Disney – Is it An Accounting Mouse Trap?

We continue to urge caution for those invested in Disney. The stock is now $88.01 cents down from $93 when we first wrote our research brief.  

Original Research Published December 11, 2022

In late November 2022, Disney announced that Bob Iger would return as CEO with a mandate to improve profitability in its streaming business. Iger was CEO previously for a 15 plus year tenure. He stepped down in February 2020 giving the reins to Bob Chapek, who ran Disney’s park business. Something about this change doesn’t sit right with us.

Industry and some media reports have indicated that Chapek’s demise occurred when Disney’s CFO went to the board and stated that she had no faith in Chapek. There has been other speculation that Disney was “playing with the books” – specifically – changing an allocation methodology for unknown reasons. Is Chapek a fall guy for others? Or is there something else going on here?

When Iger first retired in February 2020, we speculated that Iger knew that Disney was going to be in trouble because of COVID – so from a self-interested standpoint, there was no reason to hang around as CEO when a cushy board seat would suffice. Several years ago, investors were clamoring for a succession plan and Iger gave it to them.

At the time, we viewed Iger’s decision to step down as odd because Disney was about to face serious issues. Was Iger scared to be CEO when times were difficult? Just one month later, with Chapek as CEO, Disney shut its parks due to COVID. This closure caused Disney’s Parks and Experience segment revenue to plunge. In fact, it reported an operating income loss for the next two years under Chapek’s reigns.

What is interesting to us is that Chapek ran the parks business and had no experience running the streaming business. Thus, we believe that Iger, although no longer the CEO, was heavily involved in guiding Chapek and driving strategic decisions. In other words, Iger never really retired and had catbird seat to criticize the negatives while absolving himself of any blame if things turned negative.

Just prior to Iger stepping down, Disney + was launched and Iger wanted it to be a business that generated recurring revenue using the creative content that Disney had already built up over a century and half. This was exactly the strategy that Chapek followed when the parks business was closed. The business plan implemented by Iger and Chapek was successful in terms of growth of subscribers. Growing from 26.5 million in 2019, Disney + now has over 164 million subscribers. So why fire Chapek? Especially now with the parks reopening and business picking up.

Upon Iger’s November 2022, he stated that the company would focus on developing its park business and has committed to a 35% plus increase in capital expenditures. From our perspective, this is just a common-sense move. After all, there was no need to spend money during the shut-down in the parks business and it was expensive to get work done due to all the safety protocols that needed to be followed. With parks open and customers returning, it is a good time to increase cap-expense in the business relative to what occurred during COVID.

So, what’s the problem?

Our skepticism about the IGER/Chapek/IGER transition comes from a review of media reports and our own review of the P&L model of the media and entertainment business as disclosed in SEC filings.

As disclosed in SEC filings, under Chapek, the linear networks business (the non-streaming part of video) increased from $24.8 billion of revenue in FY 2019 to $27.5 billion in FY 2020 or a 10.8% increase while operating expenses only increased from $17.2 billion to $18.1 billion or 5.2%. In other words, the business actually contributed significantly to profits — as reported Disney. But one year later, with Iger no longer CEO, the business grew nominally to $28.0 billion in 2021 or a 1.8% growth but related or “allocated” expenses increased 8.9%.

Just as concerning, is that at the same time, the Disney + Direct to Consumer Business revenue grow from $10.5 billion in 2020 to $16.3 billion in 2021 or 55% while expenses for that segment only grew 33%. The 33% increase seems low relative to the revenue growth and reported marketing campaigns to grow the business.

The financial variances do not make sense to us. In our view, based on SEC disclosures (and GAAP), expenses should not have increased that high relative to the nominal growth in revenue in the linear business. Alternatively, if changes to allocation methodologies were made (they are allowable), SEC filings should have disclosed this change with the new CEO transition. We found no such disclosures.

What does this mean?

Although the consolidated financial results are the same, if allocation methods were changed it would have impacted analysts’ valuation techniques especially those valued based on a sum of the value method. The streaming or Disney + business during 2020, 2021 and early part of 2022, was valued based on growth metrics not profitability. We speculate that Disney wanted a higher valuation in the streaming part of the business. As such, on its face, one must question whether or not Chapek (or others) at Disney were allocating more expenses to the old television business rather than to the new Disney+ Direct to Consumer Business. Was this CFO pressured to do this? Were linear executives uncomfortable that their PL was being impacted.

To be clear, there is nothing per-se illegal about changing internal allocations if that is what occurred, but it would be nice if DIsney clarified this variance.

Clearly, Disney’s stock has been hammered. There has been virtually no change in the price of Disney since Iger’s return to CEO and the stock is near five-year lows.

Today (December 11, 2022), with the stock at around $93 bucks, we are staying on the sidelines. We believe there is more to the story of the CEO change, and we would like to see how Disney’s business performs during this initial stage of inflation and possible recession. It will be interesting to see the year-end disclosures when Disney ultimately files its annual report with the SEC.

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