High Expectations and Timing Issues Should Not Hold Back Disney

In a very tough year for media stocks, Disney (DIS) has been a standout performer. At recent highs, the shares were up over 20% for the year, more than twice the gain in the S&P 500. DIS was a victim of its own success after reporting its latest quarterly earnings. The results were slightly above expectations but not as big a surprise as the last few quarters. The company also reminded investors that higher sports rights costs at ESPN would slow earnings growth in the cable network segment in 2015 before it accelerates again in 2016. These two factors plus higher corporate wide pension costs and lack of detailed clarity on the company’s share buyback plans in 2016 led to a 2% decline in DIS shares following its latest earnings report.

I believe the recent pullback will prove temporary as ESPN growth is locked in over the next several years as sports rights costs are known and higher affiliate fees paid by cable and satellite companies to cover the added expense have already been negotiated. In addition, sports should continue to prove attractive to advertisers and not vulnerable to loss of advertising dollars to online video.

More importantly, DIS is an incredible roll with its films. Frozen drove much of the upside to earnings expectations over the past year. Guardians of the Galaxy far outperformed expectations and is now another franchise. The next year plus brings another Avengers film, the first Pixar film in two years, the first of the new Star Wars films, and the just opened hit Big Hero Six. In its recent history, DIS earnings and shares have outperformed expectations when the content is humming as the company has incomparable synergies throughout its operating divisions including TV networks, theme parks, consumer products, and video games. Growth will get a further boost in 2017 with the opening of Shanghai Disneyland. DIS shares trade at well deserved premium to the market and peers but remain an excellent core holding with upside of 15-20% over the next year. Showing patience against any of the temporary issues mentioned should prove rewarding.

DIS is widely held by clients of Northlake Capital Management, LLC, including in Steve Birenberg’s personal accounts. Steve is sole proprietor of Northlake, a registered investment advisor. Northlake’s regulatory filings can be found at www.sec.gov. DIS is a net long position in the Entermedia Funds. Steve is portfolio manager and managing partner of Entermedia, long/short equity hedge funds focused on media, entertainment, leisure, communications, and related technologies.

Content Engine Driving Disney to Great Heights

Disney (DIS) reported a big beat to March quarter earnings expectations with EPS of $1.11 vs. consensus of 96 cents. Revenues also were ahead of expectations at $11.65 billion vs. estimates of $11.23 billion. The primary driver of the upside was the film studio but strength was pretty much across the board with exception of advertising sales at ESPN and ABC.

If there was one thing that drove the results, it was the incredible success of Frozen. DIS is unique in that hit content filters through the entire corporation and large franchises like Frozen can drive financial returns for multiyear cycles as consumer products, theme park and cruise ship attractions, Broadway shows, and Disney-themed cable networks benefit. While there will always be misses on big budget films (John Carters, Mars Needs Moms, and Lone Ranger in recent years), the company is in the midst of a powerful content cycle that includes Avengers and the individual characters, steady success at Pixar, a revived traditional animation studio helped by Pixar leadership, and newly acquired Star Wars. 2015 shapes up really big with the next Avengers film and the first of three new Star Wars film.

DIS growth is likely to slow a little in the next couple of quarters as a round of big increases in sports rights hits ESPN. The company recently held an analyst day devoted solely to ESPN so I think the street is well aware of what is coming. Even in a giant quarter at the movie studio, cable networks, dominated by ESPN, represented 59% of total company operating income, so there could be a little turbulence in the stock price even as theme parks, the film studio, interactive, and consumer products continue to benefit from the red hot content engine.

Northlake recently subscribed to a new research service, MoffettNathanson Research, that specializes in media and communications. Craig Moffett and Michael Nathanson are analysts I worked with in the past when they were at Bernstein Research. This morning they are out with a brief note on DSI reminding investors of the 2005-2007 content cycle and how the company consistently beat earnings estimates driving the stock price. The comparisons to the current period seem apt. With content driving growth, steady gains at the ESPN, solid theme park performance and excitement likely to build about Shanghai Disneyland, and a big share buyback, DIS shares should be able to sustain a premium P-E multiple. 20 times what may prove to be a conservative 2015 consensus estimate of $4.60 gets the stock to the low $90s. In a suddenly tough tape for consumer growth stocks, DIS looks like a good choice.

DIS is widely held by clients of Northlake Capital Management, LLC, including in Steve Birenberg’s personal accounts. Steve is sole proprietor of Northlake, a registered investment advisor. Northlake’s regulatory filings can be found at www.sec.gov. DIS is a net long position in the Entermedia Funds. Steve is portfolio manager and managing partner of Entermedia, long/short equity hedge funds focused on media, entertainment, leisure, communications, and related technologies.

Less Than Meets the Eye at Disney

Disney reported better than expected fourth quarter 2009 financial results. Benefiting from an extra week, the company reported adjusted EPS of 46 cents, easily beating consensus of 40 cents. Revenues also beat expectations handily, coming in at $9.69 billion against a consensus estimate of $9.26 billion.

Although it got little direct questioning on the call, I think a material portion of the upside came from the extra week. My initial back of the envelope calculations still show some upside but not enough to justify the initial 3.8% pop in the stock. I'll be surprised if the stock is up that much when it opens in NT on Friday.

Highlights of the quarter include -3% ad sales at ESPN, weak them park revenues and margins, and the expected poor performance of operating profits at the movie studio. On the upside, there was improvement at ABC and the local TV stations and affiliate fees at the cable nets continue to show steady gains.

Like other media companies that reported last week, Disney indicated ad trends are improving. Ad sales are getting an added boost from good ratings at ESPN and a decent start to the new TV season at ABC including a couple of new shows turning into hits. The company mentioned that scatter pricing is running up 20% and that option pickups for the March quarter are the best in ten years. Trends at the local TV stations improved to -15% in the September quarter. Management was less optimistic about December quarter trends than other TV station owners who reported last week.

Disney's theme parks set the company apart from the rest of the media companies. I find trends here to be a bit worse, especially adjusting for the extra week. Attendance is holding up well but the cost is high with revenues down more than 10% adjusting for the extra week and also an unspecified amount of sales of Vacation Club properties. Reported results in 4Q09 showed revenue -4% and operating income -17%. This is another indication of pressure on the business as margins are declining.

To me the most interesting comments on the call came from Bob Iger as he explained that the secular changes in DVD consumption are driving the management changes and organizational restructuring at the movie studio. Iger stuck a tone that was much more concerned than other studio owners about permanent changes to the DVD market relative to cyclical impacts.

As the call wraps up, the stock has given up about half of its initial after hours gains. Overall, I find management to be balanced in its view of the future and less hopeful than other media companies. However, at least part of this can be chalked up to the fact that Disney is normally not very promotional. Analyst questions are not particularly tough suggesting that estimates will be stable despite my initially more pessimistic view of the numbers than the street.

Disney to Finish Off Media Earnings Season

Disney wraps up September quarter earnings for media and communications companies when it reports after the close on Thursday. Analyst estimates call for EPs of 40 cents on revenue of $92.6 billion. If estimates are hit, revenues will be down about 2%, operating income will fall 15-20% and EPS will be down 4%.

At the segment level, Media Networks should hold up the best while Studio Entertainment operating profits will plunge. Media Networks includes ABC and local TV stations, ESPN, the Disney Channel, and other cable nets. Growing affiliate fees and a rebound in advertising growth, though still negative, should be the drivers at Media Networks. Studio Entertainment faces challenging comparisons and is coming off generally poorly performing movies at the global box office.

Investors will be looking for insight into several issues on the conference call. ESPN ad sales have been lagging the industry due to high auto exposure. Is the company seeing a recovery in auto that is apparent at other networks? ESPN's ratings have been good, as have sports ratings in general. IS the company able to translate ratings into ad sales?

Disney's Theme Parks remain under pressure as consumer watch their pocketbooks. The company has kept hotel occupancy at surprisingly high levels but the cost has been very aggressive pricing and depressed profit margins. Has the pricing environment improved or have promotions eased? How do advance bookings look into the holiday season and spring break 2010?

There are also lots of questions about the movie business. DVD sales remain under pressure and one could infer from sales of Dreamworks Animation's Monsters vs. Aliens initially poor DVD sales that animated titles may finally be succumbing to DVD weakness. In addition, Disney has announced has several very senior executive changes at its movie studio. When combined with the Marvel Entertainment acquisition and the deal to distribute movies for Steven Spielberg, Disney seems to taking a new approach to the movie business. The model now seems to be purely distribution with ownership or larger budget films restricted to Pixar and possibly the long-term relationship with Jerry Bruckheimer form Pirates of the Caribbean sprouted. The astute blogger and critic David Poland of The Hot Blog and Movie City News noted that the new Disney model looks an awful lot like the failed Paramount model if Pixar is excluded. I wonder if any analyst will have the guts to ask that question!

Disney Quarter Shows Stability But No Improvement

Disney's (DIS) third-quarter 2009 report looked a lot like its second-quarter 2009 report. Trends remain weak but are not getting any worse. EPS beat by a penny while revenue fell slightly short of expectations. The revenue miss led to CNBC headlines and a post-report sell-off in the shares, but the miss appears to emanate from the impossible-to-model studio entertainment segment and greater-than-expected revenue deferrals at ESPN that will be recovered in the next two quarters.

Advertising at ESPN was down close to 10%, a little worse than expected and lagging the figures posted by Time Warner (TWX) and Viacom (VIA) . But this was not unexpected given ESPN's greater exposure to auto advertising. A mid-single-digit decline at ABC and an upper 20% decline for the local TV stations were as expected and almost identical to advertising trends in the March quarter.

Theme parks offered a mixed picture. Good cost controls and promotions that drove attendance and helped cover high fixed costs allowed margin performance to improve sequentially. Bookings, however, weakened slightly with the December quarter looking down 7%.

Overall, Disney's results are similar to those reported by Viacom and Time Warner earlier this week. Business trends are stabilizing but not improving and visibility remains low.

All three stocks have rallied sharply with the market and the rest of the media stocks. Like its two peers, I expect Disney shares will sell-off slightly in response to its earnings report. The problem is not with the quarter, which has no major issue. The problem is the stock's rally reflects more than stabilization of weak trends. More signs of improvement are needed to drive the shares higher.

Unlike some others I am not willing to pay a big premium for Disney compared to the other big entertainment conglomerates. The company has unique assets and is well-managed, but the gap is closing as other companies, particularly Time Warner, improve their asset mix and operations. In addition, Disney remains more cyclical than its peers while business trends are doing nothing more than bumping along the bottom.

As with Viacom and Time Warner, I have no argument if you want to own Disney to play an improved economic outlook and operating leverage from cost-cutting. For now, though, the easy money has been made.

Disney Scraps Hong Kong Park Expansion to Shift Focus to Shanghai?

The Wall Street Journal is reporting that Disney (DIS) is putting expansion of its Hong Kong theme park on hold and laying off the employees involved in developing the expansion plans.

The Hong Kong Park has been a disappointment almost from the day the gates opened. DIS owns it in partnership with the Hong Kong government so the shortfall hasn’t been material to DIS' financials. More of a lost opportunity.

My read on this news is that DIS wants to preserve cash for the China and focus on its development of a theme park in Shanghai. I believe DIS feels that Hong Kong is not fixable, at least not with the possibility of a reasonable return on investment. At the same time, DIS probably believes they have learned their lesson in Hong Kong and won’t make the same mistakes twice (too small of a park at opening, not enough Chinese centric attractions, poorly designed marketing plans).

Most importantly, DIS sees the opportunity in Shanghai as much larger and material both as a standalone operation and as a marketing tool for other opportunities in China including the Disney Channel and merchandising.

A few months ago there were reports that DIS and the Shanghai government had made substantial progress on their partnership. News surrounding Shanghai matters to DIS stock from a long-term perspective. News out of Hong Kong is a sideshow.

I remain on the sidelines in DIS because I think investors are still underestimating the cyclical risk at theme parks local TV stations, and ESPN auto advertising exposure. DIS rightly earned a premium to its peers based on its performance over the past five years but I think that premium is no longer warranted given the risks inherent in DIS' asset mix in a still uncertain economic environment.

Selling Disney and News Corporation

On Friday, I sold all Northlake client positions in Disney and News Corporation. This is a big deal fro me as media stocks are my area of expertise and I believe that these are the two best managed, fast growing companies with the most optimistic long-term competitive positioning. I've owned Disney for more than three years and purchased News Corp last December.

The primary trigger for my sale was Viacom's announcement that it was lowering its 2Q08 forecast for advertising growth at its cable networks from 6-7% to 3-4%. As recently as May 2nd, when it reported good 1Q08 earnings, Viacom had reiterated its 2Q ad growth forecast. The implication is that national advertising has suddenly slowed. If this is the case, spillover to even the best media companies is likely.

Viacom's guidance reduction was not an isolated incident. On its own March quarter conference call, Disney stated that June quarter ad growth at ESPN would slow below recent trends before accelerating again in the September quarter. There have also been anecdotal comments about softening in the scatter market for national TV advertising. Lastly, commentary surrounding the recent upfront presentations by the major broadcast networks suggests that upfront ad sales will be down versus a year, possibly sharply.

Also worth noting is that Viacom's national advertising exposure is concentrated in cable networks, an area that has been more resilient than other national ad media for several decades. Not only that but Viacom's cable networks have enjoyed ratings growth for the past six to nine months. If a seemingly well positioned national advertising medium is seeing a sudden slowdown, it is hard to believe that a broader slowing is not underway.

Weak consumer spending patterns and poor consumer confidence reinforce the risk to ad expenditures. Advertising at the local level has been in negative territory for over year as newspapers and radio and TV stations have encountered cyclical and secular challenges. National advertising normally lags local advertising by three to six months as pointed out by numerous media analysts, most notably Merrill Lynch's Jessica Reif. The timing of Viacom's seems a little too perfect to just be a coincidence given that the economy slowed to virtually no growth late in 2007....

....According to UBS Media analyst Michael Morris, Disney should get about 22% of its total revenue advertising. Another 23% comes from theme parks, which are exposed to similar cyclical headwinds as advertising. News Corporation receives a higher 38% of its revenue form advertising, including a significant exposure to newspapers. Viacom's exposure is 35%. Time Warner has the lease ad exposure of major entertainment companies at 19% (though that goes way up following the split of Time Warner Cable). CBS is most exposed with 70% of revenue coming via advertising.

There is some reason to believe that Viacom's slowdown may not flow through to the rest of the industry. Viacom's cable networks have very narrow demographics which limits the diversity of its advertiser base. A more concentrated advertiser base means the company could just be feeling the effects of a few major advertisers cutting back.

On the other hand, Mike Morris points out the Viacom has relative less exposure to the most exposed areas in advertising such as consumer discretionary and financial. As a result, Viacom might be expected to hold up better than its peers.

The bottom line is that the risk-reward trade-off for the major media companies has soured. Disney and News Corp face headwinds in a number of their businesses and risk to earnings estimates has heightened. P-E ratios are near historical lows but that assumes estimates hold. Furthermore, if negative estimate momentum develops, there is no guarantee multiples will not contract further.

At current prices, I see no more than 20% upside in the shares of both companies even if estimates hold and Viacom's national advertising slowdown is a head fake. Disney has downside to the upper $20s, a level it reached earlier this year. I look for a risk-reward tradeoff of better than 2 to 1 to the upside for a long position. Besides Disney's exposure to national advertising, ABC has clearly lost momentum with the recent season showing double digit ratings for key shows and no recovery after the writer's strike was settled. Disney also faces tough comps at its film studio and its first major release of the summer, The Chronicles of Narnia: Prince Caspian, is headed to just 60% of its predecessor at the North American box office.

News Corp has more downside and more upside due to its operating and financial leverage. The company is facing a number of issues including a dramatic slowing in recently rapid operating income growth, questions over acquisition strategy, and concerns that monetizing MySpace will prove more difficult than expected.

I'd happily buy back both stocks at higher prices if my confidence in fundamentals returns. Northlake's strategy does not involve shorting but if fundamentals continue to deteriorate and Viacom's warning is the start of a trend shift, investors who do short may find profits at Disney, News Corp and other media stocks. I am not making a call to short the stocks now. They may go lower but I don’t see significant downside presently. I do fear a prolonged period of lagging relative performance and what I promise my clients is that I'll beat the market. Given that mandate I'd rather be in other names or cash for at least the next few months.

Another Great Quarter For Disney

Disney easily beat estimates with EPS of 58 cents coming in well ahead of the 51 cents consensus estimate. Here are the comments I posted on the quarter on RealMoney.com before and during the conference call. Alos, please find the earnings summary produced by Gary Dvorchak, my colleague at Real Money.

03:14 CST: Based on a quick read of the press release and plugging segment numbers into my spreadsheet it looks like a very good quarter will all segment revenue estimates being too low and all segment operating income estimates too low except for Consumer Products. Parks may have benefited from the timing of Easter. Disney appears to be continuing its run of absolutely superb operational performance.

04:11 CST: The quarter was excellent but in my prior post I overstated the breadth of upside on revenues. Cable Nets, Broadcasting, and Consumer Products matched estimates will the Studio and Parks beat handily. My statement ath operating income beat across the board except for Consumer Products stands.

DIS does not do guidance but does provide color. I'd say that they are very confident but see 4Q (Sept) stronger than 3Q (June). Mostly it is timing stuff for both this year and the year ago comparison. On theme parks, trends are still decent with bookings up for the rest of the fiscal year (slightly down in June Q but up nicely in Sept Q). Pricing on rooms is up slightly. International parks are definitely doing better. Overall, the theme park message is that DIS is more resilient this cycle and better positioned than in 1991 recession.

The possibility that June Q may be a bit slower relative to 2Q just reported and 4Q to come MIGHT hold back enthusiasm about the results. No reason for true longs to be concerned, however. DIS is setting the standard for large cap media companies. For that matter it is setting a standard for all large companies, especially among consumer facing peers.

Please click "Continue Reading for Gary's summary....

Disney Crushes on Earnings
By Gary Dvorchak
RealMoney Contributor
5/6/2008 7:14 PM EDT

In the current economic environment, I have been harping on owning inflation plays, weak dollar plays, and pricing power plays, and with this evening's earnings report, Disney (DIS) proved it is all three rolled into one. How's that for value? Investors were cautiously optimistic on the quarter, and DIS proved them right by reporting a blowout 58 cents of EPS 7 cents ahead of the consensus. Revenue was up nearly 10% year over year and topped the Street's $8.47 billion estimate by $240 million. Disney proved the incredible strength of the brand -- and the ability to price accordingly -- and showed it could capitalize on the weak dollar as one of America's great export companies.

Performance was fairly well balanced across all operating segments.

Media: Cable grew revenue 9% on strength at ESPN, which grew subscribers, carriage rates and advertising rates. Broadcast revenue was essentially flat, but income boomed 17% as the strong lineup cashed it in internationally.

The writers strike crimped revenue, yet management raised ad rates and used reduced programming costs to drive margins higher! (Not surprisingly, they wouldn't give any insights into the ongoing SAG talks.) ABC is set to surge as the lineup resumes, and management is driving higher CPMs in the upfronts on the strength of the lineup.

Resorts: The resorts, which are attracting acute attention, are holding up very well, with income up 33% on an 11% sales gain. Management claims to be seeing no impact from higher gasoline prices or other economic issues. The deluge of European tourists on the back of the weak dollar is predictable, but they also believe that more Americans are staying closer to home. With occupancy rates around 95%, and little discounting, clearly they have the evidence to back up the strong franchise story. Meanwhile, the overseas resorts are strong as well, notably Disney Paris, which is showing great occupancy numbers.

Studio: Revenue jumped 18%, while income demonstrated the meaning of "operating leverage" by jumping 61%. DVDs are leading the way, with Enchanted, Game Plan and No Country helping to generate a 15% gain in unit sales. Theaters cashed in on National Treasure 2 and Hannah Montana. This summer, here comes Wall-E, the new Pixar movie, but the company also has a 10-year pipeline coming from Pixar. Notably, many of the movies are going to be re-released in 3-D, which is fairly inexpensive to create but drives both ticket pricing and total net attendance. 3-D is a no-brainer to a certain extent, so look for a lot of re-releases going forward.

Consumer: Revenue grew 10%, although income declined on lower licensing minimums and the transition to self-published titles in video games. Hannah Montana and High School Musical were hot sellers, naturally.

Right now, investors are agog over the exporters like Caterpillar (CAT) and Deere (DE) who are capitalizing on the weak dollar, but many are not fully grasping Disney's position as one of America's great export companies. Yes, shipping a DVD overseas is an export, but when a German family comes to Orlando for a week, that is an export too. Disney's product, whether transportable or immobile, has worldwide appeal, and will attract the hordes of global vacationers enjoying the weakness of the U.S. dollar. What U.S. consumers are losing at the pump, they can make back by owning DIS shares.

Disney Adds A Shingle

Disney announced a new production studio, Disneynature. The studio will produce major motion picture documentaries "about the world in which we live." The first film, titled "Earth," will be released on Earth Day 2009. The film is being produced by the BBC and members of same team that created the Planet Earth series.

The press release mentions that Disneynature will embrace other Disney businesses including publishing, licensing, parks, and educational outreach. While the emphasis is clearly major motion pictures, given the strength of the Disney brand, it does nto seem like a stretch to suggest that Disneynature is the company's initial foray into non-fiction film and TV production. It does not take much imagination to envision a Disneynature TV channel.

If my speculation is correct, it is a small negative for the current, dominant industry leader in non-fiction TV, Discovery Communications (DISCA). The mere mention of Planet Earth in Disney's press release is a reminder that Discovery would be impacted by a broad Disney effort in non-fiction. Planet Earth is one of the most highly rated programs ever to run on the Discovery Channel and was at least partially responsible for the big ratings turnaround at the network last year which helped to trigger accelerating financial results and a sharp upward move in DISCA shares.

Disney is just getting started in non-fiction and has no plans beyond releasing seven films, including Earth, between December 2008 and 2012. The impact on DISCA is likely to be minor for the time being but it is something to think about. I remain optimistic about DISCA shares on the back of expanding margins, above average top line growth opportunities, and the pending restructuring into an operating company. The shares have been on my wish list for several months and may show up in Northlake client accounts soon.

Checking In On Disney

I remain long Disney across Northlake client accounts including my own accounts. Down just 3%, the shares have acted fairly well this year compared to many other media investments, particularly those with significant advertising exposure. Performance of the shares in the near future is a battle between the possibility that the economy drags down earnings and the ability of company's content engine and tight cost management to counteract.

The December quarter surprised many observers positively and it looks like the March quarter might due the same. Management has sent positive signals and datapoints on broadcast and cable network TV advertising and travels trends to Disneyworld remain positive.

Despite the currently positive backdrop, risk definitely remains. Advertising sales and travel spending historically have lagged economic downturns. Companies don’t want to pullback on product and brand development too quickly and consumers book big vacations well ahead of time and are loathe to cancel....

....If we assume that these historical trends will catch up with Disney in the next six months, Disney will have to continue to generate momentum from content and keep a tight rein on costs. I suspect both those things will happen but investors will probably not significantly reward the shares until they believe the economy will turn up. When that happens, Disney will be a big winner.

I plan to wait it out given my high degree of confidence of the management team. Investors with a shorter time horizon may not be so patient.

As an aside, the announcement earlier this week about the company's animated film release schedule though 2012 was extremely well received based on reports in trade magazines and blogs. The next Pixar film, due in June is Wall-E. About 30 minutes of it was shown to quite favorable reviews.

Disney Proving Skeptics Wrong

Disney reported an exceptional quarter. EPS of 63 cents and revenues of $10.45 billion crushed estimates of 52 cents and $10.04 billion. Revenue growth was 9% and operating income gained 15% vs. expectations of 3%. Non-recurring items contributed no more than 2 cents to the EPS number.

On the conference call, management indicated that so far they see no signs of the economy causing a slowdown. Management pointed specifically to the fact that room bookings for the March through September quarters are running modestly ahead of last year. Given the fair argument that families don’t usually cancel vacations once they are booked, it seems that the near-term worries about Disney's theme parks are unwarranted.

In fact, I think a strong argument can be made that FY08 ending in September is pretty much in bag as a decent growth year well ahead of the outlook implied by recent estimate cuts. The debate is now going to shift to FY2009 where comparisons just got tougher and theme parks could come under pressure due to unwilling ness to book vacations based on current economic conditions and headlines.

Disney has incredible creative momentum. Hannah Montana, High School Musical, Cars, Pirates of the Caribbean, new hit shows on ABC, new sports rights at ESPN, the Jonas Brothers, Club Penguin, Enchanted. Each of these properties is driving current revenue. New properties are regularly created and old properties are revived and extended. For example, Toy Story did $400 million n retail merchandise sales in 2007. In 2009, the two original Toy Story films will be re-released in 3-D ahead of the 2010 release of Toy Story 3 and a whole new merchandising push.

Along with the revenue push from creative content, Disney is very tightly managed. Margins were very good in every segment except for the studio which faced an adverse mix shift from DVDs to box office.

Ultimately, the outlook for Disney comes down to a battle between the momentum of creative content and tight cost controls vs. a weakening economy. I think it is clear that at least for the next quarter or two Disney is very well positioned to weather the economic storm. On that basis the shares look modestly undervalued for the short-term and exceptionally undervalued for the long-term assuming the economy recovers in the second half of 2008.

Here are brief segment highlights….

Broadcasting: Revenues and operating income grew 8% and 30% against expectations of 4% and 14%. The writer's strike had no material impact. Strong advertising trends and elimination of mobile losses provided a boost.

Cable Networks: ABC Family and the Disney Channel were highlighted. ESPN grew as well although growth was held back by a higher revenue deferral than a year ago. ESPN ad revs grew by double digits.

Studio Entertainment: DVD sales fell 9% which is actually not bad and better than some estimates based on published sell through data. Box office was flat. Mix shifted in favor of box office which pressured margins. The Ratatouille DVD will not be released internationally until later this quarter. This could provide a nice bump to the March quarter given that over 2/3rds of box office was earned abroad making it the #2 international Pixar film.

Theme Parks: Attendance, spending, hotel occupancy, and margins were all exceptional. As outlined above, no weakness evident yet. The rest of the fiscal year looks good. On the call, management noted that the mix in the domestic theme parks has shifted toward the cruise and vacation club businesses. Cruises are in growth mode and the vacation club is holding up very well. In addition, management noted that it has "considerable leeway" to adjust cost to demand should demand weaken or strengthen. Items pointed include park hours and entertainment offerings.

Consumer Products: Revenues grew 26% and operating income grew 37% against estimates of 12% for both. While legacy content like Cars and Toy Story was very good, this performance can be directly attributed to Hannah Montana and High School Musical in merchandising and video games. In an aside, Bob Iger noted that girls are playing more video games which works to Disney's benefit. The decision to bring video games in house looks like a smart one.

Disney Earnings Preview: Slower Growth But Looking For A Positive Surprise

Disney is expected to report its weakest growth quarter in several years but I do think investors should interpret it as the end of Disney's multiyear run of superior financial results. Tough comparisons and the challenges of a weakening consumer are driving the slower growth but there is a good chance Disney will beat estimates which will remind investors that the company is coping quite well and deserves a higher valuation.

For its fiscal first quarter ending December 31st, Disney is expected to report EPs of 52% on revenues of $10.04 billion. These figures represent EPS growth of 6% and revenue growth of 3%. Operating income which is the most closely watched financial metric at Disney is projected to grow just 3%.

These figures understate the health of Disney's business as 2007 ended because a 20% decline in profits at the company's Studio Entertainment segments is dragging down results. Each of the company's other segments including Broadcasting, Cable Networks, Theme Parks, and Consumer Products should enjoy double digit growth in operating income in the quarter.

A couple of things to keep your eye on in the report and on the call are (1) the pace of share buybacks which have been very aggressive, (2) the outlook for the theme parks given that visibility has shortened, (3) comments on progress building out the internet businesses, and (4) any impact from the writer's strike.

Here is a brief look at the company's business segments....

....Broadcasting: Despite weak overall ratings at ABC a strong market for advertising and good ratings in key time slots, should allow this segment to enjoy revenue growth of 4% and operating income growth of 14%. The shutdown of the Disney Mobile venture will benefit the quarter as well. Comments on the writer's strike especially as it relates to the March quarter will be of interest. Also the timing of political spending at the TV stations will impact guidance.

Cable Networks: This segment is projected to show revenue growth of 14% and operating income growth of 13$. ESPN is benefiting form being DVR proof leading to rising ad demand and prices even as ratings were down a bit this year. The Disney Channel is smoking although since it is not ad supported the flow through may not be quite as large as might be expected. This segment contains the company's recent acquisition of Club Penguin which could impact comparisons. As usual the timing of revenue recognition at ESPN can distort the quarter along with bumps in sports rights fees.

Studio Entertainment: This is the segment that will drag down corporate results. The problem is tough comparisons in the very profitable DVD business. Last year Pirates 2 and Cars sold extremely well. This year Pirates 2 was less popular and Ratatouille was only releases in the US. Ratatouille performed much better at the international box office. Disney did have good depth in the top 20 selling titles during the holiday season which may offset the tough comp to some extent. Disney also had a good quarter at the box office which sets up future DVD sales and also will help offset the tough DVD comp. Overall, analysts are looking for the segment to report a 3% drop in revenues but a 19% drop in operating income.

Theme Parks: Despite lots of concern there was no slowdown at the theme parks in the December quarter. Thanksgiving was the busiest ever at the domestic theme parks and reports on Christmas were robust. A weak dollar is helping. Disney vacations are booked far in advance providing some insulation against the early stages of a consumer slowdown. Thus, the discussion on the call will be about the outlook. Last week management made constructive comments. I expect those to be reiterated and fleshed out against tough questioning from analysts. At the international parks, Hong Kong is struggling while EuroDisney continues its turnaround. For the December quarter, revenues should grow 7% with operating income rising 14%.

Consumer Products: Disney's content generation engine has been on fire which should drive good growth in this segment despite tough comps. Analyst estimates call for 12% growth in revenues and operating income. High School Musical, Hannah Montana, Cars, Pirates, and Ratatouille are key properties. Video games are in this segment which can swing profits either way as the business is still in investment mode but beginning to generate hits.

Routinely Good Quarter for Disney

Disney reported 4Q07 EPS of 42 cents adjusted for a tax benefit compared to consensus of 41 cents. Revenues of $8.93 billion matched the $8.98 million consensus. Comparing the segment numbers to my spreadsheet shows a remarkable closeness. This is actually one the things I like about Disney: the company is very tightly managed and predictable (leaving aside the volatility in movie and TV production). Strong and consistent execution is especially valuable with concerns over consumer spending rising. It is also helpful to valuation of the shares. Disney trades inline with peers News Corporation and Viacom. I think the strength of management and the company's franchises are deserving of a premium valuation.

The quarter and management commentary will not do much to quell the debate over how fast Disney will grow in FY08. In general, management sounded confident about the December quarter with theme park attendance and occupancy trends looking up mid-single digits and scatter market advertising up "strong" double digits at ABC – I'd interpret that as over 20% --- and double digit at ESPN. The company has a good DVD lineup with Pirates 3, Ratatouille, and High School Musical 2.

The only issue I see in the 4Q report is the slight contraction in theme park margins....

....This is the first quarter since 3Q05 where margins did not expand at theme parks. This was the very first question in the conference call Q&A and as I suspected (and hoped), the explanation was the international parks as Hong Kong remains disappointing. Management stated that domestic theme park margins expanded again. To get to double digit growth in 2008, Disney will need theme park margin expansion. Attendance and spending trends in the December quarter provide a good start and I'll be looking to renewed margin expansion this quarter to firm up the outlook. On the conference call there were several questions about theme park visibility indicating that analysts aren't comfortable even though September quarter was good and December bookings are similar. The visibility issue will serve as fodder for Disney bears who will note that attendance could slump quickly and unexpectedly. Foreign visitation and upper middle class Americans who forgo Europe due to currency provide support, however.

I do not mean to be flippant or lazy but if you read my preview of the earnings, virtually all of the commentary on the segments is more or less repeated in the press release. So in brief…

ABC was flattish as weak ratings were offset by big advertising price increases. ESPN was great with underlying growth in advertising greater than 10% after the benefits of recognizing revenue deferrals and the ads in the new NASCAR telecasts. The studio was weak as expected due to Pirates 2 in the year ago 4Q while Pirates 3 this year was in 3Q. Consumer Products continues to benefit from Cars and Pirates merchandising and Hannah Montana and High School Musical. This is offset by increased spending on licensing development and video games. FY08 will see another step up in these spending categories which will be a modest headwind. Theme park comments are largely above but management noted that attendance grew 5%, spending per guest was up 2% and hotel occupancy was just over 90%.

Disney 4Q07 Earnings Preview

Disney is expected to report strong 4Q07 financial performance capping another great year. For 4Q, consensus calls for EPS of 42 cents, up 17%, on revenues of $9 billion, up 2%. Operating income, a key metric for Disney investors, is expected to rise 14%. Estimates are unchanged since the last quarterly report although the tone of commentary about the quarter and 2008 has improved.

Assuming the quarter contain minimal downside surprises, a good assumption in my opinion, the response in Disney shares will be all about the 21008 outlook. Disney is wrapping up its fifth consecutive year of double digit operating income growth. With stiff comparisons against 24% operating income growth in 2007 and Disney's well-chronicled exposure to consumer spending via theme parks and advertising, there is a lot of concern about how quickly growth will decelerate in 2008. Current EPS estimates show an 11% growth expectation in 2008. That is good but probably not enough to drive the shares significantly higher. However, indications form management that 2008 is shaping up better than expected, a real possibility in my opinion, would allow Disney shares to break to new highs if the market is cooperative. I am very comfortable being long heading into the report and expect to remain long for at least another quarter or two.

Here is a look at anticipated segment results for 4Q07 and FY08....

....Broadcasting: For 4Q, revenue is expected to decline 3% due to a tough comparison against strong syndication sales a year ago. Syndication revenue is very profitable so the entire segment is expected to shift from a small gain to a loss of over $30 million. ABC should be flat as weak summer ratings are offset by very strong scatter pricing. Looking to 2008, ABC is off a decent start this TV season leaving some room to the upside to the upside relative to current estimates. Nevertheless, operating income growth in 2008 is unlikely to reach above high single digits.

Cable Networks: This segment should be the driver of 4Q results with revenues rising 20% and operating income gaining 26%. Strong ratings, affiliate fee growth, revenue deferral reversals at ESPN, and the elimination of losses related to ESPN Mobile will be the key contributors to growth. One potential negative to keep an eye on is programming expenses at ABC Family and the Disney Channel. For 2008, the segment will moderate but should grow double digits as ESPN benefits from much more moderate rights fee increases and affiliate fees and advertising continue to grow. Also, upside exists at the Disney Channel form High School Musical.

Theme Parks: Mid single digit revenue growth driven by high occupancy and growing attendance should lead to margin expansion and 10% growth in operating income. Theme parks have a high fixed cost base so as long as revenue drivers are intact, margin expansion is in order. For 2008, concern about consumer spending is holding estimates back to mid to upper single digit growth. Disney may also pick up some costs related to expansion of its cruise line, California park, and time share/vacation club business. These are worthwhile investments, however, as they should lead to a surge in segment growth and margins in 2010 and beyond.

Studio Entertainment: A tough comparison vs. 2006 when Pirates 2 was in theatres suggests a tough quarter for the studio. Revenues are projected to fall 21% with profits dropping 7%. Tight const controls and lower levels of marketing support for film releases are limiting the operating income decline. DVD comps are also tough this quarter. For 2008, lack of a Pirates film sets up a tough comp as does crowded DVD release calendar this holiday season. Mid-single digit growth would be a good outcome, although expectations are low to begin with.

Consumer Products: Benefits from High School Musical and easier comps should offset higher development spending on video games, driving 6% revenue growth and 16% operating income growth in 4Q. In 2008, similar drivers should lead to growth of around 10%.

Pirates, Cars, and Rats

While preparing my fourth quarter box office preview column last week, I came across some interesting and positive data concerning Disney. One of the worries for Disney this year has been the tough comparison at the movie studio due to the phenomenal success last year of Pirates of the Caribbean: Dead man’s Chest and Cars. This year, Disney released Pirates of the Caribbean: At World’s End and Ratatouille. Domestically, both of the 2007 releases significantly trailed their 2007 counterparts. Pirates 2007 matched Pirates 2006 overseas, leaving it $100 million short. This is material difference but given the vagaries of studio accounting and the fact that the two films were made at the same time, I would be shocked if Disney even mentioned any differences in the two films profitability on its upcoming quarterly conference call.

The Cars vs. Ratatouille comparison is trickier. Cars grossed $244 million in the US vs. $203 million for Ratatouille. Overseas, however, Ratatouille looks like it will easily exceed Cars, thanks especially to fantastic grosses in France. In fact, thorough the end of September, Ratatouille had grossed $223 million abroad, $6 million more than Cars. Furthermore, Ratatouille had yet to open in the United Kingdom, Germany, Italy, Greece, or Denmark. These countries produced a combined gross of $67 million for Cars, suggesting that the final worldwide tally for Ratatouille will exceed Cars....

....Despite the global box office success of Ratatouille, analysts are still worried its overall profit contribution will fall short of Cars due to the phenomenal success of merchandise related to Cars. I would never discount the merchandise and licensing teams at Disney but selling cars is a lot easier than a rat and gourmet food.

The bottom line is that the global box office performance of Ratatouille has probably been strong enough to mitigate the concern of analysts and generate more than enough revenue and profits to meet or exceed the conservative estimates in their spreadsheets that were likely influenced by the lagging domestic box office relative to Cars. Disney faces other earnings risks given the jam packed DVD release schedule this holiday season and fears about consumer spending but it appears that one risk feared earlier this year has failed to materialize.

Disney Earnings Growth Continues Unabated

Disney (DIS) reported another strong quarter. EPS of 58 cents exceeded the 55 cent consensus estimate with revenues in line with expectations at $9.05 billion. The upside came from margins with Broadcasting being unusually strong with operating income up 127%. Cable Networks also had higher margins than analysts were expecting. The only shortfall was operating income at Studio Entertainment but this segment has notoriously volatile and difficult to predict financial performance.

Commentary about the fourth quarter and general big picture thoughts about 2008 and beyond was all positive. Between the upside surprise and the confidence expressed by management I think the concerns over DIS's future growth will moderate somewhat. This should allow the shares to resume their leadership among megacap entertainment conglomerates. All you really need to do is juxtapose the earnings reports and conference calls of Disney and Time Warner from yesterday to see why Disney shares remain attractive.

Disney also announced the acquisition of Club Penguin, a social networking site focused on the kids demographic. DIS will make an upfront payment of $350 million with an additional $350 million due if certain incentives are met. The deal should be accretive in year one and accretion will rise if the incentives are met. Club Penguin could have about $50 million in revenue and I would guess pre-tax margins are near 40%. I like the deal for DIS. Promoting Club Penguin across Disney properties should accelerate growth and in the long run the ability to use Club Penguin across the company's other assets seems plausible.

Looking more carefully at the segment level, it was another quarter of solid growth. Revenues were up 7% and operating income again rose double digits, gaining 14%. EPS for the first nine months of the fiscal year have grown by 24%....

Broadcasting had a great quarter with revenues up 9% and operating income up 127%. Programming costs were much lower due to success of ABC's schedule while international and domestic syndication of recent hits on the network drove revenue.

Cable Networks had 5% revenue growth and 9% operating income growth. ESPN and the domestic Disney owned networks led the way. Next quarter will see a big boost in revenue from ESPN deferrals but will also assume much of the NASCAR rights fees. I am not sure how this will balance out relative to expectations but I would guess that analysts knew about the rights fees already and the extra revenue will be incremental.

The volatile Studio Entertainment segment saw revenues decline rise 6% and operating income fall a worse than expected 20%. The entire issue was about a tough comparison in highly profitable DVD sales. Next quarter faces a tough comparison on theatrical box office since Pirates 2 was entirely in the third quarter a year ago and is one of the top grossing movies of all time.

Theme Parks continue to plug along with domestic attendance trends flattish but better than expected against tough comparison. Per capita spending at the parks and hotels is running up strongly helping to drive margins. Management had met its 20% margin goal but commentary on the call suggests they think they can get back towards toward record margins of 23% in the next few years.

Consumer Products remains an underappreciated segment. Revenues rose 23% and operating income was up 12%. Investments in video games and merchandising held back margins but given all the great content DIS has produced in the last few years this investment will pay off down the road. Consumer Products has the potential to surprise to the upside and help sustain growth next year as DIS faces tough comparisons elsewhere.

Disney 3Q07 Earnings Preview

Disney (DIS) faces a tough comparison when it reports its 3Q07. Projected EPS of 55 cents are up just 4% vs. a year ago. Analysts have long expected this to be the toughest comparison so it should not come as a surprise. Given ongoing concerns that DIS' best financial performance is behind it, the report and conference call could be significant to resolving the debate.

DIS has been growing at a double digit rate for several years and the stock price has responded accordingly. Financial performance in all divisions has been excellent and current profitability levels are at all-time highs pretty much across the board. No one argues that DIS' growth will not slow. Rather it is the magnitude of slowing where the debate occurs. I am in the bull camp, believing that double digit growth can continue. The stock is acting like the growth string is near the end. A good report with confident talk about the future – DIS does not provide guidance – should be greeted well but any shortfall or signs that the rest of 2007 will remain sluggish probably means the end of the bull run in DIS shares for the time being.

For 3Q07, DIS is expected to report EPS of 55 cents on revenues of $9.04 billion. Revenue growth is projected at 6%. Operating income is the key metric for DIS and it is projected to grow at or slightly ahead of revenues indicating flat to slightly higher margins.

As with most of the major media stocks, it is segment level results where the action takes place. Here is a brief preview of each segment...

Broadcasting should show revenue growth of 7% and a big 45% increase in operating income. Strong scatter pricing and the strength of ABC's primetime schedule last TV season provide the upside. In addition, costs should be down as the company had less programming development this year. DIS also had a good quarter for TV syndication which is normally highly profitable.

Cable Networks should show double digit revenue growth but just low to mid-single digit operating income growth. Revenue deferrals and somewhat soft ratings at EPSN and a tough comp vs. last year when the High School Musical DVD was shipped will hold back operating income. The Disney Channel should continue its strong growth.

Theme Parks should offer more of the same with mid-single digit revenue growth accompanied by margin expansion driving double digit operating income growth. DIS still faces tough attendance comps at its theme parks due to 2006 promotions but this segment has consistently beat estimates this year despite those tough comps.

Studio Entertainment is projected to show negative comparisons. Box office looks good but the lack of a big selling DVD title against the initial shipments of The Chronicles of Narnia a year ago creates a very difficult hurdle. Furthermore, most of the marketing expenses for Ratatouille will fall in 3Q even though the film was not launched until June 29th, creating an expense-revenue mismatch. One positive to come out of this segment this quarter should be reassuring words about the profitability of Ratatouille and Pirates of the Caribbean: At World's End both of which performed well but under some aggressive estimates.

Consumer Products was a bright spot last quarter and another good quarter is expected. Licensing revenue related to Cars, the Pirates movies, and Ratatouille should continue to grow strongly. Rising expenses as DIS develops its video game division will be a negative offset.

News On Northlake Stocks

Several stocks in the Northlake portfolio have had newsworthy items over the past week. Here is a recap of the latest news, all of which I think is positive.

Disney (DIS) completed the sale of almost all of its radio operations to Citadel Broadcasting (CDL). DIS shareholders received .0768 shares of CDL for each share of DIS they owned. DIS received $1.35 billion in cash from CDL. I plan to hold CDL and will look to add to the small positions if the shares come under pressure as DIS shareholders sell their small holdings. The profile of a DIS and CDL shareholder would seem to have little in common which could lead to lots of selling. Given that the DIS deal about doubles CDL shares outstanding, I think supply-demand imbalances could put some downward pressure on CDL. That was not the case yesterday when CDL rallied on the first day of post-closing trading. CDL has a current yield of over 5% which should limit downside....

Central European Media Enterprises (CETV) announced that it was acquiring 5% of its Romanian operation form its long-time partner and current senior executive Adrian Sarbu. CETV now owns 95% of Romania with Sarbu holdings 5% that has a newly restructured put option. CETV paid $50 million for the 5% stake, placing a value of $1 billion on Romania. I expect Romania to produce about $85 million in EBITDA this year, putting the multiple at 12 times. This actually seems a little cheap to me given that Romania has been growing at 30-40% per year and is projected to sustain a growth rate in excess of 20% for several more years. I suspect that CETV held the upper hand in the negotiations given Sarbu's small minority stake. I am always happy when CETV is able to buy more of its own operations and it is even better when the price is right. I remain a buyer of CETV which has lagged over the last month.

Endeavor Acquisition (EDA) released 2006 and 1Q07 financials for American Apparel and also filed the proxy. These filings indicate the acquisition of American Apparel remains on track for a 3Q07 closing. I have not had a chance to read all the filings but the headlines suggest that everything is on track. Management indicated that same store sales remain strong in 2Q and 1Q EBITDA suggests that the company is on track to meet 2007 guidance. The shares have moved to new highs since the filings. I still think EDA can reach $14-18 assuming American Apparel is able to maintain operating momentum in the first few quarters following the closing of the deal.

Rogers Communications (RG) announced the purchase of five traditional over-the-air TV stations in Canada. All major cities except Montreal were included. It is not a huge deal at $350 million Canadian but based on Canadian press reports it looks like a favorable deal for RG. RG shares remain right at their 52 week high and the prospects for further upside remain as wireless and cable drive mid-teens growth in operating profits and significant free cash flow begins to flow. A price target of at least $45 is realistic.

Disney Radio Sale Set To Close

While Disney (DIS) shareholders digest the box office and stock market reaction to Pirates of the Caribbean: At World's End, the company announced details of the divestiture of most its radio business. According to press release issued Friday, on June 12th, DIS shareholders will receive .0766 shares of Citadel Broadcasting (CDL) for each share of DIS they own as of the close on June 6th. CDL is buying DIS's radio business including radio stations and the ABC Radio Network. DIS will continue to be involved in radio through its ownership of the Radio Disney and ESPN radio networks and a few stations operating with content from these networks.

CDL shares have performed poorly since announcing the acquisition of the DIS radio assets last year. CDL is essentially doubling down on radio as the DIS assets are as large as CDL's current business. CDL is paying an above market price for the DIS even after DIS agreed to a modest renegotiation of the deal terms. Compounding the troubles for CDL has been deteriorating advertising growth for the radio industry as it loses share to online advertising.

While CDL shares have worked steadily lower since mid-February, radio stocks as a group have actually performed fairly well, beating the market's return about 75% of the week's so far this year according to recent data from Credit Suisse. Consequently, I think it is possible that consummation of the DIS deal might allow CDL shares to perform relatively well for a few weeks. On the other hand, the newly issued and distributed CDL shares seem likely to be sold creating a near-term supply-demand imbalance. CDL is issuing approximately 150 million shares to DIS shareholders vs. 100 million currently outstanding. Given the vastly different investment profiles of DIS and CDL, it seems fair to assume that many individual and institutional DIS shareholders will be looking to sell their newly received CDL shares....

The new CDL will be a heavily leveraged company producing significant free cash flow that it intends to sue to pay an annual dividend. Analysts believe the current yield on new CDL shares could be around 5% representing about 50% of projected free cash flow. With station sales, excess free cash flow not paid as dividends, and modestly growing free cash flow, CDL could gradually delever over the next few years. The shares presently trade at around 10 times management's suggested pro forma 2008 EBITDA of $400 million with debt equal to 6 times pro forma EBITDA. This valuation is below the current multiples on other leading radio stocks.

CDL is not without risk given the secular challenges facing the radio industry but the financial leverage looks manageable and that can be a recipe for superior shareholder returns if management has a shareholder bias. CEO Farid Suleman has a good track record from his days at Infinity Broadcasting and owns 5 million shares. Forstmann Little is a controlling shareholder. Suleman and Forstmann Little should share the priorities of most shareholders.

New CDL reminds me a little of Regal Entertainment (RGC), which is also highly levered, pays a substantial dividend that supports the stock price, and has a significant controlling shareholder. I've done well with RGC, earning a total return in excess of 20% since the initial purchase in March 2006. I think new CDL could possibly do as well in the next year so as of now I plan to hold the CDL shares that client accounts will be receiving.

Another Good Quarter For Disney

Disney (DIS) reported very good 2Q07 results driven by strong margin performance across all five operating segments. Better profitability allowed EPS to easily exceed consensus estimates coming in at 44 cents, up 19%, vs. expectations of 38 cents, up 3%. Revenues fell very slightly short of estimates at $8.07 billion, $60 million short of estimates. The revenue shortfall was concentrated in the Broadcasting and Studio Entertainment segments but was offset by better than expected revenue for Theme Parks and Consumer Products.

Despite the big beat on EPS, DIS shares immediately traded about 1.5-2% lower following the report. I suspect it is just a sell the news reaction as I really don’t see any problems at all unless you consider a $60 million revenue miss on over $8 billion in revenues a big deal. I don’t, especially when operating income exceed estimates in four of five segments and was $200-300 million ahead of the street.

The upcoming 3Q represents DIS's toughest comparison of the year. Presently, EPS are projected to be flat at 53 cents. For the first six months adjusted EPS are up 31%, so earnings momentum looks set to slack. The major issue for 3Q is that last year DIS released The Chronicles of Narnia DVD which sold extremely well. No comparable release exists this year. I'd guess that alone could cost the company in excess of $100 million in operating profits over the balance of the fiscal year, with most of the shortfall coming in 3Q. On a base of $2 billion in operating income this represents a serious challenge to overall corporate growth.

Offsetting the tough Studio comparison is the fact that for two consecutive quarters DIS's margins have expanded sharply. If overall corporate profitability has taken a full step higher then DIS earnings power is greater than currently anticipated. While some of the margin expansion can surely be linked to outstanding content performance, I think there is some permanent flow through, particularly at the Studio and Theme Parks. Strong scatter pricing at ABC and a recent ratings surge should also boost 3Q....

The 2Q report and management comments about the balance of the year suggests that 2007 estimates of $1.81 are headed higher, probably to north of $1.90. Prior to the report, growth in 2008 was projected at 12%. Maintaining 12% growth brings 2008 to $2.10 to $2.15 vs. current consensus of $2.03. At today's opening level of $36, DIS shares are not richly valued at 19 times 2007 and 17 times 2008 EPS estimates.

The shares had risen 4% into the report putting them at an all-time high. I think the strength of the report will limit any sell the news damage and with any help from the market, DIS can still attain my 2007 target of $40. I plan to hold the position I have in Northlake client portfolios.

Here are some brief segment comments:

Broadcasting: Revenues fell 7% due to less sports programming but profits were up sharply (33%) since sports rights went bye bye. Scatter pricing was up low single digits and is rising similarly this quarter. ABC's ratings have been coming on strong which sets up the upfront very nicely. No detail was provided on losses at the Disney branded mobile phone service. Some analysts may complain about non-sports revenue trends in 2Q.

Cable: ESPN is kicking butt. Profitability in the entire segment including The Disney Channel and international channels was ahead of estimates. The boost from eliminating losses on the ESPN wireless service was not quantified but certainly helped the quarter. Ratings trends at ESPN are solid and deferred revenues will flow in 2H07.

Theme Parks: Overcoming tough comparisons, theme park attendance was quite good, rising 7% in Florida and up slightly in California. Margin expansion continued driven this quarter by solid results in Paris. Hong Kong is still struggling. The margin expansion story at the domestic parks remains on track as margins are up 100 basis points in the first half. Timing issues held back margins this quarter. Attendance, occupancy, and per capita spending trends all look good for the rest of the year. Theme Parks has proven to be a nice positive surprise this year against very cautious estimates.

Studio Entertainment: Despite a $100 million shortfall in revenue, operating income exceeded estimates. Management noted lower distribution expenses due to fewer films and double digit gains in music. Spillover form Cars and Pirates 2 DVDs was not as large as expected. Put it all together and the cost cutting at the studio seems to be very well in place. The Narnia DVD sets up a tough comparison on profitability but Pirates 3 box office will mostly in 3Q this year vs. 4Q a year ago. The bigger challenge will be calendar 2008 when no Pirates film or DVD is scheduled.

Consumer Products: Revenues and operating income surprised to the upside. Royalties on very strong sales of Cars merchandise offset falling minimum guarantees and higher video game spending. Management noted that Cars merchandise sales are still growing. This is a reminder that DIS has many ways to make money on its content, especially the high quality content coming from Pixar. That will be handy to keep in mind as the inevitable hand wringing over Ratatouille begins.

Disney: Slowing Growth, High Expectations Raise The Bar

Margin expansion should propel Disney (DIS) to another quarter of greater than 10% growth in operating income when it reports 2Q07 results after the close on Tuesday. Revenue and EPS growth are only projected to grow in the low single digits due to tough comparisons. DIS has produced significant positive surprises in each of the last four quarters and estimates have been rising slightly so the expectation bar is high. With 3Q also facing a tough comp and slower growth than in recent quarters, DIS probably needs to report a positive surprise and indicate 3Q is shaping up well for the shares to move higher. An as expected quarter could lead to a sell the news reaction.

DIS is being very tightly and adeptly managed and has great momentum in its content divisions. I think the company will produce a quarter that satisfies investors. I am long and expect to remain long following the quarter looking for an exit closer to the $40 level.

Current consensus estimates call for EPS of 38 cents on revenues of $8.13 billion. A year ago EPS was 37 cents on revenues of $8.02 billion so growth is expected be just 1-2% in the headline numbers. Margin expansion at almost all division will produce better operating income growth which is the key measurement for investors....

Broadcasting will likely show down revenues due the carriage of the Super Bowl a year ago. Excluding the Super Bowl revenues will be up about 5%. Revenues and margins will benefit from the shift of Grey's Anatomy to Thursday night and should overcome generally softer ratings. Scatter market ad pricing has been strong which will also help the quarter. Losses from the Disney branded wireless MVNO will pressure the quarter.

Cable will produce another good quarter driven by the ESPN juggernaught. Revenues should grow about 7% with operating income up about 10%. Elimination of losses from the ESPN branded MVNO will boost profits. Revenue deferrals will again be an issue but will just delay revenue and profit recognition until 2H07 when football and NASCAR programming airs.

Theme Parks face another tough comparison due to the 50th anniversary celebration a year ago in California. Trends in Florida have been strong, however, and should be enough to produce an uptick on the revenue and operating income lines with an assist form cost controls. Parks in Hong Kong and Paris will continue to produce good revenue growth but sizable losses.

Studio Entertainment faces a tough comparison and is expected to see slightly lower revenue than a year ago. A smaller movie slate and cost cutting should lead to margin expansion and a gain in operating income. Last year saw very strong DVD sales and international box office from Chronicles of Narnia. This year's films performed better than expected and it is possible that DVD sales of Cars and Pirates 2 carried over into the March quarter.

Consumer Products is the smallest at DIS and will produce flat results. The winding down of minimum guaranteed revenues will be offset by the start of royalties on formerly owned Disney stores. Higher spending in the video game unit could pressure profits.

Disney's March Quarter Shaping Up Well

As mentioned in my overview of the 2007 Prudential Midwest Media Day, I came away from my meeting with Disney (DIS) with increased confidence in the outlook for March quarter earnings. The March quarter represents 2Q07 for DIS and will be reported after the close on May 8th with a conference beginning at 4:30 EDT.

There are several reasons for increased optimism about the March quarter including (1) strong scatter market pricing at ABC, (2) mid single digit gains in DVD revenue, ( 3) decent performance at the box office from this year's releases relative to what was expected to be a tough comparison, (4) fewer movie releases this year possibly offset by marketing costs for Meet The Robinsons falling in the March quarter against a June quarter theatrical release, (5) flat overall theme park attendance which is trending above conservative analyst estimates, and (6) ratings strength at ESPN and the Disney Channel and the financial benefit of ABC's taking over the #1 spot on Thursday's, the most lucrative night on TV..

The debate over DIS shares continues to revolve around the growth rate in the next 18 months....

A better than expected March quarter would put points on the board for the bulls but still won’t answer the all the questions due to continuing tough comparisons, especially in the June quarter, higher sports expenses for the NFL and NASCAR, and increasing concern about the health of the economy and how that might impact travel to the company's theme parks.

I am sticking with Northlake's long positions in DIS although upside is limited to 10-15% based on my current expectations. If the shares were to move up another couple of dollars without an increase in estimates, I'd probably take profits.

Disney: Strong 1Q07 Earnings Support Higher Target Price

Disney (DIS) reported much better than expected 1Q07 earnings with EPS coming in at 50 cents against a consensus estimate of 39 cents. Revenues were also better than expected at $9.7 billion vs. an estimate of $9.5 billion. I don’t see any unusual items that would impact the 50 cent figure so this looks like a large and clean beat.

At the segment level, revue upside came from Broadcasting and Studio Entertainment with modest upside at Cable Networks. At the operating income level, DIS came in just short of $2 billion, over $300 million ahead of analyst estimates. Cable Networks and Studio Entertainment provided all of the upside.

DIS no longer provides guidance and Q&A on the conference call was a little short because the company is hosting an analyst meeting starting tonight. However, it was clear from the tone of the call that management is very confident in the FY07 outlook. Given the big beat and confident commentary, estimates will definitely be going up by "at least" the amount of the beat. DIS looks poised to produce another year of double digit EPS and operating income growth, something that many on Wall Street, including some bulls were worried might not happen. 1Q07 results provide for a little more upside in DIS shares but maybe as importantly they dramatically reduce the risk that 2007 turns out the be the year that the DIS story ends. The toughest quarterly comps are coming in the next two quarters so reaction in the shares might be limited but DIS is likely to continue beating conservative estimates providing upside momentum to the shares. The $40 level is now clearly within reach.

Here are brief segment comments....

Broadcasting: Performed as expected with ABC doing well and the TV stations getting a boost from political advertising. Of great significance, management noted that current scatter market pricing is 10% above upfront. This should lead to estimate increases in this segment.

Cable Networks: Confounding some skeptics, ESPN continues to rock. Adjusted for a $60 million revenue deferral that has no costs attached, operating income would have risen about 10% despite the huge increase in amortization of the Monday Night Football NFL contract. Management didn’t really change their tune of calling for "average" annual growth of double digits for ESPN but the commentary suggested this would probably be reached in 2007 despite many naysayers. The NASCAR contract starts amortizing in 2007 so keep an eye on the ratings for races.

Theme Parks: Another solid quarter. Against very tough comparisons revenues rose 4% and operating income rose 6%. Attendance trends are very good in Florida driven by domestic visitors. This is another division where estimates have been cautious and the good start to the year should lead to increases in estimates for the remaining quarters.

Studio Entertainment: A huge quarter by any measure driven by DVD sales of Pirates, Cars, and Little Mermaid. Revenue rose 23 %, beating estimates by over $100 million. The flow through to operating income was superb as EBITA rose by over 200%. At $600 million, EBITDA beat estimates by $200 million. Management noted that Little Mermaid is a fully amortized title and sold very well. Also, Pirates and Cars sold at least as many units as hoped and management is not concerned about an unusual level of returns from major retailers. This is probably the last strong comparison for the Studio for several quarters.

Consumer Products: Strong merchandise licensing for Cars and Pirates could not overcome the loss of guaranteed revenue, weak video game sales, and high video game development costs. Revenues fell 8% and EBITDA fell 13%, both coming in below analyst estimates. This is DIS smallest division so the shortfall is not too much of a concern. Comparisons should improve as the year goes on.

Disney Radio Deal and Weekend Box Office

Just before Thanksgiving, Disney (DIS) and Citadel Broadcasting (CDL) announced a restructuring of CDL's deal to buy DIS' radio assets. The total value of the deal has been reduced by $100 million and an additional $200 million of cash due to DIS will now come in the form of CDL shares. Essentially, DIS is trading $300 million in cash for $200 million in CDL shares. It was widely expected the deal was going to be renegotiated since the radio industry has suffered severely since the deal was struck, so this news isn’t much of a surprise. The loss of $100 million in value is minor compared to DIS' market cap of $68 billion. DIS now will temporarily own 57% of CDL instead of 52% but the plan all along has been to pass that ownership on to DIS shareholders. It is still not certain what form the distribution will take. I think this is an acceptable outcome for DIS shareholders and it now looks closing is a near certainty by 2Q07.

In other news, the weekend box office, performed admirably against another tough comparison.....

My thesis that depth of quality product reaching all movie going demographics could limit the year-over-year declines against last year's trio of blockbusters (Harry Potter, King Kong, Narnia) provide correct this weekend. The overall weekend for the top 12 films was flat as the new Bond and Happy Feet were able to match last year's second weekend for the fourth movie in the Potter series. Bond and Happy Feet are showing very good legs and this coming weekend should be another where depth limits the damage. Comparisons then toughen again. I still think investors will look past the tough compass this holiday period leaving renewed positive sentiment toward the box office intact ahead of next May's blockbusters (Spiderman 3, Shrek 3, and Pirates 3). This is good news for major entertainment conglomerates and theatre exhibitors including DIS, News Corp (NWS), Time Warner (TWX), Lionsgate (LGF), Regal Entertainment (RGC), and Carmike Cinemas (CKEC).

Disney's Swing Factors for 2007

4Q06 earnings from Disney (DIS) left open the debate over whether the company 's four year string of double digit operating income growth is about to come to and end. With DIS shares are a premium to other diversified media conglomerates, a premium earned by the company's outstanding performance the last few years, the FY07 growth rates is critical to the performance of DIS shares in the month end.

I have strongly advocated for ownership of DIS partially on the belief that skepticism toward the 2007 growth rate would give way to the realization that DIS would continue to drive industry leading growth. What follows is a rundown of the pluses and minuses at the margin for DIS in 2007. I still think the plusses win out but you can decided for yourself.

Positive Swing Factors

• ABC is off to a great start this TV season. The shift of Grey's Anatomy to Thursday nights, popular new shows, scatter market pricing firmly above upfront, and the elimination of losses on Monday Night Football all suggest upside to the ABC, which has significant operating leverage.
• ABC's owned and operated TV stations will benefit from political advertising in 1Q07 (this quarter).
• ESPN ratings are very strong this season. MNF ratings are above guarantees, likely providing upside in profitability (or reduced losses) on this expensive rights contract. Losses on the ESPN Mobile venture won’t be repeated.
• DVD sales for Pirates , Cars, and a slate of other successful films that were released in FY06 will hit in FY07, mostly in the current quarter. This is very high margin revenue.
• The divested Disney Stores will begin to receive licensing fees.
• Merchandising revenue, again a very high margin stream, will continue to be boosted by Cars and Pirates.
• Domestic theme park attendance has held up well with flat comparisons against very tough comparisons. Revenues are still climbing as per capita spending is rising mid-single digits.
• Margin expansion will continue at the domestic parks, helped along greatly by a sharp drop in pension costs. Admittedly this is a low quality earnings stream.
• EuroDisney and Hong Kong Disneyland will see reduced losses.
• A smaller film slate means incrementally lower marketing costs.
• Cost cutting at the movie studio could save $100 million.

Negative Swing Factors

• DIS continues to invest in its video games unit. Incremental spending will be $30 million.
• Radio will ultimately be divested. Investors will probably look at pro forma growth but this division is worth -5 cents in annual EPS.
• Capital spending is going up due to theme park investment and further spending on digital content initiatives.
• Losses may be higher for the Disney branded mobile phone initiative.
• ESPN won NASCAR rights which will begin to be amortized in calendar 2007.
• Consumer products had minimum guaranteed revenue related to its sale that disappears in 2007.
• The tax rate is going up slightly.
• The Pixar acquisition will be dilutive for a full year.

In my opinion, analyst estimates somewhat favor the negative factors, leaving room for upside if the positive factors come through. Additionally, DIS appears very close to renewing its deal with Comcast (CMCSA/K) for carriage of the ESPN family of cable networks and the Disney Channel.

The deal is rumored to include the sale of DIS' minority stake in E! for over $1 billion. The sale of E!, the divestiture of radio, the acquisition of Pixar, and the investment in video games and digital content, and the continued investment in international parks and distribution signal how DIS hopes to drive growth beyond 2007. Besides what I hope will be rising estimates in 2007, I think DIS has laid out the clearest path to long-term growth with the simplest capital structure among the major entertainment conglomerates. Put those two things together and it should be obvious why I remain bullish on DIS shares.

Disney Numbers Are Good But Sell The News Wins Out

Disney (DIS) reported strong 4Q06 earnings. EPS of 36 cents compared to a rising 33 cent consensus and revenues of $8.8 billion were ahead of the consensus estimate of $8.7 billion. Segment level results were as good as or better than expected across the board with particular strength in Studio Entertainment and Theme Parks.

Despite the better than expected results I think DIS shares may trade slightly lower for two reasons. First, given the strong run-up and rising estimates, a positive surprise was expected. Thus, a sell the news setup is in place. Second, on the conference call, I thought the companies comments on swing factors for FY07 (DIS does not provide guidance) will leave the debate open as to whether the company can extend its string of double digit growth in operating income. I think the commentary gave slightly more ammunition to those who think the streak will be snapped than those who think it will continue (I think it will continue)....

Don’t read that as unusually negative. DIS management was confident and spoke of many opportunities for growth in 2007. Furthermore, the current consensus calls for less than 10% growth.

Coming off this quarter, I still like DIS and think it is one the best positioned large cap media stocks. The stock just might be due for a rest while the growth I expect in 2007 is given a chance to reveal itself.

Cable Networks was a star again as ESPN continues to grind out growth and the Disney Channel continues to monetize its ratings success. Revenues rose 16% and operating income rose 2%. Margins expanded due to the recognition of deferred revenue and lower marketing expenses. Advertising revenue growth appeared to be satisfactory based on comments on the conference call. Looking ahead, the company said that growth would be "generally consitent" with their promise that ESPN would average double digit operating income growth. Tough comparisons await due to increased rights fees for NASCAR and Monday Night Football. Thus, I'd take this comment as being favorable relative to many analysts who fear 2007 will be a loser growth year for ESPN.

Broadcasting revenues rose just 1% with operating income declining 40% off a small base of just $48 million. Management said that ABC performed well but rising costs for the Disney mobile phone service held back margins. For 2007, ABC appears to be in very good shape due to strong ratings, a good upfront and very strong scatter market advertising in response to this year's ratings success. I think Broadcasting represents a positive swing factor relative to current estimates.

Theme Parks had another good quarter, especially in light of very tough attendance comparisons. Revenues rose 8%, while operating income rose 28%. The closely watched margin expansion continued at the domestic parks helped by higher guest spending that offset flat attendance growth at the domestic parks. Operating income also got a boost from a full quarter of operations at Hong Kong Disneyland vs. mostly pre-opening costs a year ago. December quarter attendance trends look flat but that is encouraging performance against record attendance a year ago. I sense that management is more optimistic than the street about Theme Park growth in 2007.

Studio Entertainment easily beat estimates with revenues of $2 billion and operating income of $214 million against estimates of $1.85 billion and $170 million, respectively. The positive surprise emanated from the big success for Pirates and Cars at the box office and better margins for home video due to a favorable mix of titles and reduced marketing expenses. The Studio should perform exceptionally well in 1Q07 when the December quarter gets the Pirates and Cars DVDs. Comparisons toughen starting 4Q07 but the timing of Pirates 3 will help comparisons in 3Q07. Management noted that TV syndication might be down in 2007 vs. a very strong 2006.

Consumer Products did very well in merchandising due to Cars and Pirates but higher spending on developing the video games unit held back margins. Revenues slightly exceeded expectations, rising 9% but operating income grew just 1%. In 2007, these trends should continue with an incremental $30 million in spending at the video games unit offset by Pirates 2, Pirates, Cars, and the next Pixar film, Ratatouille, which is due out next June.

I have a few follow-up questions concerning the swing factors in 2007. I'll post in Market Insight if the answers offer additional insights.

Don’t read that as unusually negative. DIS management was confident and spoke of many opportunities for growth in 2007. Furthermore, the current consensus calls for less than 10% growth.

Coming off this quarter, I still like DIS and think it is one the best positioned large cap media stocks. The stock just might be due for a rest while the growth I expect in 2007 is given a chance to reveal itself.

Cable Networks was a star again as ESPN continues to grind out growth and the Disney Channel continues to monetize its ratings success. Revenues rose 16% and operating income rose 2%. Margins expanded due to the recognition of deferred revenue and lower marketing expenses. Advertising revenue growth appeared to be satisfactory based on comments on the conference call. Looking ahead, the company said that growth would be "generally consitent" with their promise that ESPN would average double digit operating income growth. Tough comparisons await due to increased rights fees for NASCAR and Monday Night Football. Thus, I'd take this comment as being favorable relative to many analysts who fear 2007 will be a loser growth year for ESPN.

Broadcasting revenues rose just 1% with operating income declining 40% off a small base of just $48 million. Management said that ABC performed well but rising costs for the Disney mobile phone service held back margins. For 2007, ABC appears to be in very good shape due to strong ratings, a good upfront and very strong scatter market advertising in response to this year's ratings success. I think Broadcasting represents a positive swing factor relative to current estimates.

Theme Parks had another good quarter, especially in light of very tough attendance comparisons. Revenues rose 8%, while operating income rose 28%. The closely watched margin expansion continued at the domestic parks helped by higher guest spending that offset flat attendance growth at the domestic parks. Operating income also got a boost from a full quarter of operations at Hong Kong Disneyland vs. mostly pre-opening costs a year ago. December quarter attendance trends look flat but that is encouraging performance against record attendance a year ago. I sense that management is more optimistic than the street about Theme Park growth in 2007.

Studio Entertainment easily beat estimates with revenues of $2 billion and operating income of $214 million against estimates of $1.85 billion and $170 million, respectively. The positive surprise emanated from the big success for Pirates and Cars at the box office and better margins for home video due to a favorable mix of titles and reduced marketing expenses. The Studio should perform exceptionally well in 1Q07 when the December quarter gets the Pirates and Cars DVDs. Comparisons toughen starting 4Q07 but the timing of Pirates 3 will help comparisons in 3Q07. Management noted that TV syndication might be down in 2007 vs. a very strong 2006.

Consumer Products did very well in merchandising due to Cars and Pirates but higher spending on developing the video games unit held back margins. Revenues slightly exceeded expectations, rising 9% but operating income grew just 1%. In 2007, these trends should continue with an incremental $30 million in spending at the video games unit offset by Pirates 2, Pirates, Cars, and the next Pixar film, Ratatouille, which is due out next June.

I have a few follow-up questions concerning the swing factors in 2007. I'll post again if the answers offer additional insights.

Another Strong Quarter On Tap For Disney But 07 Is What Matters

Disney (DIS) is expected to report strong 4Q06 earnings to wrap up its fourth consecutive year of double digit EPS growth. EPS are expected at 33 cents on revenues of $8.69 billion. The EPS comparison would represent growth of 43% against an easy comparison a year ago when $300 million in losses were recognized at Miramax.

The big debate over DIS shares concerns whether FY07, which started on 10/1/06, will continue the streak of double digit growth. Tougher comparisons at the movie studio, theme parks, ABC, and ESPN have many investors worried that growth at DIS will moderate. In fact, the current consensus EPS estimate of $1.70 for 2007 represents growth of just 7.6%. Consequently, on the conference call any comments about guidance or indications of how business is pacing for 2007 will be most likely to impact DIS shares in the near-term.

For the current quarter, growth should be broad based with each operating segment growing EBITDA by double digits. Growth at the studio will be strongest given the aforementioned easy comparison and the runaway success of the company's summer film slate led by Pirates of the Caribbean: Dead Man's Chest and Cars. ESPN is also expected to report a strong quarter as timing issues will shift about $85 million in revenues into the quarter. Consumer Products will benefit from spillover of merchandising from the box office success. Theme Parks will be driven by margin expansion as attendance was very strong a year ago in response to an effective marketing campaign built around the 50th Anniversary of Disneyland. Broadcasting should continue its turnaround led by good ratings performance and improved ad pricing at ABC. One thing that could distort results is the shift of Monday Night Football from ABC to ESPN....

Looking ahead of FY07, I remain optimistic that DIS will come through with another year of double digit growth. First, the company will benefit greatly from the December quarter release of DVDs for Pirates and Cars. Second, ABC is off to a great start this TV season which should lead to strengthening advertising sales. Third, ratings for Monday Night Football on ESPN have been very strong, likely above ratings guarantees. This should help offset the big increase in rights fees for the NFL contract and the new NASCAR contract. Fourth, DIS has made major changes at its movie studio, reducing and focusing the release slate and cutting jobs. The benefit in 2007 could be $100 million, or more than 1% of EBITDA growth.

There is no doubt that analysts are expecting these things to happen (of course, I formed my own thinking by learning from them – special props to Kathy Styponias at Prudential). However, estimates for 2007 have not gone up in the last 30 days. Therefore, I think if management signals through its commentary that 2007 is looking good, estimates could move up and DIS shares could make one more burst upward. Keep in mind that DIS has suspended providing specific guidance so the commentary on the call is what will matter.

DIS has reached my targets but since I think estimates are going up I am going to stick around a bit a longer. How much longer will definitely be influenced by what I learn after DIS reports.

Third Quarter Box Office Wrap

Following three straight weekly declines, the box office rose 6.6% vs. a year ago this past weekend. The weekend is actually the first one of the fourth quarter. Consequently, I wanted to look back at the completed numbers for the third quarter.

Despite the weakness exhibited in the final three weeks, the third quarter still held onto a good gain, up 8.2% vs. a year ago. The strength was driven early in the quarter by the massive global success of Pirates of the Caribbean: Dead Man's Chest, while Talladega Nights: The Ballad of Rick Bobby picked up the baton in August (I guess all the Hollywood execs will be looking to greenlight films with semi-colons for next summer!)....

Looking just at films released during the third quarter by the major studios, Disney (DIS) was easily the biggest winner thanks to Pirates which pulled in $420 million of the studio’s total of about $560 million. Not to be overlooked, especially from a profitability standpoint are the companies two other major releases in the quarter, Step Up and Invincible. Adding in Cars, which was the #2 movie of the summer, DIS is poised for a big holiday season for highly profitable DVD sales.

The other winning studio for third quarter releases was Sony (SNE), which had Talladega Nights leading the way to over $350 million in gross receipts. SNY had a lot of success earlier this year and is the leading studio so far in 2006.

Fox, owned by News Corp (NWS) had a weak quarter of releases but enjoyed hits early in the summer with X-Men: The Last Stand (those damn semi-colons again!) and The Devil Wears Prada.

Paramount, owned by Viacom (VIA), enjoyed a good quarter with Jackass: Number Two (there they are again!), World Trade Center, and Barnyard: The Original Party Animals (not again!). Following a long dry period, Paramount's success will come as a relief to VIA shareholders. And don’t forget the Paramount's early summer release of Mission: Impossible 3 (sorry, had to get one more in).

The worst performer among the major studios during the third quarter and the summer was the Warner Brothers division of Time Warner (TWX). The company has a series of flops from a box office and profits standpoint. I suspect this is widely noted by investors at this point, so beyond the possibility of worse than expected 3Q06 results in the Filmed Entertainment segment and another lousy quarter in 4Q when DVD sales will lag, investors are probably looking ahead to 2007 when easy comparisons and a strong release schedule lead by the next films in the Harry Potter and Ocean's Eleven franchises are due to hit theatres. Prior to 2007, Warner Brothers might have a hit on its hands with its animated musical about singing and dancing penguins, Happy Feet. Don’t believe me that penguins might strike Hollywood gold again….watch these trailers.

Finally, there could be some upside relative to consensus for Regal Entertainment (RGC) in the third quarter as the current consensus has year-over-year revenue growth of just 3.3%. I suspect investors are ahead of analysts as RGC shares have rebounded nicely since the swoon following slightly disappointing 2Q06 earnings but a good report might be enough to push RGC shares firmly into the $20s, especially given the 6% current yield against the recent bond market rally.

Near-Term Good News For Disney

Yesterday, in the post immediately below, I mentioned that Disney (DIS), News Corp (NWS, NWS.a), and Time Warner (TWX) were all trading at 52 week highs. Departing from the doom and gloom that Dominates most discussion of media stocks, I laid out some big picture thoughts that might be driving the bullish action in the stocks. However, there are actually some short-term developments that are helping each company. In particular, DIS continues to enjoy a string of good news that has driven the stock for the past couple of years.....

Most recently, DIS announced yesterday that ESPN was shutting down MVNO mobile phone business. Losses have run above expectations as subscriber growth was negligible, marketing plans were re-tuned, and phone subsidies increased. The company was guiding to $100 million in losses form this venture in FY06. I read the closing of this venture, even if it results in a significant write-off as bullish. First, analyst estimates contained anywhere from $50 to $100 million in additional losses from this venture in 2007. Jessica Reif of Merrill Lynch was using $100 million and raised her 2007 earnings estimate by 2 cents after the announcement. The big debate that has dominated the DIS discussion was whether the company could continue its multiyear string of double digit EPS growth in 2007. Elimination of the ESPN MVNO losses is a nice boost for the bulls.

Second, and more importantly, new CEO Bob Iger has promised on the last quarterly conference call that the company would take a hard look at this venture and not losses get out of control. The fact that he was willing to admit a mistake and take his lumps is a sign of real leadership. Iger has gotten high marks since taking over for Michael Eisner, receiving credit for bold moves like the Pixar acquisition and aggressive exploitation of DIS content on developing distribution platforms like the web and iTunes. I’ve always felt stocks of companies with well respected CEOs deserved a higher valuation. IN media, I think that is more the case given that the CEOs are often flamboyant and egotistical. Media CEOs are first name guys – Sumner, Rupert, Mel. I see Iger as deserving of respect for his effectiveness, not his high profile and that helps to support a premium multiple for DIS.

The final piece of recent good news for DIS is a strong start for ABC and ESPN in the fall TV season. ABC won the first full week of the new season as its risky move of Grey’s Anatomy to Thursday night opposite perennial #1 show CSI paid big dividends, with the ABC show easily winning the competition. ABC also won the first Sunday night of the season, meaning that the two most viewed nights of TV both went to the DIS-owned network. Following a lousy summer and less progress that expected last season, these signs of renewed momentum at ABC are a very welcome developments with meaningful financial upside given the high operating leverage in the network TV business model.

ESPN also is seeing early returns on its swap form Sunday night to Monday night football. Ratings for the first few Monday night games have been stellar, up more than 20% vs. Sunday ratings a year ago. ESPN also benefits as pre and post game shows advertising slots are more valuable. Additionally, ABC has much lower costs on Monday. So it looks as though the huge increase in rights fees incurred by the switch to Monday nights might pay off. At worst, it doesn’t appear that ESPN will be taking the bath that some predicted on its new NFL deal.

DIS should enjoy strong earnings growth the next several quarters driven by box office success for Pirates, Cars, and a few other films and the follow up DVD sales at Christmas. I am with the bulls who believe that 2007 will shape up as another strong growth year for DIS, further cementing the company as the premier large cap media stock.

Big Media Stocks Performing Surprisingly Well

Wow! Time Warner (TWX), Disney (DIS), and News Corporation (NWS, NWS.A) all made 52 week highs yesterday.

On the one hand I shouldn’t be surprised because the Dow and S&P 500 are at multiyear highs. On the other hand, media stocks as a group have been pretty poor over the last few years with key sub sectors like radio and newspaper suffering severely eroding fundamentals. Granted, DIS, TWX, and NWS are underrepresented in these areas but they are still exposed to the internet challenge, general advertising trends, competitive pricing in TV distribution, and weakening trends in theatrical films and DVD sales.

I suppose the new highs in these stocks could just be a gift from trading gods since yesterday was my 46th birthday. However, something broader seems at work. If I had to guess I’d point to two factors that might account for the simultaneous strength. First, the big entertainment conglomerates are growth cyclicals in terms of their earnings and cash flow. This makes them beneficiaries of soft landing scenario that is being credited with the market’s current bullish phase. Advertising represents about 20% of revenue for DIS and TWX and 40% of revenue for NWS. DIS gets and other 30% of revenue from its theme parks. Improved investor confidence in future economic growth should be reflected in higher valuations for these economically sensitive revenues. Additionally, word out of Goldman Sachs Commuicopia conference last week was that current broadcast and cable network TV advertising trends were firming. DIS, NWS, and TWX have the bulk of their advertising exposure in these national categories.

Second....

I think investors are starting to see the internet as an opportunity for these companies because they produce a huge amount of video content. Video is the flavor du jour on the internet right now and content production represents 20-25% of revenues for DIS, NWS, and TWX. Initial forays into offering TV shows and movies through iTunes, their own websites, and an YouTube have been successful and it appears that a new high margin revenue stream maybe developing. There might be a parallel to the film to VHS to DVD history. The nice thing about being a content producer is that each technological advance allows you to repackage your library and generate revenues yet again from sunken costs. The big conglomerates are also making some progress on traditional websites with NWS getting lots of credit for its purchase of MySpace and some early sings that AOL’s transition to a free site is going well.

I don’t mean to downplay the challenges faced by media companies, including these entertainment conglomerates. However, with the stocks reaching 52 week highs simultaneously for the first time in years, it reminds me that there are plenty of positives in landscape for media.

I remain long DIS for all Northlake clients and have been looking to buy NWS on a pullback. My thesis on NWS is that it should take the mantle from DIS as the fast growing big media company in 2007, which could provide a bump in its valuation.

Disney Radio Deal In Jeopardy?

Last week saw a flurry of acquisition and divestiture activity in the radio industry including news that the buyer of Disney's radio assets, Citadel Broadcasting, wants to renegotiate to lower the purchase price. News that Citadel wants to renegotiate the terms of its buyout of ABC's radio assets is not surprising and likely led to the 3% fall in DIS shares last week. Radio advertising has been weak since DIS agreed to the deal and valuation on M&A activity throughout media has fallen. Working against Citadel, however, is the fact that last week Entercom Communications agreed to buy 15 radio stations from CBS for same multiple of cash flow that Citadel is paying DIS.

I think most major DIS shareholders were previously aware of the possibility the deal could be renegotiated. As long as the deal does not fall apart, I don't see it as anything more than a near-term trading issue for DIS.

Strong Quarter For Disney But 2007 Concerns Limit Upside - For Now

Disney (DIS) reported much better than expected 3Q06 EPS. EPS of 53 cents easily beat consensus of 44 cents (3Q EPS were aided by 1-2 cent accounting benefit). Revenues were only slightly better than expected so it was operating profit performance that provided the upside. In particular, the Studio, Theme Parks, and Consumer Products provided the upside. Cable Networks also had strong profit performance. The only weak spot was Broadcasting which came in lighter thane expected on revenues and profits.

The shares should respond well to this report although I expect the debate over the 2007 growth rate to continue. Management did not provide any guidance for 2007 but did offer a list of swing factors. On the plus side, the 1-2 punch of Cars and Pirates of the Caribbean: Dead Man’s Chest should drive profits throughout the company through FY07 and FY08. Importantly, these two properties show how DIS is able to leverage successful content throughout all of its divisions. High School Musical on the Disney Channel is another example that is driving current results through TV ratings, album sales, and book sales. Also on the plus side for 2007 is a decent upfront for ABC. If ratings meet guarantees, ABC has plenty of scatter to sell and lots of digital tie-ins to sell.

Potentially holding back growth in 2007 are tough comps at the Theme Parks, the uncertainty of ratings at ABC and ESPN, slower affiliate fee growth at ESPN, the struggling overall ad market, and significant investments in distribution for consumer products. It is also unclear how much investment will occur in the ESPN and Disney mobile telephone ventures.

In the short-term, I think investors will give DIS the benefit of the doubt given the outstanding results the company has achieved over the past several years, especially recently during Bob Iger’s brief reign. DIS is playing offense with a strong lineup. Investors should continue to applaud.

Looking a little more closely at the quarter….

Broadcasting suffered from heavy investment in new pilots and costs assoicatied with the Disney Mobile venture. Radio, which is being divested, was also weak, in line with industry trends. ABC and the stations performed OK otherwise.

Cable Networks saw slightly lower than expected revenues but great margin performance so that profits were at the very high end of expectations. ESPN is performing well and the Disney Channel is benefiting from the multi-platform success of High School Musical.

Theme Parks performed particularly well on margins with revenues at the high end of expectations. I was a little surprised that analysts were assuming flat or even lower margins despite consistent gains over the past few years. Marigns rose almost 200 basis points vs. a year ago. On the call, management expressed confidence in its ability to control costs in the future, providing some defense against the tough comps in theme park attendance. Occupancy in Florida and California is over 90% and per capita spending has been rising in the upper single digits.
The Studio was a blowout in the quarter. Revenues and operating profits beat expectations by at least $100 million. DVD sales for The Chronicles of Narnia. DVD units were up 9% with lower distribution costs and lower returns. This couldbe an indicating that DIS is getting its arms around the changes in the DVD market which have accompanied slower growth. Strong box office from Cars and lower costs at Miramax also helped the quarter. Higher costs for marketing of Cars and Pirates did hold back profits.

Consumer Products was very strong, with profits beating expectations by $20-30 million. Iger opened the call noting that Cars merchandise is incredibly strong with young boys and that Pirates may be the biggest cross platfrom success the company has ever had. Strength here should continue but will be offset by increased investment in distribution channels and video games.

Cheap Is Not A Reason To Own Media Stocks

A new study by McKinsey & Co., highlighted at AdAge.com, does a good job of explaining why television advertising is facing such strong growth headwinds. The key pull quote from the AdAge article is that the study claims that "by 2010, traditional TV advertising will be one-third as effective as it was in 1990."

The article goes on to offer some statistics from the study, noting that it assumes a 15% decrease in buying power driven by cost-per-thousand rate increases; a 23% decline in ads viewed due to switching off; a 9% loss of attention to ads due to increased multitasking and a 37% decrease in message impact due to saturation....

Spending More to Reach Fewer Viewers

While TV is not alone in having its message lost due to saturation, the report does capture the secular challenge faced by TV advertising. The problem is that ad pricing keeps rising while ad viewing keeps falling. This leads to a continual increase in the cost to reach a viewer. The same thing can be said for the cost to reach a radio listener or a newspaper or magazine reader.

Appeal of the Internet Is Ability to Measure

Much of the diverted consumer is going to the Internet, but it is not just lost consumer attention to the Net that is causing advertisers problems. The idea that the Net is more measurable in terms of consumer response also is contributing to the perception that traditional media advertising is losing effectiveness.

Teens Spend 600% More Time Online Than Adults

The study also offers the sobering statistic that teens, the next generation of consumers that advertisers want to reach, spend 600% more time online than adults. In other words, the current trend against traditional media advertising could remain in place for decades.

Traditional Media Stock Valuations Reflect Challenges

Traditional media companies aren't standing still. They are expanding their online operations and changing their selling practices. And their stocks already reflect the challenges to some degree with valuations near or at historical lows for virtually all traditional media sectors.

As Monday's New York Times notes, investors will reward forward-thinking, high-performing media companies, as they have Disney (DIS) and News Corp. (NWS/NWSA) over the past year.

My key takeaway here is that cheap is not a reason to own media. Given the strong secular headwinds, look for multiyear growth acceleration such as we have seen in DIS. Or look beyond the usual suspects to growth in unusual areas like Central European Media Enterprises (CETV).

Disney 3Q06 Earnings Preview

The real excitement surrounding 3Q06 earnings from Disney (DIS) will concern how it impacts the outlook for FY07. Despite strong fundamentals and consistent double-digit growth, DIS shares have stalled over concerns about 2007. Recently, estimates have been falling and now reflect just over 10% EPS growth. Concerns surround tough comps for the theme parks, slowing affiliate fee growth at ESPN, and a plateau for the turnaround at ABC. On the flip side, the Studio is performing very well which is setting up big home video profits, cost cutting at the Studio will be significant, and the outlook for ESPN and Theme Parks is just for modestly lower growth. I remain on the bull side of this debate and expect 3Q06 results and commentary to support my view.

For 3Q, DIS is expected to report EPS of 44 cents on revenues of $8.61 billion. EPS should grow over 10%, revenues over 11%, and operating income about 25%. Operating income is benefiting from favorable timing on revenue recognition at EPSN that has penalized results year-to-date and a huge turn at the Studio which posted a loss a year ago....

Broadcasting is expected to show double digit revenue growth but incur a double digit decline in operating profits. The quarter witnessed good ratings and scatter pricing for ABC but the company spent heavily on pilots for the upcoming season where 10 new shows are on the schedule.

Over 75% of revenue at Cable Networks comes from ESPN. ESPN has enjoyed strong ratings and will recognize an extra $50 million in deferred revenue this quarter. The Disney Channel also could provide a boost this quarter due to the phenomenal success of High School Musical. Look for a 15% gain in revenues and a 25-30% gain in operating income.

Theme Parks are expected to show revenue and operating income growth of 10%. I think there could be some upside to the operating income estimates as margin expansion has been a hallmark of recent parks performance. The big question in Theme Parks is whether the tough comparisons against the 50th Anniversary fueled attendance growth will put a big dent in FY07 growth. The parks in Europe and Hong Kong are expected to at least breakeven this quarter.

The Studio will witness a big turnaround against a year ago when large write-offs for Miramax pushed the segment to a loss. This year the box office comparison is easy while the home video comparison is tough. Revenues are expected to rise 9-10% with operating profits of $100 to $125 million. Studio results can be very volatile relative to current estimates. Marketing spend for Cars and Pirates of the Caribbean: Dead Man’s Chest will hold back the quarter but the December quarter should be enormous when DVDs for both films hit store shelves.

Consumer Products is the smallest division by far but it could produce a big gain as apparently merchandise sales for Cars were among the best ever for a DIS film.

A couple of other things to be looking for on the conference call are the size of the losses for the Disney and ESPN wireless MVNOs, the magnitude and timing of savings on the cost cutting at the Studio, and an update on the sale of the company’s radio operations. With the Emmis Communications deal falling apart, there are probably fears that DIS’ deal to sell radio could be in jeopardy – that would be a definitive negative.

Weekend Box Office Still Looks Good For Disney and Regal

After 17 days in theatres, Pirates of the Caribbean: Dead Man's Chest is the fastest grossing film in history. The movie remains comfortably on track to produce better than expected profits. In fact, benefits to Disney (DIS) relative to current expectations could begin as soon as the September quarter since the film seems likely to more than recoup its production and marketing costs during its global theatrical run.

Most analysts assume that a film will lose money in its theatrical window only to produce profits later in home video and television rights. DIS does face a potential timing issue in its June quarter when the bulk of marketing costs for Pirates and Cars are likely to be booked. Pirates wasn't released until July so this could create a timing mismatch.

Pirates is the fastest film to reach $300 million, in just 16 days. The film is running $21 million ahead of the prior champ in that category: Revenge of the Sith. Weekday and weekend grosses are now both running ahead of Sith, which went on to gross $380 million. The only real question now for Pirates is whether it can catch Shrek 2 and The Phantom Menace to become the #2 grossing movie moving of all-time....

DIS is already set to release the next film in the Pirates franchise next Memorial Day. Given the fact that both films are likely to produce profits in all windows and both DVDs seem likely to fall in DIS' fiscal year ending September 2007, next year is shaping up as an enormous for profits at the company's studio. This should serve to offset some concerns about slowing overall growth for DIS next year.

Looking more broadly at the weekend box office, despite weaker than expected openings for several new films, strength in Pirates and good depth allowed the overall result to return to positive comparisons. The weekend was up about 5%, leaving the year to date gain over 6% and the current quarter running ahead by 15%. These trends remain bullish for Regal Entertainment (RGC).

Disney Pulls Back But Its Not Due To Pirates

Pirates of the Caribbean: Dead Man's Chest (POTC) continues to rule the box office. Nevertheless, Disney (DIS) shares have sold off since the movie was released. I wouldn’t chalk that up to any disappointment over the film, however.

In the early part of last week, before catching a downgrade on Thursday, DIS shares actually outperformed the market. I'd suggest that was the trading action related to the movie. Since then, I think the downgrade (built off the belief that street estimates for DIS EPS growth in 2007 are too high) and geopolitical tensions drove the shares lower. The quick strengthening in the dollar also probably contributed as DIS is sensitive to international travel at its Orlando theme park.

I maintain my view that 2007 results will not disappoint. Continued margin expansion at the theme parks, growth at ESPN, a solid upfront for ABC, and the flow through of profits from DIS very successful winter 2005 thru summer 2006 movie slate provide enough upside to meet consensus estimates. I think this fundamental strength will be evident when the company reports its June quarter. Recent sellers, shorts, and downgraders will regret their positions come the August 9th reporting date. One signal I could be right is that DIS shares finished up yesterday despite a second downgrade. I helped a tiny bit by adding DIS to a new client account.

Going back to the box office....

POTC fell about 54% last weekend from its record setting opening weekend, a performance that gives little guidance to box office observers who are trying to gauge its legs. A drop of 60% plus would have been a reason for concern while a drop of 40% would have put the film in the running for #2 all-time behind Titanic and ahead of Shrek 2. I standby my assumption that the film will gross over $400 million domestically.

Based on early international box office reports, a total of over $500 million abroad seems in the cards. In fact, with the film still only open in about 1/3rd of its foreign markets, Variety speculated the international haul could exceed $600 million making POTC the third ever film to cross $1 billion worldwide (Titanic, $1.8 billion; Return of the King, $1.1 billion).

Despite a solid weekend for POTC and in line openings for the two new films, Little Man and You, Me, and Dupree, total weekend box office fell for the first time in 8 weekends. The decline of 7% is nothing for box office bulls to be alarmed about. Last year, two of the summer's most popular movies, Charlie and the Chocolate Factory and Wedding Crashers both opened. Additionally, not be lost is the fact that the prior weekend was up an astounding $70 million, or 46%, from a year ago, and this past weekend was up 7% from 2004.

Year-to-date box office is up over 6%, implying attendance growth of about 3% this year for the supposedly dying theatre business. That myth will suffer another blow this weekend when I expect comparisons to return to positive territory. This continues to bode well for Regal Entertainment (RGC), whose shares have performed very well relative to the market's decline. I guess I'm not the only one who sees value.

Analyzing Disney's Pirates Treasure Chest

The daily box office results for Pirates of the Caribbean: Dead Man's Chest (POTC) continue to be astounding. After its record breaking opening weekend, POTC easily set mid-week daily records, and now has the 6, 7, 8, 9, and 10-day records. The film appears headed toward $400 million domestic and over $900 million worldwide, ahead of initial expectations to match the first film with $300 million domestic and $653 worldwide.

Since most of the stories about the film have focused on box office, I thought I’d take a stab at profits and see how the better than expected box office might impact EPS for Disney (DIS). Please understand that while I think the analysis is accurate and captures how POTC could be impacting DIS shares, it is overly simplistic and probably naive relative to how the film is financed, and the residuals and participations to the talent....

Initially, Wall Street was assuming that POTC domestic box office would be $300 million, worldwide box office would be $650 million, and profits from all windows would be $250 million. Here's the math on the initial profit estimates:

At $650 million in worldwide box office, rentals (the studio's 55% share of the box office) to Disney would be around $355 million. Estimates for production costs for the film range from $200 to $250 million. Prints and advertising add another $150 million to current expenses. Consequently, analysts were probably assuming the box office window would produce a loss up to $50 million.

The next window is home video. Dave Miller of Sanders Morris Harris uses a rule of thumb that home video revenue equals 1 times domestic box office with a revenue split of 75%/25% between sell-through and rental. The margin on sell-through is higher but I think it is fair to say that most models assume the margin on total home video averages around 60%. Therefore, based on the initial $300 million domestic box office estimates, home video would produce $180 million profits.

The next source of profits is sale of TV rights. I've seen models that assume TV rights are sold for 35% of domestic box office, or $100 million in the case of POTC. This seems high but remember that it would include pay TV, cable, and broadcast in the US and abroad. Let's guess an 80% margin on that revenue and you got an additional $80 million in profits.

So before DIS gets any profits on merchandise related to the film, at a $300 million domestic box office, POTC might produce $210 million in profits. I've read that POTC merchandise is selling better than any Disney or Pixar film since Toy Story 2, so initial analyst estimates of profits in the $250 million or higher range seem totally plausible. And don’t forget that Disney also benefits at its theme parks and cable networks.
There is no way of knowing of how Disney financed the film but for sake of argument I am going to assume that financing costs are included in production costs. The last few quarters, DIS has had a tax rate of 36%, which would leave $160 million in after-tax profits from the film. Based on 2 billion shares outstanding, analysts might have 8 cents of earnings just from POTC in their estimates over the next four to six quarters. Current estimates call for FY07 EPS of $1.65, so it is plausible that this one film could have equaled 5% of analyst estimates for DIS' 2007 EPS.

Of course, it now looks like POTC is tracking to generate $400 million in domestic box office and over $900 million worldwide. Compared to initial estimates, an incremental $300 million in worldwide box office turns the theatrical run from a loss of $50 million to a profit of over $100 million. TV rights revenue could now go as high $125 million pushing profits to $100 million. Home video goes to $400 million in revenue and $240 million in profits. So with box office trending above initial expectations, the film could be heading toward total profits of $440 million vs. initial estimates of $250 million.

Applying the same assumptions about taxes and shares outstanding, and POTC is now looking at adding 14
cents to DIS earnings over the next four to six quarters.

DIS is trading at about 20 times earnings so the extra 6 cents should be worth $1.20 to the stock price. Prior to Thursday's downgrade from CIBC, DIS had actually been outperforming the market since POTC was released, so I think the market has been reasonably efficient as it relates to the upside surprise for the film.

As for that downgrade, I think the analyst is going to regret it as DIS has double digit growth for 2007 in the bag with the extra POTC profits, strength in other films from the studio, the continuing gains at ABC, and steady growth at ESPN. Theme parks is the wildcard and geopolitical tensions and a slowdown in consumer spending are definitely risks. It's a risk worth taking though as comps in Florida aren’t that tough and the rest of the companies businesses can take up the slack of anything other than a significant shortfall.

Disney's Pirates Brings Big Profits

Consumers and investors tend to focus on box office and forget profits when looking at domestic box office numbers. Several analyst reports out today are looking at the profitsfor Pirates and the news is good for Disney (DIS). Analysts must have been playing it safe because several bumped their estimates by a nickel or more for FY07 which is where the profits on the film will reside due to the requirement that marketing and production costs be expensed upfront. Film profits usually come from windows like DVD and sale of TV rights that come six to 18 months after the domestic theatrical opening.

For Pirates, analysts are estimating that production costs were anywhere from $200 million to $250 million. Film advertising and print cost estimates range from $75 million to $150 million. This creates a cost basis ranging from $275 million to $400 million before additional costs related to participations for talent and any financing partners. Consequently, on the assumption that DIS will collect revenues equal to 50% of the global box office, the total worldwide take must be $550 million to $800 million for the film to reach breakeven during the theatrical run which will correlate with DIS’ 3Q and 4Q06. The first film did worldwide box office of $653 million ($305 million domestic, $348 million international). Analyst are estimating the new film to do at least as well as the first film, thus, breakeven is on the horizon. That would be good news as most films are not profitable on their theatrical run.

Analysts project that over the next 18 months, the film will produce profits for DIS form $250 million to $400 million across all windows and including merchandising. Down the road, there is also an immeasurable benefit to the theme parks. This film is the perfect example of how DIS can benefit across its divisions from successful family-oriented films. With Chicken Little, Narnia, Cars, and Pirates all having been successful since the 2005 holiday season, there is a lot of cushion in the DIS numbers over the next 4-6 quarters.

Disney Downgraded at Citigroup

On top of the slightly weaker than expected opening for Cars, Disney caught a downgrade from Citigroup which has the shares down about 3% this morning. However, the downgrade had nothing to do with Cars. Rather it was totally predicated on the analyst’s expectation that theme park revenues and operating income would fall well short of consensus in 2007 leading DIS to miss the current 2007 consensus forecast of $1.64 by 11 cents. Citigroup believes that theme park attendance will fall short due to tough comparisons against 2006 growth that was driven by the 50th anniversary marketing. Additionally, waning consumer confidence correlates with lower them park attendance.

Back to Cars, I quickly browsed through analyst commentary and found that most analysts noted the slight shortfall but few felt it would have any significant impact on profits. Merrill Lynch said that at most over the next two years when DIS is projected to earn over $3.00 combined, the shortfall could cost 3-4 cents, just 1% of EPS. Merrill went on to state that at a presentation it hosted in London last week, the head of Disney's consumer product division said that the Cars launch was the strongest for any Pixar film ever with most of the initial inventory fill selling out. This is an important point as the Pixar acquisition must be analyzed relative to its contributions across all of Disney's businesses, not just eh box office for any single film.

DIS shares have fallen almost 10% from last week’s 52-week high at today’s open. I think that more compensates for the slight shortfall of the Cars opening and Citigroup's concerns over theme park growth in 2007. Sentiment on the shares will now be sour for the short-term but as I wrote earlier today I think near-term earnings will remain very strong and Pirates of the Caribbean and June quarter earnings provide catalysts over the summer.

Cars Not Quite As Good As Expected; Overall Box Office Up Again

Cars opened at the low end of expectations with $63 million failing to provide a catalyst I had been counting on for Disney (DIS). I think the opening will hurt sentiment for DIS stock because it will make it easy for naysayers to get traction with the "they overpaid for Pixar" theme. However, DIS shares fell sharply late last week as expectations for Cars starting to come in so I don’t think there is a lot of downside left relative to the market unless the film drops much more quickly than expected at next weekend's box office or weekday grosses with kids now out of school are weak.

I am staying long DIS for Northlake clients because I think fundamental momentum is excellent with ABC, ESPN, the TV stations, the movie studio, and the theme parks all performing very well. Additionally, the shares could get another pre-opening lift ahead of the release of the summer's most anticipated movie, Pirates of the Caribbean: Dead Man's Chest , due in theatres on July 7th.

The overall box office was healthy again for the weekend, up vs. last year for the fourth straight weekend....

The top 12 films grossed 8% more than last year and all films in release were up 4%. Remember, $63 million is a huge opening and only for a Pixar film is that considered a disappointment. The weekend saw 5 films gross over $10 million with none of the leading films showing unusual declines. The top ten was filled with films appealing to all important demographic groups supporting my contention that if there is decent product the box office can still grow at its historic rate.

Year-to-date the box office is now up about 5%, with the second quarter tracking for a double digit gain. Comparisons remain easy for the next 6 to 10 weeks, so I am also sticking with my long position in Regal Entertainment (RGC). RGC went ex-dividend last week on its 30 cent quarterly payment. The shares are down about 5% before the dividend since I made the initial purchases for Northlake clients. I remain confident that a target in the $23-24 range is realistic as summer box office momentum sticks.

My Expectations for Disney's Cars

Disney (DIS) made a new 52 week high in Monday's abysmal market, likely anticipating this coming weekend’s opening of Cars. I think the Cars hype is also helping Regal Entertainment (RGC) which has performed relatively strongly the last few sessions. Northlake remains long both stocks although DIS is approaching my target for considering a sale.

I think the Cars opening will be very large, easily exceeding the $68 million for the Ice Age sequel earlier this year. One good sign for Cars is the solid legs for Over The Hedge. Although the film will not be a mega hit, its weekend-to-weekend drop-off has been modest. This shows that the market is out there for a film appealing to children. Also working in Cars favor is that young boys love to play with cars and trucks. The young boy demographic can be tough to reach. A final factor I see helping Cars is the appeal it has to the huge NASCAR fan base. NASCAR's fan base is a broad swath of middle America, one that has driven other movies like Passion of the Christ to huge numbers.

I have read a few cautious comments regarding the box office potential on some movie blogs. They are of the variety that Cars is very good but not as good as we have come to expect from Pixar.

Excluding the unusual success of Finding Nemo, the recent Pixar films each did around $250 million domestically (Toy Story 2, Monsters Inc., and The Incredibles). Incredibles and Nemo each opened at $70 million, Monsters started with $62 million, and Toy Story 2 began with $57 million.

My prediction is that Cars will pull in around $250 million for its domestic run with an opening weekend north of $80 million. The larger opening than prior Pixar films with a similar total run respects the front loading that is appearing with increasing frequency of late. Popular films are showing an increasing tendency to burn out more quickly. This is more of an issue for theatres than studios but is something to be aware when analyzing opening weekend trends.

Memorial Day Box Office

My friend and fellow money manager, Doug Kass, is making a good call to short Dreamworks Animation (DWA) on the back of less than stellar box office for Over The Hedge. There are no catalysts for DWA unless the film does surprisingly well this weekend. Short of buyout rumors becoming reality I see little upside and 10% downside.

Doug is also betting the over the weekend box office X-Men: The Last Stand (X3). Again, I think he is right. The opening weekend could be large. From what I gather buzz on the film is good, although early reviews aren’t nearly as favorable as they were for the first two films. The plot seems to advance the series by exploring the mutants more fully which should help keep X-Men a fresh franchise. Also helping is the fact that the last X-Men movie was released in 2003. The disappointing Mission: Impossible 3 had to overcome a six year hiatus from MI2. Finally, teens drive the box office and the fan base for X3 is teens....

X2 opened with $85 million in 3,741 theatres, according to BoxOfficeMojo.com, easily beating X1's opening. X2 opened on the first weekend in May whereas the current installment gets Memorial Day, usually a very good weekend for movies. I have to think that experts will be calling for X3 to match or exceed its predecessor. Remember Sunday is a full weekend day on Memorial Day weekend. I think $100 million for the 4 day weekend is a definite possibility.

For the overall box office, the weekend looks promising with good numbers likely from The Da Vinci Code, which performed strongly on Monday, and Over The Hedge, in addition to the big opening for X3. The comparison is fairly tough, however. Last year on Memorial Day, the final Star Wars movie did $70 million and new releases Madagascar and The Longest Yard did $61 million and $58 million, respectively. If Da Vinci and Over The Hedge drop 30% helped by the long weekend, even a $100 million opening for X3 would leave the top 3 films short of the top 3 from a year ago.

Nevertheless, I think a strong opening for X3 and decent holds for Da Vinci and Over The Hedge will leave box office observers and analysts in a good mood with the Cars opening just two weeks away, followed by Pirates of the Caribbean a month later. I know I've said this often recently but this is a good summer to be long Regal Entertainment (RGC) to play overall box office strength and Disney (DIS) to play what may turnout to be the two most popular movies of the summer.

X3 is from Fox and won’t likely move the needle for News Corp (NWS) shares.

NASCAR fans will get a mass sneak preview of Cars this week when the film is shown on a giant screen at Lowe's Motor Speedway as part of the racing circuit's Coca Cola 600 weekend. For you non-NASCAR fans, this is the equivalent of the Indy 500 weekend for NASCAR's giant fan base in its home of North Carolina. For us DIS longs, it better be good!!!

Weekend Box Office Report: The Da Vinci Code Comes Through

Despite poor reviews, The Da Vinci Code exceeded estimates with weekend ticket sales of $77 million in North American theatres. The weekend gross exceeded estimates in place prior to poor reviews out of Cannes. Along with a solid performance from Over The Hedge and reasonable business from other films in wide release, the year-over-year decline in the box office was limited to less than 3%, a good performance given that the final installment of Star Wars series was released on the same weekend in 2005. The weekend's results are receiving favorable commentary in the business press which should help investor sentiment and keep intact my thesis for a strong summer box office and gains in theatre stocks, including Northlake's long position in Regal Entertainment (RGC).

This coming weekend should see continued good business for The Da Vinci Code and Over The Hedge and a big opening for the latest X-Men film. The comparison is still tough but once Memorial Day is growth should pick up sharply as the early June opening of Cars and the July opening of Pirates of the Caribbean offer easy comparisons and hugely popular franchises. Both those films are from Disney, another long position held widely in Northlake client and personal portfolios.

Through Sunday, year-to-date, the box office is up about 5%, on a gain of 1% in ticket sales. The current quarter is running up 14%, comfortably ahead of analyst estimates for RGC's revenues which range from up 6% to up 11%. I see estimates for RGC heading higher over the next six to eight weeks, which should be a catalyst for the shares. Investors who buy now will also receive two 30 cent dividends in the next five months, more than 3% of the current stock price.

Looking more closely at the individual films and the studios that released them...

I think it is too early call The Da Vinci Code and Over The Hedge financial successes. Da Vinci did come in above expectations but the Saturday gross fell slightly from Friday which might indicate that bad reviews are impacting word of mouth. Additionally, while the film had one of the top 15 openings of all-time, the per screen average was the slightly lower than all the films above it. Even more so than normal, the second weekend will provide a better guide for ultimate box office success. I'd guess Da Vinci will head close to $200 million in US box office, a good but not great figure. International grosses look very strong, and Sony (SNE) has little to worry about from a financial perspective.

I think Dreamworks Animation (DWA) shares could be weak this morning. Over The Hedge actually came in slightly short of the $40 million many observers expected and earned less than comparable films like Chicken Little and Madagascar. The film will do well financially but it doesn’t appear to be a blow away hit and DWA lacks catalysts as this film is the entire 2006 story.

Finally, I wonder if Time Warner (TWX) may be looking at a write-off for Poseidon. The film cost $160 million to produce according to estimates and advertising must have been well north of $20 million. The film has grossed just $37 million so far in North America and a modest $4 million overseas.

Disney's Results Will Keep The Shares Moving Upward

Results from Disney (DIS) look awfully good to me. EPS came in at 37 cents against consensus of 31 cents. I only see a 1 cent benefit from a lower than expected tax rate so it looks like a clean beat to me. Revenues were $8.03 billion vs. consensus of $8.18 billion, yet despite the $150 million shortfall, operating income easily exceeded analyst estimates so margins were quite good. Estimates are headed higher and so are DIS shares. Northlake remains long DIS and I see no reason to exit anytime soon....

The revenue shortfall was primarily at the Studio but operating income at this division beat estimates by $40-50 million. Management attributed the better than expected profitability to continued box office strength for The Chronicles of Narnia: The Lion, The Witch, and The Wardrobe, lower distribution costs at Miramax, and strong results in TV production and syndication. Make or break for the movie studio comes this summer with the June release of Pixar's Cars and the July release of Pirates of the Caribbean. Narnia DVD sales will prove a benefit in June quarter results before the profits form the summer releases flow through the financial statements. Management is "extremely encourage by how smooth the Pixar transition has been."

Revenues also fell a little short at Cable Networks but once again profitability exceeded expectations. The operating income comparison was again penalized by deferral of revenue at EPSN to 2H06 so look for a big boost in growth starting next quarter. Cost for the ESPN Mobile venture also depressed profits. Management admitted on the call that initial response was worse than expected and that they have redone the marketing, subsidies, and distribution. So far, they are sticking to the $130 million loss for the combined Disney and ESPN Mobile ventures.

The stars in the quarter were Broadcasting and Theme Parks. Broadcasting easily beat expectations for both revenue and operating income. Compared to analyst estimates, marginal profitability looks quite high. Strength occurred at both the TV stations and ABC. Management was very confident about ABC's growth outlook for next season and indicated that the network will grow revenue nicely" in the upfront.

Theme Parks also beat on revenue and operating income. Attendance trends related to the 50th anniversary were noted. Margin expansion continues and management is sticking to still more expansion as well as attendance growth even after the anniversary benefits wear off. The recent weakness in the dollar could help international visitor attendance.

Other commentary on the call included a willingness to use balance sheet strength for acquisitions (Univision?), confirmation that Pixar will be 10 cents dilutive in the next two quarters, affirmation of double digit EPS growth in 2006 even after the dilution, and extensive discussion of the company's array of web-based video initiatives (over 5 million downloads of video at iTunes).

I have long felt that DIS was headed to the low $30s on the basis of consistent double digit growth as all the divisions are in sync. The shares are offered at $30 in the after hours market as I type this. I think the stock can still work several bucks higher on the Cars and Pirates box office and the big pickup in growth forecast for the next two quarters. DIS blew away estimates in each of the last two quarters despite supposedly tough comparisons. Estimates are going higher and the stock will follow. Only a shortfall for the summer movies or another big acquisition seem to be risk factors in the near-term. Northlake remains long DIS and I expect the shares to be further rewarded for outstanding financial performance and a clear content focused strategy that is looking ahead to digital delivery.

Disney March 2006 Quarterly Earnings Preview

Disney (DIS) reports its 2Q06 after the close on Tuesday. Consensus calls for 31 cents against 32 cents a year ago. DIS has forecast a backend loaded year leading to a fourth straight year of 10% growth. The shares have acted well all year so there is little concern about the flat year-over-year growth forecast for the latest quarter. Timing of theatrical and DVD releases, revenue deferrals at ESPN, and a shift in the Easter holiday are each contributing to the "slow 1H/grow 2H " progression in this year's results. Estimates have inched up recently for 2Q with some analysts appearing to expect a repeat of the better than expected 1Q results.

On Friday, DIS shares closed over $29 for the first time since March 2005. Investors have rewarded DIS for stringing together several years of double digit growth. Investors are also happy with Bob Iger's leadership and the content-centric strategic direction he is taking the company. The Pixar acquisition just closed, complementing the divestiture of radio as a sign that for DIS the future is content over distribution. I share Cramer's view and sense a slight shift on the street in favor of content as the proliferation of touch points with consumers via the internet, iTunes, and advanced services like VOD and DVRs are being viewed as incremental. The big entertainment companies have always benefited from technology transitions (VHS to DVD being a great recent example) and while risks are unusually high as the current business models are under severe stress, DIS at least appears to have a coherent strategy....

2Q should witness strength in Broadcasting and weakness at Studio Entertainment. Broadcasting is benefiting form the continued turnaround at ABC which benefits the network and the TV stations. The studio has another tough comparison that will lead to a down quarter despite decent box office and DVD results in the quarter. Last year saw the release of The Incredibles DVD, so a big decline in studio profits is in order. This should reverse beginning this quarter with the June release of Cars followed by the July release of the sequel to Pirates of the Caribbean. I've seen two separate polls that recently ranked Pirates as the runaway choice for most anticipated summer film. FY07 results will get the biggest financial benefit from these two releases.

Cable Networks is dominated by ESPN which faces another quarter of revenue deferrals due to the timing of sports programming. Management has confidently stated that ESPN will grow double digits through 2010.

Theme Parks should have another solid quarter and the outlook is improving with the recent weakness in the dollar. Continued improvement in margins on moderate top line growth is the story at the theme parks.

Three other items that might come up on the call include ESPN Mobile, the ESPN contracts with Comcast (CMCSA/K) and Time Warner (TWX), and aborted McDonald's (MCD) partnership. Losses for the ESPN Mobile project are expected to be considerable this year. I fear that loss estimates could rise as I believe the company has upped its handset subsidy. I have also noticed a shift in the advertising message, which might indicate initial response was poor. On the contract renewals, ESPN will look for a 10-20% increase in the first or second year of the new deals with lower single digit gains in the out years. Deals like this have been struck with other operators but CMCSA and TWX are tough negotiators and this could be a difficult fight. On Monday, news broke that DIS was ending its promotional arrangement with MCD after Cars and Pirates. DIS shares traded down on this news. I saw one comment that said this deal was worth $100 million to DIS but I have no idea if that is accurate. Apparently, DIS wants to reduce its exposure to the children's obesity issue.

I continue to like DIS with a target in the low $30s. I think the big summer box office, 2H06 EPS, and growing confidence in the growth outlook in 2007 and beyond will be the next catalysts.

I'll Take Mickey Mouse Over Bugs Bunny

Despite being stalled for most of the last year, Disney (DIS) has generally trended up over the past three years, rising from the upper teens to the mid-$20s. Guess what? DIS is set to complete its fourth straight year of double-digit EBITDA growth. By contrast, Time Warner (TWX) is struggling to stay in the upper single digits. DIS responds to its earnings report and is trying to breakout.

Icahn is right that TWX needs to grow faster to create shareholder value. Will splitting it apart do the trick? Does it need better management? DIS has studio plus cable networks plus broadcast TV plus theme parks. TWX has studio plus cable networks plus cable distribution plus AOL plus publishing. Theme parks and cable distribution are somewhat similar in that they are capital intensive. One big difference is that ESPN is stronger than TWX cable networks. AOL is obviously a big issue for TWX, but on EBITDA, its growth has been above the corporate average due to cost savings. Icahn would say Iger has a vision as he wants to monetize DIS content across all old and new technologies. That vision might be worth something in the multiple accorded DIS, but the multiples on 2006 estimates are close.

I like DIS now because its businesses are moving in the right direction together. Long term, the growth may shift back in TWX's favor, but turning around AOL on the top line is a real challenge.

Point me to a scenario that gets TWX to multiyear double-digit EBITDA growth, and the stock gets a lot more interesting. I don't see it right now, but I am all eyes.

Disney Comes Through

Disney (DIS) reported better than expected earnings with EPS coing in at 35 cents against analyst estimates taht averaged 30 cents. Estimates will go up across the board with FY06 ending September heading toward $1.45-$1.50 from $1.41 presently. Furthermore, management spoke confidently about 2Q06 (the current quarter) and reiterated expectations for a strong back half of the fiscal year. Additionally, the forecast for double digit annual growth off the 2004 base through 2008 was reiterated. This forecast applies to the entire company. In Q&A, management was asked to confirm a similar forecast they have made about ESPN. They did so and noted that while they are promising "average annual growth" if there was going to a year where that was way off the trendline they would alert investors. This is comforting as it relates to ESPN next fiscal year where new sports contracts for NASCAR and Monday Night Football kick in. Analysts have been worried that this could lead to a flat or down year for ESPN. It is also comforting in that presumably the same theory about guidance applies to the entire company.

I still see DIS as the best large cap media stock. All of its divisions are moving in sync as the Studio should join broadcast television, cable networks, theme parks, and consumer products later this fiscal year. A multi-year forecast for double digit growth for a company with so many traditional media businesses is a strong endorsement of the outlook and should be rewarded with a higher stock price...

The conference call was very positive and showed that benefits could continue to accrue to the shares from the elevation of Bob Iger. The opening comments on the call were much briefer than usual, only about 20 minutes. The press release was just 14 pages, down from the mid 20s the last few quarters. Q&A was substantive and non-confrontational. Analysts showed Iger respect and asked good questions about long-term issues. Iger responded with a clear vision that DIS is a content company that is going to monetize its opportunities in new technologies and that is not afraid to challenge its current business models. It was refreshing talk that came across as honest and candid. I think analysts and investors will respond.

Looking more deeply at the quarter, Broadcast was very strong as the turnaround at ABC was stronger than expected. Furthermore, management noted that scatter pricing had accelerated from the 1Q pace into the "double digits" for the March quarter (scatter is purchase of ads for immediate showing as opposed to those that were previously reserved -- it shows the health of the current ad environment for ABC as it is selling current inventory at a premium).

Cable Networks look like they may have been a little weaker than expected even accounting for $105 million in deferred revenue not recognized at ESPN. Adding this back produces 9% revenue growth, still a slower rate than most of the recent quarters. The operating income comparison was negative due to the loss of the extremely high margin deferred revenues, investments at ABC Family, and investments in the ESPN Mobile telephony product. These investments will continue and the full year forecast for $130 million for ESPN Mobile is headed higher.

The Studio faced tough comps but the final figures, while still down significantly year-over-year look a bit better than feared. The Studio has always been a second half story for FY06 due to the timing of product last year and this year. For example, last Christmas saw The Incredibles and National Treasure in theatres vs. only Narnia this year. In the current quarter, The Incredibles was on DVD in the March quarter last year, while this year Narnia will hit shelves on April 4, in the June quarter. Finally, the two big releases from the company that are almost certain successes, Cars from Pixar and Pirates of the Caribbean hit theatres next summer and DVD next fall or winter. The company should have very easy Studio comps in the coming September and December quarters.

Theme Parks continued to kick out good growth with the top line rising 13% and operating income growing 51% as the margin expansion story continues. Attendance and per capita spending trends both were strong and management sounded confident about the outlook.

Consumer Products is a small division, less than 10% of revenue, but it produced a nice bump in operating income on flat sales due to the absence of North American Disney Stores. Looking ahead, comps get tougher in this division and the company will be absorbing an incremental $50 million in spending on its video game operations.

Finally, Iger made comments about Pixar and the Radio divestiture. On Pixar, the only major news was that the company was looking to move to two releases a year with the second release probably being a sequel. On Radio, management did not commit to using the cash proceeds for share buybacks but with the company’s aggressive and continually renewing program (fully diluted shares are down 100 million since the end of 2004), I think that is the logical use of cash. Responding to queries about using the proceeds towards an internet acquisition, Iger and CFO Tom Skaggs said they would do a deal if a good one presented itself but they gave up little information about what they might be considering, if anything.

Disney Earnings Preview: Last Slow Quarter Before Growth Accelerates

Disney (DIS) reports after the close on Monday. Due to timing issues and a tough comparison in home video, the quarter is expected to show a year-over-year decline in EPS and EBITDA. However, DIS is still poised for strong growth in its FY06 ending this coming September. I believe the back-end loaded year is well understood by investors but it does raise the stakes the in the remaining quarters which always is a yellow flag. As long as guidance for 2006 is maintained and the company stands by its "average of double digit growth through 2008" forecast, I think DIS shares are attractive and the best bet among large cap, diversified media stocks. Entering calendar 2006, DIS has all its major businesses moving in a positive direction at the same time and there is reason to believe that these trends are sustainable. I am long DIS across the enitre Northlake client base and in my personal accounts with all purchases made in the range of $24 to $26, including some as recently as late December.

For the December quarter, which is 1Q06 for DIS, the consensus EPS estimate is 30 cents vs. 34 cents a year ago. Revenue is forecast at $8.78 billion. For the March quarter, EPS are currently forecast to be flat at 31 cents vs. 32 cents a year ago. FY06 consensus EPS calls for $1.41 vs, $1.32 a year ago, representing a gain of 7%. Growth is expected to accelerate in FY06 with EPS rising to $1.63, up 15% against the current FY06 consensus....

There are going to be lots of changes to the company's financial statements due to the Pixar (PIXR) acquisition. The figures quoted above exclude PIXR. I am positive on the PIXR deal because I think that animation remains the driving force behind DIS's growth due to the flow-through of animated product to the company's theatrical, home video, theme park, and cable network divisions. I think the addition of PIXR is worth the dilution and the integration risks given the potential boost to the company's long-term growth rate from a revived animation division.

This quarter will also debut a change in DIS's financial reporting as the company is going to fold its equity interests in four cable networks into its operating segments. This should have no impact on the bottom line but it might impact growth rates at the Cable Networks segment level. Hopefully, the company will provide historical pro forma data. The four investments include 39.6% of E! and A&E, 37.5% of the History Channel, and 50% of Lifetime. There is a lot of value in these investments that is often overlooked by investors, maybe $2.5 billion at $20 per subscriber, or $1 per DIS share after-tax.

Broadcasting should be the star performer this quarter as the turnaround at ABC is in full bloom benefiting both the network and the owned and operated stations. The station also may have gotten a boost from political spending due to the New York City Mayor's race and the NJ Governor's race. Revenues are forecast to grow 15% with EBITDA up 90%.

Cable Networks faces a tough comparison due to timing issues. ESPN has to defer $100 million in revenue due to contracts with affiliates that require revenue recognition to coincide with airing of original programming. There may also be a timing issue related to the recognition of revenues and expenses related to the company's huge NFL rights package since the quarter incorporates most of the NFL season. Revenues are forecast to grow in the mid-single digits but since the deferred revenue carries virtually a 100% margin, EBITDA will decline by mid-to-upper single digits.

Theme Parks will continue their turnaround led by solid attendance trends at the domestic parks. Revenue for the combined domestic and international parks should grow in the upper single digits despite a negative comparison at the international parks. Ongoing margin expansion at the domestic parks should lead to growth of over 20% in EBITDA for the entire segment.

The Studio should report a profit this quarter after losing over $300 million last quarter. However, the big profits at the studio will occur in 2H06 and FY07 due to the success of Chicken Little and The Chronicles of Narnia: The Lion, The Witch, and The Wardrobe and the projected success of PIXR's Cars and the sequel to Pirates of the Caribbean both due in theatres next summer. Remember that it is the DVD sales that drive profitability of the Studio.

Consumer Products is DIS's smallest division but should shoud decent growth this quarter due to the benefits of the divestiture of the company's North American retail stores.

Thoughts on the Disney-Pixar Merger

It is hard to add value on the Disney-Pixar transaction. I received a dozen virtually identical analyst reports and CNBC was basically DisneyPixarVision for two days. I do want to highlight notes by Rich Bilotti of Morgan Stanley and Dave Miller of Sanders Morris Harris. It is not really anybody's fault that the notes were similar as the story has just been awfully well covered.

You can find a slide presentation on the DIS and PIXR websites along with the press release and a replay of the conference call. There was one slide that did jump out at me and I think it explains why the merger is receiving universal praise. Here is the key excerpt: (See Continued Reading...)

Value Opportunities
• Consolidate 100% of profit and current and future films
• Positively impact Disney feature animation
• Maximize sequel potential
• Recapture distribution fees and eliminated duplicative company costs
• Leverage Pixar's intellectual property across Disney's core businesses (e.g. theme parks, licensing, videogame publishing, etc.)
• Increase Disney's overall brand strength and base of powerful, high quality content which can:
o Enhance opportunities offered by new digital distribution platforms
o Increase Disney's ability to capitalize on new consumer preferences and emerging business models
o Improve and accelerate international growth opportunities

I know that most mergers in any industry don’t work out. I also know that media mergers have about the worst record. Heck, Viacom just broke apart, Clear Channel did the same, and Time Warner is under pressure to restructure after a disastrous merger. However, after reading that list, you have to admit that the purchase of Pixar seems pretty damn straightforward. This is a simple transaction between two companies that have been working incredibly closely togther for a decade.

That is not to say it is without risks. Culture shock and dilution from a hefty price tag are obvious risks. The risk of Pixar missing on a film was there before for Disney and is offset by the risk of Disney losing Pixar completely to another studio's distribution agreement.

There were a couple of other highlights from the conference call and slides. First, Disney said it would buy back all 287 million shares it would issue to Pixar by the end of 2007. This would be partly paid for with $1 billion of Pixar's cash. Second, Disney reaffirmed its guidance for low double digit EPS growth through 2008 despite dilution from Pixar.

On the first point, as Rich Bilotti effectively noted, DIS could have bought 287 million shares without this deal. It was planning on buying over 100 million anyhow and it had plenty of borrowing capacity to up that the rest of the way. Had DIS followed this strategy, the share buyback would have added 10 cents to EPS.

I think this shows that Bob Iger and Steve Jobs, as the largest shareholder, were making a strategic decision with this deal. Pixar is all about sustaining or accelerating Disney's growth rate and better positioning the company for the digital media transition. Choosing operating strategy over financial strategy is a smart move given the ease with which Pixar slides into Disney. I think Disney should be commended for the choice and the market agrees given that it has greeted the deal favorably.

I remain long DIS in all Northlake client accounts on the basis of strong fundamentals in most of the company's businesses including cable networks, ABC, theme parks, and consumer products. The movie studio has been the one laggard and Pixar increases my confidence that it can be turned around. Add in tangential benefits from the Pixar deal like more licensing and better theme park attractions and you could argue that positive trends in the non-studio businesses were reinforced.

I think Disney is a buy with a target in the low $30s with the caveat that the December quarter represents a down year over year comparison and financials for FY06 are backend loaded, even more so now that Cars is 100% controlled and will hit late in the company's third quarter with video sales not until the first fiscal quarter of 2007 (late Fall of 2007). I own Disney in every client account and my personal accounts.

Disney to Buy Pixar?

After seeing the lead article in this morning's Wall Street JournaI, I quickly reviewed several research reports from the past month which discussed the potential acquisition of Pixar by Disney. In an all stock transaction, as speculated today in the Wall Street Journal, analysts expect EPS dilution of around 10% for DIS at a price of $60. Dilution rises to 13% at a price of $70. Any use of cash lowers dilution. The analysis used to arrive at these figures merely adds PIXR's estimated financials to Disney's. This probably overstates actual dilution since presumably there would be some synergies in a deal. For example, PIXR's EBITDA represents just its share and it is plausible that if the entire entity were under one roof the combined EBITDA of DIS and PIXR would exceed thier currently separate levels. Additionally, PIXR has only been producing one movie per year. It is equally plausible that production rises to 2 films per year.

I think the market would look beyond dilution if a deal were to occur. Animation is what drives DIS and separates it from its entertainment conglomerate peers. Theatrical box office, home video, theme parks, and consumer products are driven by DIS's success with animation. If PIXR increases the odds of success then some level of dilution is clearly acceptable....

Staying with the intangibles, a deal like this also impacts the corporate culture. DIS is noted for having a conservative culture. As a content company in a world of rapidly changing distribution, this caution could be considered a drawback. A bold move to acquire PIXR, bringing high quality and aggressive new managers like Steve Jobs and John Lassiter, would shake up DIS, arguably for the better from a competitive standpoint. A DIS-PIXR deal probably was never possible under Michael Eisner's leadership. If the deal goes down, or just the fact that it has advanced this far, means that Bob Iger has stamped DIS as his. Again, Id say that is arguably a positive at least as far as sentiment toward the shares goes.

Lots of risks in this deal for sure especially when PIXR inevitability has a movie that underperforms. However, as a DIS shareholder I'd say the dilution and risks are worth it given the potential invigoration of the company's crucial animation division and conservative corporate culture.

Weekend Box Office Report: Good For Disney and Lions Gate

The holiday weekend box office did nothing to stop the skeptics worries about faltering ticket sales as total receipts were down 16% from the same weekend a year ago, although vs. 2004 the receipts were up 6%. Despite the lackluster overall results, the news was good for Disney (DIS) and Lions Gate Entertainment (LGF)....

The monster hit The Chronicles of Narnia: The Lion, The Witch, and The Wardrobe continued to pull in big bucks for DIS. The film fell a moderate 35% from last weekend (on a 3 day basis) and brought in $12.2 million pushing its domestic gross to $263 million. The film looks like it could head toward $300 million in its U.S. run, matching or slightly exceeding the haul of the latest Harry Potter film. Overseas revenue continues strong as well and the film has now brought in over $320 million in international markets. While DIS is sharing the financial success of Narnia with a company controlled by Philip Anschultz, the film is important in that it has established an potential seven film series which DIS can put through its many windows including home video, theme parks, and merchandising. DIS shares have acted well this year on the success of Narnia and indication that December quarter theme park trends were solid. I still think DIS shares have further upside as most of the company's divisions have good operating momentum in 2006.

LGF's latest horror release, Hostel held up fairly well for a horror film, falling about 50% over the 3 day comparison and pulling in $11.7 million for the 4 day weekend. The film has now grossed $37 million and looks headed north of $50 million. The economics on Hostel are unclear but with a production cost of under $5 million, there is plenty of money to go around. The success of Hostel was just one of several news items for LGF over the weekend. On Friday, the Wall Street Journal reported that Starbucks (SBUX) has settled on LGF release Akeelah and the Bee as its first film in a push to replicate the coffee chains success in music distribution with DVDs. SBUX will add a big promotional effort to LGF's own work for the film. SBUX screened a dozen films before settling on Akeelah so hopefully that is a sign it is a good film. LGF was also in the news this weekend when the New York Post reported that the company may be close to settling a long-awaited deal to launch a horror channel in partnership with a leading cable or satellite company. LGF is likely to supply the content and management for the channel in return for distribution and a minority stake. I think this is one genre that has yet to be exploited on TV and a good deal could add lots of value for LGF over a multi-year time frame. I still own a small amount of LGF and plan to hold on as it appears after several disappointments the next couple of quarters are shaping up well. I think the stock has a shot at reaching the mid $10 range over the next six months, a gain of 20% against the latest quote.

Chronicles of Narnia Performing Very Well for Disney

With the kids out of school and lots of folks on vacation, everyday is a Saturday for the box office, and Disney (DIS) looks like a big winner as The Chronicles of Narnia: The Lion, The Witch, and The Wardrobe is established at the top of the charts bringing in around $9 million a day. The film looks set to soar well over $200 million in domestic box office by the end of the New Year’s weekend and I think it has a shot at matching the box office for the latest film in Warner Brothers Harry Potter series. The Narnia franchise appears to be established and looks set to contribute for years as the current and upcoming movies cycle through the DIS operating divisions.

DIS is setting up for a couple of real strong quarters on the financial side and I think the market has got to notice soon. DIS is one of those large cap stocks trading at a moderate P-E that the market has ignored. Consensus for 2006 is $1.41, placing the P-E at 17, quite reasonable in my opinion, given momentum at ESPN, the movie studio, the theme parks and ABC and the possible sale of the radio business. Negotiations with Pixar Animation (PIXR) have not resulted in any announcement yet. The outcome could cut both ways for DIS and a negative result is one of the only near-term risks I see in the DIS story.

Disney's Movie Studio Suddenly Looking Good

The only presentation I heard from Disney (DIS) at last week's UBS Media Conference came from George Bodenheimer, who heads up ESPN. The story at ESPN is excellent with double digit average growth in operating income through 2009 as most costs and affiliate fees are locked in. Recently, ESPN has been a bright spot while the movie studio has been the company's Achilles heel. Now, less than a month after the studio reported a $300 million loss, things are suddenly looking up for the Studio Entertainment segment.....

Following on the heels of the success of DIS's first computer-generated animated film, Chicken Little, the company's attempt at establishing a multi-film, multi-year franchise from C.S. Lewis' Chronicles of Narnia series got off to a roaring start this past weekend. The Chronicles of Narnia: The Lion, The Witch, and The Wardrobe opened with a better than expected domestic box office of $67.1 million. Estimates I had surveyed centered around $50 million. The film had the third best opening of 2005, trailing only the latest Star Wars and Harry Potter flicks. Narnia also opened strong overseas with $42 million. BoxOfficeGuru.com also noted that the opening weekend compared favorably with the latest two Pixar films, The Incredibles and Finding Nemo which each opened with $70 million. Exit polls for the film were very favorable which might allow it to weather this coming week's opening of the extremely well-reviewed and certain blockbuster King Kong.

went on to earn $261 million in the U.S. and $369 million abroad, while Finding Nemo earned $339 million domestically and $525 million in international markets. The first Narnia film seems unlikely to match those numbers but a domestic gross north of $200 million seems likely with international numbers even higher. Most importantly, the $150 million gamble DIS made on the production costs for the film (and a marketing budget that probably reached at least $50 million) appears to have been a good bet. DIS now has a franchise to match Warner Brothers (owned by Time Warner) Harry Potter series and with seven books in the Narnia series the company likely has a blockbuster opening every December through 2011. Furthermore, a children's based franchise gets a multiplier effect at DIS due to the company's theme park and merchandising businesses.

Less than a month ago, the studio was causing great concern among DIS investors. Now, two consecutive hits make the studio's results for FY06 ending next September look very promising. Two more surefire hits are in the pipeline for next summer with the Pixar release Cars and the sequel to Pirates of the Caribbean. DIS's reliance on the suddenly mature home video market is still a concern but returns on recent theatrical releases have held up better than library catalogue and the next twelve months should see the four films mentioned in this note generate the sale of potentially 80 million DVD units. At $15 wholesale, that is $1.2 billion in revenue and, even on depressed margins, over $300 million in operating profits.

I think the back-to-back success of Chicken Little and The Lion, The Witch, and The Wardrobe set up DIS shares to finally move up towards my long-standing target in the low $30s. The studio, cable networks, ABC, and the theme parks all appear set for good results in FY06 and trade publications suggest the sale of the company's radio assets for as much as $3 billion could be announced anytime. DIS remains a long position across the entire Northlake client base.

Follow-Up Data Points From Disney Conference Call

After reading through analyst commentary on Disney (DIS) this morning I wanted to provide a few additional data points that were not included in my earnings summary. These points do not change my conclusion that the quarter was slightly worse than expected and the outlook for share gains in the next few months is worse than I previously expected. However, 2006 still looks like a strong year with multiple drivers which should limit downside in the shares to this morning's initial decline due to the disappointing quarter....

Here are some follow-up points I may have missed:

� Three of the five segments reported mid-teens or better growth although all the segments were either inline or slightly below analyst estimates.

� Attendance at the parks in FL and CA was up 10% and 15%, respectively last quarter. December quarter bookings are trending up mid-single digits. This is a positive as it suggests that so far at least the fears about fuel and home heating costs are not hurting attendance.

� Scatter market pricing for ads at ABC is up mid-single digits over upfront pricing. Scatter pricing is up double digits at ESPN and ABC Family.

� TV and Radio pacings remain weak. After growing in the very low single digits in the September quarter, trends in December are unchanged.

� DIS is buying back a lot of stock. In the just concluded fiscal year, the company bought back 91 million shares for $2.4 billion, including 42 million shares in the September quarter. One analyst noted that an additional 40 million shares have already been bought this quarter. This is also a big positive as it shows capital allocation discipline that is less apparent at other major media companies
.
� Earnings estimates are coming very slight for 2006 but still represent solid double digit growth.

Once again, the quarter and the back end loaded FY06 make me less optimistic about DIS stock performance over the next few months. I remain long DIS but might change my mind, particularly if the shares rebound from this morning's initial sell-off. DIS does have several near-term catalysts including the possibility of the sale of the radio stations and a strong opening Thanksgiving weekend for The Lion, the Witch, and the Wardrode.

Disney Reports Mixed Quarterly Earnings

Disney (DIS) reported mixed 4Q05 results, slightly worse than analyst estimates on a segment basis. Analysts didn't seem too concerned about the quarter on the conference call, however, as there were very few questions about the details. Rather the focus was on long-term issues and the forecast for 2006. I think the questions on long-term issues may have been heightened by the fact that this was Bob Iger's first call where he was the whole show. On that front, I think he did quite well. He came across as very sincere and accepted the challenges facing traditional media companies. But he was equally strong in discussing how DIS is not afraid to confront the new environment and has lots of significant projects going in wireless and broadband distribution....

Regarding 2006, management stuck to its forecast for double digit growth although noted that it would be a back end loaded due to the timing of theatrical releases. In particular, the release of the next Pixar film, Cars next June, followed by the Pirates of the Caribbean next July will have a big impact. Management seemed confident in near �term trends at ESPN, ABC, and the theme parks. 2006 will also benefit from an easy comparison against $100 million in pre-opening expenses incurred at Hong Kong Disneyland in 2005. I don�t think that 2006 analyst EPS estimates, currently $1.47, will change at all as a result of the latest quarter or the conference call. That said the next quarter or two may see numbers fall a penny or two only to have those pennies added to the last two fiscal quarters.

To me, the quarter and the outlook is a bit disappointing as I was hoping for a much more clearly positive picture and estimates trending upward. Coming off the nice bounce in the stock over the past month, these results are likely to fall short from an investor's perspective. On the other hand, when I listen to Iger discuss long-term issues and look at what DIS is already doing and its current asset base, I think it is well positioned relative to the other media conglomerates. The question becomes whether you want to own a media conglomerate at all. I am not sure and I am less optimistic about DIS now in terms of year ahead stock price performance than I was 24 hours ago.

Looking at the quarter on a segment basis, Theme Parks and Consumer Products closely tracked estimates. Theme Parks saw 9% revenue growth translate into 14% operating income growth. Margin expansion is the key story here so this is a good sign. On the call, management called for further margin expansion in 2006 and beyond even after the company absorbs some employee benefit increases in 2006. Consumer Products comparisons were down year-over-year due to the sale of the Disney Stores in North America. This is a small division but could hold back corporate results somewhat in 2006 as it contains the company's video games efforts which are undergoing a major investment cycle.

Results at Broadcast and Cable Networks came in slightly short of optimistic expectations. Broadcast was actually pretty much on target as the turnaround at ABC and the syndication profits I outlined in the preview at Touchstone drove results. Management was quite optimistic about syndication over the next few years and if ABC ratings and the ad market hold, the Broadcast turnaround should extend several more years. I found Cable Networks results to be short of analyst expectations on both revenue and operating income. Unfortunately, there were o questions about this on the call so I can't add much. The press release did note higher programming expenses at ABC Family. Management was very firm about forecasting double digit annual growth at ESPN through 2009 based on locked in affiliate fees and programming expenses. This is a positive.

Finally, the Studio lost a little over $300 million, at the high end of guidance. This suggests that my preview thoughts that DIS productions performed poorly enough for write-offs was accurate. Management seemed to suggest about 2/3rds of the loss was Miramax related. Most of the discussion on the conference call concerned the 2006 movie slate and current forecasts for a modest up year seem appropriate although recent flops will negatively impact the next quarter or two as they move through home video windows.

On other topics, there was no mention of the radio sale and Iger said he wouldn�t add to Steve Jobs recent comments on Pixar negotiations. There was a lot of discussion of home video trends. Iger noted that top theatrical titles continue to perform well but that lesser theatrical titles, library, and direct to video releases are struggling. He noted that there were 10,000 DVD releases in the last year including 1,500 TV shows and just 354 recent theatrical releases. This shows how congested the DVD market is and why sell through of many titles is moderating. It doesn't sound like DIS expects much improvement in 2006 but expectations are now in check so a flat market won�t hurt estimates.

Previewing Disney's September Quarter Earnings

Disney (DIS) reports after the close tonight. Current consensus estimates call for EPS and revenue of 18 cents and $7.9 billion, respectively. EPS are down a penny from a year ago and revenue is up 5.5%. Operating income growth is projected at just a 2.2% gain. These headline figures mask a better underlying story as DIS has already announced a $275-300 million write-off at its studio related primarily to Miramax films due to the departure of the Weinstein Brothers. DIS had several big budget flops of its own in the quarter so presumably these are included in the write-off. If not, that could be the source of a negative surprise. I am not that concerned about the movie studio as investors will put the tough quarter behind them due to the success of Chicken Little and likely success of upcoming films The Lion, the Witch, and the Wardrobe based on the Narnia series and the sequel to Pirates of the Carribean which returns its entire cast. The original Pirates grossed over $300 million at the domestic box office and brought in another $260 million in the home video window. That makes up for a bunch of Brothers Grimm....

Another key to the quarter will be results at home video, which has slowed sharply and to which DIS has disproportionately high exposure at 18-20% of revenues. DIS also has done a lot of family-oriented direct-to-video releases, an area that has been noticeably weak of late. Also worth watching is results at the Touchstone TV studio. This has been a laggard area but is at the start of a series of likely syndication hits, starting small this quarter but growing over time as current hits Desperate Housewives, Lost, and Grey's Anatomy reach the 100 episode level. In the just concluded fiscal year, Touchstone operated near-breakeven, an improvement of $90 million year-over-year. Another swing of $100 million or more to the positive could occur over the next year or two.

Looking at the fourth quarter on a segment basis, the big gains are expected at the Broadcast and Cable Networks. Besides a turn in syndication, Broadcast will benefit from the ratings success at ABC. For the quarter, a shift from a loss of $75 million to a gain of $80 million is expected for all of Broadcast. Cable Networks are expected to grow around 25% as timing of revenue recognition at ESPN will be favorable this quarter reversing the 1H05 drag. Theme Parks estimates have recently come down a bit but the expectation is still for a double digit gain driven by margin expansion and an easy comparable to Florida's hurricane ravaged 2004.

I also hope the conference call provides some insights into the sale of the company's radio stations. The recently announced sale of Susquehanna's radio stations was completed at a good price that implies over $2 billion in value to DIS. DIS seems likely to dedicate any cash received on the transaction to further share repurchases, which I think will be well received by analysts.

The reason I see the quarterly as appositive catalyst is that it will shift investor focus to FY06 which should be another good year for DIS. Given all the negative sentiment toward growth at traditional media companies, I'll bet a lot of investors would be surprised to learn that 2006 will mark the fourth consecutive year of double digit operating growth at DIS. FY06 will be driven by the continuing turnaround at ABC and Touchstone and further expansion in theme park margins. ESPN should show double digit growth off rising affiliate fees and advertising revenue. Interestingly, and in my opinion, a source of upside for FY06, current analyst estimates do not look for a big rebound at the movie studio. This despite the strong lineup already mentioned, a good run for the Jodie Foster film Flightplan, and hopefully non-recurring $250-$300 million write-off.

Current consensus EPS estimates for DIS in FY06 ending September are $1.47. I think those estimates cold prove low (estimates range up to $1.59) but even at consensus, I do not find the P-E of 17 times to be unduly challenging given another year of double digit operating growth. I also think it is worth noting that DIS has minimal exposure to traditional media distribution assets with TV and radio stations contributing only 5% of revenue and no exposure to newspapers or cable plant. I think this benefit outweighs the added risk of the company's exposure to cyclical trends through its Theme Parks.

ABC Season Off To Good Start For Disney

Goldman Sachs had a note out on Monday indicating that the fall season at the Walt Disney (DIS) owned ABC Network is off to a good start. Ratings for key returning shows including Desperate Housewives, Lost, and Grey's Anatomy were all up over last year's season opening shows with Lost actually setting an all-time high rating....

...A turnaround at ABC is one of the key catalysts for DIS shares so this is good news. According to reports from the upfront last spring, ABC held back inventory in its returning hit shows so strong ratings should allow for premium pricing on this inventory relative to the subdued upfront pricing. However, one week certainly does not make a season and ABC can�t claim unqualified success unless some of the new shows grab decent ratings. On that front, Goldman noted that Invasion got off to a decent start. Political drama Commander in Chief debuted last night to good reviews including an excellent write-up in Tuesday's Chicago Tribune (I was watching Part II of the excellent Bob Dylan PBS documentary No Direction Home).

The turnaround at ABC has become more important to the DIS story given fears about discretionary consumer spending due to elevated energy prices, the big bath at the movie studio recently announced, and the collective yawn at the successful opening of Hong Kong Disneyland that was expected to be a positive catalyst. Last fall, when ABC first showed improved ratings, DIS shares rallied from about $23 to $28 by year end, so a precedent for ABC driving the shares might exist.

Other possible catalysts before year end include box office success for the Chronicles of Narnia film, a new deal with Pixar where recent rumors indicate something might be in the works, resolution of the sale of company's radio stations, and decent 2006 guidance when the company reports fourth quarter 2005 earnings in late October. Next summer's Pirates of the Caribbean sequel is sure to be a hit but I can�t wait that long for good news.

DIS has been a disappointing stock since I went long at $26 earlier this year. Hopefully, the next few news items will be positive setting the stage for better performance for the shares as expectations have been reduced and the bar lowered.

Disney Earnings Fail To Provide Desired Catalyst For Shares

Disney (DIS) shares fell 3% on Wednesday in reaction to the company's 3Q05 earnings report. The quarter was decent but I found the 3Q results disappointing as I was expecting an unequivocally strong report to act as a catalyst for the shares. However, I did not find the results to a major miss and was a bit surprised with the harsh reaction by the market. Coming off the quarter, I am holding all client positions and still think the shares belong in the low $30s. However, comps toughen in the second half of calendar 2006, so the window is narrowing a bit for that objective to be achieved. My key takeaway from the quarter is that things better liven up in the next two quarters or owning the shares will have been a waste of time....

....Rather than recap the quarterly financial figures, I thought I'd just add a few impressions from the report and the analyst commentary that followed:

� The Street was surprised by weakness in the Studio which was mostly attributed to the lackluster DVD sales. However, DIS DVD results were worse than the other studios this quarter which indicates that for now at least the problem is lack of hit movies as much as the slowing DVD market. This has been on ongoing at DIS as outside of Pixar films the company has had few hits the last several years. The FY06 film slate looks promising with a Pirates of the Caribbean sequel and new films off established properties such as Chicken Little and the Chronicles of Narnia. As of now, the street expects a 10% growth in the Studio operating income in FY06 against a 20% decline in FY05. This is likely the biggest risk to current estimates although DIS will be playing catch up in the relatively hot TV DVD market this fall when Desperate Housewives and Lost hit stores.

� The company is committed to expanding its presence in mobile content and admitted that there could be material start-up losses. This represents another risk to future estimates.

� The turnaround at ABC is starting to have a financial impact and I think estimates in FY06 could be low in the Broadcast division. One analyst noted that ABC held back inventory from its hit shows in the upfront which means that if pricing and ratings hold, a good amount of premium priced inventory will be available for the new TV season.

� Share buybacks accelerated and were ahead of analyst estimates. DIS has a very good balance sheet and will be underleveraged by my taste in the next few years. If Radio is divested for cash this will lead to further deleveraging. A key question for the future is what the company does with its financial strength. Given the split at Viacom and the big buyback at Time Warner, this is one of the only area where DIS currently falls short of its peers.

Finally, Ray Katz at Bear Stearns noted in his quarterly summary that he though there were already subtle changes at DIS as leadership transitions from Eisner to Iger. He noted a willingness to consider wide ranging alternatives for the structure of a radio divestiture, a possible softer negotiating position with Pixar, and a willingness to challenge traditional business methods such as theatrical windows. I think Ray be on to something although the immediate financial impact may be negative. However, in a changing and challenging environment for traditional media a more flexible DIS would be a good thing.

Will Slowing Growth in DVD Sales Hurt Disney and Lions Gate?

Below expectation sales of DVDs of The Incredibles coming on the heels of a much larger shortfall for Shrek 2 have accelerated already brewing concerns about DVDs as a growth engine for movie studios. This has ramifications for Disney (DIS) and Lions Gate Entertainment, (LGF). Disney (DIS) has benefited greatly from sales of DVDs from its library of animated hits and my investment thesis on LGF rests largely on margin expansion related to DVD sales from the string of recent box office success the company has enjoyed....

Prior to the shortfalls for The Incredibles and Shrek 2, Wall Street was already been worried about the sustainability of DVD growth due to peaking penetration of DVD players in households in the U.S. and abroad. There is also evidence that after several years of growth the ratio of DVD titles per DVD player has begun to plateau. Another factor that could be having an impact of DVD sales is an accelerated sales cycle. Much like theatrical box office, it appears that DVD sales have a shortening life span, possibly less than a month for most titles that were recently in domestic box office release. On the flip side, reading too much into shortfalls for titles with expected sales of 40 million or more units might not be applicable to companies that are not reliant on just one or two titles per year.

Given theses issues, my long positions in DIS and LGF should be questioned. Both stocks were under pressure last week, at least partially related to fears about DVD sales.

For DIS, DVD sales are not a catalyst to my bull thesis. Rather growth will be driven by the turnaround at ABC, improved theme park attendance and margins, a strong FY06 film slate, possible sale of radio, opening of Hong Kong Disneyland, the Disneyland 50th Anniversary celebration, and continued growth in cable networks. I think these catalysts will overcome any shortfall in sales of DVDs.

For LGF, I think the company has had enough recent box office success to offset any reduction in DVD unit sales. On its conference call last week, management noted that initial sales of Diary of a Mad Black Woman were extremely strong and I am willing to bet that sales of Crash to be released in September won�t disappoint. Each film should sell 3 to 5 million DVD units. Together I think these two titles can drive financial results comfortably above the conservative guidance for FY06 provided by management.

So I am staying long DIS and LGF even as I respect that the DVD market may be maturing.

Disney Selling Radio?

Following comments on the last quarterly conference from Bob Iger, speculation has increased that Disney (DIS) may be looking to sell its radio stations and the ABC Radio Network. Recent articles in trade magazines and The Wall Street Journal leave the impression that the division is being shopped, or at least it is being made known that bids would be considered. My original thesis for buying DIS shares noted many catalysts but the sale of company's Radio division was not inlcuded. If a sale were to occur, I think Wall Street would approve and bull case for DIS over the next twelve months would have another pillar of support....

....According to a new research report by CSFB analyst Bill Drewery, the DIS radio properties should generate about $215 million in EBITDA (operating cash flow) in 2005. Trailing four-quarter EBITA for all of DIS is almost $4.7 billion, so while a sizable business, radio is not a core business.

Sale Price Would Be Favorable

DIS owns 25 major market radio stations, many of which are highly rated. Given the scarcity of major market stations for sale, I think the sale of the station group would take place at a solid multiple despite all the pessimism and recent slow growth for radio. With many publicly traded radio companies fetching 11 to 12 times EBITDA, I think the DIS radio operations could go for near 15 times EBITDA, or $3 billion.

According to research and articles I've read, DIS has owned these assets for many decades and the cost basis is close to zero. Therefore, taxes will take a big bite out of the proceeds, possibly leaving DIS with only around $2 billion in after-tax proceeds.

Major Acquisition Seems Unlikely

DIS seems unlikely to undertake a major acquisition unless cable networks are for sale. Cablevision's (CMCSA, CMCSK) AMC, IFC, and Women's Entertainment come to mind. I've always thought that a DIS acquisition of E.W. Scripps (SSP) was very logical given the overlap in Scripps ABC TV stations and the nice fit for Scripps cable networks with the DIS image (Food Network, HGTV). However, SSP would cost north of $10 billion.

Any swap of radio for cable networks would be slightly dilutive due to the higher valuation placed on cable networks but would be accretive to the corporate growth rate. One or more major market television stations offer DIS more synergy than radio but swaps one slow-growth asset for another. I suppose an Internet acquisition could make strategic sense, and there have been lots of mid-size Internet deals of late but I can't think of anything logical for DIS to acquire in the Internet industry.

Proceeds Could Go to a Share Buyback

I think the most likely use of proceeds if radio is sold would be for share repurchase. At the end of the last quarter, DIS had net debt to EBITDA of just two times, so adding a little leverage by swapping radio for the repurchase of 65 million to 70 million shares seems like a plausible scenario. This scenario would be dilutive to EPS by about three cents against trailing 12-month earnings of $1.21. However, dropping the slow-growth radio business would probably be viewed favorably by Wall Street despite the slight dilution.

The bottom line is that sale of radio by DIS would reinforce the bullish setup for DIS shares given great operating momentum and identifiable catalysts like the ABC turnaround, expanding theme park margins, and the opening of Hong Kong Disneyland in September. As an owner of DIS shares, I am not clamoring for the sale of radio but I'll have no complaints if the rumors become reality. DIS has upside to the low to mid-$30s and remains the best big-cap media stock to own.

ABC Concludes Successful Upfront: Positive for Disney

The annual upfront television advertising market moved close to conclusion last week for the broadcast television networks. ABC, CBS, and FOX all announced their sales. Only NBC, which is in the weakest position due to a 15% decline in ratings last TV season, has yet to wrap up its sales. The upfront market is when the networks sell commitments for the upcoming fall season. Commitments passed the fourth fiscal quarter can be cancelled subject to certain limitations so the upfront is not a firm indicator of the future advertising. However, it does give a sense of the ad market and can be important to individual networks and their parent companies.

I have written bullishly on Disney (DIS) and among the key catalysts was the likelihood that ABC would experience a strong upfront market for its ABC network. The results for ABC announced last week did not disappoint....

....ABC sold $2.1 billion of advertising, up 30% against a year ago, and much higher than expectations of a 20% increase. Upfront sales equal the cost per thousand viewers (CPM) times the guaranteed ratings times the percentage of inventory sold. ABC sold about 80% of its advertising at CPMs up 4%-6%. In the 2004 upfront, ABC sold a similar amount advertising. Therefore, with CPMs up 4%-6%, the math concludes that the ratings guarantee is up 22%. This seems unusually high but remember that ABC ratings were up 16% in the just-concluded season, so ABC is really providing a guarantee that ratings will rise another 6% in the upcoming season. Given the company's ratings momentum, the success of mid-season replacement Grey's Anatomy, and the new fall schedule, analysts and industry observers seem quite comfortable with the ABC ratings guarantee.

For ABC and DIS, these upfront results are good news. According to management, ABC will operate slightly above breakeven in the fiscal year ending this September. Assuming upfront sales hold and the remaining 20% of advertising can be sold at least in line with upfront levels, ABC should see a several hundred million dollar increase in operating profits in the fiscal year ending September 2006. DIS will also benefit from increased ABC ratings thanks to a spillover effect on its owned and operated TV stations.

Additional catalysts for DIS shares include improved theme park visits driven by the 50th anniversary celebration at Disneyland and trips booked by foreigners prior to the recent strength in the dollar. DIS will also benefit from a strong movie lineup in FY06, rising theme park margins, and what looks to be a highly successful launch of Hong Kong Disneyland in September. Northlake remains long DIS and believes it stands out clearly among large-cap media stocks.

Disney Story Intact Following Strong Quarterly Earnings

Disney (DIS) reported strong quarterly earnings earlier this month and the follow-up conference call confirmed operating trends remain excellent across the entire company. The shares sold off a bit when the earnings were reported but have since rallied to their highest level since late April as analysts had favorable commentary and raised earnings estimates for 2005 and 2006. Fundamentals are very strong at DIS and if the company just hits its numbers over the next few quarters, the stock has upside into the low $30s.....

During the company's conference call, DIS provided no detailed guidance made many individual references to current quarter trends and all were very positive. Here are some examples:

These tidbits suggested that management was at least confirming third-quarter EPS estimates of 38 cents, up 22% vs. a year ago and giving the go ahead to analysts to slightly raise their estimates.

The call began with broad overviews provided by both Michael Eisner and Bob Iger. Eisner emphasized the company's global opportunities and noted that the company has recently completed a major investment phase and is now reaping the rewards. He mentioned big expansions at the themes parks, newly launched cable networks, new programming at cable and broadcast networks, and the development of the live stage business. This struck me as a good way to spin the DIS story: The company responded to problems and made good decisions and is now gaining operating leverage as revenues rise against waning investment spending.

Iger's comments closely paralleled Eisner's but he spoke more about how technology offered Disney opportunities in wireless and broadband Internet. He also stressed India as the next frontier now that China has been seeded for the opening of Hong Kong Disneyland.

There really were very few issues that came up on the call. Management refused to comment specifically on DVD sales of The Incredibles but said that trends are fine. Free cash flow was way down vs. a year ago but the company had a good explanation for higher-than-expected receivables and lower-than-expected payables related to timing factors involved with Incredibles. However, management admitted that free cash would be down slightly against very high levels a year ago. Share buybacks will continue but could be lowered if an acquisition opportunity arose. There was no commitment to sell Radio but I thought the commentary implied a good price could see it sold. There were no comments on a new Pixar deal. If Pixar goes elsewhere, it will be a near-term negative for the shares.

In summary, DIS has a strong fundamental outlook that should extend through the current fiscal year ending in September and continue through 2006. Growth rates will moderate some as fundamentals move from turnaround to sustained growth. I don't think a moderation in the growth rate will prevent the shares from moving higher. DIS trades at a premium to its big-cap entertainment conglomerate peers. The premium is deserved and won't get in the way of upside for the shares as long as operating trends remain firm.

Improved Ratings At ABC Help Disney's TV Stations

Last week, I initiated a position in Walt Disney (DIS) based on the company's strong operating momentum and identifiable catalysts. Among the several catalysts I mentioned was the upfront market, the launch of Hong Kong Disneyland in the fall, 3Q EPS to be reported on May 11 (better than expected with rising guidance and estimates to follow?), better results at the Florida theme park due to foreign travel and a weak dollar, and margin expansion at the theme parks. One thing I failed to mention was the potential benefit ABC's owned-and-operated TV stations would get from the improved ratings at the ABC Network in primetime....

Disney owns ten television stations that broadcast the ABC network including stations in the largest markets of New York, Los Angeles, Chicago, Philadelphia, San Franscisco, and Houston. These stations produce operating cash flow of about $275 million annually. Cash flow should gain a direct benefit from better ABC network ratings because local ad inventory sold in primetime will be at higher prices and because better lead-ins to local newscasts could cause those ratings and ad rates to rise. Since ABC stations generally have highly rated newscasts in the major markets, Disney should be able to monetize any ratings boost fairly easily.

Given estimates for slightly over $6 billion in operating cash flow in the fiscal year ending in September 2005, a marginal benefit at the TV station level can't move the needle much. However, the investment thesis at Disney is that virtually all of its businesses have operating momentum at the same time. Broad based strength can produce positive surprises -- a few million here, a few million there, and suddenly you've got an extra penny in EPS, better guidance and rising estimates. Disney is one of the few places in large-cap media where the possibility of this scenario exists.

Upfront Ad Market A Potential Catalyst for Disney

One of the reasons I like Disney (DIS) is that it has strong fundamental operating momentum with identifiable catalysts. One catalyst is the upfront network television advertising market that gets underway this month. The upfront market occurs each spring when the broadcast and cable television networks sell options on much of the advertising time for the next fall's new television season. The turnaround of ABC should finally have a tangible economic impact as ABC will be able to sell a larger percentage of its inventory at higher prices than it has in many years. This should lead to a multi-hundred-million dollar shift in profitability at ABC, which is meaningful against a $6 billion-plus operating cash flow estimate for 2005....

Understanding Broadcast Network Ad Trends

An interesting dynamic has played out over the last decade as, despite steadily deteriorating ratings, the networks have been able to consistently raise the pricing of television advertising spots. The reason for this was on display last Thursday night. President Bush's news conference occurred at the start of primetime on the most watched night in television when advertising is priced at its dearest. CBS, which is normally the least watched network when it comes to news (excluding 60 Minutes), easily won the ratings race for the Bush news conference with 11.8 million viewers compared to 6.9 million for NBC and 5.8 million for ABC. Fox News Channel led the cable outfits with 2.7 million viewers followed by CNN with 896,000 and MSNBC with 569,000.

Broadcast Networks Still Draw Largest Audiences

A couple of things are worth noting in these figures. First, the broadcast networks are still the only place where really large audiences exist. Second, CBS won the hour because the press conference took place when the smash hit Survivor is usually on. Third, no one really watches cable news most nights. Fourth, the decline at CNN has been astounding and complete.

The first two points explain why the broadcast networks have been able to continually raise prices despite steady and significant ratings erosion. Advertisers need to reach mass audiences to launch new products and build brands. They still really only have one choice that is easy and efficient: broadcast television. Hit shows can pull down 15 to 25 million viewers (people watched the press conference on CBS because they had tuned into CBS for Survivor). Even poorly rated network shows draw millions of viewers. Add these large audiences to the superior advertising imagery available via television and the broadcast networks still are the place to be for advertisers. Thus, pricing remains firm and the broadcast network business remains viable even as ratings decline.

Upfront Market Could Be Hurt By Tivo Type Products

Ratings erosion and time shifting and ad-skipping products like Tivo are gradually taking their toll. In fact, this year some observers believe the upfront market will finally stumble against these larger trends. As the upfront unfolds, analysts expect an overall increase of 2%-4%. ABC, owned by DIS, should have the strongest upfront with rising pricing and more inventory sold. CBS should also perform solidly due to its ratings strength across most nights of the week. FOX will likely be mixed as its ratings success is narrowly focused on a few shows, while NBC will suffer greatly vs. prior years as its ratings have dropped sharply (down over 10% vs. a year ago). Wall Street seems prepared for these outcomes, so the key thing to monitor will be how the upfront develops against these benchmarks. For DIS, all that should be needed is confirmation of the strong upfront.

Disney: New Buy

Disney Investment Thesis: Strong fundamentals with identifiable catalysts make DIS the choice among big-cap entertainment stocks despite its premium valuation compared to its peers.

I've been very close to taking a long position in Disney (DIS) over the past couple of months. My working thesis has been that fundamental momentum is the strongest at DIS among the major entertainment companies justifying the slight valuation premium on 2005 operating cash flow. Furthermore, operating momentum is strong enough that consensus estimates could prove low....

....Finally, DIS has identifiable catalysts including the opening of the Hong Kong Disney park (under budget), a pickup in international travel in Orlando due to the weak dollar, and the start of the upfront market for broadcast TV in May where ABC will get their first significant identifiable benefits from its renewed ratings strength. Though still a long shot, a new deal with Pixar (PIXR) would be greeted well on the Street.

DIS trades at slightly less than 10 times 2005 operating cash flow, about a 10% premium to Time Warner (TWX) and Viacom (VIA). However, if fundamentals hold, DIS should have faster growth in 2006 which means the premium narrows. If operating momentum remains intact and DIS meets Wall Street estimates, the shares could trade into the low $30s. The bottom line is that DIS is the cleanest story in big cap media with the best fundamentals and clearly-defined catalysts. Sometimes you get what you pay for.