Merrill seems to have good things to say about most of them.

Networks are doing OK & if you add good studio performance to that, you've got yourself an outperforming stock.

With Merrill hinting longer-term upside to $51/share I think people will take notice. Overall sentiment regarding Disney is still quite cautious.

The stock is headed towards new 52-week highs today putting $32.50+ levels in play, I suspect.

It's cheap & it's got catalysts. What else do you need.

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