Walt Disney Co quarterly report, Q2 FY2019

Business context and reporting period

The Walt Disney Company’s unaudited Form 10-Q covers the quarter and six months ended March 30, 2019, compared with the periods ended March 31, 2018. Disney completed its acquisition of Twenty-First Century Fox (21CF) on March 20, 2019; 21CF and Hulu results are included only from that date. Fiscal 2019 reporting also reflects revised segment definitions and adoption of new revenue-recognition guidance, so some comparisons are not on identical accounting or business bases.

Financial performance and position

Unless noted, amounts are in U.S. dollars; financial statement amounts are in millions.

• Earnings quality: Reported results include a $4.917 billion non-cash gain from remeasuring Disney’s existing Hulu stake when it obtained control. The gain contributed $2.46 to quarterly diluted EPS and $2.50 to six-month diluted EPS after the filing’s stated tax and noncontrolling-interest effects. Quarterly results also include $662 million of restructuring and impairment charges and a $353 million impairment of the Vice investment.
• Segment trends: Quarterly Parks, Experiences and Products operating income rose 15% to $1.506 billion; Media Networks fell 3% to $2.185 billion; Studio Entertainment fell 39% to $534 million; and Direct-to-Consumer & International (DTCI) losses widened to $393 million from $188 million. For six months, Parks operating income rose 12%, while Studio fell 50% and DTCI losses widened to $529 million from $230 million. 21CF reported $25 million of segment operating income for the post-acquisition period.
• Cash flow and liquidity: Six-month operating cash flow declined 11%. Continuing-operations investing used $12.683 billion, including $9.901 billion net cash used for acquisitions and $2.390 billion of capital expenditures. Cash and cash equivalents were $10.108 billion at March 30, 2019, versus $4.150 billion at September 29, 2018. Current assets were $34.277 billion against current liabilities of $44.376 billion.
• Debt: Reported borrowings totaled $56.961 billion at March 30, 2019, versus $20.874 billion at September 29, 2018, reflecting the acquisition and related financing. The balance included $15 billion outstanding under a 364-day bridge facility, which management expected to pay down using after-tax RSN divestiture proceeds. Disney reported $12.250 billion of unused committed bank capacity and said it met its interest-coverage covenant by a significant margin.

Material changes versus the prior comparable period

• Revenue rose modestly, but segment operating income declined as Studio results weakened, DTCI investment and losses increased, and integration costs accumulated. Parks was the main source of operating-income growth.
• Reported profit growth substantially reflects the one-time Hulu remeasurement gain; it should not be read as equivalent growth in recurring operating performance. The prior-year six-month comparison also included a $1.691 billion net Tax Act benefit, versus a $34 million benefit in the current period.
• Disney acquired 21CF for approximately $69.5 billion: $35.7 billion in cash and $33.8 billion in Disney shares. The acquisition materially increased assets, goodwill, debt and noncontrolling interests. Disney’s ownership of Hulu rose to 60%, and Hulu was consolidated.
• Disney adopted ASC 606 using the modified retrospective method. The filing reports a $116 million reduction to opening retained earnings; adoption’s impact on segment operating income was a $27 million reduction for the quarter and an $88 million benefit for the six months. Prior-year figures were not restated.

Outlook, management commentary, risks and contingencies

• Management expected fiscal 2019 capital expenditures to be approximately $1 billion above fiscal 2018’s $4.5 billion, mainly due to park and resort investment. Management did not expect ASC 606 adoption to materially affect full-year fiscal 2019 results.
• Disney planned to launch Disney+ in late 2019. Management described ongoing investment in ESPN+, Disney+ preparation, streaming technology and Hulu as drivers of DTCI losses; execution, consumer demand, content costs, competition, regulation and broadband access are identified risks.
• The 21CF restructuring plan was expected to incur severance and related costs of about $1.5 billion. Disney had recorded $403 million of severance-related costs and $259 million of acquisition-related equity compensation charges; additional costs, including possible lease termination costs, were not yet estimable. The plan was expected to be completed by the end of fiscal 2021.
• Regulatory approvals required divestitures of 21CF sports assets. On May 3, 2019, after quarter-end, Disney agreed to sell 21 of the 22 RSNs for approximately $10 billion, subject to customary conditions including DOJ approval. Brazil and Mexico sports operations also remained to be divested. The filing states that Hulu redeemed WarnerMedia’s approximate 10% interest on April 15, 2019; NBCU’s participation could affect Disney’s resulting Hulu ownership.
• Disney cited higher indebtedness and reduced financial flexibility as risks. Standard & Poor’s lowered its ratings on March 12, 2019 to A/A-1 from A+/A-1+. Management said operating cash flow and access to capital markets could be affected by macroeconomic conditions. The company also cited seasonality, changing consumer preferences, theatrical performance, advertising conditions, foreign exchange exposure and tax uncertainties. Management did not believe the disclosed legal actions had resulted in a probable material loss.
• Six-month results are not necessarily indicative of full-year performance, and Disney’s businesses are seasonal. The filing also noted that the 2019 internal-control assessment would exclude 21CF, consistent with SEC guidance for recently acquired businesses.

Most important facts for investors to verify

• How much of reported earnings and EPS growth is attributable to the non-cash Hulu gain and other comparability items, versus recurring operating performance.
• Progress on integrating 21CF, realizing cost synergies, finalizing purchase accounting and completing required divestitures; verify the net proceeds and debt repayment from RSN sales.
• Debt reduction, refinancing of the $15 billion bridge facility, interest costs, credit ratings and liquidity after acquisition-related commitments.
• Whether DTCI revenue growth and subscriber economics improve enough to offset programming, technology and launch costs, including those associated with Disney+ and ESPN+.
• Studio performance and film-cost assumptions, Parks attendance and guest spending, and the effects of seasonality, competition and foreign exchange.
• Final restructuring costs, tax exposures and the effect of accounting changes on period-to-period comparisons.